Principles of Economics (2)

Dr. Nahla Azzam

Department of Economics
Faculty of Economic Studies
and Political Science
Alexandria University

2024 – 2025

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 Preface
Macroeconomics focuses on the behavior of
aggregate indicators such as GDP (Gross Domestic
Product), inflation, unemployment, and the roles of
government fiscal and monetary policy in maintaining
economic stability. In a world where economic forces
are interconnected and evolving, understanding these
principles is crucial for businesses, governments, or
individuals to make informed decisions.

This eBook is a tool designed to engage students

actively with the material, though questions, and
practical examples to enhance their learning
experience; developing a deeper understanding of how
governments, businesses, and individuals interact
within the economy or economic system.

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 Contents

• Chapter (1): Introduction to Macroeconomics.

• Chapter (2): Definition and measuring of GDP.
• Chapter (3): Unemployment, Inflation and Long
Run Growth.
• Chapter (4): GDP in a closed economy without a
Government.
• Chapter (5): GDP in a closed economy with
Government.
• Chapter (6): Money Market and Equilibrium
Interest Rate.
• Chapter (7): Aggregate Demand in the Goods
and Money Markets.

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 Chapter (1)
Introduction to Macroeconomics

Chapter Outline
1. Microeconomics and Macroeconomics.
2. Major Concerns of Macroeconomic Issues.
3. Some Basic Macroeconomic Concepts.
4. Main Components of the Macroeconomy.
5. The Circular Flow of Income, Output, and Expenditure.
6. The Role of the Government in the Economy.

https://www.youtube.com/watch?v=ZTJ5jDBs5mM

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 1. Microeconomics and Macroeconomics

• Microeconomics: Examines the functioning of

individual industries and the behavior of individual
decision-making units, as firms and households. Using
assumptions about how these units behave (firms
maximize profits; households maximize utility), we can
derive conclusions about how markets work and how
resources are allocated.

• Macroeconomics: Deals with the Aggregate behavior

of the economy as a whole. Macroeconomics focuses
on the determinants of total national income, deals with
aggregates such as aggregate consumption and
investment, business cycles, living standards, inflation,
and unemployment. It also asks how governments can
use their monetary and fiscal policy instruments to help
stabilize the economy.

Thus, both are concerned with the decisions of households

and firms. Microeconomics deals with individual decisions;
macroeconomics deals with the sum of these individual
decisions.

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Q. State which of the following is a macroeconomic issue
and which is a microeconomic issue:
1. The change in the price of Cars relative to the price of
bikes.
2. Historical trends in the growth of real national income.
3. Is it sensible for a government to subsidize tobacco
production?
4. Why do some countries grow faster than others?
5. Should the government attempt to influence the interest
rate to lower inflation?

2. Macroeconomic Concerns
The major concerns or goals of macroeconomics are:
a) Output growth
b) Unemployment
c) Inflation and deflation
Policy makers in any economy seek to achieve: high
output growth, low unemployment, and low inflation rates.

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 • high rates of output and economic growth rate.
• low rates of unemployment.
• low rates of inflation.

a) Output Growth
Economies tend to experience short-term ups and
downs in their performance. The technical name for these
ups and downs is the business cycle. The main measure of
how an economy is doing is aggregate output;
• Business cycle: The cycle of short-term ups and
downs in the economy.
• Aggregate output: The total quantity of goods and
services produced in an economy during a given time
period. When aggregate output decreases, the
average standard of living declines. When firms
reduce production, they lay off workers, increasing
the rate of unemployment.
➢ Economic growth versus Business Cycles:
✓ Economic growth (output): is the long-term increase
in the productive capacity of the economy, i.e.: it
reflects the ability of the economy to produce goods
and services.
✓ Business Cycles: are the short-term ups & downs in
the economy.

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3. Some Basic Macroeconomic Concepts

• Recession: A period during which aggregate output

declines for two consecutive quarters.
• Depression: A prolonged and deep recession.
• Expansion, recovery, or boom: The period in the
business cycle from a trough up to a peak during
which output and employment grow.
• Contraction, recession, or slump: The period in the
business cycle from a peak down to a trough during
which output and employment fall.

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 • In this business cycle, the economy is expanding as
it moves through point A from the trough to the
peak (expansion or recovery).
✓ When the economy moves from a peak (top of the
cycle) down to a trough (bottom of the cycle),
through point B, the economy is in recession.

b) Unemployment
Unemployment rate: The percentage of the labor force
that is unemployed.
The unemployment rate is closely related to the
economy’s aggregate output (higher unemployment means
lower output). Thus, the existence of unemployment
indicates that the goods market, or the aggregate labor
market is not in equilibrium. This is a main concern of
macroeconomists.
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 c) Inflation
Keeping inflation low has long been a goal of
government policy. Especially problematic are
hyperinflations, or periods of very rapid increases in the
overall price level. The goal of policy makers is to avoid
prolonged periods of inflation in order to pursue stability.

• Inflation: An increase in the overall price level.

• Hyperinflation: A period of very rapid increases in the
overall price level.
• Deflation: A decrease in the overall price level.
• Stagflation: A situation of both high inflation and high
unemployment.

4. Main Components of the Macroeconomy

Understanding how the macroeconomy works is

challenging because everything seems to affect everything
else. Thus, it is helpful to divide the participants in the
economy into four groups or sectors:

(1) Households (domestic consumers).

(2) Firms (domestic producers).
(3) The government (Public sector).
(4) The rest of the world (Foreign sector).

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At the macroeconomic level, the economy can be divided
into three key markets in which these groups deal together:
(1) The Goods-and-Services Market
(2) The Labor market.
(3) The Money market.

1. Goods-and-Services Market
• Households and the government purchase goods and
services from firms in the goods-and-services market.
• Firms purchase goods and services from each other and
also supply to the goods-and-services market.
• Households, the government, and firms demand from
this market.
• The rest of the world buys from and sells to the goods-
and-services market.

2. Labor Market
• In the labor market, households supply labor and firms
and the government demand labor.
• Labor is also supplied to and demanded from the rest of
the world. Thus, the labor market has become an
international market.

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3- Money Market
• Households supply funds to the money market—the
financial market—in the expectation of earning income
in the form of dividends on stocks and interest on
bonds.
• Households also demand (borrow) funds from this
market to finance various purchases.
• Firms borrow to build new facilities in the hope of
earning more in the future.
• The government borrows by issuing bonds.
• The rest of the world borrows from and lends to the
money market.

This borrowing and lending is coordinated by financial

institutions; as commercial banks, and insurance companies,
which take deposits from one group and lend them to others.

When the government borrows, it issues “promises” called

Treasury bonds, notes, or bills in exchange for money. Firms
can borrow by issuing corporate bonds or shares of stocks
that gives dividends to the shareholders.
These four groups interact in the economy in a variety of
ways, involving either receiving or spending income.

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 5. The Circular Flow of Income, Output, and
Expenditure
A useful way of seeing the economic interactions among the
four groups in the economy is the circular flow diagram.
➢ The income flows from the domestic producers (firms)
and government to the households.
➢ The spending on final goods and services flows from
households to firms.
Every transaction must have two sides; everyone’s
expenditure is someone else’s receipt.
✓ The Circular flow: is a diagram showing the income
received and payments made by each sector of the
economy.

https://www.youtube.com/watch?v=5usTTouGlnU

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 ➢ Households;
• They work for firms and the government, and
receive wages, rents, and interest from firms for
their work, they also receive other payments from
the government, such as Social Security benefits,
and welfare payments.
• These payments from the government (for which
the recipients do not supply goods, services, or
labor) are transfer payments.
• Together, these receipts make up the total income
received by the households.
• They spend by buying goods and services from
firms and by paying taxes to the government.
These items make up the total amount paid out by
the households.
• The difference between the total receipts and the
total payments of the households is the amount
that the households save or dissave. Saving by
households is a “leakage” from the circular flow
because it withdraws income from the system.
➢ Firms;
• They sell goods and services to households and the
government. These sales earn revenue, which
shows up in the circular flow diagram as a flow
into the firm sector.

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 • They pay wages, interest, and rents to households,
and taxes to the government. These payments are
shown flowing out of firms.
➢ The government;
• It collects taxes from households and firms.
• It also makes payments; it buys goods and
services from firms, pays wages and interest to
households, and makes transfer payments to
households. If the government’s revenue is less
than its payments, the government is dissaving.
➢ Foreign Sector;
• Households spend some of their income on
imports—goods and services produced in the
rest of the world (receipts for the foreign
sector).
• Similarly, people in foreign countries purchase
exports—goods and services produced by
domestic firms and sold to other countries
(payments from the foreign sector).

❖ Note that:
✓ Final spending on goods and services is made by
individuals + investment spending + government
consumption + exports.
✓ Withdrawals of spending arise when income received is
not spent on the domestic economy. Therefore, Saving,
taxes and imports represent a leakage from the circular
flow (S +T + IM).

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 ✓ Injections of spending are those that come from sources
other than domestic incomes (exogenous). Therefore,
Investment, government consumption and exports
represent injections into the circular flow (I + G + X).
✓ For any equilibrium level of national activity (GDP)
injections must equal leakages.
saving + taxes + imports = investment + government
consumption + exports
(S +T + IM) = (I + G + X)

6. The Role of the Government in the Economy

The two main policies by which the government can affect
the economy are fiscal policy and monetary policy.
(1) Fiscal policy; Government policies concerning taxes
and spending.
• The government collects taxes from households and
firms and spends them on goods and services as
hospitals, schools and highways.
• An expansionary fiscal policy is a policy in which
taxes are cut and/or government spending increases.
A contractionary fiscal policy is the reverse.

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(2) Monetary policy; Tools used by the central bank to
control the short-term interest rate.
• The nation’s central bank determines the quantity of
money in the economy, which in turn affects
interest rates.
• The central bank ’s decisions have important effects
on the economy. In fact, the task of trying to smooth
out business cycles is generally left to the nation’s
central bank (that is, to monetary policy).

Review Questions
1. We can use macroeconomic analysis to
A. understand marginal changes in the macroeconomic.
B. understand why economies grow.
C. learn how to balance a checkbook.
D. study the choices made by households.
2. The economy goes through an expansion between a
________ and a ________.
A. deflation; stagflation.
B. boom; bust.
C. trough; peak.
D. peak; recession.
3. When the government changes taxes and spending, it
is implementing
A. monetary policy.
B. incomes policy.
C. fiscal policy.
D. supply -side policy.
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 Chapter (2)
Definition and measuring of GDP

Chapter Outline:
1. Definition of GDP.
2. Measurement Of GDP:
A.The Output Approach.
B. The Spending Approach.
C. The Income Approach.
3. Real and Nominal Measures of GDP.
4. GDP and GDP per capita (GDPP).
5. Limitations of the GDP Concept.

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 1. Definition of GDP
➢ What is GDP?
• GDP is the most important measure of output,
reflecting the economy’s economic performance.
• Gross Domestic Product: GDP is the total market
value of all final goods and services produced during
a given period within a country (domestically).
We have to distinguish between two types of output:
a) Final goods and services; goods and services
produced for final use; and are not used as inputs by
other firms.
b) Intermediate goods and services; the outputs of some
firms that are used in further processing as inputs by
other firms.
If we add up the market value of all outputs of all firms, we
will obtain a total that is greatly in excess of the value of the
economy’s actual output. This is called double counting or
multiple counting.
➢ What is excluded from GDP counting?
From the GDP definition, the following items are not
involved in the GDP:
A. Intermediate Goods.
B. Used Goods and Services (old houses and cars).
C. Paper Transactions (bonds & stocks).
D. Output produced abroad (by the country`s citizens).
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A. The value of intermediate goods; The value of
intermediate goods is not counted in GDP to avoid
double counting. Double counting can also be avoided
by counting only the value added during some stages of
production.

