CH 21

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Chapter 21
The Simplest Short-

Run Macro Model
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Learning Objectives
1. Differentiate between desired expenditure and actual

expenditure.
2. Explain the determinants of desired consumption and

desired investment expenditures.
3. Define equilibrium national income.
4. Explain how a change in desired expenditure affects

equilibrium income, and how this change is reflected by the
multiplier.
Copyright © 2005 Pearson Education Canada Inc.

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21.1 Actual Vs. Desired Agg. Expend.
The National Income and Expenditure Accounts (NIEA) divide

actual GDP, calculated from the expenditure side, into its
components: Ca, Ia , Ga, and NXa.
RECALL: GDP = Ca + Ia + Ga + NXa.

Is an accounting identity.
Every year (week, month) if we added up Ca, Ia , Ga, and
NXa we will get actual output GDP.
The small ‘a’ indicates we are measuring what each groups
actually spent during the time period.

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21.1 Desired Aggregate Expenditure
Total desired (planned, intended) expenditure on

domestically produced goods and services can be
divided into similar categories:
• desired consumption (C),

• desired investment (I),
• desired government purchases (G), and
• desired net exports (NX).
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The sum of these components is called desired aggregate

expenditure, or more simply Aggregate Expenditure (AE).
AE = C+I+G+(X-IM)
Components of aggregate expenditure that do not depend on
national income are called autonomous expenditures.
Components of aggregate expenditure that do change in
response to changes in national income are called induced
expenditures.
What Does “Desired” Really Mean?
“Desired” expenditure is not just a list of what consumers and firms

would buy if they had no constraints on their spending — it is much more
realistic than that. Desired expenditure is what consumers and firms
would like to purchase, given their real-world constraints of income and
market prices. Their ‘intended’ or ‘planned’ expenditures.
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Desired Consumption Expenditure
There are only two possible uses of disposable income:

consumption (C) or saving (S).
The factors that influence consumption or saving are given in

the consumption function and the saving function.
In the simplest theory, consumption is determined primarily by

current disposable income (YD).
In more advanced theories of consumption, individuals are

explicitly forward looking, and current income is less important
than some measure of “permanent” or “lifetime” income.

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The simple consumption function is written as:
C = a + bYD
where a represents autonomous consumption expenditure
and bYD represents induced consumption expenditure.
C 45º line
Notice that the slope of the

45º line is one. The slope
of the simple consumption
a Slope = b function is less than one.
YD
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Consider C = a + bYd where a = 4000 and b =0.5
Yd a + bYd = C
$ 0 $4000 $ 0 $ 4000
$ 5000 $4000 $ 2500 $ 6500
$ 8000 $4000 $ 4000 $ 8000
$10000 $4000 $ 5000 $ 9000
$15000 $4000 $ 7500 $11500
$20000 $4000 $10000 $14000
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Picture of the Consumption Function

C C= a + bYd
$14000
Break even
$8000
$6000
$4000
Intercept $0 $5000 $8000 Yd

$20000
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Exercise: do the chart and graph
Repeat the above exercise using the following
a b you should find
$5000 0.5 intercept shifts up

$3000 0.5 intercept shifts down
$4000 0.7 slope rotates upwards
$4000 0.3 slope rotates downwards
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The marginal propensity to consume (MPC) relates the

change in desired consumption to the change in disposable
income that brings it about — it is the slope of the
consumption function.
MPC = ∆ C/∆ YD (equals b )
In the previous diagram, the MPC is the same at any level of
income.
The average propensity to consume (APC) is equal to total

consumption divided by total disposable income. The APC
falls as the level of income rises.
APC = C/YD

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Yd C APC MPC
C / Yd ∆ YD ∆ C ∆C/∆YD
$ 0 $ 4000 …
$5000 $2500 0.5
$ 5000 $ 6500 1.30
$3000 $1500 0.5
$ 8000 $ 8000 1.00
$2000 $1000 0.5
$10000 $ 9000 0.90
$5000 $2500 0.5
$15000 $11500 0.77
$5000 $2500 0.5
$20000 $14000 0.70
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What about savings??

If C = a + bYd and Yd = C + S then S= -a +(1-b)Yd
Yd C Savings = Yd - C
$ 0 $ 4000 -$4000
$ 5000 $ 6500 -$1500
$ 8000 $ 8000 $ 0
$10000 $ 9000 $1000
$15000 $11500 $3500
$20000 $14000 $6000
Calculate APS = S/YD MPS = ∆ S/∆ YD

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45º line
600
Desired Xonsumption
450 C
300
150 •
150 300 450 600

Real Disposable Income
Desired Saving
150 S
Both consumption and 0
saving rise as disposable -30 150 300 450 600
income rises. -150 Real Disposable Income

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The average propensity to save (APS) is equal to total desired

saving divided by total disposable income:
APS = S/YD
The marginal propensity to save (MPS) relates the change in
desired saving to the change in disposable income that
brought it about:
MPS = ∆ S/∆ YD
Since all of YD is either consumed or saved, we have:

• APC + APS = 1
• MPC + MPS = 1

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Shifts in Consumption 600

45º line
Desired Consumption
Functions C1 C0
450 •
Suppose there is an
unexpected 300
increase in wealth.
150 •
The consumption
function will shift 30
upward, and the saving 150 300 450 600
function downward. Real Disposable Income
Desired Saving
Other reasons the 150
S0
consumption function S1
might shift include 0
-30 150 450 600
changes in interest 300
-150 Real Disposable Income
rates or expectations.
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Desired Investment Expenditure
Investment expenditure is the most volatile component of

GDP. Changes in investment expenditure are strongly
associated with economic fluctuations.
Three important determinants of aggregate investment

expenditure are:
• the real interest rate,

• changes in the level of sales, and
• business confidence.

