1. 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

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
See the introduction to Chapter 20 in the main text.

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
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.

4. 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 of the main text.

5. 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.

6. 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.

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

8. 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.
See Section 20-1 and Figure 20-2 in the main text.
Income

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

10. 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

11. 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

12. 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.

13. 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.

14. 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.