ECON 2010 Chapter : Sgmac11
©2010 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER 11| Aggregate Expenditure and
Output in the Short Run
Chapter Summary and Learning Objectives
11.1 The Aggregate Expenditure Model (pages 340–343)
Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.
Aggregate expenditure (AE) is the total amount of spending in the economy. The aggregate
expenditure model focuses on the relationship between total spending and real GDP in the short run,
assuming that the price level is constant. In any particular year, the level of GDP is determined by the
level of total spending, or aggregate expenditure, in the economy. The four components of aggregate
expenditure are consumption (C), planned investment (I), government purchases (G), and net exports
(NX). When aggregate expenditure is greater than GDP, there is an unplanned decrease in inventories,
which are goods that have been produced but not yet sold, and GDP and total employment will increase.
When aggregate expenditure is less than GDP, there is an unplanned increase in inventories, and GDP and
total employment will decline. When aggregate expenditure is equal to GDP, firms will sell what they
expected to sell, production and employment will be unchanged, and the economy will be in
macroeconomic equilibrium.
11.2 Determining the Level of Aggregate Expenditure in the Economy (pages 343–356)
Discuss the determinants of the four components of aggregate expenditure and define marginal
propensity to consume and marginal propensity to save. The five determinants of consumption are
current disposable income, household wealth, expected future income, the price level, and the interest
rate. The consumption function is the relationship between consumption and disposable income. The
marginal propensity to consume (MPC) is the change in consumption divided by the change in
disposable income. The marginal propensity to save (MPS) is the change in saving divided by the
change in disposable income. The determinants of planned investment are expectations of future
profitability, real interest rate, taxes, and cash flow, which is the difference between the cash revenues
received by a firm and the cash spending by the firm. Government purchases include spending by the
federal government and by local and state governments for goods and services. Government purchases do
not include transfer payments, such as Social Security payments by the federal government or pension
payments by local governments to retired police officers and firefighters. The three determinants of net
exports are the price level in the United States relative to the price levels in other countries, the growth
rate of GDP in the United States relative to the growth rates of GDP in other countries, and the exchange
rate between the dollar and other currencies.
11.3 Graphing Macroeconomic Equilibrium (pages 356–362)
Use a 45°-line diagram to illustrate macroeconomic equilibrium. The 45°-line diagram shows all the
points where aggregate expenditure equals real GDP. On the 45°-line diagram, macroeconomic
equilibrium occurs where the line representing the aggregate expenditure function crosses the 45° line.
The economy is in recession when the aggregate expenditure line intersects the 45° line at a level of GDP
that is below potential GDP. Numerically, macroeconomic equilibrium occurs when:
Consumption + Planned Investment + Government Purchases + Net Exports = GDP.
262 CHAPTER 11 | Aggregate Expenditure and Output in the Short Run
©2010 Pearson Education, Inc. Publishing as Prentice Hall
11.4 The Multiplier Effect (pages 363–369)
Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.
Autonomous expenditure is expenditure that does not depend on the level of GDP. An autonomous
change is a change in expenditure not caused by a change in income. An induced change is a change in
aggregate expenditure caused by a change in income. An autonomous change in expenditure will cause
rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a
multiplier effect on equilibrium GDP. The multiplier effect is the process by which an increase in
autonomous expenditure leads to a larger increase in real GDP. The multiplier is the ratio of the change
in equilibrium GDP to the change in autonomous expenditure. The formula for the multiplier is: 1/(1 −
MPC.)
Because of the paradox of thrift, an attempt by many individuals to increase their saving may lead to a
reduction in aggregate expenditure and a recession.
11.5 The Aggregate Demand Curve (pages 369–371)
Understand the relationship between the aggregate demand curve and aggregate expenditure. Increases
in the price level cause a reduction in consumption, investment, and net exports. This causes the
aggregate expenditure function to shift down on the 45°-line diagram, leading to a lower equilibrium real
GDP. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand curve
shows the relationship between the price level and the level of aggregate expenditure, holding constant all
factors other than the price level that affect aggregate expenditure.
