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Aggregate Expenditure

and Equilibrium Output

The Core of Macroeconomic Theory
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.
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.
Explaining Spending Behavior
All income is either spent on consumption or saved
in an economy in which there are no taxes.
Saving / Aggregate Income - Consumption
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.
Household Consumption and 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.
C a bY =
0 1 b<
Household Consumption and Saving
The fraction of a change in income that is saved is
called the marginal propensity to save (MPS).
1 MPC+MPS
Once we know how much consumption will
result from a given level of income, we
know how much saving there will be.
Therefore,
S Y C -
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 (DY),
consumption rises by
\$75 billion (DC).
C Y 100 75 .
Consumption Function (alternative formulation)
) ( T Y c c C -

c
-Autonomous consumption
c

-Marginal Propensity to Consume (MPC)

) ( T Y -
-Disposable Income (DI) (Income - Net Taxes)
The Determinants of Consumption
Wealth
Affects consumption
expenditures
The price level
Affects real purchasing power
of financial assets
The interest rate
Causes consumers to
postpone consumption
Expectations (of income or
prices)
A more optimistic outlook on
the economy will raise
consumers expenditures
Y
\$
C
C
C
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 100 75 .
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 investmentinventory 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
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.
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.
Investment Function
I I
Investment is autonomous (independent of income)
Present Value
Internal Rate of Return

n
n
i i i
PV

1
\$
...
1
\$
1
\$
2
2
1
1
The Present Value of a stream of payments

Where I can be interpreted as the internal rate of return
Present Value
Internal Rate of Return

19 1
1
5
...
1
5
5
i
mil
i
mil
mil PV

The Present Value of a 100 million Lotto pay off
Interest Rate Present Value
6.0% (\$60,790,582.46)
7.0% (\$56,677,976.21)
8.0% (\$53,017,996.00)
9.0% (\$49,750,573.90)
10.0% (\$46,824,600.46)
15.0% (\$35,991,155.97)
20.0% (\$29,217,478.40)

Investment and the Investment
Function
At this point investment is
planned investment
expenditures (I)
Investment is closely linked
to the interest rate, since
interest represents the
opportunity cost of
investing in capital
The investment function
will shift with changes in
profits
Investment spending (I)
Nominal
interest rate
D
D
Autonomous Investment
Although investment is related
to the interest rate and
investment does not depend in
any significant way on
disposable income
As such, investment is
autonomous
However, changes in the
interest rate or expectations for
profits will still shift
autonomous investment
Real disposable income
\$
I
I
I
Determinants of Investment
Below are all the things that can cause a shift
in the investment function

The interest rate
Expectations of future profits
Technology

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.
I C AE
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.
Equilibrium Aggregate
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
Equilibrium Aggregate
Output (Income)
Equilibrium Aggregate
Output (Income)
C Y 100 75 . I 25
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
Equilibrium Aggregate
Output (Income)
Y Y 100 75 25 .
Y C I
(1)
C Y 100 75 .
(2)
I 25
(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 100 75 25 .
Y Y - .75 100 25
Y Y - .75 125
.25 125 Y
Y
125
25
500
.
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.
The S = I Approach to Equilibrium
Aggregate output will be equal to
planned aggregate expenditure only
when saving equals planned investment
(S = I).
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 economythat is, it does
not change when the economy changes.
In this chapter, for example, we consider planned
investment to be autonomous.
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.
The Multiplier Equation
The marginal propensity to save may be
expressed as:
MPS
S
Y

D
D
MPS
I
Y

D
D
Because DS must be equal to DI for
equilibrium to be restored, we can
substitute DI for DS and solve:
therefore, D D Y I
MPS

1
multiplier
MPS

1
, or
multiplier
MPC

-
1
1
The Multiplier
After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.
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.
The Paradox of Thrift
When households become
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.
Government Expenditures and
Autonomous Net Taxes
We will assume that
government expenditures
(G) and net taxes (T) are
autonomous
This assumption will keep
our models from becoming
overly complex
It will also allow us to
easily analyze fiscal policy
as both G and T change
It would be possible to
consider taxes that vary
with GDP (income taxes)
Real income
\$
G
T
G G
T T

Autonomous Net Exports (X - M)

