1

» we have already introduced GDP as the most commonly used measure

of output and welfare – taking into account its drawbacks;

» we have also seen that even in most developed economies in the world,
GDP fluctuates: economic booms and recessions are subject to
economic and political analysis;

» in order to explain the fluctuations in real GDP, we will develop a model

based on the circular flow we discussed previously;

» for simplicity, we will ignore differences between GDP, GNP, GNI and
use the terms „output” and „income” interchangeably.

2
» We observe the short-term fluctuations in real GDP – but isn’t it the case,
that – concluding from microeconomic analysis – the level of output should
depend on the inputs the economy has at its disposal and their productivity,
which usually do not change rapidly?

» Economist distinguish between actual output and potential output:

» Actual output is what the economy actually produces in a given period.

» Potential output is the economy’s output when inputs are fully employed. It
tends to grow over time as the supply of inputs or their productivity grow.
˃ Potential output is not the maximum the economy can conceivably
make: it is the output when every market in the economy is in its long-
run equilibrium (all resources are used effectively).
3
» We will analyze the factors determining the long-run economic growth
at the end of the semester – first we will concentrate on the deviations
of the short-term actual output from potential output.

» Since potential output does not change rapidly, we will assume that
potential output is fixed in the short run.

» There are three situations possible in the short run:

▪ actual output < potential output

▪ actual output = potential output
▪ actual output > potential output

» We will analyze the causes and consequences of all three possibilities.

4
In order to analyze our short run fluctuations of output (or to put it more
precisely – deviations of actual output from potential output), we have to
introduce two crucial assumptions:

1. All prices and wages in the economy are fixed at a given level.

2. At these fixed prices and wages, the economy has spare resources
(there are workers without a job who would like to work and firms
with spare capacity they could profitably use).

5
» What results from our assumptions of:
▪ fixed prices and wages,
▪ existence of spare resources in the economy?

1. Since there are spare resources in the economy, actual output must be
different (smaller) than the potential output (where all markets are in
equilibrium).

2. Aggregate demand must be the factor determining output: since there

are spare resources in the economy, and it is not necessary to increase
wages to hire more workers in order to produce more, any rise in
demand will result in an increase in output until potential output is
reached! 6
» Aggregate demand determines output: what we call a short-run
equilibrium is a situation where actual output equals aggregate demand

YE = AD
(the economy reaches short run equilibrium if the companies produce exactly
the amount of goods that is demanded in a given period).

» What are the sources of aggregate demand in the economy?

» Actually, we have already answered this question introducing our national

accounts definitions:

▪ closed economy without a government: Y = AD = C + I

▪ closed economy with a government: Y = AD = C + I + G
▪ open economy: Y = AD = C + I + G + X -Z

7
We have to analyze the determinants of C, I, G, X and Z☺
What determines the households’ consumption and saving decisions? Let
us start with a closed economy without a government model:

» We assume that households’ consumption demand rises with

aggregate income, ceteris paribus – the more we earn, the more we
consume ☺

» This positive relation between income and consumption demand is

called the consumption function. The consumption function shows
aggregate consumption at each level of income.

» But how much do households want to consume at any given income?

8
Economists assume that there are two parts of consumption demand:

1. Autonomous consumption demand (Ca – autonomous means that this

is the part of the consumption demand determined by other factors
than income (or to put it differently: households wish to consume Ca
even if their income Y is 0).

˃ Ca may be partially explained as the minimum consumption needed

for survival, that at zero current income may be financed by dissaving
or running down the households’ assets.

˃ Ca may also change in response to other economic variables – for

example expectations about households’ future income.

2. Consumption directly dependent upon current income.

9
Economists assume that there are two parts of consumption demand:

1. Autonomous consumption demand.

2. Consumption directly dependent on current income – to describe which

part of the current income households want to spend on goods and
services, economists introduce the category of the marginal propensity to
consume:

» marginal propensity to consume (c or the MPC) is the fraction of each extra

pound (zloty, dollar) of disposable income that households wish to
consume.

