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1. Aggregate Output in the Short Run  Potential output – the output the economy would
  • 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. Initial Model  Prices and wages are fixed  At these prices, there are workers
  • 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 demand- determined

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

3. Aggregate Demand  Given no government and no international trade, aggregate demand has two components:
  • 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
  • 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. The Consumption Function The consumption function shows desired aggregate consumption at each level of aggregate
  • 5. The Consumption Function

The consumption function shows desired aggregate consumption at each level of aggregate income With zero income,
The consumption function shows desired aggregate
consumption at each level of aggregate income
With zero income,
desired consumption
C = 8 + 0.7 Y
is 8 (“autonomous
consumption”).
{
8
The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
for each additional £1 of
income, 70p is consumed.
0
Income
5. The Consumption Function The consumption function shows desired aggregate consumption at each level of aggregate
5. Saving Function  Saving is income not consumed.  When income is zero, saving is
  • 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

5. Saving Function The saving function shows desired saving at each income level. 0 Income S

5. Saving Function

The saving function shows desired saving at each income level.

The saving function shows desired saving at each income level. 0 Income S = -8 +
0 Income
0
Income
S = -8 + 0.3 Y
S = -8 + 0.3 Y
The saving function shows desired saving at each income level. 0 Income S = -8 +
The saving function shows desired saving at each income level. 0 Income S = -8 +

Since all income is either saved or spent on consumption, the saving

function can be derived

from the consumption function or vice versa.

The saving function shows desired saving at each income level. 0 Income S = -8 +
5. Saving Function The saving function shows desired saving at each income level. 0 Income S
5. Saving Function The saving function shows desired saving at each income level. 0 Income S
5. Saving Function The saving function shows desired saving at each income level. 0 Income S
6. Aggregate Demand  In the simple model, aggregate demand is simply consumption demand plus investment
  • 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

7. The Aggregate Demand Schedule AD = C + I C I Income and what firms
  • 7. The Aggregate Demand Schedule

AD = C + I

AD = C + I C I Income
C I
C I
C
I
Income
Income

and what firms plan to

spend on investment.

The AD function is the vertical addition of C and I.

autonomous.)
autonomous.)
Aggregate demand is what households plan to spend on consumption
Aggregate demand is
what households plan
to spend on consumption
(For now I is assumed
(For now I is assumed
8. Equilibrium Output: output – expenditure approach  Wages and prices are fixed in the model
  • 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

8. Equilibrium Output 45 o line E AD The 45 o line shows the points at
  • 8. Equilibrium Output

8. Equilibrium Output 45 o line E AD The 45 o line shows the points at
45 o line E AD The 45 o line shows the points at which desired spending
45 o line
E
AD
The 45 o line shows the
points at which desired
spending equals output
or income.
Given the AD schedule,
equilibrium is thus at E.
This the point at which
planned spending equals
actual output and income.
Output, Income
8. Adjustment towards Equilibrium AD 45 o line E B C Suppose the economy begins with
  • 8. Adjustment towards

Equilibrium

AD 45 o line E B C
AD
45 o line
E
B
C
Suppose the economy begins with a lower output, AD > Y If firms have stock, they
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
Output, Income
Either way, the firm
should increase
outputs

21.11

9. An Alternative Approach An equivalent view of equilibrium is seen by equating planned investment (
  • 9. An Alternative Approach

9. An Alternative Approach An equivalent view of equilibrium is seen by equating planned investment (
An equivalent view of equilibrium is seen by equating planned investment ( I ) to planned

An equivalent view of

equilibrium is seen by equating

planned investment (I)

to planned saving (S)
to planned saving (S)
equilibrium at E again giving us
equilibrium at E
again giving us
S E I Output, Income
S
E
I
Output, Income
The two approaches are equivalent.
The two approaches are equivalent.
9. An Alternative Approach An equivalent view of equilibrium is seen by equating planned investment (
10. Effects of a Fall in Aggregate Demand – autonomous consumption or investment Notice that the
  • 10. Effects of a Fall in Aggregate

Demand

autonomous consumption or investment

Notice that the change in equilibrium output is larger than the original change in AD.
Notice that the change in equilibrium output is
Notice that the change in equilibrium output is

larger than the original change in AD.

