ECON 1220A:

Introductory Macroeconomics –
L5. Aggregate Expenditure Model

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In this lecture…
• Introduce the Aggregate Expenditure Model
• The Four Components of Aggregated Expenditure
• Focuses on the (very) short-run determination of total output in the
economy
• Introduce the Multiplier Effect

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Aggregate Expenditure Model
• Aggregate expenditure (AE): Total spending in the economy: the sum
of consumption, planned investment, government purchases, and net
exports.

• Aggregate expenditure model: A macroeconomic model that focuses

on the (very) short-run relationship between total spending and real
GDP, assuming that the price level is constant.

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Four Components of Aggregate Expenditure
• The four components in our model is the same four that we introduced in a
previous chapter as the components of GDP:
Consumption (C): Spending by households on goods and services
Planned investment (I): Planned spending by firms on capital goods, and by
households on new homes
Government purchases (G): Spending on all levels of government on goods and
services
Net exports (NX): The value of exports minus the value of imports

• Aggregate expenditure is the sum of these:

AE = C + I + G + NX

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Planned Investment vs. Actual Investment
• Our aggregate expenditure model uses planned investment, rather than
actual investment
• i.e. the definition of aggregate expenditures is slightly different from GDP.
• The difference is that planned investment spending does not include the
build-up of unplanned inventories: goods that have been produced but not
yet sold
Planned investment = Actual investment – unplanned change in inventories
• Equilibrium in the economy occurs when spending on output is equal to
the value of output produced; that is:
Aggregate expenditure = GDP

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Adjustment to Macroeconomic Equilibrium
• Just like markets for a particular product may not be in equilibrium
(quantity supplied may not equal quantity demanded at the current
price), the economy may not be in equilibrium.

If . . . then . . . and . . .
aggregate expenditure is the economy is in
equal to GDP inventories are unchanged macroeconomic equilibrium.
aggregate expenditure is GDP and employment
less than GDP inventories rise decrease.
aggregate expenditure is GDP and employment
greater than GDP inventories fall increase.

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Determining the Level of
Aggregate Expenditure in the
Economy

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Consumption
Consumption tends to follow a relatively smooth, upward trend; its
growth declines during periods of recession.
What affects the level of consumption?
• Current disposable income
• Household wealth
• Expected future income
• The price level
• The interest rate

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The Consumption Function

èHouseholds spend a consistent fraction of each extra dollar of real disposable

income on consumption.
èAn 1-unit change in real disposable income will change the real consumption by
Marginal Propensity to Consume (MPC) 9
Income, Consumption, and Saving
What is the relationship between Consumption and National Income?
• Households receive income by contributing their factors of production.
• The income is either consumed, saved, or used to pay taxes (assume TR = 0)
• Therefore,
National Income = Consumption + Saving + Taxes
Y=C+S+T
∆Y = ∆C + ∆S + ∆T
Assume taxes is constant over time, i.e. ∆T = 0, then
∆Y = ∆C + ∆S

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Consumption and National Income
∆Y = ∆C + ∆S
Divide the above equation by ∆Y:
∆Y ∆C ∆S
∆Y = ∆Y +∆Y
1 = MPC + MPS
∆C
where the Marginal Propensity to Consume (MPC) = ∆Y, and
∆S
Marginal Propensity of Save (MPS) = ∆Y
Marginal Propensity to Consume (Save): the change in consumption
(saving) given a 1 unit change in Disposable Income

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Determinants of Planned Investment
• What affects the level of investment?
• Expectations of future profitability
• Interest rate
• Taxes
• Cash flow

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Government Purchases (G)
• Real government purchases include purchases of goods and services.
• This category does not include transfer payments; only purchases for
which the government receives some good or service.

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Net Export (NX)
• Net exports equals exports minus imports.
• The value of net exports is affected by:
• Local Price level vs. the price level in other countries
• Local growth rate vs. growth rate in other countries
• Local currency exchange rate

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Graphing Macro Equilibrium

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The 45°- Line Diagram
Suppose in the whole economy there is
a single product: Pepsi.
• For the economy to be in equilibrium,
the amount of Pepsi produced must
equal the amount of Pepsi sold.
• Then any point on the 45° line could be
an equilibrium—like points A or B.
• At point C, the economy’s inventories
of Pepsi are being depleted, and
production must rise.
• At point D, inventories of Pepsi are
growing, so production must fall.

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The 45°- Line Diagram
• We can apply this model to a real
economy, with real national income
(GDP) on the x-axis, and real aggregate
expenditure on the y-axis.
• This model is also known as the
Keynesian cross, because it is based on
the analysis of economist John
Maynard Keynes.
• Only points on the 45° line can be a
macroeconomic equilibrium, with
planned aggregate expenditure equal
to GDP.

