Explain aggregate expenditure
Analyse the determinants of consumption, investment, government spending and net exports.
The Circular Flow of Income and the Multiplier
This chapter moves from the circular flow to a Keynesian model of income determination. It explains what drives aggregate expenditure, how planned injections and leakages determine equilibrium income, and why an initial change in spending can produce a larger final change in real GDP.
Aggregate expenditureConsumptionInvestmentInjections & leakagesMultiplierAcceleratorParadox of thriftOutput gaps
What this chapter prepares you to do
Find equilibrium income
Use both the 45° income–expenditure model and the injections–withdrawals approach.
Calculate the multiplier
Work with marginal propensities to consume, save, tax and import, then apply the multiplier to changes in autonomous spending.
Diagnose output gaps
Distinguish deflationary and inflationary gaps and connect them to full-employment income.
High-grade habit: keep planned and actual expenditure separate. Ex post, total expenditure equals output because unsold output appears as inventory investment; equilibrium requires planned expenditure to match planned output without unintended inventory changes.
Chapter sections
24.1
The components of aggregate demand
National income can be viewed as total output, total income or total expenditure. In an open economy with government, aggregate demand is:
AD = C + I + G + (X − M)
C = consumption · I = investment · G = government expenditure · X = exports · M = imports
C = consumption · I = investment · G = government expenditure · X = exports · M = imports
For the income–expenditure model, the focus is on planned aggregate expenditure (AE). Changes in firms' inventories matter because unplanned stock accumulation or depletion signals that planned spending and planned output are not equal.
Consumption and saving
Keynes treated household disposable income as the main determinant of consumption. Disposable income is what households have available for consumption and saving after direct taxes and transfers have been taken into account.
Book-style propensity example: if household consumption is $80 and disposable income is $100, APC = 80/100 = 0.8. If income rises to $110 and consumption rises to $87, the increase in consumption is $7 from an income increase of $10, so MPC = 7/10 = 0.7. The remaining 0.3 of the additional income is saved.
Average propensities
APC = C ÷ Y
APS = S ÷ Y
APS = S ÷ Y
They show the shares of total disposable income used for consumption and saving.
Marginal propensities
MPC = ΔC ÷ ΔY
MPS = ΔS ÷ ΔY
MPS = ΔS ÷ ΔY
They show how an additional unit of disposable income is divided between consumption and saving.
Worked example: disposable income rises from $500m to $600m and consumption rises from $420m to $490m. MPC = 70 ÷ 100 = 0.70. The remaining 0.30 of each extra dollar is saved in this simple two-way allocation, so MPS = 0.30.
Consumption also depends on household wealth, expectations of future income, interest rates, borrowing conditions and expectations about inflation. A change in disposable income causes a movement along the consumption function; changes in other influences shift the function.
The consumption function
The consumption function shows consumption rising with real disposable income, other influences held constant. Its slope is the marginal propensity to consume (MPC); for example, an MPC of 0.7 means households spend $70 of each extra $100 of income and save the remaining $30.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
A change in disposable income causes a movement along the consumption function and is called induced consumption. A change in wealth, expectations, interest rates or another non-income influence shifts the function and changes autonomous consumption.
Extension from the book: Friedman’s permanent-income hypothesis suggests households base consumption partly on the income they expect over a longer period, so a temporary income change may have only a small effect. The life-cycle hypothesis similarly suggests people smooth consumption over their lives, borrowing when young, saving during higher-earning years and drawing down savings in retirement.
Extension — consumption over time: the permanent-income hypothesis emphasises expected normal income rather than temporary fluctuations in current income. The life-cycle hypothesis suggests households try to smooth consumption over their lifetime, borrowing when young, saving during peak earning years and using accumulated wealth in retirement.
Saving
Saving is the counterpart of consumption. The saving function relates saving to disposable income. Saving caused by a change in income is induced saving; shifts caused by factors such as interest rates or confidence are autonomous.
Investment and the accelerator
Investment is expenditure that adds to the capital stock. Firms invest to replace depreciated capital and to expand productive capacity. A central influence is expected demand.
Accelerator intuition: a firm does not invest simply because demand is high; what matters is the change in expected demand or output. If sales begin rising rapidly, the firm may need extra machinery and buildings. If output is still high but stops growing, induced investment can fall because no further expansion of capacity is required.
Demand/output growth acceleratesFirms expect capacity to become insufficient.
→Desired capital stock risesExtra machines, buildings or equipment are needed.
→Investment increasesThis is the accelerator effect.
The accelerator therefore links investment to the change in output or expected demand, not simply to its level. Investment triggered by output changes is induced investment. Investment arising from other influences is autonomous investment.
Other investment determinants include interest rates, retained profits, the opportunity cost of using internal funds, business confidence, expectations of future profits and uncertainty. High or unstable inflation can discourage investment by making future returns harder to predict.
