INTRODUCTION TO

MACROECON0MICS (ECN 1215)

UNIT 2 LECTURE NOTES

Charles Masili Banda

Department of Economics
The University of Zambia
 The Economy’s
Income and Expenditure

When judging whether the economy is

doing well or poorly, it is natural to look
at the total income that everyone in the
economy is earning.
 The Economy’s
Income and Expenditure

• For an economy as a whole, income must

equal expenditure because:
Every transaction has a buyer and a seller.
Every dollar of spending by some buyer is
a dollar of income for some seller.
 Gross Domestic Product

• Gross domestic product (GDP) is a

measure of the income and
expenditures of an economy.
• It is the total market value of all final
goods and services produced within a
country in a given period of time.
 The Circular-Flow Diagram

The equality of income and expenditure

can be illustrated with the circular-flow
diagram.
 The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services bought

Firms Households

Inputs for Labor, land, and

production Market for capital
Factors
Wages, rent, and of Production Income
profit
 The Measurement of GDP
GDP is the market value of all final
goods and services produced within a
country in a given period of time.
 The Measurement of GDP

• Output is valued at market prices.

• It records only the value of final goods, not
intermediate goods (the value is counted only
once).
• It includes both tangible goods (food, clothing,
cars) and intangible services (haircuts,
housecleaning, doctor visits).
 The Measurement of GDP

• It includes goods and services currently

produced, not transactions involving goods
produced in the past.
• It measures the value of production within
the geographic confines of a country.
 The Measurement of GDP

• It measures the value of production that

takes place within a specific interval of
time, usually a year or a quarter (three
months).
 What Is Counted in GDP?

GDP includes all items

produced in the economy
and sold legally in markets.
 What Is Not Counted in GDP?

• GDP excludes most items that are

produced and consumed at home and
that never enter the marketplace.
• It excludes items produced and sold
illicitly, such as illegal drugs.
 Other Measures of Income

1) Gross National Product (GNP)

2) Net National Product (NNP)
3) National Income
4) Personal Income
5) Disposable Personal Income
 1) Gross National Product

• Gross national product (GNP) is the total

income earned by a nation’s permanent
residents (called nationals).
• It differs from GDP by including income that
our citizens earn abroad and excluding
income that foreigners earn here.
 2) Net National Product (NNP)

• Net National Product (NNP) is the total

income of the nation’s residents (GNP)
minus losses from depreciation.
• Depreciation is the wear and tear on the
economy’s stock of equipment and
structures.
 3) National Income

• National Income is the total income earned

by a nation’s residents in the production of
goods and services.
• It differs from NNP by excluding indirect
business taxes (such as sales taxes) and
including business subsidies.
 4) Personal Income
• Personal income is the income that households
and noncorporate businesses receive.
• Unlike national income, it excludes retained
earnings, which is income that corporations
have earned but have not paid out to their
owners.
• In addition, it includes household’s interest
income and government transfers.
 5) Disposable Personal Income

• Disposable personal income is the income

that household and noncorporate
businesses have left after satisfying all their
obligations to the government.
• It equals personal income minus personal
taxes and certain nontax payments.
 The Components of GDP

GDP (Y ) is the sum of the following:

 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)

Y = C + I + G + NX
 The Components of GDP
• Consumption (C):
 The spending by households on goods and
services, with the exception of purchases of
new housing.
• Investment (I):
 The spending on capital equipment,
inventories, and structures, including new
housing.
 The Components of GDP

• Government Purchases (G):

 The spending on goods and services by local,
state, and federal governments.
 Does not include transfer payments because
they are not made in exchange for currently
produced goods or services.
• Net Exports (NX):
 Exports minus imports.
 Real versus Nominal GDP

• Nominal GDP values the production of

goods and services at current prices.
• Real GDP values the production of goods
and services at constant prices.
 Real versus Nominal GDP
An accurate view of the economy
requires adjusting nominal to real
GDP by using the GDP deflator.
 GDP Deflator
• The GDP deflator measures the current
level of prices relative to the level of prices
in the base year.
• It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than a
rise in the quantities produced.
 GDP Deflator

