The Core of Macroeconomic Theory

• The level of GDP, the overall price level, and the level of
employment—three chief concerns of macroeconomists—are
influenced by events in three broadly defined “markets”:
– Goods-and-services market
– Labor market
– Financial (money) market

• What determines GDP and what causes inflation and

unemployment?

1
 How We Build Up the Core?
Lecture 3

Lecture 7

Lecture 4

Lecture 9

Lecture 8

Lecture 5 Lecture 6

2
 Lecture 3

Aggregate Expenditure
and Equilibrium Output

3
 Broad Outline
• In the short run, aggregate output is determined primarily by
aggregate expenditure.

• So we have to look at the components of aggregate

expenditure. Recall the expenditure approach in calculating
GDP implies that AE = C + I + G + (EX - IM).

• In today’s Lecture, we have two assumptions.

– Assumption 1: Closed Economy
– Assumption 2: No Government

• Hence today we will focus on consumption (C) and investment

(I) as the only components of aggregate expenditure.
4
 Aggregate Output and Aggregate Income
• Aggregate output is the total quantity of goods and services
produced in an economy in a given period.
• Aggregate income is the total income received by all factors
of production in a given period.
• Because every dollar of expenditure is received by someone
as income, we can compute total GDP by adding up the total
spent on all final goods and services during a period or by
adding up all the income--wages, rents, interest and profits--
received by all factors of production.
• Therefore in any given period, there is an exact equality
between aggregate output (what is produced by factors) and
aggregate income (what is received by factors).

5
 Y ≡ aggregate output ≡ aggregate income

• Aggregate output (income) (Y) is a combined term used to

remind you of the exact equality between aggregate output
and aggregate income.
• When output increases, additional income is generated. More
workers are hired and paid and owners earn more profits.
When output is cut, income falls. Workers are laid off or paid
less and profits may fall.
• You should be reminded of this fact whenever you encounter
the combined term aggregate output (income) (Y).
• When we talk about aggregate output(income) (Y), we mean
real GDP, or the total quantity of goods and services
produced (expressed in constant prices).

6
 Two Tips on Aggregate Output
• Aggregate output can also be considered the aggregate
quantity supplied because it is the amount that firms are
supplying (producing) during a period.
• In the discussion below, we use the term aggregate output
(income) instead of aggregate quantity supplied, but keep in
mind that these two are equivalent.
• In Lecture 2, we introduced real GDP as a measure of total
quantity of output produced in the economy in a given
period.
• When we talk about aggregate output (income) (Y), we mean
real GDP, or the total quantity of goods and services
produced . Sometimes you see Y= $100 billion. But keep in
mind such Y is expressed in constant prices so that it only
reflects the change in quantity.
7
 Income, Consumption, and Saving

• A household can do two, and only two, things with its

income: It can either buy goods and services—that is, it
can consume (C)—or it can save (S).

• Saving (S) is the part of its income that a household does not
consume in a given period.
S ≡Y −C

• The triple equal sign means that this equation is an identity,

or something that is always true by definition.

8
 The Keynesian Theory of Consumption

• In The General Theory of Employment, Interest and Money,

Keynes, the father of macroeconomics, argued that household
consumption is directly related to its income.
The fundamental psychological law, upon which we are
entitled to depend with great confidence both a priori from
our knowledge of human nature and from the detailed facts
of experience, is that men (and women, too) are disposed, as
a rule and on average, to increase their consumption as their
incomes increase, but not by as much as the increase in their
income.

9
A Consumption Function for a Household

• A consumption function
for an individual
household shows the
level of consumption (c)
at each level of
household income (y).

10
An Aggregate Consumption Function
• The aggregate consumption
function shows the level of
aggregate consumption (C)
at each level of aggregate
income (Y).

• In the straight line

consumption curve:
C = a + bY

• a: exogenous consumption

• bY: induced consumption

11
An Aggregate Consumption Function
• The upward slope (b>0)
indicates that higher
levels of income lead to
higher levels of
consumption spending.

