Ch204 - U N I T III DETERMINATION OF INCOME EMPLOYMENT AND...

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D ETERMINATION OF I NCOME AND E MPLOYMENT UNIT-III
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Introduction It is an established principle in macroeconomics that the aggregate demand and the aggregate supply together determine the level of aggregate output of goods and services, aggregate employment and the general price level in an economy. Therefore, as the first step, the meaning of the concepts of aggregate demand and aggregate supply are explained below. Aggregate Demand Aggregate demand is the total demand for goods and services in the economy. The aggregate demand is usually related to the price level. An inverse relationship could be assumed between these two variables. That is, the greater the price level the lower the aggregate demand and vice versa. 1 Figure 4.1 shows the aggregate demand curve. In the Figure 4.1, the curve AD is the aggregate demand curve. The X-axis A GGREGATE D EMAND AND A GGREGATE S UPPLY IN M ACROECONOMICS C HAPTER 4 1 Explanation of specific reasons for the downward sloping nature of the aggregate demand curve is beyond the scope of this book. It may be dealt with during higher studies in economics. 2 The Classical school of economics ranged from Adam Smith in the 18 th century to A. C. Pigou in 20 th century. The Classical approach to macroeconomics (all writings on macroeconomics prior to that of John Maynard Keynes) believed that the economy would normally be in a state of full- employment equilibrium. The reason for this belief was their acceptance of Say’s law of markets. Say’s law, in brief, maintained the impossibility of any deficiency in aggregate demand. measures the output of goods and services. The Y-axis measures the price level. Aggregate Supply Aggregate supply is the total supply of goods and services in the economy. In respect of aggregate supply there is no such clear-cut relationship with the price level. In macroeconomics we have two different kinds of aggregate supply concepts based on two different sets of assumptions. They are: (a) the Classical concept of aggregate supply, and (b) the Keynesian concept of aggregate supply. We shall take up these two concepts one by one. Classical Concept of Aggregate Supply In the Classical 2 concept, the aggregate supply is perfectly inelastic with respect to the price level. This means that changes in the price level have no
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I NTRODUCTORY M ACROECONOMICS 42 effect on the aggregate supply. The classical aggregate supply curve is shown in Figure 4.2. The X-axis measures the output. The Y-axis measures the price level. The curve AS is the aggregate supply curve. Q * is the full-employment level of output of goods and services. The aggregate supply curve is a vertical line at the full-employment level of output. This means that changes in the price level have no effect on the aggregate supply.
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