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
 Converting Nominal GDP to Real GDP

Nominal GDP is converted to real GDP

as follows:
(Nominal GDP20xx )
Real GDP20xx = X 100
(GDP deflator20xx )
 Real and Nominal GDP

Price of Quantity of Price of Quantity of

Year Hot dogs Hot dogs Hamburgers Hamburgers
2001 $1 100 $2 50
2002 $2 150 $3 100
2003 $3 200 $4 150
 Real and Nominal GDP

Calculating Nominal GDP:

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600
2003 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200
 Real and Nominal GDP

Calculating Real GDP (base year 2001):

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
2003 ($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500
 Real and Nominal GDP

Calculating the GDP Deflator:

2001 ($200/$200) x 100 = 100
2002 ($600/$350) x 100 = 171
2003 ($1200/$500) x 100 = 240
 GDP and Economic
Well-Being

• GDP is the best single measure of the

economic well-being of a society.
• GDP per person tells us the income and
expenditure of the average person in the
economy.
 GDP and Economic
Well-Being

• Higher GDP per person indicates a higher

standard of living.
• GDP is not a perfect measure of the
happiness or quality of life, however.
 GDP and Economic
Well-Being

• Some things that contribute to well-being are

not included in GDP.
 The value of leisure.
 The value of a clean environment.

 The value of almost all activity that takes place

outside of markets, such as the value of the time
parents spend with their children and the value of
volunteer work.
 Measuring GDP: The National Income
and Product Accounts
• What is GDP and How Do We Measure It?
– GDP: Value of Domestically Produced Output
– Business, Consumer, and Government Accounting
• The Equivalence of Three Methods (Output/ Product,
Income and Expenditure Methods)
 The Product Approach
• Value Added: VA = total revenue – the value of
intermediate goods
 The Expenditure approach
• GDP = Consumption (C)
+ Investment (I)
+ Government Expenditure (G)
+ Net Exports (NX=X-IM)
 The Income approach
• GDP = Wage Income
+ After-Tax Profits
+ Interest Income
+ Taxes
 What is GNP?
• GNP = GDP + NFP
NFP: Net Factor Payments
= Factor payments to a country’s citizens
- Factor payments to foreigners
 What does GDP Leave Out?
• Nonmarket activity: home production, leisure,
……
• Underground economy: illegal drug trade,
baby-sitting, ……
• Valuing Government Production
 Nominal and Real GDP and Price
Indices
• Nominal GDP: GDP at current price
• Real GDP: GDP corrected for inflation
 Measures of the Price Level

•Implicit GDP Price Deflator

= (Nominal GDP / Real GDP) * 100
•CPI(t) = (Cost of base year quantities at
prices of year t / Cost of base year
quantities at base year prices) * 100
 Problems Measuring Real GDP and
Prices
• Substitution Biases: make CPI upward biased.
• Accounting for Quality Changes: increase in
prices maybe reflect the improvement in
quality. Inflation is biased upward.
• Treatment of Newly-Introduced Goods: bias
downward GDP growth, upward the inflation
 National Income

National Income Accounting

 Factor Market Product Market

Factor services Goods & services

Real Flow

Factor Owners Firm Consumers

Money Flow

Factor Income Cost Revenue Expenditure

The flow of economic activities in a 2-sector economy

 GNP v.s. GDP
• Gross National Product (GNP)
– The total value at market prices of final goods and services
produced by the citizens in an economy in a specified
period.
• Gross Domestic Product (GDP)
– The total value at market prices of final goods and services
produced within the domestic boundary of a territory in a
specified period
 GNP & GDP

• Resale of existing houses 

• Sale of used cars / existing shares 
• Commission / Brokers’ fee 
• Imputed rents of owner-occupied dwellings 
 Real GNP & Nominal GNP
& Per capita GNP

