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Aggregate Demand
Aggregate supply

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Aggregate Demand
Meaning

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.

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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


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.

AD Schedule
Price level AD quantities or Yr
6 10
5 12
4 18
3 30
2 44
1 60


In the AD Schedule we notice an inverse
relationship between level of prices and
the quantities or real income. As the price AD Schedule
level falls (through 6 to 1) Aggregate Price level AD quantities or Yr
Demand goes on increasing (from 10 6 10
through 60). In the figure, the same 5 12
information has been presented 4 18
graphically (in the form of the AD curve).
3 30
In the figure price has been measured
2 44
along the vertical and AD quantity along
1 60
the horizontal axis. The inverse relation
between the two is apparent since the AD
curve slopes downwards.


AD Schedule
Price level AD quantities or
Yr
6 10
5 12
4 18
3 30
2 44
1 60


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.


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.


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.


Three Effects

There are three different effects operating on the
aggregate demand as a result of rising price level, or
under inflationary conditions.

These are
1. Wealth Effect,
2. Rate of interest Effect and
3. Trade Effect.


AD Schedule Wealth Effect
Price AD
level quantities
or Yr Professor A.C. Pigou had first stated and
6 10 analyzed wealth effect under inflationary
5 12
4 18 conditions of the price level changes. With a
3 30 rise in the price level, value of the given
2 44
1 60
money income of consumers (assuming supply
of money to be constant) decreases.


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.


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


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


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.


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.


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.


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.


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.


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.


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.
Aggregate Supply Schedule
Price Quantity supplied
1 5
2 15
3 30
4 48
5 58
6 60


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.


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.


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.


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


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.


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.


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.


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.


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.


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.


Equilibrium

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.


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.


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


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.


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


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