I. Introduction
A. Objectives
1. To study the components of Aggregate Expenditure (AE).
2. To learn about their relative magnitudes and volatility.
3. To understand how they are determined.
4. To understand how the components determine the equilibrium aggregate expenditure
B. Outline of Lecture
1. The composition of Aggregate Expenditure
2 Consumption and saving
3. Investment
4 Government and foreign demand
5. Total aggregate expenditure
C. I want to clear up a source of confusion. Begg refers to aggregate expenditure (AE) as aggregate demand (AD).
1. Begg's use of terminology is non-standard.
2. You may wish to make pen changes in your text.
a. Where Begg refers to aggregate demand (AD), replace that by aggregate expenditure (AE).
I. The Components of Aggregate Expenditure (AE)
A. In this analysis we will assume a fixed price level.
1. We are now interested in showing how the aggregate quantity demanded (YD) is determined at a given price level (P)
2. Later we will examine the effects of changes in the price level (P).
(B 21-2)
B. There are four components of aggregate expenditure:
1. consumption expenditures, (C)
2. Investment, (I)
3. government purchases of goods and services, (G) and
4. net exports (NX).
C. Hence AE = C + I + G + NX
D. Expenditure Patterns in the U.S.A.:
1. (C) Consumption is the largest part of aggregate expenditure
a. but does not fluctuate much.
2. (I) Investment is a smaller component of aggregate expenditure
a. but is quite volatile.
3. (G) Government spending is about the same as Investment
a. but is much less volatile.
4. (NX) net exports is close to zero,
a. but it is also quite volatile
E. Co-variations in expenditures in the US
1. Consumption (C) and government spending (G) tend to move together.
2. Consumption (C) and investment (I) tend to move together
3. Investment (I) and net exports (NX) tend to move in opposite directions
II. Consumption Expenditure and Saving
A. Households can allocate their disposable incomes (YD = Y - NT) either to:
1. Consumption or
2. Saving
YD = C + S
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A. Consumption expenditure (C) is the value of the goods and services purchased by households.
B. The most important factors affecting consumption expenditure are
1. disposable income (YD) and
2. expected future disposable income (EXYD).
C. Disposable income (YD) is the aggregate income that households receive for supplying the services of factors of production
1. plus transfers from government (TR) or (B) and
2. less the direct taxes (T) they pay.
YD = Y + TR - T = Y - NT
D. A household's expected disposable income (EXYD) depends on:
1. income growth prospects and
2. growth prospects of the member's jobs.
E. Increases in either disposable income (YD), or expected disposable income,(EXYD) will raise consumption expenditure (C).
F. The consumption function is: the relationship between:
1. consumption spending (C) and
2. disposable income (YD),
3. holding everything else constant.
C = f(YD)
G. The consumption function shows:
1. the level of aggregate consumption (C) desired
2. at each level of disposable income (YD).
H. The consumption function can be expressed as
1. An equation
a. C = CA + b * YD
b. e. g. C = 10 + .9 * YD
2. A schedule
YD C
0 10
10 19
20 28
100 100
200 190
3. A curve on a graph
a. Consumption (C) on the y-axis
b. Disposable Income (YD) on the x-axis
I. The 45 degree line (slope of 1) connects all points at which:
1. Consumption (C) measured on the vertical axis equals
2. disposable income (YD) measured on the horizontal axis.
J. When the consumption function is below the 45 degree line,
1. Consumption (C) is less than disposable income (YD)
C < YD
b. saving (S) is positive;
S > 0
c. Household savings (S) is equal to Disposable income (YD) less consumption (C)
S = YD - C
2. When the consumption function is above the 45 degree line,
a. Consumption (C) exceeds disposable income (YD)
C > YD
b. saving (S) is negative,
S < 0
c. Negative saving is called dissaving.
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A. The savings function is the relationship between:
1. saving (S) and
2. disposable income (YD),
3. holding everything else constant.
