Output and Aggregate Demand

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Output and Aggregate Demand

• Begg, Fischer Dornbusch
• Economics 7th Edition
• Chapter 20

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• Potential output is the economys output when
  inputs are fully employed
• Not the same as the maximum an economy can
  conceivably make.
• It is the output when every market in the economy
  is in long run equilibrium
• 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
• At these prices and wages there are workers who
  would like to work and firms with spare capacity
  i.e. the economy has spare resources
• 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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Consumption and Income in the UKat Constant 1995
Prices, 1989-2001
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 A
(autonomous consumption)
The Marginal Propensity to Consume (the slope of
the function) is c i.e. for each additional 1 of
income, c is consumed.
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The saving function
The saving function shows desired saving at each
income level
Since all income is either saved or spent, the
saving function can be derived from the
consumption function and vice versa.
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Aggregate Demand
Aggregate demand is the amount firms and
households plan to spend at each level of income
i.e. AD C I
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Equilibrium Output
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Equilibrium output and employment
45o line
E
Desired spending
Ye
Yf
Output, Income
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An alternative approach
An equivalent view of equilibrium is seen by
equating planned investment (I) and planned
saving (S) again giving us equilibrium at Ye.
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A fall in aggregate demand
Suppose the economy starts at Ye. A fall in
aggregate demand to AD leads the economy to a
new equilibrium at Ye.
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(No Transcript)
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The Multiplier
The multiplier is the ratio of the change in
equilibrium output to the change in autonomous
spending that caused the change.
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The Paradox of Thrift
Unplanned increase in stocks
With the new savings function S, there is a new
lower equilibrium level of income.