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Supply of goods and services in a country depends on the productive capacity of the country and the capacity does not change in the shortrun. Economy needs to adjust to changes in aggregate demand so that the aggregate supply matches with aggregate demand i.e., becomes equal to aggregate demand Increase in effective demand (consumption demand plus investment demand) will lead to increase in aggregate supply and also, of national income. Consumption demand depends on propensity to consume. Therefore, in order to increase national income propensity to consume should be increased. Investment depends on marginal efficiency of capital (mec) and rate of interest but since the rate of interest is relatively stable, change in investment largely depends on change in mec and expected rate of profit from investment. MEC depends on replacement cost of the capital goods and profit expectations of which the later is a more important determinant of investment. Thus, if a country wants to increase national income and employment, it should create conditions in which profit expectations of investors/businessmen go high.
General Comments
Effective Demand E
&
I N V E S T
I=S Investment
National Income
Y1
Abscissa shows national output (GNP) and the ordinate shows consumption demand and investment demand. The 450 line represents aggregate supply, also called Income line and shows two things: (a) total output or aggregate supply and (b) national income i,e,, national output in terms of money
Inflationary and Deflationary Gap Inflationary gap is a situation when consumption and investment spending together are greater than the full employment level GNP i.e., the people demand more goods and services than the amount of that produced. Deflationary gap comes into existence if total aggregate demand is insufficient to create full employment.
Inflationary Gap
Y = C + S aggregate supply D C, I, G Inflationary gap C+I+G C+I Aggregate Demand B C Consumption A
I=S Investment
YX
YFX = full employment limit on real output and YFX = total demand = C + I + G; YX = total real output, which is the required real output but cannot be reached (it is beyond YFX i.e., the full employment limit). Thus the demand for output is YxD and the supply is YFXB creating an inflationary gap AB
Deflationary Gap
Y = C + S aggregate supply D C, I, G Deflationary gap C+I+G A C + I + G C+I Aggregate Demand C Consumption YX Output =National Income YFX
YFX = Total out at full employment level. Total demand is (C + I + G) and it cuts the 450 line at D. But if (C + I + G) is not achieved and the actual demand is (C + I + G), the equilibrium would be at B creating a deflationary gap AB.