S = f (YD)
B. This relationship can be expressed as
1. An equation
a. S = -CA + (1- b) * YD
b. e. g. S = -10 + .1 * YD
2. A schedule
YD S
0 -10
10 -9
20 -8
100 0
200 10
3. A curve on a graph
a. Saving (S) on the y-axis
b. Disposable Income (YD) on the x-axis
D. The 45 degree line (slope of 1) connects all points at which:
1. saving (S), measured on the vertical axis equals
2. disposable income (YD) measured on the horizontal axis.
E. When the saving function is below the horizontal axis
1. Consumption (C) exceeds disposable income (YD)
C > YD
2. saving (S) is negative,
S < 0
3. Negative saving is called dissaving.
F. When the saving function is above the horizontal axis
1. Consumption (C) is less than disposable income (YD)
C < YD
2. saving (S) is positive;
S > 0
G. Since a household can only consume or save its disposable income,
1. Consumption plus Saving always add up to disposable income (YD).
YD = C + S
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A. There are two key parameters of the consumption function.
1. The marginal propensity to consume (MPC) and
2. autonomous consumption (CA)
B. The average propensity to consume (APC) equals:
1. total consumption (C) divided by
2. total disposable income (YD);
APC = C / YD
C. The average propensity to consume (APC) varies with the level of income
1. As average income (Y) rises,
a. the average propensity to consume (APC) falls.
2. As people's incomes rise,
a. they are able to meet their consumption requirements with a smaller proportion of their income.
D. The average propensity to save (APS) equals:
1. Total saving (S) divided by total
2. disposable income (YD).
APS = S / YD
E. The average propensity to save (APS) varies with the level of income
1. In general, as aggregate income (Y) rises,
a. the average propensity to save (APS) rises.
F. The marginal propensity to consume (MPC) is:
1. the fraction of each extra unit of disposable income (YD) spent on consumption (C);
MPC = DELTA C / DELTA YD
2. The MPC equals the slope of the consumption function (b).
MPC = b
3. The MPC is the change in consumption (C) divided by the change in disposable income (YD).
MPC = DELTA C / DELTA YD = b
3. The marginal propensity to consume (MPC) out of disposable income (YD) is typically designated by the letter "b"
G. the marginal propensity of save (MPS) is:
1. the fraction of the each extra unit of disposable income (YD) that is saved.
MPS = DELTA S / DELTA YD
1. The MPS equals the slope of the savings function.
a. The slope of the savings function is equal to 1 minus the MPC.
MPS = 1 - b
2. The MPS is equal to the change in savings (S) divided by the change in disposable income (YD).
MPS = DELTA S / DELTA YD = (1 - b)
E. The marginal propensity to save (MPS) out of disposable income is typically designated by the expression (1 - b)
1. Since each extra unit of disposable income must go into consumption (C) or be saved (S),
2. The MPC plus the MPS equals 1.
a. MPC + MPS = 1 and
b. MPS = 1 - MPC
2. Econometric studies show
a. For the US, the estimated MPC out of disposable income is 0.90.
b. For the UK, the estimated MPC is about the same.
c. For Vietnam, the estimated MPC is 0.xx.
H. Autonomous consumption (CA) refers to the consumption spending that would occur even if disposable income (YD) were zero.
1. CA is the ordinal intercept of the consumption function
2. The relationship between the APC and the MPC is given by the equation
APC = (CA / YD) + MPC
a. As long as CA is positive, the APC will be greater than the MPC
APC > MPC
b. As long as CA is positive, the APS will be less than the MPS
APS < MPS
c. If CA is zero, then APC = MPC
I. Endogenous consumption (CE) is that portion of consumption (C) that changes as disposable income changes (YD).
1. Endogenous consumption (CE) is equal to:
a. the level of disposable income (YD) times
b. the marginal propensity to consume (MPC)
CE = MPC * YD
J. Total consumption (C) is the sum of autonomous consumption (CE) plus endogenous consumption (CE)
C = CA + CE
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(B 22-2)
A. In most countries disposable income (YD) is closely related to GDP (Y);
1. In the US, about 30 % of GDP (Y) is paid to government as net taxes (NT),
a. The Average Net Tax Rate (t) is 30% or .3
b. so disposable income (YD) equals 70% (or 0.70) of GDP (Y).
i. Thus YD = Y * (1 - t)
YD = Y - NT
t = NT/Y = .3
NT = .3 Y
YD = Y - .3Y = .7Y
c. As incomes (Y) rise,
i. taxes (T) rise and
ii. transfer payments (TR) fall
iii. so net taxes (NT) rise.
iv. So the gap between YD and Y increases.
