Potential output


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Potential output



Prices and wages are fixed.

  • Prices and wages are fixed.

  • The actual quantity of total output is demand-determined.

    • This will be a Keynesian model.
  • For now, also assume:

  • Later chapters relax these assumptions.



Given no government and no international trade, aggregate demand has two components:

  • Given no government and no international trade, aggregate demand has two components:

    • Investment
    • Consumption
      • households’ demand for goods and services
  • so, AD = C + I



Households allocate their income between consumption and saving.

















The multiplier is the ratio of the change in equilibrium output to the change in autonomous spending that causes the change in output.

  • 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.



A change in the amount households wish to save at each income leads to a change in equilibrium income, but no change in equilibrium saving, which must still equal planned investment. This is the paradox of thrift.

  • A change in the amount households wish to save at each income leads to a change in equilibrium income, but no change in equilibrium saving, which must still equal planned investment. This is the paradox of thrift.

  • Thus, when aggregate demand is low and the economy has spare resources, the paradox of thrift shows that a reduction in the desire to save will increase spending and increase the equilibrium income level.

  • Society benefits from higher output and employment. And since investment demand is autonomous, a change in the desire to save has no effect on the desired level of investment.






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