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The Principle of Effective Demand: Aggregate Demand and Aggregate Supply

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❶Marginal Propensity to Consume.

Changes in Aggregate Demand

Key Questions
The Slope of the Aggregate Demand Curve
Accounting Topics

According to this law, as aggregate income increases, the total consumption expenditure in the economy also increases, but in a lesser proportion than the increase in income. In other words the proportion of income spent on consumption goes on falling as income increases. This is because as income increases, the individual wants are satisfied to a larger and larger extent.

So when income increases further, people do not consume the entire income. They save a part of it. Hence, there is bound to be a gap between income and consumption.

According to Keynes, with the increase in income, both consumption and savings increase; but a consumption increases at a diminishing rate, and b saving increases at an increasing rate. It is common observation that as the income of an individual rises, his consumption expenditure also rises, but not to the full extent of rise in income of the individual. Broadly, it may be sold that this rule of consumption is true of the community as a whole, as the community is composed of individuals.

The following table indicates how consumption expenditure C rises with rise in income Y. Consumption and Saving Function. The table related to Aggregate Income and Aggregate Consumption Expenditure indicates that initially the people have to manage their minimum consumption expenditure, even if there is no income.

This is autonomous consumption expenditure. Although income is zero, some people have to spend, some amount on consumption in order to keep their body and soul together.

If income is zero, some people may be required to borrow or beg or resort to dissaving i. Thus, one part of expenditure on consumption is independent of income and is constant or autonomous. At this level, income Y is equal to consumption expenditure C hence, saving S is zero.

Thus, with increase in the level of income, consumption expenditure does not increase at the same rate. There is a gap between aggregate income and consumption expenditure. Keynes' psychological law of consumption states that "as income goes on increasing, the consumption also increases but at a rate less than increase in income.

Following is the diagrammatic representation of the behaviour of consumption function as given in the psychological law of consumption. OA on the vertical axis shows autonomous consumption at zero level of income. At this point consumption is equal to income. The Propensity to Consume, which is also called consumption function, is an expression of an empirical income consumption relationship.

Keynes states that other things being equal consumption is a function of income. Algebraically, the relationship between consumption, as a dependent variable, and aggregate income, as the independent variable, is expressed as: The Propensity to Consume or the consumption function shows the relationship between aggregate consumption expenditure C and aggregate income Y. The Propensity to Consume does not mean a mere desire to consume, but the actual amount of real consumption, that takes place or that is expected to take place at various income levels.

We can construct a schedule of propensity to consume, by using the same data, which is used in understanding the Keynesian Psychological Law of Consumption. Schedule of Propensity to Consume. Aggregate Income in crore. Aggregate Consumption in crore.

Average Propensity to Consume. Marginal Propensity to Consume. A schedule of the -propensity to consume is a statement showing the functional relationship between the level of aggregate consumption and aggregate income at each level of income. Two aspects of Propensity to Consume, viz. In dealing with the Propensity to Consume or consumption function, Lord J. Keynes considered its two technical attributes: The Average Propensity to Consume A. The Average Propensity to Consume APC is defined as the ratio of aggregate consumption to aggregate income in a given period of time.

The value of average propensity to consume, for any income level, may be calculated by dividing consumption by income. In the schedule of Propensity to Consume Table 9. It is obvious that the proportion of income spent on consumption decreases as income increases. It follows that A. Marginal Propensity to Consume M. The Marginal Propensity to Consume MPC is defined as the ratio of the change in the level of aggregate consumption to a change in the level of aggregate income.

As per Table No. The consumption function depends upon the income level. According to Keynes, consumption function is affected by certain subjective psychological factors and objective institutional factors. These factors can be briefly described as follows: These factors are internal factors. They are dependent on the psychological characteristics of human nature, institutional pattern and social practices.

Basically, they are human behavioural factors, which have an influence on individual's consumption decisions and are fairly stable during the short period. According to Keynes, individual's nature compels them not to spend their entire income. Hence, they save part of their income. Following are the motives which induce people to save and hence influence consumption levels. Generally, people save a large part of their income as a precaution against future unforeseen contingencies and thus, to that extent, the current consumption is reduced.

Individual has to provide for the future needs like higher education of children, maintenance of dependants, maintenance during old age etc. Hence, individual is likely to reduce his or her present consumption in order to save more. In order to earn income, people invest in shares, debentures or other income earning assets.

This is likely to reduce their present consumption. Generally, people have the desire to enjoy improved standard of living and also higher status in the future. Such a motive for improvement reduces current consumption. In order to attain some measure of independence and power in man's life, man intends to save more.

This motive is likely to dampen present consumption. Undertaking business in future, providing for capital investment in future, which can be achieved through current savings i. Individual takes pride in leaving substantial wealth to his or her children. Also, a person may like to give donations: Such a motive of pride may dampen present consumption.

The desire to satisfy pure miserliness i. These factors are called exogenous or , external factors as they , are external to the individual's behaviour, which,, in turn, has a strong bearing on their consumption expenditures. If income in terms of wage rate increases, consumption expenditure increases.

A change in income distribution will cause change in expenditure on consumption. Consumption expenditure depends upon disposable income. If there is a change in disposable income there will be a change in expenditure, on consumption. Change in the rate of interest is likely to affect consumption function. An increase in the rate of interest may have a dampening impact on consumption.

On the other hand, a fall in the rate of interest may encourage people to consume more. Capital gains are due to sudden change in money value of wealth. The consumption expenditure of wealthy classes is likely to be extremely susceptible to unforeseen change in the value of their wealth. During the period of prosperity, huge unexpected gains or windfall gains may accure to the capitalist class, and as a result their consumption may increase. Some examples of windfall' gains are unexpected rise in profits caused due to unexpected upswing in business.