YD = Y - NT
B. The marginal propensity to consume out of real GDP (MPC') is:
1. the change in consumption expenditure (C) divided by
2. the change in real GDP (Y).
MPC' = DELTA C / DELTA Y
C. The Marginal Propensity to Consume out of GDP (MPC') is equal to
1. the MPC out of YD
2. multiplied by (1 - the average net tax rate (t))
MPC ' = MPC * (1 - t)
a. Proof
Define MPC'
(1) MPC' = DELTA C / DELTA Y
Define MPC
(2) MPC = DELTA C / DELTA YD
From the definition of MPC
(3) DELTA C = MPC * DELTA YD
From definition of YD
DELTA YD = DELTA Y - DELTA NT
DELTA NT = t * DELTA Y
DELTA YD = DELTA Y - t * DELTA Y
Factor out DELTA Y
DELTA YD = DELTA Y * ( 1 - t)
Substitute into Equation 3
DELTA C = MPC * DELTA Y * (1- t)
Substitute into Equation 1
MPC' = MPC * DELTA Y * (1 - t) / DELTA Y
Divide LHS by DELTA Y
MPC' = MPC * (1 - t)
c. (1 - t) is the fraction of GDP (Y) that goes to Disposable Income (YD)
d. Since (1 - t) is less than one,
i. MPC' is less than MPC.
MPC' < MPC
2. In the US the marginal propensity to consume out of GDP (MPC') equals
i. the MPC = (0.90) times
ii. the fraction of GDP that goes to disposable income (1 - t) = (0.70)
iii. MPC' = 0.63.
b. In general the MPC out of GDP (MPC') will be smaller than the MPC out of YD.
i. The effect of net taxes (NT) is to reduce the MPC'.
ii. The larger the value of t, the smaller the value of MPC' and the larger the gap between MPC and MPC'.
III. Investment
A. Gross investment (I) demand is the total desired purchases of new investment goods during a time period.
1. Investment goods include:
a. plant
b. equipment
c. inventories
2. Gross investment (I) demand is comprised of:
a. net investment (purchases of new capital equipment) and
b. replacement investment (purchases to replace worn out or depreciated capital).
B. The amount of investment spending (I) generally does not depend on the level of income (Y).
C. The amount of investment (I) demand depends on three factors:
1. real interest rates (r),
2. profit expectations, and
3. the existing capital stock (K).
C. The higher the real interest rate (r), the lower the amount of investment demanded (I).
1. The real interest rate, (r) is:
a. the rate of interest paid by the borrower and received by the lender
b. after taking account of changes in the value of money caused by inflation.
2. The real interest rate (r) approximately equals:
a. the nominal interest rate (rn) minus
b. the inflation rate (INFRTE).
r = rn - INFRTE
i. If the inflation rate is 0, then r = rn
c. The real interest forgone is the opportunity cost of using your funds to finance an investment project.
i. The lower the real interest rate (r), the lower the cost of any given project.
ii. Some projects that are not profitable at high real interest rates (r) become profitable at low r's
iii. The lower the real interest rates, (r) the larger the number of profitable projects.
2. The greater the expected profit from new capital (II), the larger the investment desired. (I)
a. Among the influences on profit expectations are:
i. Taxes on profits
ii. Phase of business cycle
iii. International developments
3. A firm's capital stock (K) influences its investment decisions in two ways:
a. The larger the capital stock (K),
i. the more investment is needed to replace depreciated capital.
b. The greater the degree of utilization of existing capital,
i. the larger the amount of investment is needed.
