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Title: Aggregate Expenditure and Equilibrium Output


1
Aggregate Expenditure and Equilibrium Output
2
The Core of Macroeconomic Theory
3
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.

4
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.

5
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

6
Household Consumption and Saving
  • Some determinants of aggregate consumption
    include
  • Household income
  • Household wealth
  • Interest rates
  • Households expectations about the future
  • In The General Theory, Keynes argued that
    household consumption is directly related to its
    income.

7
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.

8
Household Consumption and Saving
  • The fraction of a change in income that is saved
    is called the marginal propensity to save (MPS).
  • Once we know how much consumption will result
    from a given level of income, we know how much
    saving there will be. Therefore,

9
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).

10
Consumption Function (alternative formulation)
-Autonomous consumption
-Marginal Propensity to Consume (MPC)
-Disposable Income (DI) (Income - Net Taxes)
11
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

C

C
C
Y
12
Deriving a Saving Function from a Consumption
Function
Y Y - C S S
AGGREGATE INCOME (Billions of Dollars) AGGREGATE INCOME (Billions of Dollars) AGGREGATE INCOME (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars)
0 100 100 -100
80 160 160 -80
100 175 175 -75
200 250 250 -50
400 400 400 0
600 550 550 50
800 700 700 100
1,000 850 850 150
13
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 changeis
    partly determined by how much households decide
    to buy, which is not under the complete control
    of firms.

change in inventory production sales
14
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.

15
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.

16
Investment Function
Investment is autonomous (independent of income)
17
Present Value Internal Rate of Return
The Present Value of a stream of payments Where
I can be interpreted as the internal rate of
return
18
Present Value Internal Rate of Return
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)
19
Investment and the Investment Function
Nominal interest rate
  • 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 expectations for business profits

D
D
Investment spending (I)
20
Autonomous Investment
  • Although investment is related to the interest
    rate and business expectations, 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


I
I
I
Real disposable income
21
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

22
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.

23
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.

24
Equilibrium Aggregate Output (Income)
aggregate output / Y planned aggregate
expenditure / AE / C I equilibrium Y AE, or
Y C I
Disequilibria
Y gt C I aggregate output gt planned aggregate
expenditure inventory investment is greater than
planned actual investment is greater than planned
investment
C I gt Y planned aggregate expenditure gt
aggregate output inventory investment is smaller
than planned actual investment is less than
planned investment
25
Equilibrium Aggregate Output (Income)
26
Equilibrium Aggregate Output (Income)
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. 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. 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. 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. 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. 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
27
Equilibrium Aggregate Output (Income)
There is only one value of Y for which this
statement is true. We can find it by rearranging
terms
By substituting (2) and (3) into (1) we get
28
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.

29
The S I Approach to Equilibrium
  • Aggregate output will be equal to planned
    aggregate expenditure only when saving equals
    planned investment (S I).

30
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.

31
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.

32
The Multiplier Equation
  • The marginal propensity to save may be expressed
    as
  • Because DS must be equal to DI for equilibrium to
    be restored, we can substitute DI for DS and
    solve

therefore,
, or
33
The Multiplier
  • After an increase in planned investment,
    equilibrium output is four times the amount of
    the increase in planned investment.

34
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.

35
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.

36
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)


G
T
Real income
37
Autonomous Net Exports (X - M)
  • If both exports (X) and imports (M) are
    autonomous, then net exports are autonomous


X-M
X-M
X-M
Real disposable income
38
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.

39
Variable Imports
  • Imports may very well be related to income
  • This makes net exports decrease with income


X-M
Real disposable income
40
Aggregate Expenditure and Income
41
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

42
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

43
Planned Aggregate Expenditure (trillions of
dollars)
44
Deriving Equilibrium Income and Output

45o
CIG(X-M)
Equilibrium Real GDP
Real GDP
45
The Simple Spending Multipliers

CIG(X-M)
45o
CIG(X-M)
?I
Simple spending multiplier ?GDP/?I 1/(1-MPC)
1/MPS
Real GDP
?GDP
46
The Spending Multiplier and the Circular Flow
(MPC .8)
47
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

48
Appendix B--The Algebra of the Income and
Expenditure Model
49
Appendix B--Introducing Variable Imports
50
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.

51
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.

52
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.

53
An Aggregate Consumption Function Derived from
the Equation C 100 .75Y
AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (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
54
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

55
The Aggregate Demand Curve
56
Shifts in the Aggregate Demand Curve
P
CIG(X-M)
45o
CIG(X-M)
Y
P
AD
AD
Y
57
Appendix A--Variable Net Exports
P
X-M
Real GDP
CIG
P
CIG(X-M)
Real GDP
58
The Circular Flow of Income and Expenditure
59
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
  • paradox of thrift
  • planned aggregate expenditure (AE)
  • saving (S)

60
Consumption and Aggregate Expenditure
61
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

62
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

63
The Consumption and Savings Functions

C
?C
MPC ?C/?DI
?DI
real disposable income

S
MPS ?S/?DI
real disposable income
64
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 to
    added savings
  • 0 lt MPC lt 1
  • MPS 1 - MPC

65
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

66
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

67
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

68
Leakages Equal Injections
  • The two equalities for GDP written together
    give, GDP YDI T C I G ( X - M )
  • Since S DI - C S T M I G X (leakages
    injections)

69
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
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