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CHAPTER 3
OUTPUT AND AGGREGATE
DEMAND

Keynesian Economics

1. Keynesian Economics focuses on using active government

policy to manage aggregate demand in order to address or
prevent economic recessions.
2. Keynes developed his theories in response to the Great
Depression, and was highly critical of classical economic
arguments that natural economic forces and incentives
would be sufficient to help the economy recover.
3. Activist fiscal and monetary policy are the primary tools
recommended by Keynesian economists to manage the
economy and fight unemployment.
The General Theory of Employment, Interest, and Money

By the end of this chapter, you

should be able to…
1. Determine components of aggregate demand
2. Analyse consumption and investment
demand
3. Define the marginal propensity to consume C
4. Show how aggregate demand determines
equilibrium output
5. Calculate the multiplier
6. Aggregate demand and multiplier effect in an
open economy

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1. COMPONENTS OF AGGREGATE DEMAND.

•Aggregate demand is created by four sectors:

Households, firms, the government and the
foreign sector.

•Without a government or a foreign sector, there

are two sources of demand: consumption
demand by households and investment demand
by firms.

•Consumption demand and investment demand

are chosen by different economic groups and
depended on different things

1. COMPONENTS OF AGGREGATE DEMAND.

CONSUMPTION DEMAND.

•Households buy goods and services from car to

cinema tickets.
•These consumption purchases account for most
of personal disposable income
•Given its disposable income, each household
plans how much to spend and to save.
•In the aggregate, households’consumption
demand rise with aggregate personal disposable
income.

1. COMPONENTS OF AGGREGATE DEMAND.

THE CONSUMPTION FUNCTION

•The positive relation between income

and consumption demand is called the
consumption function
•The consumption function shows
aggregate consumption demand at each
level of income

C = f(Yd)

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1. COMPONENTS OF AGGREGATE DEMAND.

INVESTMENT SPENDING
•Investment is expenditure on capital goods –
for example, new machines, offices, new
technology.
•Investment is a component of Aggregate
Demand (AD) and also influences the capital
stock and productive capacity of the economy
(long-run aggregate supply)
•Firms’investment demand depends on
firms’current guesses about how fast the
demand for their output will increase.
•Which factors determining the investment
decision by firms?

1. COMPONENTS OF AGGREGATE DEMAND.

INVESTMENT SPENDING
Main factors influencing investment by firms:
Economic growth
•Firms invest to meet future demand.
• If demand is falling, then firms will cut back on
investment.
•If economic prospects improve, then firms will
increase investment as they expect future
demand to rise.
•There is strong empirical evidence that
investment is cyclical. In a recession, investment
falls, and recover with economic growth.
•I = f(Y)
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1. COMPONENTS OF AGGREGATE DEMAND.

INVESTMENT SPENDING

Accelerator theory
The accelerator theory states that investment depends on the
rate of change of economic growth.

In other words, if the rate of economic growth increases from

1.5% a year to 2.5% a year, then this increase in the growth rate
will cause an increase in investment spending as the economy is
on an up-turn.

The accelerator theory states that investment is highly dependent

on the economic cycle.
I = f(Y)

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1. COMPONENTS OF AGGREGATE DEMAND.

INVESTMENT SPENDING

Interest rates
Investment is financed either out of current savings or by
borrowing.
Therefore investment is strongly influenced by interest rates.
High interest rates make it more expensive to borrow.
High interest rates also give a better rate of return from keeping
money in the bank.
With higher interest rates, investment has a higher opportunity
cost because you lose out the interest payments.

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Interest rates

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1. COMPONENTS OF AGGREGATE DEMAND.

GOVERNMENT
•Government spending G on goods and services
adds directly to aggregate demand.
•The government also levies taxes and pays out
transfer benefits.
•Net taxes are taxes minus transfer benefits.
•T= Tx - Tr
•Disposable income (Yd, DI) is gross income
minus taxes plus benefits, that is , the net income
available to spend or save.
•Yd =Y – Tx + Tr = Y – (Tx – Tr) = Y – T
•Yd = Y - T
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1. COMPONENTS OF AGGREGATE DEMAND.

GOVERNMENT

•Unlike consumption and investment, G is

determined directly by government
spending decisions
•G is a constant
• G = Go

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1. COMPONENTS OF AGGREGATE DEMAND.

FOREIGN TRADE: NET EXPORT

•Exports X are goods and services made at

home but sold abroad.
•Imports M are goods and services made
abroad but bought by domestic residents.

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1. COMPONENTS OF AGGREGATE DEMAND.

FOREIGN TRADE: NET EXPORT

•Demand for imports rises when domestic

income and output rise.

•M = f(Y)

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1. COMPONENTS OF AGGREGATE DEMAND.

