PRINCIPLES OF MACROECONOMICS

ECO 103
The Maldives National University
Faculty of Education

Expenditure Multipliers
Determinant of Equilibrium Income Theory

Lecture 4

AHMED MUNAWAR
HOW DOES OUR ECONOMY WORK? TWO SECTOR

First, the productive sector

employs resources (such as
labour) and uses them to
create goods and services the Firm
(output).
HOW DOES OUR ECONOMY WORK? TWO SECTOR

Households consume these

goods and services and
provide Firms with the
resources (such as labour)
that they require. Households
HOW DOES OUR ECONOMY WORK? TWO SECTOR

The activities of Households

and Firms are linked.
Households provide
resources to Firms and earn
income (such as salaries and HouseholdsFirms
wages) in exchange.
Firms produce goods and
services which they sell to
Households.
HOW DOES OUR ECONOMY WORK? TWO SECTOR

Households provide
resources to Firms and earn
income (such as salaries and Households Firms
wages) in exchange.
Firms produce goods and
services which they sell to
Households.
Resources and goods and
services flow one way
These are called Real Flows
because they are physical
items
Money Flows go in the other
direction
HOW DOES OUR ECONOMY WORK? TWO SECTOR

This is called the Circular Flow Model. It is made up of Real Flows and Money
Flows.

Households Firms
HOW DOES OUR ECONOMY WORK? TWO SECTOR

Green colour Money Flow

Organ colour Real Flow

Income

Resources
Households Firms

Goods and Services

Consumer Spending
HOW DOES OUR ECONOMY WORK? THREE SECTOR

So,
The there are two
Financial new money
Sector includesflows, savings
banks, and companies
insurance investment.
and other financial
institutions.Households save any income not spent with this sector
Firms go to banks to borrow funds for expansion: new factories, new machines
or research and development. This is called investment.
Income

Households Firms

Consumer Spending

Finance
Sector
HOW DOES OUR ECONOMY WORK? THREE SECTOR

The Government Sector levy Taxes and Spends money on goods and
services.

Income

Households Taxes Taxes Firms

Spending Government Spending

Sector

Consumer Spending

Finance
Sector
HOW DOES OUR ECONOMY WORK? FOUR SECTOR
Another sector to add is the Overseas Sector. Firms sell their products to
foreign buyers, earning export receipts.
A real flow of exports is matched by a money flow, export receipts.

Income

Households Taxes Taxes

Firms

Government Spending
Sector

Consumer Spending

Finance
Sector
HOW DOES OUR ECONOMY WORK? FOUR SECTOR
Firms also import goods and services to use or sell.
The real flow of imports is matched by the money flow, import payments.

Income

Households Taxes Taxes

Firms

Government Spending
Sector

Consumer Spending

Finance
Sector
HOW DOES OUR ECONOMY WORK? FOUR SECTOR

Our new model, showing money flows only, now looks like this.

Income

Households Taxes Taxes Firms

Government Spending
Sector

Consumer Spending

Finance
Sector
EQUILIBRIUM AND FULL-EMPLOYMENT

• Equilibrium will occur when there is no tendency for an

economy to change. It refers to a situation when all
consumers and firms have no incentive to change their
behaviour.
• Full employment equilibrium is the situation of
equilibrium in an economy at the best efficient and full
utilization of resources.
• “An economy can be at the equilibrium but not always to
be at full-employment”(Keynes).
 DETERMINATION OF EQUILIBRIUM
NATIONAL INCOME
• Keynesian model is drawn based on the relationship
between income (Y) and expenditure (AE):
• Components of Aggregate Expenditure (AE):
1. CONSUMPTION, C = f (Yd)
2. INVESTMENT, I = f (i, Y)
3. GOVERNMENT EXPENDITURE, G
4. NET EXPORT (X – M)

• Y = AE
 Y = C + I + G + (X – M); where, C = f (Yd) ,
 C is a function of Real Disposable Income (income after tax),
where, Yd = Y – t
 METHODS OF FINDING EQUILIBRIUM

• The level of national income equilibrium can be

determined using three methods? They are:
1. Using a table;
2. Using a figure/graph; and
3. Using a mathematical equation.

