(6) Aggregate Expenditure and Output

Aggregate expenditure (AE)

The total planned spending in the economy on final goods and services: AE = C + I + G + NX

Components of aggregate expenditure

Consumption, planned investment, government purchases, and net exports

Marginal propensity to consume (MPC)

The fraction of additional income that is spent on consumption; MPC = ΔC / ΔY

Marginal propensity to save (MPS)

The fraction of additional income that is saved; MPS = ΔS / ΔY; MPC + MPS = 1

Consumption function

The relationship between consumption and disposable income

Disposable income

Income after taxes have been paid and transfers received; equal to national income minus net taxes

Planned investment

Business spending on capital goods that firms intend to undertake; depends on profitability, interest rates, taxes, and cash flow

Inventories

Goods produced but not yet sold; unplanned changes indicate disequilibrium between AE and GDP

Macroeconomic equilibrium

Occurs when planned aggregate expenditure equals real GDP (AE = GDP)

45° line diagram

A graph showing all points where AE = GDP; also called the Keynesian cross

Autonomous expenditure

Spending that does not depend on the level of GDP (e.g. government spending)

Induced expenditure

Spending that changes when GDP changes (e.g. consumption)

Multiplier

The ratio of change in equilibrium GDP to change in autonomous expenditure; 1 / (1 - MPC)

Multiplier effect

The process by which an initial increase in spending leads to a larger overall increase in GDP

Paradox of thrift

If many households increase saving at once, overall spending and GDP may fall, reducing total saving

Aggregate demand (AD) curve

Shows the relationship between the price level and the quantity of real GDP demanded

Effect of rising price level on AE

Higher prices reduce consumption (via wealth effect), investment (via interest rates), and net exports → AE falls

Effect of falling price level on AE

Lower prices raise consumption, investment, and net exports → AE rises

Q - If MPC = 0.8, the value of the multiplier is:

C) 5

Q - If aggregate expenditure is less than GDP, then:

B) Firms experience unplanned inventory increases

Q - An unplanned increase in inventories suggests that:

C) Aggregate expenditure is less than GDP

Q - Which of the following will increase planned investment?

C) Higher cash flow and profit expectations

Q - When AE = GDP, inventories are:

C) Constant

If the government increases spending by $200 billion and MPC = 0.75, the change in GDP will be approximately:

D) $800 billion

According to Keynes, the paradox of thrift occurs when:

B) Higher saving reduces consumption and total output