Meeting 10, Aggregate Expenditure and Equilibrium Output

Aggregate Expenditure and
Equilibrium Output
The relationship between output and
expenditure
• Remember that in macroeconomics:
Agregate output = agregate income = agregate expenditure =
agregate value added.
• Aggregate expenditure refers to the total expenditure on
purchase of goods and services produced by a country in a
given period.
• 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.
• Agregate value-added refers to the additional value of the
goods and services created by all stages of the production
process in an economy in a given period.
• As we have already discussed, the component
of aggregate expenditure is: consumption (C),
investment (I), government spending (G), and
net exports (NX).
• Thus: Y = C + I + G + NX, which means that:

1) The value of the output of an economy is
determined by the value of spending on that
output. The higher the expenditure, the greater
output.
2) The equilibrium income (output) is achieved if
the output is equal to the value of spending.
Income (I), Consumption (C),
and Saving (S)
• A household can do two things with its
income: It can buy goods and services
(consumption) or it can save (saving).
• Saving is the part of its income that a

household does not consume in a given
period.
S=Y-C
Consumption Behavior
• 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.
An Aggregate Consumption Function
For simplicity, we assume that points of aggregate consumption,
when plotted against aggregate income, lie along a straight line.
C = a + bY
0 < b = MPC < 1
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.
Suppose that C = 100 + 0.75Y
• 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).
Y 0 80 100 200 400 500 800

C 100 160 175 250 400 475 700
From Consumption to Savings
Y=C+S S=Y-C
If C = 100 + 0,75Y then:
S = Y – (100 + 0.75Y) = Y – 100 – 0.75Y
S = 0.25Y - 100
Y C S
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
500 475 25
800 700 100
Planned Invesment (I)
• Investment refers to purchases by firms of new
buildings and equipment and additions to
inventories, all of which add to firms’ capital
stocks.
• 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.
Planned Invesment (I)
• 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.
Planned Aggregate Expenditure (AE)
Suppose that C = 100 + 0.75Y and I = 25, then:
AE = C + I = 100 + 0.75Y + 25 = 125 + 0.75Y
To determine
planned aggregate
expenditure (AE), we
add consumption
spending (C) to
planned investment
spending (I) at every
level of income.
Equilibrium Aggregate Output (Income)
In macroeconomics, equilibrium in the goods market is the point
at which planned aggregate expenditure is equal to aggregate
output.
Agregate output = Y
Planned agregate expenditure = AE = C + I
Equilibrium: Y = AE = C + I
Disequilibra :
 Y > C + I which mean : (1) aggregate output > planned aggregate
expenditure. (2) inventory investment is greater than planned. (3)
actual investment is greater than planned investment.
 Y < C + I which mean : (1) planned aggregate expenditure > aggregate

output. (2) inventory investment is smaller than planned. (3) there is
unplanned inventory disinvestment.
Inventory Adjusment
Finding Equilibrium Output Algebraically
Suppose: • Y = 100 + 0.75Y + 25

1) Y = C + I
2) C = 100 + 0.75Y There is only one value of Y for
which this statement is true. We
3) I = 25 can find it by rearranging terms:
By substituting (2) and (3) into (1) Y – 0.75Y = 125
we get:
0.25Y = 125
Y = (125/0.25) = 500
Y = 100 + 0.75Y + 25
(Y = 500) is equilibrium
income.
The Saving-Investment Approach to Equilibrium
Savings is leakage from the flow of expenditure. If planned investment is

exactly equal to saving, then planned aggregate expenditure is exactly equal
to aggregate output, and there is equilibrium.
The “S = I Approach” to Equilibrium
Aggregate output will be equal to planned aggregate

expenditure only when saving equals planned
investment (S = I).
Finding Equilibrium Output From S = I
 Finding the saving • Finding equilibrium
function: income:
 Suppose C = 100 + 0.75Y, • S=I
then: • Supoose I = 25
 S = Y – C = Y – (100 + • 0.25Y – 100 = 25
0.75Y) = Y – 100 – 0,75Y • 0.25Y = 125
= 0.25Y - 100
• Y = (125/0.25) = 500
So the result, (Y = 500), is the same as the results when

we use the aggregate expenditure planned approach.
The Multiplier
• 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.
The Multiplier of Autonomous
Investment
• The multiplier of autonomous investment
describes the impact of an initial increase in
planned investment on income equilibrium.
• ∆Y = ∆I x (1/MPS)
Where:
Multiplier = (1/MPS) = [1/(1-MPC)]
∆ = a change
• When Y changes, C and S change too.
∆C = MPC x ∆Y
∆S = MPS x ∆Y
Suppose ∆I = 25
After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.
Why is ∆Y > ∆I ?
The Paradox of Thrift
When households are
concerned about the
future and plan to save
more, the corresponding
decrease in consumption
leads to a drop in
spending and income.
In their attempt to save more, households have caused a

contraction in output, and thus in income. They end up
consuming less, but they have not saved any more.
Government in the Economy
• Government can affect the macroeconomy
through two policy channels: fiscal policy and
monetary policy.
– Fiscal policy is the manipulation of government
budget (spending and taxation).
– Monetary policy refers to the behavior of the
Central Bank regarding the nation’s money supply.
Adding Net Taxes (T) and Government Purchases
(G) to the Circular Flow of Income
Adding Net Taxes (T) and Government Purchases
(G) to the Circular Flow of Income
• When government enters the picture, the
aggregate income identity gets cut into three
pieces:
– Yd = Y – T
– Yd = C + S
–Y–T=C+S
–Y=C+S+T
• And aggregate expenditure (AE) equals:
– AE = C + I + G
Adding Taxes to the
Consumption Function
• C = a + bYd
• Yd = Y – T
• C = a + b (Y - T)
• With taxes a part of the picture, the aggregate

consumption function is a function of
disposable, or after-tax, income.
Equilibrium Output: Y = C + I + G
An Example
• Suppose :
C = 100 + 0.75 (Y – T)
I = 100
T = 100
G = 100
• Equilibrium Income :
Y=C+I+G
Y = 100 + 0.75 (Y-100) + 100 + 100
Y – 0.75Y = 100 -75 + 100 + 100 = 225
Y = (225/0.25) = 900

Meeting 10, Aggregate Expenditure and Equilibrium Output

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Meeting 10, Aggregate Expenditure and Equilibrium Output

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Aggregate Expenditure and

• Thus: Y = C + I + G + NX, which means that:

• Saving is the part of its income that a

• In The General Theory, Keynes argued that

The slope of the consumption

Y 0 80 100 200 400 500 800

 Y < C + I which mean : (1) planned aggregate expenditure > aggregate

Suppose: • Y = 100 + 0.75Y + 25

Savings is leakage from the flow of expenditure. If planned investment is

Aggregate output will be equal to planned aggregate

So the result, (Y = 500), is the same as the results when

In their attempt to save more, households have caused a

• With taxes a part of the picture, the aggregate

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