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Chapter Twenty FourChapter Twenty Four
Aggregate Expenditure Aggregate Expenditure and Equilibrium Outputand Equilibrium Output
Income, Consumption, and Income, Consumption, and Saving (Y, C, and S)Saving (Y, C, and S)
Saving = Income - Consumption
S = Y - C
The Role of IncomeThe Role of Income
Disposable IncomeDisposable Income: The current income you receive in your paycheck, after you pay taxes.
Expected Future IncomeExpected Future Income: The income you expect to receive in the future
The Role of IncomeThe Role of Income
Higher Income
Higher Consumption
Income = Consumption + Savings Income = Consumption + Savings Y = C + SY = C + S
Income
Consumption
Savings
Consumption ScheduleConsumption Schedule
Income 0 1000 2000 3000 4000
Consumption 500 1250 2000 2750 3500
Assuming Taxes=0
Consumption ScheduleConsumption Schedule
Income 0 1000 2000 3000 4000
Consumption 500 1250 2000 2750 3500
Saving -500 -250 0 250 500
= +
Graphing the Consumption FunctionGraphing the Consumption Function
Consumption
4000
3000
2000
1000
Household Income400020001000 3000
45o line
Graphing the Consumption FunctionGraphing the Consumption Function
0
1000
2000
3000
4000
0 1000 2000 3000 4000
Consumption
Household Income
Consumption
Slope of the Consumption FunctionSlope of the Consumption Function
0
1000
2000
3000
4000
5000
0 1000 2000 3000 4000
Consumption
45o
C
Household Income
C
YSlope =
C
Y
Slope of the Consumption FunctionSlope of the Consumption Function
0
1000
2000
3000
4000
5000
0 1000 2000 3000 4000
Consumption
45o
C
Household Income
C = 750
Y = 1000
Slope = 0.75
The Consumption FunctionThe Consumption Function C = 500 + .75*IncomeC = 500 + .75*Income
People buy goods even when their income is zero
75% of each dollar of income is consumed
25% of each dollar is saved
0.75 is the Marginal Propensity to Consume (MPC)
MPC and MPSMPC and MPS
The marginal propensity to consumemarginal propensity to consume (MPC) is that fraction of a change in income that is consumed or spent.
The marginal propensity to savemarginal propensity to save (MPS) is that fraction of a change in income that is saved.
SavingsSavings
Savings = Income - ConsumptionMPS: marginal propensity to saveMPS = 1 - MPC
Consumption & SavingConsumption & Saving
Consumption
45o
ConsumptionFunction
Y C
S
Household Income
Increase in MPCIncrease in MPC
An increase in the MPC increases the slope of the consumption function...
Increase in MPCIncrease in MPCConsumption
45o
ConsumptionFunction
Household Income
Increase in the ConstantIncrease in the Constant
An increase in the constant shifts the entire consumption function upward, parallel to the original.
Increase in the ConstantIncrease in the ConstantConsumption
45o
ConsumptionFunction
Household Income
What Determines the Level of What Determines the Level of Planned Investment?Planned Investment?
Real interest rates
Expected future profits
What Determines the Level of What Determines the Level of Planned Investment?Planned Investment?
Lower Interest Rates
Higher ExpectedFuture Profits
More Investment
(I)
Actual InvestmentActual Investment
Actual Investment = Planned Investment + Inventories
Inventories = Production - Sales
Inventory AdjustmentInventory Adjustment
Consumers buy more than firms planned Inventories fall Actual Investment falls short of Planned Investment
Output AdjustmentOutput Adjustment
Inventories are lower than desiredFirms will increase productionOutput will rise
Output<
C
Planned Investment
Inventory AdjustmentInventory Adjustment
Output=
C
ActualInvestment
Inventory AdjustmentInventory Adjustment
ActualInvestment
Planned Investment =
Change inInventories
Inventories decline by the difference between planned investment and actual investment.
Inventory AdjustmentInventory Adjustment
Inventory AdjustmentInventory Adjustment
Consumers buy less than firms planned Inventories rise Actual Investment exceeds Planned Investment
Output AdjustmentOutput Adjustment
Inventories are higher than desiredFirms will decrease productionOutput will fall
Output>
C
Planned Investment
Inventory AdjustmentInventory Adjustment
C
Output=
ActualInvestment
Inventory AdjustmentInventory Adjustment
ActualInvestment
=
Change inInventories
Inventories increase by the difference between planned investment and actual investment.
Planned Investment
Inventory AdjustmentInventory Adjustment
Aggregate Expenditures ScheduleAggregate Expenditures Schedule
Income Y 0 1000 2000 3000 4000
Consumption 500 1250 2000 2750 3500
PlannedInvestment 50 50 50 50 50
Agg. Expend. C + I 550 1300 2050 2800 3550
PlannedAggregate Expenditures AE = C + I
Aggregate Income, Y45o
C
I
Aggregate Expenditures = C + IAggregate Expenditures = C + I
PlannedAggregate Expenditures
500
550
AE = C + I
Unplanned rise in inventories. Output falls.
