Chapter 3 Macro

Adigrat University Dep.
t of AcFn Macroeconomics 2019
3. Income Determination Model in Closed Economy
3.1. Consumption and Investment spending (Two Sector Model)
Aggregate demand and equilibrium output
In closed Economy Aggregate demand is the total amount of goods demanded in the economy.
Distinguishing among goods demanded for consumption (C), for investment (I), by the
government (G), aggregate demand is given by:-
AD= C+I+G ………………………………….. 3.1
In general, the quantity of goods demanded, depends on the level of income in the economy. But
for now we shall assume that the amount of goods demanded is constant, independent of the
level of income.
To discuss the equilibrium output we use a graphical depiction as follows.
AD
AD = Y
M
N E UI>0 AD
UI< 0
Y
45o Y3 Y1 Y2
Output
Fig 3.1 Equilibrium with constant AD
In the above diagram AD represents aggregate demand, the 45o line labeled AD =Y Shows that
aggregate demand is equal to the level of output. This line is used as a reference line that
translates any horizontal distance into an equal vertical distance.
Chapter III Page 1 of 35

Adigrat University Dep.t of AcFn Macroeconomics 2019
At point “M” total output produced is greater than quantity demanded. Firms would be unable to
sell all they produce and would find their warehouses filling with inventories of unsold goods.
Hence, they will reduce there as at point “N” output demand exceeds total output produced; as a
result firms produce more. Point “E” shows equilibrium level of output. Firms are selling as
much as they produce, people are buying the amount they want to purchase, and there is no
tendency for the level of output to change.
Equilibrium Output and National Income Identity
We defined equilibrium output as that level of output at which aggregate demand for goods is
equal to output:
AD = C+I+G = Y ………………………………………. 3.2
Here recall the definition of AD, it is the total amount of goods people want and able to buy
where as investment and consumption in the national income accounts are the amounts of the
goods actually bought. In particular, the investment measured in the national accounts includes
involuntary or unintended (or undesired) inventory changes, which occur where firms find
themselves selling more or fewer goods than they had planned to sell.
We thus distinguish between the actual aggregate demand measured in accounting context and
the economic concept of planned (desired, intended) aggregate demand.
Take a look at the above figure and see that at point M, the planned aggregate demand is greater
than the actual demand; the excess output should be added to the firm’s inventories. In the
national income accounts additions to inventories are counted as investment. This is shown as:-
UI = Y-AD …………………………………………….. 3.3

Where AD = Aggregate demand, Y =Total output and UI = Unplanned investment
At equilibrium level of income, there is no involuntary inventory accumulation or rundown. The

planned spending is equal to actual output, thus Y= AD and UI = 0

Note that at point “N” actual demand is greater than planned AD as a result firms rundown their
inventories and UI becomes negative as shown in the diagram.
The Consumption Function
The “fundamental psychological law” forwarded by Keynes states that “men are disposed, as a
rule and on the average, to increase their consumption as their income increases but not by as
much as the increase in their income”. In other words, as income increases, consumers will spend
part but not all of the increase, choosing instead to save some part of it. Therefore, the total
increase in income will be accounted for by the sum of the increase in consumption expenditures
and the increase in personal saving.
1. Average propensity to consume (APC)
The average consumption- income relationship is defined by the ratio of consumption to income
for different levels of Y. Symbolically;
APC= C/Y
Where APC = Average propensity to consume, C = Consumption and Y= Income.
As you can see from table 3.1 below, at Y of 40, we have C of 50, hence APC= C/Y =50/40
=1.25. You can calculate APC for any level of income by the same method and notice that as Y
increases APC declines. In other words C increases less than proportionally with increase in Y
and vice versa.
2. Marginal propensity to consume (MPC)
It shows how a given change in the level of income will be divided between a change in
consumption and saving. It is given as
MPC= ∆C/∆Y …………………………………………… 3.5
Where MPC= Marginal propensity to consume, ΔC = Change in consumption and

ΔY = Change in income.

