Principles of Macroeconomics (1 of 2)

Global Edition

Part III
The Core of Macroeconomic
Theory

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Part III The Core of Macroeconomic
Theory
• The level of GDP, the overall price level, and the level of
employment are influenced by events in three markets:
– Goods-and-services market
– Financial (money) market
– Labor market

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure III.1 The Core of
Macroeconomic Theory

• We build up the macroeconomy slowly. In Chapters 23 and 24, we examine the market
for goods and services. In Chapters 25, we examine the money market.

• Chapter 26 introduces the aggregate supply (AS) curve and the Fed rule and derives the
aggregate demand (AD) curve. Chapter 27 uses the AS/AD model to examine policy
and cost effects, and Chapter 28 discusses the labor market.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Principles of Macroeconomics (2 of 2)
Global Edition

Chapter 8
Aggregate Expenditure
and Equilibrium Output

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline and Learning
Objectives (1 of 2)
8.1 The Keynesian Theory of Consumption
• Explain the principles of the Keynesian theory of
consumption.
8.2 Planned Investment (I) versus Actual Investment
• Explain the difference between planned investment and
actual investment.
8.3 Planned Investment and the Interest Rate (r)
• Understand how planned investment is affected by the
interest rate.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline and Learning
Objectives (2 of 2)
8.4 The Determination of Equilibrium Output (Income)
• Explain how equilibrium output is determined.
8.5 The Multiplier
• Describe the multiplier process and use the multiplier
equation to calculate changes in equilibrium.
Looking Ahead
Appendix: Deriving the Multiplier Algebraically
• Show that the multiplier is 1 divided by 1 minus the MPC.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter 8 Aggregate Expenditure and
Equilibrium Output (1 of 2)
• 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).

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter 8 Aggregate Expenditure and
Equilibrium Output (2 of 2)
• aggregate output (income) (Y) A combined term used to
remind you of the exact equality between aggregate output
and aggregate income.
• You must think in “real terms”: Output Y refers to the
quantities of goods and services produced, not the dollars
circulating in the economy.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Keynesian Theory of
Consumption (1 of 4)
• In Keynes’s classic The General Theory of Employment,
Interest, and Money, current income played the key role in
determining consumption levels in the economy.
• consumption function The relationship between
consumption and income.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 8.1 A Consumption Function
for a Household
• A consumption function for
an individual household
shows the level of
consumption at each level
of household income.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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 higher levels of
income lead to higher
levels of consumption
spending.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Keynesian Theory of
Consumption (2 of 4)
• We can use the following equation to describe a straight-
line consumption curve:
C  a  bY
• marginal propensity to consume (MPC) That fraction of
a change in income that is consumed, or spent.

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

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Keynesian Theory of
Consumption (3 of 4)
• aggregate saving (S) The part of aggregate income that
is not consumed.
S Y C
• The triple equal sign (≡) means that this equation is an
identity, or something that is always true by definition.
• identity Something that is always true by definition.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Keynesian Theory of
Consumption (4 of 4)
• marginal propensity to save (MPS) That fraction of a
change in income that is saved.

MPC + MPS  1
• 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).
• 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).

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 8.3 The Aggregate
Consumption Function Derived from
the Equation C = 100 + 0.75Y
Aggregate Aggregate
Income, Y Consumption, C

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

• 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 0.75.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Figure 8.4 Deriving the Saving Function from the
Consumption Function in Figure 8.3
Y  C  S
Aggregate Aggregate Aggregate Saving
Income Consumption

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

• 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.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Economics In Practice (1 of 3)
Behavioral Biases in Saving Behavior
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.

In studying retirement systems,

researchers have found that simply
changing the enrollment process from an
opt-in structure to an opt-out system
increases enrollment in retirement
pension plans.

CRITICAL THINKING

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?
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Other Determinants of Consumption
• In practice, the decisions of households about how much
to consume in a given period are also affected by:
– Their wealth
– The interest rate
– Their expectations of the future

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Planned Investment (I) versus Actual
Investment
• Inventory is the stock of goods that a firm has awaiting
sale.
• planned investment (I) Those additions to capital stock
and inventory that are planned by firms.
• 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.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 8.5 Planned Investment
Schedule

• Planned investment spending is a negative function of the interest rate. An

increase in the interest rate from 3% to 6% reduces planned investment from
I0 to I1.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Other Determinants of Planned
Investment
• The decision of a firm on how much to invest depends,
among other things, on 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.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Determination of Equilibrium
Output (Income) (1 of 3)
• 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
• So, equilibrium can also be written:
Equilibrium: Y  C  I

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Determination of Equilibrium
Output (Income) (2 of 3)

Y CI
aggregate output > planned aggregate expenditure

C  I Y

planned aggregate expenditure > aggregate output

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Table 8.1 Deriving the Planned
Aggregate Expenditure Schedule and
Finding Equilibrium*
(1) (2) (3) (4) (5) (6)

Aggregate Aggregate Planned Planned Unplanned Equilibrium?

