CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 27 PART III The Core of Macroeconomic Theory The level of GDP, the overall price level, and the level of employment—three chief concerns of macroeconomists—are influenced by events in three broadly defined “markets”: Goods-and-services market Financial (money) market Labor market

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 28 PART III The Core of Macroeconomic Theory  FIGURE III.1 The Core of Macroeconomic Theory We build up the macroeconomy slowly. In Chapters 8 and 9, we examine the market for goods and services. In Chapters 10 and 11, we examine the money market. Then in Chapter 12, we bring the two markets together, in so doing explaining the links between aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve. In Chapter 13, we introduce the aggregate supply curve and determine the price level (P). We then explain in Chapter 14 how the labor market fits into the macroeconomic picture.

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 PART III THE CORE OF MACROECONOMIC THEORY Aggregate Expenditure and Equilibrium Output Fernando & Yvonn Quijano Adapted from: CHAPTER OUTLINE The Keynesian Theory of ConsumptionPlanned Investment ( I ) The Determination of EquilibriumOutput (Income)The Multiplier

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of 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. Y = aggregate output (income)

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of The Keynesian Theory of Consumption  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.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of The Keynesian Theory of Consumption Consumption function: C = a + bY  FIGURE 8.2 An Aggregate Consumption Function The upward slope indicates that higher levels of income lead to higher levels of consumption spending.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of The Keynesian Theory of Consumption marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent. aggregate saving (S) The part of aggregate income that is not consumed. S ≡ Y – C marginal propensity to save (MPS) That fraction of a change in income that is saved. MPC + MPS ≡ 1

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of The Keynesian Theory of Consumption E.g. Suppose C = Y When Y 0 = $800, C 0 = (800) = $700 S 0 = 800 – 700 = $100 When aggregate income increased by $200 (  Y=200) to $1000, how much of that extra $200 will be spent? How much will be saved? When Y 1 = $1000, C 1 = (1000) = $850 S 1 = 1000 – 850 = $150   Y = Y 1 - Y 0 = $200  C = C 1 - C 0 = $150  S = S 1 - S 0 = $50 MPC =  C/  Y = 150/200 = 0.75 MPS =  S/  Y = 50/200 = 0.25

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of The Keynesian Theory of Consumption  FIGURE 8.3 The Aggregate Consumption Function Derived from the Equation C = Y AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) ,000850

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of The Keynesian Theory of Consumption  FIGURE 8.4 Deriving the Saving Function from the Consumption Function in Figure 8.3 Y- C=S AGGREGATE INCOME (Billions of Dollars) AGGREGATE CONSUMPTION (Billions of Dollars) AGGREGATE SAVING (Billions of Dollars) , When Y = C, S = 0 When Y < C, S is negative When Y > C, S is positive

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of The Keynesian Theory of Consumption Other Determinants of Consumption In practice, the decisions of households on how much to consume in a given period are also affected by: (i)their wealth (ii)the interest rate (iii)their expectations of the future (better job prospect, government future policy announcements).

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of Planned Investment (I)  FIGURE 8.5 The 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.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of The Determination of Equilibrium Output (Income) planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. AE ≡ C + I At equilibrium, aggregate output = planned aggregate expenditure Y = AE Y = C + I

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of The Determination of Equilibrium Output (Income) TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium 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 (Y < C + I)  75 No (Y < C + I)  25 No (Y < C + I) Yes No (Y > C + I) No (Y > C + I) 1, No (Y > C + I)

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of The Determination of Equilibrium Output (Income)  FIGURE 8.6 Equilibrium Aggregate Output Y < C + I Y > C + I

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of The Determination of Equilibrium Output (Income) Adjustment to Equilibrium If output is greater than planned spending, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before. aggregate output > planned aggregate expenditure Y > C + I

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of The Determination of Equilibrium Output (Income) Adjustment to Equilibrium If output is less than planned aggregate expenditure, unplanned inventory reductions have occurred. In this case, firms will respond by increasing output. As output increases, income rises, consumption rises, and so on, until equilibrium is restored, with Y higher than before aggregate output < planned aggregate expenditure Y < C + I

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of The Determination of Equilibrium Output (Income) Adjustment to Equilibrium Suppose C = Y, and I = 25 At equilibrium, Y = C + I = ( Y) + 25 = Y 0.25Y = 125 Y = 125 / 0.25 = 500  The equilibrium level of output is 500

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium Given that: Y ≡ C + S At equilibrium, Y = C + I C + S = C + I S = I  only when planned investment equals saving will there be equilibrium.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of The Determination of Equilibrium Output (Income) Adjustment to Equilibrium Suppose C = Y, and I = 25 Given that Y ≡ C + S = ( Y) + S S = Y At equilibrium, S = I Y = Y = 125 Y = 125 / 0.25 = 500  The equilibrium level of output is 500

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium  FIGURE 8.7 The S = I Approach to Equilibrium Saving and planned investment are equal at Y = 500.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of The Multiplier multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. E.g. Investment multiplier =  Y/  I Government spending multiplier =  Y/  G Tax multiplier =  Y/  T 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. For simplicity, let us consider planned investment (I) is exogenous. Suppose I increases by 25 to 50, how much will the equilibrium level of output (Y) increase? We will see that Y will not increase by a mere 25, but will increase by a multiple of the change in I.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 28 New Equilibrium Given that C = Y, and I = 50 (increases by 25) At equilibrium, Y = C + I = ( Y) + 50 = Y 0.25Y = 150 Y = 150 / 0.25 = 600  The new equilibrium level of output is 600 (increase from 500)  I = 25, but  Y= 100, so how times Y increases? 4 times Multiplier =  Y/  I = 100/ 25 = The Multiplier

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of The Multiplier  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. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 ( ), or four times the amount of the increase in planned investment.

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of The Multiplier The Multiplier Equation At equilibrium, Y = C + I Given that C = a + bY where b (slope) =  C/  Y = MPC Substituting Y = C + I = (a + bY) + I Y - bY = a + I Y (1 – b) = a + I

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of The Multiplier The Multiplier Equation, or Since MPC + MPS ≡ 1,

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 28 Returning to the question when I increases by 25, how much will Y increase? Given that C = Y MPC = The Multiplier So, when  I = 25,  Y= 25 x 4 = 100

CHAPTER 8 Aggregate Expenditure and Equilibrium Output © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 28 of The Multiplier The Multiplier Equation The Paradox of Thrift An increase in planned saving from S 0 to S 1 causes equilibrium output to decrease from 500 to 300. The decreased consumption that accompanies increased saving leads to a contraction of the economy and to a reduction of income. But at the new equilibrium, saving is the same as it was at the initial equilibrium. Increased efforts to save have caused a drop in income but no overall change in saving. Can this paradox be averted? Yes, if the extra savings can be channeled into additional investment (i.e. I will move up)