Unit 3

Aggregate Expenditure and

Equilibrium Output

School of Economics and Management

Hanoi University of Science and Technology
In this unit, students could:

• Explain the principles of the Keynesian theory of consumption.

• Explain the difference between planned investment and actual
investment.
• Understand how planned investment is affected by the
interest rate.
• Explain how equilibrium output is determined.
• Describe the multiplier process and use the multiplier
equation to calculate changes in equilibrium.

Aggregate Demand and Equilibrium Output 1

Contents
1. The Keynesian Theory of Consumption
2. Planned Investment (I) versus Actual Investment
3. Planned Investment and the Interest Rate (r)
4. The Determination of Equilibrium Output (Income)
5. The Multiplier

Aggregate Demand and Equilibrium Output 2

Preliminary
aggregate output The total quantity of goods and services produced (or supplied) in an
economy in a given period.
aggregate income The total income received by all factors of production in a given period.

In any given period, there is an exact equality between aggregate output (production) and
aggregate income. You should be reminded of this fact whenever you encounter the
combined term aggregate output (income) (Y).

aggregate output (income) (Y) A combined term used to remind you of the exact equality
between aggregate output and aggregate income.

From the outset, you must think in “real terms.” Output Y refers to the quantities of goods
and services produced, not the dollars circulating in the economy.
Also, we are taking as fixed for purposes of this unit and the next the interest rate (r) and
the overall price level (P).

Aggregate Demand and Equilibrium Output 3

The Keynesian Theory of Consumption
We all recognize that for consumption as a whole, as well as for
consumption of most specific categories of goods and services,
consumption rises with income.

While Keynes recognized that many factors, including wealth and interest
rates, play a role in determining consumption levels in the economy, in his
classic The General Theory of Employment, Interest, and Money,
current income played the key role.

This simple observation plays a large role in helping us understand the

workings of the aggregate economy.
Household’s Consumption and Income
consumption function The relationship between consumption and
income.

A consumption function for

an individual household
shows the level of
consumption at each level of
household income.

Aggregate Demand and Equilibrium Output 5

Aggregate Consumption Function
With a straight line consumption curve, we can use the following equation to describe the
curve:

C = a + bY
The aggregate consumption function shows
the level of aggregate consumption at each
level of aggregate income.
The upward slope indicates that higher levels
of income lead to higher levels of
consumption spending.
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
Aggregate Demand and Equilibrium Output 6
Aggregate Consumption Function
C = C0 + mpc.Y
▪ C0: autonomous consumption
▪ mpc: marginal propensity to consume

Aggregate Demand and Equilibrium Output 7

Aggregate Saving
▪ aggregate saving (S) The part of aggregate income that is not
consumed.
S≡Y–C

▪ marginal propensity to save (MPS) That fraction of a change in income

that is saved.
▪ Because the MPC and the MPS are important concepts, it may help to
review their definitions.
▪ 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).
Aggregate Demand and Equilibrium Output 8
Deriving Aggregate Saving Function
S=Y–C
S = Y – (C0 + mpcY)
S = -C0 + (1 – mpc)Y or S = -C0 + mpsY

▪ mps: marginal propensity to save

▪ mps = 1 – mpc

Aggregate Demand and Equilibrium Output 9

Example of Consumption Function
Let aggregate consumption function C = 100 + .75Y
Aggregate Aggregate In this simple
Income, Y Consumption, C
consumption
0 100 function,
80 160 consumption is 100
at an income of
100 175
zero.
200 250 As income rises, so
400 400 does consumption.
600 550
For every 100
increase in income,
800 700 consumption rises
1,000 850 by 75.
The slope of the line
is .75.

