Aggregate output in the short run Potential output

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 ©The Mc. Graw-Hill Companies, 2002

Some simplifying assumptions • Prices and wages are fixed • The actual quantity of total output is demanddetermined – this will be a Keynesian model • For now, also assume: – no government – no foreign trade • Later chapters relax these assumptions ©The Mc. Graw-Hill Companies, 2002

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 ©The Mc. Graw-Hill Companies, 2002

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) ©The Mc. Graw-Hill Companies, 2002

Consumption and income in the UK at constant 1995 prices, 1989 -2001 Income is a strong influence on consumption expenditure – but not the only one. ©The Mc. Graw-Hill Companies, 2002

The consumption function Consumption The consumption function shows desired aggregate consumption at each level of aggregate income With zero income, desired consumption is 8 (“autonomous consumption”). C = 8 + 0. 7 Y The marginal propensity to consume (the slope of the function) is 0. 7 – i. e. for each additional £ 1 of income, 70 p is consumed. 8 0 Income 5 ©The Mc. Graw-Hill Companies, 2002

Saving The saving function shows desired saving at each income level. S = -8 + 0. 3 Y 0 Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. Income 6 ©The Mc. Graw-Hill Companies, 2002

Aggregate demand 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 C The AD function is the vertical addition of C and I. (For now I is assumed autonomous. ) Income 7 ©The Mc. Graw-Hill Companies, 2002

Desired spending Equilibrium output 45 o line E AD The 45 o line shows the points at which desired spending equals output or income. Given the AD schedule, equilibrium is thus at E. This the point at which planned spending equals actual output and income. Output, Income 8 ©The Mc. Graw-Hill Companies, 2002

An alternative approach S, I An equivalent view of equilibrium is seen by equating S E planned investment (I) to planned saving (S) again giving us equilibrium at E I Output, Income The two approaches are equivalent. 9 ©The Mc. Graw-Hill Companies, 2002

Effects of a fall in aggregate demand Desired spending 45 o line AD 0 AD 1 Suppose the economy starts in equilibrium at Y 0. a fall in aggregate demand to AD 1 leads the economy to a new equilibrium at Y 1 Y 0 Output, Income Notice that the change in equilibrium output is larger than the original change in AD. 10 ©The Mc. Graw-Hill Companies, 2002

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. ©The Mc. Graw-Hill Companies, 2002