Chapter Twenty Four Aggregate Expenditure and Equilibrium Output

Chapter Twenty FourChapter Twenty Four

Aggregate Expenditure Aggregate Expenditure and Equilibrium Outputand Equilibrium Output

Income, Consumption, and Income, Consumption, and Saving (Y, C, and S)Saving (Y, C, and S)

Saving = Income - Consumption

S = Y - C

The Role of IncomeThe Role of Income

Disposable IncomeDisposable Income: The current income you receive in your paycheck, after you pay taxes.

Expected Future IncomeExpected Future Income: The income you expect to receive in the future

The Role of IncomeThe Role of Income

Higher Income

Higher Consumption

Income = Consumption + Savings Income = Consumption + Savings Y = C + SY = C + S

Income

Consumption

Savings

Consumption ScheduleConsumption Schedule

Income 0 1000 2000 3000 4000

Consumption 500 1250 2000 2750 3500

Assuming Taxes=0

Consumption ScheduleConsumption Schedule

Income 0 1000 2000 3000 4000

Consumption 500 1250 2000 2750 3500

Saving -500 -250 0 250 500

= +

Graphing the Consumption FunctionGraphing the Consumption Function

Consumption

4000

3000

2000

1000

Household Income400020001000 3000

45o line

Graphing the Consumption FunctionGraphing the Consumption Function

0

1000

2000

3000

4000

0 1000 2000 3000 4000

Consumption

Household Income

Consumption

Slope of the Consumption FunctionSlope of the Consumption Function

0

1000

2000

3000

4000

5000

0 1000 2000 3000 4000

Consumption

45o

C

Household Income

C

YSlope =

C

Y

Slope of the Consumption FunctionSlope of the Consumption Function

0

1000

2000

3000

4000

5000

0 1000 2000 3000 4000

Consumption

45o

C

Household Income

C = 750

Y = 1000

Slope = 0.75

The Consumption FunctionThe Consumption Function C = 500 + .75*IncomeC = 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 MPSMPC and MPS

The marginal propensity to consumemarginal propensity to consume (MPC) is that fraction of a change in income that is consumed or spent.

The marginal propensity to savemarginal propensity to save (MPS) is that fraction of a change in income that is saved.

SavingsSavings

Savings = Income - ConsumptionMPS: marginal propensity to saveMPS = 1 - MPC

Consumption & SavingConsumption & Saving

Consumption

45o

ConsumptionFunction

Y C

S

Household Income

Increase in MPCIncrease in MPC

An increase in the MPC increases the slope of the consumption function...

Increase in MPCIncrease in MPCConsumption

45o

ConsumptionFunction

Household Income

Increase in the ConstantIncrease in the Constant

An increase in the constant shifts the entire consumption function upward, parallel to the original.

Increase in the ConstantIncrease in the ConstantConsumption

45o

ConsumptionFunction

Household Income

What Determines the Level of What Determines the Level of Planned Investment?Planned Investment?

Real interest rates

Expected future profits

What Determines the Level of What Determines the Level of Planned Investment?Planned Investment?

Lower Interest Rates

Higher ExpectedFuture Profits

More Investment

(I)

Actual InvestmentActual Investment

Actual Investment = Planned Investment + Inventories

Inventories = Production - Sales

Inventory AdjustmentInventory Adjustment

Consumers buy more than firms planned Inventories fall Actual Investment falls short of Planned Investment

Output AdjustmentOutput Adjustment

Inventories are lower than desiredFirms will increase productionOutput will rise

Output<

C

Planned Investment

Inventory AdjustmentInventory Adjustment

Output=

C

ActualInvestment

Inventory AdjustmentInventory Adjustment

ActualInvestment

Planned Investment =

Change inInventories

Inventories decline by the difference between planned investment and actual investment.

Inventory AdjustmentInventory Adjustment

Inventory AdjustmentInventory Adjustment

Consumers buy less than firms planned Inventories rise Actual Investment exceeds Planned Investment

Output AdjustmentOutput Adjustment

Inventories are higher than desiredFirms will decrease productionOutput will fall

Output>

C

Planned Investment

Inventory AdjustmentInventory Adjustment

C

Output=

ActualInvestment

Inventory AdjustmentInventory Adjustment

ActualInvestment

=

Change inInventories

Inventories increase by the difference between planned investment and actual investment.

Planned Investment

Inventory AdjustmentInventory Adjustment

Aggregate Expenditures ScheduleAggregate Expenditures Schedule

Income Y 0 1000 2000 3000 4000

Consumption 500 1250 2000 2750 3500

PlannedInvestment 50 50 50 50 50

Agg. Expend. C + I 550 1300 2050 2800 3550

PlannedAggregate Expenditures AE = C + I

Aggregate Income, Y45o

C

I

Aggregate Expenditures = C + IAggregate Expenditures = C + I

PlannedAggregate Expenditures

500

550

AE = C + I

Unplanned rise in inventories. Output falls.

