Output and Expenditure in the Short Run
Aggregate expenditure (AE)
The total amount of spending on the economy’s output:
Aggregate Expenditure
AE = C + I + G + NX
• Consumption (C)
• Planned Investment (I)
• Government Purchases of Goods + Services (G)
• Net Exports (NX)
Actual investment in a year can differ from planned investment: businesses
“invest” in unintended inventories if sales fall short of what they expected
Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y)
AE = C + I + G + NX = Y
Components of Real Aggregate Expenditure, 2008
The Aggregate Expenditure Model
Adjustments to Macroeconomic Equilibrium
Actual investment in a year can differ from planned investment: businesses
“invest” in unintended inventories if sales fall short of what they expected
IF …
Aggregate expenditure is
equal to GDP
Aggregate expenditure is
less than GDP
THEN …
AND …
inventories are
unchanged
the economy is in
macroeconomic
equilibrium.
inventories rise
GDP and employment
decrease.
Aggregate Expenditure is
greater than GDP
inventories fall
GDP and employment
increase.
Real Consumption Expenditure, 1979 - 2009
Consumption follows
a smooth, upward
trend, interrupted
only infrequently by
recessions.
The most important variables that determine the level of C:
•
Current disposable income
• Household wealth: Assets minus liabilities
Including equity in owner occupied houses?
Making Do Changes in Housing Wealth
the
Connection
Affect Consumption Spending?
Many macroeconomic
variables, such as
GDP, housing prices,
consumption
spending, and
investment spending,
rise and fall at about
the same time during
the business cycle
The most important variables that determine the level of C:
•
Current disposable income
• Household wealth: Assets minus liabilities
Including equity in owner occupied houses?
• Expected future income
People try to keep their consumption fairly steady from year-to-year
 save for a rainy day
• The price level
Higher price level reduces real value of monetary wealth
• The interest rate
High interest rate discourages spending on credit/encourages saving
• New, gotta-have styles and products
The Consumption Function
The Relationship between Consumption and Income, 1960– 2008
The Consumption Function
Marginal propensity to consume (MPC) The slope of the
consumption function: The amount by which consumption spending
changes when disposable income changes.
Change in consumptio n
C
MPC 

Change in disposable income YD
When disposable income changes:
Change in consumption = ΔYD× MPC
For a textbook economy:
The Relationship between Consumption and National Income
when net taxes are constant  ΔYD = ΔNI
Income, Consumption, and Saving
National income = Consumption + Saving + Taxes
Y=C+S+T
Change in national income = Change in consumption + Change in saving
+ Change in taxes
Y  C  S  T
If taxes are always a constant amount, ΔT = 0
ΔY = ΔC + ΔS
1 = MPC + MPS
Calculating the Marginal Propensity to
Consume and the Marginal Propensity to Save
C
MPC 
Y
NATIONAL
INCOME AND
REAL GDP (Y)
S
MPS 
Y
CONSUMPT
ION
SAVING
(C)
(S)
$9,000
$8,000
1,000
10,000
8,600
1,400
11,000
9,200
1,800
12,000
9,800
2,200
13,000
10,400
2,600
MARGINAL
PROPENSITY TO
CONSUME (MPC)
MARGINAL
PROPENSITY TO
SAVE (MPS)
—
—
0.6
0.4
0.6
0.4
0.6
0.4
0.6
0.4
Planned Investment = I
Real Investment, 1979 - 2009
Investment is
subject to larger
changes than is
consumption.
Investment
declined
significantly during
the recessions of
1980, 1981–1982,
1990–1991, 2001,
and 2007–2009.
The most important variables that determine the level of investment:
• Expectations of future profitability
Waves of optimism and pessimism
• Major technology changes: new products & processes
• The interest rate
• Taxes
• Cash flow  Retained earnings for financing investment
• Current capacity utilization
Government Purchases = G
Real Government Purchases, 1979 – 2009
Government
purchases grew
steadily for most
of the 1979–2009
period, with the
exception of the
early 1990s, when
concern about the
federal budget
deficit caused real
government
purchases to fall
for three years,
beginning in
1992.
Net Exports (NX)
Real Net Exports, 1979–2006
Net Exports = NX
Real Net Exports, 1979 – 2009
Net exports were
negative in most
years between
1979 and 2009.
Net exports have
usually increased
when the U.S.
economy is in
recession and
decreased when
the U.S. economy
is expanding,
although they fell
during most of the
2001 recession.
