Aggregate Expenditure and Equilibrium Output

The Core of Macroeconomic Theory

Aggregate Output and Aggregate Income (Y)

Aggregate output i the total quantity of good and er!ice produced (or upplied) in an economy in a gi!en period" Aggregate income i the total income recei!ed by all factor of production in a gi!en period"

Aggregate Output and Aggregate Income (Y)

Aggregate output (income) (Y) i a combined term u ed to remind you of the exact equality bet#een aggregate output and aggregate income" $hen #e tal% about output (Y)& #e mean real output& or the quantitie of good and er!ice produced& not the dollar in circulation"

Explaining 'pending (eha!ior

All income i either pent on con umption or a!ed in an economy in #hich there are no taxe " 'a!ing Aggregate Income Con umption

)ou ehold Con umption and 'a!ing

'ome determinant of aggregate con umption include*
+" ," -" ." )ou ehold income )ou ehold #ealth Intere t rate )ou ehold / expectation about the future

In The General Theory& 0eyne argued that hou ehold con umption i directly related to it income"

)ou ehold Con umption and 'a!ing

C = a + bY
The lope of the con umption function (b) i called the marginal propensity to consume (MPC), or the fraction of a change in income that i con umed& or pent"

0 < b<1

)ou ehold Con umption and 'a!ing

The fraction of a change in income that i a!ed i called the marginal propensity to save (MPS).

MPC + MPS 1
Once #e %no# ho# much con umption #ill re ult from a gi!en le!el of income& #e %no# ho# much a!ing there #ill be" Therefore&

S Y C

An Aggregate Con umption 1unction 2eri!ed from the Equation C 3 +44 5 "67Y

C = 1 0 0 + .7 5 Y
At a national income of 8ero& con umption i 9+44 billion (a)" 1or e!ery 9+44 billion increa e in income ( Y)& con umption ri e by 967 billion ( C)"

Con umption 1unction (alternati!e formulation)

C = c + c(Y T )
c c (Y T )
-Autonomous consumption -Marginal Propensity to Consume (MPC) -Disposable ncome (D ) ( ncome - !et "a#es)

The 2eterminant of Con umption

$ealth
: Affect con umption expenditure

The price le!el

: Affect real purcha ing po#er of financial a et

C C C

The intere t rate

: Cau e con umer to po tpone con umption

Expectation (of income or price )

: A more optimi tic outloo% on the economy #ill rai e con umer / expenditure

2eri!ing a 'a!ing 1unction from a Con umption 1unction

C = 1 0 0 + .7 5 Y S Y C
Y
AGGREGATE INCOME (Billions of Dollars) 0 80 100 200 400 600 800 1,000

C
AGGREGATE CONSUMPTION 100 160 175 250 400 550 700 850

S
AGGREGATE SAVING -100 -80 -75 -50 0 50 100 150

(Billions of Dollars) (Billions of Dollars)

;lanned In!e tment (I)

Investment refer to purcha e by firm of ne# building and equipment and addition to in!entorie & all of #hich add to firm / capital toc%" One component of in!e tment<in!entory change<i partly determined by ho# much hou ehold decide to buy& #hich i not under the complete control of firm "
change in inventory = production sales

Actual !er u ;lanned In!e tment

esire! or planne! investment refer to the addition to capital toc% and in!entory that are planned by firm "

Actual investment i the actual amount of in!e tment that ta%e place= it include item uch a unplanned change in in!entorie "

The ;lanned In!e tment 1unction

1or no#& #e #ill a ume that planned in!e tment i fixed" It doe not change #hen income change " $hen a !ariable& uch a planned in!e tment& i a umed not to depend on the tate of the economy& it i aid to be an autonomous varia"le.

