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• # 5. The Consumption Function

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.
income, 70p is consumed.
0
Income

0
Income
S = -8 + 0.3 Y

C
I
Income

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

autonomous.)
Aggregate demand is
what households plan
to spend on consumption
(For now I is assumed

• # 8. Equilibrium Output

45 o line
E
The 45 o line shows the
points at which desired
spending equals output
or income.
equilibrium is thus at E.
This the point at which
planned spending equals
actual output and income.
Output, Income

# Equilibrium

45 o line
E
B
C
Suppose the economy
begins with a lower
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

# planned investment (I)

to planned saving (S)
equilibrium at E
again giving us
S
E
I
Output, Income
The two approaches are equivalent.

# Demand –

## autonomous consumption or investment

Notice that the change in equilibrium output is

# larger than the original change in AD.

45 o line
Suppose the economy
starts in equilibrium
at Y 0.
a fall in aggregate
to a new equilibrium
at Y 1 .
Y 0
Y 1
Output, Income

45 o line
Output, Income
Y 1
Y 0

# Leads the economy to a new equilibrium at Y 1.

Suppose the economy

# Keynesian Consumption

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

# Why is the MPC important?

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

# Total impact of \$100

Change in GDP = \$500
\$500
Change in Savings = \$100
Total Impact =
\$100/(1-MPC) =
\$100/0.2 =
complete
rounds are
After all

Y*
S’
Y
Y
S

S