1. Income Determination
The aggregate expenditure/aggregate supply model is designed to explain how the different sectors of the economy interact to determine the size and composition of GDP (Y) in the short run.
The model is an equilibrium model.
Equilibrium is a state of rest where there are either no forces causing change or equal opposing forces.

2. Equilibrium
Equilibrium is achieved in the model when aggregate spending or expenditures just equal aggregate supply or output.
Aggregate expenditures = Aggregate Supply AE AS

3. Aggregate Expenditures
Aggregate expenditures are comprised of all spending done in the economy during a given period of time.
Aggregate expenditures are the sum of consumption spending by the household sector, investment spending by businesses, government spending by all levels of government, and net exports.
AE = C + I + G + (X-M)

4. Aggregate Supply
Aggregate supply is GDP. It is all final goods and services produced during a given period of time.
AS = GDP or Y
Aggregate supply is assumed to be perfectly responsive to spending.
Whenever expenditures change, aggregate supply changes by an equal amount.

5. Aggregate Supply According to the circular flow diagram andAE AS
According to the circular flow diagram and
the NIPA, GDP measured from the spending
side equals GDP measured from the
income side.
We use this relationship to draw the AS line.
Note that at point E, the distance 0B=0D=ED.
Every point on the AS line represents some
amount of GDP. B E D Y

6. Aggregate Supply
We depict aggregate supply graphically with a ray from the origin.
Every point on the ray represents GDP measured either from the expenditure side or from the income side.
GDP measured from the expenditure side is on the vertical axis.
GDP measured from the income side is on the horizontal axis.
The AS line in this model NEVER moves.

7. Consumption Spending
Consumption is defined as all spending done by the household sector on durables, non-durables, and services.
Consumption is assumed to be determined primarily by disposable income (Yd), but it also may be affected by taxes, changes in the price level, and real wealth.
C = a0 + bYd is the consumption function.

8. Consumption Function The intercept of the consumption function,AS
C = a0 + bYd
The intercept of the consumption function,
a0, represents subsistence consumption.
The slope of the consumption function,
/\C//\Y, is called the marginal propensity
to consume, MPC.
The MPC shows by how much
consumption changes as income changes.
/\C
/\Y a0 Y

9. Consumption and SavingAS
The savings function can be derived
from the consumption function.
At point E, C = Yd, so S = 0.
At point A, C>Yd by the amount AB,
so S <0 by the amount A’B’.
At point C, C<Yd by the amount CD,
so S >0 by the amount C’D’.
Note that the intercept of the savings
function is –a, reflecting the fact that
when Yd is 0, savings are drawn down. C
C=a + bYd D E A a B
Y Y Y Y S
S=-a + (1-b)Yd C’ B’ D’ E Y A’ -a

10. Investment
Investment is defined as all spending done by the business sector on plant, equipment, and inventories.
An important determinant of investment spending is the rate of interest.
There is a negative relationship between investment and the rate of interest.
As interest rates rise, investment falls.
As interest rates fall, investment rises.

11. Interest Rates and Investment
The negative relationship between interest rates and investment exists because firms must either borrow or generate their own funds to invest.
As a result, firms are willing to invest in only those projects that pay a return in excess of the borrowing cost or rate of interest paid.
When rates are high, few projects are sufficiently profitable, but as rates fall, more and more projects become profitable.

12. Investment and the Rate of Interest
At i2, the higher rate of interest,
investment equals I1. Only a few projects
are profitable at this high level.
At i1, the lower rate of interest,
investment equals I2. As the rate of interest
falls, more projects become profitable. i2 i1 I
I I2
Investment

13. Investment in the AE/AS ModelC + I AS
C + I2 = AE2
Investment enters the model as a
lump sum.
An increase in investment
spending from I1 to I2 shifts
aggregate expenditures from AE1
to AE2.
A decrease in investment spending
from I2 to I1 shifts aggregate
expenditures from AE2 to AE1.
Note that as investment changes
so does equilibrium income, Y. B
C + I1 = AE1 A
Y Y2 Y

14. Saving and Investment Investment enters the AE/AS model as a
C,I AS
C+I C
Investment enters the AE/AS model as a
lump-sum equal to the amount CD, and is
shown by a parallel line drawn above C by
the amount CD. Equilibrium occurs at point C.
Investment enters the S/I model as a
horizontal line that intercepts the vertical
axis at the amount CD. Equilibrium occurs
at the point C’. C D E a
Y Y Y Y
S,I S C’ I E Y -a

15. Government Spending
Government spending is defined as all spending done by all levels of government on goods and services.
Government spending enters the model as a lump-sum.
We invoke this simplifying assumption because there is no consistent relationship between government spending and the level of national income.

