1. © © The McGraw-Hill Companies, 2002 0 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. © © The McGraw-Hill Companies, 2002 1 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. © © The McGraw-Hill Companies, 2002 2 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. © © The McGraw-Hill Companies, 2002 3 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. © © The McGraw-Hill Companies, 2002 4 Consumption and income in the UK at constant 1995 prices, 1989-2001 Income is a strong influence on consumption expenditure – but not the only one.

6. © © The McGraw-Hill Companies, 2002 5 The consumption function Income Consumption C = 8 + 0.7 Y The consumption function shows desired aggregate consumption at each level of aggregate income 0 The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed. With zero income, desired consumption is 8 (autonomous consumption).8

7. © © The McGraw-Hill Companies, 2002 6 The saving function S = -8 + 0.3 Y Income Saving 0 The saving function shows desired saving at each income level. Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa.

8. © © The McGraw-Hill Companies, 2002 7 The aggregate demand schedule Income Aggregate demand C Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. AD = C + I I The AD function is the vertical addition of C and I. (For now I is assumed autonomous.)

9. © © The McGraw-Hill Companies, 2002 8 Equilibrium output Output, Income Desired spending 45 o line The 45 o line shows the points at which desired spending equals output or income. AD Given the AD schedule, This the point at which planned spending equals actual output and income. equilibrium is thus at E. E

10. © © The McGraw-Hill Companies, 2002 9 I planned investment (I) An alternative approach S, I Output, Income An equivalent view of equilibrium is seen by equatingS to planned saving (S) The two approaches are equivalent. E again giving us equilibrium at E

11. © © The McGraw-Hill Companies, 2002 10 Effects of a fall in aggregate demand Output, Income Desired spending 45 o line AD 0 Y0Y0Y0Y0 Suppose the economy starts in equilibrium at Y 0. a fall in aggregate demand to AD 1 AD 1 leads the economy to a new equilibrium at Y 1. Y1Y1Y1Y1 Notice that the change in equilibrium output is larger than the original change in AD.

12. © © The McGraw-Hill Companies, 2002 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. 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.