Potential output is the
economy’s output when inputs
are fully employed.
Since markets trade the smaller
of supply and demand, output
is demand-determined when
there is excess supply and
wages and prices have yet to
adjust to restore long-run
equilibrium. Output then
depends only on aggregate
demand.
Personal disposable income
is the income households
receive from firms, plus transfer
payments received from the
government, minus direct taxes
paid to the government. It is the
net income households can
spend or save.
The consumption function
shows aggregate consumption
demand at each level of
personal disposable income.
The marginal propensity to
consume is the fraction of each
extra pound of disposable
income that households wish to
consume.
The saving function shows
desired saving at each income
level.
Investment demand is firms’
desired or planned additions to
physical capital (factories and
machines) and to inventories.
Aggregate demand is the
amount firms and households
plan to spend at each level of
income.
When prices and wages are
fixed, at short-run equilibrium
output aggregate demand or
planned spending equals the
output actually produced.
The multiplier is the ratio of the
change in equilibrium output to
the change in autonomous
spending that caused the
change.
The marginal propensity to
Save is the fraction of each
extra unit of income that
households wish to save.
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