Ch2 aggregate expenditure

MACROECONOMICSMACROECONOMICS
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Aggregate Expenditure
and Equilibrium Output
CHAPTER 2CHAPTER 2

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Aggregate Output and
Aggregate Income (Y)
 Aggregate output is the total quantity of
goods and services produced (or supplied) in
an economy in a given period.
 Aggregate income is the total income
received by all factors of production in a given
period.

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Aggregate Output and
Aggregate Income (Y)
 Aggregate output (income) (Y) is a
combined term used to remind you of the
exact equality between aggregate output
and aggregate income.
 When we talk about output (Y), we mean
real output, or the quantities of goods and
services produced, not the dollars in
circulation.

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Income, Consumption,
and Saving (Y, C, and S)
 A household can do two, and only two, things with its
income: It can buy goods and services—that is, it can
consume—or it can save.
 Saving is the part of its income that a household
does not consume in a given period.
S = Y - C

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Household Consumption and
Saving
 Some determinants of aggregate
consumption include:
1. Household income
2. Household wealth
3. Interest rates
4. Households’ expectations about the future
 In The General Theory, Keynes argued that
household consumption is directly related to
its income.

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Saving
 The relationship between
consumption and income is
called the consumption
function.
• For an individual household,
the consumption function
shows the level of
consumption at each level
of household income.

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Saving
 The slope of the
consumption function
(b) is called the
marginal propensity
to consume (MPC), or
the fraction of a change
in income that is
consumed, or spent.
bYaC +=
1b0 <<

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Saving
 The fraction of a change in income that is saved is
called the marginal propensity to save (MPS).
• Once we know how much consumption will
result from a given level of income, we
know how much saving there will be.
1MPSMPC =+

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An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
C Y= +1 0 0 7 5.
AGGREGATE
INCOME, Y
(BILLIONS OF
DOLLARS)
AGGREGATE
CONSUMPTION, C
(BILLIONS OF
DOLLARS)
0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850

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An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
 At a national income of
zero, consumption is
$100 billion (a).
 For every $100 billion
increase in income
(∆Y), consumption
rises by $75 billion
(∆C).
C Y= +1 0 0 7 5.

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Deriving a Saving Function
from a Consumption Function
S Y C≡ −
Y - C = S
AGGREGATE
INCOME
(Billions of
Dollars)
AGGREGATE
CONSUMPTION
(Billions of
Dollars)
AGGREGATE
SAVING
(Billions of
Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
C Y= +1 0 0 7 5.

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Planned Investment (I)
 Investment refers to purchases by firms of
new buildings and equipment and additions to
inventories, all of which add to firms’ capital
stock.
 One component of investment—inventory
change—is partly determined by how much
households decide to buy, which is not under
the complete control of firms.
change in inventory = production – sales

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Actual versus Planned Investment
 Desired or planned investment refers to the
additions to capital stock and inventory that
are planned by firms.
 Actual investment is the actual amount of
investment that takes place; it includes items
such as unplanned changes in inventories.

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The Planned Investment Function
 For now, we will assume
that planned investment is
fixed. It does not change
when income changes.
 When a variable, such as
planned investment, is
assumed not to depend on
the state of the economy, it
is said to be an
autonomous variable.

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Planned Aggregate Expenditure
(AE)
Planned aggregate
expenditure is the
total amount the
economy plans to
spend in a given
period. It is equal to
consumption plus
planned investment.
ICAE +≡

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Equilibrium Aggregate
Output (Income)
 Equilibrium occurs when there is no
tendency for change. In the macroeconomic
goods market, equilibrium occurs when
planned aggregate expenditure is equal to
aggregate output.

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Output (Income)
Y > C + I
aggregate output > planned aggregate expenditure
inventory investment is greater than planned
actual investment is greater than planned investment
Disequilibria:
C + I > Y
planned aggregate expenditure > aggregate output
inventory investment is smaller than planned
actual investment is less than planned investment
aggregate output : Y
planned aggregate expenditure : AE = C + I
equilibrium: Y = AE, or Y = C + I

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Output (Income)

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Output (Income)
C Y= +1 0 0 7 5. I = 2 5
Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures
in Billions of Dollars) The Figures in Column 2 are Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
AGGREGATE
OUTPUT
(INCOME) (Y)
AGGREGATE
CONSUMPTION (C)
PLANNED
INVESTMENT (I)
PLANNED
AGGREGATE
EXPENDITURE (AE)
C + I
UNPLANNED
INVENTORY
CHANGE
Y − (C + I)
EQUILIBRIUM?
(Y = AE?)
100 175 25 200 − 100 No
200 250 25 275 − 75 No
400 400 25 425 − 25 No
500 475 25 500 0 Yes
600 550 25 575 + 25 No
800 700 25 725 + 75 No
1,000 850 25 875 + 125 No

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Output (Income)
Y Y= + +1 0 0 7 5 2 5.
Y C I= +(1)
C Y= +1 0 0 7 5.(2)
I = 2 5(3)
By substituting (2) and
(3) into (1) we get:
There is only one value of Y
for which this statement is
true. We can find it by
rearranging terms:
Y Y= + +1 0 0 7 5 2 5.
Y Y− = +.7 5 1 0 0 2 5
Y Y− =.7 5 1 2 5
.2 5 1 2 5Y =
Y = =
1 2 5
2 5
5 0 0
.

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The Saving/Investment
Approach to Equilibrium
If planned investment is exactly equal to saving,
then planned aggregate expenditure is exactly
equal to aggregate output, and there is equilibrium.

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The S = I Approach to Equilibrium
 Aggregate output will be equal to planned
aggregate expenditure only when saving
equals planned investment (S = I).

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The Multiplier
 The multiplier is the ratio of the change in
the equilibrium level of output to a change in
some autonomous variable.
 An autonomous variable is a variable that is
assumed not to depend on the state of the
economy—that is, it does not change when
the economy changes.
 In this chapter, for example, we consider
planned investment to be autonomous.

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The Multiplier
 The multiplier of autonomous investment
describes the impact of an initial increase in
planned investment on production, income,
consumption spending, and equilibrium
income.
 The size of the multiplier depends on the
slope of the planned aggregate expenditure
line.

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The Multiplier Equation
M P S
S
Y
=
∆
∆
M P S
I
Y
=
∆
∆
• Because ∆S must be equal to ∆I for
equilibrium to be restored, we can
substitute ∆I for ∆S and solve:
therefore, ∆ ∆Y I
M P S
= ×
1
m u l t i p l i e r
M P S
≡
1 , or m u l t i p l i e r
M P C
=
−
1
1
 The marginal propensity to save may be
expressed as:

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The Multiplier
• After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.

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The Size of the Multiplier
in the Real World
 The size of the multiplier in the U.S.
economy is about 1.4. For example, a
sustained increase in autonomous
spending of $10 billion into the U.S.
economy can be expected to raise real
GDP over time by $14 billion.

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 When households
become concerned
about the future and
decide to save more,
the corresponding
decrease in
consumption leads to
a drop in spending
and income.
• Households end up consuming less, but
they have not saved any more.

Ch2 aggregate expenditure

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Ch2 aggregate expenditure