determination-of-national-income-topic-2-1

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Unformatted text preview: Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: The Determination of National Income 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 2. Initial Model Prices and wages are fixed At these prices, there are workers without a job who would like to work and firms with spare capacity they could profitably use The actual quantity of total output is demanddetermined – this will be a “Keynesian” model – Government intervention to keep output close to the potential output For now, also assume: – no government – no foreign trade Later topics relax these assumptions 21.3 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 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 Household consumtpion expenditure (£bn.) 500 475 450 425 400 375 350 400 425 450 475 500 525 550 Real disposable income (£bn.) Income is a strong influence on consumption expenditure – but not the only one. 21.6 Consumption and Income in Mauritius, current prices 21.7 5. The Consumption Function The consumption function shows desired aggregate consumption at each level of aggregate income Consumption With zero income, C = 8 + 0.7 Y desired consumption is 8 (“autonomous consumption”). 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 21.8 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 21.9 5. Saving Function Saving The saving function shows desired saving at each income level. S = -8 + 0.3 Y 0 Income Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. 21.10 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 21.11 Aggregate demand 7. The Aggregate Demand Schedule AD = C + I I C Income Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) 21.12 8. Equilibrium Output: output – expenditure approach Wages and prices are fixed in the model AD < Potential Output, then firm cannot sell as much as they would like Involuntary excess capacity and involuntary unemployment 21.13 Desired spending 8. Equilibrium Output o The 45 line shows the 45 line points at which desired spending equals output E AD or income. Given the AD schedule, o equilibrium is thus at E. Output, Income This the point at which planned spending equals actual output and income. 21.14 Desired spending 8. Adjustment towards Equilibrium 45o line E AD Suppose the economy begins with a lower output, AD > Y If firms have stock, they can sell more by unplanned B C Output, Income No stock, they must turn away customers Either way, the firm should increase outputs 21.15 S, I 9. An Alternative Approach S An equivalent view of equilibrium is seen by equating planned investment (I) E I Output, Income to planned saving (S) again giving us equilibrium at E The two approaches are equivalent. 21.16 10. Effects of a Fall in Aggregate Demand – autonomous consumption or investment 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. 21.17 10. Effects of a Fall in Aggregate Demand – a change in MPC Desired spending 45o line Y1 AD0 Suppose the economy starts in equilibrium at Y0. AD1 There is a change in MPC Y0 Leads the economy to a new equilibrium at Y1. Output, Income 21.18 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 in demand; 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. 21.19 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 of planned 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 21.20 11. The Paradox of Thrift In equilibrium, planned saving equals planned investment and the latter is unaltered. Thus, planned saving cannot change S S Y Y* S’ Y In equilibrium, planned saving = planned investment; A fall (rise) in desire to save induces a rise (fall) in output to keep planned saving equal to planned investment 21.21 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 21.22 ...
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