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
effective

DETERMINATION 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
C = a + bY
...(ii)
I = Ia

...(i)

..(iii)

Substituting the values of C and I in equation (i) we have

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

...(iv)

The equation (v) shows the equilibrium level of national

income when aggregated demand
equals aggregate supply.

The equation (v) reveals that autonomous consumption and autonomous

investment (a + Ia) generates so much expenditure or aggregate demand
which is equal to the
income 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 + 0.8Y
Given the above, find out the equilibrium level of income.
Solution. The equilibrium level of income is
Y=C+I
...()
c = 200 + o.sy
I = 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 Y
I = 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
Y = 20 + 0.6Y + 10 + 0.2K
Y = 30 + 0.8V
Y - O.SY = 30
Y(1 - 0.810 = 30
0.2 Y = 30

Thus, we find that the equilibrium level of income to be equal to

NATIONAL 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 .
6

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.