MPC is the slope of the consumption function. For instance take Y o= 120 Y1 = 160 then ∆Y= 40
and also consider Co= 110 C1 = 140 and then ∆C = 30 hence MPC = ∆C/∆Y = 30/40 = ¾. In
figure 3.2 for any point the slope is calculated to be ¾ therefore the slope of the consumption
function is the geometric representation of the MPC.
C=Ca + cY………………………………………………… 3.6

Where C = Consumption, Ca = Autonomous consumption, cY = Induced consumption and
Y = Level of income.
If we consider the above diagram Ca= 20, MPC=c =3/4 hence the consumption function equation
will have the form of: C= 20+ ¾ Y
If we divide the consumption function equation by Y then we will have the general equation of
APC given as:
APC = C/Y = Ca/Y + C------------------------------- (2)

Where
APC-Average propensity to consume
C- Consumption
Ca- autonomous consumption
Y- is level of income.
Saving Function
Panel (B) of figure 3.2 shows the saving function, which is the counterpart of the consumption
function shown in panel (A). In panel (A), the amount of saving at any level of income is the
difference between the consumption function and the level of income when income is 40,
consumption is 50 and saving is -10 saving function lies below the x-axis. When income is 160,
consumption is 140 and saving is 20 and saving function is above the x-axis.
1. Average Propensity to Save (APS)
It is the saving counter part of APC and is given by

APS=S/Y--------------------------------------- (1`)
Where
APS-Average propensity to save
S-Saving
Y-Income Level
For instance when Y= l20, S=10, hence APS =S/Y= 10/120 = 0.083. As you can see on table 3.1
APC can be calculated for different levels of income. Here one thing you have to note is that,
since income is either consumed or saved the sum of APC and APS should be one. Hence,
APC + APS= 1 or
APS= 1-APC ------------------------------------ (2`)
2. Marginal propensity to save (MPS)
There is also the saving counterpart of MPC and it is denoted as
MPS = ∆S/∆Y ------------------------------------- (3`)

Where
MPS- Marginal propensity to save
ΔS- Change in saving
ΔY-Change in income
Since ∆Y must be devoted to either ∆C or ∆S, the two ratios ∆C/∆Y and ∆S/∆Y must add up to
one. That is:
MPC + MPS = 1 or MPS = 1-MPC------------------------- (4`)
On table 3.1 you recall that MPC= ¾ for all levels of output hence MPS= 1-3/4= ¼
Saving Function Equation
The general equation for a linear saving function is given as;

S=Sa + sY

Where
S- Total saving
Sa- Autonomous saving
Y- Income
sY – induced saving
If we divide the saving function equation by Y, then we will have the general equation for APS.
That is:
APS= S/Y = Sa/Y + s
Note: by definition saving is equal to income minus consumption, algebraically
S=Y-C,
But according to equation (1) above C= Ca + cY, substituting on the equation we have S=Y-(Ca
+cY) = Y-Ca-cY this can be rearranged as;
S= - Ca+ (1-c) Y
Note: 1-c =s since c+s=1
The relationship between income, consumption and saving is shown by using the following
hypothetical income, consumption and saving schedule.
Table 3.1 income, consumption and saving schedule
No income consumption (C) saving APC MPC APS MPS
(Y) (S)
1 0 20 -20 - - - -
2 40 50 -10 1.25 0.75 -0.25 0.25
3 80 80 0 1 0.75 0 0.25
4 120 110 10 0.92 0.75 0.083 0.25
5 160 140 20 0.87 0.75 0.125 0.25
6 200 170 30 0.85 0.75 0.15 0.25
7 240 200 40 0.83 0.75 0.167 0.25
8 280 230 50 0.82 0.75 0.18 0.25
Graphically

