Principles of

Macroeconomics
D. Curtis and I. Irvine

2020 - A
(CC BY-NC-SA)
 Principles of Macroeconomics
an Open Text by Douglas Curtis and Ian Irvine

Version 2020 — Revision A

Be a champion of OER!
Contribute suggestions for improvements, new content, or errata:
• A new topic
• A new example
• An interesting new question
• Any other suggestions to improve the material
Contact Lyryx at [email protected] with your ideas.

Creative Commons License (CC BY-NC-SA): This text, including the art and illustrations, are available
under the Creative Commons license (CC BY-NC-SA), allowing anyone to reuse, revise, remix and
redistribute the text.
To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/
132 Aggregate expenditure & aggregate demand

aggregate expenditure function (AE) has the right position and slope, there is a level of output
at which planned expenditure and output are equal (Y = AE). Then revenue the business sector
receives from sales of current output just covers the costs of production including expected profit.
Planned expenditure and planned output are in equilibrium.

Aggregate demand is determined by equality between planned aggregate expen-

diture (AE) and real GDP.

This equality between planned expenditure and output determines the position of the AD curve, as
shown in the upper part of the diagram.

The interactions of expenditure, output, and income shown in the lower part of Figure 6.1 define a
basic macroeconomic model.

6.2 Aggregate expenditure

The model starts with the expenditure categories defined and measured in national accounts and
described in Chapter 4. By the expenditure approach, GDP (Y ) is the sum of consumption (C),
investment (I), and exports (X ), minus imports (IM). Then we can write:
GDP(Y ) = C + I + X − IM (6.1)

Expenditure as measured by national accounts is the sum of actual expenditures by business and
households.

GDP(Y ) is the national accounts measure of the sum of actual expenditure in the
economy.

Aggregate expenditure (AE) is planned expenditure by business and households. The distinction
between planned and actual expenditures is a key factor in explaining how the national income and
employment are determined.

Aggregate expenditure (AE) is planned expenditure by business and households.

Induced expenditure
A simple short-run model of the economy builds on two key aspects of planned expenditure,
namely induced expenditure and autonomous expenditure. First, an important part of the expendi-
ture in the economy is directly related to GDP and changes when GDP changes. This is defined
as induced expenditure. It is mainly a result of household expenditure plans and expenditure on
imported goods and services embodied in those plans.
 6.2. Aggregate expenditure 133

Induced expenditure is planned expenditure that is determined by current income

and changes when income changes.

The largest part of consumption expenditure by households is induced expenditure, closely linked
to current income. This expenditure changes when income changes, changing in the same direc-
tion as income changes but changing by less than income changes. The marginal propensity to
consume (mpc = c) defines this link between changes in income and the changes in consumption
they induce. The mpc is a positive fraction.

Marginal propensity to consume (mpc = c = ∆C/∆Y ) is the change in consumption

expenditure caused by a change in income.

Household’s expenditures on imports are at least partly induced expenditures that change as income
and consumption expenditure changes. The marginal propensity to import (mpm = m) defines
this link between changes in income and the changes in imports. The mpm is also a positive
fraction because changes in income induce changes in imports in the same direction but by a
smaller amount.

Marginal propensity to import (mpm = m = ∆IM/∆Y ) is the change in imports

caused by a change in income.

Because expenditure on imports is not demand for domestic output, aggregate induced expen-
diture for the economy is determined by subtracting induced import expenditure from induced
consumption expenditure to get induced expenditure on domestic output.

Induced expenditure (c − m)Y is planned consumption expenditures net of imports

that changes when income changes.

The relationship between expenditures and national income (GDP) is illustrated in Table 6.1 using
a simple numerical example and then in Figure 6.2 using a diagram.
134 Aggregate expenditure & aggregate demand

Table 6.1: The effects of changes in GDP on consumption, imports and expenditure.

Consumption function: C = 0.8Y

Imports function: IM = 0.2Y
Y Induced C = ∆C/∆Y Induced IM = ∆IM/∆Y Induced expenditure
(∆C − ∆IM)/∆Y
0 0 0 0
50 40 10 30
100 80 20 60
75 60 15 45

The first row of the table illustrates clearly that if there were no income there would be no in-
duced expenditure. The next two rows show that positive and increased incomes cause (induce)
increased expenditure. The final row shows that a fall in income reduces expenditure. The induced
expenditure relationship causes both increases and decrease in expenditure as income increases or
decreases.

Figure 6.2 shows the same induced expenditure relationships in a diagram.

Figure 6.2: Induced expenditures

Consumption
& Imports
C = 0.8Y

60
C − IM = 0.6Y

45
40
∆(C − IM) = 15

30
∆Y = 25

IM = 0.2Y

10

GDP (Y )
0 50 75

The slope of the C − IM line is: ∆(C − M)/∆Y = 15/25 = 3/5 = 0.6.

Positive slopes of the consumption and import lines in the diagram show the positive relationship
 6.2. Aggregate expenditure 135

between income and expenditure. A rise in income from 0 to 50 induces a rise in aggregate expen-
diture from 0 to 30 because consumption expenditure increases by 40 of which 10 is expenditure on
imports. If income were to decline induced expenditure would decline, illustrated by movements
to the left and down the expenditure lines.