10. Effects of a Fall in Aggregate Demand – autonomous consumption or investment Notice that the
45 o line AD 0 Suppose the economy starts in equilibrium at Y 0. AD 1
45 o line
AD 0
Suppose the economy
starts in equilibrium
at Y 0.
AD 1
a fall in aggregate
demand to AD 1
Leads the economy
to a new equilibrium
at Y 1 .
Y 0
Y 1
Output, Income
10. Effects of a Fall in Aggregate Demand – a change in MPC 45 o line
  • 10. Effects of a Fall in Aggregate Demand a change in MPC

45 o line AD 1 Output, Income Y 1 Y 0 AD 0 starts in equilibrium
45 o line AD 1
45 o line
AD 1
Output, Income Y 1 Y 0
Output, Income
Y 1
Y 0

AD 0

starts in equilibrium

at Y 0.

There is a change in MPC

45 o line AD 1 Output, Income Y 1 Y 0 AD 0 starts in equilibrium

Leads the economy to a new equilibrium at Y 1 .

Suppose the economy
Suppose the economy
10. Effects of a Fall in Aggregate Demand – a change in MPC 45 o line
11. The Multiplier  The multiplier is the ratio of the change in equilibrium output to

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.

Keynesian Consumption 80% to Consumption $1 Disposable Income 20% to Savings % of extra $ of

Keynesian Consumption

80% to Consumption $1 Disposable Income 20% to Savings
80% to Consumption
$1
Disposable
Income
20% to Savings

% of extra $ of

Income used for Consumption is Marginal Propensity to Consume

Keynesian Consumption 80% to Consumption $1 Disposable Income 20% to Savings % of extra $ of
Keynesian Consumption 80% to Consumption $1 Disposable Income 20% to Savings % of extra $ of
Why is the MPC important? Cumulative Increase in GDP (MPC = 0.8) $100 $180 $244 Government

Why is the MPC important?

Cumulative Increase in GDP (MPC = 0.8) $100 $180 $244
Cumulative Increase in GDP (MPC = 0.8)
$100
$180
$244
Government spends $100 on road repair
Government
spends $100
on road
repair
$80*0.8=$64 and save $16 Retailers spend contractors Road $20 spend $80 and save
$80*0.8=$64
and save $16
Retailers
spend
contractors
Road
$20
spend $80
and save

$20

$36

Government spends $100 on road repair $80*0.8=$64 and save $16 Retailers spend contractors Road $20 spend
…
Why is the MPC important? Cumulative Increase in GDP (MPC = 0.8) $100 $180 $244 Government

Cumulative Increase in Savings (MPS = 0.2)

Why is the MPC important? Cumulative Increase in GDP (MPC = 0.8) $100 $180 $244 Government
Total impact of $100 … Change in GDP = $500 $500 Change in Savings = $100

Total impact of $100

…
… Change in GDP = $500 $500 Change in Savings = $100 Total Impact = $100/(1-MPC)
Change in GDP = $500 $500 Change in Savings = $100 Total Impact = $100/(1-MPC) =
Change in GDP = $500
$500
Change in Savings = $100
Total Impact =
$100/(1-MPC) =
$100/0.2 =
complete
rounds are
After all
Reality Check  US multiplier is about 1.8 – 2.2 depending on kind of spending 

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

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

11. The Paradox of Thrift  In equilibrium, planned saving equals planned investment and the latter

11. The Paradox of Thrift

  • In equilibrium, planned saving equals planned investment and the latter is unaltered.

  • Thus, planned saving cannot change

Y* S’ Y Y S
Y*
S’
Y
Y
S

In equilibrium,

S
S

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

11. The Paradox of Thrift  A change in the amount households wish to save of

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