Basic Macroeconomics

Relationships
ASSUMPTIONS AND SIMPLIFICATIONS

Keynes created the aggregate expenditures model in the middle of the Great Depression, hoping to explain
both why the Great Depression, hoping to explain both why the Great Depression happened and how it
might have ended.

A ‘Stuck-Price’ Model

The simplifying assumptions underpinning the aggregate expenditures model reflect the economic
conditions that prevailed during the Great Depression. The most important assumption is that prices are
fixed. The aggregate expenditures model is an extreme version of a sticky-price model. It is a stuck-price
model because the price level cannot change at all.

Keynes made this simplifying assumption because he had observed that prices had not declined
sufficiently during the Great Depression to boost spending and maintain output and employment at
their Great Depression levels.

Unplanned Inventory Adjustments

To Keynes, the Great Depression’s massive unemployment of labor and capital was caused by firms
reacting in a predictable way to unplanned increases in inventory levels. Sometimes inventories either rise
or fall more than intended because demand is either unexpectedly high or unexpectedly low

Households and businesses unexpectedly reduced their spending. which caused inventories of unsold goods
to surge. They reduced their rates of production, in some cases shutting down factories completely until
inventory levels declined. Reduced production brought with it discharged workers, idle factory lines, and,
in some cases shuttered factories gathering dust.

The model’s other key assumption - the one that allows it to achieve equilibrium - is that production
decisions are made in response to unexpected changes in inventory levels. If inventories are unexpectedly
rising firms will cut back on production so as to balance production with sales and prevent inventory
levels from exceeding warehouse capacity. If inventories are falling firms will increase production so as to
take advantage of an unexpectedly good selling environment

Current Relevance

The Keynesian aggregate expenditure model remains relevant today because many prices in the modern
economy are inflexible downward over short periods of time. The aggregate expenditures model, helps us
understand how the modern economy is likely to adjust to various economic shocks over shorter periods
of time
Income-consumption and income-saving relationships and schedules

Consumers by nature will consume more if they earn more, but they will not consume it all. In examining
the consumption-income relationship, we are also exploring the relationship between income and saving.
Economists define savings (S) as ‘not spending’ or ‘that part of disposable (after-tax) income (Yd) not
consumed”

The Consumption and Saving schedules

Consumption Schedule

This is a schedule showing the amounts households plan to spend on consumer goods at different levels of
disposable income. In the aggregate. households increase their spending as their disposable income rises
and spend a larger proportion of a small disposal income than of a large disposable income. But there is
more to it than only the relationship between GDP and Consumption

Saving Schedule

A schedule that shows the amounts households plan to save (plan not to spend on consumer goods) at
different levels of disposable income.

Break-even income is the level of disposable income at which households plan to consume all their
income and save none of it, also, in an income transfer program, the level of earned income at which
subsidy payments become zero

Marginal Propensities

The proportion, or fraction, of a change in the income consumed, is called the MPC (The fraction of any
change in disposable income spent on consumer goods; equal to the change in consumption divided by teh
change in disposable income. The MPC is the ratio of a change in consumption to a change in the income
that cause the consumption change:

The fraction of any change in disposable income that households save is equal to the change in saving
divided by the change in disposable income. The MPS is the ratio of change in savings to change in
income that brought it about
The sum of the MPC and the MPS for any change in disposable income must always be 1. Consuming or
saving out extra income is an either/or proposition; the fraction of any change in income not consumed
is, by definition, saved. Therefore, the fraction consumed (MPC) plus the fraction saved (MPS) must
exhaust the whole change in income.

MPC and MPS as slopes

The MPC is the numerical value of the slope of the consumption schedule, and the MPS is the numerical
value of the slope of the saving schedule

Exogenous Consumption and Saving

The Keynesian model calls for exogenous consumption that is not income-related. In other words, it is the
aggregate amount of money spent by consumers when income (Y) is zero, if:

In the model, the assumption is that the money would be drawn from previous savings, calling dissavings,
if:

We can summarize the consumption and saving schedules (C and S) by identifying the three variable that
will eventually determining the schedule:

Variable 1: C and S are determined by Yd

Variable 2: C are S is determined by MPC ( c) and MPS (1 - c), respectively

Variable 3: C and S will finally be influenced by the exogeneous consumption Co

More features of the equilibrium GDP lead us to the revelation that both of these schedules. each with
their own approach, can be used in determining the equilibrium GDP (Y) equations. The first approach
involving consumption schedule is also referred to as the expenditures approach while the second
approach involves saving and is referred to as the injections and the leakages approach.

