Chapter Twenty Four

Aggregate Expenditure
and Equilibrium Output
Income, Consumption, and
Saving (Y, C, and S)

Saving = Income - Consumption

S=Y-C
 The Role of Income
Disposable Income:
Income The
current income you receive in
your paycheck, after you pay
taxes.
Expected Future Income:
Income The
income you expect to receive in
the future
 The Role of Income

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

Savings

Income

Consumption
Consumption Schedule

Income Consumption
0 500
1000 1250
2000 2000
3000 2750
4000 3500

Assuming Taxes=0
Consumption Schedule

Income Consumption Saving

0 500 -500
1000 1250 -250
2000 = 2000
+ 0
3000 2750 250
4000 3500 500
Graphing the Consumption Function

Consumption o
45 line
4000

3000

2000

1000

1000 2000 3000 4000

Household Income
 Graphing the Consumption Function
Consumption
4000

3000 Consumption

2000

1000

0 1000 2000 3000 4000

Household Income
 Slope of the Consumption Function
Consumption
5000

4000
C
3000
C
2000
Y C
1000 Slope =
45o
Y
0
0 1000 2000 3000 4000
Household Income
 Slope of the Consumption Function
Consumption
5000 Slope = 0.75
4000
C
3000
C = 750
2000
Y = 1000
1000

0 45o

0 1000 2000 3000 4000

Household Income
The Consumption Function
C = 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 MPS
The marginal propensity to consume
(MPC) is that fraction of a change in
income that is consumed or spent.

The marginal propensity to save

(MPS) is that fraction of a change in
income that is saved.
 Savings
Savings = Income - Consumption
MPS: marginal propensity to save
MPS = 1 - MPC
 Consumption & Saving
Consumption

S Consumption
Function

Y C

45o
Household Income
 Increase in MPC

An increase in the MPC

increases the slope of the
consumption function...
 Increase in MPC
Consumption
Consumption
Function

45o
Household Income
Increase in the Constant

An increase in the constant shifts

the entire consumption function
upward, parallel to the original.
 Increase in the Constant
Consumption
Consumption
Function

45o
Household Income
What Determines the Level of
Planned Investment?

Real interest rates

Expected future profits

 What Determines the Level of
Planned Investment?

Lower Interest Rates More

Investment
Higher Expected (I)
Future Profits
 Actual Investment
Actual Investment = Planned
Investment + Inventories
Inventories = Production - Sales
 Inventory Adjustment
 Consumers buy more than firms
planned
 Inventories fall
 Actual Investment falls short of
Planned Investment
 Output Adjustment

Inventories are lower than desired

Firms will increase production
Output will rise
 Inventory Adjustment

Planned
Investment

Output
<
C
 Inventory Adjustment
Actual
Investment

Output
=
C
 Inventory Adjustment

Change in
Inventories

=
Planned
Investment

Actual
Investment
Inventories decline by the difference between
planned investment and actual investment.
 Inventory Adjustment

 Consumers buy less than firms planned

 Inventories rise
 Actual Investment exceeds Planned
Investment
 Output Adjustment

Inventories are higher than desired

Firms will decrease production
Output will fall
 Inventory Adjustment

Output
> Planned
Investment

C
 Inventory Adjustment
Actual
Investment

Output
=
C
 Inventory Adjustment

Change in
Inventories

Planned
Investment =
Actual
Investment
Inventories increase by the difference between
planned investment and actual investment.
Aggregate Expenditures Schedule

Income Planned Agg. Expend.

Y Consumption Investment C+I
0 500 50 550
1000 1250 50 1300
2000 2000 50 2050
3000 2750 50 2800
4000 3500 50 3550
 Aggregate Expenditures = C + I
Planned
Aggregate
Expenditures AE = C + I

C
I

45o
Aggregate Income, Y
Planned Output > Aggregate Expenditures
Aggregate
Expenditures
AE = C + I

Unplanned rise in inventories.