10
» marginal propensity to consume (c or the MPC) is the fraction of each extra
pound (zloty, dollar) of disposable income that households wish to
consume.

» different people may exhibit different marginal propensities to consume (in

case of the poor, it may even equal 100%, in case of the rich – it may be
much lower). But in general, the MPC is a positive fraction between 0 and 1:
you can consume nothing out of additional income and save it all, or you can
consume 100% of your additional income).

» In macroeconomics, we are interested in aggregate behavior of the

household sector – the aggregate MPC and the aggregate consumption
function should reflect average behavior for the population as a whole.

11
If Ca is a positive constant, and MPC is a positive fraction between 0 and 1, then

C = Ca + MPC x Y

» Thus, the consumption function is a straight line, that may be completely

described by its intercept – the height at which it crosses the vertical axis
and its slope – the amount it rises for each unit we move horizontally to the
right.

» The intercept is determined by autonomous consumption, the slope

depends on the marginal propensity to consume!

12
 The consumption function

• The consumption function

C shows aggregate consumption
C = Ca + MPC xY demand at each aggregate
income.

• With zero income, autono-

mous consumption is Ca.

• The marginal propensity to

consume MPC is the slope of
A the line, the fraction of each
0 extra pound (zloty, dollar) that
Y
households wish to spend.
13
 The consumption function

• The intercept of the

C consumption function is
C = Ca + MPC xY determined by autonomous
consumption;

• the slope of the consumption

function depends on the
ΔC
marginal propensity to
consume!
ΔY
A

0 Y

14
Saving is income not consumed:

Y=C+S S=Y-C

» when income Y = 0, saving is – Ca: households are dissaving, or running down

their assets

» Since a fraction MPC of each pound (zloty, dollar) of extra income is consumed, a
fraction (1 – MPC) of each extra pound (zloty, dollar) of income is saved.

» (1 – c) is the marginal propensity to save (MPS) – it represents the fraction of

each extra unit of income that households wish to save.

» Since an extra pound (dollar, zloty) of income is divided into extra desired
consumption and extra desired saving, and there is no other way for the
households to allocate additional income, MPC + MPS = 1 15
The relationship between the consumption function and the saving function:

Y = C + S so S = Y – C
C = Ca + MPC x Y
S = Y – (Ca + MPCxY)
S = Y - Ca – MPCxY
S = - Ca + Y - MPCxY
S = - Ca + Y (1-MPC)

Since MPC + MPS = 1, 1-MPC=MPS

Thus:
S = - Ca + MPSxY

16
 The saving function
• The saving function
shows desired saving
at each income level.

S = - Ca + MPSxY • Since all income is

saved o is spent on
consumption, the
saving function can
0 be derived from the
-A Y consumption
function and vice
versa.

17
» We try to analyze aggregate demand in a closed economy without
government: Y = AD = C + I

» We already know the consumption function – and how about

investment spending?

18
» Investment – as we already know, the companies’ planned spending on new
capital goods in the form of factories, machinery and buildings, but also –
changes in inventories.

» Investment demand – the firms’ desired or planned additions to physical

capital (factories and machines) and to inventories.

» Does the investment demand depend on current income?

» Firms’ Investment demand depends mainly on the anticipated demand for

their output: companies increase their investment if they anticipate an
increase in demand for their goods, and decrease investment if they anticipate
a negative demand shock.

» Thus, the firms’ investment demand is not directly determined by current

level of income in the economy: to put it in other words, investment demand
is autonomous (planned investment is constant, independent of current
19
output and income).
 Investment demand

I
0 Y
20
To sum up:

» in our simple model of a closed economy without government,

aggregate demand is the amount firms and households plan to spend at
each level of income – it is simply households’ consumption demand
(C) plus firms’ investment demand (I)

AD = C + I

» We can also the AD function adding the constant amount of I for the
desired (planned) investment to the previous consumption function.

