1. © The McGraw-Hill Companies, 2008 Chapter 20 Output and aggregate demand David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. © The McGraw-Hill Companies, 2008 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

3. © The McGraw-Hill Companies, 2008 Some simplifying assumptions Prices and wages are fixed Actual output is less than potential output Excess capacity so the actual quantity of total output is demand-determined –this will be a Keynesian model –An increase in demand will increase the production. For now, also assume: –no government –no foreign trade Later chapters relax these assumptions

4. © The McGraw-Hill Companies, 2008 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

5. © The McGraw-Hill Companies, 2008 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)

6. © The McGraw-Hill Companies, 2008 Consumption and income in the UK at constant 1995 prices, 1989-2004 Income is a strong influence on consumption expenditure – but not the only one.

7. © The McGraw-Hill Companies, 2008 Consumption and income in Turkey, 1996-2005 7

8. © The McGraw-Hill Companies, 2008 The consumption function Income Consumption C = 8 + 0.7 Y The consumption function shows desired aggregate consumption at each level of aggregate income 0 The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed. With zero income, desired consumption is 8 (“autonomous consumption”).8

9. © The McGraw-Hill Companies, 2008 The saving function S = -8 + 0.3 Y Income Saving 0 The saving function shows desired saving at each income level. Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa.

10. © The McGraw-Hill Companies, 2008 The aggregate demand schedule Income Aggregate demand C 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.)

11. © The McGraw-Hill Companies, 2008 Equilibrium output Output, Income Desired spending 45 o line The 45 o line shows the points at which desired spending equals output or income. AD Given the AD schedule, This the point at which planned spending equals actual output and income. equilibrium is thus at E. E

12. © The McGraw-Hill Companies, 2008 I planned investment (I) An alternative approach S, I Output, Income An equivalent view of equilibrium is seen by equatingS to planned saving (S) The two approaches are equivalent. E again giving us equilibrium at E

13. © The McGraw-Hill Companies, 2008 Effects of a fall in aggregate demand Output, Income Desired spending 45 o line AD 0 Y0Y0Y0Y0 Suppose the economy starts in equilibrium at Y 0. a fall in aggregate demand to AD 1 AD 1 leads the economy to a new equilibrium at Y 1. Y1Y1Y1Y1 Notice that the change in equilibrium output is larger than the original change in AD.

14. © The McGraw-Hill Companies, 2008 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. –Multiplier= 1/1-mpc

15. © The McGraw-Hill Companies, 2008 The multiplier –Suppose that the mpc=0.9. –The change in investment by one unit increases the national output by one unit, so the income will increase by one unit. The consumption will increase by 0.9. That would increase the output and income by 0.9, so additionally the consumption will increase by 0.81, etc. –At the end the total effect is 1/1-0.9=10