MACROECONOMICSPPT4

MODULESINCLUDEDINTHISPPT1
Module1:RevisitingGoodsMarket,Consumptionfunction,
Savingfunction,Investmentfunction
Module2:Aggregateexpendituremodel/SKM/Keynesian
Cross
2sector
3sector
4sector
Module3:Multiplier
Module3:ApplicationtheUSrecessionof20072009

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Module1:RevisitingGoodsMarket,
Consumptionfunction,Savingfunction,
Investmentfunction
RECALL:THECOMPOSITIONOF
GDP

GDPMP = C + I + G+ X-M

Where MP denotes Market Price

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IDEAOFGOODSMARKET
GDPMP=C+I+G+XM

TheL.H.SrepresentstheAggregatesupplyofdomestically
producedgoods&services(ASG&S)whiletheR.H.S
representstheAggregateDemandfordomestically
producedgoods&services(ADG&S)inacountry.

Thus,theaboveequationrepresentstheequationof
Goods/Productmarketoftheeconomy

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GDPINATWOSECTORECONOMY
GDP=C+I
or,Y=C+I

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CONSUMPTION(C)
Chiefcomponentofaggregatedemand
Referstohouseholdspending
IsdenotedbyC
ThisCisafunctionofincome

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CONSUMPTIONFUNCTION
Consumption(C)increaseswithincome(Y)this
relationshipbetweenconsumption&incomeisdescribed
byconsumptionfunction
Itisgivenas

C= c0 + c1Y

with0<c1<1
Thecoefficientc1iscalledmarginalpropensityto
consume(MPC)

Note:readnationalconsumptionbehaviourfromtext
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MARGINALPROPENSITYTO
CONSUME(MPC)
MPCistheincreaseinconsumptionperunitincreasein
income
MPC=C/Y=c(0<c1<1)
ThisimpliesthatconsumptionincreasesasYincreasesbut
theincreaseinCislessthanthatinY

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SAVING(S)
Savingisthatpartofanindividualsincomewhichisnot
spent
Inasimpleeconomy
Y=C+S
Or, S = Y C
= Y (c0 +c1Y)
= - c0 +(1-c1) Y
= - c0+s1Y
= s0 + s1 Y

Wheres1=(1c1)&s0=c0

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SAVINGFUNCTION
Thisshowsthemagnitudesofsavingatdifferent
levelsofY
S=s0+s1Y, where,0<s1<1
s1iscalledthemarginalpropensitytosave

Note:s0=c0
s1=1c1

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MARGINALPROPENSITYTOSAVE
(MPS)
MPSistheincreaseinsavingsperunitincreaseinincome
MPS=S/Y=s(0<s1<1)
ThisimpliesthatsavingisanincreasingfunctionofYbut
theincreaseinSislessthanthatinY

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RELATIONBETWEENMPC&MPS
MPC+MPS=1

Y=C+S
Y=C+S
1= C/Y+S/Y
1 = MPC + MPS

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RELATIONBETWEENAPC&APS

Y=C+S
1=C/Y+S/Y
1 = APC + APS

APCrepresentstheproportion/percentageofincomethatis
consumedwhileAPSrepresentstheproportion/percentageof
incomethatissaved

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INVESTMENT(I)
Grossprivatedomesticinvestment
Associatedwithbusinesssectorsaddingtothephysical
stockofcapital,includinginventories
Itisgrossinthesensethatdepreciationisnotdeducted
Itisdomesticinthesensethatthisisinvestmentspending
bydomesticresidents&notspendingongoodsproduced
withinthecountry
Investmentmaybeassumedtobeindependentofincome
(autonomous)
Itcanalsobeafunctionoflevelofincome(Y)&rateof
interest(i)(thiswhatitactuallyisrealworld)

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INVESTMENTFUNCTION
IfIisautonomous,I=I
IfIisafunctionofincome,thenI=I(Y)
Inparticular,letI=n+Y,(n,>0)
theparameternistheautonomouscomponentof
investment&thecomponentdependingonincome(Y)
whichiscalledmarginalpropensitytoinvestment(MPI)

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MARGINALPROPENSITYTO
INVESTMENT(MPI)
MPIistheincreaseininvestmentperunitincreasein
income
MPI=I/Y=(0<<1)
ThisimpliesthatinvestmentisanincreasingfunctionofY
buttheincreaseininvestmentislessthanthatinY
IfI=IthenMPI=0

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INVESTMENTASFUNCTIONOF
INCOME&INTERESTRATE
I=I(Y,i),whereI/Y >0&I/ i<0