The marginal propensities to spend are the slopes of the expenditure lines. If, for example, GDP
increased from 50 to 75 in the diagram, consumption expenditure on domestic goods and services
C − IM would increase by 15. The slope of the C − IM line is defined as rise/run which is 15/25 =
0.6. By similar observations and calculations the slopes of the C line and the IM line are ∆C/∆Y =
0.8 and ∆IM/∆Y = 0.2.

These induced expenditure relationships are fundamentals of a basic macro model. The numerical
values used here are chosen just to illustrate the relationships. Values used in the model of an actual
economy, like the Canadian economy, would be estimated by econometric analysis of Canadian
data. It is important that these relationships remain stable even as economic conditions change. The
close statistical relationship between income and consumption in Figure 6.3 and size and stability
of consumption share in expenditure GDP are strong evidence in support of that stability.

Figure 6.3: A Consumption Function for Canada, 2000–2018

1 200 000
Consumption expenditure, C, mill 2012$

1 100 000

1 000 000

900 000

800 000

700 000

600 000
1400000 1600000 1800000 2000000

Gross domestic product, Y, mill 2012$

Source: Statistics Canada Table 36-10-0222-01 Gross Domestic

Product, expenditure-based, (x 1,000,000 2012$)
136 Aggregate expenditure & aggregate demand

Autonomous expenditure
The second part of GDP expenditure is where the real action lies. It covers the important changes
in expenditure that drive the business cycles in economic activity. Autonomous expenditure (A),
is the planned expenditure that is not determined by current income. It is determined instead by
a wide range of economic, financial, external and psychological conditions that affect household
and business decisions to make expenditures on current output.

Autonomous expenditure (A) is planned expenditure that is not determined by cur-

rent income.

Consumption and imports have an autonomous component in addition to the induced component.
But investment (I) and exports (X ) are the major autonomous expenditures. Figure 6.4 shows the
independence of autonomous expenditure from income. Unlike induced expenditure, autonomous
expenditure does not change as a result of changes in GDP. The slope of the A line in the diagram
is zero (∆A/∆Y = 0). However, a change in autonomous expenditure would cause a parallel shift
in the A line either up or down. An increase in A is shown.

Figure 6.4: Autonomous expenditure

Autonomous
Expenditure (A)

A1 A1

∆A

A0 A0

GDP (Y )

Investment expenditure (I) is one volatile part of aggregate expenditure. It is expenditure by busi-
ness intended to change the fixed capital stock, buildings, machinery, equipment and inventories
they use to produce goods and services. In 2018 investment expenditures were about 27 percent
of GDP. Business capacity to produce goods and services depends on the numbers and sizes of
factories and machinery they operate and the technology embodied in that capital. Inventories of
 6.2. Aggregate expenditure 137

raw materials, component inputs, and final goods for sale allow firms to maintain a steady flow of
output and supply of goods to customers.

Firms’ investment expenditure on fixed capital depends chiefly on their current expectations about
how fast the demand for their output will increase and the expected profitability of higher future
output. Sometimes output is high and rising; sometimes it is high and falling. Business expecta-
tions about changes in demand for their output depend on many factors that are not clearly linked to
current income. As a result we treat investment expenditure as autonomous, independent of current
income but potentially volatile as financial conditions and economic forecasts fluctuate. For exam-
ple, the sharp drop in crude oil prices in late 2017 and again in the spring of 2020 changed market
and profit expectations dramatically for petroleum producers and for a wide range of suppliers
to the industry. Investment and exploration projects were cut back sharply, reducing investment
expenditure.

Exports (X ), like investment, can be a volatile component of aggregate expenditure. Changes in

economic conditions in other countries, changes in tastes and preferences across countries, changes
in trade policies, and the emergence of new national competitors in world markets all impact on
the demand for domestic exports.

To illustrate this volatility in exports and in investment, Figure 6.5 shows the year-to-year changes
in investment, exports, and consumption expenditures in Canada from 1999 to 2017. You can
see how changes in investment and exports were much larger than those in consumption. This
volatility in investment and exports causes short-term shifts in aggregate expenditure which cause
business cycle fluctuations in GDP and employment. More specifically, the data show the sharp
declines in investment and exports that caused the Great Recession in 2009 and even though these
autonomous expenditures increased in 2010 those increases were not large or persistent enough to
restore pre-recession levels of autonomous expenditure. Indeed investment expenditures declined
again in 2015 and 2016 before recovering in 2017 and 2018.
138 Aggregate expenditure & aggregate demand

Figure 6.5: Annual percent change in Real Consumption, Investment and Exports
Canada 2000–2017

20
Change in consumption
15 Change in investment
Change in exports
10
Percent change

−5

−10

−15
2000

2002

2004

2006

2008

2010

2012

2014

2016
Year

Source: Statistics Canada Table 36-10-0222-01

The aggregate expenditure function

The aggregate expenditure function (AE) is the sum of planned induced expenditure and planned
autonomous expenditure. The emphasis on ‘planned’ expenditure is important. Aggregate expen-
diture is the expenditure households and businesses want to make based on current income and
expectations of future economic conditions. Expenditure based GDP in national accounts mea-
sures, after the fact, the expenditures that were made. These may not be the same as planned
expenditure. Some plans may not work out.

Aggregate expenditure (AE) is the sum of planned induced and autonomous expen-
diture in the economy.

Aggregate expenditure (AE) equals the sum of a specific level of autonomous expenditure (A0 ) and
induced expenditure [(c − m)Y ] or in the simple notation introduced above:

AE = A0 + (c − m)Y (6.2)