Aggregate demand is the total demand made by all members of the society for all goods and services. In macroeconomic analysis such aggregate demand is a function of the general level of prices. Here, the price of any individual good or the demand for it from an individual member is not under consideration. It is the demand for all goods and its dependence on the level of all prices that is being analyzed.
Aggregate Demand and Aggregate Supply - Presentation Transcript
1. Aggregate Demand and Aggregate supply by eNotesMBA The Best References for MBA
2. Aggregate Demand
Aggregate demand is the total demand made by all members of the society for all goods and services. In macroeconomic analysis such aggregate demand is a function of the general level of prices. Here, the price of any individual good or the demand for it from an individual member is not under consideration.
It is the demand for all goods and its dependence on the level of all prices that is being analyzed.
3. Such a general level of prices is in the form of a price index which is usually Consumer’s Price Index (CPI)/ Wholesale Price Index (WPI)
This demand on the other hand represents demand for real national income which can be denoted as Yr.
Aggregate Demand (AD) is then a function of the price level (P) and the relation between the two can be expressed in the form of a schedule
4. By scheduled pairs of prices and AD quantities we mean that at arbitrarily given prices, expected quantities demanded are related. On the basis of a demand schedule we can also represent it graphically.
5. In the AD Schedule we notice an inverse relationship between level of prices and the quantities or real income. As the price level falls (through 6 to 1) Aggregate Demand goes on increasing (from 10 through 60). In the figure, the same information has been presented graphically (in the form of the AD curve). In the figure price has been measured along the vertical and AD quantity along the horizontal axis. The inverse relation between the two is apparent since the AD curve slopes downwards.
6. Aggregate Demand Curve
7. Inverse Relationship
In case of the individual demand curve the price - quantity relation is inverse and hence the demand curve slopes downwards.
This is because of both substitution effect which is negative and income effect which is positive. In such cases we concentrate only on the changes in the price of a single commodity, assuming prices of all the substitute goods to be constant.
Therefore the good (say X) for which price rises, becomes relatively dearer, and part of its demand is shifted to other substitutes which are relatively cheaper.
Therefore the demand for good X falls. On the other hand, with rise in the price, the consumer’s real income falls since the purchasing power of his money income decreases (he will have to shell out more money to buy the same amount of good X at its higher price).
Hence his demand for good X decreases. Therefore both price and income effects cause demand to fall with a rise in the price of a good.
8. In case of changes in aggregate demand and general price level such a simple relation does not hold good.
In this case since prices of all the goods are rising simultaneously there cannot be any substitution effect.
Moreover, with rising price level money income of labor and other factor owners who provide their services is likely to go up. Therefore, their capacity to spend is likely to increase and demand for goods may actually rise, instead of falling, or may at least remain constant even with a rise in price level.
9. For this reason, the inverse relationship (downward sloping curve) of the aggregate demand curve cannot be explained with the same reasoning as that of the individual demand curve.
Yet the price level and aggregate demand continue to hold a negative or inverse relation because of the presence of the three distinct effects.
10. Three Effects
There are three different effects operating on the aggregate demand as a result of rising price level, or under inflationary conditions.
- Wealth Effect,
- Rate of interest Effect and
- Trade Effect.
11. Wealth Effect
Professor A.C. Pigou had first stated and analyzed wealth effect under inflationary conditions of the price level changes. With a rise in the price level, value of the given money income of consumers (assuming supply of money to be constant) decreases.
12. With a fall in the purchasing power of their income consumers become poorer and have to reduce their consumption.
By way of an example a person with fixed money income of Rs. 100 can purchase 25 units of a commodity, price of the commodity being Rs. 4. But s/he can purchase only 20 units of the commodity when price rises to Rs. 5.
Thus the real income or wealth of a consumer diminishes from 25 to 20 even when his money income is constant.
13. Such a wealth effect results in the consumer reducing his demand with a rising price level. Contrary would be the case under the conditions of deflation and falling prices.
In that case his wealth effect will be positive and enable him to purchase larger quantities of all goods and services. Hence, the presence of the wealth effect continues to maintain an inverse relation between price level changes and aggregate demand
14. Rate of interest Effect
Rate of interest is also a price like all other prices of goods and services. It is the price paid for the use of money or for the use of loanable funds.
