Understanding how the entire economy behaves requires looking at broad indicators like total demand and total supply. This unit dives into the concept of aggregate demand (AD) and aggregate supply (AS) and how they determine the overall level of economic activity. It also introduces two major schools of thought—Classical and Keynesian economics—that offer different perspectives on how economies function, especially during crises.
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What is Aggregate Demand?
Aggregate demand refers to the total demand for goods and services in an economy at a given price level and time. It’s not just about consumers buying things—it includes spending by households, businesses, government, and foreign buyers (exports).
Components of Aggregate Demand:
Consumption (C) – Household spending on goods and services
Investment (I) – Business expenditure on capital like machinery
Government Spending (G) – Expenses on public services and infrastructure
Net Exports (X – M) – Exports minus imports
So, the formula becomes:
AD = C + I + G + (X – M)
Each of these components is influenced by various factors. For example, consumption depends on income levels, while investment depends on interest rates and business confidence.
What is Aggregate Supply?
Aggregate supply is the total quantity of goods and services that firms are willing and able to produce in an economy at a certain price level. It reflects the productive capacity of the economy.
There are two types of AS:
Short-run Aggregate Supply (SRAS): Can change with prices due to sticky wages and contracts.
Long-run Aggregate Supply (LRAS): Represents the full employment level of output; vertical because price changes don’t affect long-term output.
In simple terms, when prices go up, businesses might supply more in the short run, but in the long run, the output depends on factors like technology, labor, and capital.
Consumption and Saving Functions
These two functions help us understand how people use their income.
Consumption Function: Shows the relationship between income and how much households consume. Generally, as income rises, consumption also increases—but not by the full amount.
Example: If you earn ₹10,000 more, you might spend ₹8,000 and save ₹2,000.
Saving Function: The part of income not consumed. It’s influenced by income, interest rates, and future expectations.
These functions are important because they show how money flows in the economy—either back into the market (through spending) or into banks (as savings).
Classical vs. Keynesian Economics
Two major schools of thought offer different views on how economies work.
Classical Economics:
Believes in self-regulating markets.
Say’s Law: “Supply creates its own demand.” This means if you produce something, someone will buy it.
Advocates for minimum government intervention.
Assumes wages and prices adjust quickly to changes.
In this view, unemployment is only temporary because the economy will correct itself naturally.
Keynesian Economics:
Developed by John Maynard Keynes during the Great Depression.
Believes that demand drives the economy, not just supply.
Introduced the concept of Effective Demand – the actual demand that determines employment and output.
Supports government intervention to manage demand through fiscal and monetary policies.
Keynes argued that in times of economic downturn, people stop spending and businesses stop investing, leading to job losses. Government spending can help break this cycle.