Aggregate demand is planned spending on goods (and services).
The AD schedule shows aggregate demand at each level of income and output.
This chapter neglects planned spending by foreigners and by the government,
studying consumption demand by households and investment
demand by firms (desired additions to physical capital and to inventories).
We treat investment demand as constant.
Consumption demand is closely though not perfectly related to personal
disposable income. Without taxes or transfers, personal disposable
income and total income coincide.
Autonomous consumption is desired consumption at zero
income. The marginal propensity to consume(MPC)
is the fraction by which planned consumption rises when income rises by a
pound. The marginal propensity to save (MPS) is the fraction
of an extra pound of income that is saved. Since income is consumed or saved,
MPC + MPS = 1.
For given prices and wages, the goods market is in equilibrium when output
equals planned spending or aggregate demand. Equivalently, in equilibrium,
planned saving equals planned investment. Goods market equilibrium
does not mean output equals potential output. It means planned spending equals
actual spending and actual output.
The equilibrium output is demand-determined because we
assume that prices and wages are fixed at a level that implies an excess supply
of goods and labour. Firms and workers are happy to supply whatever output
and employment is demanded.
When aggregate demand exceeds actual output there is either unplanned disinvestment
(inventory reductions) or unplanned saving (frustrated customers). Actual
investment always equals actual saving, as a matter of definition. Unplanned
inventory reductions or frustrated customers act as a signal to firms to raise
output when aggregate demand exceeds actual output. Similarly, unplanned additions
to stocks occur when aggregate demand is below output.
A rise in planned investment increases equilibrium output by a larger amount.
The initial increase in income to meet investment demand leads to further
increases in consumption demand.
The multiplier is the ratio of the change in output to
the change in autonomous demand that caused it. In the simple model of this
chapter, the multiplier is 1/[(1 – MPC)] or 1/MPS. The multiplier exceeds
1 because MPC and MPS are positive fractions.
The paradox of thrift shows that a reduced desire to save
leads to an increase in output but no change in the equilibrium level of planned
saving, which must still equal planned investment. Higher output off sets
the reduced desire to save at each output level.
