Learning Outcomes
• The macroeconomic theory that we now study explains the
deviation of actual from potential GDP, that is the GDP gap
• The determination of GDP in the short run depends on the
behaviour of key categories of aggregate spending:
consumption, investment, government spending, and net
exports
• Consumption spending depends on disposable income and
wealth
• Investment spending depends on real interest rates and business
confidence
• A necessary condition for GDP to be in equilibrium is that
desired domestic spending equals actual output
The Terminology of Business Cycles
The calculation of average and marginal propensity to consume
The Consumption and Saving Functions
450
2000
C
1500
500
S
1000
250
500 0
-100
450 -500
500 1000 1500 2000 500 1000 1500 2000
Real Disposable Income Real Disposable Income
(i). Consumption Function [£ million] (ii). Saving Function [£ million]
Consumption and Saving Schedules [£ Million]
Disposable Desired Desired
Income consumption saving
0 100 -100
100 180 -80
400 420 -20
500 500 0
1000 900 +100
1500 1300 +200
1750 1500 +250
2000 1700 +300
3000 2500 +500
4000 3300 +700
The consumption and saving functions
• Both consumption and saving rise as disposable income rises.
• Line C relates desired consumption to disposable income.
• Its slope is the marginal propensity to consume (MPC).
• Saving is all disposable income that is not spent on consumption.
• The relationship between disposable income and desired saving is shown by
line S.
• Its slope is the marginal propensity to save (MPS).
• Any given amount of disposable income must be accounted for by
consumption plus saving.
• Consumption and saving schedules (Table) show the numerical values of
desired consumption and saving at each level of income, and correspond to
the C and S lines in the Figure
The Aggregate Expenditure Function in a Closed Economy
With No Government [£ Million]
GDP Desired Desired Desired aggregate
[National Income] consumption investment expenditure
[Y] expenditure expenditure [AE = C + I]
[C = 100 +0.8Y] [I = 250]
100 180 250 430
400 420 250 670
500 500 250 750
1000 900 250 1150
1500 1300 250 1550
1750 1500 250 1750
2000 1700 250 1950
3000 2500 250 2750
4000 3300 250 3550
An Aggregate Expenditure Function
5000
AE
4000
3000
2000
1000
350
1000 2000 3000 4000 5000
Real National Income Function [GDP] [£m]
An aggregate expenditure function
• The aggregate expenditure function relates total desired
expenditure to national income.
• Here desired expenditure is the sum of desired consumption
and desired investment.
• It is assumed that desired investment is £250 million while
consumption is £100 million plus 0.8 times income.
• So when income is zero there is autonomous expenditure of
£350 million.
• The marginal propensity to spend is 0.8.
The Determination of Equilibrium GDP
GDP Desired aggregate
[National Income] expenditure
[Y] [AE = C + 1]
100 430
400 670 Pressure on Y
500 750 to rise
1000 1150
1500 1550
1750 1750 Equilibrium Y
2000 1950
3000 2750
Pressure on Y
4000 3550
to fall
Equilibrium GDP
3000 450
[AE = Y]
E0 500
2000 S
Desired saving (£m)
I
250
1000 0
-100
350
450 -500
0
1000 Y0 2000 3000 Y0
1000 2000 3000
Real National Income [GDP] [£m] Real National Income [GDP] [£m]
[i]. An Aggregate Expenditure Function[AE = Y] [ii]. Saving Function[S = I]
Equilibrium GDP
• GDP is in equilibrium where aggregate desired expenditure
(AE) equals national output.
• In the figure equilibrium GDP occurs at E0 where AE intersects
the 450 line.
• If GDP is below Y0 desired AE will exceed national output and
production will rise.
• If GDP is above Y0 desired AE will be less than national output
and production will fall.
• When saving is the only withdrawal and investment is the only
injection, the equilibrium level of GDP is also that where saving
equals investment.
Revision Aide 2.2
The simple multiplier
• An increase in the autonomous component of desired
aggregate expenditure increases equilibrium GDP by a
multiple of the initial increase.
• The initial equilibrium is at E0, where AE0 intersects the 450
line. Here desired expenditure equals national output.