Other Non-income Determinants of Consumption and Saving

The amount of disposable income is the basic determinant of the amount households will consume and
save. Certain determinants other than income might prompt households to consume more or less at each
possible level of income and thereby change the locations of consumption and saving schedules.

WEALTH: The amount that households spend and save from current income depends partly on the
value of existing wealth they have already accumulated. By ‘wealth’ we mean the value of real and
financial assets. When assets boost value of existing wealth, households increase their spending and
reduce their savings

The wealth effect is the tendency for people to increase their consumption spending when the
value of their financial and real assets rises and to decrease their consumption spending when
the value of those assets falls

EXPECTATIONS: Household expectations about future prices and income may affect current spending
and saving. Current consumption schedule shifts up and the current saving schedule shifts down. Or
expectations of recession and thus lower income in the future may lead households to reduce
consumption and save more today
REAL INTEREST RATES: When real interest rates (those adjusted for inflation) fall, households tend
to borrow more, consume more and save less. Lower interest rates diminishes the incentive to save
because of the reduced interest ‘payment’ to the saver . These effects on consumption and saving,
are modest. They mainly shift consumption towards some products (those bought on credit) and
away from others. At best, lower interest rates shift the consumption schedule slightly upward and
the saving schedule slightly downward.
HOUSEHOLD DEBT: In drawing a certain consumption schedule, household debt as a percentage of
disposable income is held constant. But when a consumer as a group increases their household debt,
they can increase current consumption at each level of Yd. Increased borrowing shifts the
consumption schedule upward. In contrast, reduced borrowing shifts the consumption schedule
downward

THE INTEREST RATE-INVESTMENT RELATIONSHIP

The investment decision is a marginal benefit-marginal cost decision. The marginal benefit from
investment is expected rate of return businesses hope to realize. The marginal cost is the interest rate that
must be paid for borrowed funds. We will see that businesses will invest in all projects for which the
expected rate of return exceed the interest rate, therefore, are the two basic determinants of investment
spending

Expected Rate of Return

Investment spending is guided by the profit motive: businesses buy capital goods only when they think
such purchases will be profitable. Expected rate of return describes the increase in profit a firm
anticipates it will obtain by purchasing capital (or engaging in research and development); expressed as a
percentage of the total cost of the investment activity.

*This is an expected rate of return, not a guaranteed rate of return. The investment may or may not
generate revenue and therefore profit as anticipated. Investment involves risk

The Real Interest Rate

The role of interest rate in the investment decision does not change. When the firm uses money from
savings to invest in the sander, it incurs an opportunity cost because it forgoes the interest income it
could have earned by lending the funds to someone else. That interest cost, converted to percentage
terms need to be weighed against the expected rate of return.

The real rate of interest, rather than the nominal rate, is crucial in making investment decisions. The real
interest rate is the nominal rate less the rate of inflation.

Investment Demand Curve

We now move from a single firms investment decision to total demand for investment goods by the entire
business sector. Assume that every firm has estimated the expected rates of return from all investment
projects and has recorded those data. We can cumulate (successively sum) these data by asking, how
many rands’ worth of investment projects have an expected rate of return of say, 16% or more.
The investment demand curve is constructed by arraying all potential investment project in descending order of their expected rate of return. The curve

slopes downward, reflecting an inverse relationship between the real interest rate (the financial ‘price’ of each rand of investing) and the quantity of

investment demanded

Consumption, Savings and Investment Schedules

To add the investment decisions of businesses to the consumption plans of households, we need to
construct an investment schedule showing the amounts business firms collectively intend to invest - their
planned investment - at each possible level of GDP.

