In any given period there is an exact equality between aggregate output production and aggregate income Be reminded of this when you encounter combined term aggregate output income Y Aggregate output means real GDP The Keynesian Theory of Consumption If you nd your income going up you will spend more than you did before Rise in consumption will be less than full rise in income Consumption function relationship between consumption and income Upward sloping because consumption increases with income Equation C a bY a point at which function intersects C axis a constant b slope of line or deltaC deltaY deltaC b x deltaY MPS deltaS deltaY S Y C Income not consumed is saved MPC of 75 means consumption changes by 75 of the change in income MPC slope of consumption function deltaC deltaY Marginal propensity to consume MPC the fraction of a change in income that is consumed or spent Aggregate saving S the part of aggregate income that is not consumed Marginal propensity to save MPS the fraction of a change in income that is saved MPC MPS 1 Other determinants of consumption Households with higher wealth are likely to spend more than households with less wealth Lower interest rates reduce cost of borrowing so lower interest rates are likely to stimulate spending As households think about what fraction of incremental income to consume versus save their expectations about the future play a role If households are optimistic and expect to do better in the future they may spend more at the present than if they think the future will be bleak Planned Investment I For time being we assume that planned investment is xed Does not change when income changes so graph is horizontal line Planned investment those additions to capital stock and inventory that are planned by rms Actual investment actual amount of investment that takes place includes items such as unplanned changes in inventories If rm overestimates now much it will sell in a period it will end up with more in its inventory than it planned to have On other occasions inventories may be lower than planned when sales are stronger than expected The Determination of Equilibrium Output Income Equilibrium occurs when there is no tendency for change In macroeconomic goods market equilibrium occurs when planned aggregate expenditure is equal to aggregate output Planned aggregate expenditure AE total amount the economy plans to spend in a given period AE C I Equilibrium Y AE Equilibrium Y C I Suppose aggregate output is greater than planned aggregate expenditure Y C I When output is greater than planned spending there is unplanned inventory investment Firms planned to sell more of their good than they sold and the difference shows up as unplanned increase in inventories Suppose planned aggregate expenditure is greater than aggregate output Y C I When planned spending exceeds output rms have sold more than they have planned to Inventory investment is smaller than planned The Saving Investment Approach to Equilibrium Because appreciate income must be saved of spent Y C S Equilibrium condition Y C I C S C I S I Thus there will be equilibrium only when planned investment equals savings Adjustment to Equilibrium How do rms react to disequilibrium Consider actions rms might take when planned aggregate expenditure exceeds aggregate output income Already know the only way rms can sell more than produce is by selling some inventory this means when planned aggregate expenditure exceeds aggregate output unplanned inventory reductions have occurred and rms will increase output If rms increase output income will also increase and then consumption will increase The Multiplier Multiplier ratio of the change in equilibrium level of output to a change in some exogenous variable Exogenous variable variable that is assumed not to depend on state of economy that is does not change when economy changes planned investment We can ask how much the equilibrium level of output changes when planned investment changes Remember we are not trying to explain why planned investment changes simply asking how much the equilibrium level of output changes when planned investment changes Consider sustained increase in planned investment of 25 that is suppose I increases from 25 to 50 and stays at 50 If equilibrium existed at I 25 an increase in planned investment of 25 will cause disequilibrium with planned aggregate expenditure greater than aggregate output by 25 Firms immediately see unplanned reductions in inventories then increase output If planned investment I goes up by 25 initially and is sustained at this higher level an increase of output of 25 will not restore equilibrium because it generates even more consumption C The Multiplier Equation Assume the market is in equilibrium at income level of Y 500 Suppose planned investment I thus planned aggregate expenditure AE increases and remains higher by 25 Planned aggregate expenditure is greater than output there is an unplanned inventory reduction and rms respond by increasing output income Y This leads to second round of increases and so on Planned aggregate expenditure AE C I is not equal to aggregate output Y unless S I the leakage of saving must exactly match injection of planned investment spending for economy to be in equilibrium Recall also that there is sustained increase of 25 in plan Ed investment spending Income rises consumption rises and so does saving Our S I approach to equilibrium leads us to conclude that equilibrium will be restored only when saving has increased by exactly the amount of initial increase in I Otherwise I will continue to be greater than S and C I will continue to be greater than Y The change in equilibrium deltaY is equal to initial change in planned investment deltaY times 1 MPS MPS deltaS deltaY or deltaI deltaY Multiplier 1 MPS Multiplier 1 1 MPC MPC deltaC deltaY
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