:+:CHAPTER 3 Aggregate Expenditure and Equilibrium Output

posted on 15 Feb 2011 15:56 by marry-dodo


Aggregate Expenditure and Equilibrium Output


Aggregate Output and Aggregate Income (Y)

          One way of measuring the output of the economy, real GDP, is to add up all the spending by households, businesses, government, and foreigners on domestically produced goods and services. As a result, changes in spending by any of these groups can affect real GDP and, consequently, unemployment.

In this lecture, we will focus on spending by households and firms. We will develop a framework that illustrates how changes in spending affect the economy. In the next chapter, we will add government spending and spending by the rest of the world to this framework.

Aggregate Output and Aggregate Income (Y) 

Let us quickly review a few basic concepts before we move on. Recall that the aggregate output of an economy is all of the goods and services the economy produces. Real GDP is one measure of this output. Because it controls for changes in prices, an increase in real GDP means the amount of goods and services produced in an economy has increased. Fluctuations in real GDP define the oscillation of the economy between recessions and expansions. As such, we are interested in the real aggregate output of the economy: real GDP.

We also learned that the expenditures by one component of the economy means income for another component. Recall that real GDP can also be measured by adding up all the income for different groups in the economy. Real GDP, therefore, is a measure of both the aggregate output and aggregate income for an economy. We will refer to aggregate income with the symbol Y.

Income, Consumption, and Saving (Y, C, and S) 

Households receive income from wages, interest, rental payments made to them, and other sources. What do they do with this income? There are two basic choices: they can spend it or save it. The amount that households spend during some period of time is called consumption. The remaining income can be saved. The amount that households save during some time period is called saving.

Income that households do not consume (C) will be saved (S). The marginal propensity to save (MPS) is the fraction of additional income (Y) spent on savings (S) and can be written as:


marginal propensity to save (MPS) = ∆S/∆Y

In our earlier example, the MPC equaled 0.75. With an additional $1 billion, $750 million will go to C and the remainder ($250 million) will go to S. In other words, when MPC = 0.75, then MPS = 0.25. This relationship between MPC and MPS can be written as:

  The relationship between saving and consumption can be illustrated with the aggregate consumption function figure we saw earlier. One feature will be added to it: a 45o line. With the numbers along each axis being the same, a 45o line has a very useful feature. At every point along the 45o line, the values on one axis are equal to the values along the other axis. 

  All along the 45o line, aggregate consumption (vertical axis) equals aggregate income (horizontal axis). Note that the aggregate consumption line crosses the 45o line at $400 billion. That means when aggregate income equals $400 billion, aggregate consumption also equals $400 billion.

Think again about saving. When aggregate income and aggregate consumption are both $400 billion, all income goes toward consumption and there is no saving. When aggregate income exceeds aggregate consumption, the extra income goes toward saving and saving is positive. Consider the point in the figure when aggregate income is $800 billion, aggregate consumption is $700 billion. At this level of income, there will be $100 billion in saving.

When income is less than consumption, there is dissaving and saving is negative. In the figure, such a point occurs at an aggregate income level of $200 billion.

Aggregate Output and Aggregate Income 
Planned Investment (I) & Planned Aggregate Expenditure (AE)

The aggregate savings on the part of households in the economy provide the money for investment. Recall that investment is the building of new factories, the purchases of new equipment, as well as additions to inventories. While buying corporate stocks and bonds, money market funds, and other saving alternatives is not considered to be investment, the use of those funds by firms to buy new plants and equipment, or to build up inventories, is considered investment.

Unlike consumption spending by households, however, investment is not completely under the control of firms. The building up or drawing down of inventories can occur, unplanned, when consumers buy more or fewer products than firms anticipated.

REALITY CHECK: For example, if Microsoft plans on selling 50 million copies of Windows 2000 and produces that many, but consumers only purchase 40 million copies, inventories of Windows 2000 will be larger than planned.

The amount of new plants, equipment and inventory that is planned by firms is called desired or planned investment. The actual amount spent on plants, equipment and actual investment, including any unplanned additions or drawdown of inventories, is called actual investment. The amount of planned and actual investment in an economy depends on a host of factors. We will take these up in later lectures. For now, however, we will make the assumption that the amount of actual investment is fixed. This means that it does not vary with the level of income, changes in expectations, or any of a host of other factors. This will keep things simpler until we get used to this framework for analyzing the economy. In the figures we will use for the rest of this lecture, investment is assumed to be fixed at $25 billion. This is shown by the following figure:


Planned Aggregate Expenditure (AE) 

Planned aggregate expenditure (AE) is the total amount that the economy plans to spend in a given period. It is defined as being identical to consumption plus planned investment.