Output and Expenditure in the Short Run Aggregate expenditure (AE) The total amount of spending on the economy’s output: Aggregate Expenditure AE = C + I + G + NX • Consumption (C) • Planned Investment (I) • Government Purchases of Goods + Services (G) • Net Exports (NX) Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y) AE = C + I + G + NX = Y

Components of Real Aggregate Expenditure, 2006 EXPENDITURE CATEGORY EXPENDITURE (BILLIONS OF 2000 DOLLARS) Consumption $8,091 Investment 1,946 Government 1,998 Net Exports −618

The Aggregate Expenditure Model Adjustments to Macroeconomic Equilibrium Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected IF … THEN … AND … Aggregate expenditure is equal to GDP inventories are unchanged the economy is in macroeconomic equilibrium. less than GDP inventories rise GDP and employment decrease. Aggregate Expenditure is greater than GDP inventories fall GDP and employment increase.

Real Consumption Expenditure C = $C/CPI FIGURE 11-1 Real Consumption, 1979–2006

The most important variables that determine the level of consumption: • Current disposable income • Household wealth: Assets minus liabilities • Expected future income People try to keep their consumption fairly steady from year-to-year  save for a rainy day • The price level Higher price level reduces real value of monetary wealth • The interest rate High interest rate discourages spending on credit and encourages saving

The Relationship between Consumption and Income, 1960– 2006 The Consumption Function: The relation between consumption and disposable income Marginal propensity to consume (MPC) The amount by which consumption spending changes when disposable income changes = slope of consumption function. The Relationship between Consumption and Income, 1960– 2006 Consumption Function

The Consumption Function Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes. We can also use the MPC to determine how much consumption will change as income changes: Change in consumption = Change in disposable income × MPC

The Relationship between Consumption and National Income when net taxes are constant

Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving National income = Consumption + Saving + Taxes Y = C + S + T Change in national income = Change in consumption + Change in saving + Change in taxes If taxes are always a constant amount, ΔT = 0 ΔY = ΔC + ΔS

1 = MPC + MPS MPS = 1 - MPC Income, Consumption, and Saving Marginal propensity to save (MPS) The change in saving divided by the change in disposable income. or, 1 = MPC + MPS MPS = 1 - MPC

MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) Solved Problem 11-2 Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save NATIONAL INCOME AND REAL GDP (Y) CONSUMPTION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) $9,000 $8,000 1,000 — 10,000 8,600 1,400 0.6 0.4 11,000 9,200 1,800 12,000 9,800 2,200 13,000 10,400 2,600

Determining the Level of Aggregate Expenditure in the Economy Planned Investment (I) Real Investment, 1979–2006

Waves of optimism and pessimism The most important variables that determine the level of investment: • Expectations of future profitability Waves of optimism and pessimism • Major technology changes: new products & processes The interest rate • Taxes • Cash flow Current capacity utilization

The “new” information economy of the 1990s

Government Purchases (G) Real Government Purchases, 1979–2006

Net Exports (NX) Real Net Exports, 1979–2006

Net Exports (NX) The most important variables that determine the level of net exports: • The price level in the United States relative to the price levels in other countries • The growth rate of GDP in the United States relative to the growth rates of GDP in other countries • The exchange rate between the dollar and other currencies

Graphing Macroeconomic Equilibrium Learning Objective 11.3 Graphing Macroeconomic Equilibrium FIGURE 11-8 The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Graphing Macroeconomic Equilibrium

Graphing Macroeconomic Equilibrium

Graphing Macroeconomic Equilibrium Learning Objective 11.3 Graphing Macroeconomic Equilibrium Showing a Recession on the 45°-Line Diagram FIGURE 11-11 Showing a Recession on the 45°-Line Diagram

Planned Aggregate Expendi ture Unplan ned Change in Invent ories Macroeconomic Equilibrium Real GDP (Y) Consump tion (C) Planned Invest ment (I) Govern ment Purchases (G) Net Exports (NX) Planned Aggregate Expendi ture (AE) Unplan ned Change in Invent ories Real GDP Will … $8,000 $6,200 $1,500 – $500 $8,700 –$700 increase 9,000 6,850 1,500 –500 9,350 –350 10000 7,500 10,000 be in equili brium 11000 8,150 10,650 +350 decrease 12000 8,800 11,300 +700 Don’t Let This Happen to YOU! Don’t Confuse Aggregate Expenditure with Consumption Spending

The Multiplier Effect

= Change in autonomous spending that sparks an expansion Learning Objective 11.4 The Multiplier Effect Autonomous expenditure An expenditure that does not depend on the level of GDP. Multiplier The increase in equilibrium real GDP in response to increase in autonomous expenditure, e.g. Expenditure multiplier = ΔY/ΔI Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC = Change in autonomous spending that sparks an expansion + Change in consumption spending induced by increasing output and income.

The Multiplier Effect in Action   ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP ROUND 1 $100 billion $0 ROUND 2 75 billion 175 billion ROUND 3 56 billion 231 billion ROUND 4 42 billion 273 billion ROUND 5 32 billion 305 billion . ROUND 10 8 billion 377 billion ROUND 15 2 billion 395 billion ROUND 19 1 billion 398 billion n $400 billion

Making the Connection The Multiplier in Reverse: The Great Depression of the 1930s The multiplier effect contributed to the very high levels of unemployment during the Great Depression. Year Consumption Investment Net Exports Real GDP Unemployment Rate 1929 $661 billion $91.3 billion $9.4illion $865 billion 3.2% 1933 $541 billion $17.0 billion -$10.2 billion $636 billion 24.9%

The Multiplier Effect A Formula for the Multiplier

Summarizing the Multiplier Effect 1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases. 2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. 3 The larger the MPC, the larger the value of the multiplier. 4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on taxes, imports, prices and interest rates.

The Aggregate Demand Curve The Effect of a Change in the Price Level on Real GDP

Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure, holding constant all other factors that affect aggregate expenditure.

K e y T e r m s Aggregate demand curve Aggregate expenditure (AE) Aggregate expenditure model Autonomous expenditure Cash flow Consumption function Inventories Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Multiplier effect

Appendix The Algebra of Macroeconomic Equilibrium 1 Consumption function 2 Planned investment function 3 Government spending function 4 Net export function 5 Equilibrium condition

Appendix The Algebra of Macroeconomic Equilibrium The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get: Or, Or, Or,

Appendix The Algebra of Macroeconomic Equilibrium Remember that is the multiplier. Therefore an alternative expression for equilibrium GDP is: Equilibrium GDP = Autonomous expenditure x Multiplier