-
8(20)
Aggregate
Expenditure and
Equilibrium Output
OUTLINE OF TEXT MATERIAL
I.
Introduction
A.
This chapter starts presenting
macroeconomic theory.
1.
2.
B.
1.
2.
3.
???
What factors determine GDP?
What causes inflation and unemployment?
Newly-produced goods and services (GDP)
markets
Assets markets (financial and
real)
Labor markets
Macroeconomics divides the economy into
three sectors:
TEACHING TIP:
Introductory students often have a difficult time
mastering the
basic
Keynesian
model. You can
ease their task considerably by using the same
symbols and abbreviations as the
text.
It
is
surprising
how
disturbed
students
become
even
if
a
superscript
is
changed
to
a
subscript!
?
II.
Aggregate Output and
Aggregate Income (Y)
A.
When
aggregate output increases, additional income is
generated and vice versa.
1.
2.
3.
Aggregate
output
is the total quantity of goods
and services produced (or
supplied) in
an economy in a given period.
Aggregate
income
is the total income received by
all factors of production
in a given
period.
Aggregate
output
(income)
(Y)
is
a
combined
term
used
to
remind
students
of
the
exact
equality
between
aggregate
output
and
aggregate
income.
63
64
Principles of Macroeconomics
B.
Income, Consumption, and Saving (Y, C,
and S)
1.
2.
Disposable personal income is consumed
and saved.
Saving
is the
part of
its income that a household
does not consume in a given period.
Since we are assuming no government and
no taxes, disposable personal
income
and personal income are the same.
???
TEACHING
TIP:
Explain
the
meaning
of
the
identity
symbol
(
?
)
as
this
is
the
first
time
most
students will have seen it used.
The
authors
make
a
careful
distinction
between
saving
(the
part
of
income
not
spent,
a
flow
variable) and savings (wealth, a stock
variable). Rather than forcing your students to
listen for
that trailing s, just call
savings wealth instead.
?
C.
???
Explaining Spending Behavior
TEACHING
TIP:
The
text
uses
lowercase
letters
for
the
household
consumption
function
and
uppercase letters for
the aggregate consumption
function.
?
1.
Household Consumption and Saving depend
on:
a.
b.
c.
Household
income:
higher
income
leads
to
higher
spending
and
saving.
Household
wealth:
higher
wealth
leads
to
higher
spending
and
saving.
Interest rates reflect the cost of
borrowing, so lower rates increase
spending
but
may
reduce
saving
(there
are
income
and
substitution effects).
Households’
expectations
about
the
future:
If
expectations
improve, spending will increase.
d.
???
TEACHING TIP: This is a good point to
introduce the permanent income model (but probably
too
early
to
call
it
that).
Just
point
out
that
if
your
expectations
of
your
future
income
suddenly
increase
(you’ve
discovered
Great
Aunt
Clara
has
included
you
in
her
will),
you
will
probably
increase your spending
today.
?
2.
The
consumption
function
is
the
relationship
between
spending
and
disposable income.
a.
b.
The
marginal
propensity
to
consume
(MPC)
is
the
fraction
of
a
change in income that is
consumed.
The MPC is also the slope of
the consumption function.
???
TEACHING TIP:
Keynes described it best when he wrote in the
General Theory of Employment,
Interest, and Money
(Book III, Chapter 8): “The fundamental
psychological law…is that men are
disposed, as a rule and on the average,
to increase their consumption as their income
increases,
but not by as much as the
increase in their income.”
?
3.
The
saving
function
is the relationship between
saving and income.
a.
b.
c.
The
marginal
propensity to save (MPS)
is the
fraction of a change
in income that is
saved.
The MPS is also the slope of the
saving function.
The MPC and the MPS
must sum to one.
Chapter 8 [20]:
Aggregate Expenditure and Equilibrium Output 65
???
TEACHING
TIP:
Explain
this
point
in
the
following
way:
For
the
entire
economy
the
MPC
must
take
on
a
value
between
0
and
1.
Any
change
in
income
(
Y
)
will
be
divided
up
between
consumption (
C
)
and saving (
S
), that is
?
