CHAPTER 8

Aggregate Expenditure
and Equilibrium Output

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 Aggregate Output and
Aggregate Income (Y)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Aggregate output is the total

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

• Aggregate income is the total

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

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 31
 Aggregate Output and
Aggregate Income (Y)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Aggregate output (income) (Y) is

a combined term used to remind
you of the exact equality between
aggregate output and aggregate
income.

• When we talk about output (Y), we

mean real output, or the quantities
of goods and services produced,
not the dollars in circulation.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 31
 Income, Consumption,
and Saving (Y, C, and S)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• A household can do two, and only two,

things with its income: It can buy goods
and services—that is, it can consume—or it
can save.

• Saving (S) is the part of its income that a

household 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.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 31
 Household Consumption and Saving
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Some determinants of aggregate

consumption include:
1. Household income
2. Household wealth
3. Interest rates
4. Households’ expectations about the
future
• In The General Theory, Keynes
argued that household consumption
is directly related to its income.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 31
 Household Consumption and Saving

C = a + bY
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The slope of the

consumption function (b) is
called the marginal
propensity to consume
(MPC), or the fraction of a
change in income that is
consumed, or spent.

0  b<1

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 31
 Household Consumption and Saving
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The fraction of a change in income that is

saved is called the marginal propensity
to save (MPS).

MPC + MPS  1
• Once we know how much consumption will
result from a given level of income, we
know how much saving there will be.
Therefore,

S Y−C
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 31
 An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y

C = 100+ .75Y
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, C
(BILLIONS OF (BILLIONS OF
DOLLARS) DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 31
 An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y

C = 100+ .75Y
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• At a national income of
zero, consumption is
$100 billion (a).

• For every $100 billion

increase in income
(DY), consumption rises
by $75 billion (DC).

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 31
 Planned Investment (I)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Investment refers to purchases by firms of

new buildings and equipment and additions
to inventories, all of which add to firms’
capital stock.

• One component of investment—inventory

change—is partly determined by how much
households decide to buy, which is not
under the complete control of firms.

change in inventory = production – sales

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 31
 Actual versus Planned Investment
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Desired or planned investment

refers to the additions to capital
stock and inventory that are planned
by firms.

• Actual investment is the actual

amount of investment that takes
place; it includes items such as
unplanned changes in inventories.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 31
 The Planned Investment Function
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• For now, we will assume

that planned investment is
fixed. It does not change
when income changes.

• When a variable, such as

planned investment, is
assumed not to depend on
the state of the economy, it
is said to be an
autonomous variable.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 31
 Planned Aggregate Expenditure (AE)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Planned aggregate
expenditure is the
total amount the
economy plans to
spend in a given
period. It is equal to
consumption plus
planned investment.

AE  C + I
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 31
 Equilibrium Aggregate
Output (Income)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 31
 Equilibrium Aggregate
Output (Income)
aggregate output / Y
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

planned aggregate expenditure / AE / C + I

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

Disequilibria:
Y>C+I
aggregate output > planned aggregate expenditure
inventory investment is greater than planned
actual investment is greater than planned investment

C+I>Y
planned aggregate expenditure > aggregate output
inventory investment is smaller than planned
actual investment is less than planned investment
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 Equilibrium Aggregate
Output (Income)
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 31
 Equilibrium Aggregate
Output (Income)

C = 100+ .75Y I = 25
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures
in Billions of Dollars) 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
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
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 31
 Equilibrium Aggregate
Output (Income)

Y = C+ I Y = 100+ .75Y + 25
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

(1)
(2) C = 100+ .75Y There is only one value of Y
(3) I = 25 for which this statement is
true. We can find it by
By substituting (2) and rearranging terms:
(3) into (1) we get:
Y − .75Y = 100 + 25
Y = 100+ .75Y + 25 Y − .75Y = 125
.25Y = 125
125
Y= = 500
.25
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 31
 The S = I Approach to Equilibrium
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• Aggregate output will be equal to

planned aggregate expenditure only
when saving equals planned
investment (S = I).

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 31
 The Multiplier
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The multiplier is the ratio of the change in

the equilibrium level of output to a change
in some autonomous variable.
• An autonomous variable is a variable that is
assumed not to depend on the state of the
economy—that is, it does not change when the
economy changes.

• In this chapter, for example, we consider

planned investment to be autonomous.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 31
 The Multiplier
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The multiplier of autonomous

investment describes the impact of
an initial increase in planned
investment on production, income,
consumption spending, and
equilibrium income.

• The size of the multiplier depends on

the slope of the planned aggregate
expenditure line.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 31
 The Multiplier Equation
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The marginal propensity to save may be

expressed as:
DS
MPS =
DY
• Because DS must be equal to DI for
equilibrium to be restored, we can
substitute DI for DS and solve:
DI 1
MPS = therefore, D Y = D I 
DY MPS
1 1
multiplier  , or multiplier =
MPS 1 − MPC
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 The Multiplier
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 31
 The Size of the Multiplier
in the Real World
C H A P T E R 8: Aggregate Expenditure and Equilibrium Output

• The size of the multiplier in the

U.S. economy is about 1.4.
For example, a sustained
increase in autonomous
spending of $10 billion into the
U.S. economy can be expected
to raise real GDP over time by
$14 billion.

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