• The terms and conditions of national income equilibrium is

Aggregate Demand (AD) = Aggregate Supply (AS).
• In a two-sector economy, aggregate demand is made up of
consumption and investment, namely AD = C + I
TWO APPROACHES IN FINDING EQUILIBRIUM
1. Total Approach.
 Equilibrium may occur when planned aggregate expenditure is equivalent to
planned output. That is when AD (aggregate demand) = AS (aggregate supply).
2. Injection-Leakage Approach
 Equilibrium also can be determined when:
INJECTION = LEAKAGE
 Injections are additional spending from:
investments (I),
government purchases (G) and
exports (X).

 Leakages are withdrawals from:

savings (S),
tax payment (T) and
imports (M).
 So, at equilibrium,
I+G+X = S+T+M
INJECTION = LEAKAGE
 1. CONSUMPTION AND SAVING

 Disposable Income (Yd) is used for Consumption

spending (C) and Saving (S).

• Yd = C + S

 C = f (Yd), S = f (Yd)

 Both C and S is a function of income, Y and having a

positive relationships.
 ( Y rises, C and S also will rise).
 1. CONSUMPTION AND SAVING

 Given that;

• Consumption function: C = a + b Yd

• Saving function: S = – a + (1 – b) Yd

 There is 2 components of Consumption spending by

households:
• C1, Autonomous Consumption = a

• C2, Induced Consumption = bYd

Where,

b is the Marginal Propensity to Consume (MPC).

 1. CONSUMPTION AND SAVING

C1 = a (Autonomous Consumption)
– This is a fixed amount irrespective of the income earned,

– This is the part of consumption which does not vary with the level
of income (Y increases but “a” is constant).

C2 = bY (Induced Consumption)
– This is an amount that depends on the disposable income,

– This is the amount of consumption spending by households that is

induced by disposable income (Y increases, C increases).
 MPC & MPS
• b is the Marginal Propensity to Consume (MPC).
– The ratio of the change in real consumption to the
change in real disposable income
Change in consumption Δ C
MPC =
Change in disposable income ΔY
MPC + MPS = 1
• 1- b is the Marginal Propensity to Save (MPS).
– The ratio of the change in saving to the change in
disposable income
Change in Saving Δ S
MPS =
Change in disposable income Δ Y
 APC & APS
• Average Propensity to Consume (APC).
• The proportion of total disposable income that is
consumed
Consumption (C)
APC =
Disposable Income (Y)

APC + APS = 1
• Average Propensity to Save (APS).
• Saved proportion of total disposable income

Saving
APS =
Disposable Income (Y)
 EXAMPLE 1
Y C S APC APS MPC MPS
0 60 -60 - - - -
100 120 -20 1.2 -0.2 0.6 0.4
200 180 20 0.9 0.1 0.6 0.4
300 240 60 0.8 0.2 0.6 0.4
400 300 100 0.75 0.25 0.6 0.4
500 360 140 0.72 0.28 0.6 0.4

 As income increases, APC falls but APS rises.

 Meanwhile, MPC and MPS are constant.

 1. CONSUMPTION FUNCTION
• For simplicity, we assume that points of aggregate
consumption, when plotted against aggregate income, lie
along a straight line.

C = a  bY
• The slope of the consumption
function (b) is called the marginal
propensity to consume (MPC), or
the fraction of a change in income
that is consumed, or spent.

0  b<1
CONSUMPTION FUNCTION

C  100 .75Y
• At a national income of
zero, consumption is
$100 billion (a).
• For every $100 billion
increase in income (DY),
consumption rises by
$75 billion (DC).
 CONSUMPTION FUNCTION

C  100 .75Y
AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, C
(BILLIONS OF (BILLIONS OF
DOLLARS) DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850
 SAVING FUNCTION
The amount that households
• Some part of income earned is saved. draw out from their wealth to
consume when no income
• Two components of Savings (S): earned.

• autonomous dissaving, S1 = – a
• induced saving, S2 = (1 – b) Y The amount of saving that is
induced by earnings of
disposable income.
where,
(1 – b) = Marginal Propensity to Save (MPS).
= S/Y
= slope of saving function.
 SAVING FUNCTION, S

Saving

S = – a + (1– b)Yd

0 Yd (real output)
–a

(1 – b) is the slope of saving function = ΔS/ΔY

 1. CONSUMPTION AND SAVING

C  100 .75Y

S  Y C
AGGREGATE AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, C SAVING, S

(ALL IN BILLIONS OF DOLLARS)

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
400 550 50
800 700 100
1,000 850 150
 CONSUMPTION & SAVING FUNCTION

C,S Y = AD
Y = C + S,
When S = 0, Y=C
Y = C at the C = a + bYd
breakeven,
e S = – a + (1– b)Yd
point, e.
a
45º Yd (real output)
0

–a MPC + MPS =1, thus MPS = (1 – MPC).

