Aggregate Expenditure, Economic Output, and Inflation

Potential output is what the economy can produce when its resources are used at normal rates, which is also considered the full-employment Gross Domestic Product (GDP). This is considered the maximum sustainable output by an economy. Aggregate output is the amount actually produced. In spite of its name, potential output is not the greatest output by an economy, but it is the greatest output possible without straining economic resources, such as requiring overtime labor, and, therefore, it is the output that the economy gravitates to after an output gap is created, such as by changes in inflation or in the cost of resources. Over time, labor and capital increase, and technology improves, increasing both economic efficiency and economic output.

However, over the short term, inflation, interest rates, and other factors can cause aggregate output to fall below potential output. Hence, a main objective of modern monetary policy is to adjust inflation, usually accomplished by adjusting the target interest rate, to return economic output to its potential output. However, monetary policy can only be successful if the relationships between economic output, inflation, and interest rates are understood.

Inflation and Aggregate Expenditure

Aggregate expenditure is the total amount spent for the economy's output by all households, firms, foreigners, and the government. Prices are determined by the equilibrium between aggregate demand and aggregate supply, but aggregate expenditure is the amount actually spent, revealing actual demand at current prices and aggregate supply.

When aggregate expenditure is less than aggregate output, inventories will increase and prices will fall. Firms will lower production and lay off workers to save on costs and lower prices to sell their inventory. If the resulting aggregate output is less than potential output, then this will cause a recessionary output gap (aka recessionary gap), leading to a fall in employment and inflation.

By contrast, when aggregate expenditure exceeds aggregate output, inventories fall, causing firms to hire more workers and to invest in other factors of production, such as land or machinery, to produce more. If aggregate expenditure exceeds the potential output of the economy, then firms must pay higher prices for its factors of production, including overtime to its workers, and pay higher variable costs when using existing facilities for longer time periods to increase production. This increased demand leads to an expansionary output gap (aka inflationary gap), which, in turn, increases prices sharply — demand-pull inflation.

Higher inflation will eventually cause aggregate expenditures to decrease, because higher prices reduces the wealth of consumers, thus leading to lower spending. This is particularly true for poorer consumers, since they tend to spend all the money that they have, to pay for essentials. Generally, the marginal propensity to consume, which is the proportion of income spent for products and services, is inversely proportional to the wealth of the consumer, so inflation will curtail the spending of poorer consumers compared to wealthier consumers, which will lower aggregate expenditures even more than if the effects of inflation were spread evenly across the population.

Greater risk and cheaper imports also decrease aggregate expenditures. Higher inflation causes increased risk, motivating people to save more, rather than spend. Moreover, imports become cheaper relative to domestically produced goods and services, so a greater proportion of the money spent is for imports.

Components of Aggregate Expenditure

The components of aggregate expenditure consist of household consumption, business investment, government purchases, and net exports, equal to exports minus imports. Business investment is the purchase of real capital used in the production of its goods or services. Although most people consider investments to be the purchase of securities, such as stocks or bonds, this money is ultimately used by firms to buy products and services to produce final goods and services. Otherwise, financial instruments would not earn a return on investment unless that money can be put to work to create income from real goods or services.

Since aggregate expenditure is the total spending on the economy's total output, imports are subtracted from exports, since the amount spent on imports is the amount not spent on the economy's output.

Aggregate Expenditure = Consumption + Investment + Government Purchases + Net Exports.

Net Exports = Exports − Imports

The aggregate expenditure equation is usually written as:

Y = C + I + G + (X − M) = GDP

Note that aggregate expenditure equals the GDP.

Long-Run Real Interest Rates and Aggregate Expenditure

Interest rates are determined by the equilibrium between the supply and demand of loanable funds. Lenders want to be compensated for the risk of credit defaults, the opportunity cost of deferring purchases or investments for the term of the loan period (what economists call time preference or the marginal rate of time preference, which is expressed as an interest rate), and the expected rate of inflation. The nominal interest rate is the market rate of interest that includes compensation for the expected rate of inflation; the real interest rate equals the nominal rate minus the inflation premium. Central banks can manage the real interest rate by changing the supply of loanable funds, by changing the nominal interest rate. Real interest rates are considered rather than nominal interest rates because, over the long-term, the economy compensates for the inflation by simply changing nominal prices.

How does the real interest rate change the level of economic output?

Higher real interest rates reduces aggregate expenditure by increasing the cost of loans while increasing the earnings from savings. Both factors reduce expenditures by reducing consumption and investments, and therefore, aggregate expenditure. Higher real interest rates also increase the foreign exchange rate with other currencies, increasing the cost of exports while decreasing the cost for imports. Hence, more of the national income is spent for imports, while net exports decline. Lower real interest rates have the opposite effects.

