1.

Aggregate Output in the Short Run

Potential output
the output the economy would produce if all factors of production were fully employed what is actually produced in a period which may diverge from the potential level
21.0

Actual output

2. Initial Model

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
21.1

3. 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
21.2

4. 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)
21.3

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).
The marginal propensity to consume (the slope of the function) is 0.7 i.e. for each additional 1 of income, 70p is consumed. Income
21.4

{
0

5. Saving Function

Saving is income not consumed.

When income is zero, saving is -A Since a fraction c of each extra pound is consumed , a fraction of 1 c of income is saved

MPC + MPS = 1
S = -A + (1-C)Y
21.5

5. Saving Function
The saving function shows desired saving at each income level.

S = -8 + 0.3 Y

Income

Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa.

21.6

6. Aggregate Demand

In the simple model, aggregate demand is simply consumption demand plus investment demand AD: add I to the previous consumption function
The slope of AD is the MPC

21.7

7.

The Aggregate Demand Schedule

AD = C + 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

21.8

8. Equilibrium Output: output

expenditure approach

Wages and prices are fixed in the model

AD < Potential Output, then firm cannot sell as much as they would like Involuntary excess capacity and involuntary unemployment
21.9

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. This the point at which planned spending equals actual output and income.
21.10

Output, Income

8. Adjustment towards Equilibrium

45o line
E AD Suppose the economy begins with a lower output, AD > Y If firms have stock, they can sell more by unplanned No stock, they must turn away customers Either way, the firm should increase outputs
21.11

Output, Income

9. An Alternative Approach
S

An equivalent view of equilibrium is seen by equating

planned investment (I)

to planned saving (S) again giving us equilibrium at E

Output, Income

The two approaches are equivalent.

21.12

10.

Effects of a Fall in Aggregate

Demand

autonomous consumption or investment 45o line

AD0 Suppose the economy starts in equilibrium AD1 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.
21.13

10. Effects of a Fall in Aggregate Demand a change in MPC

45o line

AD0 Suppose the economy starts in equilibrium at Y0. AD1 There is a change in MPC
Leads the economy to a new equilibrium at Y1.

Y1

Y0
Output, Income

21.14

11. 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. It tells us how much output change after a shift in

demand; K = Y/

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.
21.15

Keynesian Consumption
80% to Consumption $1 Disposable Income

20% to Savings

% of extra $ of Income used for Consumption is Marginal Propensity to Consume

Why is the MPC important?

Cumulative Increase in GDP (MPC = 0.8) $100 $180 $244

Government spends $100 on road repair

Road contractors spend $80 and save $20

Retailers spend $80*0.8=$64 and save $16

$20 $36 Cumulative Increase in Savings (MPS = 0.2)

Total impact of $100

Change in GDP = $500

After all rounds are complete

Total Impact = $100/(1-MPC) = $100/0.2 = $500

Change in Savings = $100

Reality Check
US multiplier is about 1.8 2.2 depending on kind of spending Simplistic, but gives benchmark

Expansions (why do we monitor consumer spending?) think about CNN report Recessions (why is consumer spending an indicator of recession?)

11. The Paradox of Thrift

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

21.20

11. The Paradox of Thrift

In equilibrium, planned saving equals planned investment and the latter is unaltered. Thus, planned saving cannot change 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
21.21

11. The Paradox of Thrift

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

21.22