David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 16 Output and aggregate demand
0 Questions
In each case, decide whether the AD schedule is shifting or whether the economy is moving along a given AD
schedule:
(a) After the US sub-prime mortgage market crisis, there was a wave of pessimism among UK consumers,
who decided to play safe and save more, even before their incomes fell.
(b) UK consumer spending has risen because households are having a good year and enjoying high incomes.
(c) The 2012 Olympic Games in London are causing an investment boom in the construction industry.
To check your answers to these questions, go to page 685.
Adjustment towards equilibrium
Suppose in Figure 16.5 that the economy begins with an output of Yp below equilibrium output Y*.
Aggregate demand AD1 exceeds output Y1• If firms have inventories from the past, they can sell more than
they have produced by running down stocks for a while. Note that this destocking is unplanned; planned
changes of stocks are already included in the total investment demand I.
If firms cannot meet aggregate demand by unplanned destocking, they must turn away customers.
Either response - unplanned destocking or turning away customers - is a signal to firms to raise
output above Y1• Hence, at any output below Y*, aggregate demand exceeds output and firms get signals to
raise output.
Conversely, if output is initially above its equilibrium level, Figure 16.5 shows that output will then exceed
aggregate demand. Firms cannot sell all their output, make unplanned additions to inventories and respond
by cutting output.
Hence, when output is below its equilibrium level, firms raise output. When output is above its equilibrium
level, firms reduce output. At the equilibrium output Y*, firms sell all their output and make no unplanned
changes to their stocks. There is no incentive to change output.
In this example, short-run equilibrium output is Y*. Firms sell all the goods they produce, and households
and firms buy all the goods they want. But nothing guarantees Y* is the level of potential output.
The economy can end up at a short-run equilibrium output below potential output, with no forces then
present to move output to potential output. At the given level of prices and wages, a lack of aggregate
demand will prevent expansion of output above its short-run equilibrium level.
Investment during the crash of 2009
Our simple model of aggregate demand assumes that output is the principal driver of
consumption demand but does not directly affect investment demand. This does not mean that
investment demand is always constant, merely that it is not well explained by changes in income. In later
chapters we return to the question of what does affect investment demand.
Even at this early stage, it is a good idea to check our theory is proceeding along the right lines. How did
consumption and investment respond during the crash of 2009? The figure below shows UK data during
2007-10. It shows annual percentage changes in output, consumer spending and investment.
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