21
Aggregate demand function

• AD is what households plan

to spend on consumption
AD and firms plan to spend on
investment;

C • Since investment is constant

and autonomous,
I
consumption is the only part
of aggregate demand that
increases with income (apart
from autonomous
consumption, which is also
Y
constant and independent of
current income). 22
We know that in our model:

» wages and prices are fixed;

» the economy has spare resources;

» aggregate demand determines output: what we call a short-run equilibrium is

a situation where actual output equals aggregate demand (planned spending
by households and companies)

YE = AD

(the economy reaches short run equilibrium if the companies produce exactly the
amount of goods that is demanded in a given period).
23
Aggregate demand function
• But how to determine the
right level of aggregate
demand and output, at which
the Y = AD short run
equilibrium condition is met?
AD

• Graphically it is simple: we
should include the 45-degree
line!

• Along the 45-degree line

quantities on the horizontal
Y and vertical axes are equal…
24
Aggregate demand function
• Along the 45-degree line
quantities on the horizontal
and vertical axes are equal…

• The point at which the AD

AD schedule crosses the 45-
E degree line, is the only point
at which aggregate demand
AD is equal to income Y.

• Hence E is the equilibrium

point at which planned
Y
spending equals actual
output and actual income.
25
 Aggregate demand function
• Hence E is the equilibrium
point at which planned
spending equals actual
output and actual income.

AD • At any other output, output

E is not equal to aggregate
F demand.
AD1
• Suppose output and income
are only Y1: aggregate
demand AD1 exceeds actual
Y
output: spending plans
Y1 cannot be realized at this
output level (there is 26

unplanned saving).
 Aggregate demand function

• Suppose output and income

are Y2 now: aggregate
demand AD2 is less than
actual output: companies are
AD not able to sell the total
D output produced, so there is
AD2 E
unplanned investment
(companies add to stocks -
invest in working capital).

Y2 Y

27
The AD schedule – moving along it or shifting it?
• The AD schedule is a straight line
whose position depends on its
intercept (autonomous demand)
and its slope (the MPC).

AD • Changes in income, ceteris paribus,

E induce movements along a given AD
schedule.

• All other changes in aggregate

demand are shown as parallel shifts
in the AD schedule or changes in
Y the slope of the AD schedule.

28
 The AD schedule – moving along it or shifting it?

• If firms get more optimistic about

AD1 future demand and decide to invest
more, autonomous demand
AD
increases and the new AD schedule
is parallel to but higher than the
E
initial AD schedule.
∆I
• The new equilibrium income is
higher.

Y Y1 Y

29
The AD schedule – moving along it or shifting it?
• The slope of the AD schedule – how
aggregate demand changes as
income changes – is determined by
the MPC.
E1
AD • A change in the MPC changes the
slope of the AD schedule, causing it
to rotate around the point on the
E vertical axis at which income is zero.

• An increase in MPC changes the

slope of the AD curve: more money
Y Y1 Y is spent on consumption now at any
given level of output, so the
equilibrium income increases. 30
 Another way to look at equilibrium output:

» Equilibrium output equals the demand from investment and consumption:

Y=C+I

» Planned saving S is defined as the part of income Y not devoted to planned

consumption C:

S = Y – C so Y = C + S

» This implies than in equilibrium (and only in equilibrium) planned investment I

equals planned saving

I=S 31
 At equilibrium output, planned I equals planned S

S, I

E
Spl = -Ca + KSOxY
Ipl

-Ca
Output, income

How does that happen?

32
 At equilibrium output, planned I equals planned S

» firms make their investment decisions and households make their saving and
consumption plans: they are not the same decision units to automatically
equate I and S….

» But: planned saving depends on income, and planned investment does not:
equilibrium income adjusts to make households plan to save as much as firms
are planning to invest!

» Planned investment is autonomous (horizontal line) and planned saving

increases with income and output (marginal propensity to save exceeds zero) –
so the equilibrium output must be the only one where I = S!

33
Let us consider an example:
» in an economy: MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.

What is the equilibrium output in this economy?

