Chapter 7: Aggregate Demand & Supply

Aggregate Demand (AD)

Aggregate Demand is the total planned expenditure (demand for goods and services) in an economy at a given price level and in a given time period.

AD = C + I + G + (X – M)

• C (Consumption): Household expenditure on goods and services. The largest component of AD. Depends on income (consumption function: C = a + bY).
• I (Investment): Planned expenditure by firms on capital goods (machinery, buildings). Assumed autonomous (fixed) in the simple Keynesian model.
• G (Government Expenditure): Government spending on goods, services, and public works. Also assumed autonomous.
• NX or (X – M) (Net Exports): Exports minus Imports. In a two-sector (closed) economy, NX = 0, so AD = C + I. In a three-sector economy, AD = C + I + G.

AD is a flow concept — measured over a period of time. It slopes upward with income in the Keynesian diagram (since consumption rises with income).

Aggregate Supply (AS)

Aggregate Supply is the total value of goods and services that all producers in an economy are willing to produce and sell at a given price level in a given period.

In the Keynesian model, AS equals the total income generated in production. Since income = wages + rent + interest + profit:

AS = National Income (Y)

In a Keynesian income-expenditure diagram, AS is represented by a 45° line from the origin. Every point on the 45° line shows where output (AS) exactly equals income — i.e., all income is either consumed or saved (Y = C + S). The 45° line is not a supply curve in the traditional sense; it simply maps all points where planned expenditure equals output.

The Keynesian assumption is that the economy can be at underemployment equilibrium — the AS line is not vertical at full employment. Prices are sticky, and the economy can produce at any level up to full employment.

Effective Demand

Effective Demand is the level of aggregate demand (planned expenditure) that actually gets realised — it is the point where AD equals AS. This determines the equilibrium level of output and employment in the economy.

• If AD > AS: Inventories fall, producers increase output → income rises towards equilibrium.
• If AD < AS: Inventories pile up, producers cut output → income falls towards equilibrium.
• If AD = AS: Equilibrium — no tendency to change. This is the point of effective demand.

Keynes argued that effective demand (not supply) determines income and employment. An economy could be stuck at a low effective demand equilibrium with unemployment — hence the need for government intervention.

Propensity to Consume — APC and MPC

The consumption function C = a + bY shows the relationship between consumption (C) and income (Y), where 'a' is autonomous consumption and 'b' is MPC.

• Average Propensity to Consume (APC): APC = C ÷ Y. Fraction of total income spent on consumption. APC can be greater than 1 when consumption exceeds income (dissaving at low income levels).
• Marginal Propensity to Consume (MPC): MPC = ΔC ÷ ΔY. Fraction of additional income spent on consumption. MPC is always between 0 and 1 in Keynesian theory (0 < MPC < 1).

As income rises, APC falls (a smaller proportion of total income is consumed) while MPC remains relatively stable.

Propensity to Save — APS and MPS

Since income is either consumed or saved (Y = C + S), the saving propensities are the mirror image of consumption propensities.

• Average Propensity to Save (APS): APS = S ÷ Y. Fraction of total income saved. APS can be negative at low income levels (dissaving). APC + APS = 1.
• Marginal Propensity to Save (MPS): MPS = ΔS ÷ ΔY. Fraction of additional income saved. MPC + MPS = 1, so MPS = 1 – MPC.

Key relationships to remember:

• MPC + MPS = 1 (since ΔY = ΔC + ΔS)
• APC + APS = 1 (since Y = C + S)
• APC can be > 1; MPC is always between 0 and 1
• APS can be negative; MPS is always between 0 and 1

Key Concepts at a Glance

Sample MCQs — Chapter 7: Aggregate Demand & Supply