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

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 figures in column (2) are based on the equation C  100  0.75Y
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
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.

• 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.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
The Determination of Equilibrium
Output (Income) (3 of 3)
• Find the equilibrium level of output (income) algebraically:
Y CI (equilibrium)

C  100  0.75Y (consumption function)

I  25 (planned investment)

Y  100
  0.75
 Y  25

C I

Rearranging terms :

Y  0.75Y  100  25
0.25Y  125
125
Y  500
0.25
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
The Saving/Investment Approach to
Equilibrium
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
out of equilibrium.
• By substituting C + S for Y in the equilibrium condition:
C S  C  I

SI
• Equilibrium occurs only when planned investment equals
saving.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Adjustment to Equilibrium
• If firms react to unplanned inventory reductions (increases)
by increasing output, an economy with planned spending
greater (less) than output will adjust to equilibrium, with Y
higher (lower) than before.
• Figure 8.6 shows that at any level of output above (below)
Y = 500, output will fall (rise) until it reaches equilibrium at
Y = 500.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Economics In Practice (2 of 3)
The Rise and Fall of Nokia
Up until 2007, Nokia supplied nearly 48
percent of the world's mobile phones. At the
national level, it accounted for 4 percent of
Finland’s GDP, 21 percent of total exports,
and 14 percent of corporate tax revenues.
However, Nokia’s fortune reversed in 2007
with the advent of Apple’s iPhone and other
Android devices.

The decrease in global demand resulted in a

disequilibrium due to the accumulation of
unplanned inventory. Nokia responded by
massive production cutbacks and several
rounds of immense layoffs. This decline in CRITICAL THINKING
production slashed its global market share
from 46.7 percent in 2007 to a mere 1 1. Do you think that during its golden
percent in 2017. Further, its share of market years from 1998 to 2007 Nokia had
capital in Helsinki's stock exchange plunged unplanned inventory levels? How did
from 70 percent to 13 percent during the this impact the overall level of Finnish
same period. GDP?
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
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.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 8.8 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.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Multiplier Equation
S
Recall: MPS 
Y
• Because ΔS must be equal to ΔI for equilibrium to be
restored, we can substitute ΔI for ΔS and solve:
I
MPS 
Y
1
Y  I 
1  MPS

• Therefore:
1 1
multiplier  or multiplier 
MPS 1  MPS

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Economics In Practice (3 of 3)
The Paradox of Thrift
An increase in planned saving from
S0 to S1 causes equilibrium output
to decrease from 500 to 300.
The corresponding decreased
consumption leads to a reduction of
income.
Increased efforts to save have
caused a drop in income but no
overall change in saving.

CRITICAL THINKING
1. Draw a consumption function corresponding to S0 and S1 and
describe what is happening.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
The Size of the Multiplier in the Real
World
• The size of the multiplier is reduced when:
1. Tax payments depend on income.
2. We consider Fed behavior regarding the interest rate.
3. We add the price level to the analysis.
4. Imports are introduced.
• In reality, the size of the multiplier is about 2.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Looking Ahead
• In this chapter, we took the first step toward understanding
how the economy works.
• We discussed how the economy might adjust back to
equilibrium when it is out of equilibrium.
• We also discussed the effects on equilibrium output from a
change in planned investment and derived the multiplier.
• In the next chapter, we retain these assumptions and add
the government to the economy.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Review Terms and Concepts (1 of 2)
• actual investment • marginal propensity to
• aggregate income consume (MPC)
• • marginal propensity to save
aggregate output
(MPS)
• aggregate output (income) (Y)
• multiplier
• aggregate saving (S)
• planned aggregate
• consumption function expenditure (AE)
• equilibrium • planned investment (I)
• exogenous variable Equations:
• Identity • S≡Y−C
• MPC ≡ slope of consumption
function ≡ ΔC ÷ ΔY
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Review Terms and Concepts (2 of 2)
• MPC + MPS ≡ 1
• AE ≡ C + I
• Equilibrium condition: Y = AE or Y = C + I

• Saving/investment approach to equilibrium: S  I

• Multiplier ≡ 1 ÷ MPS ≡ 1 ÷ 1−MPC

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter 8 Appendix: Deriving
the Multiplier Algebraically
Recall our consumption function: C  a  bY

In equilibrium: Y CI

Substituting the first equation into the second: Y  a  bY  I

1
Rearranging terms and solve for Y in terms of I: Y  (a  I )
(1  b)

 1 
Change I by some amount, ΔI: Y  I  
 1  b 

 1 
Because b ≡ MPC: Y  I   
 1  MPC 

1
The multiplier is: 1  MPC
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.