Y = AD
AD = C + I
C = 10 + 0,6Y
Y = 10 + 0,6Y + 30
0,4Y = 40
Y = 100
And how about planned saving?
S = -10 + 0,4 Y
S = -10 + 0,4x100 = -10 + 40 = 30
S=I
(or: S = Y – C 34

C = 10 + 0,6x100 = 10 + 60 = 70 S = 100 – 70 = 30 ☺

» What would happen in our economy if income exceeded 100?

let us assume that actual output Y = 120

in our economy: MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.
therefore AD:
AD = C + I
AD = 10 + 0,6x120 + 30 = 112  AD<120 (aggregate demand is lower than Y)
and
S = -10 + 0,4x120 = -10 + 48 = 38  I ≠ 𝑆 (planned investment does not equal
planned saving)

If income in our economy exceeds the equilibrium income (100), households want
to save more (38) than firms want to invest (30)…

Since AD = 112, companies will not be able to sell all the output produced (120): 35
there will be unplanned inventories (120-112 = 8)
» What would happen in our economy if income exceeded 100?

Since AD = 112, companies will not be able to sell all the output produced (120):
there will be unplanned inventories (120-112 = 8)

Does actual saving equal actual investment?

Planned S = actual S = 38 (there is no unplanned saving)

Actual investment = planned investment + unplanned investment
Planned investment = 30
Unplanned investment = 120 – 112 = 8 (unplanned inventories)
Actual investment = 30 + 8 = 38

Actual investment = actual saving

36

Injections = leakages from the circular flow!

» What would happen in our economy if actual income was below 100?
in our economy: MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.
Actual output Y = 90
AD = 10 + 0,6x90 + 30 = 94  AD>Y (AD is higher than actual income)

Does actual saving equal actual investment?

Households and firms want to buy more (AD=94) than the economy actually
produced (Y=90)  there must be unplanned saving (94 – 90 = 4)

Actual investment = planned investment = 30 (companies invest what they

planned and there is no unplanned investment)
Planned saving = -10 + 0,4x90 = -10 + 36 = 26
Actual saving = planned saving + unplanned saving  Actual saving = 26 + 4 = 30
Actual investment = actual saving
37
Injections = leakages from the circular flow!
» What would happen in our economy if actual income was below 100?
in our economy: MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.
Y = 90
AD = 10 + 0,6x90 + 30 = 94  AD>Y (AD is higher than actual income)

There is another possibility:

» If firms have inventories, when AD exceeds actual output in a given period,
companies may make unplanned inventory reductions:

There is no unplanned saving (people may buy what they want)  actual saving =
planned saving = -10 + 0,4x90 = -10 + 36 = 26
There is unplanned investment (stocks are depleted - disinvestment) = - 4
So actual investment = planned investment + unplanned investment
Actual investment = 30 + (-4) = 26
Actual investment = actual saving 38
Injections = leakages from the circular flow!
 45o line
AD1 Suppose the economy
starts in equilibrium
at Y0.
AD0
An increase in aggregate
demand (to be precise – in
autonomous demand – eg.
investment) to AD1…

….leads the economy

Y0 Y1 to a new equilibrium
Output, Income at Y1.

39
Notice that the change in equilibrium output is
larger than the original change in autonomous demand!
Do you remember our economy where:

MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.

Y = 100 (initial equilibrium output)

Let us assume now that firms decide to invest more: ΔI = 10 (new investment = 40)

What is the new equilibrium output in this economy?

Y = AD
AD = C + I
C = 10 + 0,6Y
Y = 10 + 0,6Y + 40
0,4Y = 50
Y = 125
An increase in investment by 10 resulted in an increase in equilibrium output 40

by 25!
Why does an increase in investment by 10 result in an increase in equilibrium
output by 25?

» Higher investment demand induces an increase in output and income that then
induces an extra increase in consumption (households have more money at
their disposal, so ceteris paribus – holding their Ca, MPC and MPS constant,
they will plan to consume and save more).

» Therefore, total demand increases by more than the initial increase in

investment.

