1. Chapter Twenty Four Aggregate Expenditure and Equilibrium Output

2. Income, Consumption, and Saving (Y, C, and S) Saving = Income - Consumption S = Y - C

3. The Role of Income 4 Disposable Income 4 Disposable Income: The current income you receive in your paycheck, after you pay taxes. 4 Expected Future Income 4 Expected Future Income: The income you expect to receive in the future

4. The Role of Income Higher Income Higher Consumption

5. Income = Consumption + Savings Y = C + S Income Consumption Savings

6. Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Assuming Taxes=0

7. Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Saving -500 -250 0 250 500 = +

8. Graphing the Consumption Function Consumption 4000 3000 2000 1000 Household Income 4000200010003000 45 o line

9. Graphing the Consumption Function Consumption Household Income Consumption

10. Slope of the Consumption Function Consumption 45 o C Household Income DCDC DYDY Slope =  C  Y

11. Slope of the Consumption Function Consumption 45 o C Household Income D C = 750 D Y = 1000 Slope = 0.75

12. The Consumption Function C = 500 +.75*Income 4 People buy goods even when their income is zero 4 75% of each dollar of income is consumed 4 25% of each dollar is saved 4 0.75 is the Marginal Propensity to Consume (MPC)

13. MPC and MPS marginal propensity to consume 4 The marginal propensity to consume (MPC) is that fraction of a change in income that is consumed or spent. marginal propensity to save 4 The marginal propensity to save (MPS) is that fraction of a change in income that is saved.

14. Savings 4 Savings = Income - Consumption 4 MPS: marginal propensity to save 4 MPS = 1 - MPC

15. Consumption & Saving Consumption 45 o Consumption Function Y C S Household Income

16. Increase in MPC An increase in the MPC increases the slope of the consumption function...

17. Increase in MPC Consumption 45 o Consumption Function Household Income

18. Increase in the Constant An increase in the constant shifts the entire consumption function upward, parallel to the original.

19. Increase in the Constant Consumption 45 o Consumption Function Household Income

20. What Determines the Level of Planned Investment? 4 Real interest rates 4 Expected future profits

21. What Determines the Level of Planned Investment? Lower Interest Rates Higher Expected Future Profits More Investment (I)

22. Actual Investment 4 Actual Investment = Planned Investment + Inventories 4 Inventories = Production - Sales

23. Inventory Adjustment ñ Consumers buy more than firms planned ñ Inventories fall ñ Actual Investment falls short of Planned Investment

24. Output Adjustment ñ Inventories are lower than desired ñ Firms will increase production ñ Output will rise

25. Output < C Planned Investment Inventory Adjustment

26. Output = C Actual Investment Inventory Adjustment

27. Actual Investment Planned Investment = Change in Inventories Inventories decline by the difference between planned investment and actual investment. Inventory Adjustment

28. ñ Consumers buy less than firms planned ñ Inventories rise ñ Actual Investment exceeds Planned Investment

29. Output Adjustment ñ Inventories are higher than desired ñ Firms will decrease production ñ Output will fall

30. Output > C Planned Investment Inventory Adjustment

31. C Output = Actual Investment Inventory Adjustment

32. Actual Investment = Change in Inventories Inventories increase by the difference between planned investment and actual investment. Planned Investment Inventory Adjustment

33. Aggregate Expenditures Schedule Income Y 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Planned Investment 50 Agg. Expend. C + I 550 1300 2050 2800 3550

34. Planned Aggregate Expenditures AE = C + I Aggregate Income, Y 45 o C I Aggregate Expenditures = C + I

35. Planned Aggregate Expenditures 500 550 AE = C + I Unplanned rise in inventories. Output falls. Aggregate Income, Y 45 o Output > Aggregate Expenditures

36. Planned Aggregate Expenditures 500 550 AE = C + I Unplanned fall in inventories. Output rises. Aggregate Income, Y 45 o Output < Aggregate Expenditures