Rate of interest also shows a tendency to move upward under inflationary conditions or rising prices. With rising price level and with a constant supply of money, there is an increased demand for liquidity or money and credit resources
15. This is because the rising price level reduces purchasing power of money. Hence a greater quantity of money is needed to carry out a given volume of transactions.
Both households and producers create an increased demand for money under conditions of rising price level. Consequently, with constant supply, growing demand for money tends to raise its price in the form of rate of interest. With higher rates of interest, borrowing becomes dearer and the tendency to save rather than consume is induced.
16. Consequently demand for goods and services both from consumers and investors starts declining. Therefore a rising level of prices results in a fall in the aggregate demand due to a rise in the rate of interest.
17. Rising level of prices finally causes fall in the aggregate demand via foreign trade effect. Under the conditions of inflation domestic prices of goods are higher than international price levels.
This makes import of goods attractive since import prices are lower and goods are cheaper than domestic products.
Again because of an inflationary rise in the prices of export goods, foreign demand for exported goods declines.
Both these processes together reduce demand for domestically produced goods and services.
18. Shifts in Demand
As in the case of the individual demand curve, aggregate demand curve shows a tendency to shift leftward or rightward. The demand curve shifts in this manner when aggregate demand tends to rise without any change in the domestic price level. In other words this occurs when aggregate demand alters for causes other than changes in the price level.
There are a variety of causes contributing to shifts in aggregate demand. When the public authority increases its expenditure, more purchasing power is put in the hands of people who create an increasing demand.
19. If the rates of taxes are reduced then again people’s capacity to spend increases and aggregate demand will rise. International demand and supply conditions may also contribute to shifts in the aggregate demand curve.
Rising price level in countries abroad may make exports of a country relatively cheaper and cause an increased demand for exports. On the contrary under such conditions imported goods become relatively dearer, the demand for which declines and this results in a rise in demand for indigenous products.
When all these factors are moving in the opposite direction, they will result in a fall in the aggregate demand and rightward shift in the AD curve.
20. In the figure DD is the original demand curve. On this demand curve at a given price level P1 aggregate demand is of the size q1.
But when the demand curve shifts rightward or upward, as D1D1 then at the same price level P1 demand increases from q1 to q2. This means that there has been an increase in demand at the same price.
If we consider the higher demand curve D1D1 to be the initial demand curve, then the demand curve DD denotes leftward or downward shift. This time it means that at the same price there has been a decrease in demand.
21. Aggregate Supply
Aggregate supply is the total quantity supplied by the producers and sellers. In the scheduled form it is presented through a range of expected quantities supplied at arbitrarily chosen prices.
22. Direct Relationship
Aggregate supply shows a direct relationship with the changes in the price level. As price level rises (from 1 through 6) the quantity supplied goes on increasing (from 5 through 60).
The direct relationship between price and aggregate supply is due to the same reason as in the case of individual supply curve.
In both the cases the cost of production goes on increasing with every addition to the goods produced.
Therefore more and more supply can be made only when the price level is rising in order to cover rising cost of production.
23. The quantity supplied has been measured along horizontal axis and price level has been shown on the vertical axis.
Because of the direct relation between the two, the supply curve O-AS is continuously rising upwards. However, there is an important difference in the behavior between individual and aggregate supply curves.
24. An individual supply curve is moderately steep throughout. But in case of aggregate supply curve, two distinct phases are noticeable. Initially the AS curve is flatter and rises upwards only gradually.
In the figure ON is such an initial phase. But later on the AS curve becomes steeper and finally becomes a vertical straight line. In the figure, N-AS is such steeper phase.
25. The Two Phases
Initially, at the low levels of output produced and supplied, a very small proportion of available resources is utilized.
So long as labor, plants and equipment, land etc. are underutilized or unemployed, marginal cost of employing them is relatively low.
Therefore more and more output can be produced and supplied with reasonably small rises in the price level
26. But as resource utilization tends to a fuller level, the marginal cost of employing resources starts rising sharply. Ultimately, when all available resources are exhausted, the condition of no further supply of real goods and services is reached (that is the full employment level).
If the price level beyond this point continues to move upward it can no more induce additional production and supply. Rising price level will then be purely inflationary without adding any more to the output level.
