1. CChhaapptteerr 99
AAggggrreeggaattee EExxppeennddiittuurree aanndd
AAggggrreeggaattee DDeemmaanndd

2. CCCCoooonnnnssssuuuummmmppppttttiiiioooonnnn
• Consumption tends to reflect income.
• The positive and stable relationship between
consumption and income
– This is true for the household and for the
economy as a whole.

3. LO1 Disposable Income, Consumption,
and Saving in the United States
Exhibit 1

4. TThhee CCoonnssuummppttiioonn FFuunnccttiioonn
• Based on Disposable Income, households
decide how much to save and how much to
consume.
• Dependent Variable: Consumption
– This means consumption depends on income.
• Independent Variable: Disposable Income

5. U.S. Consumption Depends on
Disposable Income
LO1
Exhibit 2

6. LO1
Exhibit 3
The Consumption Function
11
10
8 9
7
6
5
0 1 2 3 4 5 6 7 8 9 1011121314
Real disposable income (trillions of dollars)
1 2 3 4
Real consumption (trillions of dollars)
C
The consumption function,
C, shows the relationship
between consumption and
disposable income, other
things constant.

7. Marginal Propensities to Consume and
to Save
 Marginal propensity to consume, MPC
 Fraction of additional income that is spent
 Change in consumption // cchhaannggee iinn iinnccoommee
 Marginal propensity to save, MPS
 Fraction of additional income that is saved
 CChhaannggee iinn ssaavviinngg // cchhaannggee iinn iinnccoommee
 MPC + MPS = 1
 The sum of all disposable income, 100%- either saved or
consumed.

8. MMPPCC,, MMPPSS,, aanndd tthhee SSllooppeess
 MPC
 The slope of the Consumption function
 MPS
MPC = D
C
DI
D
 The slope of the Saving function
MPS = D
S
DI
D

9. LO1 Exhibit 4
Marginal Propensities to Consume and to Save
Real consumption (trillions of dollars)
(a) Consumption function (b) Saving function
Real saving (trillions of dollars)
0
MPC=ΔC/ΔDI=0.4/0.5=4/5
a
b
MPS=ΔS/ΔDI=0.1/0.5=1/5
c
ΔC=0.4
ΔDI=0.5 ΔDI=0.5
Real disposable income 0 (trillions of dollars)
d
ΔS=0.1
The slope of the C function equals the marginal propensity to consume.
For the straight-line C function in (a), the slope is the same at all levels of income and
is given by the change in consumption divided by the change in disposable income
that causes it: MPC=4/5.
The slope of the S function in (b) equals the marginal propensity to save, MPS=1/5.

10. Non-income Determinants of
Consumption
• Net Wealth and Consumption
– The value of all assets that each household owns
minus an liabilities or debt.
– It is a stock variable.
– May include a home, furnishings, automobiles,
bank accounts, stocks and bonds.

12. Non-income Determinants of
Consumption
• The Price Level:
– When price level changes, so does the real value
of cash and bank accounts.
– An INCREASE in the price level reduces the
purchasing power of money holdings, causing
households to consume less and save more at
each income level.
– BUT, if the price level DECREASES-the opposite
will happen.

13. Non-income Determinants of
Consumption
• The Interest Rate:
– The reward savers earn for deferring consumption
and the cost borrowers pay for current spending
power.
– The higher the interest rate, the less is usually
spent on credit.
– The lower the interest rate, the more is usually
spent on credit.

14. Non-income Determinants of
Consumption
• Expectations:
– Future income increases would increase current
consumption.
– Future price level increases would increase
current consumption.
– Future interest rate increase would increase
current consumption.

15. LO1 Exhibit 5
Shifts of the Consumption Function
C’’
C
C’
Real disposable income
Real consumption
An upward shift, such as from
C to C’’, can be caused by an
increase in net wealth, a
decrease in the price level, an
favorable change in consumer
expectations, or a decrease in
the interest rate.
0
A downward shift of the consumption function, such as from C to C’, can be caused
by a decrease in net wealth, an increase in the price level, an unfavorable change in
consumer expectations, or an increase in the interest rate.

16. TThhee LLiiffee--CCyyccllee HHyyppootthheessiiss
• Do people with high incomes save a larger
fraction of their income than those with low
incomes?
– Theory and evidence support this
– On average, net savings over a lifetime is usually
little or nothing.

17. IInnvveessttmmeenntt
1) New factories, office buildings, malls, and
new equipment
2) New housing
3) Net increases in inventories
It is NOT stocks and bonds!!!

