EQUILIBRIUM IN THE MARKET

FOR GOODS AND SERVICES

The Aggregate Expenditure Model
• Assumptions:

➢The price level is fixed

➢Aggregate demand determines real GDP.

➢Firms are willing to sell as much as their customers are willing to

buy at the predetermined price levels.

➢Y as GDP: total income – total expenditure – output

The Aggregate Expenditure Model
• Aggregate planned Expenditure (AE): the amount households,

firms, and the government would like to spend on goods and

services.
𝐴𝐸 = 𝑓(𝑌)
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀
The Aggregate Expenditure Model
➢Consumption (C) and Saving (S)

𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑
❑𝐶0 : autonomous consumption

❑𝑌𝑑 : disposable income

𝑌𝑑 = 𝑌 − 𝑇
▪ T: tax (net tax)
❑𝑀𝑃𝐶: Marginal propensity to consume: the fraction of a change in disposable income that
is spent on consumption, 0 < 𝑀𝑃𝐶 < 1

∆𝐶
𝑀𝑃𝐶 =
∆𝑌𝑑
𝑀𝑃𝐶 = 𝐶′(𝑌𝑑 )
The Aggregate Expenditure Model
➢Consumption (C) and Saving (S)

𝑆 = 𝑌𝑑 − 𝐶 = 𝑌𝑑 − 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑
= −𝐶0 + 1 − 𝑀𝑃𝐶 . 𝑌𝑑
= 𝑆0 + 𝑀𝑃𝑆. 𝑌𝑑
❑𝑀𝑃𝑆: Marginal propensity to save: the fraction of a change in disposable income
that is saved.

∆𝑆
𝑀𝑃𝑆 =
∆𝑌𝑑
𝑀𝑃𝑆 = 𝑆 ′ 𝑌𝑑 = 1 − 𝑀𝑃𝐶
consumption (C) and saving (S)
C 450
E C

Co
S
0
Yd
- Co

7
The Aggregate Expenditure Model
➢Investment (I)

𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌
❑𝐼0 : autonomous investment

❑𝑀𝑃𝐼: Marginal propensity to invest: the fraction of an increase in Y that is

spent on investment

➢Government purchases (G)

𝐺 = 𝐺0
The Aggregate Expenditure Model
➢Exports (X)

𝑋 = 𝑋0
➢Imports (M)

𝑀 = 𝑀0 + 𝑀𝑃𝑀. 𝑌
❑𝑀𝑃𝑀: Marginal propensity to import: the fraction of an increase in Y that is spent on
imports, 𝑀𝑃𝑀 > 0

∆𝑀
𝑀𝑃𝑀 =
∆𝑌
𝑀𝑃𝑀 = 𝑀′(𝑌)
The Aggregate Expenditure Model
• Aggregate planned Expenditure (AE): the amount households, firms,

and the government would like to spend on goods and services.

𝐴𝐸 = 𝑓(𝑌)
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

• The economy is in equilibrium when:

actual expenditure = planned expenditure.

𝑌 = 𝐴𝐸
The Aggregate Expenditure Model
Closed economy, no government (X=M=T=G=0)
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. 𝑌
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌
⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝑀𝑃𝐶. 𝑌 + 𝑀𝑃𝐼. 𝑌
= 𝐴 + (𝑀𝑃𝐶 + 𝑀𝑃𝐼). 𝑌
➢ 𝐴 = 𝐶0 + 𝐼0 : autonomous expenditure

• Equilibrium: 𝑌 = 𝐴𝐸
⇒ 𝑌 = 𝐶0 + 𝐼0 + (𝑀𝑃𝐶 + 𝑀𝑃𝐼). 𝑌

1
⇒𝑌= . 𝐶0 +𝐼0
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼
= 𝑘. 𝐴
AE 450

AE
E
AE0

AE1
A

0 Y
Y1 Y0
12
The Aggregate Expenditure Model
Closed economy, no government (X=M=T=G=0)
The Multiplier
1
𝑘=
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼
∆𝑌
𝑘=
∆𝐴
➢The Multiplier is the amount by which a change in autonomous

expenditure is magnified or multiplied to determine the change in

equilibrium expenditure.
The Aggregate Expenditure Model
Closed economy, with government (X=M=0)
• Government:

➢Government purchases

𝐺 = 𝐺0

➢Tax (net tax)

𝑇 = 𝑇0 + 𝑡. 𝑌 (0 < 𝑡 < 1)

❑𝑇0 : autonomous tax

❑𝑡: Marginal tax rate

❑𝑡. Y: induced tax

The Aggregate Expenditure Model
Closed economy, with government (X=M=0)
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
❑Autonomous tax
𝑇 = 𝑇0

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑀𝑃𝐶. 𝑌 − 𝑇0 + 𝑀𝑃𝐼. 𝑌
= 𝐶0 + 𝐼0 + 𝐺0 − 𝑀𝑃𝐶. 𝑇0 + (𝑀𝑃𝐶 + 𝑀𝑃𝐼). 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼
= 𝑘. 𝐴
The Aggregate Expenditure Model
Closed economy, with government (X=M=T=G=0)
The Multiplier