Aggregate Income, Y45o

Output > Aggregate ExpendituresOutput > Aggregate Expenditures

PlannedAggregate Expenditures

500

550

AE = C + I

Unplanned fall in inventories. Output rises.

Aggregate Income, Y45o

Output < Aggregate ExpendituresOutput < Aggregate Expenditures

PlannedAggregate Expenditures

500

550

AE = C + I

Planned Investment = Actual InvestmentOutput does not change.

Aggregate Income, Y

Equilibrium

45o

Output = Aggregate ExpendituresOutput = Aggregate Expenditures

Income IdentitiesIncome Identities

C + S + T = Y (household budget) C + I = AE (planned expenditure)

AE = Y (equilibrium)

In equilibrium...In equilibrium...

C + S = Y

C + I = AE

AE = Y

S = I

Adjustment to EquilibriumAdjustment to Equilibrium

Expenditures

C

C + I

2000

2000

2200

2200

2400

2400

I = 100 C = 2300Y = 2400S = 100

Aggregate Income, Y

45o

Adjustment to EquilibriumAdjustment to EquilibriumExpenditures

C

C + I

2000

2000

2200

2200

2400

2400

I = 50C=2150Y= 2200S = 50

Aggregate Income, Y45o

Adjustment to EquilibriumAdjustment to Equilibrium- C & S -- C & S -

Consumption=600+.75Y

AggregatePlannedExpenditures

Savings = -600 + .25Y

600

Aggregate Income, Y45o

Adjustment to EquilibriumAdjustment to EquilibriumAE < Y and S > IAE < Y and S > I

Consumption=600+.75Y

Investment=$50

Expenditures

Savings

600

650

AE = C + I

Aggregate Income, Y

45o

Adjustment to EquilibriumAdjustment to EquilibriumAE < YAE < Y

Expenditures

600

650

AE = C + I

Actual Inventoriesexceedexceed

Planned Inventories

$3000 Aggregate Income, Y

45o

When AE < Y, Output is too When AE < Y, Output is too High...High...

Firms produce more than consumers and firms want to buyInventories accumulateActual inventories exceed planned inventoriesFirms will cut back on production

Adjustment to EquilibriumAdjustment to EquilibriumAE > YAE > Y

Expenditures

600

650

AE = C + I

Actual Inventories less than Planned Inventories

$800 Aggregate Income, Y

When AE > Y, Output is too Low...When AE > Y, Output is too Low...

Firms produce less than consumers and firms want to buyInventories declineActual inventories are less than planned inventoriesFirms will increase on production

Adjustment to EquilibriumAdjustment to EquilibriumAE = YAE = Y

Expenditures

600

650

AE = C + I

Actual Inventories equal Planned Inventories

$2600 Aggregate Income, Y

When AE = Y, Equilibrium...When AE = Y, Equilibrium...

Equilibrium income: the level at which C+I = YPlanned Inventories = Actual Inventories

The Simple Model and the The Simple Model and the MultiplierMultiplier

C = 500 + 0.75*Y I = 50

Equilibrium:C + I = Y2200 = Y

Suppose that I rises to 60...Suppose that I rises to 60...

C = 500 + 0.75*YI = 60

Equilibrium:C + I = Y2240 = Y

Where do the numbers come Where do the numbers come from??from??

C + I = 500 + 0.75Y + 60 = 560 + 0.75YSet C + I equal to Y:

560 + 0.75 Y = YSolve for Y:

560 + 0.75Y - 0.75Y = Y - 0.75 Y560 = 0.25 Y560/0.25 = Y implies Y = 2240

Aggregate PlannedExpenditure

2240

2240

2200

2200

I=50

I=60

Aggregate Income, Y

The change in I causes a shift in AEThe change in I causes a shift in AE

Investment spending increases by 10,but income increases by 40...

Investment spending increases by 10,but income increases by 40...

The Multiplier!!The Multiplier!!

Multiplier effectMultiplier effect: Equilibrium GDP increases by more than the change in I or autonomous CChanges in autonomous expenditures multiply through the economy.Multiplier = 1/(1-MPC)1/(1-MPC) = 1/MPS

Suppose $10 is injected into the Suppose $10 is injected into the economy, with an MPC = .75:economy, with an MPC = .75:

$10$7.50

$2.50

$5.63

1.87

$4.22

$1.41

S S S

Y=

C

CC

$3.17

$1.05

C

S

$10, $17.50, $23.13, $27.35, $30.52,...

Add up the increments in Y:Add up the increments in Y:

$10 + $7.50 + $5.63 + $4.22 + ... = $40$40 = $10 * multiplier = $10 * 4

Review Terms & ConceptsReview Terms & Concepts

Actual investment Aggregate income Aggregate output Autonomous variable Change in inventory Consumption function Planned investment Equilibrium

Identity Investment Marginal propensity to

consume (MPC) Marginal propensity to

save (MPS) Multiplier Paradox of thrift Saving