18. Investment
LO2
Gross private domestic investment
New physical capital
New housing
Net increases to inventories
Firms purchase new capital
Expect higher return
Market interest rate
Opportunity cost of investing in capital

19. Rates of Return on Golf Carts and
the Opportunity Cost of Funds
25
20
15
10
8
0 $2,000 $4,000 $6,000 $8,000 $10,000
Investment
5
Nominal interest rate (percent)
Market rate
of interest
Expected rate
of return
An individual firm invests
in any project with a rate
of return that exceeds the
market interest rate.
At an interest rate of 8%,
Hacker Haven purchases
three golf carts, investing
$6,000.
LO2 Exhibit 6

20. Investment
LO2
Investment demand curve
Inverse relationship
Quality of investment demanded
Market interest rate
Other things constant
Business expectations
Optimistic expectations
Investment demand increases

21. Investment Demand Curve for the
Economy
The investment demand
curve for the economy sums
the investment demanded
by each firm at each interest
rate.
At lower interest rates, more
investment projects become
profitable for individual firms,
so total investment in the
economy increases.
LO2 Exhibit 7
10
8
0 0.9 1.0 1.1 Investment
(trillions of dollars)
6
Nominal interest rate (percent)
D

22. IInnvveessttmmeenntt aanndd DDiissppoossaabbllee IInnccoommee
• How does investment vary with income in the
economy?
– The link between investment and income is
weaker than investment and consumption.
– Investment depends more on interest rates and
on business expectations than on income levels.

23. IInnvveessttmmeenntt FFuunnccttiioonn
• The investment function assumes that
investment is unrelated to disposable income.
• Investment is assumed to be autonomous
with respect to disposable income.

24. Investment Function
1.1
1.0
I’’
I’
12.0 14.0
Investment is assumed to be independent of income, as shown by
horizontal lines. Thus, investment is assumed to be autonomous.
A decrease in the
interest rate or more
upbeat business
expectations would
increase investment at
every level of income, as
shown by the upward
shift from I to I’’.
An increase in the
interest rate or less
favorable business
expectations would
decrease investment at
every level of income, as
shown by the downward
shift from I to I’.
LO2 Exhibit 8
0.9
Investment (trillions of dollars)
I
0 2.0 4.0 6.0 8.0 10.0
Real disposable income
(trillions of dollars)

25. Non-income Determinants of
Investment
• The interest rate
– An increase in interest rate will cause a decrease in
investment.
• Higher opportunity cost
– An decrease in interest rate will cause an increase in
investment.
• Lower opportunity cost
• Business Expectations
– Investment plans
– Wars
– Tax changes

26. Annual Percentage Change in U.S. Real
GDP, Consumption, and Investment LO2
Exhibit 9

27. GGoovveerrnnmmeenntt PPuurrcchhaassee FFuunnccttiioonn
 Government purchases of goods and services
 Government purchase function:
 Government purchases unrelated to DI
 Autonomous
 Increase in government purchases
 Upward shift of G function

28. GGoovveerrnnmmeenntt PPuurrcchhaasseess
• Transfer Payments:
– Outright grants from government to households
– Vary inversely with DI
• Net Taxes:
– Transfer Payments minus taxes

29. Net Exports
LO4
 Net exports = Exports – Imports
 Income increases: imports increase
 Autonomous of income
 If Imports > Exports: Net exports < 0
 If Exports > Imports: Net exports > 0
 Non-income determinants of net exports
 Price level (U.S. and foreign)
 Interest rates (U.S. and foreign)
 Foreign income
 Exchange rate

30. LO4 Exhibit 10
Net Export Function
-380
-400
-420
Net exports (billions of dollars)
12.0 14.0
X’’-M’’
X-M
0 2.0 4.0 6.0 8.0 10.0
Real disposable income
(trillions of dollars)
X’-M’
A decrease in the
value of the dollar
would increase net
exports at each level of
income, as shown by
the shift up to X’’-M’’.
An increase in the value of the dollar relative to other
currencies would decrease net exports at each level of income,
as shown by the shift down to X’-M’.
Net exports here are assumed to be independent of disposable
income, as shown by the horizontal lines. X-M is the net export
function when autonomous net exports equal -$400 billion.

31. Composition of Aggregate
Expenditure
 Consumption, C
 Stable; long term trend: increase
 Investment, I
 Fluctuates
 Government purchase, G
 Long-term trend: declined
 Net exports, X-M
 Last decade: -4%
LO5

32. LO5 Exhibit 11
U.S. Spending Components as
Percentages of GDP Since 1959

33. AAggggrreeggaattee EExxppeennddiittuurree aanndd IInnccoommee
 A dollar spent (expenditure)=A dollar earned (income)
 Aggregate expenditure components
 Consumption, C – varies with income
 Investment, I – autonomous
 Government purchases, G – autonomous
 Net exports, (X-M) - autonomous
 Government budget: balanced
 G = Net taxes