B. Used Goods and Services; GDP is concerned only

with new, or current, production. Old output is not
counted in current GDP because it was already counted
when it was produced. It would be double counting to
count sales of used goods in GDP because no new
production has taken place.

C. Paper Transactions; sales of stocks and bonds are not

counted in GDP. These exchanges are just transfers of
ownership of assets and do not correspond to new
production. The brokerage commission for selling
stocks is included in the GDP as it is a payment in return
for a service.

D. Output Produced Abroad by Domestically Owned

Factors of Production; GDP is the value of output
produced by factors of production located within a
country. The output produced by citizens abroad is not
counted in GDP because the output is not produced
within the country. However, the output produced by
foreigners working in the country is counted in its GDP
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 because the output is produced within the country. Also,
profits earned in the country by foreign-owned
companies are counted in the country’s GDP.

➢ GDP and GNP:

• Gross national product (GNP) is the total market value

of all final goods and services produced within a given
period by factors of production owned by a country’s
citizens, regardless of where the output is produced.

GNP = GDP - output produced by the foreigners inside a

country + output produced by citizens outside.
1. If output produced by citizens abroad > Output
produced by foreigners inside the country
GNP > GDP
2. If output produced by citizens abroad ˂ Output
produced by foreigners inside the country
GNP˂ GDP

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 3. If output produced by citizens abroad = Output
produced by foreigners inside the country
GNP = GDP

Q. Explain why you agree or disagree with the following:

1. The intermediate goods are not included in the
calculation of GDP to avoid double counting.
2. GDP and GNP for a given country are always equal.
3. Paper transactions have to be counted in the GDP,
because these exchanges produce new goods and
services to the economy.
4. Used cars and houses are counted in current GDP.

2. Measurement of GDP
The overall economic activities of any economy (its GDP)
can be measured in three different ways:

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 1. The Output Approach; GDP is measured as the value
of all final goods and services produced in the economy.
2. The Expenditure Approach; GDP is measured by the
expenditure needed to purchase all final goods and
services produced during the period; thus, by adding up
the total amount spent on all final goods and services
during a given period.
3. The Income Approach; GDP is measured by the
income generated from the act of production of goods
and services; by adding up the income—wages, rents,
interest, and profits—received by all factors of
production in producing final goods and services.
These methods lead to the same value for GDP because
Every payment (expenditure) by a buyer is a receipt
(income) for the seller. We can measure either income
received or expenditures made, and we will end up with the
same value of total output.

1. The Output Approach

In calculating GDP, we can:
• sum up the value added at each stage of production, or
• take the value of final sales (at the last stage).
The value added: Each firm’s value added is the net value of
its output, that is the value of its output minus the value of
inputs that it bought from other firms. Value added: is the
difference between the value of goods as they leave a stage
of production and the cost of the goods as they entered that
stage.
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 • The value-added concept is used to avoid double-
counting.
• It measures each firm’s own contribution to total output
or the market value of what is produced by that firm.

The sum of all values added in an economy is a measure of

the economy’s total output.
Example: The following table shows the Value Added in
the production of a gallon of gasoline:

✓ GDP (value-added) = (3.00+0.30+0.30+0.40) = $ 4.00

✓ GDP (value of final sales) = $ 4.00

The four stages of the production of a gallon of gasoline are:

• In the first stage, value added is the value of the crude
oil.
• In the second stage, the refiner purchases the oil from
the driller, refines it into gasoline, and sells it to the
shipper. The refiner pays the driller $3.00 per gallon
and charges the shipper $3.30. The value added by the
refiner is thus $0.30 per gallon.
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• The shipper then sells the gasoline to retailers for $3.60.
The value added in the third stage of production is
$0.30.
• Finally, the retailer sells the gasoline to consumers for
$4.00. The value added at the fourth stage is $0.40;
• The total value added in the production process is
$4.00, the same as the value of sales at the retail level.

• Adding the total values of sales at each stage of

production ($3.00 + $3.30 + $3.60 + $4.00 = $13.90)
would overestimate the value of the gallon of gasoline
due to double counting.

Problem (1):
The following table illustrate data about one
economic sector which consists of three factories:
spinning, textile, and ready-made clothes (Millions of
dollars):

Calculate the contribution of this sector to the GDP

using:
1- The value-added method.
2- The value of final sales method.

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Solution:
1. The value added = total value of final sales -
intermediate purchases (last period - first period)
Value added for spinning= 5,000 – 0 = $5,000
Value added for textile= 10,000 – 5,000 = $5,000
Value added for ready-made clothes = 30,000 – 10,000
= $20,000
Total value added (contribution to GDP) = 5,000 + 5,000
+ 20,000= $30,000.

2. The value of final sales = the value of ready-made

clothes = $30,000.

▪ What about inventory not sold! Is it included in GDP?

Some of the firms’ current output might not be sold, and
hence, will be kept in stores or warehouses;
✓ Inventory or stock refers to produced goods that are not
sold, but are held by a business with a view of future
sale.
✓ Therefore, inventory produced in a given period must
be included in current GDP; as it is not reflected in final
sales. Otherwise, GDP will be under-estimated.
Problem (2):
The following table contains data about one economic
sector which consists of three factories: spinning, textile and
ready-made clothes ($Millions)

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Calculate the contribution of this sector to the GDP using:
1- The value-added method.
2- The value of final sales method.
Solution:
1. The value added = value of output - value of inputs
from other firms + change in inventory [(End- period)
– (First - period)].
• Value added for spinning= 5000 – 0 + (3000-1000) =
$7000
• Value added for textile= 10000 – 5000 + (2000-500)
=$6500
• Value added for ready-made clothes = 30000 - 10000 +
(5000-2000) = $23000
• Total value added (contribution to GDP) = 7000 + 6500 +
23000= $36500.
2. The value of final sales = the value of final goods +
changes in inventory.
=30000+ [(3000+2000+5000) - (1000+500+2000)] =
30000 + 6500 = $36500.

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2. The Expenditure Approach
From the expenditure side of the national accounts GDP can
be calculated by measuring the total amount spent on all final
goods and services in a given time period.
GDP = C + I + G + [X - IM]
There are 4 categories of expenditure:
1. (C) is private consumption expenditures.
2. (I) is investment in fixed capital and inventories.
3. (G) is government consumption.
4. [X -IM] represents net exports, or exports minus
imports.

1. Private Consumption Spending (C)

Private consumption spending is spending by
individual consumers on goods and services produced and
sold to their final users during the year.
It consists of:
1- Durable Goods: Goods that last a relatively long time,
such as cars, television sets, and microwave ovens.
2- Non-durable Goods: Goods that are used up fairly
quickly, such as food and clothes.
3- Services: such as haircuts, telephone calls, legal and
medical services and education.
Private consumption does not include purchases of
existing houses or cars as these are not part of current
production. This involves only ownership transfer of an
existing asset.

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 So, used goods and services (old houses and cars) and
paper transactions (bonds & stocks) are not included in the
GDP to avoid double counting.

2. Gross Investment Spending (I)

Investment spending is spending on the production of goods
not for present consumption but rather for future use, these
goods are called investment or (capital) goods. It can be
divided in to:
1- Fixed Capital Formation: Creating new capital goods,
such as machines, computers, and factory buildings (i.e.,
non-residential investment).
2- Residential investment: Housing construction -by
households or firms- is counted as investment spending
rather than consumption spending, since it yields a utility
(housing services) over a long period of time.
3- Changes in inventories: Inventories are new goods that
firms produce now but intend to sell later. All firms hold
stocks of their own outputs to allow firms to meet orders in
spite of temporary fluctuations in the rate of outputs or sales.
An increase of stocks and unfinished goods in the production
process counts as current investment because it represents
goods produced, but not used for current consumption. The
economy’s total quantity of capital goods is called the capital
stock.

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 Gross investment Vs. Net Investment

3. Government Consumption Spending (G)

• Government consumption spending is all government
purchases or spending on final goods and services. e.g.,
expenditure on school buildings, teachers’ salaries, health
care, street lighting and military salaries.
• Transfer Payments from government to people for which
no good or service is received in exchange at the same
period are excluded in computing GDP. Transfer
payments may include: social security, old age pensions,

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 disability pensions, unemployment benefit, income
support, student grants.
• Only government spending on currently produced goods
and services is included as part of GDP.
4. Net Exports (X-IM)
1. Exports (X); It is the value of output produced in a
country and purchased by foreigners, so it should be
included in its GDP.
2. Imports (IM); It is the value of output produced by a
foreign country and purchased by residents of a country,
so it should not be included in its GDP. It contributes to
the foreign country’s GDP.
3. Net Exports (X–IM); Is the difference between foreign
expenditure on domestic goods (exports) & the domestic
expenditure on imported goods (imports).
Net exports = (X – IM)

Total Expenditure (Spending)

GDP = C + I + G + (X- IM)

GDP expenditure-based is the sum of private consumption
(C), government consumption (G), gross investment (I), and
net export spending (X-IM); on currently produced goods
and services.

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• Personal consumption expenditures (C) = Durable
goods + non-durable goods + Services
• Gross private domestic investment (I) =
Nonresidential + Residential + Change in business
inventories
• Government consumption (G) = Federal + State and
local
• Net exports (EX – IM) = Exports (EX) - Imports (IM)

GDP = C+I+G+(X-M)

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Solution:
Personal Consumption (C) = 659.3+1592+3234.5=$5485.8
Gross Private Domestic Investment (I)
=846.9+327.2+67.9=$1242.

Government Spending (G) = 523.8+928.9=$1452.7

Net Exports (X–IM) = 957.1-1058.1=$-101
GDP = C+I+G+(EX–IM) = 5485+1242+1452.7
101=$8079.5

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Solution:
• GDP = C+I+G+(X-IM) = 1000+(1100+200) + 600+
(200-150) = $2950 million.
• GNP = GDP + receipts of income from abroad –
payments of income to foreigners abroad = 2950 +
200 - 50=$3100 million.
• NNP = GNP – depreciation = $2900 million.

3. The Income Approach

A method of computing GDP that measures the income
received by all factors of production in producing goods and
services. This will yield the net domestic income (NDP).
Incomes of factors of production:
1- wages ⇒for workers.
2- rent for ⇒ land.
3- interest or dividends ⇒ for capital (bonds& Stocks).
4- profits ⇒ for entrepreneur.
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The Main Income Categories
1. Compensation of Employees: it is the payment for the
services of labor, this is wages.
2. Mixed Incomes: this category covers self-employed
individuals who are running their own business. It is not
clear what proportion of their incomes is equivalent to
a wage and what proportion is the profits.
3. Operating Surpluses: It is the profits of firms, net
business income after payment to hired labor and for
materials inputs and before direct taxes. Some profits
are paid out as dividends to owners of firms (distributed
profits), others retained for use by firms (undistributed
profits).
Distributed + undistributed profits are included in GDP
✓ From net domestic product (DI) to net national
income (NI):
Net domestic product (w + r+ i+ p) + Net receipts from
abroad = Net National income (NI)
✓ Adding depreciation, we obtain GDI(GDP) and
GNI(GNP)
• Gross Domestic Income
Total income earned by factors of production located within
a country (citizens or foreigners).
(net domestic income + depreciation = GDP)
• Gross National income
Total income earned by country’s citizens (located within a
country or outside it).
(net national income + depreciation = GNP)

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Other Income Concepts
Personal income: income that is earned by or paid to
individuals, before allowing for personal income taxes, and
after transfer payments.

