Chapter 21 The determination of national income David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 21.2 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 21.3 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 21.4 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 21.5 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) 21.6 Consumption and income in the UK at constant 1995 prices, 1989-1998 350 375 400 425 450 475 500 400 425 450 475 500 525 550 Real disposable income (£bn.) Household consumtpion expenditure (£bn.) Income is a strong influence on consumption Income is a strong influence on consumption expenditure – but not the only one. expenditure – but not the only one. 21.7 The consumption function Income Income C o n s u m p t i o n C o n s u m p t i o n C = 8 + 0.7 Y C = 8 + 0.7 Y The consumption function shows desired aggregate The consumption function shows desired aggregate consumption at each level of aggregate income consumption at each level of aggregate income 0 0 With zero income, With zero income, desired consumption desired consumption is 8 (“autonomous is 8 (“autonomous consumption”). consumption”). { { 8 8 The The marginal propensity marginal propensity to consume to consume (the slope of (the slope of the function) is 0.7 – i.e. the function) is 0.7 – i.e. for each additional £1 of for each additional £1 of income, 70p is consumed. income, 70p is consumed. 21.8 The saving function S = -8 + 0.3 Y S = -8 + 0.3 Y Income Income S a v i n g S a v i n g 0 0 The saving function shows The saving function shows desired saving at each desired saving at each income level. income level. Since all income is either Since all income is either saved or spent on saved or spent on consumption, the saving consumption, the saving function can be derived function can be derived from the consumption from the consumption function or function or vice versa. vice versa. 21.9 The aggregate demand schedule Income Income A g g r e g a t e d e m a n d A g g r e g a t e d e m a n d C C Aggregate demand is Aggregate demand is what households plan what households plan to spend on consumption to spend on consumption and what firms plan to and what firms plan to spend on investment. spend on investment. AD = C + I AD = C + I I I The AD function is The AD function is the vertical addition the vertical addition of C and I. of C and I. (For now I is assumed (For now I is assumed autonomous.) autonomous.) 21.10 Equilibrium output Output, Income Output, Income D e s i r e d s p e n d i n g D e s i r e d s p e n d i n g 45 45 o o line line The 45 The 45 o o line shows the line shows the points at which desired points at which desired spending equals output spending equals output or income. or income. AD AD Given the Given the AD AD schedule, schedule, This the point at which This the point at which planned spending equals planned spending equals actual output and income. actual output and income. equilibrium is thus at E. equilibrium is thus at E. E E [...]... equilibrium at E The two approaches are equivalent 21. 11 Effects of a fall in aggregate demand Desired spending 45o line Y1 AD0 Suppose the economy starts in equilibrium AD1 at Y0 a fall in aggregate demand to AD1 Y0 Leads the economy to a new equilibrium at Y1 Output, Income Notice that the change in equilibrium output is larger than the original change in AD 21. 12 The multiplier The multiplier is the ratio... 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 21. 13 . spending equals actual output and income. actual output and income. equilibrium is thus at E. equilibrium is thus at E. E E 21. 11 An alternative approach S , I S , I Output, Income Output, Income An. Chapter 21 The determination of national income David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 21. 2 Aggregate. model  For now, also assume: – no government – no foreign trade  Later chapters relax these assumptions 21. 4 Aggregate demand  Given no government and no international trade, aggregate demand has two