3.16: Planned Aggregate Expenditure III

Equilibrium in the economy is reached when the amount people and businesses plan to spend is exactly equal to the total goods and services being produced. At this point, everything that firms produce is being purchased. There are no unexpected increases or decreases in inventory, and businesses have no reason to change their level of production.

Planned spending includes two parts: what households plan to consume and what businesses plan to invest. While investment is usually assumed to stay the same, consumption grows as people earn more. Even when income is low, some basic level of spending still takes place. As income rises, people tend to spend more, which causes total planned spending to rise as well.

To understand how equilibrium works, imagine a situation where businesses are producing a certain amount of goods, and people are planning to spend exactly that same amount. In this case, everything that is made gets sold. Firms don’t end up with too much stock, and they don’t run short either. But if production is more than what people plan to spend, businesses will be left with extra products. This leads to a buildup of inventory, which signals to firms to slow down production. On the other hand, if people plan to spend more than what’s being produced, goods will sell out quickly, and firms may increase their output to keep up.

This balance between planned spending and output is what keeps the economy steady in the short run. It helps explain why businesses adjust production when demand and supply don’t match.

Equilibrium in the economy occurs when planned aggregate expenditure is equal to aggregate output. To determine this equilibrium level, we use the planned expenditure schedule and represent it graphically.

This graph represents aggregate output on the horizontal axis and planned aggregate expenditure on the vertical axis.

A horizontal line represents fixed planned investment at twenty-five dollars across all income levels. Separately, planned consumption is plotted, starting from its intercept and increasing steadily with rising output levels.

Combining consumption and investment results in the planned aggregate expenditure curve, which slopes upward. This curve demonstrates that planned expenditure increases as aggregate output rises, reflecting the positive relationship between income and spending.

A forty-five-degree line is drawn from the origin to serve as a reference for equilibrium—it represents all points where aggregate output exactly equals planned expenditure.

The intersection of the planned expenditure curve and the forty-five-degree line represents equilibrium

Thus, equilibrium is achieved at an aggregate output level of five hundred dollars, where firms sell exactly what they plan to produce, and the economy is in balance.