Aggregate Demand and

Aggregate Supply:
Classical and
Keynesian Approach
Dr. Shylajan, C.S

Topics of Discussion

Aggregate Demand
The Downward-Sloping Aggregate
Demand Curve
Shifts in Aggregate Demand
Aggregate Supply
Classical Theory
Says Law
Short run and long run Aggregate
supply curve

Topics of Discussion

Labour market equilibrium under

classical and Keynesian models
Keynesian Theory of Output
Determination
The Meaning of Equilibrium under
Keynesian model
Output Determination by Consumption
and Investment (Simple economy)

AD & AS: Classical and

Keynesian Approach
Aggregate Demand is the total demand
for goods and services in the economy.
It depends on the aggregate price level
Aggregate Supply curve shows the price
level associated with each level of
output.
AS is the level of total national output
that will be produced at each level of
price, other things held constant.

Why AD Downward
sloping?

The level of aggregate demand declines as

the overall price level in the economy rises.
(assuming other things constant). Why?

Aggregate Demand and Aggregate supply

interact to determine equilibrium price and
output (Real GDP)

Movements along the Aggregate Demand

and Shifts of Aggregate Demand

Shifts in Aggregate
Demand

1. Due to change in policy variables

Due to change in variables such as
money supply, tax policy,
government expenditures etc

2. Due to exogenous variables

(Foreign output, war, etc for
instance)

Aggregate Demand

Our focus is on aggregate demand as

the determinant of the level of
output

Prices are given and constant

We need to know how given policy

actions shift the aggregate demand
curve at a given level of prices.

Short run vs Long run

Aggregate Supply

Because the firms that supply

goods and services have flexible
prices in the long run but sticky
prices in the short-run, the AS
relationship depends on the time
horizon.

Classical model

The classical model describes how the

economy behaves in the long run.
We derive Long Run AS from the
classical model.
The amount of output produced
depends on the fixed amounts of capital
(K) and labor (L) and on the available
tecnology
Y= F(K, L)

Classical model

According to Classical model, output

does not depend on the price level.
Hence a vertical Long Run AS curve.
In the long run, the intersection of the
AD curve with its vertical AS curve
determines the price level.
Please note that if the AS curve is
vertical, then changes in AD affects
prices, but not output. (Graph)

Says Law of Markets

The classical economy:- The prices

and wages are flexible.
Hence the economy is stable
The economy moves automatically
and quickly to its full-employment
output equilibrium
No need for government intervention
Business cycles are temporary

Says law

J B Say
Overproduction is impossible
Supply creates its own demand
Classical model:-output is
determined by AS, and AD affects
only the price level
People can buy whatever the firms
produce. Hence no oversupply

Says law

No role for AD
Changes in the fiscal policy, investment,
monetary policy or other spending factors no
impact on output or employment
Prices and wages adjust quickly and flexibly to
maintain full employment
Changes in AS leads to changes in real output
(Graph)
Failure of Classicalism was clear during Great
Depression of 1930s with huge unemployment

Says law

The classical model and vertical AS

curve applies only in the long run
In the short run, prices are sticky
Hence SR AS curve is not vertical
In the short run, price level is fixed
and firms are willing to sell as much
as their customers are willing to buy

Says law

The short run equilibrium of the

economy is the intersection of the AD
curve and the horizontal AS curve.
Hence, changes in AD do affect the
level of output.
For instance, by increasing spending
by investors we can increase output
without increasing over all price.
(Graph)

Labor market
equilibrium

Demand for labor function

Supply of labor function
Equilibrium in the labour market
Classical Model: Wage flexibility
and full employment
Keynesian model: Sticky wages
and prices

Labor market
equilibrium

The demand for a factor of production

reflects the marginal productivity of
that output.
Why demand for labour curve is
downward sloping?
The supply of labor: labour supply
refers to the number of hours that the
population desires to work in gainful
activities.

Keynesian Income
Determination : Simple
Economy
In a simple economy aggregate
demand is the sum of the demand for
consumption and investment goods.

It is the amount of goods people want

to buy

Investment demand (I) is assumed

constant or independent of income.

Determination of
Equilibrium Income and
Output in a Simple Economy
No government, no trade
(Keynesian
Theory)

Output is at its equilibrium when planned Aggregate

Demand (C + I) is equal to actual output (Y)
AD = C +I
Y = AD
Quantity of output produced (Y) is exactly equal to the
quantity demanded (AD)

Determination of
Equilibrium Income and
Output in a Simple Economy

At the equilibrium level of output,

firms are selling as much as they
produce, people are buying the
amount they want to purchase.

So there is no inventory problem.

Deriving the Aggregate Demand

Schedule and Equilibrium Output
C 1 0 0 .7 5 Y

I 25

Deriving the Planned Aggregate Demand Schedule and Finding Equilibrium.

The Figures in Column 2 are Based on the Equation C = 100 + .75Y.