❑Autonomous tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼
The Aggregate Expenditure Model
Closed economy, with government (X=M=0)
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
❑Induced tax
𝑇 = 𝑡. 𝑌 (0 < 𝑡 < 1)

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑀𝑃𝐶. 1 − 𝑡 . 𝑌 + 𝑀𝑃𝐼. 𝑌
= 𝐶0 + 𝐼0 + 𝐺0 + ሾ𝑀𝑃𝐶. 1 − 𝑡 + 𝑀𝑃𝐼]. 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼
= 𝑘. 𝐴
The Aggregate Expenditure Model
Closed economy, with government (X=M=T=G=0)
The Multiplier

❑Induced tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶. (1 − 𝑡) − 𝑀𝑃𝐼
The Aggregate Expenditure Model
Closed economy, with government (X=M=0)
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
❑Net tax
𝑇 = 𝑇0 + 𝑡. 𝑌 (0 < 𝑡 < 1)

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑀𝑃𝐶. 𝑌 − 𝑇0 − 𝑡. 𝑌 + 𝑀𝑃𝐼. 𝑌
= 𝐶0 + 𝐼0 + 𝐺0 − 𝑀𝑃𝐶. 𝑇0 + ሾ𝑀𝑃𝐶. 1 − 𝑡 + 𝑀𝑃𝐼]. 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼
= 𝑘. 𝐴
The Aggregate Expenditure Model
Closed economy, with government (X=M=T=G=0)
The Multiplier

❑Net tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶. (1 − 𝑡) − 𝑀𝑃𝐼
The Aggregate Expenditure Model
Open economy
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
𝑋 = 𝑋0 𝑀 = 𝑀0 + 𝑀𝑃𝑀. 𝑌
❑ Autonomous tax
𝑇 = 𝑇0

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0 + 𝑀𝑃𝐶. 𝑌 + 𝑀𝑃𝐼. 𝑌 − 𝑀𝑃𝑀. 𝑌

= 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0 + (𝑀𝑃𝐶 + 𝑀𝑃𝐼 − 𝑀𝑃𝑀). 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
= 𝑘. 𝐴
The Aggregate Expenditure Model
Open economy
The Multiplier

❑Autonomous tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
The Aggregate Expenditure Model
Open economy
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
𝑋 = 𝑋0 𝑀 = 𝑀0 + 𝑀𝑃𝑀. 𝑌
❑Induced tax
𝑇 = 𝑡. 𝑌

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 + 𝑀𝑃𝐶. 1 − 𝑡 . 𝑌 + 𝑀𝑃𝐼. 𝑌 − 𝑀𝑃𝑀. 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
= 𝑘. 𝐴
The Aggregate Expenditure Model
Open economy
The Multiplier

❑Induced tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
The Aggregate Expenditure Model
Open economy
𝐶 = 𝐶0 + 𝑀𝑃𝐶. 𝑌𝑑 = 𝐶0 + 𝑀𝑃𝐶. (𝑌 − 𝑇)
𝐼 = 𝐼0 + 𝑀𝑃𝐼. 𝑌 𝐺 = 𝐺0
𝑋 = 𝑋0 𝑀 = 𝑀0 + 𝑀𝑃𝑀. 𝑌
❑Net tax
𝑇 = 𝑇0 + 𝑡. 𝑌

⇒ 𝐴𝐸 = 𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0 + 𝑀𝑃𝐶. 1 − 𝑡 . 𝑌 + 𝑀𝑃𝐼. 𝑌 − 𝑀𝑃𝑀. 𝑌

1
𝑌 = 𝐴𝐸 ⇒ 𝑌 = . 𝐶0 +𝐼0 +𝐺0 + 𝑋0 − 𝑀0 − 𝑀𝑃𝐶. 𝑇0
1 − 𝑀𝑃𝐶. 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
= 𝑘. 𝐴
The Aggregate Expenditure Model
Open economy
The Multiplier

❑Net tax

1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑘 =
1 − 𝑀𝑃𝐶 1 − 𝑡 − 𝑀𝑃𝐼 + 𝑀𝑃𝑀
The Aggregate Expenditure Model
Leakages and Injections
• Leakages: reduce AE

• Injections: increase AE

𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

𝑌𝑑 = 𝑌 − 𝑇
൜ ⇒𝑌−𝑇 =𝐶+𝑆
𝑌𝑑 = 𝐶 + 𝑆
⇒𝑌 =𝐶+𝑆+𝑇
𝑌 = 𝐴𝐸 ⇒ 𝐶 + 𝑆 + 𝑇 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀
⇒𝑆+𝑇+𝑀 =𝐼+𝐺+𝑋
(leakages) (injections)
The paradox of saving
• “As people attempt to save more, the result is both a decline in

output and unchanged saving.”

