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 savings, 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 savings, which must still equal planned
investment. Higher output offsets the reduced desire to save at each output level.
