Aggregate Demand (AD) and Aggregate Supply (AS) 1. Aggregate demand (AD)

Aggregate demand refers to collective behavior of all buyers in a marketplace. In other words, it is the relationship between various quantities of output that all people together will buy at various price levels in a defined period. Therefore, it illustrates the total demand for all goods and services rather than the demand for a single product. The relationship between average prices and real output in terms of quantity per year is shown in Figure 6.1. The aggregate demand curve slopes downward because of real balance effect, foreign trade effect and interest rate effect.

Figure 6.1: Aggregate Demand

Real balances effect: The most apparent reason for downward slope of AD curve is that a decrease in the prices of goods and services makes the rupee more valuable. Suppose you have Rs. 1000. How much can you buy with this money? It will depend on the current price level. At the current price level, you can buy goods and services worth Rs.

1000. But, how much can you buy if prices rise? Rs 1000 will not get you the same amount of goods and services. The real value of money is measured by how much goods and services can be bought with one rupee.

Suppose the price level increases by 25% in a year. What will happen to real value of your money? At the end of the year, the real value of your money will be = (money at the beginning of the year)/(1+(percentage increase/100))

= Rs 1000/(1+0.25)

= Rs 800

So, the purchasing power of your money has decreased in the given year. Or, at the end of the year, you won't be able to buy the same amount of goods and services that you would have bought at the beginning of the year.

However, a decrease in the price level will have opposite effect. It means that the money is worth more when prices fall. So, you will be able to buy more goods and services without any increase in income level.

Thus, real balances effects cause an inverse relationship between real output and price level i.e., aggregate demand curve is downward sloping.

Foreign trade effect: Changes in imports and exports are also responsible for downward slope of AD curve. Consumers now have a choice of buying either domestic or foreign goods. The relative price in two countries is the decisive factor. If the average prices of goods that are produced in India are rising, Indians may buy more imported goods.

Similarly, if the prices fall in India, they may buy more goods that are produced in India.

Interest rate effect: Changes in price level affect the demand for loans which in turn, affect the interest rates. When price levels are lower, the demand for loans will also be lower. And due to lower demand for loans, interest rates will fall. When money is available at a cheaper rate, it encourages people to borrow more and make loan – financed purchases. So, it can be said that when price levels are lower, people buy more. Again, this is a inverse relationship between price and quantity.

6.4.2. Aggregate supply (AS)

Aggregate supply is the real value of output producers are willing and able to bring to market at alternative price levels (ceteris paribus). The slope of the curve is always positively upward as shown in Figure 6.2. Upward slope of AS curve reflects profits and costs effects.

Figure 6.2: Aggregate Supply

Profit effect: Producers produce goods and services to earn profits. They can earn profits only when their selling prices are higher than their costs of production.

Therefore, changing the price level will affect the profitability of the producers. When prices of goods and services fall, profits also fall. In the short run, the costs in terms of rent, interest payments, negotiated wages, etc. are fixed.

When output prices fall, these costs will remain the same and the producer’s profit will be reduced. Producers respond to this situation by reducing the rate of output.

Similarly, when output prices increase, profit margins will also increase because in the short run, the costs will remain constant. When profit margins increase, producers try to produce and sell more goods and services. So, the rate of output increases in case of an increase in price levels. This is reflected in the upward slope of the aggregate supply curve.

Cost effects: Another reason for the upward slope of the aggregate supply curve is cost.

As explained earlier, the profit of a producer increases when the price level increases because some costs remain constant in the short run. But not all costs remain constant.

They may have to pay overtime wages to increase their output. If the supply of inputs is limited, it may also lead to an increase in cost. These cost pressures increase when the rate of output increases. As time passes, the costs that were initially constant will also move upward. Therefore, the cost of producing goods and services will increase. In such cases, producers will increase the output only when the prices of the output increases at least at the rate cost of production is increasing.