Detailstobedonelater

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Module2:Aggregateexpenditure
model/SKM/KeynesianCross
AGGREGATEEXPENDITUREMODEL:INCOME
DETERMINATIONINASIMPLETWOSECTOR
ECONOMY(SIMPLEKEYNESIANMODEL)
Equilibriuminthegoodsmarketinasimpletwosector
economyisgivenby
Aggregatesupply=Aggregatedemand
Y=C+I
AccordingtoKeynesC=C(Y)
Inparticular,letC=c0+c1Y
KeynesassumesinvestmentIisautonomous
I=I(given)

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 SKM(CONTD)
Therefore,Y=c0+c1Y+I
Y=(c0+I)/(1c1)=Ye equilibrium
income/output

Thus,equilibriumincomeinaneconomydependsdirectlyon
autonomousconsumption(c0),autonomousinvestment(I)andMPC
(c1)i.e.indirectlyonMPS(s1=1c1)

Graphicalrepresentationoftheequilibriumisshowninnextslide

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 EQUILIBRIUMINCOME
DETERMINATIONINSKMYe represents the equilibrium
level of income/output in the two
sector economy. At any level of
income to left of this, AD > AS
leading to unintended inventory
deccumulation & hence
C, I
producers tend to increase their
output produced.
AS = Y At any level of income to right of
Ye, AS> AD leading to
unintended inventory
C+ I = AD
accumulation. Hence producers
tend to cut back production.
C = c0 + c1Y Thus, whenever, output/income is
to left of Ye, output produced
tend to increase. Whenever,
output/income is to right of Ye, it
I tends to reduce. Hence Ye is a
c0 22
stable equilibrium
Ye Y
EQUILIBRIUMOUTPUT/INCOME
DETERMINATIONWITHSAVING&
INVESTMENT
EquilibriumimpliesAD=AS
C+I=Y
C+IC+S(sinceY=C+S)
IS
So,atequilibriumS=I

Note,thisisplannedsavingsofhouseholdsandplannedinvestment
offirms.Macroequilibriumisachievedwhenplansforsavingsand
plansforinvestmentareinbalanceinaneconomy
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 LEVELSOFINCOME/OUTPUT,
PLANNEDSAVINGS&INVESTMENT
National Planned Planned Planned Unintended
income/output consumption savings($) investment inventory
($) ($) (autonomous) changes($)
($)
5000 5100 100 300 400
5500 5500 0 300 300
6000 5900 100 300 200
6500 6300 200 300 100
7000 6700 300 300 0
7500 7100 400 300 100
8000 7500 500 300 200
8500 7900 600 300 300

Equilibrium : here C+ S = C + I
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Graphical representation of the equilibrium with saving-investment is shown in
next slide
 GRAPHICALREPRESENTATIONOF
SAVINGINVESTMENT
EQUILIBRIUM Ye represents the equilibrium level
of income/output in the two sector
economy. At any level of income
to left of this,
S< I leading to unintended
Savings, Investment

inventory decumulation & hence

s1 Y producers tend to increase their
s0 +
- output produced.
S=
E At any level of income to right of
Ye, S > I leading to unintended
I
inventory accumulation. Hence
producers tend to cut back
Ye Income/output production.
Thus, whenever, output/income is
to left of Ye, output produced tend
to increase. Whenever,
output/income is to right of Ye, it
tends to reduce. Hence Ye is a
stable equilibrium
Pls note: the income which is not consumed is saved and is taken to be a withdrawal
from the economy/system. Thus, if S>I, it implies that households are planning to save more25than
to spend. Hence firms will not be able to sell the entire output they are planning to invest on and
hence there is unintended inventory accumulation. It is reverse when S <I
QUESTION
Supposeincomegeneratedinaperiodis$8500billion.
Householdstrytosave$600billionbutinvestmentplans
toabsorbonly$300billion.Whatwillbetheresult?