34. AAggggrreeggaattee EExxppeennddiittuurree aanndd IInnccoommee
 AE = C + I + G + (X – M)
 Aggregate expenditure line
 Planned spending
 At each level of real GDP (aggregate output;
aggregate income)
 Given price level
 Slope of AE line = MPC, since all other components are
autonomous

35. AAggggrreeggaattee EExxppeennddiittuurree aanndd IInnccoommee
 Income – Expenditure model
 AE line, given price level
 45-degree line
 Spending = real GDP
 Aggregate output demanded (real GDP)
 AE = real GDP

36. AAggggrreeggaattee EExxppeennddiittuurree aanndd IInnccoommee
 If spending > real GDP
 Decrease inventories
 Increase
 Production and employment
 Income and spending
 If real GDP > spending
 Unsold goods: increase inventories
 Decrease
 Production and employment
 Income and spending

37. Total Output
(Real GDP-measured
in
trillions)
Planned
Aggregate
Expenditures
Tendency of
Output
$12.40 $12.70 Expand
12.70 12.85 Expand
13.00 13.00 Equilibrium
13.30 13.15 Contract
13.60 13.30 Contract

38. LO1
Deriving the Real GDP Demanded
for a Given Price Level
C + I + G + (X - M)
e
a
d
15.0
14.8
14.0
13.2
0 13.0 14.0 15.0 Real GDP
(trillions of dollars)
13.0
Aggregate expenditure (trillions of dollars)
45°
Real GDP demanded for a
given price level is found
where aggregate expenditure
equals aggregate output – that
is, where spending equals the
amount produced, or real
GDP.
This occurs at point e, where
the aggregate expenditure line
intersects the 45-degree line.
b
c
Exhibit 1

39. TTTThhhheeee SSSSppppeeeennnnddddiiiinnnngggg MMMMuuuullllttttiiiipppplllliiiieeeerrrr EEEEffffffffeeeecccctttt
• Keynes also argued that even a minor
disturbance would often be amplified into a
major disruption.
• The multiplier indicates that changes in
autonomous expenditures, those that don’t
vary with income, will exert an amplified
impact on output and income.

40. TThhee SSppeennddiinngg MMuullttiipplliieerr EEffffeecctt
• The spending multiplier is the ratio of the
change in real GDP to the initial change in any
component of aggregate expenditures,
including consumption, investment,
government spending, and net exports.

41. TTTThhhheeee SSSSppppeeeennnnddddiiiinnnngggg MMMMuuuullllttttiiiipppplllliiiieeeerrrr EEEEffffffffeeeecccctttt
Spending Multiplier change in equilibrium GDP
inital change in aggregate exp
enditures
MPC
Spending Multiplier
-
=
1
1
=

42. Stage Additional
Income
Additional
Consumption
Marginal
Propensity to
Consume
Round 1 1,000,000 750,000 3/4
Round 2 750,000 562,500 3/4
Round 3 562,500 421,875 3/4
Round 4 421,875 316,406 3/4
Round 5 316,406 237,305 3/4
Round 6 237,305 177,979 3/4
Round 7 177,979 133,484 3/4
Round 8 133,484 100,113 3/4
Round 9 100,113 75,085 3/4
Round 10 75,085 56,315 3/4
All Others 225,253 168,939 3/4
Total 4,000,000 3,000,000 3/4
Spending Multiplier= 1/ (1-MPC) = 4
This implies that the account injected into the economy will be four times
greater than the monetary value.

43. Aggregate Demand for Goods and
Services
• Quantity: the output of the entire economy
– Real GDP
• Price: the price level in the entire economy
– Price Index: CPI, GDP deflator
• Since demand in the goods and services
market aggregates, then the purchases of all
consumers, investors, government, and
foreigners is called Aggregate Demand (AD).

44. AAggggrreeggaattee DDeemmaanndd CCuurrvvee
• Aggregate Demand (AD) Curve: Shows the
various quantities of domestically produced
goods and services consumers are willing to buy
at different price levels in the economy.
• It shows the level of real GDP purchased by
Households, government, and foreigners (net
exports) at different possible price levels during a
time period
– Example of the Curve
• What does it mean to be downward sloping?
– Is this the same as individual demand?

45. Example of AD Curve
Price Level
AD
Real GDP

46. WWhhyy iiss iitt ddoowwnnwwaarrdd ssllooppiinngg
Three major reasons
1. A lower price level will increase the
purchasing power of money ( Real Balances
Effect)
2. The interest rate effect
3. Domestic goods become cheaper than
foreign goods (the net exports effect)

47. NNoonn--pprriiccee DDeetteerrmmiinnaannttss ooff AADD
• Changes in Consumption
• Changes in Investment
• Changes in Government Purchases
• Net Exports