Aggregate Expenditure and Equilibrium Output

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Aggregate Expenditureand Equilibrium Output
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The Core of Macroeconomic Theory
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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.

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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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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
• 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.

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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.

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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).

• Once we know how much consumption will result
  from a given level of income, we know how much
  saving there will be. Therefore,

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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 (DY),
  consumption rises by 75 billion (DC).

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Consumption Function (alternative formulation)
-Autonomous consumption
-Marginal Propensity to Consume (MPC)
-Disposable Income (DI) (Income - Net Taxes)
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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
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Deriving a Saving Functionfrom a Consumption
Function
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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
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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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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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Investment Function
Investment is autonomous (independent of income)
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Present ValueInternal Rate of Return
The Present Value of a stream of payments Where
I can be interpreted as the internal rate of
return
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Present ValueInternal 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)
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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)
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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
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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

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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.

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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 AggregateOutput (Income)
aggregate output / Yplanned aggregate
expenditure / AE / C Iequilibrium Y AE, or
Y C I
Disequilibria
Y gt C I aggregate output gt planned aggregate
expenditureinventory investment is greater than
plannedactual investment is greater than planned
investment
C I gt Yplanned aggregate expenditure gt
aggregate outputinventory investment is smaller
than plannedactual investment is less than
planned investment
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Equilibrium AggregateOutput (Income)
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Equilibrium AggregateOutput (Income)
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Equilibrium AggregateOutput (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
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The Saving/InvestmentApproach to Equilibrium

• 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).

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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
  economythat 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

• Because DS must be equal to DI for equilibrium to
  be restored, we can substitute DI for DS and
  solve

therefore,
, or
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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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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
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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
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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.

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Variable Imports

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

X-M
Real disposable income
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Aggregate Expenditure and Income
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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

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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

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

45o
CIG(X-M)
Equilibrium Real GDP
Real GDP
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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
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The Spending Multiplier and the Circular Flow
(MPC .8)
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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

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

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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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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.

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

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The Aggregate Demand Curve
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Shifts in the Aggregate Demand Curve
P
CIG(X-M)
45o
CIG(X-M)
Y
P
AD
AD
Y
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Appendix A--Variable Net Exports
P
X-M
Real GDP
CIG
P
CIG(X-M)
Real GDP
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The Circular Flow of Income and Expenditure
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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)

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Consumption and Aggregate Expenditure
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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

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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

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The Consumption and Savings Functions

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

S
MPS ?S/?DI
real disposable income
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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

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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

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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

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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

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Leakages Equal Injections

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

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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