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Macroeconomic Equilibrium
Any point on the 45° line could be an equilibrium; but how do we know
which one will be the equilibrium in a given year?
• To determine this, recall that when they receive additional income,
households consume some of it, and save some of it.
• The resulting consumption function tells us how much consumers will
spend (real expenditure) when they have a particular income (real GDP).
• This will determine Consumption (C) in the equation
Y = C + I + G + NX
• Macroeconomic equilibrium simply means the left side (real GDP) must
equal the right side (planned aggregate expenditure).
• i.e. y = x

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Macroeconomic Equilibrium
• We start by placing the
consumption function on the
diagram.
• If there was no other expenditure
in the economy, then the
macroeconomic equilibrium would
be where the consumption
function crossed the 45° line;
there, income (GDP) equals
expenditure.

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Macroeconomic Equilibrium
• But there are other expenditures.
We will assume they are not
affected by income; that they are
predetermined or autonomous.
• Then we add the other
expenditures: planned investment…
• … government purchases…
• … and net exports.
• These are vertical shifts in real
expenditure, because their values
do not depend on real GDP.
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Macroeconomic Equilibrium
At last, we have macroeconomic
equilibrium: the point at which
1. Income equals expenditure, i.e.
Y = C + I + G + NX
2. The level of consumption is
consistent with the level of income,
according to the consumption
function.
• We call this top-most line the
aggregate expenditure function.

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Adjustment to Macroeconomic Equilibrium

• In this economy, macroeconomic

equilibrium occurs at $10 trillion.
• What if real GDP were lower, say $8
trillion?
• Aggregate expenditure would be
higher than GDP, so inventories
would fall.
• This would signal firms to increase
production, increasing GDP.
• The reverse would occur if real GDP
were above $10 trillion.

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Adjustment to Macroeconomic Equilibrium
• Macroeconomic equilibrium can occur
anywhere on the 45° line. Ideally, we
would like it to occur at the level of
potential GDP.
• If equilibrium occurs at this level,
unemployment will be low—at the
natural rate of unemployment, or the
full employment level.
• But for various reasons, this might not
occur. For example, maybe firms are
pessimistic and reduce investment
spending.
• Then the equilibrium will occur below
potential GDP—a recession.

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The Role of Inventories
• Inventories play a critical role in this model of the economy.
• When planned aggregate expenditure is less than real GDP, firms will
experience unplanned increases in inventories.
• Then even if spending returns to normal levels, firms have excess
inventories to sell; and they will do this instead of increasing
production to normal levels.

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A numerical Example of Macroeconomic
Equilibrium
• The table below shows several hypothetical combinations of real GDP and
planned aggregate expenditure.
Planned
Real Planned Government Net Aggregate Unplanned
GDP Consumption Investment Purchases Exports Expenditure Change in Real GDP
(Y) (C) (I) (G) (NX) (AE) Inventories Will …
$8,000 $6,200 $1,500 $1,500 − $500 $8,700 −$700 increase
9,000 6,850 1,500 1,500 −500 9,350 −350 increase
be in
10,000 7,500 1,500 1,500 −500 10,000 0 equilibrium
11,000 8,150 1,500 1,500 −500 10,650 +350 decrease
12,000 8,800 1,500 1,500 −500 11,300 +700 decrease
Note: The values are in billions of 2009 dollars

• As real GDP changes, consumption changes but planned investment, government

purchases, and net exports stay constant.
• Macroeconomic equilibrium can occur only at $10,000 billion; otherwise, the
unplanned change in inventories will cause firms to change production and real 25
GDP will change.
The Multiplier Effect

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Autonomous and Induced Expenditures
• A small change in planned aggregate
expenditure can cause a larger
change in equilibrium real GDP.
• Planned investment, government
purchases, and net exports are
autonomous expenditures: their
level does not depend on the level of
GDP.
• But consumption has both an
autonomous and induced effect. So
its level does depend on the level of
GDP, and this produces the upward-
sloping AE line.

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Autonomous and Induced Expenditures
• An increase in an autonomous
expenditure shifts the aggregate
expenditure line upward.
• When this happens, real GDP increases
by more than the change in
autonomous expenditures; this is the
multiplier effect.
• The value of the increase in
equilibrium real GDP divided by the
increase in autonomous expenditures
is the multiplier.