550
Output falls.
500

45o
Aggregate Income, Y
Planned Output < Aggregate Expenditures
Aggregate
Expenditures
Unplanned fall in inventories.
Output rises. AE = C + I

550
500

45o
Aggregate Income, Y
Planned Output = Aggregate Expenditures
Aggregate
Expenditures
Equilibrium
AE = C + I

550
Planned Investment = Actual Investment
500
Output does not change.
45o
Aggregate Income, Y
 Income Identities

 C + S + T = Y (household budget)
 C + I = AE (planned expenditure)
 AE = Y (equilibrium)
 In equilibrium...

C+S=Y

C + I = AE S=I

AE = Y
 Adjustment to Equilibrium
Expenditures
C+I
2400
C
2200

I = 100
2000 C = 2300
Y = 2400
S = 100
45o

2000 2200 2400 Aggregate Income, Y

 Adjustment to Equilibrium
Expenditures
C+I
2400
C
2200

I = 50
2000 C=2150
Y= 2200
S = 50
45o
Aggregate Income, Y
2000 2200 2400
 Adjustment to Equilibrium
-C&S-
Aggregate
Planned
Expenditures
Savings = -600 + .25Y

Consumption=600+.75Y

600

45o
Aggregate Income, Y
 Adjustment to Equilibrium
AE < Y and S > I
Expenditures AE = C + I
Investment=$50

Savings

Consumption=600+.75Y
650
600

45o
Aggregate Income, Y
 Adjustment to Equilibrium
AE < Y
AE = C + I
Expenditures

Actual Inventories
exceed
650
Planned Inventories
600
45o

$3000 Aggregate Income, Y

When AE < Y, Output is too
High...
Firms produce more than
consumers and firms want to buy
Inventories accumulate
Actual inventories exceed planned
inventories
Firms will cut back on production
 Adjustment to Equilibrium
AE > Y
Expenditures

AE = C + I

650
600
Actual Inventories less than Planned Inventories
$800 Aggregate Income, Y
When AE > Y, Output is too Low...

Firms produce less than consumers

and firms want to buy
Inventories decline
Actual inventories are less than
planned inventories
Firms will increase on production
 Adjustment to Equilibrium
AE = Y
Expenditures

AE = C + I

Actual Inventories equal

Planned Inventories
650
600

$2600 Aggregate Income, Y

 When AE = Y, Equilibrium...

Equilibrium income: the level at

which C+I = Y
Planned Inventories = Actual
Inventories
The Simple Model and the
Multiplier

 C = 500 + 0.75*Y
 I = 50

Equilibrium:
C+I=Y
2200 = Y
Suppose that I rises to 60...

C = 500 + 0.75*Y
I = 60

Equilibrium:
C+I=Y
2240 = Y
 Where do the numbers come
from??
C + I = 500 + 0.75Y + 60 = 560 + 0.75Y
Set C + I equal to Y:
560 + 0.75 Y = Y
Solve for Y:
560 + 0.75Y - 0.75Y = Y - 0.75 Y
560 = 0.25 Y
560/0.25 = Y implies Y = 2240
Aggregate
The change in I causes a shift in AE
Planned
Expenditure I=60

2240
I=50

2200

2200 2240 Aggregate Income, Y

Investment spending increases by 10,
but income increases by 40...
 The Multiplier!!
Multiplier effect:
effect Equilibrium GDP
increases by more than the change in I
or autonomous C
Changes in autonomous expenditures
multiply through the economy.
Multiplier = 1/(1-MPC) = 1/MPS
Suppose $10 is injected into the
economy, with an MPC = .75:
S S S S
1.87 $1.41 $1.05
$2.50

C
C
$10 C
$7.50 C
$5.63
$4.22 $3.17

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

 Add up the increments in Y:

$10 + $7.50 + $5.63 + $4.22 + ... = $40

$40 = $10 * multiplier = $10 * 4
 Review Terms & Concepts
 Actual investment  Identity
 Aggregate income  Investment
 Aggregate output  Marginal propensity to
consume (MPC)
 Autonomous variable
 Marginal propensity to
 Change in inventory
save (MPS)
 Consumption function  Multiplier
 Planned investment  Paradox of thrift
 Equilibrium  Saving