Chapter 21 The determination of national income

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 1 The McGraw-Hill Companies, 2002 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 2 The McGraw-Hill Companies, 2002 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 3 The McGraw-Hill Companies, 2002 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) 4 The McGraw-Hill Companies, 2002 Household consumtpion expenditure (bn.) Consumption and income in the UK

at constant 1995 prices, 1989600 2001 575 550 525 500 475 450 425 400 375 350 400 425 450 475 500 525 550 575 600 625 650 Real disposable income (bn.) Income is a strong influence on consumption expenditure but not the only one. 5 The McGraw-Hill Companies, 2002 The consumption

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

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

Income 7 The McGraw-Hill Companies, 2002 Aggregate demand The aggregate demand schedule Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. AD = C + I I C

The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) Income 8 The McGraw-Hill Companies, 2002 Desired spending Equilibrium output 45o line E AD The 45o 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 9 The McGraw-Hill Companies, 2002 An alternative approachAn equivalent view of S, I equilibrium is seen by equating S E

planned investment (I) to planned saving (S) again giving us equilibrium at E I Output, Income The two approaches are equivalent. 10 The McGraw-Hill Companies, 2002 Effects of a fall in aggregate demand Desired spending 45o line AD0

AD1 Suppose the economy starts in equilibrium at Y0. 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. 11 The McGraw-Hill Companies, 2002

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. 12 The McGraw-Hill Companies, 2002

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