Chapter 20 Output and aggregate demand David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

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 See the introduction to Chapter 20 in the main text.

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 These assumptions underlie the analysis of this Chapter, but will all be relaxed in later Chapters. See the introduction to Chapter 20 in the main text.

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 See Section 20-1 and 20-2 of the main text.

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 (plus transfers less taxes) See Section 20-1 of the main text.

Consumption and income in the UK at constant 1995 prices, 1989-2001 See Section 20-1 of the main text. Figure 20-1 shows a similar picture but for a longer time period, which creates a stronger impression of linearity in the relationship. The data shown here are measured at constant 1995 prices. Income is a strong influence on consumption expenditure – but not the only one.

Consumption and income in Turkey at current prices, 1996-2005

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. See Section 20-1 and Figure 20-2 in the main text. Income

The saving function S = -8 + 0.3 Y Saving 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. See Section 20-1 and Figure 20-3 in the main text. Income

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 See Section 20-2 and Figure 20-4 in the main text. Income

Equilibrium output 45o line E AD The 45o line shows the points at which desired spending equals output or income. equilibrium is thus at E. E Desired spending AD Given the AD schedule, See Section20-3 and Figure 20-5 in the main text. Adjustment towards this equilibrium is expected: if output is below the equilibrium, then there will be an unplanned rundown of stocks, and firms will realize that they can sell more, because AD exceeds supply. SO the signals are there to ensure that the economy moves towards equilibrium. Similarly if output is above equilibrium, stocks will accumulate, and firms will realize that they are producing too much. This the point at which planned spending equals actual output and income. Output, Income

An alternative approach An equivalent view of equilibrium is seen by equating S, I S to planned saving (S) I planned investment (I) E again giving us equilibrium at E See Section 20-4 and Figure 20-6 in the main text. Output, Income The two approaches are equivalent.

Effects of a fall in aggregate demand 45o line Suppose the economy starts in equilibrium at Y0. AD0 a fall in aggregate demand to AD1 AD1 Desired spending leads the economy to a new equilibrium at Y1. Y1 See Section 20-5 and Figure 20-7 in the main text. Y0 Output, Income Notice that the change in equilibrium output is larger than the original change in AD.

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. See Section 20-6 in the main text.