• A slope less than one

(b<1) indicates that
consumption increases
less than income.

12
 Marginal Propensity to Consume
• Marginal propensity to consume (MPC) is the fraction of a
change in income that is consumed, or spent.
∆C
MPC ≡ slope of consumption function ≡
∆Y
• The Greek letter ∆(delta) means “change in”.

• In the linear consumption function C = a + bY, MPC = b.

• For example, if income (Y) is $100 in 2010 and $110 in

2011, ∆Y for this period is $110-$100=$10.

• If MPC = 0.8, ∆C = MPC × ∆Y= 0.8 × 10 = 8.

13
 Marginal Propensity to Save
• Marginal propensity to save (MPS) is the fraction of a
change in income that is saved.
• The identity S ≡ Y - C implies that
MPC + MPS ≡ 1
• The MPC is the fraction of an increase in income that is
consumed (or the fraction of a decrease in income that
comes out of consumption). The MPS is the fraction of an
increase in income that is saved (or the fraction of a
decrease in income that comes out of saving).
∆C ∆S
MPC ≡ , MPS ≡
∆Y ∆Y

14
Consumption Function Derived From:
C = 100 + .75Y

15
 Investment

• Investment refers to purchases by firms which add to:

– capital stock of new buildings and equipment and
– change in inventories

• Inventory change is partly determined by how much

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

change in inventory = output – sales

16
 Example of Change in Inventory

Year Inventory Output Sales Change in Inventory

(beginning of year) inventory (end of year)
2007 20 100 90 10 30
2008 30 90 110 -20 10
2009 10 102 102 0 10

17
 Planned Investment (I)

• Planned investment (I) is those additions to capital stock and

inventory that are planned by firms.

• Actual investment is the actual amount of investment that

takes place; it includes items such as unplanned changes in
inventories.

• Why planned investment could be different from actual

investment?

18
 Planned versus Actual Investment

• Example: A firm plans to buy $5 million in machines and to

have no change in inventories. It does buy $5 million in
machines, produces 20,000 cars expecting to sell them all, but
sells only 18,000 cars.

• The planned investment of the firm is ?

• The actual investment of the firm is ?

• Actual investment can differ from planned investment if a firm

misestimates how much it will sell. Any misestimation means
that the change in its inventories.

19
 Planned versus Actual Investment

• Example: A firm plans to buy $5 million in machines and to

have no change in inventories. It does buy $5 million in
machines, produces 20,000 cars expecting to sell them all, but
sells only 18,000 cars.

• The planned investment of the firm is $5million in machines.

• The actual investment of the firm is $5million in machines,

plus the value of 2000 unsold cars, i.e. the increase in
inventories.

20
Planned Investment (I)
• For now, we will assume
that planned investment is
fixed. It does not change
when income changes. So
its graph is a horizontal line.

• When a variable, such as

planned investment, is
assumed not to depend on
the state of the economy, it
is said to be an exogenous
variable.

21
Planned Aggregate Expenditure (AE)
• Planned aggregate
expenditure (AE) is the
total amount the
economy plans to spend
in a given period, so
planned aggregate
expenditure can also be
considered the aggregate
quantity demanded.
• It is equal to consumption
plus planned investment
(under Assumption 1 & 2):
AE ≡ C + I

22
 Equilibrium Output (Income)

• Equilibrium occurs when there is no tendency for change. In

macroeconomic goods market, equilibrium occurs when
planned aggregate expenditure -- the aggregate quantity
demanded, is equal to aggregate output (income) -- the
aggregate quantity supplied.

