Principles of Economics

Twelfth Edition

Chapter 23
Aggregate
Expenditure and
Equilibrium Output

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Aggregate Expenditure and Equilibrium Output

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.

• aggregate output (income) (Y): Real GDP

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The Keynesian Theory of Consumption

In Keynes’s classic The General Theory of Employment, Interest, and Money

(1936), current income played the key role in determining consumption levels
in the economy.

aggregate consumption function (C) The relationship between consumption

and income.

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The aggregate consumption
function shows the level of
aggregate consumption at each
level of aggregate income.

The positive slope indicates

that higher levels of income
lead to higher levels of
consumption spending.

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Linear consumption function:

When Y=0, aggregate consumption=a

a: autonomous consumption expenditure (the amount of consumption that does

not depend on the income).

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marginal propensity to consume
(MPC) That fraction of a change
in income that is consumed, or
spent.

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The Keynesian Theory of Consumption

aggregate saving (S) The part of aggregate income that is not consumed.

&

Linear aggregate saving function:

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When Y=0, aggregate saving=-a

marginal propensity to save (MPS) That fraction of a change in income that is

saved.

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The Keynesian Theory of Consumption

MPC is the fraction of an increase in income that is consumed (or the fraction
of a decrease in income that comes out of consumption).

MPS is the fraction of an increase in income that is saved (or the fraction of a
decrease in income that comes out of saving).

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Ex: If the graph of consumption function is given, write out the algebraic
equation for this function.

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Ex: Given the consumption function C=50+0.60Y, determine the level of
autonomous consumption and MPC values. Determine the saving function.
Graph the consumption and saving functions.

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Ex: Assume the level of saving that would take place in an economy is -$200
even when aggregate output is zero. Also assume that the MPS is 0.1. Then
derive the algebraic expression for the saving function and consumpiton
function.

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Ex: You are given the following information. Calculate consumption at each level
of income, MPS, and MPC.

Income Saving
(millions of $) (millions of $)
0 -100
500 -50
1000 0
1500 50
2000 100
2500 150
3000 200

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Other Determinants of Consumption

In practice, the decisions of households about how much to consume in a given

period are also affected by:

Their wealth
The interest rate
Their expectations of the future

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Planned Investment (I) versus Actual Investment

planned investment (I) 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.

Inventory is the stock of goods that a firm has awaiting sale.

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Planned Investment (I) versus Actual Investment

If a firm overestimates how much it will sell in a period , it will end up with
more in inventory than it planned to have.

If a firm underestimates how much it will sell in a period , it will start to use its
inventories.

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Planned Investment and the Interest Rate (r)

When the interest rate falls, it becomes less costly to borrow, and more
investment projects are likely to be undertaken.

Increasing the interest rate, ceteris paribus, is likely to reduce the level of
planned investment spending.

Negative relationship between interest rate and planned

investments.

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 I

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Other Determinants of Planned Investment

The decision of a firm on how much to invest depends, among other things, on
its expectations of future sales.

The optimism or pessimism of entrepreneurs about the future course of the

economy can have an important effect on current planned investment.

Keynes used the phrase animal spirits to describe the feelings of entrepreneurs.

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The Determination of Equilibrium Output

equilibrium Occurs when there is no tendency for change.

In the macroeconomic goods market:

Equilibrium occurs when planned aggregate expenditure (AE) is equal to

aggregate output (Y).

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The Determination of Equilibrium Output

planned aggregate expenditure (AE) The total amount the economy plans to
spend in a given period. Equal to consumption plus planned investment:

• So, equilibrium can also be written:

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The Determination of Equilibrium Output

aggregate output > planned aggregate expenditure:

aggregate output < planned aggregate expenditure:

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The Determination of Equilibrium Output

aggregate output = planned aggregate expenditure:

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Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium

Aggregate Aggregate Planned Planned Unplanned Equilibrium?