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ANSWERTOPREVIOUSQUESTION
Y=C+Sinagivenperiod
NowY=8500&S=600.
InvestmentisI=300implyingS>I.Thushouseholdsare
planningtosavemorethanfirmsareplanningtoinvestto
produceoutput.Thus,firmswillnotbeabletosellalltheir
output.Thiswillresultininventory(unintended)
accumulation.Thisinturnwillleadingtocuttingbackof
outputbyfirmsinfollowingperiod

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 SKMWITHBOTHC&IFUNCTIONSOF
INCOME
Y=C+I
Y=C(Y)+I(Y)
Y=co+c1Y+n+Ywherec0>0;n>0areconstants
Y=(co+n)/{1(c1+)}c1=MPC&=MPIbothof
whichliebetween0&1

Thus,equilibriumincomeinaneconomydependsdirectlyon
autonomousconsumption(c0),autonomousinvestment(n)andMPC
(c1)plusMPI().
Alternatively,
YC(Y)=I(Y)
s0+s1Y=n+Y wheres0>0;n>0areconstants
Y=(ns0)/(s1) s1=MPS&=MPIbothof
whichliebetween0&1
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Thus,equilibriumincomeinaneconomydependsdirectlyon
autonomousinvestment(n)andMPI()&indirectlyonautonomous
savings(so)andMPS(s1)
PARADOXOFTHRIFT
Peoplespropensitytosaveincreasesi.e.ifpeople
becomethrifty,thentotalsavingsintheeconomy
willbehigher
Highersavingscanleadtomoreinvestment

Incomewillincreasesduetomultipliereffectof
investment
Economicgrowthwilltakeplace

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THEPARADOX
Inadevelopedcapitalisteconomyincreasein
propensitytosaveactuallyleadstoafallin
income&consumptionwithnoincreaseintotal
savings(S)intheeconomyatall.

The effect of an increase in propensity to save

(greater thriftiness of people) on equilibrium levels of income,
consumption & saving is called Paradox of Thrift

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GRAPHICALREPRESENTATIONOF
PARADOXOFTHRIFT
People becoming thrift implies MPS
increases (here s1 > s1). Here it is shown by
shift of saving function from S to S1. As a
result income has fallen from Ye to Ye. As
income falls consumption also falls leading to
Saving & investment

fall in Aggregate demand, hence GDP, hence

income (from Ye here to Ye)

S1 = -so + s1Y

S = -so + s1Y

Ye Ye Income/Output

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GOVERNMENTINTRODUCEDIN
SKM:ATHREESECTORMODEL
LetGbealsoautonomouslygiven,then,
Y=C(Yd)+I+G
=c0+c1(Yd)+I+G
=c0+c1(YtY)+I+G
=c0+c1Yc1tY+I+G

Equilibriumincome/outputisgivenby
Ye=(c0+I+G)/{1c1(1t)}

Thus,equilibriumincomeinaneconomydependsdirectlyon
autonomousconsumption(c0),autonomousinvestment(I),
autonomousgovernmentexpenditure(G)andMPC(c1)and
indirectlyontaxrate(t)
Note:nowwithgovernmentintroducedCbecomesafunctionofYdinsteadof
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YwhereYd=YT
GOVERNMENT&FOREIGNSECTOR
INTRODUCEDINSKM:AFOURSECTOR
MODEL
LetI,G&(XM)beallautonomouslygiven,then,
Y=C+I+G+(XM)(XM=NE)
Equilibriumincome/outputisgivenby
Ye=(c0+I+G+NE)/{1c1(1t)}

Thus,equilibriumincomeinaneconomydependsdirectlyon
autonomousconsumption(c0),autonomousinvestment(I),
autonomousgovernmentexpenditure(G),autonomousnet
exportsandMPC(c1)andindirectlyontaxrate(t)

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EQUILIBRIUMVERSUSFULL
EMPLOYMENTGDP
A key point about the equilibrium GDP of the aggregate
expendituresmodelisthatitneednotequaleconomysfull
employment GDP i.e. actual real GDP is far below its
potentiallevel
A recessionary gap is the amount by which aggregate
expenditures at the full employment GDP fall short of
thoserequiredtoachievefullemploymentGDP
An inflationary expenditure gap is the amount by which
aggregate expenditures at the fullemployment GDP
exceedthosejustsufficienttoachievethefullemployment
GDP.

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 EQUILIBRIUMVERSUSFULLEMPLOYMENT

AE0
AE1
Aggregate expenditures

530
(billions of dollars)

510
Recessionary
490 expenditure
gap = $5 billion

Full
employment
45
490 510 530
Real GDP
(a) 35
Recessionary expenditure gap
Here,the$5billionrecessionaryexpendituregapcausesa$20billionnegativeGDPgap.
LO5
 EQUILIBRIUMVERSUSFULLEMPLOYMENT

AE2
Inflationary AE0
expenditure
gap = $5 billion

Full
employment

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Here,the$5billionistheinflationaryexpendituregap
LO5

