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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
PART
The Core of
Macroeconomic
Theory
III
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
The level of GDP, the overall price level, and the level of
employment
—
three chief concerns of macroeconomists
—
are
influenced by events in three broadly defined “markets”:
Goods

and

services market
Financial (money) market
Labor market
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE III.1
The Core of Macroeconomic Theory
We build up the
macroeconomy
slowly.
In Chapters 8 and 9, we examine the market for goods and services.
In Chapters 10 and 11, we examine the money market.
Then in Chapter 12, we bring the two markets together, in so doing explaining the links
between aggregate output (
Y
) and the interest rate (
r
), and derive the aggregate demand
curve.
In Chapter 13, we introduce the aggregate supply curve and determine the price level (
P
).
We then explain in Chapter 14 how the labor market fits into the macroeconomic picture.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER OUTLINE
8
Aggregate
Expenditure and
Equilibrium Output
The Keynesian Theory of Consumption
Other Determinants of Consumption
Planned Investment (
I
)
The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium
Adjustment to Equilibrium
The Multiplier
The Multiplier Equation
The Size of the Multiplier in the Real World
Looking Ahead
Appendix: Deriving the Multiplier Algebraically
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
aggregate output
The total quantity of goods and services produced
(or supplied) in an economy in a given period.
aggregate income
The total income received by all factors of
production in a given period.
In any given period, there is an exact equality between aggregate output
(production) and aggregate income. You should be reminded of this fact
whenever you encounter the combined term
aggregate output (income) (
Y
)
.
aggregate output (income) (
Y
)
A combined term used to remind you
of the exact equality between aggregate output and aggregate income.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
consumption function
The relationship between consumption and income.
FIGURE 8.1
A Consumption
Function for a Household
A consumption function for an
individual household shows the
level of consumption at each
level of household income.
The Keynesian Theory of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
To explain aggregate spending behavior, economists speculate
that an increase in aggregate income in a given period will result in
an increase in aggregate consumption in all of the following
instances, except:
a.
When household wealth increases.
b.
When interest rates rise.
c.
When households form positive expectations about the future.
d.
None of the above. In all of the cases above, aggregate
consumption will rise.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
To explain aggregate spending behavior, economists speculate
that an increase in aggregate income in a given period will result in
an increase in aggregate consumption in all of the following
instances, except:
a.
When household wealth increases.
b.
When interest rates rise.
c.
When households form positive expectations about the future.
d.
None of the above. In all of the cases above, aggregate
consumption will rise.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
With a straight line consumption curve, we can use the following equation to
describe the curve:
FIGURE 8.2
An Aggregate
Consumption Function
The aggregate consumption function
shows the level of aggregate
consumption at each level of
aggregate income.
The upward slope indicates that
higher levels of income lead to higher
levels of consumption spending.
The Keynesian Theory of Consumption
C
=
a
+
bY
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
marginal propensity to consume (
MPC
)
That fraction of a change in income
that is consumed, or spent.
aggregate saving (
S
)
The part of aggregate income that is not consumed.
S
≡
Y
–
C
The Keynesian Theory of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
When aggregate consumption is plotted along a straight line,
C
=
a
+
bY
, an increase in income results in an increase in consumption
equal to:
a.
b
.
b.
b
times Δ
Y
.
c.
a
times Δ
Y
.
d.
a
+
b
.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
When aggregate consumption is plotted along a straight line,
C
=
a
+
bY
, an increase in income results in an increase in consumption
equal to:
a.
b
.
b.
b
times Δ
Y
.
c.
a
times Δ
Y
.
d.
a
+
b
.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
identity
Something that is always true.
marginal propensity to save (
MPS
)
That fraction of a change in income that
is saved.
MPC
+
MPS
≡
1
Because the
MPC
and the
MPS
are important concepts, it may help to review
their definitions.
The marginal propensity to consume (
MPC
) is the fraction of an increase in
income that is consumed (or the fraction of a decrease in income that comes
out of consumption).
The marginal propensity to save (
MPS
) is the fraction of an increase in income
that is saved (or the fraction of a decrease in income that comes out of saving).
The Keynesian Theory of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.3
The Aggregate
Consumption Function Derived from the
Equation
C
= 100 + .75
Y
In this simple consumption function,
consumption is 100 at an income of
zero.
As income rises, so does
consumption.
For every 100 increase in income,
consumption rises by 75.
The slope of the line is .75.
Aggregate
Income,
Y
Aggregate
Consumption,
C
0
100
80
160
100
175
200
250
400
400
600
550
800
700
1,000
850
The Keynesian Theory of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.4
Deriving the Saving Function
from the Consumption Function in Figure 8.3
Because
S
≡
Y
–
C
, it is easy to derive the
saving function from the consumption
function.
A 45
°
line drawn from the origin can be
used as a convenient tool to compare
consumption and income graphically.
At
Y
= 200, consumption is 250.
The 45
°
line shows us that consumption is
larger than income by 50.
Thus,
S
≡
Y
–
C
=
50.
At
Y
= 800, consumption is less than
income by 100.
Thus,
S
= 100 when
Y
= 800.
Y
AGGREGATE
INCOME
C
AGGREGATE
CONSUMPTION
= S
AGGREGATE
SAVING
0
100

