Macroeconomics (ECON 1211)
Lecturer: Dr B. M. Nowbutsing
Topic: The Determination of National Income
1.
n
Aggregate Output in the Short
Run
Potential output
–
n
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
21.1
2. Initial Model
n
n
n
n
n
Prices and wages are fixed
At these prices, there are workers without a job
who would like to work and firms with spare
capacity they could profitably use
The actual quantity of total output is demanddetermined
– this will be a “Keynesian” model
– Government intervention to keep output close
to the potential output
For now, also assume:
– no government
– no foreign trade
Later topics relax these assumptions
21.2
3. Aggregate Demand
n
Given no government and no
international trade, aggregate
demand has two components:
–
Investment
n
n
–
Consumption
n
n
firms’ desired or planned additions to
physical capital & inventories
for now, assume this is autonomous
households’ demand for goods and services
so, AD = C + I
21.3
4. Consumption Demand
n
Households allocate their income
between CONSUMPTION and
SAVING
n
Personal Disposable Income
–
income that households have for
spending or saving
–
income from their supply of factor
services (plus transfers less taxes)
21.4
Consumption and income in the UK
at constant 1995 prices, 1989-1998
Household consumtpion
expenditure (£bn.)
500
475
450
425
400
375
350
400
425
450
475
500
525
550
Real disposable income (£bn.)
Income is a strong influence on consumption
expenditure – but not the only one.
21.5
Consumption and Income in
Mauritius, current prices
Gross National Disposable Income
Consumption and Income (1990 -2006) Mauritius
250000
200000
150000
100000
50000
0
0
50000
100000
150000
200000
Household Consumption
21.6
5. The Consumption Function
The consumption function shows desired aggregate
consumption at each level of aggregate income
With zero income,
C = 8 + 0.7 Y desired consumption
is 8 (“autonomous
consumption”).
8
The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
for each additional £1 of
income, 70p is consumed.
{
0
Income
21.7
5. Saving Function
n
Saving is income not consumed.
n
When income is zero, saving is -A
n
Since a fraction c of each extra
pound is consumed , a fraction of 1 –
c of income is saved
n
MPC + MPS = 1
n
S = -A + (1-C)Y
21.8
5. Saving Function
The saving function shows
desired saving at each
income level.
S = -8 + 0.3 Y
0
Income
Since all income is either
saved or spent on
consumption, the saving
function can be derived
from the consumption
function or vice versa.
21.9
6. Aggregate Demand
n
In the simple model, aggregate
demand is simply consumption
demand plus investment demand
n
AD: add I to the previous
consumption function
n
The slope of AD is the MPC
21.10
7.
The Aggregate Demand
Schedule
AD = C + I
I
C
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)
Income
21.11
8. Equilibrium Output: output –
expenditure approach
n
Wages and prices are fixed in the
model
n
AD < Potential Output, then firm
cannot sell as much as they would
like
n
Involuntary excess capacity and
involuntary unemployment
21.12
8. Equilibrium Output
45o
E
o line shows the
The
45
line
points at which desired
spending equals output
AD or income.
Given the AD schedule,
equilibrium is thus at E.
Output, Income
This the point at which
planned spending equals
actual output and income.
21.13
8. Adjustment towards
Equilibrium
45o line
E
AD
Suppose the economy
begins with a lower
output, AD > Y
B
If firms have stock,
they can sell more by
unplanned
C
No stock, they must
turn away customers
Either way, the firm
should increase
outputs
Output, Income
21.14
9. An Alternative Approach
S
An equivalent view of
equilibrium is seen by
equating
planned investment (I)
E
I
Output, Income
to planned saving (S)
again giving us
equilibrium at E
The two approaches are equivalent.
21.15
10.
Effects of a Fall in Aggregate
Demand –
autonomous consumption or investment
45o line
Y1
AD0 Suppose the economy
starts in equilibrium
AD1 at Y0.
a fall in aggregate
demand to AD1
Y0
Leads the economy
to a new equilibrium
at Y1.
Output, Income
Notice that the change in equilibrium output is
larger than the original change in AD.
21.16
10. Effects of a Fall in Aggregate
Demand – a change in MPC
45o line
Y1
AD0 Suppose the economy
starts in equilibrium
at Y0.
AD1 There is a change in
MPC
Y0
Leads the economy
to a new equilibrium
at Y1.
Output, Income
21.17
11. The Multiplier
n
n
The multiplier is the ratio of the change in
equilibrium output to the change in autonomous
spending that causes the change in output.
It tells us how much output change after a shift in
demand; K = ∆Y/
n
n
∆AD
K = 1/ (1- MPC) = 1/MPS
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.
21.18
11. The Paradox of Thrift
n
n
n
n
Earlier, we analyse a shift in AD caused by
changed in autonomous investment
Now consider a parallel shift in the AD schedule
caused by a change in autonomous part of
planned consumption and savings
An autonomous consumption increase of 10 will
cause an upward shift in AD
This is equivalent to a fall in autonomous saving,
thus a parallel downward shift in saving function
21.19
11. The Paradox of Thrift
n
n
In equilibrium, planned saving equals planned
investment and the latter is unaltered.
Thus, planned saving cannot change
S
S
Y
Y*
S’
Y
In equilibrium,
planned saving = planned
investment; A fall (rise) in
desire to save induces
a rise (fall) in output to
keep planned saving equal
to planned investment
21.20
11. The Paradox of Thrift
n
n
A change in the amount households wish to save
of each levels of income leads to a change in
equilibrium income, but no change in equilibrium
saving, which must equal planned investment.
This is the paradox of thrift
If all households decide to increase saving, this
will lead to a fall in AD, employment, income but
no rise in saving
21.21