Chapter 8
Aggregate
Expenditure and Equilibrium Output
The Keynesian Theory of Consumption
Determinants of Consumption
Planned Investment (I) versus Actual
Investment
Planned Investment and the Interest Rate (r)
Other Determinants of Planned Investment
The Determination of Equilibrium Output
(Income)
The Saving/Investment Approach to
Equilibrium
Adjustment to Equilibrium
The Multiplier
The Multiplier Equation
The Size of the Multiplier in the Real World
Appendix: Deriving the Multiplier
Algebraically
AGGREGATE OUTPUT AND AGGREGATE INCOME (Y)
aggregate output The total quantity of goods and
services produced in an economy in a given period.
aggregate income The total income received by all
factors of production in a given period.
In any given period, there is an exact equality between aggregate output
(production) and aggregate income. You should be reminded of this fact
whenever you encounter the combined term aggregate output (income) (Y).
aggregate output (income) (Y) A combined term used to
remind you of the exact equality between aggregate
output and aggregate income.
Important to Note:
• Chapters 8 – presents the basic Keynesian macroeconomic
model. There is no government in this initial presentation.
Government is added in Chapter 9
• The Keynesian model assumes that producers meet
demand at preset prices – prices are assumed to be fixed.
• All of the adjustment is quantity
• The shortcoming of their assumption is that it does not
explain changes in prices and inflation.
Another Important Note:
Think in Real Terms
•When we talk about output (Y), we mean real output (real
GDP), not nominal output (P x Y).
•The main point is to think of Y as being in real terms - the
quantities of goods and services produced, not the dollars
circulating in the economy.
The Business Cycles – Why do They Occur?
Log-run trend in
potential GDP
Boom
Slump
•Over time, real GDP fluctuates around an overall upward trend. Such
fluctuations are called business cycles. When output rises, we are in the
expansion phase of the cycle; when output falls, we are in a recession.
Unemployment Rate : 1950 - July 2015
July 2015:
5.3%
In this last recession: Number of people unemployed
increased from 7 million to 14 million
Are Recessions Caused by Declining Labor Demand?
Real
Wage
Rate
Labor
Supply
E
$25
F
20
90
Million
Normal
Labor
Demand
Recession
Labor
Demand?
100
Million
Employment
In theory, a recession could be caused by a sudden leftward shift
in the labor demand curve, causing employment to fall. But with
flexible wages, the labor market clears, so there would be no rise
in unemployment, contradicting the facts of actual recessions.
Sticky Wages and Leftward Shift in Labor Demand
– With sticky or rigid wages, the real wage
remains unchanged as labor demand
shifts to the left.
–
you get unemployment !
– this seems to fit what happens in realworld recessions
A Recession Caused by Declining Labor Demand - Wage
rate rigid at $25
Real
Wage
Rate
Labor
Supply
H
E
$25
20
F
80
Million
90
Million
Normal
Labor
Demand
Recession
Labor
Demand?
100
Million
What is the
level of
unemployment
in this graph?
How many
people want to
work in this
graph?
Employment
Downward wage rigidity prevents the labor market from clearing.
This could, in theory, explain the rise in unemployment during a
recession.
Are Wages Rigid and WHY?
• They seem to be • Institutional factors such as unions and
minimum wage.
• Employers are hesitant to lower wages negative effect on worker morale and
productivity
10
Decrease in Total Spending
– Total spending plays an important role in
real-world economic fluctuations
– Once we step away from the classical
model and the assumption that all wages
are flexible and markets clear, a
combination of a sudden drop in total
spending combined with wage rigidity can
explain economic fluctuations
11
Short-Run Macro Model
• Macroeconomic model that explains
how changes in spending can affect
real GDP in the short run.
• Components of Spending: C, I, G, EX and
IM.
• Short-run is month-to-month, quarter-to
quarter, year-to-year.
– Long-run model discussed later covers
multi-year time frame – 10-15 years.
12
Start with Consumption Spending (C)
• Recall that C (household consumption) is
about 70% of total spending on final goods and
services.
• Consumption spending increases when:
– Income (Y) rises
– Wealth (W) rises
– The interest rate (r) falls
– Households become more optimistic about the
future - positive expectations about the future
13
The Keynesian Theory of Consumption
For consumption as a whole, as well as for
consumption of most specific categories of
goods and services, consumption rises with
income.
While Keynes recognized that many factors,
including wealth and interest rates, play a
role in determining consumption levels in the
economy. In his classic The General Theory
of Employment, Interest, and Money, current
income (Y) played the key role.
