PRINCIPLES OF

MACROECONOMICS
TENTH EDITION
PART III The Core of Macroeconomic Theory

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly
1 ofTefft
11
 Aggregate
Expenditure and 8
Equilibrium Output
CHAPTER OUTLINE
The Keynesian Theory of Consumption
Other Determinants of Consumption
Planned Investment (I)
The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium
Adjustment to Equilibrium
The Multiplier
PART III The Core of Macroeconomic Theory

The Multiplier Equation

The Size of the Multiplier in the Real World
Looking Ahead
Appendix: Deriving the Multiplier Algebraically

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 Aggregate output The total quantity of goods and services produced
(or supplied) in an economy in a given period.

Aggregate income (Y) The total income received by all factors of

production in a given period. E.g. wages, rent..

Planned Aggregate expenditure (AE): is the total amount the

economy plans to spend in a given future period.

The AE in a closed economy without government can be written as

PART III The Core of Macroeconomic Theory

follows:
AE= C+I

Where: C: consumption expenditure.

I: planned gross investment.

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 The Keynesian Theory of Consumption

Keynesian consumption function:

• The Kenyesian theory assumes that income is the main determinant of

consumption.

• The aggregate consumption function shows the level of aggregate

consumption at each level of aggregate income.

• The consumption function as follows:

C = a + b*Y
PART III The Core of Macroeconomic Theory

C: aggregate consumption
a: minimum level of consumption when Y=zero. (Part of consumption doesn’t
depend on income)
b: slope of consumption function or (MPC)
Y: aggregate income (output).

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 The Keynesian Theory of Consumption

Marginal propensity to consume (MPC) That fraction of a change in income

that is consumed, or spent.

C
marginal propensity to consume  slope of consumption function 
Y

Note: 0 > MPC > 1

PART III The Core of Macroeconomic Theory

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 The Keynesian Theory of Consumption

With a straight line consumption curve, we can use the following equation to
describe the curve:
C = a + bY

 FIGURE 8.2 An Aggregate

Consumption Function
The aggregate consumption function
shows the level of aggregate
consumption at each level of
aggregate income.
The upward slope indicates that
PART III The Core of Macroeconomic Theory

higher levels of income lead to higher

levels of consumption spending.

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 The Keynesian Theory of Consumption

Aggregate saving (S) The part of aggregate income that is not consumed.
The difference between aggregate income and aggregate consumption.

S=Y–C
Derivation of saving function:

S=Y-C

S= Y- (a + bY)
PART III The Core of Macroeconomic Theory

S= Y-a-bY

S= -a + Y(1-b)……… saving function

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 The Keynesian Theory of Consumption

MPC + MPS ≡ 1

Because the MPC and the MPS are important concepts, it may help to review
their definitions.
PART III The Core of Macroeconomic Theory

The marginal propensity to consume (MPC) is the fraction of an increase in

income that is consumed (or the fraction of a decrease in income that comes
out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in income

that is saved (or the fraction of a decrease in income that comes out of saving).

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 The Keynesian Theory of Consumption

Question,
If you are given a following consumption function:
C = 100 + 0.75Y.
1. Determine the minimum level of consumption.
2. Derive the saving function.
3. Determine the dissaving level at income =0.
4. Calculate both C and S at Y=0, 80,100, 200, 400, 600, 800, 1000
5. Calculate the marginal propensity to consume (MPC) and the marginal
PART III The Core of Macroeconomic Theory

propensity to save (MPS) at each level of income.

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 The Keynesian Theory of Consumption
 FIGURE 8.3 The Aggregate
Consumption Function Derived from the
Equation C = 100 + .75Y
In this simple consumption function,
consumption is 100 at an income of
zero.
As income rises, so does
consumption.
For every 100 increase in income,
consumption rises by 75.
The slope of the line is .75.

Aggregate Aggregate
Income, Y Consumption, C
PART III The Core of Macroeconomic Theory

0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850

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 The Keynesian Theory of Consumption
 FIGURE 8.4 Deriving the Saving Function
from the Consumption Function in Figure 8.3
Because S ≡ Y – C, it is easy to derive the
saving function from the consumption
function.
A 45° line drawn from the origin can be
used as a convenient tool to compare
consumption and income graphically.
At Y = 200, consumption is 250.
The 45° line shows us that consumption is
larger than income by 50.
Thus, S ≡ Y – C = 50.
At Y = 800, consumption is less than
income by 100.
Thus, S = 100 when Y = 800.
PART III The Core of Macroeconomic Theory

Y  C = S
AGGREGATE AGGREGATE AGGREGATE
INCOME CONSUMPTION SAVING

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150

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 The Keynesian Theory of Consumption

Other Determinants of Consumption

In practice, the decisions of households on how much to consume in a

given period are also affected by their wealth, by the interest rate, and
by their expectations of the future.

