Chapter Six Output, Aggregate Expenditure, and Aggregate Demand

Slides are prepared by Dr. Amy Peng, Ryerson University

Chapter SixChapter SixOutput, Aggregate Output, Aggregate

Expenditure, and Aggregate Expenditure, and Aggregate DemandDemand

Macroeconomics by Curtis, Irvine, and BeggMacroeconomics by Curtis, Irvine, and BeggCanadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.

Chapter 6 2

Learning Outcomes

This chapter explainsThis 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


Chapter 6.1 3

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


Chapter 6.1 4

AD, AE, and Output when Price is Constant

AD

AS

Y0

Real GDP and Income

GD

P D

efla

tor

P0

Y

P

E AE (P0)

Y = AE

Y0

Real GDP and Income

Agg

rega

te E

xpen

ditu

reA0

Y

AE

E

45o

Planned Aggregate Expenditure is positively related to real income and output

Short run equilibrium: Y = AE


Chapter 6.2 5

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


Chapter 6.2 6

The Consumption Function

Figure 6.2 The Consumption Function in Canada, 1961-2004

100000

200000

300000

400000

500000

600000

700000

100000 200000 300000 400000 500000 600000 700000

Real Disposable Income

Re

al

Co

ns

um

pti

on

E

xp

en

dit

ure

C = C0 + cY

C0: autonomous consumption

c: MPC = ΔC / ΔY


Chapter 6.2 7

The Consumption Function:A Numerical Example

Y C MPC S = Y - C MPS

0 20

50 60

100 100

150 140

200 180

C = 20 + 0.8 Y


0 20

50 60 0.8

100 100 0.8

150 140 0.8

200 180 0.8

-20

-10

0

10

20

0.2

0.2

0.2

0.2


Chapter 6.2 8

The Saving Function:A Numerical Example


0 20 -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

MPS = 1 - MPC


Chapter 6.2 9

The Saving Function

• S = Y – C

• S = Y – (C0 + cY) = - C0 + (1 - c)Y

= S0 + sY

Saving (S)

Real GDP and Income (Y)

S = -20 + 0.2Y

-20

-10

050 10

0


Chapter 6.2 10

Investment Expenditure

• Investment expenditure is planned additions by business to their stock of physical capital and to inventories

• I = I0

• Investment is autonomous

Real GDP and Income

I = I0I0


Chapter 6.2 11

-20

-15

-10

-5

0

5

10

15

20

25

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Year

Pe

rce

nta

ge

Ch

an

ge

Change in Consumption Change in Investment

Annual Percent Change in Real Investment and Consumption

Expenditures


Chapter 6.3 12

The Aggregate Expenditure Function:

A Numerical ExampleY C I AE =

C + I

0 20 15

50 60 15

100 100 15

150 140 15

200 180 15

C = 20 + 0.8 Y

I = 15

AE = C + I

AE = 20 + 0.8 Y + 15

AE = 35 + 0.8 Y

35

115

135

155

175


Chapter 6.3 13

Aggregate Expenditure

Real Consumption C

Real GDP and Income

C = 20 + 0.8Y

50 100

20

35

120

AE = 35 + 0.8Y

135

I = 15


Chapter 6.3 14

Equilibrium Output

When wages and prices are fixed

• Involuntary excess capacity InvoluntaryInvoluntary unemploymentunemployment

• A short-run equilibrium short-run equilibrium occurs when aggregate expenditure or planned spending equals the output produced


Chapter 6.3 15

45o

Real domestic product, GDP

Ag

gre

gat

e E

xpen

dit

ure

s

AE = C0 + I0 + cYY=AE

The 45o Diagram and Equilibrium Output

AE

AEe

C0 + I0

Y1 Ye

ED

B


Chapter 6.3 16

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)

• 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 17

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


Chapter 6.4 18

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


Chapter 6.4 19

At Equilibrium,Planned Saving Equals Planned

InvestmentSaving (S)


S = -C0 + (1-c)Y

- C0

0Ye Y2

I = I0

1. S = I

2. -C0 + (1-c)Y = I0

3. Ye = (C0 + I0) / (1 – c)

Note: Planned versus Actual


Chapter 6.5 20

45o


Ag

gre

gat

e E

xpen

dit

ure

s

AEY=AE

The Multiplier:Changes in AE and Equilibrium

OutputAE

C0 + I0

Ye’ Ye

E

E’

AE’

ΔYC0 + I1

ΔI


Chapter 6.5 21

Adjustment to Shifts in Investment ExpenditureY I C=20+0.8Y AE Y-AE Unplanned

InventoryOutput

Step 1 175 15 160 175 0 zero Constant

Step 4 166 10 152.8 162.8 3.2 rising Falling

Step 3 170 10 156 166 4 rising Falling

Step 2 175 10 160 170 5 rising Falling

NEW

Eq’m 150 10 140 150 0 zero Constant


Chapter 6.5 22

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 = 35Y = 175.

• Suppose investment decline to I = 10

• AE = 30 + 0.8Y (1-0.8)Y = 30 Y = 150


Chapter 6.5 23

Multiplier

• The Multiplier defines the change in equilibrium output and income caused by a change in autonomous expenditure

A

YmultiplierTh

e


Chapter 6.5 24

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

8.01

1

)8.0()8.0(8.01 32

Multiplier

Multiplier


Chapter 6.5 25

Multiplier

AE) of slope1(

1

)1(

1

Multiplier

cMultiplier

The Multiplier and the MPSThe 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


Chapter 6.6 26

The Paradox of Thrift

Saving (S)


S0 + (1-c)Y

S0

0YeYe

1

I = Ig

S1 + (1-c)Y

S1


Chapter 6.6 27

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.


Chapter 6.7 28

45o


Ag

gre

gat

e E

xpen

dit

ure

s

AE

Y=AE

Equilibrium Output and Aggregate Demand

AE

A0

Ye Ye’

AE’

ΔY

A1

ΔA

Ye Ye’

P0

ΔY

AS

AD

AD’



Chapter 6.7 29

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


Chapter 6 30

Chapter Summary

• Aggregate demandAggregate demand determines real output and national income in the short run when price is constant

• Equilibrium between AEAE and YY determines AD• AEAE is planned spending on goods and services• ConsumptionConsumption (C) is a function of disposable income • Autonomous consumptionAutonomous consumption and marginal propensity marginal propensity

to consumeto consume (MPC)• SavingSaving function, MPS and MPC + MPS = 1• The economy is in equilibrium when output equals

planned spending (Y = AEY = AE)


Chapter 6 31

Chapter Summary

• Equilibrium outputEquilibrium output is determined by AE and AD when prices and wages are fixed

• When AE exceeds actual output, there is an unplanned unplanned fall in inventoriesfall in inventories

• A rise in planned investmentplanned investment is an increase in autonomous expenditure

• The multipliermultiplier determines the change in equilibrium income caused by a change in autonomous expenditure

• The paradox of thrift• The equilibrium outputequilibrium output determined by AE = Y

determines the position of the ADposition of the AD curve in AD/AS model

Documents

Chapter Six Output, Aggregate Expenditure, and Aggregate Demand