No Such Thing as a Free Lunch: Principles of Economics (Part 107)

I'm not a macroeconomics person.

Bill Gates

Aggregate Expenditure and Equilibrium Output

(Part A)

by

Charles Lamson

We now begin our discussion of the theory of how the macroeconomy works. In parts 100 and 101 we learned how to calculate gross domestic product (GDP), but what factors determine it? In parts 104 and 106 we learned how to define and measure inflation and unemployment, but what circumstances cause inflation and unemployment? What, if anything, can government do to reduce unemployment and inflation?

Analyzing the various components of the macroeconomy is a complex undertaking. 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 markets

•  Financial (money) markets

•  Labor markets

Before we begin our discussion of aggregate output and aggregate income, we need to stress that production, consumption, and other activities that we will be discussing in the following posts are ongoing activities. Nevertheless, it is helpful to think about these activities as if they took place in a series of production periods. A period might be a month long or perhaps 3 months long. During each period, some output is produced, income is generated, and spending takes place. At the end of each period we can examine the results. Was everything that was produced in the economy sold? What percentage of income was spent? What percentage was saved? Is output (income) likely to rise or fall in the next period?

Aggregate Output and Aggregate Income (Y)

Each period, firms produce some aggregate quantity of goods and services, which we refer to as aggregate output (Y). In part 102, we introduced real gross domestic product as a measure of the quantity of output produced in the economy, Y. Output includes the production of services, consumer goods, and investment goods. It is important to think of these as components of "real" output.

We have already seen that GDP (Y) can be calculated in terms of either income or expenditures. Because every dollar of expenditure is received by someone as income, we can compute total GDP (Y) either by adding up the total spent on all final goods during a period or by adding up all the income---wages, rents, interest, and profits---received by all the factors of production.

We will use the variable Y to refer to both aggregate output and aggregate income because they are the same seen from two different points of view. When output increases, additional income is generated. More workers may be hired and paid; workers may put in, and be paid for, more hours; and owners may earn more profits. When output is cut, income falls, workers may be laid off or work fewer hours (and be paid less), and profits may fall.

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 (input).

Aggregate output can also be considered the aggregate quantity supplied, because it is the amount that firms are supplying (producing) during the period. In the discussions that follow, we use the phrase aggregate output (income), instead of aggregate quantity supplied, but keep in mind that the two are equivalent. Also remember that "aggregate output" means "real GDP." 

Think in Real Terms From the outset you must think in "real-terms." For example, when we talk about (Y), we mean real output, not nominal output. Although we discussed in part 102 that the calculation of real GDP is complicated, you can ignore these complications in the following analysis. To help make things easier to read, we will frequently use dollar values for Y, but do not confuse Y with nominal output. The main point is to think of Y as being in real terms the quantities of goods and services produced, not the dollars circulating in the economy.

Income, Consumption, and Saving (Y, C, and S)

Each period (a month or 3 months) households receive some aggregate amount of income (Y). We begin our analysis in a simple world with no government and a "closed" economy, that is, no imports and no exports. In such a world, a household can do two, and only two, things with its income: It can buy goods and services---that is, it can consume or it can save. This is shown in Figure 2. The part of its income that a household does not consume in a given period is called saving. Total household saving in the economy (S) is by definition equal to income minus consumption (C):

saving ≡ income - consumption

S ≡ Y - C

The triple equal sign means this is an identity, or something that is always true. You will encounter several identities in the next several posts, which you should commit to memory.

Remember that saving does not refer to the total savings accumulated over time. Saving (without the final s) refers to the portion of a single period's income that is not spent in that period. Saving (S) is the amount added to accumulated savings in a given period. Saving is a flow variable (a variable whose value depends on a period of time rather than an instant, example being the GDP); savings is a stock variable (a variable whose value depends on an instant rather than a period of time).  

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 431-433*

end