FOREIGN TRADE: NET EXPORT

•Export demand depends mainly on what is

happening abroad.
•Foreign income and foreign demand are
largely unrelated to domestic output, we
can treat the demand for exports as
autonomous.
•It does not depend on the level of domestic
demand.
•X = Xo

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER
2.1. Consumption and Saving.
w Consumption function: Y = f(Yd)
C= Co + Cm.Yd
• Co – Autonomous consumption demand
(When Yd = 0): Households wish to consume
Co even if Yd is zero – reflecting the minimum
consumption needed for survival.
• Cm (MPC): Marginal Propensity to consume –
the fraction of each extra pound of disposable
income that households wish to consume)

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER
2.1. Consumption and Saving.
w Consumption function:
C= Co + Cm. Yd
• Different people may exhibit different
marginal propensities to consume.
• Poor people, with many unmet needs, are
likely to spend immediately any extra income
that they receive => Cm close to 1.

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER
2.1. Consumption and Saving.
w Consumption function:
C= Co + Cm.Yd
• Billionaires may already be consuming
everything they could possibly want. For them,
any extra income is largely unspent: Cm is
close to 0.
• In macroeconomics, we are interested in
aggregate behaviour => 0< Cm <1
• The aggregate consumption reflects average
behaviour for the population as a whole.

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER
2.1. Consumption and Saving.
w Consumption function:
C= Co + Cm.Yd
rC
Cm(MPC) =
rYd

0 < Cm < 1: the slope of the

consumption functions

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2.1 Consumption and Saving.

The following data on the payment of Yd (DI) and the

economic performance of an economy:

Yd 0 300 600 900 1200 1500 1800

(DI)

C 200 400 600 800 1000 1200 1400

Co = 200
Cm = 200/300 = 2/3
C = 200 + 2/3Yd

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2.1 Consumption and Saving.

• Consumption C
function:
C=200+ 2/3 Yd
C=200+ 2/3 Yd

600

200

600 Yd

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER
2.1. Consumption and Saving.
w Saving is income not consumed.
w Since a fraction Cm of each pound of extra
income is consumed, a fraction (1 – Cm) of
each extra pound of income is saved
w The marginal propensity to save Sm (MPS) is
(1 - Cm)
w Cm + Sm = 1 or MPC + MPS = 1

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2.1 Consumption and Saving

Saving: S= So + Sm.Yd
•So – Autonomous saving (When Yd = 0)
•Sm (MPS): Marginal Propensity to Saving

rS
Sm(MPS) = 0< Sm <1
rYd

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2.1 Consumption and Saving.

The following data on the payment of Yd (DI) and the

economic performance of an economy:

Yd 0 300 600 900 1200 1500 1800

(DI)

C 200 400 600 800 1000 1200 1400

Co = 200
Cm = 200/300 = 2/3
C = 200 + 2/3Yd

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2.1 Consumption and Saving

• Saving

Yd 0 300 600 900 1200 1500 1800

(DI)

C 200 400 600 800 1000 1200 1400

S -200 -100 0 100 200 300 400

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2.1. Consumption and Saving

• Saving function:
S=-200+ 1/3 Yd S
Sm: slope of the
saving function
S=-200+ 1/3 Yd

600 Yd
-200

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2.2. INVESTMENT SPENDING

• Investment function:
I = Io + ImY

v Io – Autonomous investment
Im: Marginal investment

rI
Im = (0 < Im <1)
rY

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2.2. INVESTMENT
• I function:
• Ex:
I = 50 + 1/6 Y
I

I = 50 + 1/6 Y
150

I = Io
50

Y
600

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C+I
C
S

HOUSEHOLDS FIRMS

Injection = Withdraw

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2.3 DETERMINING AGGREGATE DEMAND

• Without a government or a foreign sector, there
are two sources of demand: consumption demand
by households and investment demand by firms.
• Aggregate demand AD is the sum of consumption
demand C and investment demand I (simple
model)
AD = C + I
• Yd = Y – T = Y
• AD = Co + Cm.Yd + Io + Im.Y = Co + Cm.Y +
Io + Im.Y
Equilibrium output: : Y = AD
Co + Io
Y =
1 - Cm - Im

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2.3 DETERMINING AGGREGATE DEMAND

Ex:

C = 200 + 2/3 Yd The aggregate demand function: Y = AD

I = 50 + 1/6 Y AD AD = 250+5/6 Y
aAD = 250+5/6 Y
1500 O

Equilibrium output:

Y = AD
a Y = 1500
250

450 Y, Yd
1500

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v Adjustment towards equilibrium

AD
AD = C + I

B
AD3
A
AD2
C
AD1

450 Y
Y1 Y2 Y3

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2.3 DETERMINING AGGREGATE DEMAND

Y = AD
ó Yd = C + I
óC+S=C+I

=> I = S I, S

Equilibrium output: I = S
O
S =- 200 + 1/3 Yd I = 50+1/6 Y
I = 50 + 1/6 Y 50 Y, Yd
50+1/6 Y =-200+1/3 600 1500
Yd -200 S = -200+1/3 Yd
a Y = 1500

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3. Basic Multiplier Model

In economics, a multiplier broadly refers to an
economic factor that, when increased or changed,
causes increases or changes in many other related
economic variables.
In terms of gross domestic product, the multiplier
effect causes gains in total output to be greater than
the change in spending that caused it.
rY = k. rAD
C = Co + Cm . Yd (Cm or MPC)
I = Io (Im = 0)
1
k= 1 – MPC
1
Or k= MPS

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AD
I, S

AD2 = C + I2
AD1 = C + I1
S

rAD I2
rY
450 I1

Y1 Y2 Y Y1 Y2

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4.3. Determining Ye when AD changes

The multiplier tells us how much output
changes after a shift in aggregate demand.

