chapter 8- aggregate expenditure and equilibrium output

7/31/2019 Chapter 8- Aggregate Expenditure and Equilibrium Output

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Chapter 8 - Aggregate Expenditureand Equilibrium Output

Alice T. Valerio, P h.D.DLSU-D


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Chapter OutlineThe Keynesian Theory of ConsumptionOther Determinants of Consumption

Planned Investment ( I )

The Determination of Equilibrium Output (Income)The Saving/Investment Approach to EquilibriumAdjustment to Equilibrium

The MultiplierThe Multiplier EquationThe Size of the Multiplier in the Real World

Looking Ahead


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The Core of Macroeconomic

Theory


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Aggregate Output and

Aggregate Income ( Y ) Aggregate output is the totalquantity of goods and servicesproduced (or supplied) in aneconomy in a given period.

Aggregate income is the total

income received by all factors of production in a given period.


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Aggregate Output and

Aggregate Income ( Y ) Aggregate output (income) (Y) is acombined term used to remind you of theexact equality between aggregate outputand aggregate income.When we talk about output ( Y ), we mean

real output , or the quantities of goods andservices produced, not the dollars/pesos incirculation.


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Income, Consumption,

and Saving ( Y , C , and S )A household can do two, and only two, thingswith its income: It can buy goods andservices that is, it can consume or it can

save.Saving (S) is the part of its income that ahousehold does not consume in a given period.Distinguished from savings , which is the

current stock of accumulated saving.

S Y C The triple equal sign means this is an identity , or

something that is always true.


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Explaining Spending BehaviorAll income is either spent on consumption orsaved in an economy in which there are notaxes.

Saving = Aggregate Income Consumption


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Household Consumption and

SavingSome determinants of aggregate consumptioninclude:1.

Household income2. Household wealth3. Interest rates4. Households expectations about the

futureIn The General Theory , Keynes argued thathousehold consumption is directly related toits income.


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SavingThe relationship betweenconsumption and income iscalled the consumption

function . For an individual household, the

consumption function shows the levelof consumption at each level of household income.


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Saving

The slope of the

consumption function ( b) iscalled the marginal

propensity to consume(MPC), or the fraction of achange in income that isconsumed, or spent.

C a bY =

0 1b C + I aggregate output > planned aggregate expenditure

inventory investment is greater than planned

actual investment is greater than planned investment

Disequilibria:

C + I > Y planned aggregate expenditure > aggregate output

inventory investment is smaller than planned

actual investment is less than planned investment

aggregate output = Y planned aggregate expenditure = AE = C + I

equilibrium: Y = AE , or Y = C + I


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Equilibrium AggregateOutput (Income)


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C Y 100 75. I 25Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figuresin Billions of Dollars) The Figures in Column 2 are Based on the Equation C = 100 + .75 Y .

(1) (2) (3) (4) (5) (6)

AGGREGATEOUTPUT

(INCOME) ( Y )AGGREGATE

CONSUMPTION ( C )PLANNED

INVESTMENT ( I )

PLANNEDAGGREGATE

EXPENDITURE ( AE )C + I

UNPLANNEDINVENTORY

CHANGEY (C + I )

EQUILIBRIUM?(Y = AE ?)

100 175 25 200 100 No

200 250 25 275 75 No

400 400 25 425 25 No500 475 25 500 0 Yes

600 550 25 575 + 25 No

800 700 25 725 + 75 No

1,000 850 25 875 + 125 No


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Y Y 100 75 25.

Y C I (1)

C Y 100 75.(2)

I 25(3)

By substituting (2) and (3) into (1)we get:

There is only one value of Y for whichthis statement is true. We can find it byrearranging terms:

Y Y 100 75 25.

Y Y .75 100 25

Y Y .75 125.25 125Y

Y 125

25

500

.


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The Saving/InvestmentApproach to Equilibrium

If planned investment is exactly equal to saving, thenplanned aggregate expenditure is exactly equal to aggregate

output, and there is equilibrium.


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The S = I Approach to EquilibriumAggregate output will be equal toplanned aggregate expenditure

only when saving equals plannedinvestment ( S = I ).


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The Determination of Equilibrium Output (Income)

Adjustment to EquilibriumThe adjustment process will continue as long as output(income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions byincreasing output, an economy withplanned spending greater than output will adjust toequilibrium, with Y higher than before. If plannedspending is less than output, there will be unplanned

increases in inventories. In this case, firms will respondby reducing output. As output falls, income falls,consumption falls, and so on, until equilibrium isrestored, with Y lower than before.


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The MultiplierThe multiplier is the ratio of the change in theequilibrium level of output to a change insome autonomous variable.

An autonomous variable is a variable thatis assumed not to depend on the state of theeconomy that is, it does not change whenthe economy changes.

In this chapter, for example, we considerplanned investment to be autonomous.


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The MultiplierThe multiplier of autonomous investmentdescribes the impact of an initial increase in

planned investment on production, income,consumption spending, and equilibriumincome.

The size of the multiplier depends on theslope of the planned aggregate expenditureline.


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The Multiplier Equation

MPS S

Y

D

D

MPS I

Y

D

D

Because D S must be equal to D I for equilibrium to berestored, we can substitute D I for D S and solve:

therefore, D DY I MPS

1

multiplier MPS

1 , or multiplier MPC

1

1

The marginal propensity to save may be expressedas:


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The Multiplier After an increase in

planned investment,equilibrium output is four times the amount of theincrease in plannedinvestment.


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The MultiplierThe Multiplier Equation

The Paradox of ThriftThe Paradox of Thrift

An increase in planned saving from S 0 to S 1 causes equilibrium output todecrease from 500 to 300. Thedecreased consumption thataccompanies increased saving leads toa contraction of the economy and to areduction of income. But at the newequilibrium, saving is the same as itwas at the initial equilibrium. Increasedefforts to save have caused a drop inincome but no overall change in

saving.


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The Size of the Multiplierin the Real World

The size of the multiplier inthe U.S. economy is about1.4. For example, a sustainedincrease in autonomousspending of $10 billion into

the U.S. economy can beexpected to raise real GDP over time by $14 billion.

REVIEW TERMS AND CONCEPTS


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actual investmentaggregate incomeaggregate outputaggregate output (income) (Y)aggregate saving (S)

consumption functionequilibriumexogenous variableIdentitymarginal propensity to consume

(MPC)marginal propensity to save

(MPS)

REVIEW TERMS AND CONCEPTS

multiplierplanned aggregate expenditure (AE)planned investment (I)

1. S Y C 2.3. MPC + MPS 1 4. AE C + I 5. Equilibrium condition: Y = AE or

Y = C + I6. Saving/investment approach to

equilibrium: S = I

7.

slope of consumption functionC

MPC Y

D

D

- MPC MPS 11

1

Multiplier


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END OFLECTURE

chapter 8- aggregate expenditure and equilibrium output

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