In!e tment 1unction

I=I
n$estment is autonomous (in%epen%ent o& income)

;re ent >alue Internal ?ate of ?eturn

'n '1 '( PV = + + ... + 1 ( n ( 1 + i ) (1 + i ) (1 + i )
")e Present *alue o& a stream o& payments +)ere can be interprete% as t)e internal rate o& return

;re ent >alue Internal ?ate of ?eturn

5mil 5mil PV = 5mil + + ... + 1 1, (1 + i ) (1 + i )
")e Present *alue o& a 100 million -otto pay o&&
Intere t ?ate @"4A 6"4A C"4A B"4A +4"4A +7"4A ,4"4A ;re ent >alue (9@4&6B4&7C,".@) (97@&@66&B6@",+) (97-&4+6&BB@"44) (9.B&674&76-"B4) (9.@&C,.&@44".@) (9-7&BB+&+77"B6) (9,B&,+6&.6C".4)

In!e tment and the In!e tment 1unction

Nominal At thi point in!e tment i interest rate planned in!e tment expenditure (I) In!e tment i clo ely lin%ed to the intere t rate& ince intere t repre ent the opportunity co t of in!e ting in capital The in!e tment function #ill hift #ith change in expectation for bu ine profit

D D
Investment spending (I)

Autonomou In!e tment

Although in!e tment i related to the intere t rate and bu ine expectation & in!e tment doe not depend in any ignificant #ay on di po able income
: A uch& in!e tment i Dautonomou E

)o#e!er& change in the intere t rate or expectation for profit #ill till hift autonomou in!e tment

I I I
Real disposable income

2eterminant of In!e tment (elo# are all the thing that can cau e a hift in the in!e tment function
: The intere t rate : Expectation of future profit : Technology

;lanned Aggregate Expenditure (AE)

Planne! aggregate e#pen!iture i the total amount the economy plan to pend in a gi!en period" It i equal to con umption plu planned in!e tment"

AE C + I

Equilibrium Aggregate Output (Income)

$%uili"rium occur #hen there i no tendency for change" In the macroeconomic good mar%et& equilibrium occur #hen planned aggregate expenditure i equal to aggregate output"

Equilibrium Aggregate Output (Income)

aggregate output Y planned aggregate expenditure AE C 5 I equilibrium* Y 3 AE& or Y 3 C 5 I

2i equilibria* Y>C5I
aggregate output F planned aggregate expenditure in!entory in!e tment i greater than planned actual in!e tment i greater than planned in!e tment

C5I>Y
planned aggregate expenditure F aggregate output in!entory in!e tment i maller than planned actual in!e tment i le than planned in!e tment

Equilibrium Aggregate Output (Income)

Equilibrium Aggregate Output (Income)

C = 1 0 0 + .7 5 Y
(1)
AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT (I)

I = (5
(4)
PLANNED AGGREGATE EXPENDITURE (AE) C+I

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.

(2)

(3)

(5)
UNPLANNED INVENTORY CHANGE Y ( C + I)

(6)

EQUILIBRIUM? (Y = AE?)

100 200 400 500 600 800 1,000

175 250 400 475 550 700 850

25 25 25 25 25 25 25

200 275 425 500 575 725 875

100 75 25 0 + 25 + 75 + 125

No No No Yes No No No

Equilibrium Aggregate Output (Income)

(+) (,) (-)

Y = C + I C = 1 0 0 + .7 5 Y

Y = 1 0 0 + .7 5 Y + ( 5
There i only one !alue of Y for #hich thi tatement i true" $e can find it by rearranging term *

I = (5

(y ub tituting (,) and (-) into (+) #e get*

Y = 1 0 0 + .7 5 Y + ( 5

Y .7 5 Y = 1 0 0 + ( 5 Y .7 5 Y = 1 ( 5 .( 5 Y = 1 ( 5
1(5 Y = = 500 .( 5

The 'a!ingGIn!e tment Approach to Equilibrium

If planned in!e tment i exactly equal to a!ing& then planned aggregate expenditure i exactly equal to aggregate output& and there i equilibrium"

