Capter 16 Output and Aggregate Demand 1 Chapter 16: Begg, Vernasca, Fischer, Dornbusch (2012).McGraw Hill

Learning Objectives Potential output vs. current output Distinguish between autonomous expenditure and induced expenditure and explain how real GDP influences expenditure plans Explain how real GDP adjusts to achieve equilibrium expenditure Explain the expenditure multiplier 2

Aggregate Output Full employment output (or potential output) is the level of output produced when the labor market is in equlibrium and the economy is producing at full employment Potential output is not the maximum level of output an economy can produce 3

Aggregate Output Potential output reflects the level of labour that workers wish to supply Current output what is currently produced, and might be diverge from potential output 4

The Aggregate Expenditure Model Prices and wages are fixed Output is determined by the demand side For the time being, we assume that there is no Government Foreign Trade 5

The Aggregate Expenditure Model A model that explains what determines the quantity of real GDP demanded and changes in that quantity at a given price level Aggregate Expenditure: Consumption, and Investment 6

The Aggregate Expenditure Model The key assumption is that we divide expenditure plans into: Autonomous expenditure does not respond to changes in real GDP Induced expenditure does respond to changes in real GDP 7

The Consumption Function All income is either spent on consumption or saved in an economy in which there are no taxes Saving = Aggregate Income-Consumption 8

The Consumption Function Some of the determinants of aggregate consumption: Household Income Household Wealth Interest rates Household’s expectations about the future 9

The Consumption Function In the General theory, Keynes argued that consumption depends directly on income Consumption function: C =A+ cY 10

The Consumption Function The slope of the consumption function ( c ) is called the marginal propensity to consume (MPC), or the fraction of a change in income that is consumed, or spent, 0<c<1 11

The Consumption Function 12 C = b + cY ∆C ∆Y c ∆C A

The Consumption Function The fraction of a change in income that is saved is called the marginal propensity to save (MPS). Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore, 13

The Consumption Function 14 At a national income of zero, consumption is $100 billion ( a ). For every $100 billion increase in income (  Y), consumption rises by $75 billion (  C).

The Consumption Function 15 = Disposable Income (DI) (Income - Net Taxes) C = A + c (Y – T) A = autonomous consumption expenditure c = marginal propensity to consume

The Determinants of Consumption Expectations: a more optimistic outlook on the economy will raise consumer’s expenditures The interest rate cause consumers to postpone consumption Others: price level, and wealth 16

Changes in the Consumption Function Consumption expenditure increases and the consumption function shifts upward if The real interest rate falls Wealth increases Expected future income increases 17

Real interest rates falls, wealth increases, expected future income increases Changes in Consumption Function 18 ysyshsjjahbjjhdbfkjslkjba slkjnaslkjcnbaklsjcnalijks xncsjsbjbjhbjbjhbjbjhbjbj habjhsbjhbashb ysbjhbashb Real interest rates increases, wealth decreases, expected future income decreases

The Saving Function 19 Y-C=S AGGREGATE INCOME (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) ,

Investment Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock. One component of the inventory is determined by how much households decide to buy, which is not under complete control of firms 20

Investment Change in Inventory = Production - Sales 21

Actual versus Planned Investment Desired or Planned investment refers to the additions to capital stock and inventory that are planned by firms. Actual Investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories 22

The Planned Investment Function For now, we assume that planned investment is fixed That is, it does not change when income changes The planned investment is an autonomous variable 23

The Planned Investment Function 24

Investment Function Investment is autonomous (independent of income) 25

Investment Function At this point investment is planned investment expenditures (I) Investment is closely linked to the interest rate, since interest represents the opportunity cost of investing in capital The investment function will shift with changes in expectations for business profits 26

Autonomous Investment Although investment is related to the interest rate and business expectations, investment does not depend in any significant way on disposable income As such, investment is “autonomous” However, changes in the interest rate or expectations for profits will still shift autonomous investment 27

Determinants of Investment Factors that can cause a shift in the investment function are: The interest rate Expectations Technology 28

Planned Aggregate Expenditure = Aggregate Demand Planned aggregate expenditure is the total amount the economy plans to spend in a given period. It is equal to Aggregate Demand. It is equal to consumption (C) plus planned investment (I). 29

Aggregate Demand 30

Equilibrium In the macroeconomics good market, equilibrium occurs when desired spending equals to aggregate output, income 31

Equilibrium Output = Desired Spending Y =AD = C + I Disequilibria Output > Desired Spending Output < Desired Spending 32

Equilibrium 33

Equilibrium Aggregate Demand: Output (Income) Deriving the Desired Spending Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C = Y. (1)(2)(3)(4)(5)(6) AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT (I) DESIRED (AD) C + I UNPLANNED INVENTORY CHANGE Y (C + I) EQUILIBRIUM? (Y = AD)  100 No  75 No  25 No Yes No No 1, No

Equilibrium Aggregate: Output (Income) (1) (2) (3) By substituting (2) and (3) into (1) we get: There is only one value of Y for which this statement is true. We can find it by rearranging terms:

The Saving and Investment approach to equilibrium Aggregate output (Y) will be equal to Aggregate Demand only when saving equals planned investment (S = I). 36

The Multiplier The multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable. An autonomous variable is a variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. In this chapter, for example, we consider planned investment to be autonomous 37

The Multiplier The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income. The size of the multiplier depends on the slope of the planned aggregate expenditure line. 38

The Multiplier The marginal propensity to save may be expressed as: Because  S must be equal to  I for equilibrium to be restored, we can substitute  I for  S and solve: 39

The Multiplier 40 After an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment. AD 2 = C + I + ∆I AD 1 = C + I ∆AD = ∆C + ∆I

The Paradox of Thrift When households become concerned about the future and decide to save more, the corresponding decrease in consumption leads to a drop in spending and income. Households end up consuming less, but they have not saved any more.