8 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Aggregate Expenditure and Equilibrium Output

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 31 The Core of Macroeconomic Theory

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 31 The Core of Macroeconomic Theory This chapter starts presenting macroeconomic theory. 1.What factors determine GDP? 2.What causes inflation and unemployment? B.Macroeconomics divides the economy into three sectors: 1.Newly-produced goods and services (GDP) markets 2.Assets markets (financial and real) 3.Labor markets

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 31 Aggregate Output and Aggregate Income (Y) 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 When aggregate output increases, additional income is generated and vice versa.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 31 Aggregate Output and Aggregate Income (Y) 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.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 31 Income, Consumption, and Saving (Y, C, and S) 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. The triple equal sign means this is an identity, or something that is always true.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 31 Explaining Spending Behavior All income is either spent on consumption or saved in an economy in which there are no taxes. Saving / Aggregate Income  Consumption

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

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 31 AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) Aggregate Saving S (BILLIONS OF DOLLARS) , S = Y - C

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 31 Household Consumption and Saving The relationship between consumption and income is called the consumption function. For an individual household, the consumption function shows the level of consumption at each level of household income.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 31 Household Consumption and Saving 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.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 31 Household Consumption and Saving The fraction of a change in income that is saved is called the marginal propensity to save (MPS). Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 31 An Aggregate Consumption Function Derived from the Equation C = Y AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) ,000850

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 31 An Aggregate Consumption Function Derived from the Equation C = Y At a national income of zero, consumption is $100 billion ( a ). For every $100 billion increase in income (  Y), consumption rises by $75 billion (  C).

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 31 Deriving a Saving Function from a Consumption Function Y-C=S AGGREGATE INCOME (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) ,

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 31 Because S = Y – C, it is easy to derive a saving function from a 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 = 250. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 31 The consumption function and the saving function are mirror images of one another. No information appears in one that does not also appear in the other. These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody aggregate household behavior.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 31 Planned Investment (I) Consumption, as we have seen, is the spending by households on goods and services, but what kind of spending do firms engage in? The answer is investment. Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock. To an economist, an investment is something produced that is used to create value in the future.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 31 Spending on buildings and equipment is called business fixed investment. inventories are part of the capital stock. When firms add to their inventories, they are investing— they are buying something that creates value in the future One component of investment— is 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

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 31 Actual versus Planned Investment Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms. Because we assume households have complete control over their consumption, planned consumption is always equal to actual consumption, while planned investment is not always equal to actual investment)

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 31 Actual Versus Planned Investment A firm may not always end up investing the exact amount that it planned. Actual investment, is the actual amount of investment that takes place. If actual inventory investment turns out to be higher than firms planned, then actual investment is greater than I, planned investment.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 31 The Planned Investment Function I For now, we will assume that planned investment is fixed. It does not change when income changes. this means the planned investment function is a horizontal line.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 31 Planned Aggregate Expenditure (AE) Planned aggregate expenditure is the total amount the economy plans to spend in a given period. It is equal to consumption plus planned investment.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 31 Equilibrium Aggregate Output (Income) we have described the behavior of firms and households. We now discuss the nature of equilibrium and explain how the economy achieves equilibrium. 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 AE = Planned Outputs

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 31 Equilibrium Aggregate Output (Income) Y > C + I aggregate output > planned aggregate expenditure inventory investment is greater than planned actual investment is greater than planned investment Disequilibria: C + I > Y planned aggregate expenditure > aggregate output inventory investment is smaller than planned actual investment is less than planned investment aggregate output / Y planned aggregate expenditure / AE / C + I equilibrium: Y = AE, or Y = C + I

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 31 Equilibrium Aggregate Output (Income) 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 = Y. (1)(2)(3)(4)(5)(6) AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT (I) PLANNED AGGREGATE EXPENDITURE (AE) C + I UNPLANNED INVENTORY CHANGE Y  (C + I) EQUILIBRIUM? (Y = AE?)  100 No  75 No  25 No Yes No No 1, No

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 31 Equilibrium Aggregate Output (Income)

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 31 Equilibrium Aggregate Output (Income) (1) (2) (3) By substituting (2) and (3) into (1) we get: There is only one value of Y for which this statement is true. We can find it by rearranging terms:

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 31 The Saving/Investment Approach to Equilibrium Because aggregate income must either 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 H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 31 The Saving/Investment Approach to Equilibrium The saving/investment approach to equilibrium is 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.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 31 The Saving/Investment Approach to Equilibrium saving is like a leakage out of the spending stream. Only if that leakage is counterbalanced by some other component of planned spending can the resulting planned aggregate expenditure equal aggregate output. This other component is planned investment (I).

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 31 The Saving/Investment Approach to Equilibrium The leakage out of the spending stream— saving—is matched by an equal injection of planned investment spending into the spending stream. For this reason, the saving/investment approach to equilibrium is also called the leakages/injections approach to equilibrium.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 31 The Saving/Investment Approach to Equilibrium If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 31 The S = I Approach to Equilibrium Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y=500.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 31 The Multiplier The multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous or independent 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.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 31 The Multiplier In this chapter, for example, we consider planned investment to be autonomous. The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 31 The Multiplier The size of the multiplier depends on the slope of the planned aggregate expenditure line.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 31 The Multiplier After an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 31 The Size of the Multiplier in the Real World 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.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 31 The Paradox of Thrift When households become concerned about the future and decide to save more, the corresponding decrease in consumption leads to a drop in spending and income. Households end up consuming less, but they have not saved any more.

C H A P T E R 8: Aggregate Expenditure and Equilibrium Output © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 41 of 31 Review Terms and Concepts actual investment actual investment aggregate income aggregate income aggregate output aggregate output aggregate output (income) (Y) aggregate output (income) (Y) autonomous variable autonomous variable change in inventory change in inventory consumption function consumption function desired, or planned, investment (I) desired, or planned, investment (I) equilibrium identity investment marginal propensity to consume (MPC) marginal propensity to consume (MPC) marginal propensity to save (MPS) marginal propensity to save (MPS) multiplier paradox of thrift paradox of thrift planned aggregate expenditure (AE) planned aggregate expenditure (AE) saving (S) saving (S)