The determination of national income

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 21.1 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 21.2 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 21.3 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 21.4 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) 21.5 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.) Ho us eh old co ns um tp ion ex pe nd itu re (£ bn .) Income is a strong influence on consumption expenditure – but not the only one. 21.6 The consumption function Income C = 8 + 0.7 Y The consumption function shows desired aggregate consumption at each level of aggregate income 0 With zero income, desired consumption 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. 21.7 The saving function S = -8 + 0.3 Y Income 0 The saving function shows desired saving at each income level. Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. 21.8 The aggregate demand schedule Income C Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. AD = C + I I The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) 21.9 Equilibrium output Output, Income 45o line The 45 o line shows the points at which desired spending equals output or income. AD Given the AD schedule, This the point at which planned spending equals actual output and income. equilibrium is thus at E. E 21.10 An alternative approach Output, Income An equivalent view of equilibrium is seen by equating I planned investment (I) S to planned saving (S) The two approaches are equivalent. again giving us equilibrium at E E 21.11 Effects of a fall in aggregate demand Output, Income 45o line AD0 Y0 Suppose the economy starts in equilibrium at Y0. a fall in aggregate demand to AD1 AD1 Leads the economy to a new equilibrium at Y1. Y1 Notice that the change in equilibrium output is larger than the original change in AD. 21.12 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.