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
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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
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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
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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)
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Household consumtpion
expenditure (£bn.)
Consumption and income in the UK
at constant 1995 prices, 1989-2001
600
575
550
525
500
475
450
425
400
375
350
400 425 450 475 500 525 550 575 600 625 650
Real disposable income (£bn.)
Income is a strong influence on consumption
expenditure – but not the only one.
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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”).
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, 70p is consumed.
8
0
Income
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The saving function
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
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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
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Equilibrium output
45o line
E
AD
The 45o 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
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An alternative approach
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.
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Effects of a fall in aggregate demand
45o line
AD0
AD1
Suppose the economy
starts in equilibrium
at Y0.
a fall in aggregate
demand to AD1
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.
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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.
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