Quarterly U.S. Consumption and Income, 2000–2014
11000.0
C = 453.95 +0.8713(Y)
10500.0
R² = 0.9783
10000.0
9500.0
9000.0
8500.0
8000.0
8500.0
9000.0
9500.0
10000.0
10500.0
11000.0
11500.0
12000.0
Consumption function The relationship between
consumption and income.
 FIGURE 8.1 A Consumption
Function for a Household
A consumption
function for an
individual
household shows
the level of
consumption at
each level of
household
income.
With a straight line consumption curve, we can use the
following equation to describe the curve:
C = a + bY
 FIGURE 8.2 An Aggregate
Consumption Function
The aggregate
consumption function
shows the level of
aggregate consumption at
each level of aggregate
income.
The upward slope
indicates that higher
levels of income lead to
higher levels of
consumption spending.
marginal propensity to consume (MPC) That fraction of
a change in income that is consumed, or spent.
marginal propensity to consume  slope of consumption function 
C
Y
aggregate saving (S) The part of aggregate income that
is not consumed.
S≡Y–C
The triple equal sign means that this equation is an identity,
or something that is always true by definition.
identity Something that is always true.
INCOME, CONSUMPTION, AND SAVING
(Y, C, AND S)
Saving ≡ Aggregate Income − Consumption
marginal propensity to save (MPS) That fraction of a
change in income that is saved.
MPC + MPS ≡ 1
Because the MPC and the MPS are important concepts, it
may help to review their definitions.
The marginal propensity to consume (MPC) is the fraction
of an increase in income that is consumed (or the fraction
of a decrease in income that comes out of consumption).
The marginal propensity to save (MPS) is the fraction of an
increase in income that is saved (or the fraction of a
decrease in income that comes out of saving).
FIGURE 8.3 The Aggregate Consumption Function Derived from the
Equation C = 100 + .75Y
In this simple consumption
function, consumption is 100 at
an income of zero.
As income rises, so does
consumption.
For every 100 increase in
income, consumption rises by 75.
The slope of the line is .75.
Aggregate
Income, Y
Aggregate
Consumption, C
0
100
100
175
200
250
400
400
600
550
800
700
1,000
850
Exercise
C = 100 +.90Y
AGGREGATE
INCOME, Y
(BILLIONS OF DOLLARS)
0
100
200
400
600
800
1,000
AGGREGATE
CONSUMPTION, C
(BILLIONS OF DOLLARS)
Deriving the Saving Function from the Consumption Function in
Figure 8.3
Because S ≡ Y – C, it is easy to derive the
saving function from the 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 = 50.
At Y = 800, consumption is less than
income by 100.
Thus, S = 100 when Y = 800.
Y

C
=
S
AGGREGATE
AGGREGATE
AGGREGATE
INCOME
CONSUMPTION
SAVING
0
100
-100
100
175
-75
200
250
-50
400
400
0
600
550
50
800
700
100
1,000
850
150
Exercise
C = 100 + .75 Y
S=Y - C
S=?
Other Determinants of Consumption
The assumption that consumption depends only on income
is obviously a simplification.
In practice, the decisions of households on how much to
consume in a given period are also affected by their wealth,
by the interest rate, their expectations of the future, and
taxes
• Households with higher wealth are likely to spend
more, other things being equal, than households with
less wealth.
• Lower interest rates are likely to stimulate spending.
• If households are optimistic and expect to do better in
the future, they may spend more at present than if
they think the future will be bleak.
Factors that Shift the Consumption
Function Upward
• an increase in household wealth (W)
• a decrease in interest rates (r)
• households become more optimistic
about the future ( )
• reduction in taxes (T)
26
Upward Shift in the Consumption Function
Real Consumption
Spending ($ Billions)
6,000
W↑, r ↓, T ↓ ,
5,000
4,000
3,000
Consumption
Function
2,000
1,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real income ($ billions)
27
Factors that Shift the Consumption
Function Downward
• a decrease in household wealth (W)
• an increase in interest rates (r)
• household became more pessimistic
about the future ( )
• increase in taxes (T)
28
Downward Shift in the Consumption Function
Real Consumption
Spending ($ Billions)
6,000
5,000
4,000
3,000
Consumption
Function
W ↓, r ↑, T ↑,
2,000
1,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real income ($ billions)
29
Movement Along Versus a Shift
• Move along the consumption function
– is caused by a change in income
• Shift of the consumption function
– is caused by a change in factors beside
income that cause consumption spending
to change (W, T, r, expectations)
30
Planned Investment (I) versus Actual
Investment
A firm’s inventory is the stock of goods that it has
awaiting sale.
planned investment (I) Those additions to capital
stock and inventory that are planned by firms.
actual investment The actual amount of investment
that takes place; it includes items such as unplanned
changes in inventories.
If a firm overestimates how much it will sell in a period, it
will end up with more in inventory than it planned to have.