C. Investment demand (II) is the relationship between:
1. the amount of planned investment (I) and
2. the real interest rate (r).
II = f (r)
D. The demand for investment goods (II) can be expressed as
1. an equation
2. A schedule
3. A line on a graph
E. The investment demand schedule, (II) is a list of:
1. how much investment (I) is demanded
2. at each real interest rate (r),
3. holding everything else constant.
a. (e.g. holding constant profit expectations and the capital stock)
r I
10% 100
8% 200
6% 250
4% 275
2% 300
2. The investment demand curve graphs the investment demand schedule, (II).
a. The real interest rate (r) on the y-axis
b. The level of investment (I) on the x-axis
c. This is a reversal of normal graphing practice, similar to Supply and Demand.
D. Since investment (I) depends negatively on the real interest rate (r),
1. the investment demand (II) curve is downward sloping.
DELTA I / DELTA r < 0
E. Changes in the expected profitability of investment (or in existing capital) shift the investment demand (II) curve.
1. If profits are expected to increase
a. II will shift to the right
2. A larger capital stock (K) will shift II to the right.
a. Investment (I) for replacement grows steadily over time.
b. An increase in the rate of utilization will shift the II curve to the right.
3. In the US, changes in the II curve due to profit expectations were more important in determining I than changes in real interest rates (r).
a. Investment (I) was insensitive to changes in real interest rates (r).
4. It is generally assumed that investment demand (II) is not affected by current GDP (Y) because:
a. firms are concerned with future sales when they decide to invest.
b. Investment expenditure is autonomous
I = IA
IV. Government Purchases of Goods and Services
A. Government purchases of goods and services (G) include spending for schools, roads, military, administration.
1. They do not include transfer payments (TR) or benefits (B) (e.g. government pensions)
B. Government purchases (G) are in large part determined by the political process.
1. They do not vary in a systematic way with fluctuations in real GDP (Y).
2. They are made on fixed timetables and do not respond quickly to changing economic situations.
a. Government expenditure is autonomous
G = GA
V. Net Exports
A. Net exports (NX) are:
1. Expenditures by foreigners on goods produced in the country (exports) (X) minus
2. expenditures by residents of the country on foreign produced goods (imports) (Z).
NX = X - Z
B. Exports (X) are determined by decisions made in the rest of the world.
1. Exports (X) are determined by four main factors :
a. real GDP (Y) in the rest of the world;
b. The degree of international specialization;
c. The prices of domestic goods relative to prices of foreign goods; and
d. foreign exchange rates.
2. Exports (X) increase with
a. increases in foreign real GDP (Y),
b. increases in international specialization,
c. decreases in relative domestic prices.
b. The lower the value of the domestic currency relative to foreign currencies.
3. Export expenditure is autonomous
X = XA
a. The export function can be graphed as a horizontal line.
i. Exports (X) on the y-axis
ii. GDP (Y) on the x-axis
C. Imports (Z) are influenced by four major factors:
a. domestic real GDP (Y)
b. The degree of international specialization;
c. The prices of foreign-made goods relative to prices of similar domestic goods;
d. and foreign exchange rates.
5. Imports (Z) increase with
a. Increases in domestic real GDP (Y),
Z = f (Y)
b. Increases in international specialization,
c. Increases in relative domestic prices.
d. The higher the value of the domestic currency relative to foreign currencies.
6. Imports are endogenous. They vary with domestic income (Y)
Z = f (Y)
a. Assumed to be linear function of GDP (Y) starting at the origin.
Z = MPZ * Y
b. The marginal propensity to import Z is the slope of the import function
MPZ = DELTA Z / DELTA Y
7. Because imports (Z) are endogenous, net exports (NX) are endogenous
NX = f (Y)
D. The net export function is the relationship between:
1. net exports (NX) and
2. domestic GDP (Y),
3. holding constant all other influences on exports (X) and imports (Z).
