Question

Outline the final equation of the aggregate demand and aggregate supply curve and identify the variables and how each variable affects the model.

Answer 1

AGGREGATE DEMAND :-

Aggregate demand means the total demand for final goods and services in the economy. It also means the aggregate or total expenditure on final goods and services an economy. AD is defined as ' the sum total of demand for all goods and services in an economy during the period of an accounting year'.Aggregate demand is synonyms with aggregate expenditure. If people tend to spend more than what they were spending on goods and services earlier, it means rise in aggregate demand and vice versa. AD can be related with price level and income level. There is a negative relation between AD and the price level, that means AD falls with increase in price level and vice - versa. On the other hand there is a positive relation between them. When income increases AD decreases and vice-versa. The equation of AD is

AD= C+I+G+(X-M)

Here,

C is the Private Consumption Expenditure

I is the Private Investment Expenditure

G is the Government Expenditure

(X-M) is the Net Exports

These are the four main components of AD. Let we know how these variables affect on AD.

1. Private Consumption Expenditure :-

It refers to the total expenditure incurred by the households on the purchase of goods and services during a given period of time. There is a positive relationship between consumption and income. As income rises, consumption also rises and vice-versa.

2. Private Investment Expenditure :-

It refers to planned expenditure by the producing sector for the investment such as purchase of capital goods, plant and machinery etc. It is affected by the rate of interest and the marginal efficiency of capital. There is a negative relation between rate of interest and investment demand.

3. Government Expenditure :-

Govt expenditure refers to Govt planned expenditure on purchase of consumer and capital goods to fulfil common needs of the society. Government demand depends upon society's welfare needs and not guided by the profit motive. This expenditure is affected by the Govt policy.

4. Net Exports:-

Net export is defined as the aggregate of all demand for our goods and services by foreign countries over our country's demand for foreign countries' goods and services. Actually it is the difference between exports and imports of goods and services.

AGGREGATE SUPPLY :

Aggregate supply is the money value of total money supply of goods and services available for purchase by an economy during a given period. It is the National Income(Y) or Net National Product at factor cost (NNPfc). The equation of AS is:

AS= C+S

or Y=C+S

Where C is the Consumption Expenditure and S is Savings. These are the main components of AS.

1. Consumption :-

Consumption is always positive even when income is zero because autonomous consumption is there. When income increases consumption increases and vice - versa.

C=f(Y)

2. Savings:-

A major portion of income is spent on consumption of goods and services and the balance is saved. Thus, savings increses with increase in income and vice-versa. There is apositive relationship between these two:-

i) savings are positive when consumption is less than income: C<Y

ii) savings are zero when consumption is equal to income:C=Y, this is called Break-even point.

iii) savings become negative when the level of income is low:C>Y

Therefore savings is the function of income, S=f(Y)

The aggregate supply curve which is 45degree positively sloping line from the origin.