Keynesian Aggregate Demand and Output

Aggregate demand is the total planned spending on goods and services produced in an economy. In the basic Keynesian model, with prices fixed and unused productive capacity, equilibrium output is the level at which planned aggregate expenditure equals production, so firms have no reason to change output.

What determines aggregate demand?

The economy's spending decisions determine how much output firms can expect to sell. The simplest model considers households and firms, leaving out government and foreign trade.

• In this two-sector model, AD = C + I, where C is planned consumption and I is planned investment.
• The consumption function is C = C₀ + cY, where C₀ is autonomous consumption, Y is income, and c is the marginal propensity to consume, with 0 < c < 1.
• Planned investment is assumed to be autonomous, meaning that it does not change with current income in this model.
• Including government and foreign trade gives AD = C + I + G + (X - M), adding government purchases and net exports.

How output moves towards equilibrium

Equilibrium requires Y = AD: output, which generates income, must equal planned spending. Firms respond to discrepancies through changes in production.

• If planned expenditure exceeds output, firms experience an unplanned fall in inventories and increase production, raising employment and income.
• If planned expenditure falls short of output, unsold goods cause an unplanned rise in inventories, prompting firms to reduce production.
• In the expenditure-income diagram, equilibrium occurs where the aggregate expenditure line intersects the 45-degree line, along which expenditure equals output.

Equilibrium income and the multiplier

Combining the consumption function with autonomous investment gives Y = C₀ + cY + I. Therefore, Y = (C₀ + I)/(1 - c).

• An increase in autonomous spending creates income, part of which households spend, generating further rounds of income and consumption.
• The expenditure multiplier is 1/(1 - c), so the increase in equilibrium income exceeds the initial increase in autonomous spending under the model's assumptions.

Why equilibrium need not mean full employment

A deficient level of aggregate demand can produce equilibrium below full-employment output: firms may have no incentive to expand even while workers remain unemployed. Higher autonomous spending, including government expenditure, can raise output when resources are idle; as capacity constraints bind, additional demand increasingly raises prices rather than real output.