Chapter Twenty Four
Aggregate Expenditure
and Equilibrium Output
Income, Consumption, and
Saving (Y, C, and S)
Saving = Income - Consumption
S=Y-C
The Role of Income
Disposable Income: The
current income you receive in
your paycheck, after you pay
taxes.
Expected Future Income: The
income you expect to receive in
the future
The Role of Income
Higher
Income
Higher
Consumption
Income = Consumption + Savings
Y=C+S
Savings
Income
Consumption
Consumption Schedule
Income
0
1000
2000
3000
4000
Consumption
500
1250
2000
2750
3500
Assuming Taxes=0
Consumption Schedule
Income
0
1000
2000
3000
4000
=
Consumption
500
1250
2000
2750
3500
+
Saving
-500
-250
0
250
500
Graphing the Consumption Function
Consumption
45o line
4000
3000
2000
1000
1000
2000
3000
4000
Household Income
Graphing the Consumption Function
Consumption
4000
Consumption
3000
2000
1000
0
0
1000
2000
3000
4000
Household Income
Slope of the Consumption Function
Consumption
5000
4000
C
3000
DC
2000
DY
1000
DC
Slope =
45o
0
0
1000
2000
3000
DY
4000
Household Income
Slope of the Consumption Function
Consumption
Slope = 0.75
5000
4000
C
3000
DC = 750
2000
DY = 1000
1000
45o
0
0
1000
2000
3000
4000
Household Income
The Consumption Function
C = 500 + .75*Income
People buy goods even when their
income is zero
75% of each dollar of income is
consumed
25% of each dollar is saved
0.75 is the Marginal Propensity to
Consume (MPC)
MPC and MPS
The marginal propensity to consume
(MPC) is that fraction of a change in
income that is consumed or spent.
The marginal propensity to save
(MPS) is that fraction of a change in
income that is saved.
Savings
Savings = Income - Consumption
MPS: marginal propensity to save
MPS = 1 - MPC
Consumption & Saving
Consumption
Consumption
Function
S
Y
C
45o
Household Income
Increase in MPC
An increase in the MPC
increases the slope of the
consumption function...
Increase in MPC
Consumption
Consumption
Function
45o
Household Income
Increase in the Constant
An increase in the constant shifts
the entire consumption function
upward, parallel to the original.
Increase in the Constant
Consumption
Consumption
Function
45o
Household Income
What Determines the Level of
Planned Investment?
Real interest rates
Expected future profits
What Determines the Level of
Planned Investment?
Lower Interest Rates
Higher Expected
Future Profits
More
Investment
(I)
Actual Investment
Actual Investment = Planned
Investment + Inventories
Inventories = Production - Sales
Inventory Adjustment
 Consumers buy more than firms
planned
 Inventories fall
 Actual Investment falls short of
Planned Investment
Output Adjustment
Inventories are lower than desired
Firms will increase production
Output will rise
Inventory Adjustment
Planned
Investment
Output
<
C
Inventory Adjustment
Actual
Investment
Output
=
C
Inventory Adjustment
Change in
Inventories
Planned
Investment
=
Actual
Investment
Inventories decline by the difference between
planned investment and actual investment.
Inventory Adjustment
 Consumers buy less than firms planned
 Inventories rise
 Actual Investment exceeds Planned
Investment
Output Adjustment
Inventories are higher than desired
Firms will decrease production
Output will fall
Inventory Adjustment
Output
>
Planned
Investment
C
Inventory Adjustment
Actual
Investment
Output
=
C
Inventory Adjustment
Change in
Inventories
Planned
Investment
=
Actual
Investment
Inventories increase by the difference between
planned investment and actual investment.
Aggregate Expenditures Schedule
Income
Y
0
1000
2000
3000
4000
Consumption
500
1250
2000
2750
3500
Planned
Investment
50
50
50
50
50
Agg. Expend.
C+I
550
1300
2050
2800
3550
Planned
Aggregate
Expenditures
Aggregate Expenditures = C + I
AE = C + I
C
I
45o
Aggregate Income, Y
Planned
Aggregate
Expenditures
Output > Aggregate Expenditures
AE = C + I
Unplanned rise in inventories.
Output falls.