Module3:Multiplier
THEMULTIPLIERANALYSIS
InSKMofincomedetermination,equilibriumlevelofnational
incomedependsonADwhichdependsonAggregate
Expenditure(C+I)
InequilibriumY=E(=C+I).IfEthenY
Now,E=C+I.ApartofEisdependentonincome&hence
cannotincreasewithoutanincreaseinincome.Butthe
autonomouspartofEisindependentofincome.
Achangeinautonomousexpenditureleadstoachangein
aggregatedemand&hencetoachangeinincome(Y)

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MULTIPLIER
TheratioofchangeinYtothechangeinautonomous
expenditurethatbringsaboutthechangeinYiscalledthe
multiplier

Multiplier = Y/ A,
Where A is the autonomous expenditure

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TYPESOFMULTIPLIER
Recallinafoursectormodel,equilibriumincomeisgiven
as:Ye=(c0+I+G+NE)/{1c1(1t)}
Theentirenumeratorismadeupofautonomous
components.Accordinglythetypesofmultipliersthatwe
mayhaveis:
Investmentmultiplier
Governmentexpendituremultiplier
Foreigntrademultiplier

Note:InSKMwithnogovernmentandforeigntrade,only
theinvestmentmultiplierworks
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KEYNESMULTIPLIER:
INVESTMENTMULTIPLIER
Keynespropoundedtheconceptofmultiplierwith
referencetothetotaleffectofsomeinitialchangein
autonomousinvestmentonthenationalincome.
Keynesmultiplierisknownasinvestmentmultiplieror
incomemultiplier

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KEYNESINVESTMENTMULTIPLIER
Theessenceofinvestmentmultiplieristhatthetotal
changeinequilibriumincomethatsomeinitialchangein
autonomousinvestmentbringsaboutwouldbesome
multipleofthelatter
IfIstandsforthechangeinautonomousinvestment&
YistheresultantchangeinY,thentheinvestment
multiplierkis

k= Y/ I

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EXPLAININGTHEMULTIPLIER
Tobedoneinclass
k=Y/I>1
Y>ItoobtainYbroughtaboutbytheincreasein
autonomousinvestment,wehavetomultiplyIbyk.Hencek=
Y/Iiscalledthe(investment)multiplier.

Y=I+MPC.I+MPC2.I+..+MPCn1
=(1MPCn)/(1MPC).I

(thisisaninfiniteGPserieswithMPCascommonratio)

Now,MPC<1,henceasperformulaforsumofGPseries
Y=1/(1MPC)*I[sinceMPCntendsto0asn]
ork=1/(1MPC)
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USINGAGRAPH(OPTIONAL)

TheEffectsofan
Increasein
AutonomousSpending
(eg.I)onOutput

Anincreasein
autonomous
spendinghasamore
thanoneforone
effectonequilibrium
output.

44
USINGAGRAPH(OPTIONAL)
Thefirstroundincrease
indemand,shownbythe
distanceAB(equalsRs1
billion=increaseinI).
Thisfirstroundincrease
indemandleadstoan
equalincreasein
production,orRs1billion,
whichisalsoshownby
thedistanceinAB.
Thisfirstroundincrease
inproductionleadstoan
equalincreaseinincome,
shownbythedistancein
BC,alsoequaltoRs1
billion. 45
USINGAGRAPH(OPTIONAL)
Thesecondroundincreasein
demand,shownbythedistance
inCD,equalsRs1billiontimes
thepropensitytoconsume.
Thissecondroundincreasein
demandleadstoanequal
increaseinproduction,also
shownbythedistanceDC,and
thusanequalincreasein
income,shownbythedistance
DE.
Thethirdroundincreasein
demandequalsRsc1billion,times
c1,themarginalpropensityto
consume;itisequaltoRsc1xc1=
Rsc12billion.
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USINGWORDS
Tosummarize:
Anincreaseindemand(followinganincreaseinautonomous
investmenthere)leadstoanincreaseinproductionanda
correspondingincreaseinincome.Theendresultisanincrease
inoutputthatislargerthantheinitialshiftindemand,bya
factorequaltothemultiplier.