We will use I to refer to planned investment, not necessarily
actual investment.
Planned Investment and the Interest Rate (r)
Increasing the interest rate, ceteris paribus, is likely to reduce the level
of planned investment spending. When the interest rate falls, it
becomes less costly to borrow and more investment projects are likely
to be undertaken.
 FIGURE 8.5 Planned
Investment Schedule
Planned investment
spending is a negative
function of the interest
rate. An increase in the
interest rate from 3
percent to 6 percent
reduces planned
investment from I0 to I1.
Other Determinants of Planned Investment
The decision of a firm on how much to invest depends on,
among other things, its expectation of future sales.
The optimism or pessimism of entrepreneurs about the
future course of the economy can have an important effect
on current planned investment. Keynes used the phrase
animal spirits to describe the feelings of entrepreneurs.
For now, we will assume that planned investment simply
depends on the interest rate.
Keep in Mind aggregate output The total quantity of goods and services produced
(or supplied) in an economy in a given period.
aggregate income The total income received by all factors of
production in a given period.
In any given period, there is an exact equality between aggregate
output (production) and aggregate income.
aggregate output (income) (Y) A combined term used to remind you of the
exact equality between aggregate output and aggregate income.
Output = Income
From the outset, you must think in “real terms.” Output Y refers to the quantities
of goods and services produced, not the dollars circulating in the economy.
Also, we are taking as fixed for purposes of this
chapter and the next the interest rate (r) and the
overall price level (P).
The Determination of Equilibrium Output (Income)
equilibrium Occurs when there is no tendency for change. In the
macroeconomic goods market, equilibrium occurs when planned
aggregate expenditure (AE) is equal to aggregate output (Y).
planned aggregate expenditure (AE) The total amount the economy
plans to spend in a given period. Without G, EX and IM, AE is equal to
consumption plus planned investment:
AE ≡ C + I.
Equilibrium: Y = C + I
Aggregate output = planned aggregate expenditure
Y>C+I
aggregate output > planned aggregate expenditure
C+I>Y
planned aggregate expenditure > aggregate output
TABLE 8.1 Deriving the Planned Aggregate Expenditure
Schedule and Finding Equilibrium. 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 = AE?)
Y  (C + I)
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
The 45o Line
•A 45° line = translator line
•It allows us to measure any
horizontal distance as a vertical
distance instead
Using a 45° Line to Translate Distances
A
Dollars
1. Using a 45° line . . .
Consumption
Function
3. into an equal vertical
distance (BA).
45°
0
B
2. we can translate any horizontal
distance (such as 0B) . . .
Dollars
Figure 8.6 The Determination of Equilibrium Output
(Income)
Planned Aggregate Expenditure
45°
Output exceeds
spending. Unplanned
rise in inventories
800
725
E
AE=C+I
Along the 45° line,
income = expenditure
500
Equilibrium Y=C+I
275
200
Spending exceeds output.
Unplanned fall in inventories
0
200
500
800
Aggregate Output, Y
39
The Mechanics of Income Determination
• If Expenditure line is above 45° line
• Total spending > Total output
• Production is below equilibrium
• Inventories fall so firms increase production
• If Expenditure line is below 45° line
• Total spending < Total output
• Production is above equilibrium
• Inventories rise and firms cut back production
40
The Equilibrium Level of Output (Income) Algebraically.
There is only one value of Y for which this statement is true, and we can find it
by rearranging terms:
The equilibrium level of output is 500, as shown in Table 8.1 and Figure 8.6.
The Saving/Investment Approach to Equilibrium
Because aggregate income must 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:
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.
 FIGURE 8.7 The S = I
Approach to Equilibrium
Aggregate output is equal
to planned aggregate
expenditure only when
saving equals planned
investment (S = I).
Saving and planned
investment are equal at Y =
500.
Adjustment to Equilibrium
If AE > Y, planned spending is greater than output, there
will be unplanned inventory reductions. Firms respond by
increasing output.
If AE< Y, planned spending is less than output, there will be
unplanned increases in inventories. Firms will respond by
reducing output. As output falls, income falls, consumption
falls, and so on, until equilibrium is restored, with Y lower
than before.
As Figure 8.6 shows, at any level of output above Y = 500,
such as Y = 800, output will fall until it reaches equilibrium
at Y = 500, and at any level of output below Y = 500, such
as Y = 200, output will rise until it reaches equilibrium at Y
= 500.
The Multiplier
multiplier The ratio of the change in the equilibrium level
of output to a change in some exogenous variable.
exogenous variable A variable that is assumed not to
depend on the state of the economy—that is, it does not
change when the economy changes.
The size of the multiplier depends on the slope of the
planned aggregate expenditure line: C+I.