• Real GNP=(Nominal GNP/GNP Deflator)*100

• Per capita GNP = GNP / Population size

 Measurement of National Income
• Income Approach
 NNP at factor cost OR National Income
• Output Approach
 GDP at factor cost
• Expenditure Approach
 GDP at market Prices
 Measurement of National Income
Expenditure Approach
C+I+G+X-M GDP at market price
-
Indirect sales tax
+
Indirect subsidies

GDP at factor cost  Output Approach
+
Factor Income- Factor Income
from abroad paid abroad 
Net income from abroad

GNP at factor cost
-
Depreciation
 Income Approach
NNP at factor cost  W+I+R+P
 Wages,
interest, rent,
profits
 Items excluded from National Income
Accounting
• Second-hand goods
• Intermediate goods
• Non-marketed goods / services
Volunteer work / Housework
• Unreported / Illegal market transactions
 Merits & Uses of National Income
Statistics
• Reflecting & comparing the standards of living of
different countries
Per capita real GNP  standard of living
• Providing information to the government and firms
for economic planning
• Reflecting the economic growth of a country
% change in real GNP over a period of time
 Limitations of National Income
Statistics
• Factors that may understate the standard of
living / the welfare
– Exclusion of the value of leisure
Same Q produced with fewer working hours  higher
welfare
– Exclusion of non-marketed / unreported
transactions
 Limitations of National Income
Statistics
• Factors that may overstate the standard of
living / the welfare
– Undesirable Side-effects of Production
Air pollution / traffic congestion /…
Understate the real / social costs to society 
externality /divergence between social costs &
private costs
 When comparing economic performances
using national income statistics,
• Price Level
use real GNP  eliminate the effect of inflation
• Size of Population
 use per capital GNP
• Income Distribution
more even distribution  higher welfare
• Composition of National income
more consumption, less national defence  higher welfare
• Exchange Rates
expressed in the same currency
whether the exchange rates reflects the purchasing power of the 2
currencies
Simple Keynesian Model

National Income Determination

Two-Sector National Income Model
 Exogenous & Endogenous Variables

• Exogenous Variable
– the value is determined by forces outside the
model
– any change is regarded as autonomous
– I, G, X
• Endogenous Variable
– the value is determined inside the model
– factor to be explained in the model
– Y, C,
 Linear Functions
• Consumption Functions
– C= f(Y)
1. C= C’
2. C= cY
3. C= C’ + cY
 Linear Functions
• C’, c are exogenous variables
• C, Y are endogenous variables
• Y is independent variables
• C is dependent variables
 Linear Functions
• Can you express the 3 consumption functions
graphically?
 Linear Functions
• C= f(Y, W)
• If wealth is deemed as a relevant factor but is
not explicitly included in the consumption
function C=C’+ cY
• a rise in wealth W  will lead to a rise in the
exogenous variable C’
• graphically, the consumption function C will
shift upwards
 Linear Functions
• What happens if c  ?
• What happens if Y  ?
 Linear Functions
• Consumption function can also be a
relationship between consumption C and
interest rate r.
• What do you think of the relationship
between the variables, i.e., consumption C
and interest rate r?
• Are they positively correlated or negatively
correlated?
National Income Determination Model
• Assumptions:
– National income Y is defined as the total real
output Q
– A constant level of full national income Yf
– Serious unemployment, i.e., there are many idle
or unemployed factors of production
National Income Determination Model
(cont’d)
– Income / output can be raised by using currently
idle factors without biding up prices
– Price rigidity or constant price level
– There are only households and firms (2-sector).
No government and foreign trade
 National Income Identities

• An identity is true for all values of the variables

• In a 2-sector economy, expenditure consists of
spending either on consumption goods C OR
investment goods I.
• Aggregate expenditure (AE OR E) is ,by
definition, equal to C plus I
–EC+I
 National Income Identities
• National income Y received by households, by
definition, is either saved S OR consumed C.
–YC+S
 National Income Identities
• Aggregate expenditure E is, by definition,
equal to national income Y
• YE
• C+SC+I
• SI
•The Keynesian cross shows how income Y is determined for given levels of planned
investment I and fiscal policy G and T. We can use this model to show how income changes
when one of the exogenous variables change.
•Actual expenditure is the amount households, firms and the government spend on goods
and services (GDP).
•Planned expenditure is the amount households, firms and the government would like to
spend on goods and services. The economy is in equilibrium when:
•Actual Expenditure = Planned Expenditure or Y=E

