Aggregate Expenditure and Equilibrium Output

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Aggregate Expenditureand Equilibrium Output

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair 2 of 31

The Core of Macroeconomic Theory

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The Core of Macroeconomic Theory

This chapter starts presenting macroeconomic theory.

1. What factors determine GDP?

2. What causes inflation and unemployment?

B. Macroeconomics divides the economy into three sectors:

1. Newly-produced goods and services (GDP) markets

2. Assets markets (financial and real)

3. Labor markets

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Aggregate Output andAggregate 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

• When aggregate output increases, additional income is generated and vice versa.

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Aggregate Output andAggregate 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 (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 • The triple equal sign means this is an

identity, or something that is always true.

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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

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Household Consumption and Saving

• Some determinants of aggregate consumption include:

1. Household income2. Household wealth3. Interest rates4. Households’ expectations about

the future

• In The General Theory, Keynes argued that household consumption is directly related to its income.

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AGGREGATEINCOME, Y

(BILLIONS OF DOLLARS)

AGGREGATE CONSUMPTION, C


Aggregate Saving

S


0 100 -10080 160 -80

100 175 -75200 250 -50400 400 0600 550 50800 700 100

1,000 850 150

S = Y - C

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• 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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• 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<

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• The fraction of a change in income that is saved is called the marginal propensity to save (MPS).

1MPC + 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

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An Aggregate Consumption FunctionDerived from the Equation C = 100 + .75Y

C Y 1 0 0 7 5.AGGREGATE

INCOME, Y(BILLIONS OF

DOLLARS)

AGGREGATE CONSUMPTION, C


0 10080 160

100 175200 250400 400600 550800 700

1,000 850

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An Aggregate Consumption FunctionDerived 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 Functionfrom a Consumption Function

S Y C Y - C = S

AGGREGATEINCOME

(Billions of Dollars)

AGGREGATE CONSUMPTION


AGGREGATE SAVING


0 100 -10080 160 -80

100 175 -75200 250 -50400 400 0600 550 150800 700 100

1,000 850 150

C Y 1 0 0 75.

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• Because S = Y – C, it is easy to derive a saving function from a consumption function. A 45° line drawn from the origin can be used as a convenient tool to compare consumption and income graphically.

• At Y = 200, consumption is 250. The 45° line shows us that consumption is larger than income by 50. Thus S = Y – C = 250. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800.

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• The consumption function and the saving function are mirror images of one another. No information appears in one that does not also appear in the other.

• These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody aggregate household behavior.

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Planned Investment (I)

• Consumption, as we have seen, is the spending by households on goods and services, but what kind of spending do firms engage in? The answer is investment.

• Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock.

• To an economist, an investment is something produced that is used to create value in the future.

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• Spending on buildings and equipment is called business fixed investment.

• inventories are part of the capital stock. When firms add to their inventories, they are investing—they are buying something that creates value in the future

• One component of investment— is 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.

• Because we assume households have complete control over their consumption, planned consumption is always equal to actual consumption, while planned investment is not always equal to actual investment)

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Actual Versus Planned Investment

• A firm may not always end up investing the exact amount that it planned.

• Actual investment, is the actual amount of investment that takes place. If actual inventory investment turns out to be higher than firms planned, then actual investment is greater than I, planned investment.

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The Planned Investment Function I

• For now, we will assume that planned investment is fixed. It does not change when income changes.

• this means the planned investment function is a horizontal line.

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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.

IC AE

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Equilibrium Aggregate Output (Income)

• we have described the behavior of firms and households. We now discuss the nature of equilibrium and explain how the economy achieves equilibrium.

• 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.

Planned AE = Planned Outputs

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Equilibrium AggregateOutput (Income)

Y > C + Iaggregate output > planned aggregate expenditure

inventory investment is greater than plannedactual investment is greater than planned investment

Disequilibria:

C + I > Yplanned aggregate expenditure > aggregate output

inventory investment is smaller than plannedactual investment is less than planned investment

aggregate output Yplanned aggregate expenditure AE C + I

equilibrium: Y = AE, or Y = C + I

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C Y 1 0 0 7 5. I 2 5Deriving 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)

AGGREGATEOUTPUT

(INCOME) (Y)AGGREGATE

CONSUMPTION (C)PLANNED

INVESTMENT (I)

PLANNEDAGGREGATE

EXPENDITURE (AE)C + I

UNPLANNEDINVENTORY

CHANGEY (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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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 5Y Y .7 5 1 2 5.25 1 2 5Y

Y 1 2 52 5

5 0 0.

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The Saving/InvestmentApproach to Equilibrium

• Because aggregate income must either be saved or spent, by definition, Y= C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium. By substituting C + S for Y in the equilibrium condition, we can write:

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• The saving/investment approach to equilibrium is C + S = C + I. Because we can subtract C from both sides of this equation, we are left with S = I. Thus, only when planned investment equals saving will there be equilibrium.

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• saving is like a leakage out of the spending stream. Only if that leakage is counterbalanced by some other component of planned spending can the resulting planned aggregate expenditure equal aggregate output. This other component is planned investment (I).

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• The leakage out of the spending stream—saving—is matched by an equal injection of planned investment spending into the spending stream. For this reason, the saving/investment approach to equilibrium is also called the leakages/injections approach to equilibrium.

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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). Saving and planned investment are equal at Y=500.

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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 or independent 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.

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The Multiplier

• In this chapter, for example, we consider planned investment to be autonomous.

• The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.

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The Multiplier

• The size of the multiplier depends on the slope of the planned aggregate expenditure line.

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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 Multiplierin 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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The Paradox of Thrift

• 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.

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Review Terms and Concepts

actual investmentactual investment

aggregate incomeaggregate income

aggregate outputaggregate output

aggregate output (income) (aggregate output (income) (YY))

autonomous variableautonomous variable

change in inventorychange in inventory

consumption functionconsumption function

desired, or planned, investment (desired, or planned, investment (II))

equilibriumequilibrium

identityidentity

investmentinvestment

marginal propensity to consume marginal propensity to consume ((MPCMPC))

marginal propensity to save (marginal propensity to save (MPSMPS))

multipliermultiplier

paradox of thriftparadox of thrift

planned aggregate expenditure (planned aggregate expenditure (AEAE))

saving (saving (SS))

Aggregate Expenditure and Equilibrium Output

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