Title: Aggregate Expenditure and Equilibrium Output
1Aggregate Expenditureand Equilibrium Output
2The Core of Macroeconomic Theory
3Aggregate 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.
4Aggregate 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.
5Explaining Spending Behavior
- All income is either spent on consumption or
saved in an economy in which there are no taxes. - Saving / Aggregate Income - Consumption
6Household 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.
7Household 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.
8Household 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,
9An 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).
10Consumption Function (alternative formulation)
-Autonomous consumption
-Marginal Propensity to Consume (MPC)
-Disposable Income (DI) (Income - Net Taxes)
11The 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
12Deriving a Saving Functionfrom a Consumption
Function
Y Y - C S S
AGGREGATEINCOME(Billions of Dollars) AGGREGATEINCOME(Billions of Dollars) AGGREGATEINCOME(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
13Planned 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
14Actual 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.
15The 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.
16Investment Function
Investment is autonomous (independent of income)
17Present ValueInternal Rate of Return
The Present Value of a stream of payments Where
I can be interpreted as the internal rate of
return
18Present 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)
19Investment 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)
20Autonomous 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
21Determinants of Investment
- Below are all the things that can cause a shift
in the investment function - The interest rate
- Expectations of future profits
- Technology
22Planned 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.
23Equilibrium 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.
24Equilibrium 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
25Equilibrium AggregateOutput (Income)
26Equilibrium AggregateOutput (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)
AGGREGATEOUTPUT(INCOME) (Y) AGGREGATECONSUMPTION (C) PLANNEDINVESTMENT (I) PLANNEDAGGREGATEEXPENDITURE (AE)C I UNPLANNEDINVENTORYCHANGEY - (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
27Equilibrium 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
28The 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.
29The S I Approach to Equilibrium
- Aggregate output will be equal to planned
aggregate expenditure only when saving equals
planned investment (S I).
30The 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.
31The 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.
32The 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
33The Multiplier
- After an increase in planned investment,
equilibrium output is four times the amount of
the increase in planned investment.
34The 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.
35The 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.
36Government 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
37Autonomous 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
38Determinants 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.
39Variable Imports
- Imports may very well be related to income
- This makes net exports decrease with income
X-M
Real disposable income
40Aggregate Expenditure and Income
41Planned 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
42The 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
43Planned Aggregate Expenditure (trillions of
dollars)
44Deriving Equilibrium Income and Output
45o
CIG(X-M)
Equilibrium Real GDP
Real GDP
45The Simple Spending Multipliers
CIG(X-M)
45o
CIG(X-M)
?I
Simple spending multiplier ?GDP/?I 1/(1-MPC)
1/MPS
Real GDP
?GDP
46The Spending Multiplier and the Circular Flow
(MPC .8)
47Keynes 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
48Appendix B--The Algebra of the Income and
Expenditure Model
49Appendix B--Introducing Variable Imports
50Appendix
- 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.
51Household 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.
52Income, 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.
53An Aggregate Consumption FunctionDerived from
the Equation C 100 .75Y
AGGREGATEINCOME, Y(BILLIONS OF DOLLARS) AGGREGATEINCOME, 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
54Aggregate 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
55The Aggregate Demand Curve
56Shifts in the Aggregate Demand Curve
P
CIG(X-M)
45o
CIG(X-M)
Y
P
AD
AD
Y
57Appendix A--Variable Net Exports
P
X-M
Real GDP
CIG
P
CIG(X-M)
Real GDP
58The Circular Flow of Income and Expenditure
59Review 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)
60Consumption and Aggregate Expenditure
61Classical 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
62Consumption
- 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
63The Consumption and Savings Functions
C
?C
MPC ?C/?DI
?DI
real disposable income
S
MPS ?S/?DI
real disposable income
64The 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
65Planned 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
66The 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
67The 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
68Leakages 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)
69Leakages 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