Government expenditure and net exports
In this model, government expenditure is treated mainly as autonomous. Net exports depend on the exchange rate, relative inflation and competitiveness. Imports also tend to rise as domestic income rises, while exports depend partly on income and demand in the rest of the world.
For net exports, an appreciation of the domestic currency tends to make exports less price competitive and imports more competitive, while relatively high domestic inflation has a similar effect. Import demand also rises with domestic income, whereas export demand depends partly on income and spending in the rest of the world.
Exam distinction: an appreciation of the domestic currency tends to make exports less price-competitive and imports more competitive, while faster domestic income growth tends to raise import spending. These are different channels.
24.2
Equilibrium in the income–expenditure model
The income–expenditure model explains equilibrium from a Keynesian perspective while taking the price level as given. Equilibrium means that the spending plans of economic agents are compatible with firms' production plans.
Closed economy, no government:
AE = C + I and Y = C + S
Equilibrium can therefore be written as AE = Y or, equivalently, planned I = planned S.
AE = C + I and Y = C + S
Equilibrium can therefore be written as AE = Y or, equivalently, planned I = planned S.
Closed economy with no government
AE = C + I
Y = C + S
Equilibrium: AE = Y
Equivalent condition: planned I = planned S
Y = C + S
Equilibrium: AE = Y
Equivalent condition: planned I = planned S
Equilibrium in the income–expenditure model
The 45° line shows all points where AE = Y. Equilibrium occurs at Y*, where the planned aggregate-expenditure line AE = C + I crosses the 45° line, so firms’ planned output matches planned spending.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
How inventories restore equilibrium
Actual income below Y*
Planned expenditure exceeds output. Inventories fall unexpectedly, signalling firms to raise output and employment. Income moves upward toward equilibrium.
Actual income above Y*
Output exceeds planned expenditure. Inventories accumulate unexpectedly, encouraging firms to cut production. Income moves downward toward equilibrium.
Reaching equilibrium
At income below Y*, planned expenditure is greater than output and inventories fall unexpectedly, encouraging firms to expand. Above Y*, inventories accumulate unexpectedly and firms cut output. Both adjustments move the economy toward equilibrium.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
If income is below Y*, planned expenditure exceeds current output and inventories are unexpectedly run down, so firms raise production. If income is above Y*, unwanted inventories accumulate and firms cut production. This inventory response is the mechanism that makes equilibrium stable in the simple Keynesian model.
This makes the equilibrium stable within the model: unintended inventory changes generate adjustments that move income back toward Y*.
Savings = investment equilibrium
The same closed-economy equilibrium can be shown where planned saving (S) equals autonomous planned investment (I). If saving exceeds investment, inventories build and income falls toward Y*.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Leakages and injections
Saving is a leakage from the spending stream, while investment is an injection. Once government and international trade are included:
In an open economy with government, taxes and imports join saving as withdrawals, while government expenditure and exports join investment as injections. The equilibrium condition becomes S + T + M = I + G + X. In the textbook’s simplified model, injections are treated as autonomous while saving, taxes and imports rise with income.
Leakages / withdrawals: W = S + T + M
Injections: J = I + G + X
Equilibrium: S + T + M = I + G + X
Injections: J = I + G + X
Equilibrium: S + T + M = I + G + X
In the simplified model, investment, government spending and exports are treated as autonomous. Saving, taxation and imports rise with income, so the withdrawal schedule slopes upward.
Equilibrium in the injections–leakages approach
With government and international trade, equilibrium GDP Y* occurs where planned withdrawals W = S + T + M equal planned injections J = I + G + X. At this point there is no pressure for national income to change.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
24.3
The multiplier
An autonomous injection creates income for someone else. Part of that extra income is then spent, creating further income, and the process continues. The final change in equilibrium real income can therefore be larger than the initial change in autonomous expenditure.
How the multiplier unfolds: if government orders $1 billion of road building, contractors and workers receive income. They spend part of it, creating income for shops and other firms; those recipients then spend part of their new income, and the process repeats. Each round is smaller because some income leaks into saving, tax and imports.
Multiplier = change in equilibrium real income ÷ initial autonomous change in expenditure
Why the process becomes smaller each round
Each round of extra income is partly withdrawn through saving, taxation and imports. Define:
MPS
Marginal propensity to save = ΔS ÷ ΔY.
MPT
Marginal propensity to tax = ΔT ÷ ΔY.
MPM
Marginal propensity to import = ΔM ÷ ΔY.
MPW
Marginal propensity to withdraw = MPS + MPT + MPM.