16. Government in the AE/AS ModelC + I G
Government spending is drawn as a
parallel line above C+I, reflecting the
assumption that government spending
enters the model as a lump-sum.
The distance between C+I and C+I+G
represents lump-sum government
expenditures.
At Y1, consumption equals the line
segments Y1B, consumption plus
investment is Y1A, consumption
plus investment plus government
spending is Y1E, investment is
AB, and government spending is AE. AS
C+I+G
C+I E C A B Y1 Y

17. Government in the AE/AS Model
Changes in government spending cause the government line and, therefore, the aggregate expenditure line to shift.
Increases in government spending shift G and therefore AE up.
Decreases in government spending shift G and therefore AE down.

18. Government in the AE/AS ModelC + I G AS
C+I+G3 = AE3
An increase in government
spending from G2 to G3 shifts
aggregate expenditures from AE2
to AE3.
A decrease in government spending
from G2 to G1 shifts aggregate
expenditures from AE2 to AE1.
Note that as government spending
changes so does equilibrium
income, Y.
C+I+G2 = AE2 C
C+I+G1 = AE1 B A
Y Y Y3 Y

19. Saving, Investment and GovernmentAE AS
C+I+G F
C+I
Government enters the AE/AS model as a
lump-sum equal to the amount FG, and is
shown by a parallel line drawn above C+I by
the amount FG. Equilibrium occurs at point F.
Government enters the S/I model as a
horizontal line that intercepts the vertical
axis at the amount 0F. Equilibrium occurs
at the point F’. G E
a+I0
Y2 Y Y
S,I G S F’ F G E G I Y -a

20. Practice AE AS
C + I + G j
C + I h C f g c e p b d n a m Y
Y Y Y3

21. Practice
Assume Y = Y1 and using vertical line segments determine the following:
Consumption at Y1
Investment at Y1
Government spending at Y1
Aggregate expenditures at Y1
Consumption plus investment at Y1
Investment plus government spending at Y1
Repeat, assuming first that Y=Y2 and then Y=Y3

22. Net Exports
Net exports are the difference between the goods and we produce for the rest of the world and the goods and services they produce for us.
Net exports equal exports minus imports
NX = (X- M)
Net exports enter the model as a lump sum.

23. Determinants of Net Exports
Income in the rest of the world
As income in the rest of the world increases (decreases), they buy more (less) from us.
Relative prices
As our prices fall (rise) relative to prices in the rest of the world, they buy more (less) from us.
Exchange rate
As our currency appreciates (depreciates) relative to other currencies, they buy less (more) from us.

24. Determinants of Net Exports
Imports
Income at home in the domestic economy
As domestic income increases (decreases), we buy more (less) from abroad.
Relative prices
As our prices fall (rise) relative to prices in the rest of the world, we buy less (more) from abroad.
Exchange rate
As our currency appreciates (depreciates) relative to other currencies, we buy more (less) from abroad.

25. Net Exports in the AE/AS Model
Net exports (NX) is drawn as a
parallel line above C+I+G, reflecting
the assumption that net exports
enter the model as a lump-sum and
that exports exceed imports. If imports
exceed exports, net exports is drawn as
a parallel line below C+I+G.
The distance between C+I+G and
C+I+G+NX represents lump-sum
net export expenditures.
At Y1, consumption equals the line
segment Y1A, consumption plus
investment is Y1B, consumption
plus investment plus government
spending is Y1C, and consumption
plus investment plus government plus
net exports is Y1E. C + I G NX
C+I+G+NX E
C+I+G C
C+I B C A Y1 Y

26. Net Exports in the AE/AS Model
Changes in net exports cause the net exports line and, therefore, the aggregate expenditure line to shift.
Increases in net exports shift NX and AE up.
Decreases in net exports shift NX and AE down.