 Personal income = NI – retained profits of

companies
 Personal income – net income taxes = personal
disposable income
 Net income taxes= taxes – transfer payments
 Personal disposable income = consumption (C) +
saving (S).

From personal income to personal disposable income

Personal income -Taxes + transfer payments = personal
disposable income.
From personal disposable income to personal income
personal disposable income +Taxes - transfer payments =
Personal income.
Problem 1:
Suppose that the personal income $12,000 billion, the
income taxes $2,000 billion, and personal saving $3,000
billion. What is personal consumption?
Answer:
personal income- net taxes = disposable income
12,000 – 2,000 = 10,000 (Transfer payments = zero)
Disposable income - personal saving= personal consumption
10,000 - 3,000=$7,000

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From personal disposable income to GDP
personal disposable income + personal income taxes -
transfer payments + retained profits (undistributed profits)
of companies = National Income (NI)
National Income (NI) - Net receipts from abroad = Net
domestic income (NDP) + Depreciation = GDP

https://www.youtube.com/watch?v=t0qQSW0MTKY
Problem (2):
In a simple economy, use the following set of numbers:
Consumption=$400
Exports =$20
Imports =$10
Net Investment =$20
Government purchases =$100
Depreciation =$20
Payments of factor income to the rest of the world =$10
Receipts of factor income from abroad =$5
Required:
1-Calculate the gross domestic investment (I).
2-Calculate GDP.
3-Calculate GNP.
4-Calculate NNP(NI).

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Solution:
1. Gross Investment = Net Investment + Depreciation
Gross I=Net Investment + Depreciation =20+20 =40
2. GDP= C+I+G+(X–IM)
GDP=400+40+100+(20–10) =550
3. GNP= GDP+ Receipts from abroad – Payments to the
rest of the world: GNP=550+5–10=545
4. NNP = GNP–Depreciation = 545–20 =525
Problem (3):
Use the following information to answer the questions
below:
Wages 280
Rents 89
Interest 96
profits 85
net receipts from abroad 24
depreciation 170
Find the value of:
1. GDP
2. GNP Gross national income

Solution:
NDP = wages + interest+ rent +profits = 280 + 89+96+85
= $550 million
GDP = NDP + depreciation = 550 + 170= $720 million.
GNP = national income = GDP + net receipts from abroad
= 720 + 24= $744 million.

38
Problem (4):
In a simple economy, suppose that all income is either
compensation of employees or profits. Suppose also that
there are no indirect taxes.
Required: Calculate gross domestic product from the
following set of numbers, and show that the expenditure
approach and the income approach add up to the same figure.
Consumption $5,000 Compensation of employees 5,300
Investment 1,000 Government purchases 1,000
Depreciation 600 Direct taxes 800
Profits 900 Saving 1,100
Exports 500 Imports 700

Solution:
1. Expenditure Approach;
GDP = C+I+G+(X-IM) = 5000+1000+1000+ (500-700)
GDP = 7000 – 200 = $ 6800
2. Income Approach;
GDP = NDP + Depreciation
NDP = Compensation of employees (wages) + Profits +
Interests + Rents = 5300 + 900 = $ 6200
GDP = 6200 + 600 = $ 6800

39
Problem (5):
Use the following data to calculate GDP (using the Spending
approach & the Income approach), GNP, and NNP.

Solution:
1. GDP with the Spending approach;
GDP = C+I+G+(X-IM)
= 304+124+ 156+18 = $602

2. GDP with the Income approach;

GDP = NDP+ depreciation
NDP = Wages + Profits + Interests + Rent
= 67+ (200+74) + 150 + 75 = $ 566
GDP = 566 + 36 = $602

3. GNP = GDP + Net foreign factor income

= 602 + 12 = $ 614

4. NNP = GNP – depreciation

= 614 – 36 = $ 578
40
 3. Real and Nominal Measures of GDP
So far, we have looked at GDP measured at current
prices that we pay for goods and services. When we measure
something in current prices, we refer to it as a nominal value.
o Nominal GDP
• It is the value of final goods & services in the current
year measured at the current prices of the year; i.e.: all
components of GDP are valued at their current market
prices. It is GDP measured in current prices of the year.
• Any change in nominal GDP or GNI can be split in to a
change in real GDP and a change due to prices.

Nominal GDP is not a good measure of the economic

performance. WHY? It is not a good measure of the
economic performance, as it is affected by the quantity of
final goods & services produced; and also, by their prices
(inflation).
o Real GDP
• It is GDP measured at constant prices.
• It is a good measure of the economic performance, as
it is affected only by the quantity of final goods &
services produced.

✓ During inflation, as prices increase ⇨ nominal GDP is

overvalued ⇨ nominal GDP > real GDP.
✓ During recession, as prices decrease ⇨ nominal GDP is
undervalued ⇨ nominal GDP < real GDP.

41
Example:

Calculating the GDP Deflator

One of the economic policy makers’ goals is to keep
changes in the general price level small. Hence, as policy
makers need good measures of how real output is changing,
they also need good measures of how the overall price level
is changing. This is reflected by the GDP deflator.
The GDP deflator is a comprehensive price index -
covering all goods and services produced by the entire
economy – that measures the percentage change in the
general price level. Thus, it is a measure of the Inflation rate.

GDP deflator = Nominal GDP (in a given year) X 100

Real GDP (in the same year)

• If 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 > 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 ⇨ GDP Deflator >100

⇨ Prices increased.
• If 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃< 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 ⇨ GDP Deflator < 100
⇨ Prices decreased.
• If 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 ⇨ GDP Deflator = 100
⇨ Prices didn’t change, they remained constant.

42
Referring to Example (2), we can calculate the GDP
deflator:

The value of the GDP deflator indicates that prices

increased in years 2020 and 2021, compared to year 2019.

The Inflation Rate

Inflation is a sustained increase in the general price level of
goods and services in an economy during a given period of
time (one year).
Inflation rate = 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 (new) − 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 (old) ×100
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 (old)
The inflation rate between two years = (P2-P1)/P1x100

Referring again to example (2), we can use the GDP deflator

to calculate the inflation rate:
• inflation rate between 2019 & 2020
= 150-100 X 100 = 50%
100
• inflation rate between 2020 & 2021
= 180-150 X 100 = 20%
150

43
Problem (1):
The following information belongs to an economy that
produces only two goods (bread & cars). Assuming that
2018 is the base year:

1-Calculate nominal & real GDP in each year.

2-Calculate the GDP deflator in each year.
3-What’s the rate of inflation in 2019.

1. Nominal & Real GDP

• Nominal GDP in 2018 = (QB18 x PB18) + (QC18
x PC18) =(100×10)+(20×50)= $2000
• Nominal GDP 2019= (QB19 x PB19) + (QC19 x
PC19) = (110×12)+(21×55)= $2475
• Real GDP 2018= (QB18 x PB18) + (QC18 x
PC18) =(100×10)+(20×50)= $2000
• Real GDP 2019 = (QB19 x PB18) + (QC19 x
PC18) =(110×10)+(21×50)= $2150
2. GDP deflator
• GDP deflator in 2018= 2000 ×100 = 100 (The base year)
2000
• GDP deflator in 2019 = 2475×100 = 115
2150
Thus, the price level has increased.
3. Inflation rate in 2019 = 115−100 ×100 = 15%
100

44
Problem (2):
Use the data in the following table to answer the questions
below:

1.Fill in the missing data in the table.

2.Calculate the inflation rate between the last two years.
Solution:

45
 5. Limitations of the GDP Concept
Increasing GDP is one of the goals of the government’s
macroeconomic policy. However, some serious problems
arise when we try to use GDP as a measure of well-being,
for several reasons:

1- Social welfare indicators are not reflected in GDP;

• If crime levels went down, society would be better
off, but a decrease in crime is not an increase in
output, and hence, is not reflected in GDP.
• Some increases in social welfare are associated with
a decrease in GDP. For example, an increase in
leisure is an increase in social welfare associated
with a decrease in GDP, because less time is spent
on producing output.
• Most non-market activities, such as housework,
child care, do-it-yourself activity, and voluntary
work; all are not counted in GDP even though they
amount to real production, use real resources, and
satisfy real needs.
• GDP doesn’t take into account the Economic Bads;
GDP seldom reflects losses or social ills. GDP
accounting rules do not adjust for production that
pollutes the environment. The more production
there is, the larger the GDP, regardless of how much
pollution results in the process.

46
2. Underground economy or black economy;
• The part of the economy in which transactions take
place and income is generated that is unreported, and
therefore not counted in GDP. These transactions may
be legal -but they are not reported for tax purposes- or
not reported because they are illegal (as drug trade).
3. GDP per Capita;
• GDP has nothing to say about the equality distribution
of output among individuals in a society. For example,
between the case in which most output goes to a few
people and the case in which output is evenly divided
among all people. Accordingly, the World Bank
adopted a new measuring system for international
comparisons.
• The concept of GDP per Capita (GDPP) is better to
compare the GDP per head or per person, and is
calculated by dividing the country’s GDP by the total
number of its population.
GDPP = GDP / population

47
 o Do these omissions matter?
These omissions matter because they cause some problems
when GDP measures are used to compare standards of living
in different economies.
The non-market and unreported sector in less developed
countries is larger than it is in more developed countries.
Also, the non-market sector is larger in rural than in urban
economies. This means that their real GDP is underestimated
or overestimated because of these omissions.

Review Questions
Q1. Discuss why you may agree or disagree with the
following statements:
1- The value-added method is used to calculate GDP to avoid
double counting. ( )
2- We can simply calculate the national product by adding
up the production of all firms. ( )
3- Used cars and houses are counted in current GDP. ( )
4- When the value of exports exceeds the value of imports,
the net exports should be negative and reduce the GDP of the
country. ( )
5- If a firm sells its output for $40,000, pays $22,000 in
wages, $10,000 for intermediate inputs purchased from other
firms, $5,000 interest, and declares profits of $3,000. Then
the value added is zero. ( )

48
Q2. Using the spending-based definition, explain which
of the following is or is not included in the GDP:
State pensions; Company pensions; Students grants; Theatre
receipts; Judges’ salaries; Unsold cars in showroom;
Receipts from purchases of new copies of this book;
Receipts from purchases of second-hand copies of this book.
Q3. MCQS:
1) If GDP at current prices is 240 and GDP at base-period
prices is 200 the GDP deflator is:
a. 40 b. 80 c. 120
d. 1.2

2) A real measure of the volume of national output and

national income is:
a. GDP valued at current prices.
b. GDP valued at base-period prices.
c. Money GDP.
d. None of the above.

49
 Chapter (3)
Unemployment, Inflation, and Long
Run Growth

Chapter Outline
1. Measuring Unemployment.
2. Types of Unemployment.
3. Costs of Unemployment.
4. Meaning of Inflation.
5. Measures of Inflation.
6. Costs of Inflation.
7. Long Run Growth.

50
 UNEMPLOYMENT
The unemployment rate is one of the key measures of the
economic performance in any economy.

https://www.youtube.com/watch?v=-1cfJPEYkkk

1. Measuring Unemployment:
To measure unemployment, we need first to define who is
considered employed, and who is an unemployed person?
• The Employed; is any person 16 years old or older who:
(1) works for pay, either for someone else or in his own
business.
(2) works without pay in a family enterprise.
(3) has a job but has been temporarily absent.
Those who are not employed fall into one of two
categories:
(1) unemployed, or (2) not in the labor force.
• To be considered unemployed, a person must be 16 years
old or older, and is:
(1) not working.
(2) available for work (want and able to work).
(3) searching for a job but is unable to find one.

