Chapter 16 Output and aggregate demand ©McGraw-Hill Companies, 2010

Aggregate output in the short run Potential output the output the economy would produce if all factors of production were fully employed Actual output what is actually produced in a period which may diverge from the potential level ©McGraw-Hill Companies, 2010 2

Some simplifying assumptions Prices and wages are fixed. The actual quantity of total output is demand-determined. This will be a Keynesian model. For now, also assume: no government no foreign trade. Later chapters relax these assumptions. ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 Aggregate demand Given no government and no international trade, aggregate demand has two components: Investment firms’ desired or planned additions to physical capital & inventories for now, assume this is autonomous Consumption households’ demand for goods and services so, AD = C + I ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 Consumption demand Households allocate their income between consumption and saving. Personal Disposable Income income that households have for spending or saving income from their supply of factor services ©McGraw-Hill Companies, 2010 5

Consumption and income in the UK at constant 1995 prices, 1989-2004 GDP ©McGraw-Hill Companies, 2010 6

The consumption function The consumption function shows desired aggregate consumption at each level of aggregate income. With zero income, desired consumption is 8 (“autonomous consumption”). 8 C = 8 + 0.7 Y Consumption The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed. Income ©McGraw-Hill Companies, 2010 7

©McGraw-Hill Companies, 2010 The saving function The saving function shows desired saving at each income level. Saving S = -8 + 0.3 Y Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. Income ©McGraw-Hill Companies, 2010 8

The aggregate demand schedule Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. AD = C + I I The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) Aggregate demand C Income ©McGraw-Hill Companies, 2010 9

©McGraw-Hill Companies, 2010 Equilibrium output 45o line The 45o line shows the points at which desired spending equals output or income. E equilibrium is thus at E. Desired spending AD Given the AD schedule, This is the point at which planned spending equals actual output and income. Output, Income ©McGraw-Hill Companies, 2010 10

An alternative approach An equivalent view of equilibrium is seen by equating: S, I S I planned investment (I) to planned saving (S), E again giving us equilibrium at E. Output, Income The two approaches are equivalent. ©McGraw-Hill Companies, 2010 11

Effects of a fall in aggregate demand 45o line AD0 Suppose the economy starts in equilibrium at Y0. a fall in aggregate demand to AD1 AD1 Desired spending leads the economy to a new equilibrium at Y1. Y1 Y0 Output, Income Notice that the change in equilibrium output is larger than the original change in AD. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 The multiplier The multiplier is the ratio of the change in equilibrium output to the change in autonomous spending that causes the change in output. The larger the marginal propensity to consume, the larger is the multiplier. The higher is the marginal propensity to save, the more of each extra unit of income ‘leaks’ out of the circular flow. ©McGraw-Hill Companies, 2010 13

©McGraw-Hill Companies, 2010 The paradox of thrift A change in the amount households wish to save at each income leads to a change in equilibrium income, but no change in equilibrium saving, which must still equal planned investment. This is the paradox of thrift. Thus, when aggregate demand is low and the economy has spare resources, the paradox of thrift shows that a reduction in the desire to save will increase spending and increase the equilibrium income level. Society benefits from higher output and employment. And since investment demand is autonomous, a change in the desire to save has no effect on the desired level of investment. ©McGraw-Hill Companies, 2010 14

©McGraw-Hill Companies, 2010 UK Saving rates Source: OECD ©McGraw-Hill Companies, 2010 15