Such a schedule represent the investment plans of businesses in the same way as the consumption
schedule represents the consumption plans of households. In developing the investment schedule, we will
assume that this planned investment is independent of the level of current disposable income or real
output

Equilibrium GDP (Y): Y = C + I and/or S = I

In our current private closed economy, given the expenditure approach, the two components that add up
to aggregate expenditures/income/GDP (Y) are consumption, C, and gross investment, I. In equation form:

In our second approach, we can now start by saying that the leakages in the economy (S) equals the
injections. In equation form:
Saving is a leakage or withdrawal of spending from the income-expenditure stream. Saving is what causes
consumption to be less than total output or GDP. Because of saving, consumption by itself is insufficient
to remove domestic output from the shelves, apparently setting the stage for a decline in total output.

Firms do not intend to sell their entire output to consumers. Some of that output will be capital goods
sold to other businesses. Investment - the purchase of capital goods is an injection of spending into the
income-expenditures stream. As an adjunct to consumption, investment is thus a potential replacement
for the leakage of saving.

Aggregate expenditure (Income Y)

The aggregate expenditures schedule is a schedule or curve showing the total amount spent for final goods
and services at different levels of real GDP. This schedule shows the amount ( C + I) that will be spent at
each possible output or income level

Disequilibrium

No level of GDP other than the equilibrium level of GDP can be sustained. At levels of GDP below
equilibrium, the economy wants to spend at higher levels than the levels of GDP the economy is producing.

The aggregate expenditures schedule, C + I, in (a) is determined by adding the investment schedule I to the upward-sloping
consumption schedule C. Since investment is assumed to be the same at each level of GDP, the vertical distances between C and
C+I do not change. Equilibrium GDP is determined where the aggregate expenditures schedule intersects the 45^ line, in this
case at R480 billion

Economists say differences between investment and saving can occur and bring about change in
equilibrium GDP, they are referring to planned investment and saving. Equilibrium occurs only when
planned investment and saving are equal. But when unplanned changes in inventories are considered,
investment and savings are always equal, regardless of the level of GDP. Actual investment and unplanned
investment. Unplanned changed in inventories act as a balancing item that equates the actual amounts
saved and invested in any period.

Adding the Public Sector

In order to move the analysis from a private closed economy to an economy with a public sector, this
means adding government purchases and taxes to the model.

We will assume that government purchases are independent of the level of GDP and do not alter the
consumption and investment schedules. Also, the government’s net tax revenues are paid as a percentage
of the income level in the economy derived entirely from personal taxes

GOVERNMENT EXPENDITURE AND EQUILIBRIUM GDP

The R20 billion increase in government expenditures increases the GDO by R80 million from R460 to R560. In (a) adding government
expenditure shifts the curve upwards. In (b) we add the government expenditure to the investment schedule that shifts upwards and is equal
to S at R560 billion
ADDING TAXES AND EQUILIBRIUM GDP

In (a) T are introduced and the aggregate expenditure slope changes as indicates. Equilibrium GDP drops from R560 t o R430 billion. In (b) T
is added to S because it has been identified as a leakage, Leakages = Injections (S + T = (I + G) at R430 billion

Adding International Trade

Our focus will be on net exports (exports - imports) which may be positive or negative.

Net Exports and Aggregate Expenditures

Although South African goods and services produced for export are sent abroad, foreign spending on
those goods and services increases production and creates jobs and income in SA. We must include exports
as a component of each nation’s aggregate expenditures. When an economy is open to international
trade, it will spend part of its income on imports. To avoid overstating the value of domestic production
we must subtract the total amount spent on imports because such spending generates production and
income abroad. Measuring aggregate expenditure for domestic goods and services, we must subtract
imports

In our leakages/injection analysis imports is a clear leakage in the economy since it is money that is
completely leaving the domestic system and exports are a clear injection into the system given it is money
that flows into the system due to sales of domestic goods and services to foreigners

Positive net exports

Other things equal, net exports increase aggregate expenditrues and GDP beyond what would be in a
closed economy. Exports reduce the stock of available goods in an economy because some of an economy’s
output is sent abroad. Exports boost an economy’s real GDP by increasing expenditures on domestically
produced output.

Negative net exports

Negative net exports reduce the aggregate expenditure and GDP below what they would be in a closed
economy. Imports add to the stock of goods available in the economy, but they diminish real GDP by
reducing expenditures on domestically produced products.

