How total planned spending determines equilibrium output — and why the economy can get stuck below full employment.
Prof. Muhebullah Karimzada · UNBC Economics
The Building Blocks
AE = C + I + G + NX
AE=C+I+G+NX
C
Consumption
Household spending on goods & services. Largest component (~60% of GDP). Driven by income, wealth, and expectations.
I
Investment
Business spending on capital and housing investment. Most volatile component — sensitive to interest rates & expectations.
G
Gov't Spending
Government purchases of goods & services. Does not include transfers (EI, pensions) — those affect C indirectly.
NX
Net Exports
Exports minus imports (X − M). Positive when Canada sells more abroad than it buys. Affected by exchange rates & foreign income.
Equilibrium condition: The economy is in equilibrium when actual output Y equals planned aggregate expenditure AE. When AE > Y, output expands; when AE < Y, output contracts.
The Consumption Function
C = a + bY — the relationship between household income and spending.
aAutonomous consumption — spending that occurs even at zero income, financed by savings or borrowing. The y-intercept of the C line.
bMarginal propensity to consume (MPC) — the fraction of each extra dollar of income spent on consumption. The slope of the C line.
MPCIf MPC = 0.75: each extra $1 of income → $0.75 more consumption. Remaining $0.25 is saved (MPS = 1 − MPC = 0.25).
KeyThe C function slopes upward but less steeply than the 45° line — households never spend 100% of income (MPC < 1).
The Keynesian Cross
Equilibrium output is where planned spending AE equals actual output Y — where the AE line crosses the 45° line.
45° lineEvery point on this line satisfies AE = Y. It represents all possible equilibria — the economy must end up somewhere on it.
AE lineSlope = MPC. Starts above zero (autonomous spending). Less steep than 45° because MPC < 1.
Y*Equilibrium output — where AE = Y. If Y < Y*, planned spending exceeds output → firms expand. If Y > Y*, output exceeds spending → firms cut back.
Recessionary & Inflationary Gaps
Equilibrium Y* need not equal potential output Yf. When they differ, the economy faces a gap that policy must close.
📉 Recessionary Gap
Y* < Yf — the AE line crosses the 45° line to the left of potential output.
Consequence: unemployment above the natural rate. Firms are producing less than the economy is capable of. Wages and prices may fall slowly, but not quickly enough.
Fix: shift AE upward — via government spending ↑, taxes ↓, or interest rates ↓ — until Y* rises to Yf.
→ Expansionary fiscal or monetary policy
📈 Inflationary Gap
Y* > Yf — the AE line crosses the 45° line to the right of potential output.
Consequence: the economy is overheating. Demand exceeds productive capacity. Firms cannot expand output, so prices rise — inflation accelerates.
Fix: shift AE downward — via government spending ↓, taxes ↑, or interest rates ↑ — until Y* falls back to Yf.
→ Contractionary fiscal or monetary policy
Key Keynesian insight: The economy does not automatically return to Yf. Without policy intervention, it can remain stuck in a recessionary gap indefinitely — this is the core argument for active macroeconomic policy.
The Multiplier Effect
A shift in autonomous spending raises the AE line — and the new equilibrium rises by more than the initial injection.
ShiftGovernment increases spending by ΔG = 20. The entire AE line shifts up by 20 — AE₁ starts 20 above AE₀ at every income level.
New Y*The new equilibrium Y₁* is higher than Y₀*. But the increase ΔY = Y₁* − Y₀* is larger than ΔG = 20.
WhyEach round of spending becomes someone else's income. They spend a fraction (MPC), creating another round — and so on until the series converges.
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Total planned spending determines output. When spending falls short of potential, the economy stays below full employment — and won't fix itself without a push.
— Prof. Muhebullah Karimzada · ECON 101 · UNBC
AE Model · Keynesian Cross · Multiplier · Output Gaps