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.)
Household consumtpion
expenditure (£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
45
o
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
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.
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.