Expenditure, E Actual Expenditure, Y=E

Planned Expenditure,
E=C+I+G

Y2 Y* Y1 Income, Output, Y
 The Keynesian Cross
Actual Expenditures
Planned
expend

Planned Expenditures

equilibrium

Ap

Real Income (Y)

Note: MPC is the slope of the Ep function
The 45-degree line (Y=E) plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram
becomes the Keynesian Cross.
How does the economy get to this equilibrium? Inventories play an
important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories,
and this induces them to change production levels. Changes in
production in turn influence total income and expenditure, moving the
economy toward equilibrium.

Expenditure, E Actual Expenditure, Y=E

Planned Expenditure,
E=C+I+G

Y2 Y* Y1 Income, Output, Y
Consider how changes in government purchases affect the economy.
Because government purchases are one component of expenditure,
higher government purchases result in higher planned expenditure,
for any given level of income.

Expenditure, E Actual Expenditure, Y=E

B Planned Expenditure,
A E=C+I+G
DG

Y* Y1 Income, Output, Y

An increase in government purchases of DG raises planned expenditure

by that amount for any given level of income. The equilibrium moves
from A to B and income rises. Note that the increase in income Y
exceeds the increase in government purchases DG. Thus, fiscal policy
has a multiplied effect on income.
 Equilibrium Income
• Equilibrium is a state in which there is no
internal tendency to change.
• It happens when
– firms and households are just willing to purchase
everything produced Y = E (v.s. Micro: Qs = Qd)
– Income-Expenditure Approach
– planned saving is equal to planned investment S =
I
• Injection-Withdrawal Approach
 Equilibrium Income
• What is the definition of GNP (/ GDP) in
national income accounting?
• The total market value of all final goods and
services currently produced by the citizens
(/within the domestic boundary) of a country
in a specified period
 Equilibrium Income
• When there is excess supply, i.e., planned output >
planned expenditure, firms will reduce output to
restore equilibrium
• When there is excess demand, i.e., planned
expenditure > planned output, firms will increase
output to restore equilibrium
• In the Keynesian model, it is aggregate demand that
determines equilibrium output.
 Consumption Function
• Now, we will look at the 1st component of the
aggregate expenditure E  C + I i.e. C
• Empirical evidence shows that consumption C
is positively related to disposable income Yd
• Yd = Y since it is a 2-sector model
• Remember the 3 consumption functions
 Consumption Function
• Autonomous Consumption C’
– It exists even if there is no income. This can be done
by dis-saving, i.e., using the past saving
– Then, saving will be negative when income is zero.
– It is totally determined by forces outside the model
– What happens to the 3 consumption functions if C’
 ? Or C’  ?
 Consumption Function

C’ = y-intercept
D In C’

C = C’ C = cY C = C’ + cY
 Consumption Function
• Marginal Propensity to Consume MPC = c
– It is defined as the change in consumption per unit change in
income
• MPC = DC / DY
– It is the slope of the tangent of the consumption function
– For a linear function, MPC is a constant
– It is assumed that 0 < MPC < 1
– What happens to the 3 consumption functions if c ? or c  ?
 Consumption Function
• Average Propensity to Consume APC
– It is defined as the ratio of total consumption C to
total income Y
• APC = C / Y
– When C = C’ OR C = C’ + cY, APC decreases when Y
increases.
– When C = cY, APC = MPC = c = constant
 Consumption Function
• Relationship between APC and MPC
• C = C’ Divide by Y
• C/Y = C’/Y
• APC = C’/Y
• APC  when Y 
 Consumption Function
• Relationship between APC and MPC
• C = cY Divide by Y
• C/Y = c
• APC = MPC = c
 Investment Function
• Let’s look at the 2nd component of the
aggregate expenditure E  C + I
• An investment function shows the relationship
between planned investment I and national
income Y
• It can be a linear function or a non-linear
function
 Investment Function