100
80
160

80
100
175

75
200
250

50
400
400
0
600
550
50
800
700
100
1,000
850
150
The Keynesian Theory of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Fill in the blanks. Where the consumption function is below the
45
°
line, consumption is ________ than income, and saving is
________.
a.
more; positive
b.
more; negative
c.
less; positive
d.
less; negative
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Fill in the blanks. Where the consumption function is below the
45
°
line, consumption is ________ than income, and saving is
________.
a.
more; positive
b.
more; negative
c.
less; positive
d.
less; negative
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
The assumption that consumption depends only on income is obviously
a simplification.
In practice, the decisions of households on how much to consume in a
given period are also affected by their wealth, by the interest rate, and
by their expectations of the future.
Households with higher wealth are likely to spend more, other things
being equal, than households with less wealth.
The Keynesian Theory of Consumption
Other Determinants of Consumption
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.5
The Planned
Investment Function
For the time being, we will assume
that planned investment is fixed.
It does not change when income
changes, so its graph is a
horizontal line.
Planned Investment
(I)
planned investment (
I
)
Those additions to capital stock and
inventory that are planned by firms.
actual investment
The actual amount of investment that takes
place; it includes items such as unplanned changes in inventories.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
equilibrium
Occurs when there is no tendency for change. In
the macroeconomic goods market, equilibrium occurs when
planned aggregate expenditure is equal to aggregate output.
planned aggregate expenditure (
AE
)
The total amount the
economy plans to spend in a given period. Equal to
consumption plus planned investment:
AE
≡
C
+
I
.
Y > C
+
I
aggregate output > planned aggregate expenditure
C
+
I > Y
planned aggregate expenditure > aggregate output
The Determination of Equilibrium Output (Income)
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.
The Figures in Column 2 Are Based on the Equation
C
= 100 + .75
Y
.
(1)
(2)
(3)
(4)
(5)
(6)
Aggregate
Output
(Income) (
Y
)
Aggregate
Consumption (
C
)
Planned
Investment (
I
)
Planned
Aggregate
Expenditure (
AE
)
C
+
I
Unplanned
Inventory
Change
Y
(
C
+
I
)
Equilibrium?
(
Y
=
AE
?)
100
175
25
200
100
No
200
250
25
275
75
No
400
400
25
425
25
No
500
475
25
500
0
Yes
600
550
25
575
+ 25
No
800
700
25
725
+ 75
No
1,000
850
25
875
+ 125
No
The Determination of Equilibrium Output (Income)
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.6
Equilibrium
Aggregate Output
Equilibrium occurs when
planned aggregate expenditure
and aggregate output are equal.
Planned aggregate expenditure
is the sum of consumption
spending and planned
investment spending.
The Determination of Equilibrium Output (Income)
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Refer to the figure below. When aggregate output equals $800 billion,
which of the following happens?
a.
Unplanned inventory is rising, and output will tend to rise.
b.
Unplanned inventory is rising, and output will tend to fall.
c.
Unplanned inventory is falling, and output will tend to rise.
d.
Unplanned inventory is falling, and output will tend to fall.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Refer to the figure below. When aggregate output equals $800 billion,
which of the following happens?
a.
Unplanned inventory is rising, and output will tend to rise.
b.
Unplanned inventory is rising, and output will tend to fall.
c.
Unplanned inventory is falling, and output will tend to rise.
d.
Unplanned inventory is falling, and output will tend to fall.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Because aggregate income must be saved or spent, by definition,
Y
≡
C
+
S
, which is an identity. The equilibrium condition is
Y
=
C
+
I
, but
this is not an identity because it does not hold when we are out of
equilibrium. By substituting
C
+
S
for
Y
in the equilibrium condition,
we can write:
C
+
S
=
C
+
I
Because we can subtract
C
from both sides of this equation, we are
left with:
S
=
I
Thus, only when planned investment equals saving will there be
equilibrium.
The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.7
The
S
=
I
Approach
to Equilibrium
Aggregate output is equal to
planned aggregate expenditure
only when saving equals
planned investment (
S
=
I
).
Saving and planned investment
are equal at
Y
= 500.
The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
The adjustment process will continue as long as output (income) is
below planned aggregate expenditure.
If firms react to unplanned inventory reductions by increasing output,
an economy with planned spending greater than output will adjust to
equilibrium, with
Y
higher than before.
If planned spending is less than output, there will be unplanned
increases in inventories. In this case, firms will respond by reducing
output. As output falls, income falls, consumption falls, and so on, until
equilibrium is restored, with
Y
lower than before.
The Determination of Equilibrium Output (Income)
Adjustment to Equilibrium
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
multiplier
The ratio of the change in the equilibrium level of output to a change
in some exogenous variable.
exogenous variable
A variable that is assumed not to depend on the state of
the economy
—
that is, it does not change when the economy changes.
The Multiplier
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
FIGURE 8.8
The Multiplier as
Seen in the Planned Aggregate
Expenditure Diagram
At point
A
, the economy is in
equilibrium at
Y
= 500.
When
I
increases by 25,
planned aggregate expenditure
is initially greater than
aggregate output.
As output rises in response,
additional consumption is
generated, pushing equilibrium
output up by a multiple of the
initial increase in
I
.
The new equilibrium is found at
point
B
, where
Y
= 600.
Equilibrium output has
increased by 100 (600