51
A person not looking for work because he does not want a
job or is not able to work (sick or handicapped), or has given
up looking for a job; is classified as not in the labor force.
People not in the labor force include full-time students,
retirees, those staying home to take care of children, and
discouraged job seekers.
The total labor force in the economy is the number of
people employed plus the number of unemployed:
Labor Force (LF) = employed + unemployed (U)

The total population 16 years of age or older (working age

population) is equal to the number of people in the labor
force plus the number not in the labor force:
Population at working age = labor force + not in labor force

The unemployment rate is the ratio of the number of people

unemployed to the total number of people in the labor force:

Unemployment rate = unemployed (U) x100

labor force (LF)

The ratio of the labor force to the working age population

(16 years old or over) is called the labor force participation
rate:

52
 Labor force participation rate = Labor Force x 100
Population

Discouraged-worker effect: The decline in the measured

unemployment rate that results when people who want to
work but cannot find jobs grow discouraged and stop
looking, thus dropping out of the ranks of the unemployed
and the labor force. Hence, the unemployment rate is
underestimated.

Example (1):
Given the following information:
-Employed workers=100,000
-Unemployed & looking for work =20,000
-Working age population =135,000
Calculate;
1) Total Labor force.
2) Unemployment rate.
3) Labor force participation rate.
Solution
1-Labor force = 100,000+ 20,000= 120,000.
2-Unemployment rate = (20,000/120,000) × 100= 16.7%
3-Labor force participation rate= (120,000/135,000)×100 =
88.9%

53
 2. Types of Unemployment
It is useful to categorize unemployment into three types:
1. Frictional unemployment.
2. Structural unemployment.
3. Cyclical unemployment.

1. Frictional unemployment; is the portion of

unemployment resulting from the normal turnover in
the labor market; used to denote short-run job/skill-
matching problems. i.e.: it is the part of unemployment
that is due to switching jobs.
Example:
• Those searching for their first job.
• Those who leave their current jobs & search for better
ones.

2. Structural unemployment; is the portion of

unemployment that is due to changes in the structure of
the economy or from using new technologies, resulting
in a significant loss of jobs in certain industries in the
long run. i.e.: it results from the mismatch between
skills available in the labor force, and skills required for
the jobs.
• The term frictional unemployment is used to denote
short-run job/skill matching problems, that last a
few weeks. Structural unemployment denotes
longer-run adjustment problems.

54
Example:
• Those who lose their jobs because their skills
become obsolete.

• Natural rate of unemployment; is the unemployment

rate that occurs as a normal part of the functioning of
the economy. Sometimes taken as the sum of frictional
unemployment rate and structural unemployment rate.
It exists even if the economy is operating at the full
employment level. (it is estimated to range from 4-6%).
Natural Rate of Unemployment = frictional unemployment
rate + structural unemployment rate.

3. Cyclical unemployment; is any unemployment above

the natural rate (frictional plus structural), and it occurs
during recessions.

3. Costs of unemployment

The costs of unemployment are neither evenly distributed

across the population nor easily quantified. Generally, the
costs of unemployment include economic and social costs:

55
 • Economic Costs;
1. Loss of income (national and personal).
2. Lower levels of production and output due to
inefficient use of resources.
3. Loss of human capital.
4. Less savings and consumption levels.
5. Less government tax revenue.

• Social Costs;
1. Social Unrest.
2. Higher levels of crime.
3. Increased drug use.

Review Questions
Q1: Determine the type of unemployment (cyclical, frictional,
structural, or not in the labor force):
1. Ahmad has just graduated from a medical school and is
deciding which job to accept.
2. Rana quit her job to be a full-time student at Harvard.
3. Adham lost his job in General Motors during recession.
4. Yara quitted her job one month ago to look for a better job.
5. Noha lost her job 2 months ago but she is not looking for a
new job.
6. Omar quitted his job one year ago to search for a better one,
but because of the recession he did not find any job yet.
7. Amr lost his job due to the introduction of a new machine that
can do the same job.
Q2. Suppose that the number of employed workers in an economy
are 121,166,640 persons, the unemployment rate is 10.4%, and the
labor force participation rate is 72.5%.
56
Calculate:
1. The size of labor force.
2. The number of unemployed persons.
3. The number of working age population.

INFLATION

4. Meaning of Inflation:
In macroeconomics, we are concerned not with relative price
changes, but with changes in the overall price level of goods
and services.
• Inflation is defined as an increase in the overall price
level.
• Deflation is a decrease in the overall price level.

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5. Measures of Inflation:
It can be measured using any of these indices:
1- The GDP deflator (discussed in the previous chapter).
2- The Consumer Price Index (CPI).
3- The Producer Price Index (PPI).

57
2- The Consumer Price Index (CPI):
A price index computed using a bundle that represent the
average price of a consumer “market basket” of goods &
services purchased monthly by the typical urban consumer.
To construct the CPI, we have to:
a) Choose the basket of consumer goods.
b) Determine the base year prices.
c) Compare the cost of the CPI between the base year and
the current year.

Inflation rate = CPI (new)- CPI (old) x 100

CPI (old)

The CPI market basket shows how a typical consumer

divides his or her money among various goods and services.

58
The figure shows that most of a consumer’s money goes
toward housing, transportation, and food and beverages.

The CPI is a fixed-weight price index; it does not account

for consumers’ substitution away from high-priced goods.
The CPI thus has a tendency to overestimate the rate of
inflation.

This problem has important policy implications; If inflation

as measured by percentage changes in the CPI is biased
upward, Social Security payments will grow more rapidly
than they would with a better measure: The government is
spending more than it otherwise would.
• CPI differ from the GDP deflator in the following
✓ The CPI is better than the GDP deflator as a measure of
the cost of living as it covers goods and services that are
commonly bought by consumers.
✓ The GDP deflator is the most comprehensive index of
the price level as it covers all goods and services
produced in the economy.
✓ The CPI includes prices of imported goods, while the
GDP deflator does not.
Example (1):
If the CPI in 2016 = 200 and the CPI in 2017 = 250,
calculate the inflation rate.
Solution
Inflation rate = 250−200 × 100=25%
200
59
Example (2):
Assume the average consumer is buying only 2 goods, X
& Y; 2019 is the base year. Calculate:
1. Cost of CPI and CPI in 2019.
2. Cost of CPI and CPI in 2020.
3. The inflation rate.
Good Quantity Price/unit Price/unit
(2019) (2020)

X 10 $1 $2

Y 5 $8 $ 10

Solution
1. Cost of CPI and CPI in 2019:
Cost of CPI in the base year =(1x10)+(8x5)=10+40 =$50
CPI = Cost of CPI in the current year (new) = 50 x 100 = 100
Cost of CPI in the base year (old) 50

2. Cost of CPI and CPI in 2020:

Cost of CPI in the current year=(2x10)+(10x5) =20+50 =$70
CPI = Cost of CPI in the current year (new) = 70 x 100 = 140
Cost of CPI in the base year (old) 50

3. The inflation rate = CPI (new)- CPI (old) x 100

CPI (old)
= 140 – 100 x 100 = 40%
100

60
3- The Producer Price Index (PPI)
• It is an average of the prices that producers receive at
all stages in the production process, not just the final
stage.
• The three main categories are finished goods,
intermediate materials, and crude (raw) materials.
• PPI is considered a leading indicator of future consumer
prices, as changes in PPI indicate future changes in
consumer prices.

6. Costs of Inflation:
1. Inflation lowers the standard of living;
People think that inflation lowers the overall standard of
living by making goods and services more expensive. That
is, it reduces people’s purchasing power and the real value
of money.
2. Inflation May Change the Distribution of Income;
Whether you gain or lose during a period of inflation
depends on whether your income rises faster or slower than
the overall price level.
Hence, whether you gain or lose during a period of
inflation depends on whether your income rises faster or
slower than the overall price level. The effects of inflation
on the distribution of income depends on whether this
inflation is anticipated (expected) or unanticipated
(unexpected or surprising) inflation.

61
 The effects of anticipated inflation on the distribution
of income are likely to be small, since people and institutions
will adjust to the anticipated inflation.
Unanticipated inflation, on the other hand, may have
large effects, depending on how much indexing (adjusting)
to inflation there is. If many contracts are not indexed there
can be big winners and losers.
It is commonly believed that debtors (borrowers)
benefit at the expense of creditors (lenders) during an
inflation because with inflation they pay back less in the
future in real terms than they borrowed.
Inflation that is higher than anticipated benefits debtors;
inflation that is lower than anticipated benefits creditors.
Thus, the impact of inflation on debtors and creditors
depends on its impact on the real interest rate.

✓ Nominal interest rate is the interest rate paid by the

borrower to the lender, it is not adjusted for inflation.

✓ Real interest rate is the difference between the interest

rate on a loan and the inflation rate; it is negatively
related to the inflation rate.
Real interest rate = Nominal interest rate – Inflation rate

↳ If the nominal interest rate > inflation rate ⇨ real interest

rate is positive ⇨ the value of money increase ⇨ lenders
(creditors) are better-off.

62
 ↳ If the nominal interest rate ˂ inflation rate ⇨ real interest
rate is negative ⇨ the value of money decrease ⇨ borrowers
(debtors) are better-off.

3. Administrative Costs and Inefficiencies

There may be costs associated even with inflation. One
is the administrative cost associated with simply keeping up.
More frequent banking transactions may be required when
inflation is high. For example, interest rates tend to rise with
inflation.
When interest rates are high, the opportunity costs of
holding cash outside of banks is high. People therefore hold
less cash and increase their bank savings (reducing the
relatively more expensive consumption).
❑ To sum up, the costs of higher inflation rates are:
1. Lower standard of living and purchasing power of money.
2. Changes in the distribution of income in the economy as a
whole ⇒Inflation benefits borrowers at the expense of
lenders.
3. Higher administrative costs.
Example (3):
If you are given the following information:
nominal interest rate on loans is 35%.
CPI in year1 =125 and CPI in year 2 =160.
Calculate the real interest rate.
Solution
Real interest rate = nominal interest rate – inflation rate
= 35% - [ (160 −125) × 100] = 35% - 28% = 7%
125
63
 LONG RUN GROWTH
Long run economic growth can be measured in 3 ways:
1. Output growth.
2. Per-capita output.
3. Labor Productivity.
1. Output growth: The growth rate of the output of the
entire economy, i.e.; it is the long run increase in the
capacity of the economy to produce goods and services.
Output growth rate: is the growth rate of the aggregate
output in the long run.
Output growth rate= 𝒐𝒖𝒕𝒑𝒖𝒕 𝒚𝒆𝒂𝒓 (new)− 𝒐𝒖𝒕𝒑𝒖𝒕 𝒚𝒆𝒂𝒓 (old) x
𝟏𝟎𝟎
𝒐𝒖𝒕𝒑𝒖𝒕 𝒚𝒆𝒂𝒓(old)

Determinants of long run output growth:

1) Increasing the number of labor or working hours.
2) Improving labor skills to increase output per unit of labor;
through better education, training, and health.
3) Increasing the economy’s capital stock.
4) Improving the level of technology, or increasing output
per unit of the capital stock.

2. Per-capita output: The output per person in the

economy.