• Again, there can be 3 investment functions

• I = I’
• I = iY
• I = I’ + iY
• Economists usually use the first one, i.e., I= I’ as
investment is thought to be correlated with interest
rate r, instead of Y
• I’ , i are exogenous variables
• I , Y are endogenous variables
 Investment Function
• Autonomous Investment I’
– It is independent of the income level and is
determined by forces outside the model, like
interest rate.
 Investment Function
• Marginal Propensity to Invest i
– It is defined as the change in investment I per unit change
in income Y
– MPI = DI / DY
 Aggregate Expenditure Function
• Given E = C + I
• C = C’ + cY I = I’
•  E = I’ + C’ + cY
–  E = E’ + cY
 Aggregate Expenditure Function
C, I, E
I C

Slope of tangent = c

Slope of tangent=0

I = I’ C = C’+cY E = I’ + C’+ cY
 Output-Expenditure Approach
• National income is in equilibrium when
planned output = planned expenditure
• We have planned expenditure E=C+I
• Equilibrium income is Ye=planned E
• A 45°-line is the locus of all possible points
where Y = E
• When E = planned E, Y = Ye
 Output-Expenditure Approach

Y=E Planned E=C +I

C, I, E

Planned E < Y
Unintended inventory
investment
Y=planned E Actual E = Y
Planned E>Y
Unintended inventory
dis-investment
Actual E =Y
Y
Y Ye Y
 Output-Expenditure Approach
• Y = planned E
– Y = I’ + C’ + cY
• Y = E’ + cY
• (1-c)Y = E’
• Equilibrium condition
• Y= E’
1
1-c
 Output-Expenditure Approach
• If C’ or I’   E’  E   Ye 
• If c   E steeper  Ye 
• If we differentiate the equilibrium condition,
• DY/DE’ = 1/(1-c)
• Given 0 < c < 1 AND 1/(1-c) > 1
• E’   Ye by a multiple 1/(1-c) of DE’
 Expenditure Multiplier 1/(1-c)
• Assume c=0.8, DE’ = 100
• The one who receive the $100 as income will
spend 0.8($100)
• then the one who receives 0.8($100) as
income will spend 0.8*0.8($100)
• The process continues and the total increase
in income is
• $100+0.8($100) +0.8*0.8($100) +…
 Expenditure Multiplier 1/(1-c)
• The total increase in income is actually the
sum of an infinite geometric progression
which can be calculated by the first term
divided by (1- common ratio)
• The first term here is DE’ = $100 and the
common ratio is c =0.8
• The sum of GP is DE’ * multiplier
 Saving Function
• We have Y  C + S
• Saving function can simply be derived from the
consumption function
• S=Y–C if C = C’ + cY
• S = Y – C’ – cY
• S = -C’ + (1-c) Y
• S = S’ + sY where S’= -C’ and s = 1 - c
• S’ < 0 if C’ >0 S’ = 0 if C’ = 0
 Saving Function

S
S S = sY
S = S’+ sY
S = (1-c)Y
S =-C’+(1-c)Y

Slope of tangent: s =1- c

Y > Y*  S+ve
Y Y
Y*

S’
 Saving Function
• Autonomous Saving S’
• Since S= -C’ + (1-c)Y

• If C’= 0 when C= cY
•  S = (1-c)Y  S’ = 0

• If C’ +ve when C = C’ + cY
•  S = -C’ + (1-c)Y  S’ –ve

• If Y= 0  S’ = -C’  Dis-saving
 Saving Function
• Marginal Propensity to Save MPS = s
– It is defined as the change in saving per unit change in
disposable income Yd OR income Y (in a 2-sector model)
• MPS = DS/ DY
• It is the slope of tangent of the saving function
• MPS is a constant if the consumption / saving
function is linear
 Saving Function
• Average Propensity to Save APS
– It is defined as the total saving divided by total
income
• APS = S/Y
 Saving Function
• Y=C+S Differentiate wrt. DY
• DY/DY=DC/DY + DS/DY
•  1= MPC + MPS
• 1=c+s
 Injection-Withdrawal Approach
• Remember the national income identity S  I
• The equilibrium income happens when
planned Y= planned E as well as planned S =
planned I
 Equilibrium Income
• Write down the investment function I first. Then
write down the saving function S. Remember
planned S = planned I when Y is in equilibrium
{Injection-Withdrawal}

