Recall that two of the largest categories of GDP are consumption spending by households and investment spending by businesses. We will now add investment spending to the aggregate consumption framework developed earlier. We will use this framework to examine how changes in consumption or investment spending will affect the economy. To keep things simple for the time being, let us continue to ignore the government and foreign sectors of the economy. The government will be brought into the picture in the next lecture and the foreign sector will be included later.
With government spending and the foreign sector omitted for the time being, the two remaining sectors of the economy are consumption and investment spending. Let us add the two together. Recall the table earlier in the lecture that showed the amount of aggregate consumption at different levels of income (Y). Adding investment to the picture yields the following:
Planned aggregate expenditure is the sum of what households spend on consumption and planned investment by firms. With planned investment fixed at $25 billion, planned aggregate expenditure is just $25 billion more than aggregate consumption at each income level. This is shown in column 4 in the table.
Just as aggregate consumption can be graphed by plotting aggregate consumption on the vertical axis and income (Y) on the horizontal axis, so can the figures for planned aggregate expenditure listed in column 4. This is shown by the following figure:
The top panel is just the aggregate consumption function given earlier (shown in blue), with $25 billion in planned investment added at each income level (resulting in the green line labeled C + I).
In the lower panel, we add the 45 degree line to the picture. Recall that at every point along a 45 degree line, the values given by the horizontal, are equal to the values given by the vertical axis. This means that where the planned aggregate expenditure line crosses the 45 degree line, planned aggregate expenditure equals income (Y, or aggregate output).
Note that the preceding figure shows that aggregate planned expenditure equals aggregate output at $500 billion (that is where the planned aggregate expenditure line crosses the 45 degree line). What does this mean?
Recall the difference between planned and actual investment. When planned investment and actual investment are equal, there is no unplanned change in inventories. That is in essence what is happening here.
We have said before that aggregate output is the same as real GDP and that real GDP is calculated by adding the actual expenditures by different elements in the economy. With the government and foreign sectors omitted from the analysis right now, aggregate output consists of expenditures by households and firms on consumption and actual investment. It is this aggregate output that is shown on the horizontal axis in the figure above.
The vertical axis, on the other hand, shows aggregate consumption plus planned investment. At the point where actual and planned investment are the same, the values on the horizontal and vertical axes are equal, and the planned aggregate expenditure function must cross the 45 degree line. This point is termed equilibrium aggregate output for the economy.
What does all this mean for an economy? Recall that equilibrium means there is no tendency to change. When an economy is at its equilibrium level of output, the economy is stable at that level. If it is not at that level, however, there is a tendency for it to change.