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The Real Interest Rate
1. The real interest rate is the opportunity cost of using money

(either borrowed or retained earnings) for investment in
new plants and equipment.
2. It is also the opportunity cost of holding an inventory of a

given size.
3. Also, higher real interest rates mean a higher cost

associated with mortgage financing for residential
construction.
Thus, all three components of desired investment

expenditure are negatively related to the real interest rate.

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Changes in Sales
The higher the level of production and sales, the larger the
desired stock of inventories. This means that changes in the
rates of production and sales cause temporary bouts of
investment (or disinvestment) in inventories.
Business Confidence
When business confidence is high, firms will want to invest

now so as to reap future profits (investment takes time to
“come on line”).
Business confidence and consumer confidence may feed off
of one another.

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Investment Function
Desired investment is treated as autonomous –

completely unrelated to the current level of Y
We can write I=I
Were I is determined by - real interest rates

- expectations (confidence)
- changes in sales
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Investment Function (what does it look like?)

Desires Investment interest rate falls
expectations improve
I sales increase
200 I’
I
150
interest rate rises
expectations worsen
100 I’’ sales decrease
0 Y
Actual National Income
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The Aggregate Expenditure Function

The aggregate expenditure function relates the level of
desired aggregate expenditure to the level of actual national
income.
(Note the distinction between desired aggregate expenditure

and actual national income.)
In the absence of government and international trade, desired

aggregate expenditure is just equal to C + I.
AE = C + I

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Consider the following example.
The consumption function is: C = a + bYd
Suppose C = 30 + (0.8)Y
The investment function is: I = I
I = 75
The AE function is then given by:
AE = C + I = 30 + (0.8)Y + 75
and so AE = 105 + (0.8)Y

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Y C I AE
900 AE
30 54 75 129
Desired Aggregate
120 126 75 201 600
Expenditure
150 150 75 225
300
300 270 75 345
450 390 75 465
105
525 450 75 525
600 510 75 585
900 750 75 825 300 600 900
The slope of the AE function is the marginal propensity to

spend. In the simplest model with no taxes and no
international trade, this is just the MPC.

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Summary
The AE function combines the spending plans of households

and firms. It shows, for any level of actual national income, the
level of desired aggregate spending.

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21.2 Equilibrium National Income

Desired Expenditure and Actual Output
If desired aggregate expenditure exceeds actual output, there
will be pressure for output to rise.
If desired aggregate expenditure is less than actual output,

there will be pressure for output to fall.
Why? Think about what happens to inventories when

AE > Y, and why this leads to more production.

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Desired
National Aggregate Effect
Income (Y) Expenditure
OUTPUT (AE = C + I)
30 129 Pressure
120 201 On output
150 225 to rise
300 345 ↓
450 465 ↓
525 525 Equilibrium income
600 585 ↑
900 825 Pressure on output
to fall
Equilibrium occurs where aggregate desired expenditure

equals actual national income (output).

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How the Economy Gets to Equilibrium – Inventory

Adjustment Mechanism
What happens if output (GDP) is greater than desired

AE? AE < Y
- Firms cannot sell all that they are producing
- Inventories build up (unintended I)
- Signals that a decrease in output is necessary
- Firms decrease output until AE=Y

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How the Economy Gets to Equilibrium –

Inventory Adjustment Mechanism
What happens if output (GDP) is less than desired
AE? AE > Y
- Firms are selling more then they are producing
- Inventories are being run down (unintended I)
- Signals that an increase in output is necessary
- Firms increase output until AE=Y

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Desired Saving and Desired Investment

We can view the equilibrium differently by considering desired
saving and desired investment.
The difference between desired investment and desired

saving is exactly equal to the difference between desired
aggregate expenditure and actual national income.
To see this, suppose the difference between desired saving

and desired investment is equal to some number, W. Thus,
S-I=W

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Now, recall that S = Y - C. We can therefore write:
Y-C-I=W
Since AE = C + I, we can rewrite the equation again as:
Y - (C + I) = W
⇒ Y - AE = W
Thus defining the equilibrium as the level of output where

AE = Y is exactly the same as defining the equilibrium as the
level of output where S = I.

