The document explains the national income accounting identity, emphasizing that Gross Domestic Product (GDP) represents both aggregate output and income. It discusses consumption and saving behavior based on the Keynesian consumption and saving functions, as well as the impact of investment on the economy. Furthermore, it examines equilibrium conditions in the goods market and the effects of changes in consumption and investment on overall output.

1. Expenditure and output
Saving, Consumption and Investment in the Economy

2. Aggregate Output / Income
Recall the national income accounting identity:
Y = C + I + G + (X – M)
• From the identity, Y represents Gross Domestic Product (GDP).
• We know that GDP accounts for the goods and services
supplied in the economy over a given period.
• From a different perspective, GDP also accounts for all the
income received by the factors of production in a given period.
• Thus, to simplify, Y is a variable that measures both aggregate
output and aggregate income.
A look back at GDP and what it means.

3. Simplifications
• Recall that all variables are aggregates.
• Since people only care about the “real” value of their
income/output, we can assume that all variables under
consideration are expressed in real terms.
• To proceed with the analysis, we can consider the simplest
case:
• There is no government intervention in the economy
(i.e. G = 0).
• A closed economy model (i.e. [X – M] = 0).
• Thus, our model reduces to:
Y = C + I
Some assumptions to make the analysis easier.

4. Consumption
Determinants of aggregate consumption:
1. Household Income
2. Household Wealth
3. Households’ Expectations about the Future
4. Interest Rates
Identifying the factors that influence spending behavior.

5. Consumption Behavior
• Based on our simplified model, we can say that
consumption is a function of income:
C = f(Y)
• More specifically, the relationship between consumption
and income can be modeled as follows:
The Keynesian consumption function.
C = a + bY
where a = autonomous consumption
b = marginal propensity to consume (MPC)

6. C = a + bY
Consumption BehaviorThe Keynesian consumption function.
AggregateConsumption(C)
Aggregate Income (Y)
a
}Autonomous
Consumption
∆ C
∆ Y
= b = MPC
∆ C
∆ Y
Slope =

7. Saving ≠ Savings
• Saving refers to the amount from this period’s income that
has not been spent.
• It is a flow variable and may vary from period to period.
• Savings refers to the total amount that households have
saved over their lifetimes.
• It is a stock variable that totals saving from day zero to
the present.
A little note on terminology (and a lot of nitpicking).

8. Saving Behavior The Keynesian saving function.
Consider: Saving is the difference between income and
consumption.
S = Y – C
From the consumption function:
C = a + bY
Substituting:
S = Y – (a + bY)
Simplifying, we derive the saving function:
S = – a + (1 –b)Y
where (1 – b) = marginal propensity to save

9. Consumption and SavingA numerical example
Y
0
200
400
600
800
1000
C
100
250
400
550
700
850
S
-100
-50
0
50
100
150
Given:
C = 100 + 0.75Y
S = 0.25Y – 100

10. At low incomes,
consumers borrow.
Lifetime ConsumptionHow would people consume if they knew their future income with certainty?
Consumption(C)
Time (t)
C
Y
At higher incomes, consumers
save and/or pay off debt.

11. 0
250
500
750
1,000
0 200 400 600 800 1,000
-100
-50
0
50
100
150
0 200 400 600 800 1,000
Y
AggregateConsumption(C)
S
Y
C = Y
C
AggregateSavings(S)
Aggregate Income (Y)
Aggregate Income (Y)
C = 100 + 0.75Y
S = 0.25Y – 100
S = 0

12. Investment
• Review: investment, together with consumption, make up
aggregate expenditure:
Y = C + I
• From a macroeconomic standpoint, investment pertains to
purchases that add to the stock of physical capital.
• Recall the production function: Y = f(K, L)
• Investment encompasses business fixed investments and
changes in business inventories.
Conceptualizing investment.