The S 3 I Approach to Equilibrium

Aggregate output #ill be equal to planned aggregate expenditure only #hen a!ing equal planned in!e tment (S 3 I)"

The Multiplier
The multiplier i the ratio of the change in the equilibrium le!el of output to a change in ome autonomou !ariable"
: An autonomous varia"le i a !ariable that i a umed not to depend on the tate of the economy< that i & it doe not change #hen the economy change "

In thi chapter& for example& #e con ider planned in!e tment to be autonomou "

The Multiplier
The multiplier of autonomou in!e tment de cribe the impact of an initial increa e in planned in!e tment on production& income& con umption pending& and equilibrium income" The i8e of the multiplier depend on the lope of the planned aggregate expenditure line"

The Multiplier Equation

The marginal propen ity to a!e may be expre ed a *
S M PS = Y

(ecau e S mu t be equal to I for equilibrium to be re tored& #e can ub titute I for S and ol!e*
1 therefore& Y = I M PS 1 1 & or m u ltip lie r = m u ltip lie r 1 M PC M PS
I M PS = Y

The Multiplier
After an increa e in planned in!e tment& equilibrium output i four time the amount of the increa e in planned in!e tment"

The 'i8e of the Multiplier in the ?eal $orld

The i8e of the multiplier in the H"'" economy i about +"." 1or example& a u tained increa e in autonomou pending of 9+4 billion into the H"'" economy can be expected to rai e real GDP o!er time by 9+. billion"

The ;aradox of Thrift

$hen hou ehold become concerned about the future and decide to a!e more& the corre ponding decrea e in con umption lead to a drop in pending and income"

)ou ehold end up con uming le & but they ha!e not a!ed any more"

Io!ernment Expenditure and Autonomou Jet Taxe

$e #ill a ume that go!ernment expenditure (I) and net taxe (T) are autonomou
: Thi a umption #ill %eep our model from becoming o!erly complex : It #ill al o allo# u to ea ily analy8e fi cal policy a both I and T change

T =T G=G
G T
Real income

It #ould be po ible to con ider taxe that !ary #ith I2; (income taxe )

Autonomou Jet Export (K L M)

If both export (K) and import (M) are autonomou & then net export are autonomou

X ! X!

X M = X M

X !
Real disposable income

2eterminant of KLM
The follo#ing #ill cau e a hift in the net export function"
: The Exchange ?ate If the 2ollar appreciate & then export fall and import ri e& both cau ing net export to fall& or hift do#n" : 1oreign I2; (Income) A foreign income ri e & they import more good from around the #orld including the H'" 'o our export #ill ri e a #e ati fy their demand for our good "

>ariable Import
Import may !ery #ell be related to income Thi ma%e net export decrea e #ith income

M = m + m(Y T )

X!
Real disposable income

Aggregate Expenditure and Income

;lanned Expenditure
$hat about the beha!ior (the Dplan E) of our economic actor M
: Con umption (C) i DplannedE on the ba i of di po able income : In!e tment (I) i DplannedE ba ed on the intere t rate and bu ine expectation (although it i autonomou #ith re pect to I2;& or income) : I and (KLM) are imply autonomou

According to 0eyne & aggregate planned expenditure (demand) determine output and income& e!en in the long run

The IncomeLExpenditure Model

A relation hip bet#een aggregate income and planned aggregate expenditure that determine & for a gi!en price le!el& #here income (and I2;) equal planned expenditure The aggregate expenditure function i a relation hip ho#ing the amount of planned pending for each le!el of income Equilibrium occur in the model #here planned aggregate expenditure equal income (I2;)
: Hnintended change in in!entorie play a %ey role

;lanned Aggregate Expenditure (trillion of dollar )

Real Net Dis. Planned Gov't Net Planned GDP Taxes Income Cons. Saving Inv. Purchases Export Exp. 9@"4 9+"4 97"4 9."6 94"94"@ 9+"4 L94"+ 9@", 9@"7 9+"4 97"7 97"+ 94". 94"@ 9+"4 L94"+ 9@"@ 96"4 9+"4 9@"4 97"7 94"7 94"@ 9+"4 L94"+ 96"4 96"7 9+"4 9@"7 97"B 94"@ 94"@ 9+"4 L94"+ 96". 9C"4 9+"4 96"4 9@"94"6 94"@ 9+"4 L94"+ 96"C

2eri!ing Equilibrium Income and Output

$ $%o C#I#G#(X !)