» Economists measure the strength of this change in income using the category
of multiplier:

The multiplier is the ratio of the change in equilibrium output to the change in
autonomous spending that caused the change: 41

∆𝐘
Multiplier (M)=
∆𝐀𝐃𝐚
The multiplier is the ratio of the change in equilibrium output to the change in
autonomous spending that caused the change:
∆𝐘
Multiplier (M)=
∆𝐀𝐃𝐚

» In our example, the initial change in autonomous investment demand

was 10, and the final change in equilibrium output was 25 – so the
multiplier was 2,5!

» We can look at it from a different perspective:

∆Y
» Since M= , ∆Y = M x ∆Ada
∆ADa

» But what does the multiplier depend on? 42

What do we know about the multiplier?

» the multiplier tells us how much output changes after a shift in aggregate
demand (a change in autonomous demand);

» the multiplier exceeds 1 because a change in autonomous demand sets off

further changes in consumption demand – the more households earn as
owners of the factors of production, the more they will spend, ceteris paribus;

» the size of the multiplier depends on the MPC: the initial effect of a unit
increase in investment is to increase output and income by one unit as well –
but then – in accordance with the MPC – some part of the additional income is
consumed, which also contributes to an increase in AD, and thus – income;

» Additional income is divided into additional consumption and saving – and so

on… but additional increases in aggregate demand and income are getting 43
smaller and smaller… When does the process stop?
How did aggregate demand change in our example?

Step 1
» An initial increase in investment by 10 „injected” into the circular flow of our
economy resulted in an increase in AD by 10 and an increase in income by 10
as well

Step 2
» Households – who owe the factors of production – got this additional income
(10) and divided it into saving and consumption (since MPC = 0,6, 60% of the
additional income will be consumed, 40% will be saved).

» Therefore, since households spend additional 6 on consumption, AD increases

further by 6 and so does income.
44
How did aggregate demand change in our example?

Step 3
» since in step 2 income increased by 6, households will spend 0,6x6=3,6 and
save 0,4x6=2,4;
» Additional increase in consumption by 3,6 will result in an increase in AD and
income – and again, some of it (60%) will be consumed, and the rest – saved…

Only in steps 1-3 our income increased by: 10 + 6 + 3,6…

» The process continues in our circular flow as long as there are any positive
changes in income – but the changes in income are getting smaller and smaller
in accordance with an obvious pattern…

45
How did aggregate demand change in our example?

We should add up all the increases in AD and income to calculate the total
increase:

Total increase in AD and income = 1x10 + 0,6x10 + 0,62x10 + 0,63x10 + 0,64x10 +…

and so on…

» The right-hand side of this equation is called a geometric series – each term
(increase in AD and income) is 0,6 times the previous term (increase);

» Mathematicians have come up with a general formula for the sum of all the
terms in such a series:

46
𝟏𝟎
Sum of our geometric series =
𝟏−𝟎,𝟔
» Mathematicians have come up with a general formula for the sum of all the
terms in such a series:
𝟏𝟎
Sum of our geometric series =
𝟏−𝟎,𝟔

How to interpret it?

» Sum of our geometric series = sum of all increases in AD and income (∆Y)
» 10 – initial change in autonomous demand (∆ADa)
» 0,6 – marginal propensity to consume.

Therefore:

∆ADa 47
∆Y = =
𝟏−𝑴𝑷𝑪
Do you remember?

The multiplier is the ratio of the change in equilibrium output to the change in
autonomous spending that caused the change:
∆𝐘
Multiplier (M)=
∆𝐀𝐃𝐚
∆ADa ∆Y 1
Since ∆Y = =  ∆ADa =
𝟏−𝑴𝑷𝑪 𝟏−𝑴𝑷𝑪

Therefore:
1
Multiplier (M) =
𝟏−𝑴𝑷𝑪

1 1
So in our case: M = = =2,5!
𝟏−𝟎,𝟔 𝟎,𝟒
48

An increase in investment by 10 results in an increase in income by 2,5 x 10 = 25☺

Implications:
1
Multiplier (M) =
𝟏−𝑴𝑷𝑪

» The larger the MPC, ceteris paribus, the larger the multiplier.
» Since MPC + MPS = 1 (any part of an extra unit of income not spent must be
saved), 1 – MPC = MPS: we can also think of the multiplier as:

1 1
Multiplier (M) = =
𝟏−𝑴𝑷𝑪 𝑴𝑷𝑺

» The higher the marginal propensity to save, the more of each extra unit of
income leaks out of the circular flow into saving and the less goes back round the
circular flow to generate further increase in AD, output and income.