• Write down the investment function I as well as the

consumption function C. Together they are the
aggregate expenditure function E. Remember
planned Y = planned E when Y is in equilibrium
{Output-Expenditure}
 Paradox of Thrift

• This is an example of the “fallacy of

composition”
• “Thriftiness, while a virtue for the individual, is
disastrous for an economy”
• Given I = I’
• Given S = S’ + sY OR S = -C’ + (1-c)Y
• Now, suppose S’ 
• Will Ye increase as well?
A rise in thriftiness causes a decrease in national income but
no increase in realised saving.

S=S” +sY

S= S’+ sY

Excess Supply
I=I’

Ye
 Paradox of Thrift

• If a rise in saving leads to a reduction in interest rate and

hence an increase in investment (Think of the loanable
fund market), national income may not decrease

• Ye will increase if I’ increase more than S’

• Ye will remain the same if I’ increase as much as S’
• Ye will decrease if I’ increase less than S’
I  > S

S=S” +sY

S= S’+ sY

I=I”

I=I’

Ye
I  = S

S=S” +sY

S= S’+ sY

I=I”

I=I’

Ye =Ye
 When Saving Doesn’t Equal
Investment
• Classical economists stated that equilibrium
existed when total saving desired by
households equals total investment desired by
firms
• However, Keynes asked what happens when
desired savings exceeds desired investment
and prices were not free to adjust
– Prices are sticky and will not decline as inventories
build up
 When Saving Doesn’t Equal
Investment (Cont.)
– Wages are resistant to decreases
– Since interest rates are determined in the money
market, fluctuations will not necessarily
equilibrate desired saving and desired investment
– Therefore, since prices will not fall, both real
output and income will decline until desired
savings equaled desired investment at a lower
equilibrium GDP
 Consumption
and Simple GDP Determination
• Figure 1 below represents the Keynesian
cross diagram
• Real income and real output are measured in
the horizontal axis (Income: Y)
• Different types of expenditures are measured
on the vertical (Expenditure: E)
• A 45 degree line from origin traces the
equilibrium condition where E = Y
FIGURE 1 Spending determines income.
 Consumption and Simple GDP
Determination (Cont.)
• Expenditure takes two forms—consumption
and investment
– Consumption Function (C)
• Consumption is a linear function of income (Y)
– C = a + bY
• “b” is equal to the slope of the consumption line
 Consumption and Simple GDP
Determination (Cont.)
– Consumption Function (C) (Cont.)
• Marginal propensity to consume (MPC)
– The slope of the consumption functions (b)
– how much additional consumption would result from a $1
increase in income and is always less than 1
• “a” of the consumption function represents
consumption level if income were equal to zero
• The consumption function will shift up or down if the
value lf “a” changes due to increased/decreased
personal wealth
 Consumption and Simple GDP
Determination (Cont.)
– Investment (I)
• A relationship between the rate of interest on bonds
and the level of investment spending by business firms
• A negative relationship—when interest rates fall,
investment spending will increase
• Entrepreneurs invest as long as the rate of return on
investment exceeds the rate of interest
• If the rate of interest is given, the level of investment
will be constant and not a function of income
 Consumption and Simple GDP
Determination (Cont.)
• Total expenditure is equal to the sum of consumption
which varies with income and investment which is
constant (E = C + I)
• At points along the 45 degree line, total expenditure
(E) is equal to total income (Y)
• Since desired savings is equal to Y – C and E = Y, it
follows that along the 45 degree line desired savings
is equal to desired investment (S = I)
 Consumption and Simple GDP
Determination (Cont.)
• Savings Function (Figure 2) below
– The marginal propensity to save (MPS) is equal to
1 – MPC and less than 1
– This represents the slope of the savings function
which graphs a linear relationship between
savings and income

