AGGREGATE SUPPLY CURVE:

aggregate supply curve:

There are three concepts of aggregate supply curve.

One concept of aggregate supply relates the number of labour employed with the cost of production or receipts which must be recovered by employing a certain number of workers.

The second concept relates aggregate supply of output with the price level.

The other concept relates aggregate supply of output with national income.

Since in the simple Kcynesian model of determination of national income price level is assumed to be given and constant, it is the concept of aggregate supply curve which associates the level of aggregate output with the national income that is used here.

It is also worth noting that in order to simplify the analysis of determination of income and employment we assume that the nature of production function is such that average and marginal productivity of labour remains constant over a relevant portion. Along with these if money wage rate is taken to be rigid or constant, then average and marginal cost of output will not change as more output is produced and offered for sale in the market. Thus, in the Keynesian model of determination of income and employment in drawing the aggregate supply not only the stock of capital, population size, state of technology, average and marginal products of labour and money wages are assumed to remain constant but also the price level of output is held constant. This type of aggregate supply curve is shown by 45 line drawn against the X and X- axes as the line OZ in Fig. where along the A'-axis national Income and along the K-axis aggregate supply of output are measured. This 45 line should be carefully understood. All points on 45 line have the property that along with this the distance measured on the horizontal axis.

This means, as explained above, aggregate supply or national product equal national income. Further, the straight line 45 line shows that the value of aggregate output increases at a constant rate. This is so because in drawing this aggregate supply curve, price level, money wages and productivity of labour are assumed to remain constant. If price level or money wage or productivity changes as level of aggregate production is varied, then aggregate supply curve cannot be a 45 straight line throughout. It follows from above that 45 line shows two things. First, it shows varying levels of aggregate production or the supply of goods (both consumer and capital goods) will be offered for sale at the given price level. This shows that up to the level of full-employment of resources any amount of aggregate supply of output will be forthcoming at the given price level depending on the aggregate demand. The greater the aggregate demand, the greater the aggregate supply of output. Secondly, it represents national income in money terms. In fact, as you would have read in national income accounting, national product and national income are the same things.equilibrium level of national income:

C + I curve represents the aggregate demand and 45 OZ line represents aggregate supply. It will be seen in Fig. that these two curves intersect at point . That is, at point E which corresponds to the income level OV|, aggregate demand is equal to aggregate supply. Therefore, E is the equilibrium point and OY1 represents the equilibrium level of national income. Now, income cannot be in equilibrium at levels smaller than OY1. This is because at any level of aggregate output (i.e., national income) smaller than OY1, aggregate demand exceeds aggregate supply of output since C + I curve lies above 45 line which depicts aggregate supply of output.

Thus when at a given level of national income, aggregate expenditure (i.e., aggregate demand) exceeds aggregate supply of output, national income will increase. With this increase in national income or output, employment of labour will also rise to produce the increment in output. This process of expansion in output under the pressure of excess demand will continue till national income OY1 is On the contrary, the level of national income cannot be greater than OK, because at any level greater than OY1, aggregate expenditure or demand (C + I) falls short of aggregate supply of output. This will cause the increase in inventories of goods with the firms beyond the desired levels. To this situation of the unintended increase in inventories of goods, the firms will respond by cutting down production to keep their inventories at the desired levels. Thus, deficiency in aggregate demand relative to the aggregate supply of output will lead to the fall in national income and output until the level OY1 is reached where aggregate demand (C + I) is equal to the value of aggregate supply. Thus, OY1 is the equilibrium level of national income.principle of effective demand:

Aggregate demand (AD) curve C + I shows varying levels of aggregate demand at various levels of national income. Aggregate demand is not equal to aggregate supply at all levels of national income.

The particular aggregate demand which is equal to aggregate supply and therefore determines the equilibrium national income is called effective demand.

In other words, effective demand is that level of aggregate demand which becomes effective in determining equilibrium level of income because it is equal to aggregate supply. This is called Keynesian principle of effective demand. In Fig., the effective demand is equal to Y1E. Note that the level of national' income OY1 which has been determined equals the effective demand Y1E (OY1 = Y1E).

There are several other points on the aggregate demand curve but what distinguishes effective demand from all these points is that at this point aggregate demand is equal to aggregate supply. On all other points aggregate demand is either more or less than aggregate supply. Thus, the level of national income is determined by and equal to effective demand. In a two sectors Keynesian model, we can express the principle of effective demand in symbolic terms as under :

Y= AD* AD* = C+ I

Y= AD* = C + I where Y = National income

AD* = Effective demand

C = Consumption demand

I = Investment

Note that star mark on AD shows the aggregate demand which becomes effectivedetermination of equilibrium level of national income: Alzebric analysis: In a simple model of income determination in which we do not consider the impact of Government expenditure and taxation and also exports and imports, the national income is the stun of consumption demand (Q and investment demand (I), that is,

Y = C + I

where Y stands for the level of national income.

Suppose the consumption function is of the following form .

C = a + bY

a is the intercept term in the consumption function and therefore represents the autonomous consumption expenditure which does not vary with income, b is a constant which represents the marginal propensity to consume (mpc = C/Y).

