Chapter 10
Aggregate Expenditure
Purpose

Examine in more detail the demand side
of the economy, specifically focusing on
Keynesian Aggregate Expenditure model.
 John Maynard Keynes is known
as the father of macroeconomics
 Writing during the great
depression, Keynes was
interested in explaining why
depressions persist
 Main question: How to ensure
that there is enough demand for
the goods produced.
Before Keynes
Economists before Keynes believed in
Say’s Law, which states that supply
creates its own demand
 Production of goods generates incomes
which will create enough demand
 This implies that there is no need for
government intervention or demand
management policies

Before Keynes
Price
Level
Aggregate
Supply
The AS curve is vertical at
the potential GDP. The AD
has no role in influencing
the level of GDP. It only
determines the price level.
Equilibrium
price level
Aggregate
demand
0
Potential GDP
In the long run we are all dead
Keynes believed that demand is unstable which
generates a GDP level lower than potential
 The economy can be caught in an equilibrium
with a low level of GDP
 Thus, demand management policies are needed
 When asked if the economy in the long run
adjusts to the potential level of GDP, he replied:
in the long run we are all dead

Keynesian Fixed Price Model
Price
Level
The AD will determine the
equilibrium level of GDP.
However, the price level is
fixed.
Aggregate
Supply
Equilibrium
price level
Aggregate
demand
0
Low level of
GDP
Consumption and Saving
Households earn income in return for
selling factors of production
 Disposable income is the after tax income,
Yd
 Disposable income is divided between
consumption, C, and saving, S, such that

Yd=C+S
Consumption Function

The Consumption Function is the
relationship between disposable income
and consumption
Consumption Function
Consumption is
positively related to
income
 At zero income,
consumption is
positive. This level
of consumption is
called autonomous
consumption

Consumption Function
The change in
consumption as
income changes is
called the marginal
propensity to
consume (mpc)
 Graphically it is the
slope of the
consumption
function, b.

change in consumption
MPC 
change in disposable income
Saving
Saving is the income that is not consumed
 When disposable income is zero,
households dissave
 Higher income generates higher saving

Saving

The marginal propensity to save is the change
in saving as income changes
change in saving
MPS 
change in disposable income

Since an extra dollar of income is either
consumed or saved, then
MPC  MPS  1
Example
The consumption function is given by
C=100+0.8*Yd
 Autonomous consumption is……
 For every additional dollar earned, the
consumer spends……..of it.
 If disposable income equals …….., then
saving=0
Example
Yd
0
100
200
300
400
500
600
700
C
S
?
?
?
Example
Yd
0
100
200
300
400
500
600
700
C
100
180
260
340
420
500
580
660
S
-100
-80
-60
-40
-20
0
20
40
Households
dissave at low
levels of income
Example
Yd
C
S
100
45
)
500
-100
Yd
Determinants of Consumption

Disposable income
– The main determinant of consumption level
– A change in disposable income causes a
movement on the consumption line
Determinants of Consumption

Wealth
– The value of all assets owned by a household
less liabilities
– Higher wealth increases consumption at each
income level, i.e., causes an upward shift of
the consumption function
Determinants of Consumption

Expectation
– Consumers expectations about future income,
prices, wealth and job security.
– Positive expectations about the economy
increases consumption, causing an upward
shift in the consumption line
Investment
Business spending on capital goods and
inventories
 Most volatile component of aggregate
demand
 Assume that investment spending does
not depend on the level of income, i.e.
autonomous

Determinants of Investment
Interest Rate
 Profit Expectation
 Anything that affects the firm’s expected
rate of return

– Technological change
– Cost of capital goods
– Capacity Utilization
Government Spending
Second largest component of aggregate
expenditure
 Set by government authorities
independent of the current income level,
i.e. we assume that it is autonomous.

Net Exports
Spending national by the international
sector, exports minus imports
 Assume exports are autonomous
 Imports depend on the domestic income
level
 The marginal propensity to import (MPI) is
the proportion of income spent on imports

Aggregate Expenditure
The total level of spending
 AE=C+I+G+NX
 Since I and G are autonomous, then the
slopes of C, C+I, and C+I+G are the same

Aggregate Expenditure
planned Expenditure
C+I+G
C+I
C
Real GDP
Income
Value of goods and services
Aggregate Expenditure affect GDP

When planned expenditure is lower than
GDP:
– There are more goods and services on shelf
than people want to buy
Aggregate Expenditure affect GDP

