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Aggregate Expenditure (AE)› The total spending on goods and services

produced in the country. › This spending consists of four elements

and these are: Consumer spending by households (C) Investment expenditure by firms (I) Spending by the government (G) Exports to overseas countries (X)

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AE = C + I + G + ( X- M )

Aggregate output › The total quantity of goods and services

produced (or supplied) in an economy in a given period.

Aggregate income › The total income received by all factors of

production in a given period. Aggregate output (income) (Y)

› A combined term used to remind you of the exact equality between aggregate output and aggregate income.

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National incomeY = C + S + T + M

National product Y = C + I + G + X

In equilibrium:

C + S + T + M = C + I + G + X or equivalently

S + T + M = I + G + X

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Two ways to determine the equilibrium level of national income:› planned expenditure = planned output

Y = C + I + G + (X – M)› planned injection = planned leakages

I + G + X = S + T + M

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I + G + X > S + T + M (expansion)

I + G + X < S + T + M (recession)

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Circular Flow of National Income Model

Y = C + S A household can do two, and only two,

things with its income (Y): › It can buy goods and services → consume (C)› It can save → saving (S)

Consumption› Household purchases of final goods and

services. Saving

› The part of its income that a household does not consume in a given period.

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All income is either spent on consumption or saved in an economy in which there are no taxes.

Consumption is the dependent variable because depends on the disposable income.

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Some determinants of aggregate consumption include:› Household income› Household wealth› Interest rate› Households’ expectations about the future

Consumption function:› The relationship between consumption and

income, others thing constant.

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• For an individual household, the consumption function shows the level of consumption at each level of household income.

• The household consumption increased with household income, assuming other determinants remain constant.

• The higher your income is, the higher your consumption is likely to be.

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0 1 b<

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C a bY= Marginal Propensity to Consume

(MPC)

Definition:› The fraction of a change in income that is

consumed.› The change in consumption divided by the

change in income caused it. Formula:

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Y

C

function nconsumptioof slopeconsume to propensity marginal

Definition:› The part of its income that a household

does not consume in a given period. Once we know how much consumption

will result from a given level of income, we know how much saving there will be.

Formula:

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Saving ≡ income − consumption

S ≡ Y − C

Definition: › The relationship between saving and

income while other things constant. Figure:

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Marginal Propensity to Save

(MPS)

ΔS

ΔY

Slope = ΔS /ΔY

Definition:› The fraction of a change in income that is

saved.› The change in saving divided by the

change in income that caused it. Formula:

M P SS

Y

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The marginal propensity to consume plus the marginal propensity to save must sum to 1.› Because disposable income is either spent or

saved. Formula:

Question: › If Malaysia income increases from RM14.0 trillion to

RM14.5 trillion, consumption increases by RM0.4 trillion and saving by RM0.1 trillion. What is the MPC and MPS?

1MPC + MPS

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AGGREGATEINCOME, Y

(BILLIONS OF DOLLARS)

AGGREGATE CONSUMPTION, C

(BILLIONS OF DOLLARS)

0 100

80 160

100 175

200 250

400 400

600 550

800 700

1,000 850

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C Y 1 0 0 7 5.

• At a national income of zero, consumption is $100 billion (a).

• For every $100 billion increase in income (Y), consumption rises by $75 billion (C).

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C Y 1 0 0 7 5.

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S Y C Y - C = S

AGGREGATEINCOME

(Billions of Dollars)

AGGREGATE CONSUMPTION

(Billions of Dollars)

AGGREGATE SAVING

(Billions of Dollars)

0 100 -100

80 160 -80

100 175 -75

200 250 -50

400 400 0

600 550 50

800 700 100

1,000 850 150

C Y 1 0 0 7 5.

C > Y

S (-ve)

C < Y

S (+ve)

Investment › Refers to purchases by firms of new buildings

and equipment and additions to inventories, all of which add to firms’ capital stock. Inventory change is partly determined by how much

households decide to buy, which is not under the complete control of firms.

Desired or planned investment › The additions to capital stock and inventory

that are planned by firms. Actual investment

› The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

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change in inventory = production – sales

• Assume that planned investment is fixed. – It does not change

when income changes.

– not to depend on the state of the economy.

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Definition:› The total amount the economy plans to

spend in a given period. › It is equal to consumption plus planned

investment. Formula:

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ICAE

investment plannednconsumptio eexpenditur aggregate planned

Government expenditure (G)› Spending for goods and services by all

levels of government. Net taxes (T)

› Taxes paid by firms and households to the government minus transfer payments made to households by the government.

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Disposable income (Yd)› The income households have available to

spend or to save after paying taxes and receiving transfer payment.

› Formula: disposable income ≡ total income − net

taxes [ Yd ≡ (Y − T) ]

Budget deficit› The difference between what a

government spends and what it collects in taxes in a given period.

› Formula:

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[ budget deficit ≡ (G − T) ]

Before taxes:C = a + bY

After taxes:C = a + bYd

or C = a + b(Y − T)

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Expenditures by foreign residents on the product produced and sold by the domestic firms.

It depend greatly on the income level of the foreign residents and the exchange rate between domestic currency and the currency of the foreign residents.

Domestic income, Y, has no effect on real exports. The export schedule hence is a horizontal line too.

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Equilibrium› occurs when there is no tendency for

change.› In the macroeconomic goods market,

equilibrium occurs when planned aggregate expenditure is equal to aggregate output.

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Planned aggregate < output

Keynesian cross

Planned aggregate > output

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Y > C + Iaggregate output > planned aggregate expenditure

inventory investment is greater than plannedactual investment is greater than planned investment

Disequilibria:

C + I > Yplanned aggregate expenditure > aggregate output

inventory investment is smaller than plannedactual investment is less than planned investment

aggregate output: Yplanned aggregate expenditure: AE = C + I

equilibrium: Y = AE, or Y = C + I

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Y Y 1 0 0 7 5 2 5.

Y C I (1)

C Y 1 0 0 7 5.(2)

I 2 5(3)

By substituting (2) and (3) into (1) we get:

There is only one value of Y for which this statement is true. We can find it by rearranging terms:

Y Y 1 0 0 7 5 2 5.

Y Y .7 5 1 0 0 2 5Y Y .7 5 1 2 5

.2 5 1 2 5Y

Y 1 2 5

2 55 0 0

.

Consumption (C) 0.5Yd

Net investment (I) 100

Government spending (G) 200

Income Tax (T) 20

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Calculate the equilibrium level of national income

Consumption (C) 0.5Yd

Net investment (I) 100

Government spending (G) 200

Export (X) 50

Import (M) 0.35Y

Income Tax (T) 0.2Y

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Calculate the equilibrium level of national income

Multiplier› The ratio of the change in the equilibrium level

of output to a change in some autonomous variable . Autonomous variable → a variable that is assumed not

to depend on the state of the economy—that is, it does not change when the economy changes.

For example: planned investment, government expenditure and net export.

The multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.

The size of the multiplier depends on the slope of the planned aggregate expenditure line.

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The marginal propensity to save may be expressed as:

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M P SS

Y

m ultip lierM P S

1

or m ultip lierM P C

1

1

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• After an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment.

Multiplier ???

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