Per-capita output = 𝑶𝒖𝒕𝒑𝒖𝒕 (GDP)

𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏

64
Per-capita output growth: is the growth rate of output per
person.

Per-capita output growth

= 𝑷𝒆𝒓𝑪𝒂𝒑𝒊𝒕𝒂 𝒐𝒖𝒕𝒑𝒖𝒕 (new)−𝑷𝒆𝒓𝑪𝒂𝒑𝒊𝒕𝒂 𝒐𝒖𝒕𝒑𝒖𝒕 (old) ×𝟏𝟎𝟎
𝑷𝒆𝒓 𝑪𝒂𝒑𝒊𝒕𝒂 𝒐𝒖𝒕𝒑𝒖𝒕 (old)
Or:
Per-capita output growth rate
= output growth rate – population growth rate

3. Labor Productivity: The output per worker in the

economy.
Labor Productivity = 𝑶𝒖𝒕𝒑𝒖𝒕
𝑾𝒐𝒓𝒌𝒆𝒓𝒔

Labor Productivity Growth Rate: The growth rate of output

per worker.
Not everyone in a country works, and so output per worker
is not the same as output per person. Output per worker is
larger than output per person (per capita output).
Labor Productivity Growth Rate
= 𝑳𝒂𝒃𝒐𝒓 𝑷𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒊𝒕𝒚 (new) − 𝑳𝒂𝒃𝒐𝒓 𝑷𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒊𝒕𝒚 (old) x𝟏𝟎𝟎
𝑳𝒂𝒃𝒐𝒓 𝑷𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒊𝒕𝒚 (old)

65
 Review Questions
Q1: Given the following information
Year GDP (output) Employees Population

2018 $ 50,000 150 200

2019 $ 60,000 155 210
Calculate:
1. Output growth rate between the two years.
2. Per capita output (GDP) in each year.
3. Per capita output growth rate between the two years.
4. Labor productivity in each year.
5. Labor productivity growth rate between the two years.

Q2. In each of the following cases, determine who is better-

off; the borrower or the lender:
The nominal interest rate is 14%, and the inflation rate is
17%.
The nominal interest rate is 7%, and the inflation rate is 3%.
The nominal interest rate is 4%, and the inflation rate is -2%.

66
 Chapter (4)
GDP in a closed economy without a
Government
Chapter Outline
1. Basic Concepts.
2. The Keynesian Theory of consumption (C).
3. The Determination of Equilibrium Output.
4. The Simple Multiplier.

https://www.youtube.com/watch?v=xGuyGM_xq6E

In the last few chapters, we described some features of

any economy, including real GDP, inflation, and
unemployment, and we talked about how they are measured.
Now we begin the analytical part of macroeconomics:
to explain how the parts of the economy interact to produce
output.
We will try to understand short run movements in real
GDP as one of the central measures of macroeconomic
activity. Because we are interested in tracking real changes
in the level of economic activity, we focus on real, rather
67
than nominal, output. We saw earlier that GDP can be
calculated in terms of either income or expenditures. We will
use the variable Y to refer to both aggregate output and
aggregate income.
1. Basic Concepts
• Aggregate Output: The total quantity of goods and
services produced (supplied) in an economy in a given
period ⇝ real GDP.
• Aggregate Income: The total income received by all
factors of production in a given period ⇝ real income.
In any given period, there is an exact equality between
aggregate output (production) and aggregate income. You
should be reminded of this fact whenever you encounter the
combined term aggregate output (income) (Y).
• Aggregate Output (Income) (Y): A combined term
used to reflect the exact equality between aggregate
output and aggregate income.
⇝ real income = real GDP = Y ⇜
• Actual or real GDP; What the economy actually
produces.
• Potential GDP; What the economy would produce if
all resources were fully employed at their normal rate
of utilization.

68
 The deviations in real GDP around its potential lead to
unemployment (during recessions) or inflation (during
expansions), i.e.: undesirable outcomes; that policy makers
need to keep at the minimum possible levels. Hence, we
study the causes and effects of such deviations, and the main
factors that determine actual GDP, in order to determine the
necessary economic policies suitable to close these gaps and
to reduce unemployment and inflation.
The theory of GDP determination deals with desired or
planned spending;
• Planned Aggregate Expenditure (AE) is what people
desire to spend, or the total amount the economy plans
to spend in a given future period.
AE = C+ I + G + (X- IM)
The AE in a closed economy without government can be
written as follows:
AE = C + I

69
Where: C ⇒ consumption expenditure.
I ⇒ planned gross investment.
2. The Keynesian Theory of Consumption
Keynes recognized that many factors, including wealth
and interest rates, play a role in determining consumption
levels in the economy, and that consumers tend to increase
their consumption as their incomes increase, but not by the
same amount of income increase.
Thus; as your income increase, you will spend more
than you did before. However, the rise in consumption will
be less than the full rise in your income. This relationship
between consumption and income is called a consumption
function (C).
In macroeconomics, we are interested in the behavior
of the economy as a whole, the aggregate consumption of all
households in the economy in relation to aggregate income.
1- The Aggregate Consumption Function (C):
The Keynesian theory assumes that income is the main
determinant of consumption. The consumption function
shows the level of aggregate consumption at each level of
aggregate income.
The consumption function (equation) according to Keynes is
a straight-line curve that can be written as follows:
⇝ C = a + bY ⇜

70
Where:
• C is the aggregate consumption.
• Y is the aggregate output (income).
• a is the minimum level of consumption (the value of
consumption when Y=0). OR the autonomous
consumption; the part of consumption that doesn’t
depend on income; it depends on savings.
• b is the slope of the consumption function. OR the
marginal propensity to consume (MPC); it measures the
change in consumption due to the change in income.

b = MPC= ∆𝐂/ ∆𝐘
0 < MPC < 1

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 • bY is the induced consumption; the change in
consumption resulting from changes in income.
• APC is the average propensity to consume (C/Y); it
measures the proportion of income spent on
consumption. It falls as disposable income rises. WHY?
𝑨𝑷𝑪= (𝒂+𝒃𝒀)/𝒀= 𝒂/𝒀+𝒃 ⇒ as Y⇧ ⇒ 𝒂/𝒀 ⇩ ⇒ 𝑨𝑷𝑪 ⇩.
So, there is a negative relation between income and APC.
• Remember that: Y= C+S
✓ At the breakeven point, C=Y⇒ APC =1; S = 0.
✓ Before the breakeven point, C ˃Y⇒ APC >1; S < 0
(negative).
✓ After the breakeven point, C < Y⇒ APC <1; S > 0
(positive).

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2- The Aggregate Saving Function (S):
Aggregate Saving (S); is the part of aggregate income that is
not consumed, i.e.: it is the difference between aggregate
income (Y) & aggregate consumption (C).
S≡Y-C

The derivation of the saving function:

S=Y–C
S = Y – (a + bY)
S = Y – a – bY
S = - a + (1 – b) Y

(-a) is the autonomous saving (dissaving) when income is 0

0 < MPC < 1

• Marginal Propensity to Save (MPS)→ is the fraction of a

change in income that is saved, i.e.: it is the ratio of the
change in saving to the change in income ⇝MPS= ∆𝐒 /∆𝐘
(the slope).
73
✓ Along the linear consumption function, MPC & MPS
remain constant ⇝ MPC + MPS = 1; 0 < MPS < 1
• Average Propensity to Save (APS) is the proportional of
income that consumers want to save; Or the ratio of
savings to income ⇝ APS= 𝐒 /𝐘
• APC + APS = 1
✓ Along the linear consumption function, as Y⇧ ⇒ APC⇩ &
APS⇧.
✓ At the breakeven point: Y=C and S=0, APC = 1, APS=0.
✓ Before the breakeven: APC > 1, APS < 0.
✓ After the breakeven income: APC < 1, APS > 0.

Example (1):
The Aggregate Consumption Function Derived from the
Equation C = 100 + .75Y,
In this consumption function, consumption is 100 at an
income of zero. As income rises, so does consumption. For
every 100 increases in income, consumption rises by 75.
The slope of the line is 0.75

74
Example (2):
If you are given the following consumption function:
C = 200 + 0.9y
1. Determine the minimum level of consumption.
2. Derive the saving function.
3. Determine the dissaving level at income = 0.
4. Calculate both C & S at Y = 0, 1000, 2000, 3000, 4000.
5. Calculate the marginal propensity to consume (MPC) &
the marginal propensity to save (MPS) at each level of
income.
6. Calculate the average propensity to consume (APC) & the
average propensity to save (APS) at each level of income.
7. Determine the breakeven level of income.
8.Show graphically the consumption & the saving functions.

75
https://www.youtube.com/watch?v=v4M2CxK_aN4

76
Other Determinants of Consumption:
The assumption that consumption depends only on
income is obviously a simplification. In practice, the
decision of households on how much to consume in a given
period is also affected by their wealth, by the interest rate,
and by their expectations of the future. Changes in income,
wealth, interest rate, and expectations of the future may
cause changes in the consumption & saving functions.

• Movement, shift, and rotation in C & S functions:

1. Movements;
Changes in income (Y) cause movements along both C & S
functions.
Increases in income (Y) causes an upward movement along
both C&S functions.

77
 2. Shifts;
• Households with higher wealth are likely to spend
more, other things being equal, than households with
less wealth. As wealth ⇧ ⇒ C ⇧ (shifts upwards), S ⇩
(shifts downwards) & vice versa.
• Lower interest rates reduce the return on savings and
the cost of borrowing, and stimulate spending. If
interest rate ⇩ ⇒ C ⇧ (shifts upwards), S ⇩ (shifts
downwards) & vice versa.
• If households are optimistic and expect to do better in
the future, they may spend more at present. An expected
⇧ in future income⇒ C⇧ (shifts upwards), S ⇩ (shifts
downwards) & vice versa.

Q. True or False explaining why?

1. If APC is 0.6, APS will be 0.4
2. When disposable income increase, APS should decrease.
3. When MPC increase, the consumption function becomes
flatter.
4. If C=100+0.8Y, MPC and MPS are always constant.
78
3- Planned Investment (I):
• Planned investment (I); Those additions to capital stock
and inventory that are planned by firms.
• Actual investment; The actual amount of investment that
takes place; it includes items such as unplanned changes
in inventories.

• We will assume that planned investment (I) is fixed

(autonomous), i.e.: it is not affected by changes in income,
and is represented graphically by a horizontal line (I).

• Shifts in Planned investment (I)

• Interest rate; decreases in the interest rate reduces the
cost of borrowing, this encourages firms to take more
loans & increase their investment ⇒ the investment
curve shifts upward & vice versa.
⇝ i ⇩ ⇒ I ⇧ ⇝ (negative relation).

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 • Expectations & business confidence; when firms
expect to do better in the future, they tend to invest
more ⇒ the investment curve shifts upward & vice
versa ⇝ (positive relation).
• Increase in the level of technology; will increase the
expected profitability of investment, encouraging firms
to invest more ⇒ the investment curve shifts upward &
vice versa ⇝ (positive relation).

Actual Investment = Planned Investment + Unplanned

change in inventories
↳ If Actual Investment > Planned Investment ⇒Unplanned
change in inventories ⇧(+ve).
↳ If Actual Investment = Planned Investment ⇒ Unplanned
change in inventories is zero.
↳If Actual Investment < Planned Investment ⇒ Unplanned
change in inventories ⇩ (-ve).

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 3. The Determination of Equilibrium Output
(Income)
In the macroeconomic goods market, equilibrium occurs
when there is no tendency for change, i.e.: when actual
aggregate output (Y) is equal to desired or planned aggregate
expenditure.
The equilibrium level of output (GDP or income) can be
determined using two different approaches:
1. The Aggregate Expenditure approach (AE) ⇒ Y=AE.
2. The Saving/ Investment approach ⇒ S=I.