(1)

(2)

(3)

(4)

(5)

(6)

PLANNED
AGGREGATE
EXPENDITURE )
C+I

UNPLAN
NED
INVENTO
RY
CHANGE
Y (C +
I)

EQUILIBRIUM
?
(Y = C + I)

AGGREGA
TE
OUTPUT
(INCOME)
(Y)

AGGREGATE
CONSUMPTIO
N (C )

PLANNED
INVESTMEN
T(I)

100

175

25

200

100

No

200

250

25

275

75

No

400

400

25

425

25

No

500

475

25

500

Yes

600
800

550
700

25
25

575
725

+ 25
+ 75

No
No

1,000

850

25

875

+ 125

No

Output Determination by
Consumption and
Investment
Aggregate output :Y

Planned aggregate
expenditure or AD: C + I
Equilibrium: Output = AD
Equilibrium: Y = C + I

Meaning of Equilibrium
income and output

Output is at its equilibrium level

when aggregate demand (AD) is
equal to output (Y).
What is AD? It is consumption
spending plus investment spending

AD = C + I where C=a+bY
= (a + bY) + I
= (a + I) + bY

Meaning of Equilibrium
income and output

(a + I) is autonomous or
independent of level of income.
But aggregate demand also depends
on the level of income (bY)
Bcoz, consumption demand
increases with income (bY)
At equilibrium, Y = AD
Y= (a + I) + bY

Meaning of Equilibrium
income and output

Solve for equilibrium output (Ye)

Y- bY = (a +I)

Ye = 1/ (1-b) * (a +I).(1)

Where b = marginal propensity to consume or MPC

(a + I ) is autonomous spending

Finding Equilibrium
Output in a simple economy- An
Example
(1)

Y C I

(2)

C 1 0 0 .7 5 Y

(3)

I 25

By substituting (2) and

(3) into (1) we get:

Y 1 0 0 .7 5 Y 2 5

Y 1 0 0 .7 5 Y 2 5
Y .7 5 Y 1 0 0 2 5
Y .7 5 Y 1 2 5
.2 5 Y 1 2 5
125
Y
500
.2 5

Finding Equilibrium
Output in a simple
economy- Graphically

The slope of the

consumption function
measures which of the
following?

1. Marginal propensity to consume

2. Average propensity to consume
3. Aggregate level of consumption
4. Marginal propensity to save
5. Average propensity to save

Find the equilibrium

income when
investment demand
is 300 and the
consumption
function is C = 10 + .
8Y

At the equilibrium
level of real GDP,
which of the following
isUnplanned
true?
1.
inventory
investment is positive
2.Unplanned inventory
investment is negative

3.Aggregate output equals

aggregate expenditure
4.Aggregate output plus
consumption spending equals
aggregate expenditures
5.Aggregate output plus saving
equals aggregate expenditure

Topics of Discussion

The Investment Multiplier

The Multiplier in the AS-AD
Framework
Aggregate Demand by Introducing
the Government Sector
Determination of Equilibrium Income
with Government Sector
Determination of Equilibrium Income
in an Open Economy
The Paradox of Thrift

The Simple Multiplier

Model

It is the change in equilibrium output when

autonomous demand increases by one unit.

Multiplier k = 1/ (1-MPC)
Multiplier = 1/ MPS

Larger the MPC , the larger the multiplier

To study why output fluctuates, the concept

of multiplier is important.

The Multiplier

An increase in autonomous spending

raises the equilibrium level of income

The increase in income is a multiple

of the increase in autonomous
spending

The larger the MPC, the larger the

multiplier

The Multiplier in the

AS-AD Framework

In a multiplier model, we use

Consumption plus Investment
approach to determine
equilibrium output.

Equilibrium output is achieved

when aggregate expenditure
equals real GDP

The Multiplier in the

AS-AD Framework

In AS-AD framework, it is
achieved when downward sloping
Aggregate Demand Curve cuts
the upward sloping Aggregate
Supply curve

Aggregate Demand by Introducing

the Government Sector (Fiscal policy
in the multiplier model)

How governments fiscal policies affect output?

What is Fiscal Policy?

By Government taxation
By Government spending
By Transfer Payments
How government spending and taxation
programmes affect output?

Aggregate Demand by
Introducing the Government
Sector

Now we have

GDP = C + I + G +NX
Consumption expenditure
Gross private domestic investment
Government purchase of goods and
services
Net exports

Determination of
Equilibrium Income with
Government Sector

Assume we have a closed economy

So we have GDP = C + I + G
Total spending is C + I + G
Equilibrium output is determined when
aggregate spending equals GDP.
At this point, total planned spending
exactly equals total planned output.

Determination of
Equilibrium Income with
Government Sector

Three models:

1. With government spending (G)

2. Tax (as a fraction of income, tY)
3.Tax as lump sum
4. Transfer Payments (TR)

Impact of Taxation on
Aggregate Demand
The increase in taxes will
lower disposable income
Then C=a+bYd where
Yd=Y+TR-tY
Consumption schedule shifts
downwards
Government taxation tend to
reduce aggregate demand
and the level of GDP

Determination of
Equilibrium Income in an
Open Economy
GDP = C + I + G + NX
We have Exports and
Imports
Exports = X
Imports =M
Net Exports (NX) = X - M

Determination of
Equilibrium Income in an
Open Economy

What are the determinants of Exports?

Exports are exogenously given
What are the determinants of Imports?
Imports depend mostly on income of
the economy (Y)
There is autonomous import which is
independent of income or any other
variables

Determination of
Equilibrium Income in an
Open Economy

Hence, Import function is

M = mo +mY

Where mo is autonomous import

Where m is marginal propensity

to import. That is, change in
import for a change in income, Y

Determination of
Equilibrium Income in an
Open Economy

Given the consumption function,

Tax rate, Transfer payments,
Investment, Government
spending, Export, and Import
function how do we determine
equilibrium level of income?

Determination of
Equilibrium Income in an
Open Economy

Consumption is a function of
disposable income
C = a + bYd
Where Yd = (Y tY+TR)
Where tY . Proportionate tax rate
TR is Government Transfer Payments
C = a + b (Y - tY + TR)

Determination of
Equilibrium Income in an
Open Economy

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

Equilibrium is at Y = AD

Numerical problems

The Paradox of Thrift

More saving looks beneficial to individuals.

But if everybody starts saving without spending

on consumption, it will reduce demand for
goods.

The paradox of thrift implies that more personal

savings could harm the economy as a whole,
especially during recession or depression.

Japan battles with paradox of thrift?

Thanks