Chapter 23 – Aggregate Expenditure and Equilibrium Output
The Keynesian Theory of Consumption
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Keynes' economic model is built around the relationship between consumption and income.
Two things are conveyed by Keynes. To begin with, if your income increases, you will be able to
spend more than you did previously. But Keynes also has something to say about how much more
money you'll have: He believes that the increase in consumption will be less than the increase in
income, based on his analysis of the data and his knowledge of people. This simple insight goes a
long way toward explaining how the economy functions as a whole.
A consumption function is the link between consumption and income. A potential consumption
function for a single household is depicted in this diagram.
For simplicity, Figure 23.2 depicts this aggregate consumption function as a straight line with a
constant slope. When describing a straight line consumption curve, we can use the following
equation: a + bY = C. Y represents aggregate production (income), C represents collective
consumption, and a represents the point on the C-axis where the consumption function
intersects—a constant.
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The marginal propensity to consume (MPC) measures how much of a change in income is spent.
The MPC is represented by b in the consumption function.
The fraction of a change in income that is saved is known as the marginal propensity to save (MPS).
The MPC and the MPS must total up to 1 because everything not consumed is preserved. MPS +
MPC = 1.
Behavioral Biases in Saving Behavior
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Recent behavioral economics research has highlighted the significance of psychological biases in
saving behavior and proven that seemingly minor adjustments in how saving programs are
constructed can result in significant behavioral shifts.
Behavioral economists have conducted a number of research that demonstrate that most
people believe they save too little for retirement.
Interest rates play a role in many households' consumption and saving decisions. Because lower
interest rates cut the cost of borrowing, they are more likely to promote spending.
Planned Investment
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An economy's output includes both items consumed by people and investments made by firms.
Plants and equipment are some of the investments made by some firms. These aren't very
dissimilar from household consumption.
The assumption is that the planned investment is fixed. Due to unanticipated changes in
inventories, planned investment may differ from actual investment.
The assumption is that the planned investment is fixed. Due to unanticipated changes in
inventories, planned investment may differ from actual investment.
The Determination of Equilibrium Output (Income)
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Consumption plus planned investment is defined as planned aggregate expenditure: C + I = AE.
When aggregate production (Y) equals projected aggregate expenditure, the economy is said to
be in equilibrium (AE). Y = AE, then Y = C + I.
Unplanned inventory investment occurs when output exceeds planned spending (Y > C + I).
Companies expected to sell more goods than they actually did, resulting in an unplanned rise in
stocks.
Firms have sold more than they anticipated to when planned spending exceeds output (C + I > Y).
The inventory investment is lower than anticipated. The difference between planned and actual
investment is significant. There will be no unanticipated inventory investment if output is exactly
matched by planned spending. This will be a situation of disequilibrium if there is unplanned
inventory investment.
There will be equilibrium (S = I) only when planned investment equals saving.
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In the Planned Aggregate Expenditure Diagram, the Multiplier may be seen. The economy is in
equilibrium when Y = 500 at point A. When I is increased by 25, planned aggregate expenditure
exceeds aggregate output at first. Additional consumption is generated when output rises in
response, pushing equilibrium output higher by a multiple of the initial increase in I. At point B,
where Y = 600, a new equilibrium is formed. Equilibrium output has grown by 100 (600 - 500),
which is four times the planned investment increase.
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The fraction of a change in income that is saved is known as the marginal propensity to save (MPS).
It's calculated by dividing the change in S (∆S) by the change in income (∆Y).
The initial change in planned investment (∆I) multiplied by 1/MPS equals the change in
equilibrium income (∆Y). 1/MPS is the multiplier.
The following is an explanation of the Thrift Paradox. When projected saving is increased from S0
to S1, equilibrium output drops from 500 to 300. Consumption declines as a result of increased
saving, resulting in a contraction of the economy and a fall in income. However, saving remains
the same at the new equilibrium as it was at the initial equilibrium. Increased saving efforts
resulted in a decrease in income but no overall change in saving.
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