When planned expenditure is lower than
GDP:
– Unsold goods increases the stock of inventory
a firm has above the planned level
– In fact, unsold goods are called
unplanned inventory.
Aggregate Expenditure affect GDP

How does an increase in the level of
unplanned inventory affect a firms
decision to produce?
– Ideally, unplanned inventory should =0
– When firms face a positive level of unplanned
inventory, they recognize that they
overproduced.
Aggregate Expenditure
Total of goods
and services
(real GDP)
Real GDP
50
45
)
50
Real GDP
(Income
Value of goods and services)
Aggregate Expenditure
Total of goods
and services
(real GDP)
Real GDP
Unplanned
inventory
Aggregate
expenditure at
Yhigh
AE
planned Expenditure
45
)
Yhigh
Real GDP
(Income
Value of goods and services)
Aggregate Expenditure affect GDP

How does an increase in the level of
unplanned inventory affect a firms
decision to produce?
– Firms decide to produce less goods and
services

The level of GDP declines
– Thus, Yhigh is not the equilibrium level of GDP
Aggregate Expenditure affect GDP

When planned expenditure is higher than
GDP:
– There is more buying than the goods and
services offered for sale
Aggregate Expenditure affect GDP

When planned expenditure is higher than
GDP:
– The stock of goods kept as inventory declines
since firms offer it for sale
– In this case unplanned inventory
is negative, i.e., actual inventory
is lower than the planned level.
Aggregate Expenditure affect GDP

How does an decline in the level of
inventory affect a firms decision to
produce?
– When firms face an unplanned reduction in
the level of inventory, they recognize that
they under-produced
– They increase their level of production.
Real
GDP
C
I
G
AE
Unplanned
change in
inventory
Change in
real GDP
0
100
200
300
400
500
600
700
30
100
170
240
310
380
450
520
40
40
40
40
40
40
40
40
80
80
80
80
80
80
80
80
150
220
290
360
430
500
570
640
-150
-120
-90
-60
-30
0
30
60
increase
increase
increase
increase
increase
No change
decrease
decrease
Equilibrium level of Real GDP
At the equilibrium level of real GDP,
Aggregate expenditure equals value of
goods and services produced.
 In equilibrium, unplanned changes in
inventory is zero

Aggregate Expenditure
AE
planned Expenditure
AE= Real GDP
45
)
Y*
Real GDP
Income
Value of goods and services
Changes in Equilibrium Income and
Expenditure
Circular flow diagram shows that one
sector’s expenditure is another sector’s
income.
 This concept will help explain the effect of
a change in the level of autonomous
spending on GDP

Spending Multiplier
Spending multiplier is the change in
equilibrium real GDP as a result of a
change in autonomous spending
 It measures how much income is
generated by a $1 increase in autonomous
spending

Why not 1:1?
An increase in spending generates an
increase in income, which in turn
increases spending, which in turn……..
 A $1 increase in spending increases GDP
by more than $1
 Thus the name the multiplier

Example
Suppose government decides to increase
its spending by $100. This money will go
to constructing a new road (or digging
holes!)
 If the MPC is 0.7, by how much will real
GDP increase?

Road workers
Change in
income
100
Change in
spending
=100x0.7
Restaurant owner 70
=70x0.7
Hair dresser
49
=49x0.7
Total
$333.33
A $100 INCREASE IN SPENDING GENERATES A
$333.33 INCREASE IN REAL GDP
Spending Multiplier
Multiplier= 1/(1-MPC)
 Example: multiplier= 1/(1-0.7)=3.33

Spending Multiplier

The change in GDP from an autonomous
change in spending is given by
• Change in GDP=Multiplier x change in
autonomous spending

Example:
• Change in GDP=3.33 x 100=333.33
Aggregate Expenditure
AE
100
45
)
Y*
$333.33
Y**
Real GDP
Income
Value of goods and services
Recessionary Gap

Refers to the amount of autonomous
spending required to close the GDP gap
Recessionary Gap
AE
Recessionary
gap
By how much should the
government increase
autonomous spending to
close the GDP gap?
Recessionary Gap= GDP gap ÷ multiplier
45
GDP gap
)
Y*
Potential
GDP
Real GDP
Income
Value of goods and services
Deriving the AD
curve
Reducing the price
level increases AE
 At each price
level we have a
corresponding real
GDP level
 Thus the AD curve
AE

45
)
Real GDP
P0
P1
P2
AD
Real GDP
Sticky prices/ unplanned inventory/ Recessions/ Government intervention