1. The Aggregate Expenditure Approach

• Planned aggregate expenditure (AE): is total amount
the economy plans to spend in a given period. It is equal
to consumption plus planned investment: AE ≡ C + I
• The economy is defined to be in equilibrium when
aggregate output (Y) is equal to planned aggregate
expenditure (AE): Y = AE
• The equilibrium condition:
Output (Supply) = planned aggregate expenditure (Demand)
⇝ Y = AE ⇝ Y= C+I ⇜

• What happens if the economy is out of equilibrium?

↳ If Y > AE ⇨ there is an unsold part of firms output ⇨
unplanned increase in inventories ⇨ firms will have a
tendency to reduce their production ⇨ Y⇩ till equilibrium is
achieved at Y = AE.

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↳ If Y < AE ⇨ actual output is less than desired or planned
output ⇨ firms sold more than what they planned ⇨ firms
withdraw from inventories to meet the excess demand ⇨
unplanned decrease in inventories ⇨ firms will have a
tendency to increase their production ⇨ Y⇧ till equilibrium
is achieved at Y = AE.
↳ If Y= AE ⇨ Equilibrium in the goods market is achieved
only when aggregate output (Y) and planned aggregate
expenditure (C + I) are equal, or when actual and planned
investments are equal ⇨ there is no tendency for change.

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2. The Saving/ Investment (withdrawals/ injections)
approach:
• By definition, Y ≡ C + S, as aggregate income is either
saved or spent.
• The equilibrium condition is Y =C + I, but this does not
hold when we are out of equilibrium, it holds only when
AE =Y.
We can write the equilibrium condition as follows:
C+S=C+I
Subtracting C from both sides of this equation, we are left
with:
S=I
Thus, equilibrium is achieved when saving (withdrawals)
equals planned investment (injections).

S = I at one and only one level of aggregate output.

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 • Aggregate output is equal to planned aggregate
expenditure only when saving equals investment (S=I).
• The vertical distance between S and I is just equal to the
distance between the 45 line and AE.
• When desired investment exceeds desired saving,
desired aggregate spending exceeds national output by
the same amount.
• When desired investment is less than desired saving,
desired aggregate spending is less than national output
by the same amount.

• Adjustment to Equilibrium:
How can firms react to disequilibrium? Let us consider the
actions firms might take when planned aggregate
expenditure (AE) and aggregate output (Y) are not equal:
↳ If Y > AE ⇒ output > demand ⇒ unplanned inventory is
+Ve ⇒ actual investment > planned investment ⇒ Output
will fall.
↳ If Y = AE ⇒ output = demand ⇒ unplanned inventory is
zero ⇒ actual investment = planned investment ⇒
equilibrium is achieved.
↳ If Y < AE ⇒ output < demand ⇒ unplanned inventory is -
Ve ⇒ actual investment < planned investment ⇒ Output will
increase.

84
85
 ❖ True or false, explain why:
1. Firms react to an increase in inventory by reducing
output.
2. The marginal propensity to consume is the change in
consumption expenditure divided by the percentage
change in income.
3. When the economy is in equilibrium, desired
expenditure is greater than output.
4. When output is greater than desired spending, the
economy will grow.

4. The Simple Multiplier

Till now, the model we developed tells us the direction
of change in output resulting from a change in autonomous
spending; i.e., What happens to the level of real output if
policy makers decided to increase planned investment from
say, 25 to 50? ⇒ real output will increase!!! However, it says
nothing about the magnitude of this change, i.e.; by how
much will real output increase when planned investment
increase from 25 to 50?
It may surprise you to learn that the change in
equilibrium output will be greater than the initial change in
planned investment. In fact, output will change by a multiple
of the change in planned investment. The magnitude of
change in GDP induced by a given change in autonomous
expenditure is given by the multiplier.

86
 https://www.youtube.com/watch?v=e_ZhOzxgOQg

The multiplier is the ratio of the change in the equilibrium

level of output to a change in some exogenous variable.

The multiplier (K)= ΔY/ Δ A

Where;
• Δ A is the change in autonomous spending
• Δ Y the change in output (income)

An exogenous variable is a variable that does not

depend on the state of the economy—that is, a variable that
is determined outside the model, it does not change in
response to changes in the economy. Now let’s see how
much the equilibrium level of output changes when planned
investment changes?

87
▪ The Multiplier as Seen in the Planned Aggregate
Expenditure Diagram
• At point A, the economy is in equilibrium at
AE1=Y1= 500. When I increase by 25, planned
aggregate expenditure shifts up to AE2 which is now
greater than aggregate output Y1. As output rises,
additional consumption is generated, causing
unplanned reductions of inventories, pushing
equilibrium output up by a multiple of the initial
increase in I. The new equilibrium is found at point
B, where Y2 = 600. Equilibrium output has increased
by 100 ⇒ (600 - 500), or four times the amount of
the increase in planned investment.

88
• Does the multiplier effect go on forever?
• As I ⇧ ⇒AE ⇧ ⇒ AE >Y ⇒ there is a decrease in
inventory ⇒ firms will produce more to increase
Y(income) ⇝ first round of increase.
• As Y (income) ⇧ ⇒ C ⇧ ⇒ AE ⇧ ⇒ AE >Y ⇒
inventory will decrease ⇒ firms will increase
Y(income) ⇝ second round of increase.
However, this process doesn’t go on forever. Why?
Only a fraction of the increase in income is consumed in each
round. Successive increases in income become smaller and
smaller in each round of the multiplier process, due to
leakages as savings, until equilibrium is restored.
(as Y ⇧, APC ⇩ and APS ⇧). How is equilibrium restored?
As Y (income) ⇧ ⇒ S ⇧, this continues until ΔS=ΔI (25), at
this point S=I again and the equilibrium will be restored at a
new (higher) level of Y income.

89
• The multiplier equation and its size
We said that the multiplier is the ratio of change in
equilibrium income (Y) due to the change in autonomous
spending (A) ⇒ (K)= ΔY/ Δ A
At equilibrium ⇒ AE= A+bY = Y ⇒ Y- bY = A
⇒ Y(1-b) = A ⇒ Y= A [1/(1-b)]
⇒ ΔY= ΔA [1/(1-b)] ⇒ ΔY/ΔA= 1/(1-b)
⇒ K = 1/(1-b) ⇒ K = 1/(1-MPC)
Recall that the marginal propensity to save (MPS) is defined
as the change in S (ΔS) over the change in income (ΔY) ⇒
MPS = ΔS/ΔY
At equilibrium ⇒ S=I, and equilibrium is restored when
ΔS=ΔI
⇒ MPS = ΔI/ΔY ⇒ ΔY= ΔI(1/MPS) ⇒ K = 1/(1-MPC)

In our example where MPC =0.75, K= 1/(1-0.75) = 1/0.25=4

ΔC=75
⇒ΔY= ΔIx4 = 25x4=100
ΔI=25
Thus, the size of the multiplier depends on the slope of
the AE line. The steeper the slope of this line, the greater the
change in output for a given change in investment.
When planned investment is fixed, as in our example,
the slope of the (AE = C + I) line is just the marginal
propensity to consume (ΔC/ΔY). The greater the MPC, the
steeper the slope of the AE line, the greater the investment
multiplier.

90
A large MPC means that consumption increases a great deal
when income increases, and the more consumption changes,
the more output has to change to achieve equilibrium.
• As the MPC ⇧ ⇒the multiplier ⇧ (+ve relation).
• As the MPS ⇧⇒the multiplier ⇩ (-ve relation).
• The Value of the multiplier is greater than one
because → the change in investment (I) will cause a
multiple change in (Y) by more than the initial
increase in autonomous spending ⇒ K>1.

91
92
93
Problem (3):
Suppose the consumption function is given by
C=200+0.75Y, and the investment function is given by
I=100.
1-What is the level of savings at equilibrium?
2-What is the level of consumption at equilibrium?
3- If the level of income is 1400, what will be the amount of
unplanned inventory?
Solution:
1- At equilibrium S=I ⇒S=100.
2- At equilibrium Y=AE + C+I ⇒ Y= 200 + 0.75 Y+ 100
⇒ (1-0.75) Y= 300.
⇒ Y=300/0.25 ⇒ Y = 1200
C=200 + 0.75 (1200) =1100
3- If Y=1400 ⇒ AE = C+I = 200 + 0.75(1400) + 100 = 1350
Unplanned inventory = Y-AE= 1400-1350 = 50.

94
Solution:
1- The equilibrium output is the level at which Y=AE ⇒Y=
900.
2- MPC=ΔC/ Δ Y= Δ AE/ Δ Y= (1200 - 450)/(1300 - 300)
⇒
MPC = 0.75.
MPS=1–MPC = 1– 0.75 ⇒ MPS = 0.25.
3- Unplanned investment (inventory) Y - AE:
↳ At Y=300 & AE=450 ⇒ Unplanned investment
=Y- AE = 300 - 450= -150.
⇒ Actual (Y) < Planned (AE) ⇒ Production will increase.
↳ At Y=900&AE=900 ⇒ Unplanned investment
=Y- AE= 900- 900 =0.

95
 ⇒ Actual (Y) = Planned (AE) ⇒ there is no tendency to
change (equilibrium).
↳At Y=1300 & AE=1200 ⇒ Unplanned investment
=Y- AE =1300-1200 =100.
⇒ Actual (Y) ˃ Planned (AE) ⇒ Production will decrease.

96
 Chapter (5)
GDP in a closed economy with
Government
Chapter Outline
1. Government role in the economy.
2. The Determination of Equilibrium Output.
3. Fiscal Policy at work: Multiplier Effects.

https://www.youtube.com/watch?v=8cO1metHbTk

97
 1. Government in a Closed Economy
Now we will introduce the government in our closed
economy and see its role and how it can affect the economic
performance.
Actually, the government has two policies through
which it can affect the economy, these are:

A. The Monetary Policy:

The decisions of the government to change the supply of
money in the economy, in order to face some problems or
macroeconomic issues. For example;
- During a recession, demand falls, so output falls and
unemployment rise, the government can adopt an
expansionary monetary policy to increase the money
supply, thus, enhancing aggregate demand to increase,
ending the recession.
MS↑⇒D for goods and services↑⇒ firms will demand more
labor to increase production ⇒ Y↑ & U↓⇝ closing
recession.

98
 - During a boom, demand is high, so output rise and
unemployment falls, the government can adopt a
contractionary monetary policy to reduce the money
supply, thus, reducing aggregate demand, and ending
inflation.
MS↓⇒D for goods and services↓⇒ firms will demand less
labor to reduce production ⇒ Y↓ & U ↑ ⇝ ending inflation.
B. The Fiscal Policy:
The government can affect the economy by two activities:
i. The collection of taxes, and the payment of transfer
payments—into a category we call net taxes (T). So, net
taxes are equal to the tax payments made to the
government by firms and households minus transfer
payments made to households by the government.
⇝ Net Taxes (T) = taxes – transfer payments ⇜
ii. The government spending or purchases of goods and
services (G).
Now, as income (Y) flows to households, the government
takes income from households in the form of net taxes (T).
The income that ultimately gets to households is called
disposable, or after-tax, income (Yd):
disposable income ≡ total income − net taxes
Yd ≡ Y − T
Yd = C + S

99
Because disposable income is aggregate income (Y)
minus net taxes (T), we can write another identity:
Y - T =C + S
By adding T to both sides:
Y=C+S+T
Thus, aggregate income is divided into three parts.
Government takes a slice (net taxes, T), and then
households divide the rest between consumption (C) and
saving (S).