aggregate output (income) ≡ Y

planned aggregate expenditure ≡ AE ≡ C + I
equilibrium: Y = AE, or Y = C + I

23
 Disequilibrium
• Disequilibrium occurs when
Y dise > C dise + I
aggregate output > planned aggregate expenditure
(aggregate quantity supplied > aggregate quantity demanded)
Firms planned to sell more than they did so there is a rise in unplanned
inventory investment. Firms respond by reducing output. Y will decrease
until Y e = C e + I < Y dise.
or when
Y dise < C dise + I
aggregate output < planned aggregate expenditure
(aggregate quantity supplied < aggregate quantity demanded)
Firms planned to sell less than they did so there is a fall in unplanned
inventory investment. Firms respond by increasing output. Y will increase
until Y e = C e + I >Y dise .
24
 The Determination of
Equilibrium Output (Income)--Table

25
 The Determination of
Equilibrium Output (Income)--Graph

26
 The Determination of
Equilibrium Output (Income)--Algebra
• Alternatively, we can solve out the equilibrium output
(income) algebraically
(1) consumption is a function of income C = 100 + .75 Y
(2) planned investment is exogenous I = 25
(3) planned aggregate expenditure AE = C + I
(4) at equilibrium Y = AE
Substitute (1), (2) and (3) into (4)
We get Y = 100 + .75Y +25
Solve out equilibrium level of output (income) Y = 500.

27
 The Multiplier

• Multiplier is the ratio of the change in the equilibrium level

of output to a change in some exogenous variable.
• A variable that is assumed not to depend on the state of the
economy is called exogenous variable. That is, it does not
change when the economy changes.

• A variable that depends on the state of the economy is called

endogenous variable. That is, it changes when the economy
changes.

• In this lecture, the state of the economy is determined by

aggregate output (income) (Y).
28
 Exogenous and Endogenous Variables
• We assume planned investment (I) is predetermined by firms
at the beginning of each year, so it does not depend on
aggregate output (income) of that year. Therefore planned
investment (I) is an exogenous variable.

• We also understand that exogenous consumption (a) do not

depend on aggregate output (income). Therefore exogenous
consumption (a) is an exogenous variable too.

• However, induced consumption (bY) does depend on

aggregate output (income). Therefore induced consumption
(bY) and consumption (C = a + bY) are endogenous variables.

29
 The Effect of a Change in Exogenous Variable

• US plane maker Boeing plans to increase investment by $25b

in producing its new jumbo jet Boeing 747-8 Intercontinental
jumbo jet in year 2012.

• Suppose the economy was in equilibrium at Y = $500b in year

2011. And assume the consumption function is C = 100 + .75Y.

• What will happen to the aggregate output (income) in year

2012 after a $25b increase in planned investment?

30
The Multiplier Effect
• For C = 100 + .75Y, when
I increases by $25b,
equilibrium output has
increased by $100b (600
- 500), or four times the
amount of the increase
in planned investment.
• The fact that equilibrium
output changes by a
multiple of the changes
in planned investment or
any other exogenous
variable is called the
multiplier effect.

31
 What is the Intuition behind the Multiplier Effect?
Boeing increases
investment by 25 ↘
(∆AE=∆I=25)
↓
U.S. steel produces Hire more workers people spend
more steel; G.E. Pay more salaries, 75% increase in
produces more → interests, and rent, → their income on
engines; Goodyear earn more profits food, clothing, …
produces more tires (∆Y=25) (∆AE=∆C=25×.75)
↓ ↓ Hire more workers
Pay more salaries,
Firms in induced ↗ Firms in food, →
interests, and rent;
industries clothing, …
earn more profits
produce more produce more
(∆Y=25×.75)
↓ ↓ ↓
…… …… Consume more
(∆Y=25) (∆Y=25×.75) (∆AE=∆C=25×.75×.75)
↓
……
until new aggregate output (income) = new aggregate expenditure ←

32
 What is the Intuition behind the Multiplier Effect?
• The basic intuition behind the multiplier is that consumption
depends on income.