If both exports (X) and
imports (M) are
autonomous, then net
exports are
autonomous

Real disposable income
\$
X-M
X-M
X-M
M X M X - -
Determinants of X-M
The following will cause a shift in the net export function.
The Exchange Rate
If the Dollar appreciates, then exports fall and imports rise, both
causing net exports to fall, or shift down.
Foreign GDP (Income)
As foreign income rises, they import more goods from around the
world including the US. So our exports will rise as we satisfy their
demand for our goods.
Variable Imports
Imports may very well
be related to income
This makes net exports
decrease with income
Real disposable income
\$
X-M
) ( T Y m m M -

Aggregate Expenditure and
Income
Planned Expenditures
What about the behavior (the plans) of our economic
actors?
Consumption (C) is planned on the basis of disposable income
Investment (I) is planned based on the interest rate and business
expectations (although it is autonomous with respect to GDP, or
income)
G and (X-M) are simply autonomous
According to Keynes, aggregate planned expenditures
(demand) determine output and income, even in the long
run
The Income-Expenditure Model
A relationship between aggregate income and planned
aggregate expenditures that determines, for a given price
level, where income (and GDP) equals planned
expenditures
The aggregate expenditure function is a relationship
showing the amount of planned spending for each level of
income
Equilibrium occurs in the model where planned aggregate
expenditures equal income (GDP)
Unintended changes in inventories play a key role
Planned Aggregate Expenditure (trillions of dollars)
Real
GDP
Net
Taxes
Dis.
Income Cons. Saving
Planned
Inv.
Gov't
Purchases
Net
Export
Planned
Exp.
\$6.0 \$1.0 \$5.0 \$4.7 \$0.3 \$0.6 \$1.0 -\$0.1 \$6.2
\$6.5 \$1.0 \$5.5 \$5.1 \$0.4 \$0.6 \$1.0 -\$0.1 \$6.6
\$7.0 \$1.0 \$6.0 \$5.5 \$0.5 \$0.6 \$1.0 -\$0.1 \$7.0
\$7.5 \$1.0 \$6.5 \$5.9 \$0.6 \$0.6 \$1.0 -\$0.1 \$7.4
\$8.0 \$1.0 \$7.0 \$6.3 \$0.7 \$0.6 \$1.0 -\$0.1 \$7.8
Deriving Equilibrium Income and
Output
Real GDP
\$
C+I+G+(X-M)
45
o
Equilibrium Real GDP
The Simple Spending Multipliers
Real GDP
\$
C+I+G+(X-M)
45
o
C+I+G+(X-M)
DGDP
DI
Simple spending multiplier =
DGDP/DI = 1/(1-MPC) = 1/MPS
The Spending Multiplier and the Circular Flow
(MPC = .8)
Round
New
Spending
Cumulative
New
Spending
New
Saving
Cumulative
New
Saving
1 \$100.00 \$100.00
2 \$80.00 \$180.00 \$20.00 \$20.00
3 \$64.00 \$244.00 \$16.00 \$16.00
4 \$51.20 \$295.20 \$12.80 \$12.80
. . . . .
. . . . .
. . . . .
\$0.00 \$500.00 \$0.00 \$100.00
Keynes and the Great Depression
John Maynard Keynes argued that prices and wages are not sufficiently
flexible to ensure the full employment of resources
Furthermore, Keynes argued that when resources (especially labor) are
not fully employed (due to a lack of private investment expenditures),
the government could provide offsetting expenditures as a means of
stabilizing the economy
Thus, Keynesian economics places emphasis on planned expenditures
and all its components
Appendix B--The Algebra of the Income and
Expenditure Model

{

4 4 4 4 4 4 4 4 4 4 4 3 4 4 4 4 4 4 4 4 4 4 4 2 1
4 4 4 4 3 4 4 4 4 4 2 1
Spending
Autonomous
Multiplier
Simple
C
M X G I T c c
c
Y
M X G I T c c c Y
M X G I T Y c c
M X G I C Y
) (
1
1
) ( 1
) (
) (
*
-

-
- -

-
Appendix B--Introducing Variable Imports

Spending
Autonomous
Multiplier
Economy
Open
M C
T m m X G I T c c
m c
Y
T m m X G I T c c m c Y
T Y m m X G I T Y c c
M X G I C Y
)
1
1
1
) ) ( ( (
) (
*

-
-

- -

-
Appendix
Slides after this point will most likely not be covered in
class. However they may contain useful definitions, or
further elaborate on important concepts, particularly
materials covered in the text book.

