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

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 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

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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 UK
at constant 1995 prices, 1989-2001
600
575
Household consumtpion

550
expenditure (£bn.)

525
500
475
450
425
400
375
350
400 425 450 475 500 525 550 575 600 625 650
Real disposable income (£bn.)

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
Consumption

With zero income,

C = 8 + 0.7 Y desired consumption
is 8 (“autonomous
consumption”).
The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
8 for each additional £1 of
income, 70p is consumed.
0
Income

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 The saving function
Saving

The saving function shows

desired saving at each
income level.

S = -8 + 0.3 Y Since all income is either

saved or spent on
consumption, the saving
function can be derived
from the consumption
0 function or vice versa.
Income

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 The aggregate demand schedule
Aggregate demand is
Aggregate demand

AD = C + I what households plan

to spend on consumption
and what firms plan to
C spend on investment.
I
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)

Income

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 Equilibrium output
45o line
Desired spending

The 45o line shows the

points at which desired
E spending equals output
AD
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

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 An alternative approach
An equivalent view of
equilibrium is seen by
S, I

equating
S
planned investment (I)

E I to planned saving (S)

again giving us
equilibrium at E

Output, Income

The two approaches are equivalent.

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 Effects of a fall in aggregate demand
45o line
AD0 Suppose the economy
Desired spending

starts in equilibrium
at Y0.
AD1
a fall in aggregate
demand to AD1

leads the economy

to a new equilibrium
at Y1.
Y1 Y0
Output, Income
Notice that the change in equilibrium output is
larger than the original change in AD.
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 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.

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