• An increase in autonomous expenditure of A then shifts
the AE function up to AE1.
• Because desired spending is now greater that output,
production and GDP will rise.
• Equilibrium occurs when GDP rises to Y1.
• Here desired expenditure e1 equals output Y1.
The Multiplier: A Numerical Example
500
400
300
200
100
0 1 2 3 4 5 6 7 8 9 10 15 20
Spending round
A numerical example of the multiplier
• Assuming that the marginal propensity to spend out of
national income is 0.8 and there is an autonomous
expenditure increase of £100m.
• National income and output initially rises by £100m.
• Those receiving £100m in income then spend £80m.
• This £80m of income leads to further spending of £64m.
• This £64m of income lead to a further increase in spending
of £51.2m.
• If we carry on this process it will converge to an extra
income and output totalling £500m.
• The multiplier in this case is 5.
A BASIC MODEL OF THE DETERMINATION OF GDP
The macroeconomic problem: inflation and unemployment
• Models of the short-term determination of GDP explain why actual
GDP deviates from potential GDP.
• Actual GDP above potential can be associated with inflation, while
actual GDP below potential is associated with unemployment and
lost output.
Key Assumptions
• For simplicity we aggregate all industrial sectors into one, so the
economy produces only one type of output good.
• We explain GDP determination through the major expenditure
categories: private consumption, investment, government
consumption, and net exports.
A BASIC MODEL OF THE DETERMINATION OF GDP
What Determines Aggregate Expenditure
• Desired aggregate expenditure includes desired consumption, desired
investment, and desired government expenditures, plus desired net
exports.
• It is the amount that economic agents want to spend on purchasing the
national product.
• In this chapter we consider only consumption and investment.
• A change in personal disposable income leads to a change in private
consumption and saving.
• The responsiveness of these changes is measured by the marginal
propensity to consume [MPC] and the marginal propensity to save
[MPS], which are both positive and sum to one.
• This indicates that, by definition, all disposable income is either spent
on consumption or saved.
A BASIC MODEL OF THE DETERMINATION OF GDP
• A change in wealth tends to cause a change in the allocation of
disposable income between consumption and saving. The
change in consumption is positively related to the change in
wealth, while the change in saving is negatively related to this
change.
• Investment depends, among other things, on real interest rates
and business confidence. In our simple theory investment is
treated as autonomous, or exogenous, as is the constant term
in the consumption function, called autonomous consumption.
• The part of consumption that responds to changes in income is
called induced spending.
A BASIC MODEL OF THE DETERMINATION OF GDP
Equilibrium GDP
• At the equilibrium level of GDP, purchasers wish to buy exactly
the amount of national output that is being produced.
• At GDP above equilibrium, desired expenditure falls short of
national output, and output will sooner or later be curtailed.
• At GDP below equilibrium, desired expenditure exceeds
national output, and output will sooner or later be increased.
• In a closed economy with no government, desired saving equals
desired investment at equilibrium GDP.
A BASIC MODEL OF THE DETERMINATION OF GDP
• Equilibrium GDP is represented graphically by the
point at which the aggregate expenditure curve cuts
the 450 line, that is, where total desired expenditure
equals total output.
• This is the same level of GDP at which the saving
function intersects the investment function.
A BASIC MODEL OF THE DETERMINATION OF GDP
Changes in GDP
• With a constant price level, equilibrium GDP is
increased by a rise in the desired consumption or
investment expenditure that is associated with each
level of national income.
• Equilibrium GDP is decreased by a fall in desired
spending.
• The magnitude of the effect on GDP of shifts in
autonomous expenditure is given by the multiplier.
• It is defined as K = Y/A, where A is the change in
autonomous spending and Y the resulting increase
in GDP.
A BASIC MODEL OF THE DETERMINATION OF GDP
• The simple multiplier is the multiplier when the price
level is constant.
• It is equal to 1/[1 - z], where z is the marginal
propensity to spend out of national income.
• Thus the larger z is, the larger is the multiplier. It is a
basic prediction of macroeconomics that the simple
multiplier, relating £1 worth of increased spending on
domestic output to the resulting increase in GDP, is
greater than unity.