Aggregate Demand and Equilibrium Output 10

Deriving the Saving Function from the Consumption Function
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.
Y − C = S
AGGREGATE INCOME AGGREGATE CONSUMPTION AGGREGATE 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
Aggregate Demand and Equilibrium Output 11
Other Determinants of Consumption
▪ The assumption that consumption depends only on income is
obviously a simplification.
▪ 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.
▪ Lower interest rates are likely to stimulate spending.
▪ If households are optimistic and expect to do better in the
future, they may spend more at present than if they think the
future will be bleak.
Aggregate Demand and Equilibrium Output 12
Vietnam Consumer Confidence Index

Aggregate Demand and Equilibrium Output 13

EC ON OMIC S IN PRACTICE

Behavioral Biases in Saving Behavior

Economists have generally assumed that people make their saving decisions rationally, just as they
make other decisions about choices in consumption and the labor market.
Saving decisions involve thinking about trade-offs between present and future consumption.
Recent work in behavioral economics has highlighted the role of psychological biases in saving
behavior and has demonstrated that seemingly small changes in the way saving programs are
designed can result in big behavioral changes.
For example, in studying retirement systems, researchers have found that simply changing the
enrollment process from an opt-in structure to an opt-out system in which people are automatically
enrolled unless they check the “no” box dramatically increases enrollment in retirement pension
plans. Behavioral economists argue that people find this option attractive because it is easier for
them to commit to making sacrifices tomorrow than it is for them to make those sacrifices today.

THINKING PRACTICALLY
1. The Save More Tomorrow Plans encourage people to save more by committing themselves to
future action. Can you think of examples in your own life of similar commitment devices you
use?
Planned Investment (I) versus Actual Investment
▪ planned investment (I) Those additions to capital stock and
inventory that are planned by firms.
▪ A firm’s inventory is the stock of goods that it has awaiting
sale.
▪ actual investment The actual amount of investment that
takes place; it includes items such as unplanned changes in
inventories.
▪ If a firm overestimates how much it will sell in a period, it will
end up with more in inventory than it planned to have.
▪ We will use I to refer to planned investment, not necessarily
actual investment.
Aggregate Demand and Equilibrium Output 15
Planned Investment and the Interest Rate (r)
Increasing the interest rate, ceteris paribus, is likely to reduce the level of
planned investment spending. When the interest rate falls, it becomes less
costly to borrow and more investment projects are likely to be undertaken.

Planned investment spending is a

negative function of the interest rate. An
increase in the interest rate from 3
percent to 6 percent reduces planned
investment from I0 to I1.

Aggregate Demand and Equilibrium Output 16

Other Determinants of Planned Investment
▪ The decision of a firm on how much to invest depends on,
among other things, its expectation of future sales.
▪ The optimism or pessimism of entrepreneurs about the future
course of the economy can have an important effect on current
planned investment. Keynes used the phrase animal spirits to
describe the feelings of entrepreneurs.
▪ For now, we will assume that planned investment simply
depends on the interest rate.

Aggregate Demand and Equilibrium Output 17

Planned Investment Function
I = I0 + Irr

▪ I0: constant coefficient (a part of planned investment that does

not depend on any determinants of investment)
▪ Ir: slope coefficient of interest rate variable.
▪ For our simple model: assume that I is exogenous
I = I0

Aggregate Demand and Equilibrium Output 18

The Determination of Equilibrium Output (Income)
equilibrium Occurs when there is no tendency for change. In the macroeconomic
goods market, equilibrium occurs when planned aggregate expenditure is equal to
aggregate output.

planned aggregate expenditure (AE) The total amount the economy plans to spend in
a given period. Equal to consumption plus planned investment:

AE ≡ C + I

Because AE is, by definition, C + I, equilibrium can also be written:

Equilibrium: Y = C + I
Y>C+I
aggregate output > planned aggregate expenditure

C+I>Y
planned aggregate expenditure > aggregate output
Aggregate Demand and Equilibrium Output 19
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)

Aggregate Planned Unplanned

Output Planned Aggregate Inventory
Aggregate
(Income) Investment Expenditure (AE) Change Equilibrium?
Consumption
(I) C+I Y − (C + I) (Y = AE?)
(Y) (C)

100 175 25 200 − 100 No

200 250 25 275 − 75 No
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
The Determination of
Equilibrium Output (Income)
Planned aggregate expenditure is the sum of
consumption spending and planned investment
spending.

Equilibrium occurs when planned aggregate

expenditure and aggregate output are equal.

The planned aggregate expenditure function

crosses the 45° line at a single point, where
Y = 500. (The point at which the two lines
cross is sometimes called the Keynesian
cross.)

Aggregate Demand and Equilibrium Output 21

Let us find the equilibrium level of output (income) algebraically.

