Download Aggregate Expenditure and Equilibrium Output

CHAPTER
8
Aggregate Expenditure
and Equilibrium Output
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Core of Macroeconomic Theory
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Karl Case, Ray Fair
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Core of Macroeconomic Theory
• This chapter starts presenting macroeconomic theory.
• 1.
What factors determine GDP?
• 2.
What causes inflation and unemployment?
• B. Macroeconomics divides the economy into three
sectors:
• 1. Newly-produced goods and services (GDP)
markets
• 2.
Assets markets (financial and real)
• 3.
Labor markets
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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
• When aggregate output increases, additional
income is generated and vice versa.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Household Consumption and Saving
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• 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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Household Consumption and Saving
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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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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,
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S YC
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
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C  100 .75Y
AGGREGATE
INCOME, Y
(BILLIONS OF
DOLLARS)
Principles of Economics, 7/e
AGGREGATE
CONSUMPTION, C
(BILLIONS OF
DOLLARS)
0
100
80
160
100
175
200
250
400
400
400
550
800
700
1,000
850
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
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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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Deriving a Saving Function
from a Consumption Function
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C  100 .75Y
S YC
Y
-
C
=
AGGREGATE AGGREGATE
INCOME
CONSUMPTION
(Billions of
(Billions of
Dollars)
Dollars)
0
100
80
160
S
AGGREGATE
SAVING
(Billions of
Dollars)
-100
-80
100
175
-75
200
250
-50
400
400
0
600
550
50
800
1,000
700
850
100
150
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
• Because S = Y – C, it is easy to derive a
saving function from a consumption
function. A 45° line drawn from the origin
can be used as a convenient tool to
compare consumption and income
graphically. At Y = 200, consumption is 250.
The 45° line shows us that consumption is
larger than income by 50. Thus S = Y – C =
250. At Y = 800, consumption is less than
income by 100. Thus, S = 100 when Y = 800.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
• The consumption function and the saving
function are mirror images of one another.
No information appears in one that does
not also appear in the other. These
functions tell us how households in the
aggregate will divide income between
consumption spending and saving at every
possible income level. In other words, they
embody aggregate household behavior.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Planned Investment (I)
• Consumption, as we have seen, is the spending by
households on goods and services, but what kind of
spending do firms engage in? The answer is
investment.
• Investment refers to purchases by firms of new
buildings and equipment and additions to inventories,
all of which add to firms’ capital stock.
• To an economist, an investment is something
produced that is used to create value in the future.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
• Spending on buildings and equipment is called
business fixed investment.
• inventories are part of the capital stock. When
firms add to their inventories, they are
investing—they are buying something that
creates value in the future
• One component of investment— is 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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Actual versus Planned Investment
• Desired or planned investment refers to the
additions to capital stock and inventory that are
planned by firms.
• Because we assume households have complete
control over their consumption, planned
consumption is always equal to actual
consumption, while planned investment is not
always equal to actual investment)
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Actual Versus Planned Investment
• A firm may not always end up investing the
exact amount that it planned.
• Actual investment in contrast, is the actual
amount of investment that takes place. If actual
inventory investment turns out to be higher
than firms planned, then actual investment is
greater than I, planned investment.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Planned Investment Function I
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• For now, we will
assume that planned
investment is fixed. It
does not change when
income changes.
• this means the planned
investment function is a
horizontal line.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Planned Aggregate Expenditure (AE)
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• 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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Equilibrium Aggregate
Output (Income)
• we have described the behavior of firms and
households. We now discuss the nature of
equilibrium and explain how the economy
achieves equilibrium.
• 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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Karl Case, Ray Fair
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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
actual investment is less than planned investment
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Karl Case, Ray Fair
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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
850
25
875
+ 125
No
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Karl Case, Ray Fair
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Equilibrium Aggregate
Output (Income)
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Equilibrium Aggregate
Output (Income)
(2)
Y  C I
C  100 .75Y
(3)
I  25
(1)
Y  100 .75Y  25
By substituting (2) and
(3) into (1) we get:
There is only one value of Y
for which this statement is
true. We can find it by
rearranging terms:
Y  .75Y  100  25
Y  100 .75Y  25 Y  .75Y  125
.25Y  125
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125
Y
 500
.25
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Saving/Investment
Approach to Equilibrium
• Because aggregate income must either be
saved or spent, by definition, Y= C + S, which is
an identity. The equilibrium condition is Y = C +
I, but this is not an identity because it does not
hold when we are out of equilibrium. By
substituting C + S for Y in the equilibrium
condition, we can write:
• The saving/investment approach to equilibrium
is C + S = C + I. Because we can subtract C from
both sides of this equation, we are left with S = I.
Thus, only when planned investment equals
saving will there be equilibrium.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Saving/Investment
Approach to Equilibrium
• saving is like a leakage out of the spending
stream. Only if that leakage is counterbalanced
by some other component of planned spending
can the resulting planned aggregate
expenditure equal aggregate output. This other
component is planned investment (I).
• The leakage out of the spending stream—
saving—is matched by an equal injection of
planned investment spending into the spending
stream. For this reason, the saving/investment
approach to equilibrium is also called the
leakages/injections approach to equilibrium.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The S = I Approach to Equilibrium
• Aggregate output will be equal to planned
aggregate expenditure only when saving equals
planned investment (S = I). Saving and planned
investment are equal at Y=500.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Multiplier
• The multiplier is the ratio of the change in
the equilibrium level of output to a change
in some autonomous or independent
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
The Multiplier
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• After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.
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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
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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C H A P T E R 8: Aggregate Expenditure and Equilibrium Output
Review Terms and Concepts
actual investment
identity
aggregate income
investment
aggregate output
marginal propensity to consume
(MPC)
aggregate output (income) (Y)
marginal propensity to save (MPS)
autonomous variable
multiplier
change in inventory
paradox of thrift
consumption function
desired, or planned, investment (I)
equilibrium
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planned aggregate expenditure (AE)
saving (S)
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