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 - 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.

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.

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,

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).

Consumption Function (alternative formulation)

-Autonomous consumption

-Marginal Propensity to Consume (MPC)

-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

C

C

C

Y

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

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

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

Investment is autonomous (independent of income)

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

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)

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)

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

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.

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)

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

Equilibrium Aggregate Output (Income)

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

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

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

- Because DS must be equal to DI for equilibrium to

be restored, we can substitute DI for DS and

solve

therefore,

, or

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 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.

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

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

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

X-M

Real disposable income

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)

Deriving Equilibrium Income and Output

45o

CIG(X-M)

Equilibrium Real GDP

Real GDP

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

The Spending Multiplier and the Circular Flow

(MPC .8)

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

Appendix B--Introducing Variable Imports

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.

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

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

Shifts in the Aggregate Demand Curve

P

CIG(X-M)

45o

CIG(X-M)

Y

P

AD

AD

Y

Appendix A--Variable Net Exports

P

X-M

Real GDP

CIG

P

CIG(X-M)

Real GDP

The Circular Flow of Income and Expenditure

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)

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

C

?C

MPC ?C/?DI

?DI

real disposable income

S

MPS ?S/?DI

real disposable income

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

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 YDI 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