There is only one value of Y for which this statement is true, and we can
find it by rearranging terms:

The equilibrium level of output is 500, as shown in the graph

The Saving/Investment Approach to Equilibrium

Because aggregate income must be saved or spent, by definition, Y ≡ C + S,

which is an identity.
The equilibrium condition is Y = C + I, but this is not an identity because it
does not hold when we are out of equilibrium.
By substituting C + S for Y in the equilibrium condition, we can write:

C+S=C+I

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

S=I

Thus, only when planned investment equals saving will there be equilibrium.
Aggregate Demand and Equilibrium Output 23
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.

Aggregate Demand and Equilibrium Output 24
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 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.

As Figure shows, at any level of output above Y = 500,

such as Y = 800, output will fall until it reaches
equilibrium at Y = 500, and at any level of output below
Y = 500, such as Y = 200, output will rise until it
reaches equilibrium at Y = 500.
Aggregate Demand and Equilibrium Output 25
The Multiplier

multiplier The ratio of the change in the equilibrium level of output to a

change in some exogenous variable.

exogenous variable A variable that is assumed not to depend on the

state of the economy—that is, it does not change when the economy
changes.

The size of the multiplier depends on the slope of the planned aggregate
expenditure line. The steeper the slope of this line, the greater the change
in output for a given change in investment.

Aggregate Demand and Equilibrium Output 26

The Multiplier as Seen in the Planned Aggregate Expenditure Diagram

At point A, the economy is in

equilibrium at Y = 500.
When I increases by 25,
planned aggregate expenditure
is initially greater than aggregate
output.
As output rises in response,
additional consumption is
generated, pushing equilibrium
output up by a multiple of the
initial increase in I.
The new equilibrium is found at
point B, where Y = 600.
Equilibrium output has increased
by 100 (600 - 500), or four times
the amount of the increase in
planned investment.
The Multiplier Equation
Recall that the marginal propensity to save (MPS) is the fraction of a
change in income that is saved. It is defined as the change in S (∆S) over
the change in income (∆Y):
S
MPS =
Y
Because S must be equal to I for equilibrium to be restored, we can
substitute I for S and solve:
I 1
MPS = Therefore,  Y =  I 
Y MPS
It follows that
1 1
multiplier  , or multiplier 
MPS 1 − MPC
ECONOMICS IN PRACTICE
The Paradox of Thrift

An interesting paradox can arise when households attempt to increase

their saving.
An increase in planned saving from S0 to S1 causes
equilibrium output to decrease from 500 to 300.
The decreased consumption that accompanies
increased saving leads to a contraction of the
economy and to a reduction of income.
But at the new equilibrium, saving is the same as it
was at the initial equilibrium.
Increased efforts to save have caused a drop in
income but no overall change in saving.

THINKING PRACTICALLY
1. Draw a consumption function corresponding to S0 and S1 and describe what is
happening.
The Size of the Multiplier in the Real World
In considering the size of the multiplier, it is important to realize that the multiplier
we derived in this unit is based on a very simplified picture of the economy.

First, we have assumed that planned investment is exogenous. Second, we have

thus far ignored the role of government, financial markets, and the rest of the
world in the macroeconomy.

The size of the multiplier is reduced when tax payments depend on income (as
they do in the real world); when we consider Central Bank behavior regarding the
interest rate; when we add the price level to the analysis; and when imports are
introduced.

In reality, the size of the multiplier is about 2. That is, a sustained increase in
exogenous spending of $10 billion into the U.S. economy can be expected to
raise real GDP over time by about $20 billion.
Practice
You are given the following data concerning Kadwan, a country located in
the mountains: (1) Consumption function: C = 150 + 0.7Y; (2) Investment
function: I = 75; (3) AE ≡ C + I; (4) AE = Y.
a. What is the marginal propensity to consume in Kadwan, and what is the
marginal propensity to save?
b. Graph equations (1) to (4) and solve for equilibrium income.
c. Suppose equation (2) is changed to (2’) I = 90. What is the new
equilibrium level of income? By how much does the 15-currency unit
increase in planned investment change equilibrium income? What is the
value of the multiplier?
d. Calculate the saving function for Kadwan. Plot this saving function on a
graph with equation (2). Explain why the equilibrium income in this graph
must be the same as in part b.
Aggregate Demand and Equilibrium Output 31