determination of national income - topic 2

7/28/2019 Determination of National Income - Topic 2

1/23

21.0

1. Aggregate Output in the Short

Run

Potential output

the output the economy would produce

if all factors of production were fullyemployed

Actual output

what is actually produced in a period

which may diverge from the potential

level


2/23

21.1

2. Initial Model

Prices and wages are fixed

At these prices, there are workers without a jobwho would like to work and firms with sparecapacity they could profitably use

The actual quantity of total output is demand-determined

this will be a Keynesian model

Government intervention to keep output closeto the potential output

For now, also assume: no government

no foreign trade

Later topics relax these assumptions


3/23

21.2

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


4/23


5/23

21.4

5. 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 consumptionis 8 (autonomous

consumption).

{

8

The marginal propensi ty

to consume(the slope ofthe function) is 0.7 i.e.

for each additional 1 of

income, 70p is consumed.


6/23

21.5

5. Saving Function

Saving is income not consumed.

When income is zero, saving is -A

Since a fraction c of each extra

pound is consumed , a fraction of 1

c of income is saved

MPC + MPS = 1

S = -A + (1-C)Y


7/23

21.6

5. Saving Function

S = -8 + 0.3 Y

Income0

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 derivedfrom the consumption

function orvice versa.


8/23

21.7

6. Aggregate Demand

In the simple model, aggregate

demand is simply consumption

demand plus investment demand AD: add I to the previous

consumption function

The slope of AD is the MPC


9/23

21.8

7. 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

IThe AD function is

the vertical addition

of C and I.

(For now I is assumedautonomous.)


10/23

21.9

8. Equilibrium Output: output

expenditure app roach

Wages and prices are fixed in the

model

AD < Potential Output, then firmcannot sell as much as they would

like

Involuntary excess capacity and

involuntary unemployment


11/23

21.10

8. Equilibrium Output

Output, Income

45o line The 45o line shows the

points at which desired

spending equals output

or income.

AD

Given the AD schedule,

This the point at whichplanned spending equals

actual output and income.

equilibrium is thus at E.

E


12/23


13/23

21.12

9. An Alternative Approach

Output, Income

An equivalent view of

equilibrium is seen by

equating

Iplanned investment (I)

S

to planned saving (S)

The two approaches are equivalent.

again giving us

equilibrium at E

E


14/23

21.13

10. Effects of a Fall in Aggregate Demand

autonomous con sumpt ion or investment

Output, Income

45o lineAD0

Y0

Suppose the economy

starts in equilibrium

at Y0.

a fall in aggregatedemand 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.


15/23

21.14

10. Effects of a Fall in Aggregate

Demanda change in MPC

Output, Income

45o lineAD0

Y0

Suppose the economy

starts in equilibrium

at Y0.

There is a change inMPC

AD1

Leads the economy

to a new equilibrium

at Y1.Y1


16/23

21.15

11. 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.

It tells us how much output change after a shift indemand; K = Y/ AD

K = 1/ (1- MPC) = 1/MPS

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.


17/23

Keynesian Consumption

$1

Disposable

Income

80% to Consumption

20% to Savings

% of extra $ ofIncome used forConsumption is

MarginalPropensity toConsume


18/23

Why is the MPC important?

Government

spends $100

on road

repair

Cumulative Increase in GDP (MPC = 0.8)

Cumulative Increase in Savings (MPS = 0.2)

$100

Road

contractors

spend $80

and save

$20

$180

$20

Retailers

spend

$80*0.8=$64

and save $16

$244

$36


19/23

Total impact of $100

After allrounds are

complete

Change in GDP = $500

Change in Savings = $100

Total Impact =

$100/(1-MPC) =

$100/0.2 =$500


20/23

Reality Check

US multiplier is about 1.8 2.2

depending on kind of spending

Simplistic, but gives benchmark Expansions (why do we monitor

consumer spending?) think about

CNN report

Recessions (why is consumer spending

an indicator of recession?)


21/23

21.20

11. The Paradox of Thrift

Earlier, we analyse a shift in AD caused by

changed in autonomous investment

Now consider a parallel shift in the AD schedule

caused by a change in autonomous part ofplanned consumption and savings

An autonomous consumption increase of 10 will

cause an upward shift in AD

This is equivalent to a fall in autonomous saving,thus a parallel downward shift in saving function


22/23


23/23

21.22

11. The Paradox of Thrift

A change in the amount households wish to save

of each levels of income leads to a change in

equilibrium income, but no change in equilibrium

saving, which must equal planned investment.This is the paradox of thrift

If all households decide to increase saving, this

will lead to a fall in AD, employment, income but

no rise in saving

determination of national income - topic 2

Documents