27. Net Exports in the AE/AS ModelC + I G NX AS
An increase in net exports
NX2 to NX3 shifts
aggregate expenditures from AE2 to AE3.
A decrease in net exports
from NX2 to NX1 shifts aggregate expenditures from AE2 to AE1.
Note that as net exports
change so does equilibrium
income, Y.
C+I+G+NX3 = AE3
C+I+G+NX2 = AE2 C
C+I+G+NX1 = AE1 B A
Y Y Y3 Y

28. Practice
How will the following events affect the aggregate expenditure line and national income? Why?
An increase in consumer optimism
A decrease in taxes paid by consumers
A rise in the general price level
A rising preference for BMWs
A rise in the stock market
An increase in government spending
Real wealth increases
Interest rates decline
A fall in the value of the dollar

29. Equilibrium in the Model
When the model is in equilibrium, all goods and services produced are demanded by the members of the various sectors of the economy.
Aggregate expenditures = Aggregate supply
The equilibrium in this model is stable.
There are forces built into the model that push it towards equilibrium.

30. Stability of Equilibrium
At Y equal to Y1 , AE > AS by the
amount AB. The excess demand is met
by an unexpected decrease in inventories.
The sudden decrease signals producers to
increase production. As production rises,
employment and national income rise.
AE= C + I G NX AS C AE D E
At Y equal to Y3 , AE < AS by the
amount CD. Insufficient demand leads to
an unexpected increase in inventories.
The sudden increase signals producers to
decrease production. As production falls,
employment and national income fall. A B
Y Y Y3 Y
At Y2 , AE = AS.

31. Equilibrium with Algebra
Y = C + I + G
C = a + bYd
Yd = Y - T
I = I
G = G
Y = a + b(Y-T) + I + G
Y = a + bY - bT + I + G
Y - bY = a - bT + I + G
Y(1 - b) = a - bT + I + G
Y = a - bT + I + G/(1-b)
Y = C + I + G
C = Yd
Yd = Y
I = 900
G = 1300
Y = (Y-1200)
Y = Y
Y = Y
Y - 0.8Y = 1540
Y(1-0.8) = 1540
Y = 1540/0.2 = 7700

32. Practice Y = C + I + G C = 100 + 0.9 Yd Yd = Y - T
T = 30, I = 250, G = 300
Find equilibrium Y.
Let the MPC = 0.8 and all other variables remain the same and find equilibrium Y.
Let the MPC = 0.9 and taxes increase to 40 and find equilibrium Y.
Is the equilibrium stable? Why?

33. The Multiplier
The multiplier is the ratio of the change in equilibrium GDP (Y) divided by the original change in spending that causes the change in GDP.
Investment multiplier = /\Y//\I
Government spending multiplier = /\Y//\G
GDP changes by a greater amount because a single change in spending ripples through the economy changing production, employment, and consumption again and again.

34. Multiplier Process AS The multiplier process begins at an
initial equilibrium level of Y such as Y1,
where AE=AS.
It is initiated by an autonomous change
in spending that causes AE to exceed AS.
We show that change as a shift in AE from
AE1 to AE2. Now at Y1, AE is greater than
AS by the amount BE1.
At this point, inventories fall and are
replaced with new production that causes
an increase in employment. As employment
increases, income increases, and as income
increases, consumption rises.
We are now at D. We repeat the process
until we reach E2. AS AE
AE2 E2 G
AE1 D F B C E1
Y Y2 Y

35. Multiplier: Example Let /\I = 100 and the MPC = 0.8 /\I /\Yd /\C /\S

36. Multiplier Formulas
The numerical value of the multiplier can be found with the following formulas:
The formula for the investment and government spending multiplier is:
m = 1/(1-b) or equivalently m = 1/MPS
The formula for the lump-sum tax multiplier is:
m = -b/(1-b) or equivalently m = -b/MPS
Note that (1-b), the MPS, represents spending that is not occurring.
It is a leakage out of the spending stream, and as it becomes larger, the multiplier becomes smaller.

37. Practice Given the following, fill in the blanks
Yd Consumption MPC MPS Spending Multiplier
Yd = Disposable income

38. Practice Given the following, fill in the blanks
Yd Consumption MPC MPS Tax Multiplier
Yd = Disposable income

39. Practice Fill in the blanks in the table below:
MPC Multiplier Change in Y if /\I = $1000
0.9
0.8
0.75
0.6
0.5

40. Practice
If the MPC is 0.9, and the government increases spending by 1.7 billion, by how much will Y change?
If the MPC is 0.9, and the government increases taxes by 1.7 billion, by how much will Y change?
If the MPC is 0.9, and the government simultaneously increases spending and increases taxes by 1.7 billion, by how much will Y change?
Any thoughts?