Page 84 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 4: Theories of Income, Output and Employment: Keynesian Theory

Notes
Household sector formed 65% of the Gross domestic savings at 24.3% of the GDP in
2007-08, whereas private corporate sector formed 23% and public sector 12% of the share.
Encouragingly, public sector savings have been on the up, growing from 1.1% to 4.5% in
the 2003-04 to 2007-08 period.

Question:
Analyse the trend in AD during the economic slowdown in 2007-2008.
Answer: There was a fall in private consumption and increase in gross capital formation.
People were more willing to save and invest than to consume.

Source: Interesting trends in aggregate demand from the Economic Survey 2008-09
4.2.2 Aggregate Supply Curve

The aggregate supply (AS) curve shows relationship between the overall price level (P) and the
aggregate output (Y). It is also 'price-output response' curve. In the short run, it is taken to be
upward sloping, fairly flat at low levels of output and vertical when the economy is producing
the maximum it can. In the long run, the AS curve is taken to be vertical throughout, i.e. parallel
to the Y-axis. The reasons for the assumed shapes are explained below.
Short Run as Curve

Shape: The short run AS (SAS) curve (Figure 4.12) is taken to be upward sloping with two distinct
characteristics: (i) fairly flat at the low levels of output and (ii) vertical when economy is producing
the maximum. First let us see why it is upward sloping.
Figure 4.12

Why upward sloping?: When P rises, both the output prices and the input prices rise. But, in the
short run, output prices rise first and the input-prices follow with a time lag. This raises profits
of the firms during time lag and induces them to produce more. This makes the SAS curve
upward sloping.

Why fairly flat at the low levels of output?: When there is downturn in the economy the output
level is low and the firms tend to reduce output. But when output level is very low, the firms
may not reduce inputs, e.g. labour and capital already employed. There are two reasons for this
behaviour:
First, the expectations among the firms are that downturn is a temporary phase and will
be over soon.

LOVELY PROFESSIONAL UNIVERSITY 79