Aggregate Income, Y45o
Output > Aggregate ExpendituresOutput > Aggregate Expenditures
PlannedAggregate Expenditures
500
550
AE = C + I
Unplanned fall in inventories. Output rises.
Aggregate Income, Y45o
Output < Aggregate ExpendituresOutput < Aggregate Expenditures
PlannedAggregate Expenditures
500
550
AE = C + I
Planned Investment = Actual InvestmentOutput does not change.
Aggregate Income, Y
Equilibrium
45o
Output = Aggregate ExpendituresOutput = Aggregate Expenditures
Income IdentitiesIncome Identities
C + S + T = Y (household budget) C + I = AE (planned expenditure)
AE = Y (equilibrium)
In equilibrium...In equilibrium...
C + S = Y
C + I = AE
AE = Y
S = I
Adjustment to EquilibriumAdjustment to Equilibrium
Expenditures
C
C + I
2000
2000
2200
2200
2400
2400
I = 100 C = 2300Y = 2400S = 100
Aggregate Income, Y
45o
Adjustment to EquilibriumAdjustment to EquilibriumExpenditures
C
C + I
2000
2000
2200
2200
2400
2400
I = 50C=2150Y= 2200S = 50
Aggregate Income, Y45o
Adjustment to EquilibriumAdjustment to Equilibrium- C & S -- C & S -
Consumption=600+.75Y
AggregatePlannedExpenditures
Savings = -600 + .25Y
600
Aggregate Income, Y45o
Adjustment to EquilibriumAdjustment to EquilibriumAE < Y and S > IAE < Y and S > I
Consumption=600+.75Y
Investment=$50
Expenditures
Savings
600
650
AE = C + I
Aggregate Income, Y
45o
Adjustment to EquilibriumAdjustment to EquilibriumAE < YAE < Y
Expenditures
600
650
AE = C + I
Actual Inventoriesexceedexceed
Planned Inventories
$3000 Aggregate Income, Y
45o
When AE < Y, Output is too When AE < Y, Output is too High...High...
Firms produce more than consumers and firms want to buyInventories accumulateActual inventories exceed planned inventoriesFirms will cut back on production
Adjustment to EquilibriumAdjustment to EquilibriumAE > YAE > Y
Expenditures
600
650
AE = C + I
Actual Inventories less than Planned Inventories
$800 Aggregate Income, Y
When AE > Y, Output is too Low...When AE > Y, Output is too Low...
Firms produce less than consumers and firms want to buyInventories declineActual inventories are less than planned inventoriesFirms will increase on production
Adjustment to EquilibriumAdjustment to EquilibriumAE = YAE = Y
Expenditures
600
650
AE = C + I
Actual Inventories equal Planned Inventories
$2600 Aggregate Income, Y
When AE = Y, Equilibrium...When AE = Y, Equilibrium...
Equilibrium income: the level at which C+I = YPlanned Inventories = Actual Inventories
The Simple Model and the The Simple Model and the MultiplierMultiplier
C = 500 + 0.75*Y I = 50
Equilibrium:C + I = Y2200 = Y
Suppose that I rises to 60...Suppose that I rises to 60...
C = 500 + 0.75*YI = 60
Equilibrium:C + I = Y2240 = Y
Where do the numbers come Where do the numbers come from??from??
C + I = 500 + 0.75Y + 60 = 560 + 0.75YSet C + I equal to Y:
560 + 0.75 Y = YSolve for Y:
560 + 0.75Y - 0.75Y = Y - 0.75 Y560 = 0.25 Y560/0.25 = Y implies Y = 2240
Aggregate PlannedExpenditure
2240
2240
2200
2200
I=50
I=60
Aggregate Income, Y
The change in I causes a shift in AEThe change in I causes a shift in AE
Investment spending increases by 10,but income increases by 40...
Investment spending increases by 10,but income increases by 40...
The Multiplier!!The Multiplier!!
Multiplier effectMultiplier effect: Equilibrium GDP increases by more than the change in I or autonomous CChanges in autonomous expenditures multiply through the economy.Multiplier = 1/(1-MPC)1/(1-MPC) = 1/MPS
Suppose $10 is injected into the Suppose $10 is injected into the economy, with an MPC = .75:economy, with an MPC = .75:
$10$7.50
$2.50
$5.63
1.87
$4.22
$1.41
S S S
Y=
C
CC
$3.17
$1.05
C
S
$10, $17.50, $23.13, $27.35, $30.52,...
Add up the increments in Y:Add up the increments in Y:
$10 + $7.50 + $5.63 + $4.22 + ... = $40$40 = $10 * multiplier = $10 * 4
Review Terms & ConceptsReview Terms & Concepts
Actual investment Aggregate income Aggregate output Autonomous variable Change in inventory Consumption function Planned investment Equilibrium
Identity Investment Marginal propensity to
consume (MPC) Marginal propensity to
save (MPS) Multiplier Paradox of thrift Saving