BEE (2019-20) Handout-03

Aggregate Expenditure and Aggregate Output (fixed price level)

COMPONENTS OF AGGREGATE EXPENDITURE:

Aggregate spending/expenditure (AE) comprises private final consumption expenditure (C), government final consumption
expenditure (G), planned investment (I) including gross fixed capital formation and change in stock, and net exports (NX) which
equals exports minus imports, i.e., AE = C + I + G + NX. Brief description of each of these 4 components of aggregate
expenditure is given below:

(i) Consumption:
What determines the aggregate amount of goods and services purchased by the consumers in any time period? In the elementary
Keynesian model, the real income of households basically provides the answer. A rise in real income will lead households to
increase the amount of goods and services purchased and vice versa. This does not deny that there are many other less important
determinants of real consumption spending. Important variables that determine the level of consumption spending/expenditure are
discussed below:
(i) Current disposable income: The most important determinant of consumption is the current disposable income of
households. Disposable income is the income remaining to households after they have paid the personal income tax and
received government transfer payments. For most households, the higher their disposable income, the more they spend,
and the lower their income, the less they spend. So, we would expect consumption to increase when the current
disposable income of households increases and to decrease when the current disposable income of households decreases.
(ii) Household wealth: Consumption also depends on the wealth of households. A household's wealth is the value of its
assets minus the value of its liabilities. A household with Rs. 10 million in wealth is likely to spend more than a
household with Rs. 10,000 in wealth, even if both households have the same disposable income. A household with larger
wealth may be willing to spend a larger fraction of its income because it is less concerned with adding to its savings.
(iii) Expected future income: There is direct relation between expected future income and current consumption expenditure.
A household expecting an income increase in future is likely to spend more in current period. On the contrary, a
household expecting an income decrease in future is likely to reduce its current consumption expenditure.
(iv) Price Level: The price level measures the average prices of goods and services in the economy. Changes in price level
affect consumption mainly through their effect on real income or purchasing power. An increase in price level will result
in a decrease in the real income and hence in consumption.
(v) Interest rate: Household consumption spending can be divided into three categories: spending on services, such as
education, medical care, haircuts, etc.; spending on non-durable goods, such as food and clothing; and spending on
durable goods, such as automobiles and furniture. Spending on durable goods is most likely to be affected by changes in
the interest rate because a high interest increases the cost of spending financed by borrowing. Moreover, when the
interest rate is high, the reward to saving is increased and households are likely to save more and spend less.
(vi) Price expectation: If households expect prices to increase in future they may increase their current consumption
expenditure. On the other hand, households are likely to reduce their current consumption expenditure if they expect
future prices to fall.

However, the current disposable income of households is the most important determinant of aggregate consumption. Thus, we
assume that consumption depends exclusively on disposable income, i.e., consumption is a function of disposable income.

Consumption Function:
 Consumption function is a functional statement of relationship between the consumption expenditure and its
determinants. Consumption expenditure of households depends on a number of factors such as disposable income,
household wealth, interest rate, expected future income, lifestyle of the society, and availability of consumer credit, etc.
But, income is the primary determinant of consumption expenditure and saving.
 Consumption expenditure is positive linear function of disposable income, i.e., consumption expenditure increases with
increase in disposable income and decreases with decrease in disposable income.
 Consumption function (C) = Ca + bYd,
o Where ‘Ca’ is autonomous component of consumption which is independent of disposable income (does not
depend on disposable income and may be financed out of past savings) and
o ‘bYd’ is induced component of consumption which is dependent on disposable income where 'b' is marginal
propensity to consume and Yd is disposable income (income minus direct taxes paid by the households) of
households.
 b = ∆C/∆Yd, which is known as Marginal Propensity to Consume (MPC); fraction of incremental disposable income
consumed.
 The slope of the consumption function is geometric representation of MPC.
 MPC is positive but less than one. It remains constant irrespective of change in disposable income.
 Average Propensity to Consume (APC) is Consumption-Disposable Income Ratio (C/Yd). APC decreases steadily with
increase in disposable income.
 APC is always greater than MPC due to positive autonomous consumption component.
 Numerical example of consumption function: C = 100 + 0.80Yd
Saving Function:
 Saving function is the counter part of the consumption function. It states the relationship between disposable income and
saving. If one of the functions is known, the other can be easily derived.
 Saving function (S) = Sa + sYd, where
o ‘Sa’ is autonomous component of savings which is independent of disposable income (does not depend on
disposable income). Since at zero disposable income level, autonomous saving will be negative, S a is negative.
o ‘sYd’ is induced component of savings which is dependent on disposable income where 's' is marginal
propensity to save and Yd is disposable income (income minus direct taxes paid by the households) of
households.
 s = ∆S/∆Y, which is known as Marginal Propensity to Save (MPS); fraction of incremental disposable income saved.
 The slope of the saving function is geometric representation of MPS.
 MPS is positive but less than one. It remains constant irrespective of disposable income.
 Average Propensity to Save (APS) is Saving-Disposable Income ratio (S/Yd). APS increases steadily as disposable
income rises. APS is always less than MPS due to negative autonomous saving component.
 Numerical example: C = - 100 + 0.20Yd