• When planned investment increases by $25b, the total

increase in planned aggregated expenditure is:
$25 + ($25 ×0.75) + ($25 ×0.75 ×0.75) + …..
= $25×[1 + 0.75 + 0.75 ×0.75 + …]
= $25×[1 + 0.751 + 0.752 + …]
= $25×[1/(1-0.75)] = $100b

• At equilibrium, total increase in aggregate output (income)

must equal the total increase in planned aggregate
expenditure. Therefore aggregate output (income) must
increase by $100b.

33
How to Derive the Equilibrium Y Algebraically?
Consider level: Consider change:
aold I
By definition Since Yold = + old
1− b 1− b
C = a + bY , AE = C + I
a I
At equilibrium and Ynew = new + new
1− b 1− b
Y = AE It must follow that
By substituti on 1 1
∆Y = ∆a + ∆I
Y = a + bY + I 1− b 1− b
where ∆Y = Ynew − Yold
(1 − b )Y = a + I
∆a = anew − aold
a I
Y= + ∆I = I new − I old
1− b 1− b
34
 Two Ways to Derive the New Equilibrium Y

Consider level: Consider change:

anew I new 1 1
Ynew = + ∆Y = ∆a + ∆I
1− b 1− b 1− b 1− b
100 50 1 1
= + = ×0 + × 25
1 − 0.75 1 − 0.75 1 − 0.75 1 − 0.75
= 600 = 100
Ynew = Yold + ∆Y = 500 + 100 = 600

35
 The Multiplier Equation
• The multiplier measures how much Y will change following a
change in planned investment or any exogenous variable.

1 1
Since ∆Y = ∆a + ∆I
1− b 1− b
The multiplier of planned investment is
∆Y 1 1 1
= = ≡
∆I 1 − b 1 − MPC MPS
In our example
∆Y 1
= =4
∆I 1 − 0.75

36
 Question

• In our simple economy, Y = C + I, when investment rises,

equilibrium income will change by:

37
 Answer

• In our simple economy , Y = C + I, when investment rises,

equilibrium income will change by:

The equilibrium output (income) will

change by a multiple of the changes in
planned investment. We use ∆I to
denote the change in planned
investment and we understand the
multiplier is 1/MPS, so the change in
equilibrium output (income) must be
the quantity expressed in option d.

38
 Question

• In our simple economy , AE = C + I, C = 100 + 0.80Y, I = 20.

What is the equilibrium output (income)?

• If the exogenous consumption increases by 15, while planned

investment decreases by 10, what is the new equilibrium
output (income)?

39
 Answer
• In our simple economy , AE = C + I, C = 100 + .80Y, I = 20.
What is the equilibrium output (income)?
• At equilibrium Y = AE
• Y = 100 + .80Y + 20
• Solve out Y = 120/.20 = 600.

• If the exogenous consumption increases by 15, while planned

investment decreases by 10, what is the new equilibrium
output (income)?
• New Y = old Y + ∆Y
= 600 + (∆a + ∆I)/(1 - MPC)
= 600 + (15 - 10)/(1 - 0.80)
= 600 + 25
= 625.

40
 Summary of Lecture 3

• Aggregate consumption is a function of aggregate

output (income): C = a + bY.
• Planned aggregate expenditure equals consumption
plus planned investment: AE ≡ C + I.
• Equilibrium is achieved when Y = AE.
• Equilibrium output changes by a multiple of the change
in planned investment or any other exogenous variable.
The multiplier is 1/MPS or 1/(1-MPC).

41
 For Those Who are Interested
• In the consumption function C = a + bY, MPC = b.

• What is MPC in the following consumption function?

Would this consumption function be more realistic?
g 2 h
C = a + hY − Y , where Y <
2 g

• Suppose Ct is the consumption of year t, Yt is the income of

year t. In the consumption function Ct = a + bYt,
consumption in year t only depends on income in year t.
Do you think it realistic? Any other factors might affect
consumption of year t?

42