Chapter 23

Aggregate Expenditure and

Equilibrium Output
Part I
ECO136 Introduction to Economics II
Lecture Note V
Introduction
We begin the analytic part of macroeconomics : we begin to explain how the
parts of economy interact.
We will begin with the simplest case : focus on households and firms, than
we will introduce government in Chapter 24. For now we will work with a
closed economy (no trade), without a government.
In this chapter we will begin to develop a macroeconomic model to help us
to find the answers of the questions below :
• What determines the decreases and increases in GDP?
• How would GDP change when households behaviors, investment decisions
ve goverment expenditures change?
• Can we control changes in GDP? If so is it possible to shorten recessions or
accelerate economic growth?
Remember :
Along Chapter 23, we will focus on understanding movements in real
GDP. You should think in real terms.
Y (output), refers to both aggregate output and aggregate income. It is
a combined term used to remind you of the exact equality between
aggregate output and aggregate income.
aggregate output: The total quantity of goods and services
produced (or supplied) in an economy in a given period.
aggregate income: The total income received by all factors of
production in a given period.
In any given period, there is an exact equality between aggregate
output (production) and aggregate income. You should be reminded of
this fact whenever you encounter the combined term aggregate output
(income).
The Keynesian Theory of Consumption
In The General Theory of Employment, Interest, and Money, Keynes
argued that the amount of consumption undertaken by a household is
directly related to its current income.
Y↑ C↑
According to Keynes :
• If you find that your income is going up you will spend more than you did
before.
• The rise in consumption will be less than the full rise in income.
Consumptiom function is the relationship between consumption and
income.
Consumption Function for a Household

• c(y) → consumption is a function of

income.
• A consumption function for an
individual household shows the
level of consumption at each level
of household income.
• Consumption function has a
positive slope (as y increases, so
does c)
• The curve intersects the c-axis
above zero means that even at zero
income, it still must consume to
survive.
Household Income, y
An Aggregate Consumption Function

• How aggregate consumption is

likely to respond to changes in
aggregate income?
• The aggregate consumption
function shows the level of
aggregate consumption at each
level of aggregate income.
• The upward slope indicates that
higher levels of income lead to
higher levels of consumption
spending.
Because the aggregate consumption function is a straight line, we can write
the following equation to describe it:

𝐶 = 𝑎 + 𝑏𝑌

C: aggregate consumption ∆𝐶
𝑏= = 𝑀𝑃𝐶
Y : aggregate output (income) ∆𝑌

a : constant
b : slope of the line (marjinal prospensity to consume, MPC)
Marginal propensity to consume (MPC) is that fraction of a change in
income that is consumed, or spent.
Let’s say b=0,75 so an increase of 100TL (ΔY) income would increase
consumption by 100x0.75=75 TL (ΔC).
There are only two places income(Y) can go: consumption(C) or saving
(S).
Aggregate saving (S) is the part of aggregate income that is not
consumed.
𝑆 ≡𝑌 −𝐶
According to the equation above the income that is not consumed
must be saved.
In our former example is 75TL of a 100 TL increase in income goes to
consumption, 25TL must go to saving.
Marginal propensity to save (MPS) is that fraction of a change in
income that is saved. Because everything that is
∆𝑆 not consumed is saved,
𝑀𝑃𝑆 ≡ the MPC and MPS must
∆𝑌
add up to 1.
MPC + MPS = 1
The consumption and the saving function are mirror images of each
other.
We can derive saving function from consumption function :

𝑌 ≡𝐶+𝑆
𝑆 ≡𝑌−𝐶
𝑆 ≡ 𝑌 − 𝑎 + 𝑏𝑌
𝑆 ≡ 𝑌 − 𝑎 − 𝑏𝑌
𝑆 ≡ −𝑎 + 1 − 𝑏 𝑌
𝑀𝑃𝑆 ≡ ∆𝑆ൗ∆𝑌 = 1 − 𝑏
We know that MPC = b
MPS + MPC = 1
Numerical Example
𝐶 = 100 + 0,75𝑌
Y C
0 100
80 160
100 175
200 250
400 400
600 550
800 700
1000 850

• Y↑ C↑
• Y=0 → C=100 (a, the intersection of y-axis.)
• Y=200 → C=250 → S=-50
• Y= 400 → C= 400 → S=0
• Y= 800 → C= 700 → S=100
• 𝑀𝑃𝐶 = ∆𝐶Τ∆𝑌 = 250−175Τ200−100 = 0,75
 Y C S
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1000 850 150
Y=C+S
𝐶=100+0,75𝑌
𝑆≡−𝑎+(1−𝑏)𝑌
𝑆≡−100+0,25𝑌