The multiplier exceeds 1 because a change in

autonomous demand sets off further changes in
consumption demand.

The size of the multiplier depends on the

marginal propensity to consume.
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4.3. Determining Ye when AD changes

The initial effect of a unit fall in investment

demand is to cut output and income by a
unit.
If the MPC is large, this fall in income
leads to a large fall in consumption and
the multiplier is big.
If the MPC is small, a given change in
investment demand and output induces
small changes in consumption demand
and the multiplier is small 39

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OPEN ECONOMY
3.1 The effect of Net Taxes on output

v T = Tx – Tr
In an open economy:
Yd = Y – Tx + Tr = Y – T
ð rYd = - rT
ÞNegative relation between disposable income of
households and net tax

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3.1 The effect of Net Taxes on output

• T function:
§ Positive relation between Y and T.
T = f (Y) = To + Tm.Y
§ To: Autonomous tax
Tm: Marginal propensity to tax
T

T = To + TmY

rT
Tm =
rY To

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3.1 The effect of government spending on output

• G function
G = f(Y) = Go

G = Go
Go

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3.1 The government budget

• A budget is the spending and revenue plan of an
individual, a firm or a government.
•The government budget describes what goods and
services the government will buy during the
coming year, what transfer payments is will make
and how it will pay for them.
•Most of its spending is financed by taxes.

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3.1 The government budget

• When spending exceeds taxes, there is a budget deficit.

• When taxes exceed spending, there is a budget surplus.
• Government budget deficit = G - T
Budget surplus

T, G
Budget deficit

T = To + TmY

Go
G = Go
To

Yo Y

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3.1 The combined effects of

governement spending and taxation
¿ AD = C + I + G
C = Co + Cm.Yd AD
Yd = Y – T
= Y – To – Tm.Y AD

= (1 – Tm).Y – To
ÞC = Co + Cm.Y –
Cm.Tm.Y-Cm.To
ÞC= Cm.Y(1-Tm) - Cm.To
+Co
450

Yt Y

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3.2 Foreign trade and income determination

• Export and Import fuction
¿ Export function:
X = Xo
¿ Import function:
M = Mo + MmY Trade deficit)

Mo : Autonomous Import X,M

Trade surplus
Mm : Marginal propensity to import
M = Mo + MmY
• Balance of Trade
• NX: positive - Trade surplus Xo
X = Xo
• NX: negative - Trade deficit Mo

NX = X - M Yo Y

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3.2 Net export and equilibrium income

AD = C + I + G + X – M
qEquilibrium output:
Y = AD
aY = C + I + G + X – M

[Co + Io + Go + Xo – Mo – Cm.To]
Y=
[1 – Cm(1 – Tm) - Im + Mm]

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AD

AD

AD = C + I + G + X - M

450

Y cb Yp

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4.1 Determining equilibrium output (Ye)

•AS = AD
•While: AS = Y
AD = C + I + G + X – M
èY = C + I + G + X – M (1)

èEquilibrium output (Ye) must satisfy:

Aggregate Supply equal Aggregate Demand

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4.2 Determining equilibrium output (Ye)

Y = AD
aY = C + I + G + X – M

[Co + Io + Go + Xo – Mo – Cm.To]
Y=
[1 – Cm(1 – Tm) - Im + Mm]

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4.3 Determining equilibrium output (Ye)

Besides: Yd = Y - T
=> Y = Yd + T (*)
Put (*) into (1) we have:
Yd + T = C+I+G+X–M
Or :Yd – C + T + M = I + G + X
ÞS + T + M = I + G + X (2)

Þ(2) shows: to get equilibrium output, the

withdraw must equal injection

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Equilibrium output: Y = AD
ó I+G+X=S+T+M

I
M
S
C+I+G FOREIGN

C G X

HOLDHOUSES FIRMS
GOVERNMENT
(Yd = Y – T) (Y)

(injection) = (withdrawal)

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4.3. Determining Ye when AD changes

•When the output

increases rAD, the AD2
equilibrium increases AD
in the amount of rY
AD1
rY = k. rAD
1
k= rAD
1 – Cm (1-Tm) – Im + Mm

k : the multiplier 450 rY Y

Yt Yp

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