NX = f (Y)
1. The net export function can be shown as:
a. An equation
NX = X - Z
NX = XA - MPZ * Y
e.g. NX = 500 - .1 * Y
b. A schedule
Y NX
0 500
1000 400
2000 300
3000 200
c. A curve
i. Net exports (NX) on the y-axis
ii. GDP on the x- axis
2. Net exports (NX) decline as real GDP (Y) rises. Because as real GDP (Y) rises:
a. Exports (X) are constant
b. And imports (Z) increase
C. The position (intercept) of the net export function (XA) depends on:
a. Real GDP (Y) in the rest of the world
b. Degree of international specialization
c. Relative prices of domestic and foreign goods
d. Exchange rates.
V. Aggregate Planned Expenditure and Real GDP
A. Aggregate planned expenditure (APE) is the expenditure that households, firms and governments plan to undertake:
1. at a given level of GDP (Y),
2. holding everything else constant.
APE = C + I + G + NX
APE = f(Y)
3. The following are assumed to be constant:
a. Prices of outputs
b. Wages
c. Interest rates
d. Foreign incomes
e. Exchange rates
4. If any of those things change, they will shift the Aggregate Planned Expenditure (APE) curve
B. Aggregate planned expenditure (APE) may differ from actual aggregate expenditure (AE).
a. Actual expenditure (AE) is equal to real GDP (Y)
AE = Y
b. Can be represented by line with slope of 1 (the 45 degree line)
C. The aggregate planned expenditure function can be expressed as
1. an equation
2. a schedule
3. a graph
D. The aggregate planned expenditure (APE) equation can be derived by adding up the equations for the components of APE.
eg C = 10 + .8 * Y
I = 100
G = 50
X = 200
Z = .2 * Y
Hence NX = 200 - .2*Y
APE = 10 + .8*Y + 100 + 50 + 200 - .2*Y
APE = (10 + 100 + 50 + 200) + .8*Y - .2*Y
APE = 360 + .6*Y
C. The aggregate planned expenditure (APE) schedule is:
1. a list of the level of aggregate planned expenditure (APE)
2. at each level of real GDP (Y),
3. holding all other things constant.
D. The Aggregate Planned Expenditure (APE) schedule is constructed by
a. adding together C + I + G + NX
b. for each level of Real GDP (Y).
Y CA CE I G X Z APE
0 10 0 100 50 200 0 360
100 10 80 100 50 200 20 420
200 10 160 100 50 200 40 480
2. The APE schedule could be constructed from the APE equation,
e.g. APE = 360 + .6 * Y
Y APE
0 360
100 420
200 480
D. The aggregate planned expenditure curve graphs:
1. aggregate planned expenditure (APE) against
2. real GDP (Y),
3. assuming all other things constant.
E. The aggregate planned expenditure (APE)
1. Has a positive intercept (CA + I + G + X)
2. Has a positive slope
DELTA APE/ DELTA Y = MPC' - MPZ
VII Equilibrium Expenditure
(B 21-4)
A. Equilibrium expenditure occurs when aggregate planned expenditure (APE) equals real GDP (Y).
APE = Y
1. This is where the aggregate expenditure curve crosses a 45 degree line. (slope of 1)
2. In equilibrium: APE = AE = real GDP (Y)
B. Actual Aggregate Expenditure (AE) is always equal to real GDP (Y).
AE = Y
C. Actual Aggregate Expenditure (AE) may differ from planned Aggregate Expenditure (APE) because
1. Firms may end up with unplanned inventory accumulation or reductions. (UIA)
2. AE - APE = Unplanned inventory accumulation (UIA)
a. UIA may be positive or negative
3. AE = APE + Unplanned inventory accumulation (UIA)
D. In equilibrium, unplanned inventory accumulation (UIA) equals zero.
UIA = 0
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A. If aggregate planned expenditure (APE) is less than real GDP (Y),
1. The APE curve is below the 45 degree line,
2. firms find unwanted inventory accumulation (UIA).