Appendix: The Algebra of Macroeconomic Equilibrium (pages 380–381)
Apply the algebra of macroeconomic equilibrium. The chapter relies on graphs and tables to illustrate
the aggregate expenditure model of short-run real GDP. The appendix uses equations to represent the
aggregate expenditure model. Your instructor may cover or assign this appendix.
Chapter Review
Chapter Opener: Fluctuating Demand at Intel (page 339)
Intel is the world’s largest semiconductor manufacturer and a major supplier of the microprocessors and
memory chips found in most personal computers. But because of its dependence on computer sales, Intel
is vulnerable to the swings of the business cycle. As computer sales declined during the 2001 recession,
Intel’s revenues fell 21 percent and it laid off 5,000 workers. Intel was also hurt by the 2007–2009
recession. During the last quarter of 2008, its revenues fell 90 percent and it made plans to lay off 6,000
workers. Intel was hardly the only firm feeling the effects of the recession. Many firms in the United
States were cutting production and employment as a result of a decline in the total amount of spending, or
aggregate expenditure, in the economy.
The A
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ate Ex
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enditure Model
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es 340
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343
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11.1
Learning Objective: Understand how macroeconomic equilibrium is determined in the
aggregate expenditure model.
The aggregate expenditure model explains many aspects of business cycles. This model looks at the
relationship in the short run between total planned spending and real GDP. An important assumption of
the model is that the price level is constant. The main idea behind the aggregate expenditure model is that,
in any year, real GDP is determined mostly by aggregate expenditure. We define aggregate expenditure
(AE) as:
CHAPTER 11 | Aggregate Expenditure and Output in the Short Run 263
©2010 Pearson Education, Inc. Publishing as Prentice Hall
Aggregate expenditure = Consumption + Planned Investment + Government Purchases + Net Exports
where:
Consumption (C): Spending by households on goods and services, such as automobiles and haircuts.
Planned Investment (I): Spending by businesses on capital goods, such as factories, office buildings,
and machine tools, and spending by households on new homes.
Study Hint
Remember that investment expenditure includes the purchase of plant and equipment by firms, residential
construction, and any changes in business inventories. Planned investment includes only planned
inventory changes. Unanticipated or unplanned changes in business inventories are called unplanned
investment.
Government Purchases (G): Spending by local, state, and federal governments on goods and services,
such as aircraft carriers, bridges, and the salaries of FBI agents.
Net Exports (NX): Spending by foreign businesses and households on goods and services produced in
the United States minus spending by U.S. businesses and households on goods and services produced
in all other countries.
In equation form:
AE = C + I + G + NX
Planned investment in the AE function may differ from the actual level of investment. Actual investment
will include any unplanned changes in inventories caused by differences between production and sales. If
a firm produces $100 of output and only sells $80 of that output, the $20 of output produced but not sold
ends up in inventories. This $20 is included in actual investment but not in planned investment.
For the economy as a whole, equilibrium occurs when aggregate expenditure equals total production or:
AE = real GDP.
In this model, equilibrium real GDP will not change unless aggregate expenditure changes.
If AE is less than real GDP, firms are producing more output than is being purchased and there will be an
unplanned increase in inventories. Firms will respond to the increase in inventories by reducing
production and employment. If AE is more than production, firms are producing less output than is being
purchased. The only way a firm can sell more than it produces is by selling part of its inventory. Firms
will respond to this unplanned decrease in inventories by increasing production and employment. In either
case, the economy moves toward an equilibrium in which AE = real GDP. The following table—Table
11.1 in the textbook—summarizes the relationship between AE and GDP:
If … Then … And
Aggregate expenditure is
Equal to GDP
There is no unplanned inventory
change
The economy is in macroeconomic
equilibrium.
Aggregate expenditure is
Less than GDP
There is an unplanned inventory
increase GDP and employment decrease.
Aggregate expenditure is
Greater than GDP
There is an unplanned inventory
decrease GDP and employment increase.