27. Aggregate supply curve may shift upwards (leftward) or downwards (rightward).
In figure O-AS1 is the original supply curve and AS2 - AS2 is the new upwards or leftwards shifted Aggregate Supply curve.
On the new supply curve at a given price P1aggregate supply has decreased from q1 to q2.
If we were to start initially from O-AS1curve then O-AS would have been a rightward or a downward shifted supply curve showing greater quantity supplied at a given price level.
28. Such shifts in the supply curve are caused by a variety of dynamic changes taking place in the economy.
Technological improvements, skill development of labor, innovation, foreign trade prospects are some of examples of it. These factors may cause either favorable or unfavorable effects on the supply conditions.
Their unfavorable nature causes an upward shift and favorable effects lead to a downward shift. In the long run, a downward shift in the aggregate supply conditions is normally experienced when an economy has been making progress and development.
29. Short and Long Run Supply
Aggregate supply curve has two phases. Initially on the flatter portion more and more output can be produced with a small rise in the price level.
This is possible so long as some resources are unemployed or underemployed. But once the economy reaches a point close to full employment of resources, the supply curve becomes very steep and vertical.
30. These two phases can be associated with short and long run transitions in the aggregate supply conditions as well.
The flatter initial phase is a short-term phenomenon whereas steeper vertical portion is experienced in the long run.
The distinction is based on the fact that progressive fuller utilization of available resources is a time-consuming activity.
31. Relatively flatter short run supply curves while figure 15 shows long run supply curves. Corresponding to the two earlier phases there are separate supply curves.
32. Given the supply and demand curves in their aggregate form, an equilibrium level can be established at the point of their intersection.
AD and SAS are such short run curves. The two have intersected at point E which is the equilibrium; the price that is commonly offered and received is P and quantity exchanged is Y (P and Y bar).
This is only an initial equilibrium and it can alter with a shift in either the demand or supply curves.
33. Such a shift upwards in the aggregate demand curve has been shown. This causes equilibrium position to shift as well from E to E1.
In the new equilibrium position price level rises from P to P1 and real output quantity exchanged increases from Y toY1. Such an increase in the real output becomes possible because between E and E1we were still operating along the short run supply phase, where some resources were underutilized.
But once the point E1 is reached the supply curve becomes steep and vertical. Here the full employment level is reached and no more resources are available for further additions to be made to the real output. Therefore E1Y1 is a vertical full employment long run supply curve (LAS). Points such as E are partial equilibrium under employable points.
34. we have an interesting case where aggregate demand shifts and increases beyond full employment level. In this case E1 is the original point of equilibrium with AD1 and SAS1 having intersected at this point.
However this happens to be the full employment condition and LAS passes through this point which is Y1E1. If aggregate demand further shifts upwards as shown by AD2 then a new point of equilibrium is attained at E2 where AD2 and SAS1 have intersected.
The new price level is then P2 and output quantity Y2
35. However, since all available resources were fully employed and exhausted at Y output level, this increase is purely a monetary phenomenon caused by rising price level. Therefore movement from Y1 to Y2 is only an increase in money value of the real output.
This becomes possible because contracted agents of production have secured a hike in their wages, rent and interests. As a result of increase in input prices and consequent rise in the cost of production, the supply curve shifts upwards as SAS2. Yet another point of intersection between AD2 and SAS2 becomes possible at a new equilibrium level E.
In this equilibrium position we revert to the old full employment level of output Y1though the price level is now higher than before as P2. Thus in the long run after all adjustments have taken place the economy settles down at the full employment level and only price level rises upwards due to inflationary pressure.
36. Besides, there is another contributory factor which causes lapse of time between the two phases. Several resource agents or factors of production are employed on the basis of contracted remuneration. Rate of wages, rent of land and building premises, interest on the loan funds are all examples of contract payments.
These contracts last for six months, a year or for a longer period. With an initial rise in the price level contracted factor payments do not rise and quick expansion in the output becomes possible at fairly steady costs. This explains the short run, flatter portion of the supply curve.
But after the lapse of time when the contractual period is over the factor agents demand higher remuneration to compensate for the inflationary price rise.
This suddenly causes cost of production to rise sharply. The long run supply curve therefore tends to get steeper and gradually attain a vertical shape. But that both the causes namely fuller utilization of resources and renewal of contracts at higher factor prices together cause steepness and rigidity in the long run supply conditions