AGGREGATE EXPENDITURE AND INCOME EQUILIBRIUM
Assumptions: Price level is fixed and there are only changes in real GDP. There is no
depreciation and no indirect taxes. GDP = Net Domestic Income
Aggregate expenditure: the sum of desired or planned spending on domestic output by
households, firms, governments, and foreigners
AE = C + I + G + (X - IM)
National income accounts measure actual expenditures in each of the four expenditure
categories while national income theory deals with desired expenditures.
The AE function relates the level of desired AE to the level of real income.
There is a level of income (Y*) at which AE is equal to the actual level of output (Y) → Y = AE.
Actual expenditure (GDP) is equal to desired expenditure at Y*. Y* is the equilibrium level of
income or output for the economy.
If AE > Y, there is excess desired spending in the economy (excess demand) and the level of
output will tend to rise. If AE < Y, there is insufficient desired spending in the economy (excess
supply) and the level of output will tend to fall
The implicit assumption is that desired aggregate expenditure determines the amount of goods
and services produced in the economy. When AE differs from Y, equilibrium cannot be restored
through a change in price level since P is assumed to be fixed. To restore equilibrium, output
will have to increase/decrease to eliminate excess demand/supply.
Simple Model: Consumption and Investment
Consumption Function: total desired personal
consumption expenditure by all households in the
economy. Includes variables such as disposable income,
wealth, interest rates, and expectations about the future.
For simplicity, assume all these variables are constant
except disposable income, and that the consumption
function depends only on disposable income (YD).
Note: changes in the other variables will cause the
consumption curve to shift.
Keynesian Consumption Function: C = + cYD
= autonomous consumption
cYD = induced consumption
c = describes rate of change of consumption as
disposable income changes (0 < c < 1)
c = ∆C/∆YD → c is the marginal propensity to consume
out of YD (MPC )YD
Average propensity to consume (APC ) = /YD + c
Since YD = C + S, S = YD - C = YD - ( +cYD) = - + (1 - c)YD = - +sYD,
where s = ∆S/∆YD is the marginal propensity to save out of disposable income (MPS )