Aggregate Demand, Aggregate Supply, Consumption & Saving – Comprehensive Notes

Concept of Aggregate Demand (AD)

Definition
Aggregate Demand is the sum-total amount of expenditure that economic agents plan to incur on domestically produced goods and services over an accounting year at various income levels.

Essential Points

1. Economy-wide, not product-specific – AD is for all goods/services, not any single market.
2. Flow variable – Always measured per period (normally one fiscal year).
3. Two alternative reference frames
   • With respect to the general price level, AD is inversely related to price ⇒ downward-sloping AD–price curve.
   • With respect to income (Y), AD is positively related ⇒ upward-sloping AD–income curve.
   (At school/+2 level we use the latter.)
4. Minimum (“autonomous”) demand – Even when $Y=0$, planned expenditure is positive because households must survive (financed by past saving or borrowing).
5. Monetary, not physical measure – AD is recorded in monetary units of planned spending, not in physical units.
6. Desired/Planned, not actual – Always interpret AD as intentions of spending.

Formal statement
“AD equals the total planned expenditure on domestic output during an accounting year, corresponding to various possible income levels.”

AD Schedule (Income Reference)

Example data (Table-1):

Observations
• Autonomous AD: $AD=30$ when $Y=0$.
• Positive relation: AD rises as Y rises.
• Diminishing rise: After a threshold, AD lags behind Y because part of income is saved (e.g., at $Y=60$, $AD=45$).

AD Curve (Income Reference)

Conceptually derived by plotting the schedule against a 45° income line.
• Starts at $AD=30$ on vertical axis.
• Intersects 45° line at point $E$ where $AD=Y=40$ (break-even for expenditure).
• Region left of $E$: AD>Y due to autonomous demand.
• Region right of $E$: AD<Y because saving emerges.

Components of Aggregate Demand

1. Closed Economy

(a) Two-Sector (Households + Firms)

$AD = C + I$
C = household consumption expenditure.
I = private investment expenditure.

(b) Three-Sector (Households + Firms + Government)

$AD = C + I + G$
G = government expenditure (both consumption and investment undertaken on society’s behalf).

2. Open Economy (Four-Sector)

Includes the rest-of-the-world sector.
Exports add, imports subtract ⇒ net exports $(X-M)$.
$AD = C + I + G + (X - M)$

Concept of Aggregate Supply (AS)

Definition
Aggregate Supply is the total planned output (value added) of producers during an accounting year. Because value added generates income, $AS \equiv Y$ in Keynesian short-run analysis.

Key Keynesian Assumption
• Plenty of excess capacity ⇒ Firms meet any extra demand by expanding output at constant price. Hence price does not determine AS in the short run.

AS Schedule

(Table-2 example)

Perfect identity: $AS=Y$ at every point.

AS Curve

45° line from the origin – every point indicates $AS=Y$.
Validity restricted to situations with unused resources; if capacity is fully employed the curve would steepen.

Consumption Function

Definition
Functional (algebraic) relation showing how household consumption expenditure (C) varies with income (Y).

Empirical Regularities

1. Autonomous consumption – Minimum \bar{C} > 0 even when $Y=0$ ⇒ negative saving.
2. Positive relation – Higher Y ⇒ higher C.
3. Less-than-proportionate rise – Increment in C < increment in Y because part of extra income is saved.

Tabular Example (Table-3)

Graphical Features

• C-line starts at $20$ on vertical axis (autonomous consumption).
• Initially above 45° line but falls below it at higher Y ⇒ break-even point B where $C=Y=100$.

Slope = Marginal Propensity to Consume (MPC)

$MPC = \frac{\Delta C}{\Delta Y}$ measures the proportion of a rupee of additional income that is consumed.

Example from Table-3 / Fig-4:
$\Delta C = 40,\; \Delta Y = 50\; \Rightarrow \;MPC = \frac{40}{50}=0.8$.

Average Propensity to Consume (APC)
$APC = \frac{C}{Y}$. At $Y=150,\;C=140\Rightarrow APC=0.933$.

Linear Consumption Function (Algebra)

General form: $C = \bar{C} + bY$
where $b\;(=MPC)$ is the slope and $\bar{C}$ is autonomous consumption.
For the data: $C = 20 + 0.8Y$.

Illustration

• At $Y=0$ → $C=20$.
• At $Y=100$ → $C=20+0.8(100)=100$ (matches table).

Classroom Numericals

1. Given $\bar{C}=200$, $MPC=0.5$, $Y=1000$ → $C = 200 + 0.5(1000)=700$.
2. Constant MPC → Consumption function must be linear because slope is constant.

Saving Function

Identity
Income is either consumed or saved: $Y = C + S \;\Rightarrow\; S = Y - C$.

Derivation from C-function (using Table-3)

Observations
• $S=-20$ at $Y=0$ (negative saving financed by dissaving/borrowing).
• Positive slope: saving rises with income.
• Break-even at $Y=100$ where $S=0$.

Slope = Marginal Propensity to Save (MPS)

$MPS = \frac{\Delta S}{\Delta Y}$. Using $\Delta S=10, \Delta Y=50$ ⇒ $MPS = 0.2$.

Average Propensity to Save (APS)
$APS = \frac{S}{Y}$. At $Y=150, S=10 \Rightarrow APS = 0.067$.

Linear Saving Function (Algebra)

Starting from $C = \bar{C} + bY$, convert via $S = Y - C$:
$S = -\bar{C} + (1-b)Y$.
With $\bar{C}=20, b=0.8$ ⇒
$S = -20 + 0.2Y$ (matches table derived values).

Relationship of Slopes

Because $MPC + MPS = 1$, the slope of S-function is $1 - b$ where $b$ is MPC.

Sample Problems

1. If $MPC=0.6$ ⇨ slope of S-function $= 1-0.6 = 0.4$.
2. Given $\bar{C}=200$, $MPS=0.4$, $Y=1000$:
   $S = -200 + 0.4(1000) = 200$.

Relationship Between Propensity to Consume & Propensity to Save

Average Propensities

$APC = \frac{C}{Y},\; APS = \frac{S}{Y}$ ⇒ $APC + APS = 1$ – because total income must equal the sum of its two uses.

Marginal Propensities

$MPC = \frac{\Delta C}{\Delta Y},\; MPS = \frac{\Delta S}{\Delta Y}$ ⇒ $MPC + MPS = 1$ – because an extra rupee of income is either spent or saved.

Proof (Marginal):

$\Delta Y = \Delta C + \Delta S \;\Rightarrow\; \frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y} = 1$.

Practical/Conceptual Notes

• APS can be negative at very low incomes when C>Y (e.g., $Y=50,C=60 \Rightarrow APS=-0.2$).
• APC can exceed 1 under the same circumstance; MPC cannot exceed 1 because ∆C ≤ ∆Y.
• Neither MPC nor MPS can be negative since C and S each rise with Y.

Integrative Perspective & Keynesian Context

• Keynes assumed heavy unemployment and idle capacity (Great Depression backdrop). That is why price level is fixed and AS responds one-for-one to AD.
• Autonomous (minimum) consumption and autonomous AD guarantee the economy always exhibits some expenditure even at zero income – important for explaining initial injections in multiplier analysis.
• The linear forms – $C=\bar{C}+bY$ and $S=-\bar{C}+(1-b)Y$ – underpin multiplier, equilibrium income (where $AD=AS$) and fiscal policy analysis studied in subsequent chapters.