Chapter 21: The Simplest Short-Run Macro Model

Desired Aggregate Expenditure

Desired Aggregate Expenditure, AE: The sum of desired or planned spending on domestic
output by households, firms, governments, and foreigners. (What people desire to spend out of
the resources that they actually have)
AE = C + I + G + (X - M)
National income accounts measure actual expenditures in each of the 4 expenditure categories.
Our model of the macro economy also deals with desired expenditures in each of these 4
categories.
Autonomous Expenditure: Components of aggregate expenditure that are not systematically
related to national income (does not change as Y changes)
Induced Expenditure: Components of aggregate expenditure that are systematically related to
national income (changes as Y changes)
Assumptions of this Simple Model of National Income Determination
There is no trade with other countries (X = 0, M = 0)
There is no government, so no taxes (G = 0)
The price level is constant (Nominal GDP = Real GDP)
Desired Consumption Expenditure
Disposable Income, YD: The amount of income households receive after deducting what
they pay in taxes and adding what they receive in transfers
In this simple model, Disposable Income (YD) = National Income (Y)
Saving: All disposable income that is not spent on consumption
There are only 2 possible uses of disposable income - consumption and saving
The Consumption Function
Consumption Function: The relationship between desired consumption expenditure and
disposable income
The key factors that influence desired consumption are
Disposable Income
Wealth
Interest Rates
Expectations about the future
Holding constant other determinants of desired consumption, an increase in disposable
income is assumed to lead to an increase in desired consumption

There is a positive relationship between desired consumption, C and disposable income, Y D.

Consumption Function: f(YD) C = a + bYD
a: Autonomous component, the amount of desired consumption by consumers even with 0
disposable income, independent of the level of income (y-intercept)
b: Induced component, for every $1 increase in YD, desired consumption rises by a certain
amount, brought about by a change in income (slope)
Properties of the Consumption Function
Average Propensity to Consume (APC): The proportion of disposable income that
households want to consume
APC = C / YD
Marginal Propensity to Consume (MPC): The relationship between the change in desired
consumption to the change in disposable income that brought it about
MPC = C / YD = The slope of the consumption function
It has a positive slope MPC is positive, increases in disposable income lead to increases
in desired consumption expenditure
It has a constant slope MPC is the same at any level of disposable income

 The 45 Line: A line that is constructed by connecting all points where desired
consumption (y-axis) = disposable income (x-axis) and has a positive slope of 1 because
both axes are given in the same units
If C > 45 line, Savings < 0 (Dissavings)
If C < 45 line, Savings > 0
The Saving Function
Once we know the relationship between desired consumption and disposable income,
we automatically know the relationship between desired saving and disposable income
Average Propensity to Save (APS): The proportion of disposable income that households
want to save
APS = S / YD
Marginal Propensity to Save (MPS): The relationship between the change in desired
saving to the change in disposable income that brought it about
MPS = S / YD
APC + APS = 1
MPC + MPS = 1
A change in disposable income (YD) will cause a movement along the consumption
function (C) and saving function (S) curves, changing the amounts of C and S
Factors that cause a shift of the C and S curves
A change in household wealth: + in wealth shift C , shift S
A change in interest rates: - in interest rates shift C , shift S
A change in expectations about the future: optimism shift C , shift S
A movement along the consumption function shows changes in consumption induced by
changes in disposable income
A shift of the consumption function shows autonomous changes in consumption
Any event that causes the consumption function to shift must also cause the saving
function to shift by an equal amount in the opposite direction
Desired Investment Expenditure
3 categories of investment
1) Inventory Accumulation
2) New Plant and Equipment
3) Residential Construction
Inventory expenditure is the most volatile component of GDP (changes the most)
3 determinants of aggregate investment expenditure
1) Real Interest Rate
Real opportunity cost of using money (borrowed or retained earnings) for
investment purposes
+ in interest rate - in desired investment expenditure
- in interest rate + in desired investment expenditure
2) Changes in the Level of Sales

Because the size of inventories is related to the level of sales, the changes in
inventories is related to the change in the level of sales
+ in sales + in investment in inventories
- in sales - in investment in inventories
3) Business Confidence
optimism + in investment
pessimism - in investment
Desired investment spending is autonomous it does not depend on national income
The Aggregate Expenditure Function
Aggregate Expenditure Function (AE): The function that relates desired aggregate
expenditure to actual national income
Since there is no G or (X M) in this simple model, desired aggregate expenditure is
equal to desired consumption plus desired investment, C + I
AE = C + I
Marginal Propensity to Spend: The change in desired aggregate expenditure on
domestic output divided by the change in national income that brought it about, slope
of AE function (AE / Y)
The marginal propensity to spend is the amount of extra total expenditure induced
when national income rises by $1, whereas the marginal propensity to consume is the
amount of extra consumption expenditure induced when households disposable
income rises by $1
In this simple model, MPSpend = MPC, since consumption is the only kind of
expenditure that is assumed to vary with national income

Equilibrium National Income

If AE > Y, national income is to rise.
If AE < Y, national income is to fall.
The equilibrium level of national income occurs where desired aggregate expenditure equals
actual national income, AE = Y.

Changes in Equilibrium National Income

Through the adjustment in firms inventories and production levels, the level of actual national
income will adjust until this equilibrium level is achieved.
Shifts of the AE Function
A change in autonomous consumption or investment will cause a parallel shift of the AE
curve
A change in the marginal propensity to spend changes the slope of the AE function and a
change in equilibrium national income
An upward shift in the AE function increases equilibrium national income - Given this
excess demand, firms inventories are being depleted and firms respond by increasing
production
A downward shift in the AE function decreases equilibrium national income - Firms
inventories are being built up and firms respond by decreasing production

The Results Restated

A rise in the amount of desired aggregate expenditure at each level of national income
will shift the AE curve upward and increase equilibrium national income
A fall in the amount of desired aggregate expenditure at each level of national income
will shift the AE curve downward and reduce equilibrium national income
An increase/decrease in the marginal propensity to spend, z, steepens/flattens the AE
curve and increases/decreases equilibrium national income
The Multiplier
A measure of the magnitude (size) of the changes in AE that cause equilibrium national
income to rise or fall
The multiple by which national income increases when autonomous expenditure
changes

 The change in equilibrium national income divided by the change in autonomous

expenditure that brought it about, Y / A
It is > 1, since Y / A > 1
Simple Multiplier
The ratio of the change in equilibrium national income to the change in
autonomous expenditure that brought it about, calculated for a constant price
level
The size depends on the slope of the AE function, marginal propensity to spend,
z
The larger the marginal propensity to spend, the steeper the AE function and
thus, the larger the simple multiplier

Economic Fluctuations as Self-Fulfilling Prophecies

If firms and households expect the economy to improve, desired spending will increase,
which increases Y and AE even more, but the opposite is also true
Expectations about the future can be a large contributor to realizing these predictions