If MPC = b and MPS = (1 – b),
Then,
b + (1 – b) = 1
 2. INVESTMENT
• Investment is defined as the spending or purchase of capital
goods (plants, machineries, buildings and inventories) by
firms for the purpose of producing goods and services.
a. Autonomous Investment
 what firms may had intended to plan or desired or has been fixed
and does not depend on income.

b. Induced Investment
 actual investment expenditures used to produce newly produced
goods, and depends on the level of interest rate (i) future
expected profitability (e), Income (Y), Tax (t) etc.
 2(a) AUTONOMOUS INVESTMENT
Investment

I1

I0

Real Income (Y)

 An autonomous variable is a variable that is assumed not to depend on
the state of the economy—that is, it does not change when the economy
changes.
 A shift in autonomous investment upward to I1 may cause by an increase
in expected profit or a fall in interest rate but does not depend on real
income.
 2(b) INDUCED INVESTMENT
Investment (I) Real interest rate (i)
I = f(Y)

i2
e
I = f(i,  )
i1
I = f(i)

Real Income (Y)

I’ I’’ Investment

 Induced investment has a positive relationship with aggregate income.

 Induced investment has a negative relationship with real rate of interest.
• If future profit is expected to increase, at any given level of real interest rate
the investment function will increase and shift the curve to the right.
 2. INVESTMENT AND SAVING
• Investment is an injection: could increase aggregate expenditure
(AD) and boost up economic growth (income).
• Investment spending will multiply through the multiplier effect to
increase income.
• Saving is a leakage: could lower aggregate expenditure (AD) and
income.
• Saving becomes an outflow of money (leakage) from an economy.
It becomes a stock of money that is not spent.
• At equilibrium,
Saving will be equal to Investment, ( S = I )
2. EQUILIBRIUM WITH INVESTMENT
Y=AD
C,S,I Y= C+I
C+I
e2
C = a + bYd
e1

S = – a + (1– b)Yd
a
I
45º S=I
0 Yd (real output)
Y1 Y2
–a
In 2 sector economy;
equilibrium; Y = C + I
 3. GOVERNMENT EXPENDITURE
 Government expenditure (G) is considered injection as it will
bring an incoming flow of income into the circular flow of
income.
• This refers to public expenditure made by the government to provide
amenities for the public.
• They could be either recurrent expenditures or capital expenditures.

 Tax (T) is a leakage in the circular flow of national income.

• Taxes are compulsory payments in the form of cash or kind imposed
by the government on households and firms to support government
expenditure.
• Taxes can be categorized into two: direct taxes and indirect taxes.
 3. GOVERNMENT EXPENDITURE
Government Expenditure (G)

G1

G0

Real Income (Y)

 We will assume that government expenditures (G) and net taxes (T) are
Autonomous:
• This assumption will keep our models from becoming overly complex.
• It will also allow us to easily analyze fiscal policy as both G and T
change.
3. GOVERNMENT EXPENDITURE
Y=AD
Y= C+I+G e3
AD

S+T
I+G

45º S+T = I+G

0 Yd
Y1 Y2 Y3

In 3 sector economy;
equilibrium; Y = C + I+G
 4. NET EXPORT (X – M)
• Export (X) is the sale of goods and services to foreign countries,
whether they be consumer products, capital goods or raw
material.
• Import (M) is the purchase of goods and services produced by a
foreign country. Goods that are imported include consumer
products, capital goods and raw material.
• Export (X) is an injection and could increase the national income
through the foreign trade multiplier, but import (M) is a leakage.
• Thus, net export (X-M), means the real foreign sector minus the
total import of goods and services into the economy.
 4. NET EXPORT (X – M)
$

X’’-M’’

X-M

X’-M’

Real Income (Y)

 If both exports (X) and imports (M) are Autonomous, then net exports are
autonomous.
 4. NET EXPORT (X – M)
Full employment
Expenditure Y=E
Y1=C+I+G+(X-M)
(RM)
e1
Yfe=C+I+G+(X-M)

Y0 = C+I+G+(X-M)
ef

e0
45°
Real Output
Ye0 Ye1
(National Income)

