Aggregate Demand and Supply - Economics Explained PDF

**Effective Demand : ADF & ASF\ ** The notion of "effective demand" and its influence on economic activity was the central theme in Keynes\'s Theory of Effective Demand. While refuting the Classical theory which believed in strong general tendency of market mechanism to move output and employment t...

**Effective Demand : ADF & ASF\ ** The notion of "effective demand" and its influence on economic activity was the central theme in Keynes\'s Theory of Effective Demand. While refuting the Classical theory which believed in strong general tendency of market mechanism to move output and employment towards full employment, Keynes explained that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. Keynes was the first economist to advocate the role of government especially fiscal policy, as the primary means of stabilizing the economy. --------------------------------- **Meaning of Aggregate Demand** --------------------------------- The concept of aggregate demand (AD) refers to the total demand for goods and services in an economy. Thus symbolically, Aggregate Demand = C + I + G + (X-M) ¬ Consumption demand by the households (C ) ¬ Investment demand, i.e., demand for capital goods (I) by the business firms. ¬ Government expenditure (G) ¬ Net income from abroad (X -- M). ------------------------------------------ **Keynes\'s Theory of Aggregate Demand** ------------------------------------------ According to Keynes full employment is not a normal situation as stated in the *Classical* theory. He argued that economy\'s equilibrium level of output and employment may not always correspond to the full employment level of income. It is possible to have macroeconomic equilibrium at less than full employment. If current level of aggregate demand (expenditure) is not adequate to purchase all the goods produced in the economy (i. e. a situation of excess supply) then output will be cut back to match the level of aggregate demand. Keynes\'s theory of the determination of equilibrium income and employment focuses on the relationship between aggregate demand (AD) and aggregate supply (AS). According to him equilibrium employment (income) is determined by the level of aggregate demand (AD) in the economy, given the level of aggregate supply (AS). Thus, the equilibrium level of employment is the level at which aggregate supply is consistent with the current level of aggregate demand. The theory believes that \"demand creates its own supply\" rather than the Classical claim of \"supply creates its own demand\". In the following sections we discuss Keynes\' concepts of aggregate demand function, aggregate supply function and finally, the point of effective demand. -- ------------------------------- **Aggregate Demand Function** -- ------------------------------- Aggregate demand or what is called **aggregate demand price** is *the amount of total receipts which all the firms **expect to receive** from the sale of output produced by a given number of workers employed*. Aggregate demand increases with increase in the number of workers employed. The aggregate demand function curve is a rising curve as shown in Fig. 1. **Figure.1: Aggregate Demand Function** It can be seen that total expected receipts is D~1~L~1~ at OL~1~ level of employment. Total expected receipts increase to D~2~L~2~ with increase in the level of employment to OL~2~. OL~f~ is the full employment level. Initially the aggregate demand function (ADF) rises sharply as increase in the number of employment leads to increase in society\'s expenditure, thereby, increasing producer\'s expected sales receipts. There is no much increase in employment, income, expenditure and therefore producer\'s expected sales receipts as the economy reaches near full-employment. The ADF curve becomes perfectly elastic (horizontal) as the economy reaches near full-employment. Aggregate Demand In Keynes' theory of income determination is society's planned expenditure. In a laissez-faire economy it consists of consumption expenditure (C)and investment expenditure (I). Thus AD = Planned Expenditure = C + I ------------------------------- **Aggregate Supply Function** ------------------------------- Aggregate supply is determined by physical and technical conditions of production. However, these conditions remain constant in the short run. As such, given the technical conditions, output in the short run can be increases only by increasing employment of labour. Aggregate supply or what is called **aggregate supply price** is *the amount of total receipts which all the firms **must expect to receive** from the sale of output produced by a given number of workers employed.* In other words, aggregate supply price is the total cost of production incurred by producers by employing a certain given number of workers. Obviously, aggregate supply price increases with increase in the number of workers employed. The aggregate supply function curve is a rising curve and at full employment (OL~f~) it becomes perfectly inelastic (vertical) as shown in Fig. 2. **Figure.2: Aggregate Supply Function**  It can be seen that aggregate supply price or the cost of production is S~1~L~1~ at OL~1~ level of employment. It increase to S~2~L~2~ with increase in the level of employment to OL~2~. Initially, the aggregate supply function (ASF) rises slowly as labour is abundant thereby leading to slow increase in the cost of production. Larour cost rises sharply as the economy reaches near full-employment. The ASF therefore rises sharply and at full employment (OL~f~) it becomes perfectly inelastic (vertical). -- ------------------------------------------------------ **Determination of Equilibrium Level of Employment** -- ------------------------------------------------------ According to Keynes equilibrium level of employment (income) in the short run is determined by the level of effective demand. The higher the level of effective demand, the greater would be the level of income and employment and *vice versa*. This is shown in Fig. 3. Fig.3 shows the ADF and ASF together. As discussed above the ADF shows *the amount of total receipts which all the firms **expect to receive** from the sale of output produced by a given number of workers employed* and the ASF shows *the amount of total receipts which all the firms **must expect to receive** from the sale of output produced by a given number of workers employed.* Entrepreneurs expand output as long as there are opportunities to make profits. **Figure.3: Determination of Equilibrium Employment** RTENOTITLE It can be seen that up to **OL** level of employment, aggregate demand price is greater than aggregate supply price (ADF \> ASF). Producers expect greater returns than the cost of production. As such, producers expand output up to **OL** level of employment. Thus at any level of employment up to OL, there would be expansionary tendency in the economy and therefore rise in the level of employment. Beyond **OL** level of employment, aggregate demand price is less than aggregate supply price (ADF \< ASF). Producers expect less returns than the cost of production. As such, producers prefer to cut down output. Thus at any level of employment beyond **OL**, there would be contractionary tendency in the economy and therefore fall in the level of employment. At **OL** level of employment aggregate demand price equals aggregate supply price (ADF = ASF). Now there is no tendency towards economic expansion or contraction. Thus **OL** is the equilibrium level of employment. Point \'**E\'** is called the **point of effective demand**. It represents that level of aggregate demand price that is equal to aggregate supply price and thus reaches short run equilibrium position. It can be seen that equilibrium point \'**E\'** is established at **less-than-full employment equilibrium** and there is LL~f~ amount of involuntary unemployment in the economy. It is important to note that according to Keynes this unemployment is due to deficiency of aggregate demand. At full employment level there exist a gap between the full-employment level of aggregate supply price and the corresponding level of aggregate demand price.