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

2. 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

3. 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

4. ©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

5. ©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

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

7. 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 = 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

8. ©McGraw-Hill Companies, 2010
The saving function
The saving function shows
desired saving at each
income level.
Saving
S = 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

9. 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

10. ©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

11. 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

12. 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

13. ©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

14. ©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

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