Y =
?
C +
?
S
Divide each side of the above equation
by
?
Y
?
Y/
?
Y
=
?
C/
?
Y
+
?
S/
?
Y
or 1 = MPC + MPS
?
TOPIC FOR CLASS
DISCUSSION
:
Even though MPC + MPS must equal 1.00
for an entire economy that’s not true for
individuals.
Ask students if
they’ve ever had a month in which
they’
ve spent more than their income.
If so,
their
MPC
has
exceeded
1.00
for
that
month.
(Technically
it’s
the
APC,
but
don’t
let
the
discussion get bogged down in technical
details.)
This opens the door to a
larger discussion of exactly who the savers in the
economy are. Students
often find it
difficult to believe the MPC is less than 1.00
because of their personal experience.
Point out that an economy is made up of
a wide variety of people. At any time some are
going
into debt (buying a house or car)
while others are paying off debt and saving for
retirement. Still
others are spending
their wealth in retirement. Mention that
economists call this the life cycle
model of consumption, saving, and
wealth.
?
4.
???
Households
only
consume
and
save.
They
do
not
invest.
Investment
is
business spending on new plant and
equipment.
TEACHING TIP: Case and Fair
use the example C = 100 + 0.75 Y. Students
generally pick up this
material
faster
with
numerical
examples,
no
matter
how
contrived
they
seem.
Follow
the
authors’
example
through
Fig.
8.5
[20.5]
and
beyond.
Use
the
numbers.
Using
the
same
numerical examples as those in the text
may seem repetitive to you but your students will
thank
you. (After you’ve covered the
examples in the text you can, of course, make up
one or two of
your
own.)
?
D.
Planned Investment (I)
1.
Investment
is
spending
by
firms
on
new
buildings
and
equipment
and
additions to inventories.
a.
Spending
on
buildings
and
equipment
is
called
business
fixed
investment
.
Fixed
investment
is
the
gross
increase
in
the
capital
stock. Fixed
investment minus depreciation is the net increase
in
the capital stock.
The
net
change
in
business
inventories
is
included
to
convert
spending into
production. See chapter 6 [18] in this manual for
a
more complete explanation.
b.
???
TEACHING
TIP:
It
is
important
to
review
the
definition
of
investment,
as
students
will
always
want
to
associate
the
word
with
buying
financial
assets.
Use
local
examples
of
investment
to
solidify students’ understanding of the
term as applied by
economists.
?
2.
Actual Versus Planned Investment
a.
A firm may not always end
up investing the exact amount that it
planned.
b.
Firms
do
not
control
inventory
in
that
if
there
are
fewer
sales
than
expected, inventory increases and so
actual investment will be greater
than
planned.
However,
firms
sometimes
change
their
desired
inventory
levels.
Not
every
change
in
inventory
is
an
unplanned
change.
66 Principles of Macroeconomics
???
TEACHING
TIP:
It
is
im
portant
that
students
understand
the
concept
of
“unplanned
changes
in
inventories”
because
of
the
role
it
plays
in
the
equilibrium
adjustment
process.
Writing
the
following cases on the
board and then discussing them will help set the
stage for the subsequent
discussion of
the equilibrium adjustment process.
?
?
?
If
actual
investment
>
planned
investment,
then
inventories
are
accumulating
above
desired levels, giving firms the
incentive to cut back on current output (income).
If
actual
investment
<
planned
investment,
then
inventories
are
being
drawn
down
below desired levels,
giving firms the incentive to increase current
output (income).
If actual investment =
planned investment, then
inventories
are
at
the
desired
levels.
Firms will continue to produce the
current output level.
?
E.
III.
A.
Planned Aggregate Expenditure
(AE)
is consumption plus planned
investment.
At
equilibrium
, planned
aggregate expenditure is equal to aggregate
output.
1.
2.
This implies planned investment equals
actual investment.
It also implies
there is no unplanned change in inventories.
Equilibrium Aggregate Output (Income)
???
???
TEACHING
TIP:
Emphasize
that
these
three
definitions
are
really
just
three
ways
of
saying
the
same
thing.