Exercise 1
Yd 0 300 600 900 1200 1500
C 300 525 750 975 1200 1425
S
a. Calculate saving at each level of disposable income.

b. Calculate 𝑀𝑃𝐶 and 𝑀𝑃𝑆.

c. Draw the consumption line and the saving line.

Exercise 2
• Consider a closed economy with no government. Autonomous consumption is
$300 billion, marginal propensity to consume is 0.8. Planned investment is
$100 billion.
a. What is the consumption function?
b. What is the aggregate expenditure function?
c. Calculate the equilibrium level of income.
d. Suppose that firms are very optimistic about the future. Hence, they
increase investment by $100 billion. Calculate the multiplier and the final
change in equilibrium output caused by this investment increase.
Exercise 3
• Consider a closed economy with government. Autonomous consumption is
$300 billion and marginal propensity to consume is 0.8. Planned investment is
$200 billion. Government purchases are $300 billion and tax rate is 25%.
a. What is the consumption function?
b. What is the aggregate expenditure function?
c. Calculate the equilibrium level of income.
d. Suppose government purchases are increased by $200 billion. Calculate
the multiplier and the change in equilibrium output caused by this
government purchases increase.
Exercise 4
• Consider an open economy. Export is $5 billion and marginal propensity to
import is 0.14. Autonomous consumption is $10 billion, and marginal
propensity to consume is 0.8. Planned investment is $5 billion. Government
purchases are $40 billion and tax rate is 20%.
a. Calculate autonomous expenditure.
b. What is the aggregate expenditure function?
c. Calculate the equilibrium level of income.
d. Suppose government purchases are increased by $20 billion. What is the
new equilibrium income?
Exercise 5

• In an open economy, 𝑀𝑃𝐶. (1 − 𝑡) is 0.8, marginal propensity to

import is 0.4 and induced tax 𝑇 = 𝑡. 𝑌

a. Suppose investment is increased by $100 billion. How would

the equilibrium output and net exports change?

b. Instead of an increase in investment, now suppose that export

is increased by $100 billion. How would the balance of trade

change?
Exercise 7

• Suppose marginal propensity to consume is 0.6 and marginal

propensity to invest is 0.

a. Calculate the multiplier.

b. If investment is increased by 25, how much would equilibrium

output change?

c. If autonomous consumption is 60 and autonomous investment

is 90, what is the equilibrium output?

Exercise 8

• Suppose marginal propensity to consume is 0.6 and marginal

propensity to invest is 0.2.

a. Calculate the multiplier.

b. If investment is increased by 25, how much would equilibrium

output change?

c. If autonomous consumption is 60 and autonomous investment

is 90, what is the equilibrium output?

Exercise 9

• In a closed economy with no government:

𝐶 = 120 + 0,7𝑌𝑑
𝐼 = 50 + 0,1𝑌

a. Calculate the equilibrium output, consumption and investment.

b. Suppose autonomous consumption is increased by 20. What is

the new equilibrium output?

Exercise 10
• In a closed economy with no government:

𝐶 = 30 + 0,7𝑌𝑑
𝐼 = 10 + 0,1𝑌

a. Calculate the equilibrium output.

b. Calculate the multiplier.

c. If autonomous consumption is increased by 10 and autonomous

investment is increased by 5, what is the new equilibrium output?
Exercise 11

• In a closed economy with no government:

𝐶 = 400 + 0,8𝑌𝑑
𝐼 = 100

a. Calculate the equilibrium output, saving.

b. Calculate the multiplier.

c. If investment is increased by 100, how would the equilibrium

output change?
Exercise 12
Disposable income ($ billion/year) Consumption ($ billion/year)
0 8
10 16
20 24
30 32
40 40
50 48
60 56
a. What is autonomous consumption?

b. Calculate saving at each level of disposable income.

c. What is disposable income at the point where the consumption line cross the 450 line?

d. Calculate MPC and MPS.

e. What is the consumption function and the saving function?

Exercise 13

• Marginal propensity to consume is 0.7, marginal propensity to

invest is 0.1, autonomous consumption is 500, autonomous

investment is 100.

a. Calculate the multiplier.

b. Calculate the equilibrium output.

Exercise 14
Yd C S I
0 -75 100
110 -40 100
220 -5 100
330 30 100
440 65 100
550 100 100
660 135 100
770 170 100
a. Calculate consumption.
b. Calculate MPC. What is the consumption function?
c. Calculate MPS. What is the saving function?
d. What is the aggregate expenditure function?
e. What are Yd, C, S, I at the equilibrium?
Exercise 14
Yd C S I
0 -75 100
110 -40 100
220 -5 100
330 30 100
440 65 100
550 100 100
660 135 100
770 170 100
f. How would the equilibrium income change if autonomous consumption is increased by 25?

g. Would the result be different if investment is increased by 25 instead?

h. How would the equilibrium income change if autonomous consumption is decreased by 25?

i. How would the AE curve change when there are changes in autonomous factors? How
would the AE curve change when there are changes in marginal factors?