In 4 sector economy;
equilibrium; Y = C + I +G+ (X- M)
KEYNESIAN EQUILIBRIUM NATIONAL INCOME

 Keynesian assume that equilibrium output can be reached

not necessarily at the full-employment.
• The equilibrium can be less or more than the full-employment
equilibrium, causing the economy with the inflationary or
deflationary-gap.
• An inflationary gap is defined as a situation when the real aggregate
demand is more than the aggregate demand required at full-
employment.
• A deflationary gap is defined as a situation when the real aggregate
demand is less than the aggregate demand required at full-
employment.
 INFLATIONARY GAPS
Inflationary Gap
Expenditure Y=E
Y1=C+I+G+(X-M)
(RM)
e1

Yfe=C+I+G+(X-M)

ef

45°
Real Output
Yfe Ye1
(National Income)

Inflationary gap: Yfe < Ye1

 DEFLATIONARY GAPS
Deflationary Gap

Expenditure Y=E
(RM)
Yfe=C+I+G+(X-M)

Y0 = C+I+G+(X-M)
ef

e0
45°
Real Output
Ye0 Yfe
(National Income)

Deflationary gap: Yfe > Ye1

 THE MULTIPLIER
 The multiplier effect can be defined as the ratio of change in
income or national production to change in aggregate
demand (AD).

 The multiplier effect causes the income to change at a higher

rate compared to the change in AD earlier.
 Any Injection will multiply positively, while any Leakage will
multiply negatively.
 The size of the multiplier depends on the slope of the
planned aggregate expenditure line.
 INVESTMENT MULTIPLIER
Spending Multipliers, m:
Investment
i) Investment Multiplier
= mI
= 1/MPS
= 1/(1 – MPC)
Therefore, Y = 1/MPS x  I
= mI x  I
Y = mI
I
 THE MULTIPLIER
4 1 1
MPC = MPS = m= =5
5 5 1/5
3 1 1
MPC = MPS = m= =4
4 4 1/4
2 1 1
MPC = MPS = m= =3
3 3 1/3
3 2 1
MPC = MPS = m= = 2.5
5 5 2/5
7 2 1
MPC = MPS = m= = 4.5
9 9 2/9

 It can be seen that when MPC increases MPS decreases m increases

 EXAMPLE: INVESTMENT MULTIPLIER
Given, I = RM10 million
and MPC = 0.75
Therefore,
Y = 1/MPS x I
= 1/0.25 X 10 mil.
= 4 X 10 mil.
= 40 mil.
Thus, New Y = Y + 40 mil.
If the initial income, Y= 2000, then
New Y = 2000 + 40
= 2040 mil.
GOVERNMENT EXPENDITURE MULTIPLIER

GOVERNMENT EXPENDITURE MULTIPLIER = mG

Y 1
=
G MPS

• (Assume an economy without tax, Yd =Y)

Therefore, Y = 1/MPS X G
• Thus, national income increases by the
amount of Y as Government increases
spending.
That is, new Y2 = Y1 + Y
EXAMPLE:
Assume that, to achieve full-employment equilibrium,
the GDP has to be increased by
RM 5 billion and MPS is 0.5. Calculate the tax cut
required to achieve this full-employment.
tax multiplier, mT = 1 – (1/MPS)
= – MPC/MPS
= 1 – (1/0.5)
= 1–2
= –1

 tax cut, T = Y
(-1)
= - 5/(-1)
=-5
By reducing the tax RM5 billion, GDP then will
increase by RM 5 billion.
 OPEN ECONOMY MULTIPLIER

OPEN ECONOMY MULTIPLIER

= 1
(MPS + MPT + MPM)

= 1
1 – b (1-t) + m
 ACCELERATOR PRINCIPLE

state that:
“a change in Consumption would lead to a
greater change in Investment.”
i.e. a small change in DD (consumption on
output) would lead to a great change in
Investment.
∆C great ∆I
RELATIONSHIP BETWEEN MULTIPLIER AND ACCELERATOR

• The effect with multiplier is that:

I greater Y
by the multiplier, k
∆Y=k∆I
• The effect with accelerator is that:

C greater I
by the accelerator, a
∆I=a∆C
RELATIONSHIP BETWEEN MULTIPLIER AND ACCELERATOR
This means that;
with the multiplier, m and the accelerator, a
working together;

I Y AD C I