47
MULTIPLIERSHOWN
DIAGRAMMATICALLY
AS
C, I C+I

I C+I
Y = k I

k>1

Y

Y
48
RELATIONBETWEEN
MULTIPLIER&MPC
Closerelationbetweenmultiplier&MPC
GreatertheMPC,greaterwillbethesizeofthemultiplier

Direct relation between multiplier (k) & MPC (c1)

49
DIRECTRELATIONBETWEENMULTIPLIER(K)&
MPC(C)

Inasimpleeconomy,
Y=C+I
Y=C+I
1=C/Y+I/Y
1C/Y=I/Y
1MPC=I/Y
Y/I=1/(1MPC)

k = 1/(1- MPC) = 1/MPS

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GOVERNMENTEXPENDITURE
MULTIPLIER
Y/Gtheincreaseinincomeduetoincreasein
governmentexpenditure
Governmentcanaffecttheequilibriumincomeintwo
ways
Bychangingitsexpenditureongoods&services
Bychangingtheincometaxrate

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GOVERNMENTEXPENDITURE
MULTIPLIERCONTD..
Y=C+I+G
NowC=c0+c1Yd
IfnowgovernmententerswithanexpenditureGthen
Y=1/(1c1)*(c0+I+G)[sinceitisassumedthatthereis
notax,henceY=Yd]
Y/G=1/(1c1)

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BALANCEBUDGETMULTIPLIER
Ifthegovernmentwantstobalanceitsbudget,taxrevenue
(T)mustequalGovernmentexpenditure(G)i.e.G=T
Now,Yd=YT
Y=C+I+G
=c0+c1(YT)+I+G
=1/(1c1)*[c0c1T+I+G]
WhatistheeffectofbalancedbudgetonY?

53
BALANCEBUDGETMULTIPLIER
CONTD..
GovernmentbudgetincreasesYby
1/(1c1)*G
atthesametimeTreducestheYby
c1/(1c1)*T
Hencetheneteffectis
[1/(1c1)*G]+[c1/(1c1)*T]
=[1/(1c1)c1/(1c1)]G{sinceG=T}
=[(1c1)/(1c1)]G=G
Thus,

Y/ G = (1-c1)/(1-c1) = 1 54
FOREIGNTRADEMULTIPLIER
Willbetakenupaspartofopeneconomymodule

55
APPLICATION
THEUSRECESSIONOF200709
InDecember2007theUSEconomyenteredthelongest
andoneofthedeepestrecessionssincetheGreat
depressionofthe1930s
Inthesummerof2007,acrisisinthemarketformortgage
loansflaredup
Laterin2007thecrisisspreadtootherfinancialmarkets,
threatenedthesurvivalofseveralmajorUSfinancial
institutionsandseverelydisruptedtheentirefinancial
system
Creditmarketsbegantofreezeandgeneralpessimism
spreadbeyondfinancialmarketstotheoveralleconomy
Businessesandhouseholdsretrenchedontheirborrowing
andspendingandinDecember2007theeconomyentereda
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recession
THECRISISEXPLAINEDTHROUGH
AGGREGATEEXPENDITUREMODEL
Theeffectofthiscrisiscaneasilybeexplainedthroughthe
aggregateexpendituremodel
TheAE0lineinfigureinnextslideshowstheC+I+G+(XM)
Duringtherecession,bothconsumptionandinvestment
expendituresdeclinedwithplannedinvestmentexpenditures
sufferingthelargestdrop
AggregateexpenditurethusdeclinedfromAE 0toAE1inthe
figure.ThissetoffmultipledeclineinrealGDPasindicated
bythedeclineofrealGDPfrom$510billionto$490billion.
Thus,arecessionaryexpendituregapproducedoneofthe
largestnegativeGDPgapsinUSsincetheGreatDepression
Employmentsankbymorethan8millionpeopleand
unemploymentratejumpedabove10percent
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 EQUILIBRIUMVERSUSFULLEMPLOYMENT

AE0
AE1
Aggregate expenditures

530
(billions of dollars)

510
Recessionary
490 expenditure
gap = $5 billion

Full
employment
45
490 510 530
Real GDP
(a) 59
Recessionary expenditure gap
Here,the$5billionrecessionaryexpendituregapcausesa$20billionnegativeGDPgap.
LO5
POLICYINITIATIVES
The US Federal government undertook various Keynesian
policiesin2008to2009toeliminatethisrecessionaryexpenditure
gapfacingtheeconomy
In 2008 the congress acted rapidly to pass an economicstimulus
package this law provided a total of $152 billion in stimulus,
withsomeofitcomingastaxbreaksforbusinesses,butmostofit
deliveredaschecksofupto$600eachtotaxpayers,veteransand
SocialSecurityrecipients
The Obama administration and Congress enacted the American
Recovery and Reinvestment Act of 2009. this $787 billion
programon top of a $700 billion recue package for financial
institution consisted of low & middle income tax rebates, plus
large increase in expenditures on infrastructure, education and
healthcare
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