37. Planned Aggregate Expenditures 500 550 AE = C + I Planned Investment = Actual Investment Output does not change. Aggregate Income, Y Equilibrium 45 o Output = Aggregate Expenditures

38. Income Identities s C + S + T = Y (household budget) s C + I = AE (planned expenditure) s AE = Y (equilibrium)

39. In equilibrium... C + S = Y C + I = AE AE = Y S = I

40. Adjustment to Equilibrium Expenditures C C + I 2000 2200 2400 I = 100 C = 2300 Y = 2400 S = 100 Aggregate Income, Y 45 o

41. Adjustment to Equilibrium Expenditures C C + I 2000 2200 2400 I = 50 C=2150 Y= 2200 S = 50 Aggregate Income, Y 45 o

42. Adjustment to Equilibrium - C & S - Consumption=600+.75Y Aggregate Planned Expenditures Savings = -600 +.25Y 600 Aggregate Income, Y 45 o

43. Adjustment to Equilibrium AE I Consumption=600+.75Y Investment=$50 Expenditures Savings 600 650 AE = C + I Aggregate Income, Y 45 o

44. Adjustment to Equilibrium AE < Y Expenditures 600 650 AE = C + I Actual Inventoriesexceed Planned Inventories $3000 Aggregate Income, Y 45 o

45. When AE < Y, Output is too High... 4 Firms produce more than consumers and firms want to buy 4 Inventories accumulate 4 Actual inventories exceed planned inventories 4 Firms will cut back on production

46. Adjustment to Equilibrium AE > Y Expenditures 600 650 AE = C + I Actual Inventories less than Planned Inventories $800 Aggregate Income, Y

47. When AE > Y, Output is too Low... 4 Firms produce less than consumers and firms want to buy 4 Inventories decline 4 Actual inventories are less than planned inventories 4 Firms will increase on production

48. Adjustment to Equilibrium AE = Y Expenditures 600 650 AE = C + I Actual Inventories equal Planned Inventories $2600 Aggregate Income, Y

49. When AE = Y, Equilibrium... 4 Equilibrium income: the level at which C+I = Y 4 Planned Inventories = Actual Inventories

50. The Simple Model and the Multiplier > C = 500 + 0.75*Y > I = 50 Equilibrium: C + I = Y 2200 = Y

51. Suppose that I rises to 60... è C = 500 + 0.75*Y è I = 60 Equilibrium: C + I = Y 2240 = Y

52. Where do the numbers come from?? >C + I = 500 + 0.75Y + 60 = 560 + 0.75Y >Set C + I equal to Y: >560 + 0.75 Y = Y >Solve for Y: >560 + 0.75Y - 0.75Y = Y - 0.75 Y >560 = 0.25 Y >560/0.25 = Y implies Y = 2240

53. Aggregate Planned Expenditure 2240 2200 I=50 I=60 Aggregate Income, Y The change in I causes a shift in AE

54. Investment spending increases by 10, but income increases by 40... Investment spending increases by 10, but income increases by 40...

55. The Multiplier!! 4 Multiplier effect 4 Multiplier effect: Equilibrium GDP increases by more than the change in I or autonomous C 4 Changes in autonomous expenditures multiply through the economy. 1/(1-MPC) 4 Multiplier = 1/(1-MPC) = 1/MPS

56. Suppose $10 is injected into the economy, with an MPC =.75: $10 $7.50 $2.50 $5.63 1.87 $4.22 $1.41 SSS Y= C C C $3.17 $1.05 C S $10,$17.50,$23.13,$27.35,$30.52,...

57. Add up the increments in Y: >$10 + $7.50 + $5.63 + $4.22 +... = $40 >$40 = $10 * multiplier = $10 * 4

58. Review Terms & Concepts 4 Actual investment 4 Aggregate income 4 Aggregate output 4 Autonomous variable 4 Change in inventory 4 Consumption function 4 Planned investment 4 Equilibrium 4 Identity 4 Investment 4 Marginal propensity to consume (MPC) 4 Marginal propensity to save (MPS) 4 Multiplier 4 Paradox of thrift 4 Saving