Key Concepts

Aggregate demand determines real output and national income in the short run when prices are constant.

Equilibrium between aggregate expenditure (AE) and output determines aggregate demand.

Aggregate expenditure (AE) is planned spending on goods and services. The AE function \(AE = C + I + X − IM\) shows aggregate expenditure at each level of income and output.

This chapter assumes an economy without a government sector. It concentrates on the consumption expenditure (C) by households, the investment expenditure (I) by business (planned additions to plant, equipment, and inventories), exports of goods and service to foreign countries (X), and imports of goods and services from those countries (IM). We assume wages, prices, interest rates, and exchange rates are constant.

Consumption expenditure is closely though not perfectly related to disposable income. Without a government sector, there are no taxes or transfer payments. Disposable income is equal to national income.

Autonomous consumption expenditure is planned consumption, even at zero income. The marginal propensity to consume is the change in planned consumption expenditure caused by a change in income \((MPC = \Delta{C} / \Delta{Y})\). The MPC is positive but less than unity.

The marginal propensity to save is the change in planned saving caused by a change in income \((MPS = \Delta{S} / \Delta{Y})\). Since income must be either spent or saved, \(MPC + MPS = 1\).

Investment and exports are autonomous expenditures. Business’s plans to add to their factories, machinery, and inventories lead to investment expenditure. Demand from residents of other countries for domestic goods and services lead to exports.

Imports are that part of consumption, investment, and exports supplied by goods and services produced in other countries. A change in national income causes a change in imports according to the marginal propensity to import, \((MPM = \Delta{IM} / \Delta{Y})\).

For given prices and wages, the economy is in equilibrium when output equals planned spending or aggregate expenditure \((Y = AE)\). Equivalently, the economy is in equilibrium when leakages equal injections \((S+ IM = I + X)\).

Equilibrium output and income does not mean that output equals potential output. Equilibrium output might be either lower or higher than potential output.

Because we assume that prices and wages are fixed, equilibrium output is determined by aggregate expenditure and aggregate demand. Firms and workers supply the output and labour services that are demanded.

Adjustment to equilibrium is a response to unplanned changes in inventories. When aggregate expenditure exceeds actual output, there is an unplanned fall in inventories. Unplanned decreases in inventory are a signal to producers to increase output. Similarly, unplanned increases in inventories mean output is greater than aggregate expenditure. Producers will reduce output.

Starting from an equilibrium income, an increase in autonomous expenditure causes an increase in output and income. The initial increase in income to meet the increased autonomous expenditure leads to further increases in consumption expenditure through the MPC, and imports through the MPM.

The multiplier determines the change in equilibrium income caused by a change in autonomous expenditure \((\text{multiplier} = \Delta{Y} / \Delta{A})\). In the model of this chapter, the multiplier is determined by the MPC and the MPM. The multiplier \(= 1/(1 + MPC + MPM)] = 1/(1 − \text{slope of AE})\). The multiplier is greater than 1 because the MPC and MPM are positive fractions and the MPC is larger than the MPM.

The equilibrium output determined by the equality of aggregate expenditure and output determines the position of the AD curve in the AD/AS model. Changes in equilibrium output caused by changes in autonomous expenditure and the multiplier shift the AD curve horizontally, changing the equilibrium level of output and employment.

Business cycle fluctuations in output and employment are caused by fluctuations in autonomous expenditure magnified by the multiplier.