The steeper the slope of this line, the greater the change in
output for a given change in investment.
Question: what determines the slope of the AE line?
Multiplier Analysis
•
45
Multiplier Process –
What Happens When Things Change?
• What happens if investment (I) increases by $25
– $25 increase investment expenditure, I↑
– creates $25 additional income, Y↑
– MPC ˣ $25 = additional consumption spending, C↑
– creates MPC ˣ $25 additional income, Y↑
– ………
– ………
• Equilibrium GDP rises by a multiple of $25
46
At point A, the economy is in equilibrium at Y = 500.
When I increases by 25,
planned aggregate
expenditure is initially
greater than aggregate
output.
As output rises in
response, additional
consumption is
generated, pushing
equilibrium output up by a
multiple of the initial
increase in I.
The new equilibrium is
found at point B, where Y
= 600.
Equilibrium output has
increased by 100 (600 500), or four times the
amount of the increase in
planned investment.
Multiplier Analysis
•
48
The Multiplier Spending Chain:
MPC = 0.75 and Δ Spending = $1,000,000
49
Figure 11
How the Multiplier Builds
50
Multiplier Analysis
• In last example each round of spending was
0.75 of previous spending • 1 + 0.75 + (0.75)2 + (0.75)3
• 1 + R + R2 + R3 = 1/(1 – R)
• Multiplier = 1/(1 – 0.75) = 4
• In general
• 1 + MPC + MPC2 + MPC3
•
1
Multiplier 
1  MPC
51
Multiplier Analysis
•
1
Multiplier 
1  MPC
• This formula is oversimplified!
• MPC = 0.90, which would imply a
multiplier = 10
• In reality, multiplier ≈2 (average of
estimates)
• We will explain later
52
Multiplier is a General Concept
• Any increase in spending can set off the
multiplier chain
• Autonomous increase in consumption
• An increase in consumer spending without
any increase in consumer incomes
• Shift of the entire consumption function
53
EC ON OMIC S IN PRACTICE
The Paradox of Thrift
An interesting paradox can arise when households attempt to increase their saving.
An increase in planned saving from S0 to
S1 causes equilibrium output to decrease
from 500 to 300.
The decreased consumption that
accompanies increased saving leads to
a contraction of the economy and to a
reduction of income.
But at the new equilibrium, saving is the
same as it was at the initial equilibrium.
Increased efforts to save have caused a
drop in income but no overall change in
saving.
THINKING PRACTICALLY
1. Draw a consumption function corresponding to S0 and S1 and describe what is
happening.
The Size of the Multiplier in the Real World
In considering the size of the multiplier, it is important to realize that the
multiplier we derived in this chapter is based on a very simplified
picture of the economy.
First, we have assumed that planned investment is exogenous.
Second, we have thus far ignored the role of government, financial
markets, and the rest of the world in the macroeconomy.
The size of the multiplier is reduced when tax payments depend on
income (as they do in the real world); when we consider Fed behavior
regarding the interest rate; when we add the price level to the analysis;
and when imports are introduced.
In reality, the size of the multiplier is about 2. That is, a sustained
increase in exogenous spending of $10 billion into the U.S. economy
can be expected to raise real GDP over time by about $20 billion.
Looking Ahead
In this chapter, we took the first step toward understanding
how the economy works.
We assumed that consumption depends on income, that
planned investment is fixed, and that there is equilibrium.
We discussed how the economy might adjust back to
equilibrium when it is out of equilibrium.
We also discussed the effects on equilibrium output from a
change in planned investment and derived the multiplier.
In the next chapter, we retain these assumptions and add
the government to the economy.
REVIEW TERMS AND CONCEPTS
actual investment
multiplier
aggregate income
planned aggregate expenditure (AE)
aggregate output
planned investment (I)
aggregate output (income) (Y)
aggregate saving (S)
consumption function
equilibrium
exogenous variable
identity
marginal propensity to consume
(MPC)
marginal propensity to save (MPS)
1.
2.
3.
4.
5.
S≡Y−C
MPC  slope of consumption function 
MPC + MPS ≡ 1
AE ≡ C + I
Equilibrium condition: Y = AE or
Y=C+I
6. Saving/investment approach to
equilibrium: S = I
7. Multiplier 
1
1

MPS 1 - MPC
C
Y
CHAPTER 8 APPENDIX
Deriving the Multiplier Algebraically
Now look carefully at this expression and
think about increasing I by some amount,
ΔI, with a held constant. If I increases by
ΔI, income will increase by
The multiplier is
Finally, because MPS + MPC = 1, MPS is
equal to 1 - MPC, making the alternative
expression for the multiplier 1/MPS, just as
we saw in this chapter.