550
500
45o
Aggregate Income, Y
Planned
Aggregate
Expenditures
Output < Aggregate Expenditures
Unplanned fall in inventories.
Output rises.
AE = C + I
550
500
45o
Aggregate Income, Y
Planned
Aggregate
Expenditures
Output = Aggregate Expenditures
Equilibrium
AE = C + I
550
Planned Investment = Actual Investment
Output does not change.
500
45o
Aggregate Income, Y
Income Identities
C + S + T = Y (household budget)
 C + I = AE (planned expenditure)

 AE
= Y (equilibrium)
In equilibrium...
C+S=Y
C + I = AE
AE = Y
S=I
Adjustment to Equilibrium
Expenditures
C+I
2400
C
2200
I = 100
C = 2300
Y = 2400
S = 100
2000
45o
2000
2200
2400
Aggregate Income, Y
Adjustment to Equilibrium
Expenditures
C+I
2400
C
2200
I = 50
C=2150
Y= 2200
S = 50
2000
45o
2000
2200
2400
Aggregate Income, Y
Adjustment to Equilibrium
-C&SAggregate
Planned
Expenditures
Savings = -600 + .25Y
Consumption=600+.75Y
600
45o
Aggregate Income, Y
Adjustment to Equilibrium
AE < Y and S > I
Expenditures
AE = C + I
Investment=$50
Savings
Consumption=600+.75Y
650
600
45o
Aggregate Income, Y
Adjustment to Equilibrium
AE < Y
AE = C + I
Expenditures
Actual Inventories
exceed
Planned Inventories
650
600
45o
$3000
Aggregate Income, Y
When AE < Y, Output is too
High...
Firms produce more than
consumers and firms want to buy
Inventories accumulate
Actual inventories exceed planned
inventories
Firms will cut back on production
Adjustment to Equilibrium
AE > Y
Expenditures
AE = C + I
650
600
Actual Inventories less than Planned Inventories
$800
Aggregate Income, Y
When AE > Y, Output is too Low...
Firms produce less than
consumers and firms want to buy
Inventories decline
Actual inventories are less than
planned inventories
Firms will increase on production
Adjustment to Equilibrium
AE = Y
Expenditures
AE = C + I
Actual Inventories equal
Planned Inventories
650
600
$2600
Aggregate Income, Y
When AE = Y, Equilibrium...
Equilibrium income: the level at
which C+I = Y
Planned Inventories = Actual
Inventories
The Simple Model and the
Multiplier
 C = 500 + 0.75*Y
 I = 50
Equilibrium:
C+I=Y
2200 = Y
Suppose that I rises to 60...
C
= 500 + 0.75*Y
I = 60
Equilibrium:
C+I=Y
2240 = Y
Where do the numbers come
from??
C + I = 500 + 0.75Y + 60 = 560 + 0.75Y
Set C + I equal to Y:
560 + 0.75 Y = Y
Solve for Y:
560 + 0.75Y - 0.75Y = Y - 0.75 Y
560 = 0.25 Y
560/0.25 = Y implies Y = 2240
Aggregate
Planned
Expenditure
The change in I causes a shift in AE
I=60
I=50
2240
2200
2200
2240
Aggregate Income, Y
Investment spending increases by 10,
but income increases by 40...
The Multiplier!!
Multiplier effect: Equilibrium GDP
increases by more than the change in I
or autonomous C
Changes in autonomous expenditures
multiply through the economy.
Multiplier = 1/(1-MPC) = 1/MPS
Suppose $10 is injected into the
economy, with an MPC = .75:
S
$2.50
S
1.87
S
$1.41
S
$1.05
C
C
$10
C
$7.50
Y= $10,
$17.50,
C
$5.63
$23.13,
$4.22
$27.35,
$3.17
$30.52,...
Add up the increments in Y:
$10 + $7.50 + $5.63 + $4.22 + ... = $40
$40 = $10 * multiplier = $10 * 4
Review Terms & Concepts
 Actual investment
 Identity
 Aggregate income
 Investment
 Aggregate output
 Marginal propensity to
 Autonomous variable
consume (MPC)
 Marginal propensity to
save (MPS)
 Multiplier
 Paradox of thrift
 Saving
 Change in inventory
 Consumption function
 Planned investment
 Equilibrium