Recall we are looking at the four components of aggregate demand:

• consumption (C)
• investment (I)
• government spending (G)
• net exports (X-IM)

Investment (I)

Recall the investment expenditures refer NOT to money but to purchases of new factories, buildings, and equipment and inventories of firms. Where consumer savings take money out of the circular flow of income (a leakage), investment spending puts money into the economy (an injection). In fact, consumers savings are often lent out to firms to use for investment.

What factors affect the level of investment?

• Expectations. Again, expectations play an important role. Firms must expect future profitability to make the investment in the first place. Expectations of higher sales will increase investment, ceteris paribus.
• Interest rates. Interest rates represent the cost of investment if firms must borrow money to make the investment. Even if firms have the cash to buy equipment, interest rates represent the opportunity cost of investment, because that cash could have been earning that interest rate if it was not used to buy equipment. Higher interest rates discourage investment, ceteris paribus.
• Technology. Advances in cost cutting technology or the development of new products will increase investment demand, ceteris paribus, as firms acquire the better equipment or new products.

Government Spending and Net Exports (G, X-IM)

Both government spending and net exports are also assumed to be autonomous. Government expenditures are more political decisions than economic ones (although not entirely) . Net exports are more dependent on other countries' income.

Aggregate Expenditure (AE)

If we add up all of the planned spending of each component, we get aggregate expenditure, or how much consumers, firms, government, and foreigners plan to spend at each income level:

AE = C + I + G + X - IM = a + bY + I + G + X - IM

In our model, we are at an equilibrium when planned spending (AE) is equal to actual output (Y) or when

AE = Y

This equilibrium may occur below, at, or above full employment output.

Example. Suppose our model economy looks like this (in billions of dollars):

C = 100 + .75Y
I = 160
G = 200
X-IM = 40

Let's solve for the expenditure equilibrium. Equilibrium occurs when AE = Y, so

Y = C + I + G = 100 + .75Y + 160 + 200 + 40
Y = 500 + .75Y
Y - .75Y = 500
.25Y = 500
Y = 500/.25
Ye = 2000

If full employment output, Yf = 2500, our equilibrium would be below full employment output by 500. This is known as a recessionary gap. If equilibrium output exceeds Yf then there is an inflationary gap.

We can plot the equilibrium on the graph below. Note that Ye is where the AE line intersects the 45 degree line.

So even at equilibrium we can have macro failure in that we are above or below full employment. In the coming chapters we look at how we wind up away from our goal of full employment, and how the economy reacts.