 APC + APS = 1 and MPC + MPS = 1 because Y = C + S

(ii) Investment:
As mentioned earlier, planned investment (I) is nothing but gross capital formation which includes Gross Fixed Capital Formation
(GFCF) and Change in Stock (CIS). The four most important variables that determine the level of investment are briefly discussed
below:

(i) Expectations of future profitability: Investment goods, such as factories, office buildings, and machinery and equipment,
are long-lived. A firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain
strong for a period of at least several years. When the economy moves into a recession, many firms will postpone buying
investment goods even if the demand for their own product is strong because they are afraid that the recession may
become worse. The reverse may be true during an expansion. In the late 1990s, many firms increased their investment
spending in the expectation that capital goods that embodied new information and telecommunication technologies
would prove very profitable. The key point is this: The optimism or pessimism of firms is an important determinant of
investment spending.
(ii) Interest rate: A significant fraction of business investment is financed by borrowing. This borrowing takes the form of
issuing corporate bonds or borrowing from banks. Households also borrow to finance most of their spending on new
homes. The higher the interest rate, the more expensive it becomes for firms and households to borrow. Because
households and firms are interested in the cost of borrowing after taking into account the effects of inflation, investment
spending will depend on the real interest rate (nominal interest rate minus inflation rate). Therefore, holding the other
factors that affect investment spending constant, there is inverse relationship between the real interest rate and investment
spending. A higher real interest rate results in less investment spending, and a lower interest rate results in more
investment spending.
(iii) Taxes: The level of investment spending is also affected by taxes. Firms focus on the profits that remain after they have
paid taxes. Government imposes a corporate income tax on the profits corporations earn, including profits from new
buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the
after-tax profitability of investment spending. An increase in the corporate income tax decreases the after-tax profitability
of investment spending. Thus, there is inverse relationship between corporate income tax and investment spending.
(iv) Cash Flow: Many firms do not borrow to finance spending on new factories, machinery, and equipment. Instead, they use
their own funds. Cash flow is the difference between the cash revenues received by the firm and the cash spending by the
firm. Non-cash receipts or non-cash spending would not be included in cash flow. The largest contributor to cash flow is
profit. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment. During
periods of recession, many firms experience reduced profits, which in turn reduced their ability to finance spending on
new factories or machinery and equipment.

(iii) Government Expenditure:

Government expenditure includes Government Purchases of goods and services (G) and transfer payments (R) made to
households (pensions) and firms (subsidies). Transfer payments are excluded while calculating government expenditure on the
goods and services produced in the economy. When the recipients of transfer payments (households and firms) spend such
receipts on purchase of goods and services they become part of aggregate spending/expenditure. However, in present analysis, we
are assuming that government expenditure consists of government purchases of goods and services only.

(iv.) Net Exports:

Net exports equal exports minus imports. We can calculate net exports by taking the value of spending by foreign firms and
households on goods and services produced in the country (say India) and subtracting the value of spending by Indian firms and
households on goods and services produced in other countries. The three most important variables that determine the level of net
exports are briefly discussed below:
 (i) Price level in the country (say India) relative to price levels in other countries : If inflation in India is lower than inflation
in other countries, then prices of Indian products increase more slowly than the prices of products of other countries. This
difference in price levels increases demand for Indian products relative to the demand for foreign products. So, Indian
exports increase and Indian imports decrease, which increases net exports. The reverse will happen during periods when
the inflation rate in India is higher than the inflation rates in other countries; Indian exports decrease and Indian imports
increase, which decreases net exports.
(ii) Growth rate of GDP in the country (say India) relative to the growth rates of GDP in other countries: As GDP increases
in India, the incomes of households rise, leading them to increase their purchases of goods and services. Some of the
additional goods and services purchased with rising incomes will be produced in India, but some will be imported. When
incomes rise faster in India than in other countries, India consumers’ purchases of foreign goods and services will
increase faster than foreign consumers’ purchases of Indian goods and services. As a result, net export of India will fall.
When incomes in India rise more slowly than incomes in other countries, net exports of India will rise.
(iii) Exchange rate between domestic currency (say INR) and other currencies : An increase in the value of INR will reduce
exports and increase imports, so net exports will fall. A decrease in the value of INR will increase exports and reduce
imports, so net exports will rise.

EQUILIBRIUM IN COMMODITY MARKET

Our economy is 4-sector economy comprising of households, firms, government and rest of world (ROW). Commodity market
reaches an equilibrium when aggregate expenditure is equal to aggregate output/income, i.e., when Y = AE.

Thus, equilibrium is denoted by following equation:

Y = C + I + G + NX,
Where C is final consumption expenditure of households, I is investment expenditure, G is government purchases, and NX is net
export (exports minus imports).

As discussed earlier, consumption is linear function of disposable income. Thus, the consumption function is:
C = Ca + bYd,
Where Yd (disposable income) = Y – T (household income minus direct taxes paid by households)

Thus, C = Ca + b(Y-T) or C = Ca + bY – bT
I is autonomous, i.e., independent of income
Exports (X) and Imports (M) are also autonomous, hence NX (X – M) is autonomous, i.e., independent of income
The equilibrium is derived as follows:

Y = Ca + bY – bT + I + G + NX

Y – bY = Ca – bT + I + G + NX

Y (1-b) = Ca – bT + I + G + NX

1
Y= (Ca−bT + I +G+ NX )
1−b

Numerical example:

Suppose, C = 100 + 0.75Yd, I = 200, G = 100, T = 100, X = 200, M = 100

By substituting the values in equilibrium condition,

1
Y= (a−bT + I +G+ X −M )
1−b

1
Y= [100−( 0.75∗100 ) +200+100+200−100]
1−0.75

1
Y= [100−75+200+100+200−100]
0.25
Y = 4(425)

Y = 1700

DISEQUILIBRIUM IN COMMODITY MARKET

Disequilibrium will occur when aggregate expenditure is not equal to aggregate output/income, i.e., Y ≠ C + I + G + NX.
Disequilibrium may be of two types:
(i) Y > AE: In this case, aggregate expenditure is less than aggregate output. Some firms will experience an unplanned
increase in inventories and will cut down the production. As a result, aggregate output (Y) declines and may finally be
equal to aggregate expenditure. If firms do not cut back their production promptly when spending declines, they will
accumulate inventories. If firms accumulate excess inventories, then even if spending quickly returns to its normal levels,
firms will have to sell these excess inventories before they can return to producing at normal levels. The possibility that
firms will accumulate excess inventories explains why a brief decline in spending can result in a fairly long recession.
(ii) Y < AE: In this case of disequilibrium, aggregate expenditure is greater than aggregate output. Firms will experience an
unplanned decrease in inventories and will increase the production. As a result, aggregate output (Y) increases and may
finally be equal to aggregate expenditure.

Since price level is assumed to be fixed in the simple Keynesian model, equilibrium in commodity market is restored through
changes in inventories.

CHANGES IN COMMODITY MARKET EQUILIBRIUM

Condition for commodity market equilibrium is reproduced below:
1
Y= (Ca−bT + I +G+ NX )
1−b
The above equilibrium condition is based on following assumptions:
 Consumption is positive linear function of disposable income
 Disposable income = Income minus direct taxes paid by the households
 Investment (I) is autonomous
 Government expenditure (G) is autonomous
 Tax (T) is autonomous
 Exports (X) are autonomous
 Imports (M) are autonomous

Other things remaining same, the equilibrium national output/income will change if there is change in consumption expenditure,
investment, taxes, government expenditure/purchases, or net exports. Consumption expenditure is however a more stable function
of income. Therefore, the equilibrium will change due to change in investment spending, government expenditure, tax, or net
export. Change in equilibrium national output/income per unit change in autonomous component of aggregate expenditure is
termed as multiplier. Different multipliers are discussed below:

1. Investment multiplier

1
Y= (Ca−bT + I +G+ NX )
1−b
Suppose, the Investment expenditure increases by ∆I, other things remaining constant.
The ∆I causes an increase in the aggregate expenditure and, therefore, a rise in the equilibrium level of income by, say, ∆Y.
Equilibrium level of the national income with ∆I can be expressed by following equation:

1
Y + ∆Y = (Ca−bT + I + G+ NX + ∆ I )
1−b
Or
1 1
Y + ∆Y = (Ca−bT + I +G+ NX )+ (∆ I )
1−b 1−b
By subtracting Y from both sides, we get ∆Y resulting from ∆I:

1
∆Y = (∆ I )
1−b
Investment multiplier can then be obtained as:

∆Y 1
Im = =
∆ I 1−b
=> There is direct relationship between MPC (b) and Investment multiplier.

2. Government Expenditure multiplier

 1
Y= (Ca−bT + I +G+ NX )
1−b
Suppose, the government expenditure increases by ∆G, other things remaining constant.
The ∆G causes an increase in the aggregate demand (aggregate expenditure) and, therefore, a rise in the equilibrium level of
income by, say, ∆Y.
Equilibrium level of the national income with ∆G can be expressed by following equation:

1
Y + ∆Y = (Ca−bT + I + G+ NX + ∆G)
1−b
Or
1 1
Y + ∆Y = (Ca−bT + I + G+ NX ) + ( ∆G)
1−b 1−b
By subtracting Y from both sides, we get ∆Y resulting from ∆G:
1
∆Y = (∆ G)
1−b
Government expenditure multiplier can then be obtained as:

∆Y 1
Gm = =
∆ G 1−b
=> There is direct relationship between MPC (b) and Government expenditure multiplier.

3. Tax multiplier

1
Y= (Ca−b T + I +G+ NX )
1−b
Let us now introduce a change in tax by ∆T.
A change in tax (∆T) changes the national income by ∆Y.
Equilibrium level of the national income with ∆T can be expressed by following equation:

1
Y + ∆Y = [Ca−b ( T + ∆ T ) + I +G+ NX ]
1−b
Or
1
Y + ∆Y = [ Ca−bT −b ∆ T + I +G+ NX ]
1−b
Or
1
Y + ∆Y = [ Ca−bT + I +G+ NX ] + 1 [ −b ∆ T ]
1−b 1−b
By subtracting Y from both sides, we get ∆Y resulting from ∆T:

1
∆Y = (−b ∆T )
1−b
Tax multiplier can then be obtained as:

∆ Y −b
Tm = =
∆ T 1−b
=> There is direct relationship between MPC (b) and Tax multiplier.

4. Balanced Budget Multiplier

 When a government adopts a balanced budget policy it spends only as much as it collects through taxation, i.e, T = G or
∆G = ∆T
 The effect of the balanced budget policy on the national income is measured through the balanced budget theorem or
balanced budget multiplier.
 Balanced budget theorem states that the balanced budget multiplier is always equal to one.
 Therefore, the balanced budget theorem is also called unit multiplier theorem.
 Proof of the balanced budget theorem with a lump sum tax is given below.

Balanced budget multiplier (BBm) can be obtained by adding government expenditure multiplier (Gm) and tax multiplier (Tm)
BBm = Gm + Tm
 1 −b
BBm = +
1−b 1−b
1−b
BBm = =1
1−b
5. Foreign Trade Multiplier
1
Y= ( Ca−bT + I + G+ NX )
1−b

Suppose, net exports increase by ∆NX, other factors remaining constant.

The ∆NX causes an increase in the aggregate demand (aggregate expenditure) and, therefore, a rise in the equilibrium level of
income by, say, ∆Y.
Equilibrium level of the national income with ∆NX can be expressed by following equation:
1
Y + ∆Y = (Ca−bT + I + G+ NX + ∆ NX )
1−b
It can also be written as given below:
1 1
Y + ∆Y = (Ca−bT + I + G+ NX ) + ( ∆ NX )
1−b 1−b

By subtracting Y from both sides, we get ∆Y resulting from ∆NX:

1
∆Y = (∆ N X )
1−b
By rearranging, we get foreign trade multiplier as:
∆Y 1
Fm = =
∆ NX 1−b