500), or
four times
the amount of the
increase in planned investment.
The Multiplier
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Refer to the figure below. In this example, the size of the multiplier
equals:
a.
1.33
b.
25
c.
4
d.
100.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Refer to the figure below. In this example, the size of the multiplier
equals:
a.
1.33
b.
25
c.
4
d.
100.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
Because
S
must be equal to
I
for equilibrium to be restored, we can
substitute
I
for
S
and solve:
Therefore
,
, or
Recall that the marginal propensity to save (
MPS
) is the fraction of a
change in income that is saved. It is defined as the change in
S
(
∆
S
)
over the change in income (
∆
Y
):
The Multiplier
The Multiplier Equation
It follows that
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
In our simple economy (
Y
=
C
+
I
), when investment rises,
equilibrium income will change by:
a.
b.
c.
d.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
In our simple economy (
Y
=
C
+
I
), when investment rises,
equilibrium income will change by:
a.
b.
c.
d.
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
In this chapter, we took the first step toward understanding how the economy
works.
We assumed that consumption depends on income, that planned investment is
fixed, and that there is equilibrium.
We discussed how the economy might adjust back to equilibrium when it is out
of equilibrium.
We also discussed the effects on equilibrium output from a change in planned
investment and derived the multiplier.
In the next chapter, we retain these assumptions and add the government to
the economy.
Looking Ahead
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PART III
The Core of Macroeconomic Theory
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
actual investment
aggregate income
aggregate output
aggregate output (income) (
Y
)
aggregate saving (
S
)
consumption function
equilibrium
exogenous variable
identity
marginal propensity to consume
(
MPC
)
marginal propensity to save (
MPS
)
multiplier
planned aggregate expenditure (
AE
)
planned investment (
I
)
1.
S
≡
Y
−
C
2.
3.
MPC
+
MPS
≡ 1
4.
AE
≡
C
+
I
5. Equilibrium condition:
Y
=
AE
or
Y
=
C
+
I
6. Saving/investment approach to
equilibrium:
S
=
I
7.
R E V I E W T E R M S A N D C O N C E P T S
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