49
» We have already analyzed a change in equilibrium output caused by a change in
autonomous investment demand.

» What happens if – ceteris paribus – the autonomous part of planned

consumption and saving changes?

» Suppose that households increase autonomous consumption demand – there is a

parallel upward shift in the consumption function and hence also in the aggregate
demand schedule AD.

» A higher AD schedule must intersect the 45-degree line at a higher level of output
– hence equilibrium output increases.

» But what happens to planned saving?

50
But what happens to planned saving?

» Since households intend to consume more at any given income, it means that
they want to save less… but does the level of saving decrease?

» No! – since households decided to consume more, equilibrium income increased

and households have higher income at their disposal now: as we know, in a
closed economy without government planned saving always equals planned
investment – so the level of saving does not change, but the fraction of income
that is saved changes…

» Planned saving must equal planned investment in equilibrium, so equilibrium

income must have risen just enough to offset the desire to save a lower fraction
of any particular income level, leaving planned saving unaltered in new
equilibrium.
51
» Proof?
Let us look at our example again:

MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.

Y = 100 (equilibrium output)

Households decide to increase autonomous consumption demand by 10:

Ca = 20, ceteris paribus - MPC = 0,6 (thus MPS = 0,4) and I = 30.
The new equilibrium income is:
Y = AD
Y = 20 + 0,6Y + 30
0,4Y = 50
Y = 125.

And how about planned saving? 52

Ca = 20, ceteris paribus - MPC = 0,6 (thus MPS = 0,4) and I = 30.
The new equilibrium income is:
Y = AD
Y = 20 + 0,6Y + 30
0,4Y = 50
Y = 125.
And how about planned saving?

S = - Ca + 0,4xY
S = -20 + 0,4x125 = -20 + 50 = 30
Or
Y=C+SS=Y–C
C = 20 + 0,6x125 = 20 + 75 = 95
S = 125 – 95 = 30
S = 30 – and so is investment – planned investments still equals planned saving! 53
To conclude:
» A decline to thriftiness – a fall in the desire to save – does not affect planned
investment – hence in order to restore equilibrium where planned investment =
planned saving, equilibrium income must rise enough to maintain the equality of
planned saving (which depends on current income) and planned investment.

» The paradox of thrift describes this phenomenon: a change in the amount

households wish to save (and consume) at each income leads to a change in
equilibrium income, but there is no change in equilibrium saving, which must still
equal planned investment.

» Why is it a paradox?
» Common sense would suggest that if we want to consume more, we will end up
with lower level of saving, and when we want to save more, out income will
remain unaffected.
54
» Is saving beneficial for the economy? Not necessarily in this model…
Our example again:
MPC = 0,6 (thus MPS = 0,4), Ca = 10 and I = 30.
Y = 100 (equilibrium output)
C = Ca + 0,6xY  C = 10 + 60 = 70, S = I = 30

Now assume we want to save more and consume less at any income (Ca falls to 0)
Consumption function is C=0,6xY and saving: S=0,4Y
Equilibrium income must change:
Y = AD
Y = 0,6Y + 30
0,4Y = 30
Y = 75
We earn less, so we can consume less:
C = 0,6x75 = 45, but saving still equals investment: S = 0,4x75 = 30
Paradox: we still save the same sum, but equilibrium income and consumption 55

decrease… in our model, ceteris paribus, thrifty people actually seem not to know
which side their bread is buttered on…