S = -a + (1 - b)Y
FIGURE 2 Saving and investment
determine income.
 Consumption and Simple GDP
Determination (Cont.)
• Savings Function (Figure 2) (Cont.)
– The economy is in equilibrium at an income level
where the savings function is equal to a fixed
investment
– This level of income is identical to the level
where the total expenditure function crosses the
45 degree line
 Changes in GDP
• The equilibrium level of income will not
change unless there is a change in the
consumption or investment functions
• This equilibrium would be a desirable
outcome if level of income (output) was at full
employment level
 Changes in GDP (Cont.)
• Keynes argued that since the level of investment is
highly unstable, it is likely that the equilibrium
output level will not equal the full employment level
of output
• If entrepreneurs became uncertain about the future,
investment spending would decline (total
expenditure function would shift down) and
equilibrium would be established at a lower level of
GDP
 Changes in GDP (Cont.)
• Multiplier—actual decline in GDP will be a
multiple of the reduction in investment
spending
– When investment declines, income begins to
decline
– This induces a reduction in consumer spending,
further lowering the level of income
 Changes in GDP (Cont.)

• Multiplier (Cont.)
– The total change in income is related to the initial
decline in investment through the multiplier, which
takes the following form

1
Multiplier 
(1  b)

Where: b = marginal propensity to consume

 Changes in GDP (Cont.)
• Multiplier (Cont.)
– Therefore, the total change in income resulting from a
change in investment is:

1
DY  DI
1b
 Autonomous versus Induced Changes
in GDP
• Figures 3 and 4 below suggest that anything that
shifts the position of the total desired spending
function will alter GDP
• Such shifts are produced by autonomous spending
changes which are independent of GDP
• However, the multiplier was based on the idea that
autonomous spending changes will induce further
changes in spending
FIGURE 3 A decline in investment spending reduces Y by a
multiple of the change in investment.
FIGURE 4 A decline in investment spending reduces Y
by a multiple of the change in investment.
Autonomous versus Induced Changes
in GDP (Cont.)
• The larger the marginal propensity to spend
(b), the greater the induced change in
spending
• Keynes argued that consumption spending is
largely induced, while investment spending is
largely autonomous—dependent on expected
rate of return on capital and rate of interest
Autonomous versus Induced Changes
in GDP (Cont.)
• Exports and Imports
– The multiplier expression can be modified to take
account of changes in other components of
spending
– Exports add to aggregate demand and imports
reduce aggregate demand and these changes are
impacted by the multiplier
 Government to the Rescue
• Keynes was concerned that changes in autonomous
spending would cause wide fluctuations in economic
activity
• Government spending was necessary to offset the
changes in autonomous spending and restore the
economy to full employment
• Therefore, total spending is the sum of consumer,
investment, and government expenditures
Government to the Rescue (Cont.)
• Figure 5 demonstrated the effect of additional
government spending to raise the income level of the
economy, ideally to the full employment level
– Government spending (G) is added to C + I
– This increases spending in the economy to
C+ I+G
– Total impact of additional government spending is
enhanced through the multiplier
FIGURE 5 Adding government
spending raises income.
Government to the Rescue (Cont.)
• Figure 6 shows the effect of increasing taxes
which lowers income
– Government usually finances spending by taxation
– Taxation will reduce disposable income which
further reduces income through the multiplier
FIGURE 6 Introducing taxes lowers income.
Government to the Rescue (Cont.)
– Government spending and taxes can be changed
by government policy to buffer the effects of
changes in autonomous spending
– Fiscal policy—deliberate manipulation of taxes or
government spending to achieve a desired level of
income consistent with full employment
 KEYNESIAN MACROECONOMIC MODEL AND
NATIONAL INCOME ACCOUNTING