Thus total consumption demand is equal to the sum of autonomous consumption expenditure (a) and the induced consumption expenditure (bY). Now suppose that investment demand equals Ia. This investment Ia is autonomous because this does not depend on income. Thus, we get the following three equations for the determination of the equilibrium level of national income.

Y= C + I...(i)C = a + bY ...(ii)

I = Ia ..(iii) Substituting the values of C and I in equation (i) we have

V= a + bY + I...(iv)Y - bY = a + IaY (1 - b) = a + Ia (v)

The equation (v) shows the equilibrium level of national income when aggregated demandequals aggregate supply.

The equation (v) reveals that autonomous consumption and autonomousinvestment (a + Ia) generates so much expenditure or aggregate demand which is equal to theincome generated by the production of goods and services.

From the equation(v) it also follows that the equilibrium level of national income can be known from multiplying the elements of autonomous expenditure (that is, a + Ia) by the term which is equal to the value of multiplier.

Q) Suppose in an economy, autonomous investment (I) is Rs 600 crores and the following consumption function is given:C = 200 + 0.8YGiven the above, find out the equilibrium level of income.Solution. The equilibrium level of income is

Y= C + I...()c = 200 + o.syI = 600 Putting the values of C and I in the equilibrium equation (0 we have

Y= 200 + 0.8V + 600(Y - 0.8V) = 200 + 600

Y (1 - 0.8) = 800

Q) Suppose the consumption function of an economy is C - 0.8 Y. Planned investment by entrepreneurs for a year is Rs. 500 crores. Find out what will be the equilibrium level of income.Solution.Y = C + I...(/)c = 0.8 YI = Rs. 500 crores Substituting the values of C and I in (i) we have

Y= 0.8K + 500

Y- 0M =500

Y(1 - 0.8) = 500

0.2 = 500

Q) Suppose the consumption of an economy is given by C = 20 + 0.6Y The following investment function is given :I = 10 + 0.2Y

What will be the equilibrium level of national income?Solution. Note that in this problem, investment varies with income. However, this will not change our method of determining equilibrium level of income.

Y= C + I...(i)C = 20 + 0.6V

I = 10 + 0.2y Substituting the values of C and I in (i) we have

= 20 + 0.6Y + 10 + 0.2K = 30 + 0.8VY- O.SY = 30Y(1 - 0.810 = 30

0.2 Y = 30

Thus, we find that the equilibrium level of income to be equal tonational income and imployment:

In fact, the levels of national income and employment are determined jointly. It is worth nothing that, in Keynesian theory, employment is a function of income. Relation between income and labour employment is given by production function showing diminishing returns to labour. This production function can be stated as under .

According to above function, given the capital stock and technology, the greater the level of national output (i.e. income or Y), the greater will be the number of workers (N) employed. According to Keynesian theory, levels of national income and employment are determined by aggregate effective demand. In a closed economy with no intervention by the government, aggregate demand consists of consumption demand and investment demand. According to Keynes, consumption function is stable in the short run and it is investment demand which is highly volatile in-the short run as it depends on profit expectations of business men. Equilibrium at full employment level of income is determined when investment expenditure fills the saving gap at full employment level of national income.

According to Keynes, equilibrium at full-employment level of income OYF will be determined if planned investment expenditure by entrepreneurs is equal to saving HT at full-employment level of national income.

OYF Total expenditure (i.e., aggregate demand) and output produced are both equal to OQ corresponding to equilibrium point H, (OQ = OYF). In the left-side panel (a) where production function curve TP has been drawn, we have measured employment of labour on the X-axis and aggregate output on the Y-axis. With the fall in investment expenditure, aggregate demand curve shifts downward to the dotted position C + I' which intersects aggregate supply curve OZ (i.e., 45 line) at point R. As a result, new equilibrium level of national income OY1 is determined (OY1 = OQ1). It will be seen from left side panel (a) that aggregate output (i.e., national product) OQ1 is produced by employing ON1 amount of labour. Thus, as a result of fall in aggregate demand, N1NF number of workers are rendered unemployed. N1NF workers will be involuntarily unemployed. According to Keynes, there is not, any mechanism which should ensure that this involuntary unemployment will Be automatically eliminated.national income and employment: how can they be increased:

In order to increase national income through upward shift in the consumption function, the Government can reduce personal income taxes. The rate of unemployment sharply declined and the American economy was lifted out of depression. Recently, in 2003, the President George W. Bush made a cut of 3.5 billion dollars in income tax to revive the American economy. Secondly, the equilibrium level of national income (GNP) and employment can be increased by raising the rate of private investment (I). Businessmen can be induced to invest more by lowering the rate of interest and increasing the availability of credit. We know that lower the rate of interest, the higher will be the level of private investment. Alternatively, the Government may encourage private investment by reducing tax on profits so that post-tax rate of profit will be higher than before. The higher level of investment will shift the aggregate demand curve (C + I + G) upward and determine a higher level of national income and employment. Thirdly, the national income (GNP) and employment can be increased by increasing Government expenditure on goods and services (G). It was the increase in Government expenditure on Public Works Programme which was the main recommendation of Keynes to raise the level of national output and income to restore equilibrium at full-employment level. Lastly, the expansion in positive net exports (Xn) will also cause an increase in equilibrium level of national income and employment.8