Output Consumption Investment (I) Aggregate Inventory (Y = AE?)
(Income) (C=100+0.75Y) Expenditure Change
(Y) (AE) Y−(C + I)
C+I

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
1000 850 25 875 + 125 No

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Planned aggregate expenditure
is the sum of consumption
spending and planned
investment spending.

The planned aggregate

expenditure function crosses
the 45° line at a single point,
where Y = 500.

Equilibrium occurs when

planned aggregate expenditure
and aggregate output are
equal (at Y = 500).

The point at which the two

lines cross is sometimes called
the Keynesian cross.

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Adjustment to Equilibrium
If firms react to unplanned
inventory reductions by increasing
output, an economy with planned
spending greater than output will
adjust to equilibrium, with Y higher
than before.

At any level of output below Y =

500, output will rise until it reaches
equilibrium at Y = 500.

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Adjustment to Equilibrium

If firms react to unplanned

inventory increases by decreasing
output, an economy with planned
spending less than output will
adjust to equilibrium, with Y lower
than before.

At any level of output above Y =

500, output will fall until it reaches
equilibrium at Y = 500.

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The Determination of Equilibrium Output

Find the equilibrium level of output (income) algebraically:

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The Saving/Investment Approach to Equilibrium

The saving/Investment approach or the leakages/injections approach

Uses of income:

At equilibrium income (output):

Equilibrium occurs only when planned investment equals aggregate savings.

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The S = I Approach to Equilibrium

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The Multiplier

multiplier The ratio of the change in the equilibrium level of output to a change
in some exogenous variable.

exogenous variable A variable that is assumed not to depend on the state of the
economy—that is, it does not change when the economy changes.

For the simple closed economy: Only exogenous variable: I

The size of the multiplier depends on the slope of the planned aggregate
expenditure line. The steeper the slope of this line, the greater the change in
output for a given change in investment.

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Investment Multiplier

then

At the equilibrium point: then

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At point A, the economy is in
equilibrium at Y = 500. When I
increases by 25, planned aggregate
expenditure is initially greater than
aggregate output.

As output rises in response,

additional consumption is generated,
pushing equilibrium output up by a
multiple of the initial increase in I.

The new equilibrium is found at point

B, where Y = 600.

Equilibrium output has increased by

100 (600 – 500), or four times the
amount of the increase in planned
investment (as investment multiplier
is 1/MPS=1/0.25=4) .

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The Size of the Multiplier in the Real World

The size of the multiplier is reduced when:

 Tax payments depend on income

 We consider the Central Bank behavior regarding the interest rate
 We add the price level to the analysis
 Imports are introduced

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Ex: If the consumption function is C=50+0.6Y and planned investment is fixed at
TL 20. Complete the following table.

Y C I AE Unplanned Equi. Adjustment

inventory to equi.
change
0
100
175
200
300
400
500

b. If I increases from 20 to 40, calculate the new equilibrium output through the
investment multiplier.

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Ex: Assume a two sector economy where and and there
are no taxes.

a. Calculate the equilibrium level of output.

b. What would the level of consumption be if the economy were operating at

$1400. What would be the amount of unplanned investment at this level of
output? In which direction would you expect the economy to move to at $1400,
why?

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Study Questions:

Q1. Suppose that a certain country has an MPC of 0.9 and a real GDP of $400
billion. If investment spending decreases by $4 billion, what will be its new level
of real GDP?

Q2. For a legendary country, consumption function is C=200+0.8Y, investment

function is I=100.

a. What are the MPC and MPS values?

b. Graph AE and AE=Y, and solve for equilibrium income.
c.If planned investment increases to 110, what is the new equilibrium level of
income? By how much does the $10 increase in I change equilibrium income?
What is the value of multiplier?
d. Calculate the saving function. Plot S and I functions on the same graph and
determine the level of equilibrium income.

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REVIEW TERMS AND CONCEPTS

actual investment multiplier

aggregate income planned aggregate expenditure (AE)
aggregate output planned investment (I)
aggregate output (income) (Y)
aggregate saving (S)
consumption function
equilibrium
exogenous variable
marginal propensity to consume(MPC)
marginal propensity to save (MPS)

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