They may contain examples Ive used in the past, or slides I
just dont want to delete as I may use them in the future.
Household Consumption and 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.
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 servicesthat is, it can
consumeor it can save.

Saving (S) is the part of its income that a household does
not consume in a given period. Distinguished from
savings, which is the current stock of accumulated
saving.
S Y C -
An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
AGGREGATE
INCOME, Y
(BILLIONS OF
DOLLARS)
AGGREGATE
CONSUMPTION, C
(BILLIONS OF
DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850
C Y 100 75 .
Aggregate Demand and Changes in the
Price Level
An increase in the price level has a negative impact on real
GDP for three reasons
As the price level increases the real value of fixed financial assets is
diminished. This reduces consumption demand and GDP.
An increase in the price level puts upward pressure on interest
rates and downward pressure on investment
As the price level increases, foreign goods become more attractive
Of course all of these effects are reversed for a decrease in
the price level
The Aggregate Demand Curve
Y
P
AE (P)
Y
P
45
o
AE (P)
AE (P)
P
P
P
Shifts in the Aggregate Demand Curve
Y
P
C+I+G+(X-M)
Y
P
45
o
C+I+G+(X-M)
Appendix A--Variable Net Exports
Real GDP
P
X-M
P
Real GDP
C+I+G
C+I+G+(X-M)
The Circular Flow of Income and
Expenditure
aggregate income
= GDP
transfer payments
taxes
Disposable income
Financial
markets
consumption (C)
S
Investment (I)
Govt (G)
X-M
C+I+G+X-M
Review Terms and Concepts
actual investment
aggregate income
aggregate output
aggregate output (income) (Y)
autonomous variable
change in inventory
consumption function
desired, or planned, investment (I)
equilibrium
identity
investment
marginal propensity to consume (MPC)
marginal propensity to save (MPS)
multiplier
planned aggregate expenditure (AE)
saving (S)
Consumption and Aggregate
Expenditure
Classical Economists
A group of 18th- and 19th-century economists
who believed that recessions and depressions
were short-run phenomena that corrected
themselves through natural market forces;
thus the economy was self-adjusting

Consumption
Consumption is the portion of disposable
income that is spent and not saved
Consumption spending bears a close
relationship to disposable income
Consumption makes up the largest share of
aggregate planned expenditures
Approximately 2/3 of GDP
The Consumption and Savings
Functions
real disposable income
\$
C
\$
DC
DDI MPC = DC/DDI
real disposable income
S MPS = DS/DDI
The Marginal Propensity to Consume
and Save
The marginal propensity to consume (MPC) is
the fraction of a change in income that is
spent on added consumption
The marginal propensity to save (MPS) is the
fraction of a change in income that is devoted
0 < MPC < 1
MPS = 1 - MPC
Planned Versus Actual Investment
Planned investment is the amount of
investment firms plan to undertake during a
year
Actual investment is the amount of
investment actually undertaken during a year
Actual investment equals planned investment
plus unplanned changes in inventories
The Income Half of the Circular Flow
Since profits (the difference between expenditures on
output and production-related costs) are paid to firms
owners, GDP equals income:
GDP = Aggregate Income
Since disposable income is aggregate income minus taxes
(less transfer payments), GDP must equal disposable
income (DI) plus net taxes (T):
GDP = Aggregate income = DI + T
The Expenditure Half of the Circular
Flow
Disposable income is either spent on
consumption (C) or put into savings (S): DI = C
+ S
From an earlier chapter, aggregate
expenditure has four components
Consumption (C), Investment (I), Government
Purchases (G) , Net Exports (X - M)
As a result,
C + I + G + ( X - M ) = GDP
Leakages Equal Injections
The two equalities for GDP written together give,

GDP = Y=DI + T = C + I + G + ( X - M )

Since S = DI - C

S + T + M = I + G + X
(leakages = injections)

Leakages and Injections
A leakage is any
diversion of income
from the domestic
spending stream
An injection is any
payment of income
other than by firms, or
any spending other
than by domestic
households