?
TEACHING
TIP: If you have the time, Extended Application 2
shows one way of presenting the 45?
line. If time is a problem, emphasize
to your students that the 45?
line is
simply a graph of the
line
along
which
planned
spending
equals
actual
output.
The
45?
line
shows
all
the
possible
points
where
equilibrium
might
occur.
(I
try
to
avoid
using
the
phrase
“45?
line”
as
much
as
possible.)
?
B.
The Saving/Investment
Approach to Equilibrium
1.
Equilibrium occurs when savings equals
planned investment.
a.
b.
2.
Saving
always
equals
actual
investment.
(Saving
only
equals
planned investment in equilibrium.)
When saving does not equal planned
investment the difference is
the
unplanned inventory change.
Saving flow
into the financial markets and are then lent to
firms to use for
investment. The
leakage is matched by the injection as long as all
saving is
loaned to firms for fixed
investment.
a.
In
equilibrium, saving equals planned investment.
That means the
flow of saving into
financial markets will be matched by planned
investment only in equilibrium.
Saving
always
equals
actual
investment.
However,
some
of
that
investment may be an unplanned
inventory change.
b.
???
TEACHING
TIP:
If
households
save
more
than
businesses
expect
that
means
consumption
must
have been less than was forecast.
Consumption spending below what was forecast must
mean an
unplanned
inventory
increase.
It’s
easy
to
show
that
the
amount
of
the
unplanned
inventory
increase will
exactly match the unexpected drop in consumption
(increase in saving). Therefore,
any
unplanned change in saving will be exactly matched
by an unplanned change in
inventories.
?
Chapter 8 [20]: Aggregate Expenditure
and Equilibrium Output 67
???
TEACHING TIP: A simple way (and very
visual way) to show students the equivalence of
the two
equilibrium conditions Y = C +
I and S = I follows:
Draw
a
rectangle
representing
some
given
level
of
output.
As
students
already
know
from
national income accounting, output and
income are equal, so draw another rectangle (the
same
size) indicating the value of
total income in the economy.
What
happens to this income? With no government or
foreign sector, households can only spend
or
save
their
income.
Draw
a
third
rectangle
—
smaller
than
the
first
or
second
—
indicating
the
value of consumption
spending. On this rectangle, show savings as a
leakage and investment as
an injection.
The last rectangle
—
total
spending
—
shows the net
result of subtracting saving from
income and adding investment.
Compare
the
first
and
fourth
rectangles.
The
first
indicates
output;
the
fourth
indicates
total
spending
on
output.
Equilibrium
requires
these
two
rectangles
to
be
the
same
size.
When
will
this occur? Note from the diagram that
the equality of output and spending (Y = C + I)
requires
the equality of saving and
investment (S = I).
Leakages
S
Injections
I
I
C
Output<
/p>
Income
C
Aggregate
expenditure
?
C.
Adjustment to Equilibrium
1.
If output
(income)
is
greater
than
planned
aggregate
expenditure,
there
will
be
an
unplanned
inventory
increase.
The
signal
to
businesses
is
warehouses
filling
up.
Businesses
respond
by
reducing
production,
moving the economy toward equilibrium
(and, possibly, into a recession).
If
output (income) is less than planned aggregate
expenditure, there will
be
an
unplanned
inventory
decrease.
The
signal
to
businesses
is
warehouses
emptying.
Businesses
respond
by
increasing
production,
moving the
economy toward equilibrium (and, possibly, into a
boom).
2.
???
TEACHING
TIP:
Point
out
the
implicit
assumption:
The
price
level
is
constant.
Therefore,
businesses can’t
respond to unplanned inventory changes by raising
or lowering prices as well as
output.
?
IV..
The Multiplier
A.
A
change
in
planned
investment
will
cause
a
multiplied
effect
on
equilibrium
income.
1.
The
multiplier
is the ratio of
the change in the equilibrium level of output
to a change in some autonomous
variable. An
autonomous
variable
is a
variable that
is assumed not to dependon the state of the
economy
—
that
is,
it does not change when the economy changes.