Aggregate output in the short run

1
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

2
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

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

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)

5
Consumption and income in the UKat constant 1995
prices, 1989-2001
Income is a strong influence on
consumption expenditure but not the only one.
6
The consumption function
The consumption function shows desired
aggregate consumption at each level of aggregate
income
C 8 0.7 Y
Consumption
0
Income
7
The saving function
The saving function shows desired saving at
each income level.
Saving
S -8 0.3 Y
Since all income is either saved or spent on
consumption, the saving function can be
derived from the consumption function or vice
versa.
0
Income
8
The aggregate demand schedule
Aggregate demand is what households plan to spend
on consumption and what firms plan to spend on
investment.
Aggregate demand
C
Income
9
Equilibrium output
45o line
The 45o line shows the points at which
desired spending equals output or income.
Desired spending
This the point at which planned spending
equals actual output and income.
Output, Income
10
An alternative approach
An equivalent view of equilibrium is seen
by equating
S, I
Output, Income
The two approaches are equivalent.
11
Effects of a fall in aggregate demand
45o line
Suppose the economy starts in equilibrium at Y0.
AD0
Desired spending
Y0
Output, Income
Notice that the change in equilibrium output
is larger than the original change in AD.
12
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.