&'(ilibri(m Real GD"

Real GD"

The 'imple 'pending Multiplier

$ $%
o

C#I#G#(X !) C#I#G#(X !)

/imple /implespen%ing spen%ingmultiplier multiplier= = .DP0 .DP0 = =10(1-MPC) 10(1-MPC)= =10MP/ 10MP/

.DP

Real GD"

The 'pending Multiplier and the Circular 1lo# (M;C 3 "C)

New Spending 9+44"44 9C4"44 9@."44 97+",4 Cumulative Cumulative New New New Spending Saving Saving 9+44"44 9+C4"44 9,4"44 9,4"44 9,.."44 9+@"44 9+@"44 9,B7",4 9+,"C4 9+,"C4

Round + , .

. . .

. . .

. . .

. . .

. . .

94"44

9744"44

94"44

9+44"44

0eyne and the Ireat 2epre ion

Nohn Maynard 0eyne argued that price and #age are not ufficiently flexible to en ure the full employment of re ource 1urthermore& 0eyne argued that #hen re ource (e pecially labor) are not fully employed (due to a lac% of pri!ate in!e tment expenditure )& the go!ernment could pro!ide off etting expenditure a a mean of tabili8ing the economy Thu & 0eyne ian economic place empha i on planned expenditure and all it component

Appendix (LLThe Algebra of the Income and Expenditure Model

Y = C + I +G + (X M )
C

= c + c(Y T ) + I + G + ( X M ) + .... .,.... -

Y (1 c) = c cT + I + G + ( X M )
1

1 Y = c cT + I + G + ( X M ) 1 c + ...........,.......... . Autonomou O
Simple Multiplier Spending

Appendix (LLIntroducing >ariable Import

Y = C + I + G + (X M )
C

(Y T ) + I + G + ( X (m + m(Y T )) =c + c
M

Y (1 c + m) = c cT + I + G + X m + mT
1

1 ( Y = c cT + I + G + X m + mT ) ) 1 c + m Autonomou
"pen Econom! Multiplier Spending

Appendix
'lide after thi point #ill mo t li%ely not be co!ered in cla " )o#e!er they may contain u eful definition & or further elaborate on important concept & particularly material co!ered in the text boo%" They may contain example I/!e u ed in the pa t& or lide I Pu t don/t #ant to delete a I may u e them in the future"

)ou ehold Con umption and 'a!ing

The relation hip bet#een con umption and income i called the consumption &unction"

1or an indi!idual hou ehold& the con umption function ho# the le!el of con umption at each le!el of hou ehold income"

Income& Con umption& and 'a!ing (Y& C& and S)

A hou ehold can do t#o& and only t#o& thing #ith it income* It can buy good and er!ice <that i & it can consume<or it can a!e" Saving (S) i the part of it income that a hou ehold doe not con ume in a gi!en period" 2i tingui hed from savings& #hich i the current toc% of accumulated a!ing"

S Y C

An Aggregate Con umption 1unction 2eri!ed from the Equation C 3 +44 5 " 67Y

C = 1 0 0 + .7 5 Y
AGGREGATE (BILLIONS OF DOLLARS) 0 80 100 200 400 400 800 1,000 INCOME, Y AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) 100 160 175 250 400 550 700 850

Aggregate 2emand and Change in the ;rice Qe!el

An increa e in the price le!el ha a negati!e impact on real I2; for three rea on
: A the price le!el increa e the real !alue of fixed financial a et i dimini hed" Thi reduce con umption demand and I2;" : An increa e in the price le!el put up#ard pre ure on intere t rate and do#n#ard pre ure on in!e tment : A the price le!el increa e & foreign good become more attracti!e

Of cour e all of the e effect are re!er ed for a decrea e in the price le!el

The Aggregate 2emand Cur!e

"
25
o

)& (") )& (") )& (")

Y "
" " " )D

'hift in the Aggregate 2emand Cur!e

"
25o
C#I#G#(X !) C#I#G#(X !)

