Q.Elaborate the two components of Aggregate Supply in a two-sector economy.

In a two-sector economy (households and firms, with no government or foreign trade), Aggregate Supply (AS) is the total value of final goods and services that all firms in the economy plan to produce during a given period. It is identical to the National Income (Y) generated from that production.

The two components of Aggregate Supply are:

• Consumption (C): This is the total expenditure by households on goods and services. It depends primarily on disposable income and is given by the consumption function: C = a + bY, where 'a' is autonomous consumption (consumption when income is zero) and 'b' is the marginal propensity to consume (MPC). …

To understand Aggregate Supply, we first need to set the scene. In macroeconomics, we study the economy as a whole. A two-sector economy is the simplest model — it assumes only two decision-making agents: households (who consume) and firms (who produce). There is no government, no foreign trade. In this closed, private economy, the entire national output is produced by firms and then distributed to households as factor payments — wages, rent, interest, and profit.

Now, what happens to this income? Households do not spend every rupee they earn. They divide their income into two parts: what they spend on goods and services (Consumption), and what they set aside for future use (Saving). This division is the key to understanding the two components of Aggregate Supply.

Aggregate Supply is defined as the total value of final goods and services planned to be produced by all producing units in an economy during a given period. But more usefully, it is also the total income generated from that production. Since income is either consumed or saved, we can write:

Aggregate Supply (AS) = Consumption (C) + Saving (S)

Let us elaborate each component.

1. Consumption (C)

Consumption is the total expenditure by households on final goods and services during a given period. It is not a fixed number — it depends primarily on the level of income. This leads to the consumption function, which shows the relationship between consumption and income:

Here, $\bar{C}$ is autonomous consumption — the minimum consumption that occurs even when income is zero (households borrow or use past savings to survive). The term $bY$ is induced consumption, where $b$ is the marginal propensity to consume (MPC), the fraction of each additional rupee of income that is spent on consumption. So consumption has two parts: a fixed base and a portion that rises with income.

2. Saving (S)

Saving is that part of income which is not consumed. It is the residual:

$S = Y - C$ …