With the government in the economy, planned

aggregate expenditure (AE) is the sum of consumption
spending by households (C), planned investment by
firms (I), and government purchases of goods and
services (G).
AE = C + I + G

100
A government’s budget deficit is the difference between
what it spends (G) and what it collects in taxes (T) in a given
period:
Budget Deficit =G – T
✓ If G >T, the government spends more than its revenues,
so it must borrow from the public to finance the deficit.
It does so by selling Treasury bonds and bills. In this
case, a part of household saving (S) goes to the
government. The dashed lines in Figure 24.1 mean that
some S goes to firms to finance investment projects and
some goes to the government to finance its deficit ⇒
the government can adopt a contractionary fiscal policy
⇩G and/ or ⇧T, to restore equilibrium.
✓ If G <T, the government is spending less than it is
collecting in taxes, so it is running a surplus. A budget
surplus is simply a negative budget deficit ⇒ the
government can adopt an expansionary fiscal policy ⇧G
and/ or ⇩T, to restore equilibrium.
✓ If G =T, the government has a balanced budget.
➢ Adding Taxes to the Consumption Function
• Previously, we assumed an economy without a
government. Hence, aggregate consumption (C)
depends on aggregate income (Y), and we used a linear
consumption function:
C = a + bY
where b is the marginal propensity to consume (MPC).

101
 • After adding the government, it makes sense to assume
that disposable income (Yd), instead of before-tax
income (Y), determines consumption behavior. What
you have available for spending on current
consumption is your disposable income -after paying
taxes- not your before-tax income.
• Our consumption function now has consumption
depending on disposable income instead of before-tax
income.
C = a + bYd
C = a + b (Y - T)
❖ Planned Investment
The government can affect investment behavior through its
tax policies. Investment may also vary with economic
conditions and interest rates. However, we will continue to
assume that planned investment (I) is fixed.
2. The Determination of Equilibrium
Output (Income)
In a closed economy with government, the equilibrium level
of output can be determined using two approaches: -
(1) Aggregate Expenditure Approach:
Output (Supply)= Planned aggregate expenditure
(Demand).
(2) The Saving/Investment Approach:
Withdrawals (leakages)= Injections.

102
(1) Aggregate Expenditure Approach:
• Equilibrium occurs when Y = AE
• Planned aggregate expenditure in an economy with a
government is: AE = C + I + G
• The equilibrium condition is:
↳ If output (Y) exceeds AE (C + I + G) ⇝ Y >AE ⇝ an
unplanned increase in inventories ⇝ actual investment will
exceed planned investment ⇝ Y will ⇩.
↳ If output (Y) is less than AE (C + I + G) ⇝ Y <AE ⇝ an
unplanned decrease in inventories ⇝ actual investment will
be less than planned investment ⇝ Y will ⇧.

(2) The Saving/Investment Approach to Equilibrium:

• The government takes out net taxes (T) from the
circular flow of income—a leakage— and households
save (S) some of their income —also a leakage from
the flow of income.
• The planned spending injections are government
purchases (G) and planned investment (I).
• If leakages (S + T) equal planned injections (I + G),
there is equilibrium.
• By definition⇝ AE = C + I + G and Y = C + S + T
• Therefore, at equilibrium C + S + T = C + I + G
• Subtracting C from both sides; the equilibrium
condition is:
S+T=I+G

103
Equilibrium does not require that G = T (balanced budget)
or S = I, it only requires that the sum of S and T equals the
sum of I and G.

104
105
106
Problem (1):
If you are given the following data:
C = 300 + 0.75 Yd, I = 100, G = 200, T = 200
1. Calculate the equilibrium output (income) using:
a) AE approach.
b) Leakages-Injections approach.
2. Determine the level of C & S at the equilibrium level of
income.
3. Show your answers graphically.

3. Fiscal Policy Multiplier Effects

If the government were able to change the levels of either G
or T, it would be able to change the equilibrium level of
income. Assuming that the government controls G and T
(autonomous), the impact on the equilibrium level of income
is achieved through the fiscal multipliers effect. We will
review three types of fiscal multipliers:
1. Government spending multiplier.
2. Tax multiplier (Lump-sum tax multiplier).
3. Balanced-budget multiplier.

107
 1. The Government Spending Multiplier:
If the government decided to increase its spending,
planned aggregate expenditure will be greater than output ⇝
Y< AE, inventories will be lower than planned, and firms
will have an incentive to increase output.
As output rise, the economy is generating more income.
This was the desired effect: the creation of more
employment. The newly employed workers are also
consumers, and some of their income gets spent.
With higher consumption spending, planned spending will
be greater than output, inventories will be lower than
planned, and firms will raise output again.
An increase in government spending has the same impact
on the equilibrium level of income as an increase in planned
investment. Thus, the value of the spending multiplier is also
greater than one.
The spending multiplier is positively related to MPC and
negatively related to MPS.
The government spending multiplier is defined as the ratio
of the change in the equilibrium level of output to a change
in government spending.
1
government spending multiplier =
MPS

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2. The Tax Multiplier (Lump-sum tax multiplier):
• The tax multiplier is the ratio of change in the
equilibrium level of output to a tax change.
• If the government decided to cut taxes, this decrease in
taxes would increase income. The government spends
the same amount it did before the tax cut (same G), and
households find that they have a larger after-tax
income.
⇩T ⇒⇧ Yd ⇒ ⇧C ⇒ ⇧AE ˃Y ⇒ ⇩ inventories ⇒ firms
will
increase output ⇒ ⇧Y ⇒ ⇧C ⇒ a second-round
increase in C,
and so on.
• Thus, income will increase by a multiple of the initial
decrease in taxes; and vice versa.
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Note that: the multiplier for a change in taxes is not the same
as the multiplier for a change in government spending. Why
does the tax multiplier differ from the spending multiplier?
• When G increases by $1, AE increases initially by the
full amount of the rise in G ($1). However, when taxes
are cut, the initial increase in AE is only (MPC x ΔT).
Hence, the initial increase in AE is smaller for a tax cut
than for a government spending increase, and the final
effect on equilibrium income is smaller.

• Thus, the tax multiplier has a negative sign referring to the

negative relation between ΔT & ΔY, as ΔT ⇧ ⇒ΔY ⇩.
• In our example, if the MPC is 0.75, the tax multiplier is (-
0.75/0.25) = -3.

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• A tax cut of 100 (T = -100) will increase the equilibrium
level of output by (-100 x -3 = 300).
• This is different from the effect of government spending
multiplier of 4. where a 100 increase in government
spending (ΔG = 100) will increase the equilibrium level
of output by:
(100 x 4 = 400).
3. The Balanced-Budget Multiplier (Δ G = Δ T):
What if government spending (G) and taxes (T) are
increased by the same amount? The government’s budget
deficit would not change because the increase in
expenditures would be matched by an equal increase in tax
income.
You might think that equal increases in G and T have
no effect on equilibrium income. This is not true. In our
example, an increase in G of 40, with taxes (T) held constant,
should increase the equilibrium level of income by 40 the
government spending multiplier. The multiplier is 1/MPS or
1/.25 = 4. The equilibrium level of income should rise by
(40x4 =160).
What happens to AE as a result of increasing G and T
by the same amount? As government spending rises by 40⇝
the effect on Y is direct and positive. Now if the government
also collects 40 more in taxes. The tax increase has a
negative impact on overall spending in the economy, but it
does not fully offset the increase in government spending.

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As T ⇧ by 40 ⇒Yd ⇩by 40 ⇒ C ⇩by (40 x MPC). Because
MPC = 0.75, C falls by (40 x 0.75= 30). The net result is that
G rises by 40 and C falls by 30. AE will increase by 10 after
the balanced-budget increases in G and T.
The balanced-budget multiplier is the ratio of change in
the equilibrium level of output to a change in government
spending with an equal change in taxes.
The balanced-budget multiplier is equal to 1: The
change in Y resulting from the change in G and the equal
change in T are exactly the same size as the initial change in
G or T.

Returning to our example, using the government

spending multiplier, a 40 increase in G would raise
equilibrium output by 160 (40x4). By using the tax
multiplier, a tax increase of 40 will reduce the equilibrium
level of output by 120 (40x-3).
The net effect is (160-120=40). Thus, the net increase
in the equilibrium level of Y resulting from the change in G
and the change in T are exactly the size of the initial change
in G or T.

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 Chapter (6)
Money Market and Equilibrium
Interest Rate

Chapter Outline
1. Interest Rates and the Price of Bonds.
2. The Demand for Money (Md).
3. The Supply of Money (Ms).
4. The Equilibrium Interest Rate.

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 1. Interest Rates and Bond Prices
Our goal in this chapter is to provide a theory of how
the interest rate is determined, and how it can affect the
equilibrium level of income in the macroeconomy.
• Interest is the fee that borrowers pay to lenders for the use
of their funds.
• Firms and governments borrow funds by issuing bonds,
and they pay interest to the lenders that purchase the
bonds. Households also borrow from banks and finance
companies.
What are bonds?
Bonds are financial assets that have the following
properties:
1. They are issued with a face value.
2. They come with a maturity date, which is the date the
borrower agrees to pay the lender the face value of the
bond.
3. There is a fixed payment of a specified amount that is
paid to the bondholder each year. This payment is
known as a coupon (the interest rate).

When interest rates rise, the prices of existing bonds fall.

WHY?
A key relation is that market-determined prices of
existing bonds and interest rates are inversely related. The
fact that the coupon on a bond is unchanged over time does
not mean that a bond’s price is insulated from interest rate
movements. Say that after company XYZ issued its bond
with a coupon of $100, interest rates went up, so that a

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similar company will issue its bond with a coupon of $200
and sell its bond for $1,000 –just like the bond of XYZ-.
At $1,000 this bond is clearly a better deal than the
XYZ bond because the coupon is larger. If the owner of the
XYZ bond wanted to sell it, he could not get $1,000 since
people could buy the other bond for $1,000 and earn more.
Thus, the price of the XYZ bond would have to fall to have
investors be indifferent between buying it and buying the
other bond. In other words, when interest rates rise, the
prices of existing bonds fall.
Thus, the bond market directly determines the prices of
bonds, not interest rates. Given a bond’s market-determined
price, its face value, its maturity, and its coupon, the interest
rate, or yield, on that bond can be calculated; i.e.: iinterest
rates are indirectly determined by the bond market. For
simplicity, we will assume that there is only one type of
bond, and one market-determined interest rate on this bond.
Example
If you know that the interest rate (r) on a given bond is 10%,
the face value (FV) is $1000, and the coupon (C) is $100,
what is the face value if the interest fell to 5%?
Solution:
• interest rate (r) = C/ FV = 100/1000 = 10%
⇝ FV = C/ r ⇝ FV = 100/ 0.05 = $2000.
• As the interest rate (r) falls, the face value of the
bond -its price- rise.

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 2. The Demand for Money
When we speak of the demand for money, we are
concerned with how individuals divide their financial assets
between money -which does not earn interest-, and interest-
bearing securities as bonds.
As we shall see, the interest rate and nominal income
influence how much money households and firms choose to
hold.
The definition of Money Demand: it is that part of financial
assets that people decide to hold in the form of cash money
(no interest is earned).
Thus, the demand for money (holding money) has an
opportunity cost represented in the interest forgone when
using this money to buy bonds.
The demand for money is mainly determined by two
motives:
A. The transaction motive.
B. The Speculation motive.