Net Exports (NX)
The most important variables that determine the level of net exports:
• The price level in the United States relative to
the price levels in other countries
• The growth rate of GDP in the United States
relative to the growth rates of GDP in other
countries
• The exchange rate between the dollar and
other currencies
Graphing Macroeconomic Equilibrium
The Relationship between Planned Aggregate
Expenditure and GDP on a 45°-Line Diagram
Graphing Macroeconomic Equilibrium
Graphing Macroeconomic Equilibrium
Showing a Recession on the 45°-Line Diagram
Macroeconomic Equilibrium
Planned
Unplan
Planned
Govern
Aggregate
ned
Invest
ment
Net
Expenditur Change
ment
Purchases Export
e
in Invent
(I)
(G)
(NX)
(AE)
ories
Real
GDP
(Y)
Consump
tion
(C)
Real
GDP
Will …
$8,000
$6,200
$1,500
$1,500
– $500
$8,700
–$700
increase
9,000
6,850
1,500
1,500
–500
9,350
–350
increase
be in
equili
brium
10000
7,500
1,500
1,500
–500
10,000
0
11000
8,150
1,500
1,500
–500
10,650
+350
decrease
12000
8,800
1,500
1,500
–500
11,300
+700
decrease
The Multiplier Effect
Learning Objective 11.4
The Multiplier Effect
Autonomous expenditure An
expenditure that does not depend on
the level of GDP.
Multiplier The increase in equilibrium real GDP in
response to increase in autonomous expenditure, e.g.
Expenditure multiplier = ΔY/ΔI
Multiplier effect The process by which an increase in autonomous
expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC
= Change in autonomous spending that sparks an expansion
+
Change in consumption spending induced by increasing output and
income.
The Multiplier Effect in Action
ADDITIONAL
AUTONOMOUS
EXPENDITURE
(INVESTMENT)
ROUND 1
$100 billion
ADDITIONAL
INDUCED
EXPENDITURE
(CONSUMPTION)
$0
TOTAL ADDITIONAL
EXPENDITURE =
TOTAL ADDITIONAL GDP
$100 billion
ROUND 2
0
75 billion
175 billion
ROUND 3
0
56 billion
231 billion
ROUND 4
ROUND 5
.
.
.
ROUND 10
.
.
.
ROUND 15
.
.
.
0
0
.
.
.
0
.
.
.
0
.
.
.
42 billion
32 billion
.
.
.
8 billion
.
.
.
2 billion
.
.
.
273 billion
305 billion
.
.
.
377 billion
.
.
.
395 billion
.
.
.
ROUND 19
0
1 billion
398 billion
n
0
0
$400 billion
Making
the
Connection
The Multiplier in Reverse:
The Great Depression of the 1930s
The multiplier
effect contributed
to the very high
levels of
unemployment
during the Great
Depression.
Year Consumption
Investment
Net Exports
Real GDP
Unemployment Rate
1929
$661 billion
$91.3 billion
-$9.4illion
$865 billion
3.2%
1933
$541 billion
$17.0 billion
-$10.2 billion
$636 billion
24.9%
The Multiplier Effect
A Formula for the Multiplier
1
1  MPC
Y = C + I + G + NX
C depends on YD:
C = c0 + MPC x YD = c0 + MPC x (Y – T)
c0, I, G, T, and NX are autonomous—they do not depend on Y
Y = c0 + MPC x Y – MPC x T + I + G + NX
(1 – MPC) x Y = c0 + I + G – MPC x T + NX
Y = [1/(1 – MPC)] x [c0 + I + G – MPC x T + NX]
Change in equilibriu m real GDP
1
Multiplier 

Change in autonomous expenditur e 1  MPC
Summarizing the Multiplier Effect
1 The multiplier effect occurs both when autonomous
expenditure increases and when it decreases.
2 The multiplier effect makes the economy more sensitive
to changes in autonomous expenditure than it would
otherwise be.
3 The larger the MPC, the larger the value of the multiplier.
4 The formula for the multiplier, 1/(1 − MPC), is oversimplified
because it ignores some real-world complications, such as
the effect that an increasing GDP can have on taxes,
imports, prices and interest rates.
The Aggregate Demand Curve
The Effect of a Change in
the Price Level on Real GDP
Aggregate demand curve A curve that shows the
relationship between the price level and the level of
planned aggregate expenditure, holding constant all
other factors that affect aggregate expenditure.
Key Terms
Aggregate demand curve
Aggregate expenditure (AE)
Marginal propensity to
consume (MPC)
Autonomous expenditure
Marginal propensity to
save (MPS)
Cash flow
Multiplier
Consumption function
Multiplier effect
Aggregate expenditure model
Inventories
Appendix
The Algebra of Macroeconomic Equilibrium
1 C  C  MPC (Y ) Consumption function
2 I 1
Planned investment function
3 G G
Government spending function
4 NX  NX
Net export function
5
Y  C  I  G  NX
Equilibrium condition
Appendix
The Algebra of Macroeconomic Equilibrium
The letters with bars over them represent fixed, or autonomous,
values. So, C represents autonomous consumption, which had a value
of 1,000 in our original example. Now, solving for equilibrium, we get:
Y  C  MPC(Y)  I  G  NX
Or,
Y - MPC(Y)  C  I  G  NX
Or,
Y (1  MPC )  C  I  G  NX
Or,
C  I  G  NX
Y
1  MPC
Appendix
The Algebra of Macroeconomic Equilibrium
1
is the multiplier. Therefore an alternative
1  MPC
expression for equilibrium GDP is:
Remember that
Equilibrium GDP = Autonomous expenditure x Multiplier