Households with higher wealth are likely to spend more, other things
being equal, than households with less wealth.
PART III The Core of Macroeconomic Theory

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 Planned Investment (I)

Planned investment (I) Those additions to capital stock and

inventory that are planned by firms.

Investment (I) is assumed to be fixed (autonomous) → not affected by

changes in income changes, so (I) is represented by a horizontal line.

 FIGURE 8.5 The Planned

Investment Function
For the time being, we will assume
that planned investment is fixed.
It does not change when income
PART III The Core of Macroeconomic Theory

changes, so its graph is a

horizontal line.

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 The Determination of Equilibrium Output (Income)

Under a closed economy without government, the equilibrium level of output

(GDP or income) can be determined using two approaches:

1. Aggregate Approach:
• Equilibrium Occurs when there is no tendency for change In the
macroeconomic goods market.
• Equilibrium occurs when aggregate output is equal to planned aggregate
PART III The Core of Macroeconomic Theory

expenditure.

Output (Supply) = planned aggregate expenditure (Demand)

Y = AE
C+S = C+I

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 The Determination of Equilibrium Output (Income)
Y>C+I
aggregate output > planned aggregate expenditure
There is unplanned inventory investment. Firms planned to sell more of
their goods than they sold, and the difference shows up as an unplanned
increase in inventories.

When planned spending exceeds output, firms have sold more than they
planned to. Inventory investment is smaller than planned. Planned and
PART III The Core of Macroeconomic Theory

actual investment are not equal.

Equilibrium in the goods market is achieved only when aggregate output

(Y) and planned aggregate expenditure (C + I) are equal, or when actual
and planned investment are equal.

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 The Determination of Equilibrium Output (Income)
PART III The Core of Macroeconomic Theory

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 The Determination of Equilibrium Output (Income)

TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.
The Figures in Column 2 Are Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
Planned Unplanned
Aggregate Aggregate Inventory
Output Aggregate Planned Expenditure (AE) Change Equilibrium?
(Income) (Y) Consumption (C) Investment (I) C+I Y  (C + I ) (Y = AE?)

100 175 25 200  100 No

200 250 25 275  75 No
PART III The Core of Macroeconomic Theory

400 400 25 425  25 No

500 475 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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 The Determination of Equilibrium Output (Income)

 FIGURE 8.6 Equilibrium

Aggregate Output
Equilibrium occurs when
planned aggregate expenditure
and aggregate output are equal.
Planned aggregate expenditure
is the sum of consumption
spending and planned
investment spending.
PART III The Core of Macroeconomic Theory

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 The Determination of Equilibrium Output (Income)

2. The Saving/Investment Approach to Equilibrium

Y = AE

C+S=C+I

Because we can subtract C from both sides of this equation, we are

left with:

S=I
PART III The Core of Macroeconomic Theory

Thus, only when planned investment equals saving will there be

equilibrium.

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 The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium

 FIGURE 8.7 The S = I Approach

to Equilibrium
Aggregate output is equal to
planned aggregate expenditure
only when saving equals
planned investment (S = I).
Saving and planned investment
are equal at Y = 500.
PART III The Core of Macroeconomic Theory

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 The Determination of Equilibrium Output (Income)

Adjustment to Equilibrium

The adjustment process will continue as long as output (income) is

below planned aggregate expenditure.

If firms react to unplanned inventory reductions by increasing output,

an economy with planned spending greater than output will adjust to
equilibrium, with Y higher than before.

If planned spending is less than output, there will be unplanned

PART III The Core of Macroeconomic Theory

increases in inventories. In this case, firms will respond by reducing

output. As output falls, income falls, consumption falls, and so on, until
equilibrium is restored, with Y lower than before.

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 Question,

175 25 200 -100 -75

250 25 275 -75 -50
400 25 425 -25 0
475 25 500 0 25
550 25 575 50 50
700 25 725 75 100
PART III The Core of Macroeconomic Theory

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