A. The Transaction Motive:

The main reason for holding liquid money instead of
interest-bearing assets is that money is useful for buying
things, this the transaction motive.
↳ Transaction demand for money ⇨ people hold money
to buy things, and to conduct their daily transactions.

We assume that income arrives once at the beginning of the

month. While spending is spread out over time. This
mismatch between the timing of money inflow and the

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timing of money outflow (spending) is called the non-
synchronization of income and spending.

There is a positive relationship between the quantity of

money you carry for transaction reasons and the level of
income or (trading).
⇝ Y⇧⇒ Md for transactions⇧ & vice versa ⇜

B. The Speculation Motive:

One reason for holding bonds instead of money is the
speculative motive.
Since the market price of interest-bearing bonds is
inversely related to the interest rate, investors may want to
hold bonds when interest rates are high with the hope of
selling them when interest rates fall.
When interest rates are low (prices of bonds are high)
people keep money balances to use it to buy bonds when its
prices decline. This is called “speculative demand for
money”.
There is a negative relation between the speculative
demand for money and the level of interest rate.
⇝ r⇧⇒ prices of bonds ⇩ ⇒ demand for bonds ⇧ ⇒
speculative demand for money ⇧ to make capital gains ⇒ Md
⇩ (liquid money) & vice versa ⇜

❖ The Total Demand for Money

The total quantity of money demanded in the economy
is the sum of both transaction and speculative demand for
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money, i.e.: it is the sum of the demand for cash by both
households and firms.

• For both households and firms, the quantity of

money demanded at any moment depends on the
opportunity cost of holding money, a cost determined
by the interest rate.
• Because the interest rate is the opportunity cost of
holding money balances, increases in the interest rate
reduce the quantity of money that firms and
households want to hold, and decreases in the interest
rate increase the quantity of money that firms and
households want to hold.

❖ The demand for money depends

- negatively on the interest rate (r) ⇝ movements along
the Md curve.
- positively on nominal income (P.Y), both real income
(Y), and the price level (P) ⇝ shifts the Md curve to
the right or to the left.

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➢ Nominal output (income) = P • Y
• An increase in real output (Y) shifts the money
demand curve to the right.
• An increase in the (P) level shifts the money demand
curve to the right.

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 3. The Supply of Money
The central bank has its own tools to control the supply
of money (Ms) in the economy. Knowing that Ms is not
affected by changes in the interest rate (r), then the Ms curve
is represented by a vertical line.

4. The Equilibrium Interest Rate

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 Adjustments in the Money Market
↳ At any interest rate higher than the equilibrium (such
as r0);
• In the bonds market; as r is high⇝ demand for bonds ⇧
⇝ excess demand for bonds (shortage) ⇝ price of
bonds ⇧ ⇝ r will fall to r* and equilibrium is restored.

• In the money market; as demand for bonds ⇧ ⇝ demand

for money⇩⇝ Md<MS ⇝ excess supply of money
(surplus) ⇝ r will fall to r* and equilibrium is restored.

↳ At any interest rate lower than the equilibrium (such

as r1);
• In the bonds market; as r is low⇝ demand for bonds⇩⇝
excess supply of bonds (surplus) ⇝ price of bonds ⇩ ⇝
r will rise to r* and equilibrium is restored.

• In the money market; as demand for bonds ⇩ ⇝ demand

for money ⇧ ⇝ Md ˃MS ⇝ excess demand for money
(shortage) ⇝ r will rise to r* and equilibrium is
restored.

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 Chapter (7)
Aggregate Demand in the Goods
and Money Markets

Chapter Outline
1. Planned Investment and the Interest Rate.
2. Planned Aggregate Expenditure and the Interest Rate.
3. Equilibrium in Both the Goods and Money Markets.
4. Policy Effects in the Goods and Money Markets.
5. The Aggregate Demand (AD) Curve.
6. The IS-LM Model.

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 Equilibrium in the two markets
The goods market and the money market do not operate
independently, and the purpose of this chapter is to put the
two markets together. The key link between the two markets
is the interest rate (r).
In practice the main components of aggregate demand
that are affected by the interest rate are consumption and
investment. When the interest rate increases, these
components of aggregate demand decrease. For simplicity
we will assume that only investment by firms -planned
investment (I)- is affected by the interest rate.
Only by analyzing the two markets together can we
determine the values of aggregate output (Y) and the interest
rate (r) that are consistent with the existence of equilibrium
in both markets. Looking at both markets simultaneously
also reveals how fiscal policy affects the money market and
how monetary policy affects the goods market.

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 1. Planned Investment and the Interest Rate
We have assumed for simplicity that planned
investment is fixed, and we now must relax this assumption.
The real cost of an investment depends on the interest rate;
the cost of borrowing. When the interest rate rises, it
becomes more expensive to borrow and fewer projects are
likely to be undertaken. When the interest rate falls, it
becomes less costly to borrow and more investment projects
are likely to be undertaken.

➢ Other Determinants of Planned Investment

The assumption that planned investment depends only
on the interest rate is also a simplification. In practice, the
decision of a firm on how much to invest depends on, among
other things, its expectation of future sales. The optimism or
pessimism of entrepreneurs about the future course of the
economy can have an important effect on current planned
investment.

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➢ The size of the crowding-out effect and the ultimate
size of the government spending multiplier depend
on:
• First, we assumed that the quantity of Ms did not
change. If we were to assume instead that it increased
to accommodate the increase in G, the multiplier would
be larger. In this case, the higher Md would be satisfied
with a higher Ms and the interest rate would not rise.
Without a higher interest rate, there would be no
crowding-out.
• Second, the crowding-out effect depends on the
sensitivity or insensitivity of planned investment
spending (I) to changes in the interest rate (r). Crowding
out occurs because a higher interest rate reduces
planned investment spending. If planned investment

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 does not fall when the interest rate rises, there is no
crowding-out effect.
- Interest sensitivity means that (I) changes a great deal in
response to changes in (r);
- Interest insensitivity means little or no change in (I) as a result
of changes in (r).
❖ Expansionary Monetary Policy: An Increase in the
Money Supply
What will happen when the supply of money increase?
At first the money supply curve shifts to the right, the
equilibrium rate of interest falls. Planned investment
spending (I) increases.
• First, the increase in the quantity of Ms pushes down
the interest rate (r).
• Second, the lower interest rate causes planned
investment (I) to rise.
• Third, the (I) means higher AE, which means increased
output (Y), as firms react to unplanned decreases in
inventories.
• Fourth, the increase in output leads to an increase in the
demand for money (the demand for money curve shifts
to the right), which means the interest rate decreases
less than it would have if the demand for money had not
increased.
Monetary policy can be effective only if I reacts to changes
in r (if I is sensitive to r).

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 5. The Aggregate Demand (AD) Curve
Remember that the demand for money depends on
nominal income and the interest rate.
If real income (Y) increases and the price level (P) is
fixed, then nominal income (PY) increases, shifting the
money demand curve to the right, which increases the
interest rate. Also, if P increases, the money demand curve
shifts to the right, which increases the interest rate. This is
just like a Y increase; it shifts the money demand curve to
the right and increases the interest rate r.
The increase in r that results from an increase in P leads
to a fall in planned investment; so, in the new equilibrium, Y
is lower. Conversely, if P decreases, the money demand

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curve shifts to the left, which decreases r, increases planned
investment, and results in a higher equilibrium value of Y.
Thus, there is a negative relation between the price level
P and real aggregate output (income) Y. This relationship is
called the aggregate demand (AD) curve.
Aggregate demand (AD) curve is a curve that shows
the negative relation between aggregate output and the
price level. Each point on the AD curve is a point at which
both the goods market and the money market are in
equilibrium.
✓ The AD curve is more complex than a simple market
demand curve.
✓ The AD curve is not a one market demand curve, and it
is not the sum of all market demand curves in the
economy ⇝ AD is a function of the overall price level,
not the price of any single product ⇜

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 ❖ Why is the AD curve negatively sloping?
A simple demand curve shows the quantity of output
demanded (by an individual or in a single market) at every
possible price, ceteris paribus. Things are different when the
overall price level rises. When the overall price level rises,
many prices rise together.
• AD falls when the price level increases because the
higher price level causes the demand for money (Md) to
rise.
• With the money supply constant, the interest rate will
rise to re-establish equilibrium in the money market.
• It is the higher interest rate that causes aggregate output
to fall.
The AD curve traces the relation between the overall price
level and AD, taking into account the behavior of firms and
households in the goods and money markets at the same
time.

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 ▪ The Consumption Link
The consumption link provides another reason for the AD
curve’s downward slope; An increase in the price level
increases the demand for money, which leads to an increase
in the interest rate, a decrease in consumption (as well as
planned investment), and finally a decrease in aggregate
output (income).
▪ The Real Wealth Effect
Real wealth effect; is the change in consumption brought
about by a change in real wealth that results from a change
in the price level.
❖ Thus, the main reasons for the downward slope of
the AD curve are:
• The effects of money supply and money demand on the
interest rate ⇨ P↑⇒Md↑ ⇒ r↑⇒I↓⇒ AE & Y↓
• The consumption link ⇨ P↑⇒Md↑ ⇒ r↑⇒C↓⇒ AE &
Y↓
• The real wealth (real balance) effect ⇨P↑⇒ real wealth
↓ ⇒ C↓⇒ AE & Y↓
⇝ Changes in price level (P) → a movement along the AD
curve

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 6. The IS-LM Model

We can graphically determine the equilibrium level of

aggregate output (income) and the interest rate in the goods
and money markets, using two curves, the IS and the LM
curves.
We will derive these two curves and use them to see
how changes in government purchases (G) and the money
supply (Ms) can affect the equilibrium values of aggregate
output (income) and the interest rate.
❖ The IS curve (equilibrium in the Goods Market):
IS curve is a curve illustrating the negative relation
between the equilibrium value of aggregate output (income)
(Y) and the interest rate in the goods market ⇒The IS curve
is downward sloping.
The letter I stands for investment, and the letter S stands
for saving. IS refers to the fact that equilibrium in the goods
market means that planned investment equals saving.

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 Review Questions
Q1. MCQ:
1. Which of the following will cause a decrease in equilibrium
GDP?
A) An increase in government spending.
B) An increase in imports.
C)An increase in autonomous consumption.
D) An increase in exports.
2. As income increases with a linear consumption function, the
average propensity to consume (APC):
A) remains constant B) increases
C) increases up to be equal the MPC D) declines
3.Which of the following is expected to shift planned investment
function downward?
A) Lower interest rate. B) Higher level of sales.
C) Higher interest rates. D) Higher business confidence.
4. Which of the following is expected to shift saving function up?
A) Lower interest rate. B) An increase in wealth.
C) Pessimistic consumers’ expectations.
D) Optimistic consumers’ expectations.

Q2. True or False:

1. The aggregate demand curve (AD) is negatively sloped.
2. The expansionary fiscal policy has the same effect on prices
and output whatever the shape of SRAS curve.
3. If the MPC increases, the desired aggregate expenditure line
becomes flatter.
4. At equilibrium, national saving should equal investment.
5. The value of multiplier should be more than one.

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 References
• Irvine and D. Curtis. (2021). Principles of Macroeconomics.
Calgary, Alberta, Canada: Lyryx Learning Inc.

• Brue, S., & McConnell, C. (2014). Essentials of Economics.

McGraw Hill.

• Case, Karl E., Ray C. Fair, and Sharon M. Oster. (2012).

Principles of economics. Harlow, Essex, England: Prentice
Education.

• Lipsey, Richard G. & Chrystal, K. Alec. (2011). Economics.

Oxford; New York: Oxford University Press.

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