Chapter 8 - Aggregate Expenditure

and Equilibrium Output

 Chapter Outline
The Keynesian Theory of Consumption
Other Determinants of Consumption

Planned Investment (I)

The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium
Adjustment to Equilibrium

The Multiplier
The Multiplier Equation
The Size of the Multiplier in the Real World

Looking Ahead
 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.

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 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/pesos 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 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.

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 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.

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Household Consumption and Saving

C = a  bY
 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.

0  b<1
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 Household Consumption and Saving
 The fraction of a change in income that is saved is
called the marginal propensity to save (MPS).

MPC + MPS  1

• 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 Function
Derived from the Equation C = 100 + .75Y

C  100 .75Y
AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, C
(BILLIONS OF (BILLIONS OF
DOLLARS) DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850

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

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).

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Deriving a Saving Function
from a Consumption Function
C  100 .75Y
S Y C
Y - C = S
AGGREGATE AGGREGATE AGGREGATE
INCOME CONSUMPTION SAVING
(Billions of (Billions of (Billions of
Dollars) Dollars) Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
13 of 31 1,000 850 150
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 investment—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.

 Actual investment is the actual amount of

investment that takes place; it includes items
such as unplanned changes in inventories.
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Planned Investment (I)

Behavioral Biases in
Saving Behavior
Economists have generally
assumed that people make
their saving decisions rationally,
just as they make other
decisions about choices in
consumption and the labor market. Saving decisions involve thinking
about trade-offs between present and future consumption. Recent work in
behavioral economics has highlighted the role of psychological biases in
saving behavior and has demonstrated that seemingly small changes in
the way saving programs are designed can result in big behavioral
changes.

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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.
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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.

AE  C  I
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 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.

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 Equilibrium Aggregate
Output (Income)
Aggregate output = Y
Planned aggregate expenditure = AE = C + I
Equilibrium: Y = AE, or Y = C + I

Disequilibria:
Y>C+I
• Aggregate output > planned aggregate expenditure
• Inventory investment is greater than planned
• Actual investment is greater than planned investment

C+I>Y
• Planned aggregate expenditure > aggregate output
• Inventory investment is smaller than planned
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• Actual investment is less than planned investment
 Equilibrium Aggregate
Output (Income)

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 Equilibrium Aggregate
Output (Income)
C  100 .75Y 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)
PLANNED UNPLANNED
AGGREGATE AGGREGATE INVENTORY
OUTPUT AGGREGATE PLANNED EXPENDITURE (AE) CHANGE EQUILIBRIUM?
(INCOME) (Y) CONSUMPTION (C) INVESTMENT (I) C+I Y  (C + I) (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
22 of 31 850 25 875 + 125 No
 Equilibrium Aggregate
Output (Income)
(1)
Y  C I Y  100 .75Y  25
(2) C  100 .75Y There is only one value of Y for which
this statement is true. We can find it by
(3)
I  25 rearranging terms:

By substituting (2) and (3) into (1)

we get:
Y  .75Y  100  25
Y  100 .75Y  25 Y  .75Y  125
.25Y  125
125
Y  500
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.25
 The Saving/Investment
Approach to Equilibrium

If planned investment is exactly equal to saving, then

planned aggregate expenditure is exactly equal to aggregate
24 of 31 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).

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The Determination of Equilibrium Output (Income)
Adjustment to Equilibrium

The adjustment process will continue as long as output (income)

is below planned aggregate expenditure. If firms react to
unplanned inventory reductions by increasing output, an
economy with planned spending greater than output will adjust
to equilibrium, with Y higher than before. If planned spending is
less than output, there will be unplanned increases in inventories.
In this case, firms will respond by reducing output. As output
falls, income falls, consumption falls, and so on, until
equilibrium is restored, with Y lower than before.

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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 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.

 In this chapter, for example, we consider planned

investment to be autonomous.

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 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.
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 The Multiplier Equation
 The marginal propensity to save may be expressed
as:
DS
MPS 
DY
• Because DS must be equal to DI for equilibrium to be
restored, we can substitute DI for DS and solve:

DI 1
MPS  therefore, DY  DI 
DY MPS
1 , or 1
multiplier  multiplier 
29 of 31 MPS 1  MPC
 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 Multiplier Equation

The Paradox of Thrift

An increase in planned saving from S0
to S1 causes equilibrium output to
decrease from 500 to 300. The
decreased consumption that
accompanies increased saving leads to
a contraction of the economy and to a
reduction of income. But at the new
equilibrium, saving is the same as it
was at the initial equilibrium. Increased
efforts to save have caused a drop in
income but no overall change in
saving.
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 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.

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 REVIEW TERMS AND CONCEPTS

actual investment multiplier

aggregate income planned aggregate expenditure (AE)
aggregate output planned investment (I)
aggregate output (income) (Y)
1. S ≡ Y − C
aggregate saving (S) DC
2.MPC  slope of consumption function 
consumption function DY
3. MPC + MPS ≡ 1
equilibrium 4. AE ≡ C + I
exogenous variable 5. Equilibrium condition: Y = AE or
Y=C+I
Identity
6. Saving/investment approach to
marginal propensity to consume
equilibrium: S = I
(MPC)
marginal propensity to save 1 1
7. Multiplier  
(MPS) MPS 1 - MPC

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END OF
Chapter