Open economy with government:
MPW = MPS + MPT + MPM
Multiplier = 1 ÷ MPW
MPW = MPS + MPT + MPM
Multiplier = 1 ÷ MPW
In the simplified open-economy model, each extra unit of income is either re-spent domestically or withdrawn. Therefore, MPC + MPW = 1, so a higher marginal propensity to withdraw means a smaller multiplier.
| Model assumptions | Multiplier |
|---|---|
| Closed economy, no government | 1 ÷ MPS |
| Open economy, no government | 1 ÷ (MPS + MPM) |
| Closed economy with government | 1 ÷ (MPS + MPT) |
| Open economy with government | 1 ÷ (MPS + MPT + MPM) |
Worked multiplier: MPS = 0.20, MPT = 0.15 and MPM = 0.05. MPW = 0.40, so the multiplier = 1 ÷ 0.40 = 2.5. A $200m rise in autonomous investment would, within the model, raise equilibrium real income by $500m.
Do not reverse the relationship: larger marginal leakages mean a smaller multiplier. A higher MPC, other things equal, means a larger share of additional income is re-spent and therefore tends to make the multiplier larger.
Multiplier in the injections–withdrawals model
Equilibrium in the withdrawals–injections approach
An increase in government spending raises autonomous injections from J0 to J1. Equilibrium income increases from Y0 to Y1, and the horizontal change in income is larger than the original vertical injection because of the multiplier.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
The key visual point is that the vertical increase in autonomous injections is smaller than the horizontal rise in equilibrium income. The difference reflects repeated rounds of spending generated by the multiplier.
Limits to the simple multiplier story
- If domestic productive capacity is inflexible, extra demand may leak into imports or raise prices rather than produce a large increase in real output.
- Interest rates and the price level are held outside this simple model, so the real-world response may be weaker or more complex.
- Time lags matter: successive spending rounds do not occur instantly.
- Expectations can alter consumption and investment while the process is unfolding.
The paradox of thrift
The paradox of thrift arises because a collective attempt by households to save more increases leakages. In the income–expenditure model this reduces equilibrium income, potentially raising unemployment. The result appears paradoxical because saving is individually prudent and can finance investment, yet in this simplified demand-side model a rise in planned saving can depress current income.
Multiplier–accelerator interaction
The two mechanisms can reinforce one another. A rise in autonomous demand raises output through the multiplier; faster output growth can then encourage additional induced investment through the accelerator; that investment becomes a fresh injection and triggers further multiplier effects. The reverse process can amplify a downturn, helping explain cyclical fluctuations.
24.4
Inflationary and deflationary gaps
The income–expenditure model does not guarantee that equilibrium occurs at the full-employment level of real GDP. Keynes's key insight was that the economy could settle at an equilibrium with unemployment if planned expenditure is too low.
A deflationary gap means planned autonomous expenditure is insufficient to achieve full-employment income. An inflationary gap means the equilibrium implied by spending plans would lie beyond productive capacity, so real output cannot rise enough to satisfy the excess demand and the pressure instead appears as inflation.
Deflationary gap
Equilibrium real income is below the full-employment level. Autonomous expenditure is insufficient to generate full-employment output, so unused capacity and unemployment remain.
Inflationary gap
The expenditure level required for injections to equal withdrawals lies beyond the economy's full-employment capacity. Planned spending is greater than the real output the economy can produce, creating upward pressure on the price level.
A deflationary gap
The economy is in equilibrium at Y*, below full-employment income YFE. The vertical distance AB is the shortfall in autonomous expenditure required to move equilibrium to full employment.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
An inflationary gap
Planned injections and withdrawals would balance at Y*, beyond the full-employment level YFE. The vertical distance QR is the inflationary gap: spending exceeds what the economy can supply at full employment, creating upward pressure on prices.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Exam link: the size of an output gap in GDP terms is not the same thing as the vertical spending gap on an injections–withdrawals or 45° diagram. The multiplier connects a change in autonomous expenditure to a larger change in equilibrium income.
Chapter 24 revision checklist
□ Write AD = C + I + G + (X − M).
□ Explain why unplanned inventory changes indicate disequilibrium.
□ Define disposable income.
□ Calculate APC, APS, MPC and MPS.
□ Distinguish autonomous and induced consumption.
□ Explain wealth, expectations and interest rates as consumption influences.
□ Explain the permanent-income and life-cycle ideas.
□ Distinguish autonomous and induced saving.
□ Explain investment and the accelerator principle.
□ Distinguish autonomous and induced investment.
□ Explain determinants of net exports.
□ Use AE = Y to identify equilibrium income.
□ Explain the inventory adjustment mechanism.
□ Use planned S = I in a simple closed economy.
□ Identify S, T and M as leakages and I, G and X as injections.
□ Use S + T + M = I + G + X for open-economy equilibrium.
□ Calculate MPW and the multiplier.
□ Explain why greater leakages reduce the multiplier.
□ Explain the paradox of thrift and multiplier–accelerator interaction.
□ Distinguish deflationary and inflationary gaps.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.