𝑀𝑃𝑆 ≡ ∆𝑆ൗ∆𝑌 = 0 − −50 ൗ400 − 200 = 0,25

𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 0,75 + 0,25 = 1

A 45° line drawn from the origin can be used as a

convenient tool to compare consumption and
income graphically.
Other determinants of consumption :
• Wealth
wealth ↑ consumption ↑
• Interest Rate
interest rate ↓ cost of borrowing ↓ consumption ↑
• Expectations
optimistic expectations → consumption ↑
In this analysis we will focus only in income as affecting consumption.
Planned Investment (I)

• The output of economy consists not only of goods consumed by

households, but investments made by firms.
• Investments : plants, equipments, inventory Inventory : Stock of
goods that it has
• Why do firms hold inventory? awaiting sale.
• Couldn’t predict exact consumer demand.
• Cheaper to producer larger volumes.
• While purchases of machinery, buildings are always deliberate;
inventories are not always deliberate. Sometimes unexpected
changes can happen in inventories.
Planned investment : Those additions to capital stock and inventory
that are planned by firms.
Actual investment : The actual amount of investment that takes place;
it includes items such as unplanned changes in inventories.
Unplanned changes in inventories :
• If a firm overestimates how much it will sell in a period, it will end up with
more inventory than it planned to have.
• Or if firms sells more than expected inventories are lower than planned.
In our discussion I will refer to planned investments.
In equilibrium planned investment and actual investment are equal.
In oncoming chapters we will talk about the determinants of
investments. But for now in our simple model, we will assume that
planned investments are fixed and does not depend on income.
The Determination of Equilibrium Aggregate Output
(Income)
• Nature of the equlibrium & how the economy achieves equlibrium
• Equlibrium → no tendecy to change
• In the macroeconomic goods market, equilibrium occurs when
planned aggregate expenditure (AE) is equal to aggregate output(Y).
Planned aggregate expenditure (AE) is the total amount the
economy plans to spend in a given period. In a closed economy with
no government :
𝑌 ≡ 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑂𝑢𝑡𝑝𝑢𝑡
𝐴𝐸 ≡ 𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 ≡ 𝐶 + 𝐼
𝑌 = 𝐴𝐸 → 𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 → 𝑌 = 𝐶 + 𝐼
C = 100 + 0,75Y
• Graphical illustration of the same
equilibrium is on the left.
• 45 line represent all the points in the
graph where the variables on the
vertical axis (AE) is equal to variables
on the horizontal axis (Y).
• Y = 800 → 𝑌 > 𝐴𝐸 (unplanned rise in
inventory : output falls)
• Y = 200 → 𝐴𝐸 > 𝑌 (unplanned fall in
inventory : output rises)
• Y = 500 → 𝐴𝐸 = Y → equilibrium
Determination of Equilibrum Algebraically

1 𝑌 =𝐶+𝐼
2 𝐶 = 100 + 0.75𝑌
3 𝐼 = 25
By substituting (2) and (3) into (1), get

𝑌 = 100 + 0.75𝑌 + 25
There is only one value of Y for which this statement is true.
Y  0.75Y  100  25 125
0,25Y = 125
Y  500
0.25
Use the following information to fill in the blank cells in the table. This is a closed economy
without a government. Planned investment spending is determined autonomously. All figures are
in billions of TL.

a. Calculate MPC and MPS for this economy.

Consumption Planned Aggregate Planned 𝑀𝑃𝐶 = ∆𝐶ൗ∆𝑌 = 2800 − 2000ൗ2000 − 1000 = 𝟎. 𝟖

Real GDP (Y)
('C) Investment (I) Expenditures (AE)
0 1200 1600
1000 2000 400 2400 MPC + MPS = 1 → MPS=0.2
2000 2800 3200 b. How much is planned investment for every level of
3000 3600 4000 income ? (I=400)
4000 4400 4800 c. Using the table determine the equilibrium level of
5000 5200 5600 income for this economy.
6000 6000 6400
Y = AE → Y = AE = 8000
7000 6800 7200
8000 7600 8000 d. Determine equilibrium level of income algebraically.
9000 8400 8800 C = 1200 + 0.8Y (how did we write this equation?)
10000 9200 9600
AE = C + I = 1200 + 0,8Y+400
In equilibrium Y=AE so
Y = 1600 + 0.8Y → 0.2Y=1600 → Y=8000