AD-AS MODEL

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MICROECONOMICS

AD-AS MODEL

Introduction

At the market place

discussed in this section, explains the logic and process of decision making by the consumer to arrive at optimal decision, as a response to price changes.

	Learning Objectives
After reading this chapter, you are expected to learn about: 1. Understand how 2. Comprehend 3. Get familiar with 4. Realize the impact of

Meaning of Aggregate Demand

The concept of aggregate demand (AD) refers to the total demand for goods and services in an economy. AD is related to the total expenditure flow in an economy in a given period. It consists of the following:

 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).

Thus symbolically,

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

Keynes Theory of Aggregate Demand

The notion of “effective demand” and its influence on economic activity was the central theme in Keynes' book, General Theory of Employment, Interest and Money, published in 1936. While refuting the Classical theory which believed in strong general tendency of market mechanism to move output and employment towards full employment, Keynes propounded that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. According to him, 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. Thus, it is possible to have macroeconomic equilibrium at less than full employment.

Keynes's theory of the determination of equilibrium income and employment focuses on the relationship between aggregate supply (income) and aggregate demand (expenditure). Keynes used his aggregate demand-aggregate supply (AD-AS) model to argue that the economy's equilibrium level of output and employment may not always correspond to the full employment level of income. Equilibrium income on the other hand is determined by the level of aggregate demand (AD) in the economy, given the level of aggregate supply (AS). In the AD-AS model, the equilibrium level of income and employment is the level at which aggregate supply is consistent with the current level of aggregate 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 In Keynes’ theory of income determination is society’s planned expenditure. It consists of consumption expenditure (C), investment expenditure (I) and government expenditure (G).

Thus AD = Planned Expenditure = C + I + G

where,

 C = f (Y_d)and Y_d is level of disposable income (Income minus Taxes)

 I is exogenous

 G is a policy variable.

The short-run aggregate demand function can be written as

Given the consumption curve, the aggregate demand curve is obtained by adding total investment expenditure to total consumption expenditure.

Aggregate demand consists of consumption expenditure ( C ) and investment expenditure (I). [[1]] [[2]] [[3]]

DETERMINANTS OF CONSUMPTION EXPENDITURE

According to Keynes, the amount of consumption expenditure depends on the size of national income. This functional relationship is called the propensity to consume or consumption function. Symbolically it is expressed as

C = f (Y)

Where C is consumption expenditure and Y is level of income. Algebraically Keynes consumption function is given as C = a + b Y Where, a is the Minimum Subsistence Consumption Demand b is Marginal Propensity to Consume Y is Level of Income Keynes consumption curve is shown in the following diagram.

 OA is the minimum subsistence consumption demand.  Consumption curve C slopes upward which shows that consumption demand (C ) increases with increase in income (Y).  The marginal propensity to consume (MPC) is the ratio of change in consumption (∆ C) to a change in income (∆ Y)

       ∆ C

MPC = --------

       ∆ Y

       C2 Y2 – C1Y2                           C2 b

MPC = -------------------------- = ------------------

      OY2 - OY1                    Y1 Y2

DETERMINANTS OF INVESTMENT EXPENDITURE

Investment expenditure refers to the creation of new assets i.e. an addition to the stock of existing capital assets. According to Keynes investment demand depends upon two factors:

 Expected rate of profit which he calls as Marginal Efficiency of Capital (MEC). Investment demand increases with the increase in the expected rate of profit.

 The rate of interest (IR). Investment demand decreases with the increase in the rate of interest.

Symbolically, Keynes investment demand is expressed as:

Id = f ( MEC, IR)

DETERMINATION OF AGGREGATE DEMAND The following diagram shows the determination of aggregate demand which consists of consumption demand ( C ) and investment demand ( I ).

 C = f (Y) is the consumption curve which is a function of national income.

 AD = C + I is the aggregate demand curve.

 Investment demand does not directly depend upon income. The gap between the consumption curve (C) and aggregate demand curve (AD) shows investment demand.

DETERMINATION OF EQUILIBRIUM INCOME

According to Keynes, equilibrium income is determined by the level of aggregate demand (AD) in the economy, given the level of aggregate supply (AS). Aggregate Demand In Keynes’ theory of income determination aggregate demand is society’s total expenditure. It consists of consumption expenditure (C) and investment expenditure (I). Thus AD = C + I where, C = f (Y) and I = f (MEC, IR)

 Y is level of income

 MEC is marginal efficiency of capital or expected rate of returns from new capital assets.

 IR is interest rate

Given the consumption curve, the aggregate demand curve is obtained by adding total investment expenditure to total consumption expenditure.

Aggregate Supply (AS) is the money value of goods and services in an economy in a year. AS is equal to national product. It includes society’s production of consumer and capital goods/services. AS measures national product in terms of the reward to factors of production for their contribution to the national product. Thus: AS = Y = C + S where, factor receipts are equal to total consumption plus savings. The AS curve is upward sloping 450 line. Equilibrium income is determined at a point at which AD = AS. The following diagram shows the AD and AS curves and equilibrium income is determined at OY1 level of income.