Unexpected rise in the rate of return on investment in some company's shares or debentures is also an example of windfall gain. All these windfall gains may cause increase in consumption. Changes in fiscal policy of the government affected consumption. Certain type of changes in fiscal policy adversely affect consumption.

For example, increase in income tax, capital gains tax, estate duty etc. On the other hand, increase in government spending in various ways including deficit financing would increase propensity to consume. Which of the following is included in the U. Which of the following is counted in the U. Which of the following would decrease the U. If the exchange rate adjusts to 1. If the demand for the Cyprus pound increases relative to the U.

Cypriot pound would appreciate. Cypriot pound will depreciate. Maltese businessmen will purchase more American intermediate goods. American businessmen will purchase more American intermediate goods.

Suppose disposable income increases more in South Africa than it does in the United States. What is the short-run impact of this change in disposable income on U. Suppose Hondurans began purchasing real assets in the United States. How would this impact the foreign exchange market for the lempira and the dollar price of the lempira?

If the demand for the Costa Rican colone increases relative to the U. Suppose Czech businessmen began purchasing American properties. How would this impact the foreign exchange market for the koruna and the dollar? How would the changing value of the dollar impact American exports? What would be the short-run impact of a tariff on all computers imported to the United States?

A higher standard of living An increase in American production of computers An increase in foreign production of computers A decrease in the price of computers A more efficient use of resources If the United States trades with other nations according to comparative advantage, then. Suppose the legislature of Louisville voted to impose a protective tariff on chicken. Which of the following would be true in the short-run? There will be an increase in chicken production by foreign nations.

ABC Corporation argues that it needs a tariff on bread baskets so that it can grow large enough to compete with foreign producers.

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This normally increases quantity demanded further. Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices—the price level—we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen.

The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well. Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling. It means the prices people receive—their wages, the rents they may charge as landlords, the interest rates they earn—are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too.

There is no reason to expect that a change in real income will boost the quantity of goods and services demanded—indeed, no change in real income would occur. Why, then, does the aggregate demand curve slope downward? One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth the stocks, bonds, and other assets that people have accumulated and consumption one of the four components of aggregate demand.

When the price level falls, the real value of wealth increases—it packs more purchasing power. An increase in wealth will induce people to increase their consumption. The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels. The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect The tendency for a change in the price level to affect real wealth and thus alter consumption.

A second reason the aggregate demand curve slopes downward lies in the relationship between interest rates and investment. A lower price level lowers the demand for money, because less money is required to buy a given quantity of goods. What economists mean by money demand will be explained in more detail in a later chapter. But, as we learned in studying demand and supply, a reduction in the demand for something, all other things unchanged, lowers its price.

A lower price level thus reduces interest rates. Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive. A lower interest rate means lower mortgage payments, which tends to increase investment in residential houses. Investment thus rises when the price level falls. The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded.

John Maynard Keynes, a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern macroeconomics, emphasized this effect. For this reason, the interest rate effect is sometimes called the Keynes effect. A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand.

All other things unchanged, a lower price level in an economy reduces the prices of its goods and services relative to foreign-produced goods and services. The result is an increase in net exports.

The international trade effect The tendency for a change in the price level to affect net exports. Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve.

In general, a change in the price level, with all other determinants of aggregate demand unchanged, causes a movement along the aggregate demand curve. A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded Movement along an aggregate demand curve. A movement from point A to point B on the aggregate demand curve in Figure 7.

Such a change is a response to a change in the price level. Notice that the axes of the aggregate demand curve graph are drawn with a break near the origin to remind us that the plotted values reflect a relatively narrow range of changes in real GDP and the price level.

We do not know what might happen if the price level or output for an entire economy approached zero. Such a phenomenon has never been observed. Aggregate demand changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the aggregate demand curve to the right.

A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand Change in the aggregate quantity of goods and services demanded at every price level. Increases and decreases in aggregate demand are shown in Figure 7. An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve AD 1 to the right as shown in Panel a.

A reduction in one of the components of aggregate demand shifts the curve to the left, as shown in Panel b. What factors might cause the aggregate demand curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter.

We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve. Several events could change the quantity of consumption at each price level and thus shift aggregate demand. One determinant of consumption is consumer confidence.

If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture.

The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand. In the second half of the s, sustained economic growth and low unemployment fueled high expectations and consumer optimism.

Surveys revealed consumer confidence to be very high. That consumer confidence translated into increased consumption and increased aggregate demand. In contrast, a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence, as happened after the stock market crash of The same problem has plagued the economies of most Western nations in as declining consumer confidence has tended to reduce consumption.

A survey by the Conference Board in September of showed that just

What Determines the Quantity of Goods That Buyers Demand?

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The 5 determinants of demand are price, income, prices of related goods, tastes, and expectations. A 6th, for aggregate demand, is number of buyers.

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The sixth determinant that only affects aggregate demand is the number of buyers in the economy. The aggregate demand curve shows the quantity demanded at each price. It's similar to the demand curve used in microeconomics. Term aggregate demand determinants Definition: An assortment of ceteris paribus factors that affect aggregate demand, but which are assumed constant when the aggregate demand curve is canlimacizlemek.tks in any of the aggregate demand determinants cause the aggregate demand curve to shift. While a wide variety of specific ceteris paribus factors can cause the aggregate demand .

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Determinants of the Components of the Aggregate Demand By using the Aggregate Demand (AD) function, we are able to retrieve different components of aggregate demand. Factors that influence the AD of an economy include, as mentioned above, consumption, investments, government . The determinants of demand are the price of the good or service, income of the buyer, prices of related goods or services, tastes, preferences and future price expectations. The number of buyers may be considered another determinant relating to aggregate demand. The Law of Demand .