the determination of national income

Chapter 21The determination of national income David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith... Ag

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

Aggregate output in the short run

if all factors of production were fully

employed

level

Some simplifying assumptions

 The actual quantity of total output is

demand-determined

Aggregate demand

international trade, aggregate

demand has two components:

 firms’ desired or planned additions to physical capital & inventories

 for now, assume this is autonomous

 households’ demand for goods and services

 so, AD = C + I

Consumption demand

between CONSUMPTION and

SAVING

spending or saving

services (plus transfers less taxes)

Consumption and income in the UK

at constant 1995 prices, 1989-1998

350

375

400

425

450

475

500

Real disposable income (£bn.)

Income is a strong influence on consumption

expenditure – but not the only one.

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.

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.

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.)

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

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

Effects of a fall in aggregate demand

Output, Income

45 o line

AD 0

Y 0

Suppose the economy starts in equilibrium

at Y 0.

a fall in aggregate demand to AD 1

AD 1

Leads the economy

to a new equilibrium

at Y 1

Y 1

Notice that the change in equilibrium output is

larger than the original change in AD.

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.

consume, the larger is the multiplier.

save, the more of each extra unit of

income “leaks” out of the circular flow.