13. Interest Rates
• The interest rate is the opportunity cost of investment.
• An example: assume an interest rate of 5%:
• Do you take an investment that returns 10%?
• Do you take an investment that returns 7.5%?
• Do you take an investment that returns 5%?
• Do you take an investment that returns 2.5%?
Another aside on the relationship between investment and the interest rate.
MPK = (1 + r )
Marginal Product
of Capital
Gross Return on
Investment

14. More on Investment
• Firms sometimes invest more (or less) than originally
intended.
• For the present analysis, we are concerned only with
planned investment.
• There are only two principal determinants of investment:
• The interest rate.
• Business expectations.
• Investment is not a function of income: it is an autonomous
variable.
A few more notes on investment.

15. Planned InvestmentA look at the planned investment function.
PlannedInvestment(I)
Aggregate Income (Y)
I

16. EquilibriumUnderstanding the equilibrium amount of aggregate output and income.
Logically, the goods market will be in equilibrium when
planned spending exhausts all goods produced.
Y = Equilibrium Aggregate Output
C + I = Planned Aggregate Expenditure
EQUILIBRIUM:
Y = C + I
AE = a + bY + I
= (a + I) + bY

17. EquilibriumUnderstanding the equilibrium amount of aggregate output and income.
Logically, the goods market will be in equilibrium when
planned spending exhausts all goods produced.
If Y > C + I, too much is being
produced in the economy.
Consequence: Output will fall.
EQUILIBRIUM:
Y = C + I
If Y < C + I, too little is being
produced in the economy.
Consequence: Output will rise.

18. EquilibriumDoing the math.
0
200
400
600
800
1,000
0 200 400 600 800 1,000
“C + I”
Aggregate Income (Y)
AggregateExpenditure(C,I)
“C”

19. EquilibriumDoing the math.
Y C I
0 100 25
200 250 25
400 400 25
600 550 25
800 700 25
1000 850 25
Given:
Y = C + I (Equilibrium)
C = 100 + 0.75Y
I = 25

20. EquilibriumThe graphical solution: the Keynesian cross.
0
200
400
600
800
1,000
0 200 400 600 800 1,000
C + I
Anywhere in this region,
Y < C + I
Anywhere in this region,
Y > C + I
Y = C + I
Aggregate Income (Y)
AggregateExpenditure(C,I)
E

21. Equilibrium
Recall the GDP accounting identity from the income approach:
Y = C + S + T
• Maintaining the assumption that there is no government
intervention in the economy: T = 0
• This reveals another equilibrium condition:
Another perspective.
Y = C + S (1): GDP identity by income approach
AE = C + I (2): Aggregate expenditure (no gov’t)
Y = AE (3): Goods market equilibrium
C + S = C + I (4): Substitute (1) and (2) in (3)
S = I (5): Equilibrium saving & investment

22. EquilibriumAnother graphical solution.
AggregateSaving(C)
Aggregate Income (Y)
– a
S = (1-b)Y – a
0
I
E

23. The Story So FarEquilbrium: Consumption and Investment
The Equilibrium Condition: Y = C + I
Rearranging:
Substituting: Y = a + bY + I
Y = a + I + bY
Y = (a + I)
(1 – b)
1
Y – Yb = a + I
Y (1 – b) = a + I
Equilibrium Output:

24. What if...?
• An economy’s equilibrium output is determined by the
consumption and investment behavior of households and
firms.
• If that behavior changes, then equilibrium output will also
change.
• An increase in the economy-wide propensity to consume
also increases the amount of equilibrium output.
• An increase in the standard of living or in the amount of
investment also increases the amount of equilibrium
output, but by some multiple of the initial increase.
...things change?

25. AggregateExpenditure(C+I)
Aggregate Income (Y)
(a + I)
E(a + I)’
E’
The MultiplierThe effect of increases in the autonomous variables.
Investment
Multiplier
=
1
MPS

26. ProofThe Investment Multiplier.
Y = (a + I)
(1 – b)
1
Recall the equilibrium condition:
Notice the effect of a change in
planned investment on output:
∆Y =
1
MPS
∆ I

27. The Paradox of ThriftSudden increases in saving can be bad for the economy.
AggregateSaving(C)
Aggregate Income (Y)
– a
0
I
EE’