Aggregate expenditure (AE) is total planned spending in the economy. The AE model explains how the level of national income and output is determined by spending, and the multiplier explains why a change in spending produces a larger change in income.
The components of aggregate expenditure
AE = C + I + G + (X − M)
Consumption (C) — household spending, the largest component; Investment (I) — business spending on capital; Government spending (G); and net exports (X − M) — exports minus imports. Their determinants include income, confidence, interest rates, the exchange rate and government policy.
The consumption function, MPC and MPS
As income rises, households spend a fraction of each extra dollar and save the rest. The marginal propensity to consume (MPC) is the share of an extra dollar of income that is spent; the marginal propensity to save (MPS) is the share saved. Since every extra dollar is either spent or saved:
MPC + MPS = 1
Equilibrium and the role of inventories
Macroeconomic equilibrium occurs where planned AE equals output (income). If planned spending exceeds output, firms run down inventories and raise production; if spending falls short, inventories pile up and firms cut production. Output adjusts until planned AE = output.
The multiplier process
An initial injection of spending becomes income for those who receive it; they spend a fraction (the MPC) of it, which becomes income for others, who spend a fraction again — and so on in shrinking rounds. The diagram traces this for a $100m injection with MPC = 0.8.
The multiplier formula
multiplier (k) = 1 ÷ (1 − MPC) = 1 ÷ MPS
With MPC = 0.8, k = 1 ÷ 0.2 = 5, so a $100m injection ultimately raises income by $500m. A higher MPC (more spending, less leakage) gives a larger multiplier. Change in equilibrium income = injection × multiplier:
ΔY = ΔAE × k
Work the calculations together.
Predict the direction
For each, state the effect on AE and the direction of the multiplier effect on equilibrium income: (a) a rise in business confidence lifts investment; (b) households become cautious and save more (MPC falls); (c) a fall in exports.
1. If the marginal propensity to consume is 0.75, what is the marginal propensity to save?
2. Calculate the value of the multiplier when MPC = 0.75.
3. Using your multiplier from Q2, calculate the change in equilibrium income from a $200m increase in investment.
4. Explain why a higher MPC produces a larger multiplier. Refer to the multiplier process.
5. Explain the role of inventories in moving the economy towards macroeconomic equilibrium when planned aggregate expenditure exceeds output.
6. Explain, with reference to the multiplier, the effect of a fall in investment on equilibrium income and output.