Chapter 23

Aggregate Expenditure
and Equilibrium Output
 Aggregate Expenditure and
Equilibrium Output
• Output Y refers to both aggregate output and aggregate income.
• aggregate output (income) (Y): A combined term used to remind you of
the exact equality between aggregate output and aggregate income.
• !!! Think in real terms: When we talk about output (Y), we mean real
output, not nominal output (not the dollars circulating in the economy).
 Aggregate Expenditure and
Equilibrium Output
• 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).
 The Keynesian Theory of
Consumption
• In The General Theory of Employment, Interest, and Money, Keynes
argued that the amount of consumption undertaken by a household is
directly related to its current income.
• The higher your income is, the higher consumption is likely to be.
• People with more income tend to consume more than people with
less income.
• consumption function: The relationship between consumption and
income.
 A Consumption
Function for a
Household
• A consumption function for an
individual household shows the
level of consumption at each
level of household income.
• Consumption function has a
positive slope (as y increases, so
does c)
• The curve intersects the c-axis
above zero means that even at
zero income, it still must
consume to survive
 An Aggregate
Consumption
Function
• Macroeconomics is concerned with
aggregate consumption.
• How aggregate consumption is likely to
respond to changes in aggregate income?
• 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.
 The Keynesian Theory of
Consumption
• Because the aggregate consumption function is a straight line, we can
write the following equation to describe it:
C a  bY
• marginal propensity to consume (MPC): that fraction of a change in
income that is consumed, or spent.
• e.g. The consumption function here, b is the MPC. An MPC of 0.75 means
consumption changes by 0.75 of the change in income.
C
marginal propensity to consumer  slope of consumption function 
Y
 The Keynesian Theory of
Consumption
• There are only two places income can go: consumption or saving.
• 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.
• marginal propensity to save (MPS) That fraction of a change in
income that is saved.
• Everything not consumed is saved, the MPC and MPS must add up to
1: MPC + MPS 1
Numerical Example:

• 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.
Numerical Example (cont.): Deriving the Saving
Function from the Consumption Function
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.
S Y  C  50.

At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800
The Keynesian Theory of
Consumption
• The consumption function and the saving function are mirror images of one another. They
embody aggregate household behavior.
• The assumption that consumption depends only on income is obviously a simplification.
• Other determinants of consumption:
• The wealth of households
• Households with higher wealth are likely to spend more, other things being equal, than
households with less wealth.
• The interest rate
• Lower interest rates are likely to stimulate spending.
• Households’ expectations about future.
• 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.
Planned Investment (I) versus Actual
Investment
• Investment: Purchases by firms of new buildings and equipment and additions to
inventories, all of which add to firms’ capital stock.
• e.g. a restaurant owner who buys tables, chairs, cooking equipment is investing or
when a college build a new sports center, it is investing.
• Inventory is the stock of goods that a firm has awaiting sale.
• Change in inventory: production minus sales.
• 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.
 Planned
Investment
Function
• For the time being, we will
assume that planned
investment is fixed.

• It does not change when

income changes, so its
graph is a horizontal line.
 Planned
Investment and
the Interest Rate
• 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% to 6% reduces planned
investment from I0 to I1.
 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.
 Equilibrium Aggregate Output
(Income)
• planned aggregate expenditure (AE) The total amount the economy plans to
spend in a given period. It is consumption (C) plus investment (I)
AE C  I
• 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.
• In macroeconomics equilibrium is defined in the goods market as that point at
which planned aggregate expenditure is equal to aggregate output (Y)
• Aggregate output ≡Y
• Planned aggregate expenditure ≡ AE ≡ C+I
• Equilibrium: Y = AE or Y = C+I
 Equilibrium Aggregate Output
(Income)
• Equilibrium can hold if and only if planned investment and actual investment are
equal. Why?
• If aggregate output is greater than planned expenditure, there is unplanned
inventory investment.
Y C I
aggregate output > planned aggregate expenditure
• If planned expenditure is greater than aggregate output, inventory investment is
smaller than planned.

C  I Y
planned aggregate expenditure > aggregate output
 Deriving the Planned Aggregate
Expenditure Schedule and Finding
Equilibrium

The figures in column (2) are based on the equation C  100  0.75Y
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.
 The Determination of Equilibrium
Output (Income)
• Find the equilibrium level of output algebraically, recall that we know the following:
(1) Y C  I (equilibrium)
(2) C 100  0.75Y (consumption function)
(3) I 25 (planned investment)
• Substitute (2) and (3) into (1), get
Y    0.75
 100  Y  25

C I

• There is only one value of Y for which this statement is true. Rearrange terms
Y  0.75Y 100  25
0.25Y  125
125
Y 500
0.25
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.
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.
 The Multiplier
• multiplier The ratio of the change in the equilibrium level of output to
a change in some exogenous variable.
• Exogenous (autonomous) 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.
 The Multiplier
• With planned investment autonomous, how much equilibrium level of
output changes when planned investment changes?
• Consider a sustained increase in planned investment. If equilibrium existed
before, an increase in planned investment will cause a disequilibrium (AE>Y).
• Firms immediately see unplanned reductions in their inventories and they
begin to increase output. Does this restore equilibrium? No it does not.
• Because when output goes up people earn more income and a part of that
income will be spent. People buy more consumer goods.
• Increase in I also leads indirectly to an increase in C.
• The cycle starts all over again.
 The Multiplier

Increase in
Increase in
planned
agrregate
aggregate
Increase in planned output
investment expenditures

Increase in
aggregate
consumption
 The Multiplier as
Seen in the Planned
Aggregate
Expenditure Diagram
• Output and income can rise by significantly more
than initial increase in planned investment, but
how much and how large is the multiplier?
• 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 as
Seen in the Planned
Aggregate
Expenditure Diagram
• The slope of the AE≡C+I line is
just the marginal propensity to
consume (ΔC/ ΔY).
• The greater the MPC is, the
greater the multiplier.
• A large MPC means that
consumption increases a lot
when income increases.
• The more consumption changes,
the more output has to change
to achieve equilibrium.
 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 − 𝑀𝑃𝐶
• Therefore:
 The Multiplier Equation
• In our example, the MPC is 0.75, so the MPS must equal to 1-0.75, or
0.25. Thus, the multiplier is 1 divided by 0.25, or 4.
• The change in equilibrium level of Y is 4×25, or 100.
• Same analysis holds when planned investment falls.
• If planned investment falls by a certain amount, output will fall by a multiple
of the reduction I.
• As initial shock is felt and firms cut output they lay people off.
• The result: Income and subsequently consumption falls.
 Practice Question
• You are given the following data concerning a certain economy:
(1) C = 80 + 0.6 Y
(2) I = 200
(3) AE  C + I
(4) AE  Y
a) What are the marginal propensity to consume (MPC) and the marginal propensity to save
(MPS) in this economy?
b) Graph equations (3) and (4) and solve for equilibrium aggregate income (or aggregate output)
c) Suppose that equation (2) were changed to (2’) I = 150. What is the new equilibrium level of
income (or output)?
d) What is the value of multiplier?
e) Calculate the saving function. Plot this saving function on a graph with equation (2).