Chapter Six
Output, Aggregate Expenditure, and
Aggregate Demand
Macroeconomics by Curtis, Irvine, and Begg
Canadian Edition, McGraw-Hill Ryerson, 2007
Slides are prepared by Dr. Amy Peng, Ryerson University
Learning Outcomes
This chapter explains
• Aggregate demand and output in the short run
• The consumption, saving, and investment
functions
• Aggregate expenditure and equilibrium output in
the short run
• The multiplier
• How the marginal propensity to consume affects
the multiplier
• The paradox of thrift
• Equilibrium output and aggregate demand
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6
2
Aggregate Demand and Output
in the short Run
• Assumptions
– All prices and wages are fixed at a given level
– At these prices and wages, there are workers
without a job who would like to work and firms
have spare capacity they could profitably use
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.1
3
AD, AE, and Output when Price is Constant
P
AE
AS
P0
E
Aggregate Expenditure
GDP Deflator
Y = AE
AE (P0)
E
Planned Aggregate Expenditure
is positively
A0
AD and output
related to real income
o
Short run equilibrium:
Y0
Y Y = AE
Real GDP and Income
©2007 McGraw-Hill Ryerson Ltd.
45
Y0
Y
Real GDP and Income
Chapter 6.1
4
Consumption, Saving, and Investment
• Without a government or a foreign sector
AE = C + I
• Consumption Expenditure
– Disposable income
is the income net taxes and transfers
– Consumption function
explains consumption expenditure at each
level of disposable income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
5
The Consumption Function
Figure 6.2 The Consumption Function in Canada, 1961-2004
Real Consumption
Expenditure
700000
600000
C = C0 + cY
500000
C0: autonomous consumption
400000
c: MPC = ΔC / ΔY
300000
200000
100000
100000
200000
300000
400000
500000
600000
700000
Real Disposable Income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
6
The Consumption Function:
A Numerical Example
Y
C
MPC
S=Y-C
MPS
0
20
50
60
0.8
-10
0.2
100
100
0.8
0
0.2
150
140
0.8
10
0.2
200
180
0.8
20
0.2
-20
C = 20 + 0.8 Y
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
7
The Saving Function:
A Numerical Example
Y
C
MPC
S=Y-C
MPS
0
20
50
60
0.8
-10
0.2
100
100
0.8
0
0.2
150
140
0.8
10
0.2
200
180
0.8
20
0.2
-20
MPS = 1 - MPC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
8
The Saving Function
• S=Y–C
• S = Y – (C0 + cY)
= - C0 + (1 - c)Y
= S0 + sY
0
Saving (S)
S = -20 + 0.2Y
50
100
-10
-20
Real GDP and Income (Y)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
9
Investment Expenditure
• Investment expenditure
is planned additions by
business to their stock of
physical capital and to
inventories
I0
• I = I0
• Investment is
autonomous
I = I0
Real GDP and Income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
10
Annual Percent Change in Real Investment and
Consumption Expenditures
25
20
Percentage Change
15
10
5
0
1985
-5
1987
1989
-10
1991
1993
1995
1997
1999
2001
2003
2005
Year
-15
-20
Change in Consumption
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2
Change in Investment
11
The Aggregate Expenditure Function:
A Numerical Example
Y
C
I
AE =
C+I
C = 20 + 0.8 Y
0
20
15
35
I = 15
50
60
15
115
AE = C + I
AE = 20 + 0.8 Y + 15
100
100
15
135
150
140
15
155
200
180
15
175
©2007 McGraw-Hill Ryerson Ltd.
AE = 35 + 0.8 Y
Chapter 6.3
12
Aggregate Expenditure
Real Consumption C
AE = 35 + 0.8Y
135
120
I = 15
C = 20 + 0.8Y
35
20
50
100
Real GDP and Income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3
13
Equilibrium Output
When wages and prices are fixed
• Involuntary excess capacity  Involuntary
unemployment
• A short-run equilibrium occurs when
aggregate expenditure or planned
spending equals the output produced
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3
14
The 45o Diagram and Equilibrium Output
Y=AE
Aggregate Expenditures
AE
AEe
AE = C0 + I0 + cY
E
D
B
C0 + I0
45
o
Y1
Ye
Real domestic product, GDP
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3
15
Equilibrium Output
• Examples:
AE = C + I
C = C0 + cY
I = I0
• Y = C + I = C0 + cY + I0
• Y – cY = C0 + I0
• Ye = (C0 + I0) / (1 – c)
©2007 McGraw-Hill Ryerson Ltd.