Mutipliers

Multiplier effect: Chain reaction of an initial

change in income and spending that leads to a
greater change in final income and spending.
 The MPC and the Multipliers
First: the Spending Multiplier
(either investment spending or government spending)

DY = [ ? ] DI
The MPC and the Investment Multiplier
•If the investment community increases its
spending, incomes and consumption will
spiral upward in multiple rounds of earning
and spending.
•Once the process has played itself out,
the economy’s equilibrium income will be
higher by some multiple of the initial
investment spending.
The 45-degree line represents all possible
income-expenditure equilibria: Y = E. (But,
of course, there is only one point along that
line that corresponds to full employment.)
Consumption behavior is given by a linear
equation C = a + bY. In this economy, the
slope “b,” also called the marginal
propensity to consume, is one-half, or 0.5.
Investment spending is added vertically to
consumption spending: C + I is total
spending for a wholly private economy.
The economy is settled into an initial
equilibrium where Y (measured
horizontally) is equal to C+I (measured
vertically).
Now suppose that increased optimism in
the business community causes
investment spending to increase by DI .
The increased investment (DI) causes the
economy to spiral upward to a new
equilibrium, where the level of income is
higher by DY.
The MPC and the Investment Multiplier
•More generally, the multiple that relates DY
to DI is dependent on the MPC, which is
simply “b” in the equation C = a + bY.
•We can actually calculate an expression in
the form of DY = (some multiplier)DI
 DY = [ 1/(1 – b )] DI
1/(1 – b ) is the investment multiplier.
We can say, then, that if investment
spending increases by DI, then the
equilibrium level of income will increase by
1/(1 – b ) times that increase.
 The MPC and the Multipliers
Second: the Tax Multiplier
(a head tax, which is a lump-sum tax)

DY = [ ? ] DT
How do taxes affect consumption
behavior?

For a wholly private economy (no government secor):

C = a + bY

For a mixed economy (with government sector):

C = a + b(Y – T)

“T” is a lump-sum tax, a head tax, a poll tax.

“(Y – T)” is after-tax income; it’s take-home pay.
Macroeconomists call it “disposable income”.
The MPC and the Tax Multiplier

As with the spending multiplier, the

multiple that relates DY to DT is
dependent on the MPC, which is simply
“b” in the equation C = a + b(Y – T).
We can actually calculate an expression
in the form of DY = (some multiplier)DT.
 (1 – b)DY = -bDT

DY = [ -b/(1 – b )] DT
-b/(1 – b ) is the Tax Multiplier.
So, that if the tax take increases by DT, the
equilibrium level of income will increase by -
b/(1 – b ) times that increase---which is to
say that income will decrease by b/(1 - b)
time the increase in taxes.
The Multipliers

DY = 1/(1-b) DI

DY = 1/(1-b) DG
}The Spending Multipliers

DY = -b/(1-b) DT
} The Policy Multipliers
Suppose we increase G by 100 and increase T by 100.
If b = 0.80, what will the net change in Y?

DYG = 1/(1-b) DG DYT = -b/(1-b) DT

1/(1-b) = 1/(1-0.80) = 5 -b/(1-b) = -0.80/(1-0.80) = -4
DG = 100 DT = 100
DYG = 5 (100) = 500 DYT = -4 (100) = -400

DY = DYG + DYT = 500 -400 = 100

 MULTIPLIERS
Economy The multiplier Change in Y
Closed economy with 1 / [ 1 – mpc ] DG * Multiplier
government but no taxes

Closed economy with -mpc / [ 1 – mpc ] - mpc * multiplier * (DT)

government and lumpsum
taxes (T)

Closed economy with 1 / [ 1 – mpc (1 – t ) ] Changes in t change the

government and multiplier (increases in t
proportional taxes (t) reduces the multiplier)
Open economy with Changes in imports
government with 1/[1-mpc(1-t)+mpz] change the multiplier
proportional taxes and (increases in imports
imports reduce the multiplier)