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Equilibrium Illustrated 45º line

900 AE
Desired Aggregate
Equilibrium national
600
Expenditure
income is that level of •
national income where
desired aggregate 300
expenditure equals 105
actual national income.
300 600 900
Or, equivalently, it is the Saving, Investment
level of national income S
• I
where desired saving 75
equals desired investment. 0
-30 300 600 900

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21.3 Changes in Equilibrium National Income

Shifts in the AE Function AE1
AE AE AE ∆e´´
AE0
e1 ∆e´
∆e
e0
∆Y
Y0 Y1 Y Y0 Y1 Y
A movement along the AE function occurs in response to a

change in Y; a shift of the AE function indicates a change in
desired expenditure for any given level of Y.

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AE =Y AE =Y
AE AE AE1
AE1
E1
e1 • AE0
E1 AE0
e2 •
e´1
e0 •E e0
0 •E0
Y0 Y1 Y Y0 Y1 Y
Two types of shifts can occur with the AE function:

• First, the AE function can shift parallel to itself.
• Second, the slope of the AE function can change.
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The Multiplier
What is the Multiplier?

The multiplier is a measure of the size of the change in
equilibrium national income that results from a change in
autonomous expenditure.
In the simplest of macro models, the multiplier is greater than
one.
For example, a $1 billion increase in desired investment

expenditure will increase the equilibrium level of national
income by more than $1 billion.

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Suppose there is an
increase in autonomous AE AE =Y
desired expenditure equal
to ∆A. E1
e1 • AE1
We can derive the precise e´1 •
value of the simple multiplier: AE0
∆A
Simple multiplier = e0 •E
0
∆Y
∆Y 1
= Y0 Y1 Y
∆A 1-z
where z is the marginal propensity to spend out of

national income.

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AE AE =Y
AE
AE =Y E1 AE1
•
E1 AE1 AE0
•
∆A
AE0
•E ∆A •E
0
0
∆Y ∆Y
Y0 Y1 Y0 Y1
Y Y
The larger the marginal propensity to spend out of national

income (z), the steeper the AE curve and the larger the
multiplier.
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Economic Fluctuations as Self-Fulfilling

Prophecies
Households and firms base their desired investment and

consumption partly on their expectations for the future.
As a result, changes in expectations about the future can lead

to real changes in the current state of the economy.
To see this, imagine that many firms feel optimistic about

future economic prospects. This increased optimism will
increase their desired investment, shifting up the AE curve.
As we have seen, this shift will increase national income,

justifying the firms’ initial optimism.

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Now imagine the opposite scenario. It should be clear that if

firms and households are pessimistic about the future in large
numbers, the ensuing change in their behaviour will lead to a
self-fulfilling prophecy of reduced national income.
Could the Prime Minister ever announce

to the country that the government made a
‘big’ mistake!
For example: suppose that government analyst
report to the Prime Minister that having signed
the Kyoto Accord might result in a recession.

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1 of 30

The Simplest Short-

1. Differentiate between desired expenditure and actual

2. Explain the determinants of desired consumption and

3. Define equilibrium national income.

4. Explain how a change in desired expenditure affects

Copyright © 2005 Pearson Education Canada Inc.

21.1 Actual Vs. Desired Agg. Expend.

The National Income and Expenditure Accounts (NIEA) divide

RECALL: GDP = Ca + Ia + Ga + NXa.

Copyright © 2005 Pearson Education Canada Inc.

21.1 Desired Aggregate Expenditure

Total desired (planned, intended) expenditure on

• desired consumption (C),

The sum of these components is called desired aggregate

“Desired” expenditure is not just a list of what consumers and firms

Desired Consumption Expenditure

There are only two possible uses of disposable income:

The factors that influence consumption or saving are given in

In the simplest theory, consumption is determined primarily by

In more advanced theories of consumption, individuals are

Copyright © 2005 Pearson Education Canada Inc.

The simple consumption function is written as:

Notice that the slope of the

Consider C = a + bYd where a = 4000 and b =0.5

Picture of the Consumption Function

Intercept $0 $5000 $8000 Yd

Exercise: do the chart and graph

Repeat the above exercise using the following

a b you should find

$5000 0.5 intercept shifts up

The marginal propensity to consume (MPC) relates the

The average propensity to consume (APC) is equal to total

Copyright © 2005 Pearson Education Canada Inc.

What about savings??

Calculate APS = S/YD MPS = ∆ S/∆ YD

150 300 450 600

Copyright © 2005 Pearson Education Canada Inc.

The average propensity to save (APS) is equal to total desired

Since all of YD is either consumed or saved, we have:

Copyright © 2005 Pearson Education Canada Inc.

Shifts in Consumption 600

Desired Investment Expenditure

Investment expenditure is the most volatile component of

Three important determinants of aggregate investment

• the real interest rate,

Copyright © 2005 Pearson Education Canada Inc.

The Real Interest Rate

1. The real interest rate is the opportunity cost of using money

2. It is also the opportunity cost of holding an inventory of a

3. Also, higher real interest rates mean a higher cost

Thus, all three components of desired investment

Copyright © 2005 Pearson Education Canada Inc.

When business confidence is high, firms will want to invest

Copyright © 2005 Pearson Education Canada Inc.

Desired investment is treated as autonomous –

We can write I=I

Were I is determined by - real interest rates

Investment Function (what does it look like?)

The Aggregate Expenditure Function

(Note the distinction between desired aggregate expenditure

In the absence of government and international trade, desired