1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 8 Prepared by: Fernando Quijano and Yvonn Quijano Aggregate Expenditure and Equilibrium Output

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Core of Macroeconomic Theory Chapters 19-20 The Market for Goods and Services Planned aggregate expenditure Planned aggregate expenditure Consumption (C) Investment (I) Government spending (G) Net exports (EX – IM) Consumption (C) Investment (I) Government spending (G) Net exports (EX – IM) Aggregate output (income) (Y) Aggregate output (income) (Y) Equilibrium output (income) (Y*) Equilibrium output (income) (Y*) Chapter 23 Chapter 24 Chapter 25 Connections between the goods market and the money market r* Y* r* Y* Aggregate Demand and Aggregate Supply Aggregate demand curve Aggregate demand curve The Labor Market The supply of labor The supply of labor The demand for labor The demand for labor Employment and unemployment Employment and unemployment Chapters 21-22 Aggregate supply curve Aggregate supply curve The Money Market The supply of moneyThe supply of money The demand for moneyThe demand for money Equilibrium interest rate (r*)Equilibrium interest rate (r*) Equilibrium price level (P*)

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 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.Aggregate income is the total income received by all factors of production in a given period.

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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, not nominal output. Output refers to the quantities of goods and services produced, not the dollars in circulation.When we talk about output (Y), we mean real output, not nominal output. Output refers to the quantities of goods and services produced, not the dollars in circulation.

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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 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.Saving 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.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Saving / Aggregate Income  Consumption All income is either spent on consumption or saved in an economy in which there are no taxes.All income is either spent on consumption or saved in an economy in which there are no taxes.

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Explaining Spending Behavior Some determinants of aggregate consumption include: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.In The General Theory, Keynes argued that household consumption is directly related to its income.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Consumption Function for a Household The relationship between consumption and income is called the consumption function.The relationship between consumption and income is called the consumption function. The consumption function for an individual household shows the level of consumption at each level of household income.The consumption function for an individual household shows the level of consumption at each level of household income.

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Aggregate Consumption Function For simplicity, we assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight line.For simplicity, we assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight line. 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.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.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Aggregate Consumption Function Derived from the Equation C = 100 +.75Y At a national income of zero, consumption is $100 billion ( a ).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).For every $100 billion increase in income (  Y), consumption rises by $75 billion (  C).

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Aggregate Consumption Function Derived from the Equation C = 100 +.75Y AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) 0100 80160 100175 200250 400400 400550 800700 1,000850

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Consumption and Saving Since there are only two places income can go: consumption or saving, the fraction of additional income that is not consumed is the fraction saved. The fraction of a change in income that is saved is called the marginal propensity to save (MPS).Since there are only two places income can go: consumption or saving, the fraction of additional income that is not consumed is the fraction saved. 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,Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Deriving a Saving Function from a Consumption Function AGGREGATE INCOME, Y AGGREGATE CONSUMPTION, C AGGREGATE SAVING, S (ALL IN BILLIONS OF DOLLARS) 0100-100 80160-80 100175-75 200250-50 4004000 40055050 800700100 1,000850150

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Planned Investment (I) Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stocks.Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stocks. One component of investment—inventory change—is partly determined by how much households decide to buy, which is not under the complete control of firms.One component of investment—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

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Planned Investment (I) Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms.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.Actual investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

16. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Planned Investment (I) For now, we will assume that planned investment is fixed. It does not change when income changes.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.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.

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Planned Aggregate Expenditure (AE) To determine planned aggregate expenditure (AE), we add consumption spending (C) to planned investment spending (I) at every level of income.To determine planned aggregate expenditure (AE), we add consumption spending (C) to planned investment spending (I) at every level of income.

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Equilibrium Aggregate Output (Income) In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output.In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output.

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Equilibrium Aggregate Output (Income) aggregate output / Y planned aggregate expenditure / AE / C + I equilibrium: Y = AE, or Y = C + I 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. There is unplanned inventory disinvestment.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Inventory Adjustment

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Deriving the Planned Aggregate Expenditure Schedule. 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 = 100 +.75Y. (1)(2)(3)(4)(5)(6) AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT PLANNED AGGREGATE EXPENDITURE (AE) C + I UNPLANNED INVENTORY CHANGE Y  (C + I) EQUILIBRIUM? (Y = AE?) 10017525200  100 No 20025025275  75 No 40040025425  25 No 500475255000Yes 60055025575 + 25 No 80070025725 + 75 No 1,00085025875 + 125 No

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Finding Equilibrium Output Algebraically (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:

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Saving/Investment Approach to Equilibrium Saving is a leakage out of the spending stream. If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium.

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The S = I Approach to Equilibrium Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I).Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I).

25. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Multiplier The multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable.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.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.In this chapter, for example, we consider planned investment to be autonomous.

26. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Multiplier An increase in planned investment causes output to go up. People earn more income, consume some of it, and save the rest.An increase in planned investment causes output to go up. People earn more income, consume some of it, and save the rest. The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.

27. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Multiplier The size of the multiplier depends on the slope of the planned aggregate expenditure line.The size of the multiplier depends on the slope of the planned aggregate expenditure line. Because  S must be equal to  I for equilibrium to be restored, we can substitute  I for  S and solve:Because  S must be equal to  I for equilibrium to be restored, we can substitute  I for  S and solve: The marginal propensity to save may be expressed as:The marginal propensity to save may be expressed as: therefore,, or

28. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Multiplier After an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment.

29. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Multiplier In reality, the size of the multiplier is about 1.4. That is, 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.In reality, the size of the multiplier is about 1.4. That is, 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.

30. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.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.