UIA > 0
3. they cut production and real GDP (Y) by laying off workers.
4. This lowers workers' disposable incomes (YD) and therefore reduces their planned consumption (C).
a. The reduction in planned consumption (C) will be less than the reduction in wages (MPC'< 1)
b. Workers will also be reducing their planned savings (S).
c. Planned expenditure (APE) is reduced but by less than the fall in real GDP (Y).
i. Inventories will be reduced
ii. Thus the equilibrium restored.
d. Restoration of equilibrium could be a step by step process.
e. firms could go directly to equilibrium by anticipating the chain of events
B. If aggregate planned expenditure (APE) is greater than real GDP (Y)
1. The AE curve is above the 45 degree line
a. firms discover their inventories being run down below planned levels.
UIA < 0
b. Hence, they raise real GDP (Y) by increasing their production and hire more workers.
c. This raises workers' disposable incomes (YD) and also their planned consumption (C).
i. The increase in planned consumption (C) will be less than the increase in wages (MPC'< 1)
ii. Workers will also increase their planned savings (S).
d. Planned expenditure (APE) rises, but by not as much as the increase in real GDP (Y).
i. Inventories will rise to planned levels
ii. This restores equilibrium.
e. Restoration of equilibrium could be a step by step process.
f. firms could go directly to equilibrium by anticipating the chain of events
C. Once equilibrium is restored (UIA = 0) or APE = AE = real GDP,(Y) there are no further changes.
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A. The aggregate demand curve is made up of such equilibrium points where APE = AE = Y
1. One point on the Aggregate Demand Schedule (AD) for each price level (P).
2. A change in the price level (P) will shift the APE curve
1. The higher the price level (P), the lower the Aggregate Planned Expenditure (APE) because:
a. the real balance effect
b. the interest rate effect
c. the international effect
B. Note that the Aggregate Demand Schedule is not constructed like an industry demand schedule.
1. Not adding laterally the demand curves of households.
a. That analysis assumes incomes are fixed
2. Aggregate Demand Curve is a set of equilibrium points
a. At every point on the Aggregate Demand Curve, household incomes (and interest rates) have changed.
X. Summary of the lecture
Key Concepts
1. Aggregate Expenditure (AE)
4. Aggregate Planned Expenditure (APE)
5. Aggregate Planned Expenditure Schedule
6. Aggregate Planned Expenditure Curve
7. Average propensity to consume (APC)
8. Average propensity to save (APS)
8. Autonomous consumption (CA) (Tieu dung tu dinh)
9. Autonomous Investment Demand (IA) (Nhu cau dau tu tu dinh)
9. Consumption function (Ham tieu dung)
10. Dissaving
11. Equilibrium expenditure
12. Equilibrium Aggregate Output (Tong san luong can bang)
12. Investment demand
13. Investment Demand curve (II)
14. Marginal propensity to consume (MPC) (Thien huong tieu dung dien)
15. Marginal propensity to consume
out of real GDP (MPC')
16. Marginal propensity to save (MPS) (Thien huong tiet kiem bien)
17. Marginal propensity to save
out of real GDP (MPS')
18. Marginal Propensity to Import (MPZ) (Thien huong nhap khao bien)
18. Net export function
19 Nominal interest rate (rn)
19. Real interest rate (r)
20. Savings function (Ham tiet kiem)
Review questions
1. What are the components of aggregate expenditure?
2. In Viet Nam, which is the largest component of aggregate expenditure?
3. In Viet Nam, which components of Aggregate Expenditure fluctuate most?
4. What is the most important determinant of planned consumption expenditure (C)?
5. What is the difference between Disposable Income (YD) and GDP (Y)?
6. What is the relationship between the savings function and the consumption function?
7. Why is the marginal propensity to consume (MPC) less than one?
8.What are the main determinants of investment (I)?
9. Why does investment (I) increase as the real interest rate (r) falls?
10. What would happen if aggregate planned expenditure (APE) exceeded real GDP (Y)?