Generalizations of the effects of net exports on GDP mean that a decline in Xn - a decrease in exports or
an increase in imports - reduces aggregate expenditures and contracts a nation’s GDP. Conversely, an
increase in Xn - the result of either an increase in exports or a decrease in imports - increases aggregate
expenditures and expands GDP

THE MULTIPLIER EFFECT

A change in autonomous, say, investment, ultimately changes output and income by more than the initial
change in investment spending. This result is called the multiplier effect; a change in a component of
total spending leads to a larger change in GDP. The multiplier determines how much larger that change
will be; it is the ration of a change in GDP to the initial change in autonomous spending. Stated
generally:

Rearranging this equation, we can also say that:

Note these three points about the multiplier:

1. The ‘initial change in autonomous spending’ is usually associated with investment spending because
of investment’s volatility. But changes in consumption (unrelated to changes in income). net exports
and government purchases also lead to the multiplier effect.
2. The ‘initial change in spending’ associated with investment spending results from a change in real
interest rate and/or a shift of the investment demand curve
 3. Implicit in the preceding point is that the multiplier works in both directions. An increase initial
spending may create a multiple increase in GDP. and a subsequent decrease in autonomous spending
may be multiplied into a larger decrease in GDP

Rationale

The multiplier effect follows from two facts. First, the economy supports repetitive, continuous flows of
expenditures and income through which rands spent by Poggenpoel are received as income by Mogola.
Second, any change in income will vary both consumption and saving in the same direction as, and by a
fraction, of the change in income

It follows that an initial change in spending will set off a spending chain throughout the economy. The
chain of spending, although of diminishing importance at each successive step, will cumulate to a multiple
change in GDP. Initial changes in spending produce magnified changes in output and income

The MPC and the multiplier are directly related and the MPS and the multiplier are inversely related. The
precise formulas are as follows.

Recall too, that MPC + MPS = 1. Therefore MPS = 1 - MPC, which means we can also write the multiplier
formula as:

Taxes and the multiplier

When T was introduced into our model, the equilibrium GDP decreased from R560 billion to R430 billion
given a proportional tax rate of 10%. The amount we consume depends on our disposable income which is
determined first by the MPC and secondly by the tax rate. We have less disposable income because we are
not only saving a portion but we are also paying tax from that same portion. A tax rate introduced, will
therefore influenced the size of the multiplier and actually reduce it. As soon as taxes are introduced, we
need to switch from an income multiplier without taxes to a tax multiplier

Equilibrium versus full-employment GDP

Let us use the complete aggregate expenditures model to evaluate the equilibrium GDP. The R520 billion
equilibrium GDP in our complete analysis may or may not provide full employment. Indeed, we have
assumed thus far that the economy is operating at less than full employment. The economy need not
always produce full employment and price-level stability. We will also see that the economy can produce
full employment GDP even while experiencing large negative net exports

A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment
GDP fall short of those required to achieve the full-employment GDP. Insufficient total spending
contacts or depresses the economy.

Inflationary Expenditure Gap

An inflationary expenditure gap is the amount by which an economy’s aggregate expenditures at the full-
employment GDP exceed those just necessary to achieve the full employment GDP

The effect of this inflationary expenditure gap is that the excessive spending will pull up output prices.
Since businesses cannot respond to the R5 billion in excessive spending by expanding their real output,
demand-pull inflation will occur. Nominal GDP will rise because of a higher price level, but real GDP will
not. Excessive total spending causes inflation

Limitations of the model

This model has five well-known limitations

1. It does not show price level changes: The model does not indicate how much the price level will rise
when aggregate expenditures are excessive relative to the economy’s capacity. The aggregate
expenditures model has no way of measuring the rate of inflation
2. It ignores premature demand-pull inflation: Mild demand-pull inflation can occur before an
economy reaches its full-employment level of output. The aggregate expenditures mode does not
explain why that can happen
3. It limits real GDP to the full employment level of output: For a time an actual economy can expand
beyond its full-employment real GDP. The aggregate expenditures model does not allow for that
possibility
4. It does not deal with cost-push inflation: We know there are two general types of inflation: demand-
pull and cost-push. The aggregate expenditures model does not address cost-push inflation
5. It does not allow for ‘self-correction’: In reality, the economy contains some internal features that,
given enough time, may correct a recessionary expenditure gap or inflationary expenditure gap. The
aggregate expenditures model does not contain those features