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The Multiplier Effect Additional
Autonomous
Additional
Induced
Total Additional
Expenditure =
Expenditure Expenditure Total Additional
(investment) (consumption) GDP
Assume MPC = 0.75, Round 1 $100 billion $0 $100 billion
Round 2 0 75 billion 175 billion
Increase in autonomous Round 3 0 56 billion 231 billion
expenditure = $100 billion Round 4
Round 5
0
0
42 billion
32 billion
273 billion
305 billion
. . . .
• Initially, real GDP rises by . . . .
the amount of the .
Round
. . .

increase in autonomous 10
.
0
.
8 billion
.
377 billion
.
expenditure. This causes .
.
.
.
.
.
.
.
an increase in real GDP, Round
0 2 billion 395 billion
which causes an increase 15
. . . .
in production, which .
.
.
.
.
.
.
.
causes an increase in real Round
0 1 billion 398 billion
GDP… 19
. . . .
. . . .
. . . .
Round n 0 0 $400 billion
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Effect of the Multiplier
• We cannot say how long this adjustment to macroeconomic
equilibrium will take—how many “rounds”, back and forth.
• But we can calculate the value of the multiplier, as the eventual
change in real GDP divided by the change in autonomous
expenditures (planned investment, in this case):
Δ" Change in real GDP $400 billion
= = =4
Δ# Change in investment spending $100 billion

With a multiplier of 4, each $1 increase in planned investment (or any

other autonomous expenditure) eventually increases equilibrium real
GDP by $4.
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Q: How can we know the eventual value of the multiplier?
• In each “round”, the additional income prompts households to consume
some fraction (the marginal propensity to consume).
• The total change in equilibrium real GDP equals:

The initial increase in planned investment spending = $100 billion

Plus the first induced increase in consumption = MPC × $100 billion
Plus the second induced increase in consumption = MPC × (MPC × $100 billion)
= MPC2 × $100 billion
Plus the third induced increase in consumption = MPC × (MPC2 × $100 billion)
= MPC3 × $100 billion
Plus the fourth induced increase in consumption = MPC × (MPC3 × $100 billion)
= MPC4 × $100 billion
And so on …

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A Formula for the Multiplier
• This becomes the infinite sum:
Total change in GDP = $100 billion + MPC × $100 billion + MPC2× $100 billion + MPC3 × $100
billion + MPC4 × $100 billion + …)

Total change in GDP = $100 billion × (1 + MPC + MPC2 + MPC3 + MPC4 + …)

!
Total change in GDP = $100 billion × (!"#$% )

• In our case, MPC = 0.75; so the multiplier is 1/(1-0.75) = 4. A $100 billion increase
in investment eventually results in a $400 billion increase in equilibrium real GDP.
• The general formula for the multiplier is:
Change in equilibrium real GDP 1
Multiplier = =
Change in autonomous expenditure 1 − ;<=

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1. The multiplier effect occurs both for an increase and a decrease in
planned aggregate expenditure.
2. Because the multiplier is greater than 1, the economy is sensitive to
changes in autonomous expenditure.
3. The larger the MPC, the larger the value of the multiplier.
4. Our model is somewhat simplified, omitting some real-world
complications. For example, as real GDP changes, imports, inflation,
interest rates, and income taxes will change.

• The last point generally means that the value we estimate for the
multiplier, from the MPC, is too high.
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Aggregate Expenditure Equations
• Based on the example in the text, we can generate the following equations
(changing the MPC so as to generate different results):

1. C = 1,000 + 0.65Y Consumption function

2. I = 1,500 Planned investment function

3. G = 1,500 Government spending function

4. NX = −500 Net export function

5. Y = C + I + G + NX Equilibrium condition

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 Aggregate Expenditure = C + I + G + NX
At Equilibrium:
Real GDP (Y) = Aggregate Expenditure
Y = C + I + G + NX
Y = 1,000 + 0.65 Y + 1,500 + 1,500 – 500
Y – 0.65Y = 1,000 + 1,500 + 1,500 – 500
0.35 Y = 3,500
Y = 10,000

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Solving the Aggregate Expenditure Function
in Algebraic Form
• Suppose we represent the parameters of the model by letters.

1. = = = + ;<=(A) Consumption function

2. D = D Planned investment function

3. F = F Government spending function

4. HI = HI Net export function

5. A = = + D + F + HI Equilibrium condition
• The letters with bars over them are parameters—fixed (autonomous) values.

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• Solving for the equilibrium,

! = # + %&#(!) + ) + * + +,

! − %&#(!) = # + ) + * + +,

!(1 − %&#) = # + ) + * + +,

# + ) + * + +,
!=
1 − %&#
!
! = (# + ) + * + +,)×
!"#$%
i.e.
Equilibrium GDP = Autonomous Expenditure × Multiplier

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Some Limitations of the AE model
1. Prices are fixed
2. Underlying factors (e.g. factor markets, loanable-funds, money
market conditions) are not included
3. Interest rate does not enter into the model
4. Many variables (e.g. I, NX etc..) are assumed to be autonomous –
independent from income…

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Summary
üIntroduced the Aggregated Expenditure Model
üExplained the Equilibrium Condition that occurs at Y = AE
üIllustrated the Multiplier Effect in numerical and general forms

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