Only government purchases are not sensitive to the interest rate.

If the supply of money grows only as fast as the economy, then there will be a long-run real interest rate that equates aggregate expenditure with the potential output quantity. An interest rate higher than the long-run real interest rate will cause the economy to contract, to produce less than its potential output, which will increase unemployment and lessen inflation, while an interest rate lower than the long-run rate will increase inflation.

A diagram showing the relationship between real interest rates and aggregate expenditure and also showing that, when the potential output of the economy is reached, then:

  • real interest rate = long-run real interest rate.
A diagram showing the relationship between real interest rates and aggregate expenditure and also showing that when the potential output of the economy is reached then the real interest rate equals the long-run real interest rate.

Real interest rates are not the only thing that can change aggregate expenditure. Factors less sensitive to the interest rate, such as changes in consumer or business confidence or changes in government purchases or taxation, will also affect aggregate expenditure. Nonetheless, real interest rates will be a major factor in altering the economic output due to these other factors — either enhancing or blunting their effect.

When the aggregate expenditure shifts because of reasons other than changes in the interest rate, then the real interest rate itself changes. As shown in the diagram below, when the aggregate expenditure curve shifts to the right because of increased aggregate demand, the potential output remains the same, so the interest rate increases. When the potential output increases because of increasing economic efficiency, then the real interest rate decreases for a given increase in aggregate expenditure.
Diagram showing the relationship between real interest rates and aggregate expenditure and how changes in the potential output changes real interest rates, and vice versa.

Hence, interest rates are the major monetary policy tool used by central banks to keep economic output close to potential output, using inflation as a measure of the deviation from potential output. By keeping inflation low and steady, economic output will equal potential output.

Monetary Policy Reaction

The long-run real interest rate is the ideal rate because it is the rate that would prevail if economic output was a sustainable maximum, which maximizes the wealth of society. When the money supply grows with the economy, then the inflation rate would remain constant when the economy is producing its potential output. Therefore, changes in the inflation rate will reveal when the economy is deviating from its potential output.

When the real interest rate is plotted with respect to inflation, it forms the monetary policy reaction curve (MPRC). On this curve, there is an inflation rate that corresponds to the long-run real interest rate. So one monetary policy tool to achieve potential output is to adjust interest rates to achieve a target inflation rate that corresponds to the long-run real interest rate. These adjustments are often based on a rule, such as Taylor's rule, which provides some guidance as to how much the nominal interest rate should be changed to return the inflation rate to the desired target. Rules are used because it takes time to get feedback from changes in monetary policy, so using a rule that has produced the desired changes in the past is better than just changing monetary policy and waiting to see what effect it will have; the sooner that an effective monetary policy is implemented, the sooner the economy recovers.

When the inflation rate rises or falls, then the central bank will either increase or decrease nominal interest rates by slightly more than the change in inflation rate so that the economy can be returned to the target inflation rate.

Because the nominal interest rate equals the real interest rate plus expected inflation and because expected inflation takes time to change, changing the target nominal interest rate has the effect of changing the real interest rate, which changes the inflation rate.

Nominal Interest Rate = Real Interest Rate + Expected Inflation


Real Interest Rate = Nominal Interest Rate − Expected Inflation

Hence, when the central bank changes nominal interest rates, the real interest rate changes by the same amount. Since expected inflation does not change in the short term, changing the nominal interest rate directly changes the real interest rate.

This diagram of the MPRC depicts how aggressively a central bank will change interest rates (Δr) in response to a given change in inflation rates (Δπ).

A diagram of the monetary policy reaction curve, illustrating how aggressively a central bank will change interest rates in response to a given change in inflation.

Note that, over time, the long-run real interest rate will shift, because of changes in aggregate demand and changes in potential economic output. The central bank could also decide to change the target inflation rate. The MPRC will shift leftward if the long-run interest rate increases or if the target inflation rate is decreased. Likewise, the MPRC will shift rightward if the long-run interest rate decreases, or if the target inflation rate is increased.

A diagram of how the monetary policy reaction curve changes when the long-run interest rate changes.A diagram of how the monetary policy reaction curve changes when the target inflation rate changes.

When aggregate expenditure changes because of other factors that are not sensitive to the interest rate, such as changes in consumer or business confidence or changes in government purchases or taxation, then this has the effect of shifting the monetary policy reaction curve, causing the long-term real interest rate to correspond to a different inflation rate, or vice versa. Nonetheless, monitoring and adjusting the inflation rate is an effective means of monitoring and adjusting the economy.