Y "

)D

)D

Appendix ALL>ariable Jet Export

" X!
Real GD"
C#I#G C#I#G#(X !)

"

Real GD"

The Circular 1lo# of Income and Expenditure

consumption consumption(C) (C) 3inancial mar4ets 6-M 6-M n$estment n$estment(( )) .o$5t .o$5t(.) (.) C7 7.76-M

/ /

trans&er trans&erpayments payments Disposable Disposableincome income ta#es ta#es

aggregate aggregateincome income = =.DP .DP

?e!ie# Term and Concept

actual in!e tment aggregate income aggregate output aggregate output (income) (Y) autonomou !ariable change in in!entory con umption function de ired& or planned& in!e tment (I ) equilibrium identity in!e tment marginal propen ity to con ume ( MPC) marginal propen ity to a!e (MPS) multiplier paradox of thrift planned aggregate expenditure (AE) a!ing (S)

Con umption and Aggregate Expenditure

Cla ical Economi t

A group of +CthL and +BthLcentury economi t #ho belie!ed that rece ion and depre ion #ere hortLrun phenomena that corrected them el!e through natural mar%et force = thu the economy #a elfLadPu ting

Con umption
Con umption i the portion of di po able income that i pent and not a!ed Con umption pending bear a clo e relation hip to di po able income Con umption ma%e up the large t hare of aggregate planned expenditure Approximately ,G- of I2;

The Con umption and 'a!ing 1unction

$
C DI !"C !"C* * C+ C+ DI DI

real disposable income !", !",* * ,+ ,+ DI DI

,
real disposable income

The Marginal ;ropen ity to Con ume and 'a!e

The marginal propen ity to con ume (M;C) i the fraction of a change in income that i pent on added con umption The marginal propen ity to a!e (M;') i the fraction of a change in income that i de!oted to added a!ing 4 R M;C R + M;' 3 + L M;C

;lanned >er u Actual In!e tment

;lanned in!e tment i the amount of in!e tment firm plan to underta%e during a year Actual in!e tment i the amount of in!e tment actually underta%en during a year Actual in!e tment equal planned in!e tment plu unplanned change in in!entorie

The Income )alf of the Circular 1lo#

'ince profit (the difference bet#een expenditure on output and productionLrelated co t ) are paid to firm / o#ner & I2; equal income* I2; 3 Aggregate Income 'ince di po able income i aggregate income minu taxe (le tran fer payment )& I2; mu t equal di po able income (2I) plu net taxe (T)* I2; 3 Aggregate income 3 2I 5 T

The Expenditure )alf of the Circular 1lo#

2i po able income i either pent on con umption (C) or put into a!ing (')* 2I 3 C 5 ' 1rom an earlier chapter& aggregate expenditure ha four component
: Con umption (C)& In!e tment (I)& Io!ernment ;urcha e (I) & Jet Export (K L M)

A a re ult& C 5 I 5 I 5 ( K L M ) 3 I2;

Qea%age Equal InPection

The t#o equalitie for I2; #ritten together gi!e& I2; 3 S32I 5 T 3 C 5 I 5 I 5 ( K L M ) 'ince ' 3 2I L C '5T5M3I5I5K (lea%age 3 inPection )

Qea%age and InPection

A lea%age i any di!er ion of income from the dome tic pending tream An inPection i any payment of income other than by firm & or any pending other than by dome tic hou ehold