• Examples:
C = 20 + 0.8Y
I = 15
• AE = 35 + 0.8Y
• Y = AE
• Y – 0.8Y = 35
• Ye = 35 / (1 – 0.8) = 175
Chapter 6.3
16
Short-Run Equilibrium
• Adjustment towards equilibrium
– Unplanned inventory
– Output is above equilibrium  unplanned
inventory  cutting output
– Output is below equilibrium  turning away
consumers  raising output
• Equilibrium Output and Employment
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3
17
Another Approach:
Planned Saving Equals Planned Investment
•
•
•
•
•
•
•
•
Since AE = C + I
And Y = C + S
AE = Y  I = S
S = - C0 + (1-c)Y
Example : I = 15, C = 20 + 0.8 Y
S = - 20 + 0.2 Y
So -20 + 0.2 Y = 15
Y =175
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4
18
At Equilibrium,
Planned Saving Equals Planned Investment
Saving (S)
1. S = I
2. -C0 + (1-c)Y = I0
S = -C0 + (1-c)Y
3. Ye = (C0 + I0) /
(1 – c)
I = I0
0
Note: Planned versus Actual
- C0
©2007 McGraw-Hill Ryerson Ltd.
Ye
Y2
Real GDP and Income (Y)
Chapter 6.4
19
The Multiplier:
Changes in AE and Equilibrium Output
Y=AE
AE
Aggregate Expenditures
E
ΔI
C0 + I0
C0 + I1
AE
AE’
E’
ΔY
45
o
Ye’
Ye
Real domestic product, GDP
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5
20
Adjustment to Shifts
in Investment Expenditure
Y
I
C=20+0.8Y AE
Y-AE
Unplanned
Inventory
Output
Step 1 175 15
160
175
0
zero
Constant
Step 2 175 10
160
170
5
rising
Falling
Step 3 170 10
156
166
4
rising
Falling
Step 4 166 10
152.8
162.8 3.2
rising
Falling
140
150
zero
Constant
NEW
Eq’m
150 10
©2007 McGraw-Hill Ryerson Ltd.
0
Chapter 6.5
21
Multiplier
• Consumption Function: C = 20 + 0.8Y
• Investment:
I = 15
• Aggregate Expenditure: AE = 35 + 0.8Y
• Y = AE  Y = 35 + 0.8Y  (1-0.8)Y = 35
Y = 175.
• Suppose investment decline to I = 10
• AE = 30 + 0.8Y  (1-0.8)Y = 30 Y = 150
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5
22
Multiplier
• The Multiplier defines the change in equilibrium
output and income caused by a change in
autonomous expenditure
Y
The multiplier 
A
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5
23
The Size of the Multiplier
Consumption function: C = 20 + 0.8Y
Change in (Δ) Step 1
Step 2
Step 3
Step 4
Step 5
ΔI
1
0
0
0
0
ΔY
0
1
0.8
(0.8)2
(0.8)3
ΔC
0
0.8
(0.8)2
(0.8)3
(0.8)4
Multiplier  1  0.8  (0.8) 2  (0.8)3  
1
Multiplier 
1  0.8
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5
24
Multiplier
1
Multiplier 
(1  c)
1
Multiplier 
(1  slope of AE)
The Multiplier and the MPS
The higher the marginal propensity to save, the
larger is the change in saving as a result of a change
in income, the smaller the multiplier
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5
25
The Paradox of Thrift
Saving (S)
S1 + (1-c)Y
S0 + (1-c)Y
0
S1
S0
I = Ig
Ye1
Ye
Real GDP and Income (Y)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.6
26
The Paradox of Thrift
• An increase in autonomous saving
decreases autonomous consumption
• With multiplier effect, equilibrium income
declines further than the increase in
saving.
• The attempt to increase saving results in
lower output and income but no change in
saving.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.6
27
Equilibrium Output and Aggregate Demand
Y=AE
AE’
AE
Aggregate Expenditures
AE
AS
P0
ΔA
AD’
A1
A0
ΔY
ΔY
45
AD
o
Ye
Ye’
Real domestic product, GDP
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.7
Ye
Ye’
Real domestic product, GDP
28
Equilibrium Output and Aggregate
Demand
• Equilibrium output in the AE model determines
the position of the AD curve
• Any change in autonomous expenditure (ΔA)
causes a larger increase in equilibrium output
(ΔY) based on the multiplier
• As a result, ΔA causes a horizontal shift in AD,
which is equal to ΔY by ΔA and the multiplier
• Fluctuations in AD and output are caused by
fluctuations in autonomous expenditure
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.7
29
Chapter Summary
• Aggregate demand determines real output and
national income in the short run when price is
constant
• Equilibrium between AE and Y determines AD
• AE is planned spending on goods and services
• Consumption (C) is a function of disposable income
• Autonomous consumption and marginal propensity
to consume (MPC)
• Saving function, MPS and MPC + MPS = 1
• The economy is in equilibrium when output equals
planned spending (Y = AE)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6
30
Chapter Summary
• Equilibrium output is determined by AE and AD when
prices and wages are fixed
• When AE exceeds actual output, there is an unplanned
fall in inventories
• A rise in planned investment is an increase in
autonomous expenditure
• The multiplier determines the change in equilibrium
income caused by a change in autonomous expenditure
• The paradox of thrift
• The equilibrium output determined by AE = Y
determines the position of the AD curve in AD/AS model
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6
31