Aggregate Demand and Related Concepts
Aggregate Demand, Aggregate Supply, the consumption function, and the propensities to consume and save.
Definition
Aggregate Demand (AD) is the total planned expenditure on final goods and services in an economy over a year; Aggregate Supply (AS) is the total value of final output producers plan to supply over the same period.
Simple Explanation
AD is everyone's total planned spending added up; AS is everything producers plan to make — comparing the two is the starting point for figuring out where the whole economy will settle.
Detailed Explanation
In the simple two-sector model (households and firms only, no government or foreign sector), Aggregate Demand is AD = C + I, the sum of planned Consumption expenditure and planned Investment expenditure. Aggregate Supply, in this same model, is treated as exactly equal to national income (Y), since whatever value of output is produced becomes, by the circular flow, an identical value of income earned by someone.
The single most important relationship in this model is the Consumption Function, C = a + bY: consumption rises as income rises, where 'a' is autonomous consumption (the amount consumed even at zero income, financed by past savings or borrowing) and 'b' is the Marginal Propensity to Consume (MPC) — the fraction of every extra rupee of income that gets spent rather than saved.
Four related propensities are tested precisely: Average Propensity to Consume (APC = C/Y, the proportion of total income consumed), Average Propensity to Save (APS = S/Y), Marginal Propensity to Consume (MPC = ΔC/ΔY, the proportion of EXTRA income consumed), and Marginal Propensity to Save (MPS = ΔS/ΔY). Since every extra rupee of income is either spent or saved and nothing else, MPC + MPS always equals exactly 1 — though APC + APS also equals 1, the two pairs are not interchangeable, since APC/APS depend on the level of income while MPC/MPS are constant for a linear consumption function.
Because saving is simply the part of income not consumed, the Saving Function follows directly from the Consumption Function: S = Y − C = Y − (a + bY) = −a + (1−b)Y. This identity is exactly why a question can always be answered using either the consumption side or the saving side of the same relationship.
Real-life Examples
Autonomous consumption
Even a household with zero current income still spends something on food, often financed by past savings or borrowing — this is autonomous consumption (the 'a' in C = a + bY).
MPC in a pay rise
If a person earning a ₹10,000 bonus spends ₹7,000 of it and saves ₹3,000, their MPC from that bonus is 0.7 and their MPS is 0.3.
Formulas
Consumption Function
C = a + bY
Consumption as a linear function of income, with autonomous consumption a and MPC b.
Saving Function
S = −a + (1 − b)Y
Derived directly from the consumption function, since S = Y − C.
MPC + MPS Identity
MPC + MPS = 1
Every extra rupee of income is either consumed or saved.
Tables
| Concept | Formula | Meaning |
|---|---|---|
| APC | C / Y | Proportion of total income consumed |
| APS | S / Y | Proportion of total income saved |
| MPC | ΔC / ΔY | Proportion of extra income consumed |
| MPS | ΔS / ΔY | Proportion of extra income saved |
Common Mistakes
- Using APC/APS formulas when a question asks specifically for MPC/MPS — they differ unless the consumption function has no intercept (a = 0).
- Forgetting autonomous consumption 'a' and treating consumption as purely proportional to income.
- Assuming AS always equals Y in every model — this holds only in the simple two-sector Keynesian model used at this level.
Board Exam Tips
- Always derive MPS as (1 − MPC) when only MPC is given — examiners frequently test this identity.
- When deriving the saving function from the consumption function, show the substitution S = Y − C step by step.
- Define AD and AS precisely for the two-sector model before using them in any diagram or numerical.
Summary
- Aggregate Demand in the two-sector model is AD = C + I; Aggregate Supply is treated as equal to Y.
- The consumption function C = a + bY links consumption directly to income via autonomous consumption and MPC.
- MPC and MPS always sum to 1 for any change in income.
- The saving function S = −a + (1−b)Y follows directly from the consumption function.
- APC and APS depend on the income level; MPC and MPS are constant for a linear consumption function.
Practice MCQs
1. In the simple Keynesian model, Aggregate Supply is assumed to equal:
2. In the consumption function C = a + bY, the term 'a' represents:
3. If MPC = 0.75, then MPS equals:
4. Average Propensity to Consume (APC) is calculated as:
5. The saving function S = −a + (1−b)Y is derived from the fact that:
6. MPC and MPS for a linear consumption function are:
Previous Year Questions
MPC + MPS is always equal to: (a) 0 (b) 1 (c) 2 (d) Depends on income
Distinguish between Average Propensity to Consume and Marginal Propensity to Consume.