C+S
280
260
220
200
180
160
140 C+S
120
100 (+S) C
80 Panel (A)
60 S=0
40 (-S) C
20 C C
0
0 20 40 60 80 100 120 140 160 180 200 240 260 Y
S
60
40
20 S Panel (B)
0
-20 80 Y
Fig 3.2 consumption and saving function
As we can see from figure 3.2 when level of income of the consumer is zero, consumption is
given as 20 and this consumption level which is independent of the level of income is referred to
as autonomous consumption. The amount is shown by negative saving (dis-saving) of 20. As the
level of income increase and reaches 80 it is exactly equal to amount of consumption which is
the breakeven point. If we further increase income to 160, we will have consumption of 140 and
a positive saving amount of 20.

From table 3.1 we found that Sa = -20 and S = ¼ which the saving function can be represented
as: S= (-20) + ¼ Y
3.1.4. Planned investment and aggregate demand

We have now specified one component of aggregate demand, consumption
demand. The other component planned investment spending is assumed to be
constant at the level of investment for our present discussion. Since we are
considering two sector models i.e. government spending and net exports each
assumed to be equal to zero, aggregate demand is the sum of consumption and
investment demands. That is
AD= C+I, but C= Ca +cY
Hence, AD = Ca + I +cY,
Let Ca+ I= A
AD= A+cY -------------------------- (1)
The aggregate demand function above is shown in figure 3.3 part of aggregate
demand. A = Ca+I, is independent of the level of income or it is autonomous.
However, aggregate demand depends on the level of income. It increases with
the level of income since consumption demand increases with income.
C AD=Y
IU>0
AD = A+cY
AD E
I C=Ca+cY
A IN<0
Ca
450
Yo income, output
Fig 3.3 the consumption function And Aggregate demand

3.1.4. Equilibrium income and output

The equilibrium level of income is maintained when the aggregate demand
equals output, which in turn equals income. The 45 o line, AD=Y in figure 3.3
shows points at which output and aggregate demand are equal only at point E,
and the corresponding equilibrium levels of income and output (Yo), aggregate
demand exactly equal output. At that level of output and income planned
spending precisely matches production.
The arrows in figure 3.3 indicate how the economy reaches equilibrium. At any
income level below Yo, firms find that demand exceeds output and that their
inventories are declining. They therefore increase production; conversely, for
output levels above Yo, firms find inventories piling up and therefore cut
production as the arrows show. This process leads to the output level Yo, at
which current product exactly matches planned aggregate spending and
unintended inventory changes are therefore equal to zero.
The equilibrium level of income can be algebraically derived as follows.
The consumption function is given as: C = Ca+cY, at equilibrium aggregate
demand is equal to total output produced. That is AD=Y, but in equation (3),
we have AD= A+cY
Hence Y= A+cY, solving for Y, we have
Y= (1/1-c) A ----------------------------------- (1)
As you can see from the above formula the equilibrium level of output is
higher, the larger the marginal propensity to consume(c) and the higher the
level of autonomous spending (A) is.
There is a useful alternative formulation of the equilibrium condition that
aggregate demand is equal to output. In equilibrium, planned investment
equals saving this applies only in a closed two sector economy.
At equilibrium Y= AD,
But Y= C+S and AD= C+I

Hence C+S= C+I
S= I
On figure 3.3 you can see that the distance between the 45 o line and the
consumption function is the saving function. In addition, the distance between
the AD function and the consumption function is the planned investment.
These two distances are equal only at point “E”. With Yo level of income (S=I)
any point above Yo shows saving exceeding investment and any point below Yo
depict investment greater than saving.
3.1.5 The Multiplier
The concept of “multiplier” was first introduced by R.F Kahn, a colleague of
Keynes and this was used as an employment multiplier i.e. finding the effect of
an increase in investment in an employment. Keynes borrowed this concept
and developed another type of multiplier called the income multiplier or the
investment multiplier.
Definition –a multiplier is the ratio expressing the relationship between the
increase in national income and the increase in investment, which induces the
rise in income. Precisely the multiplier can be defined as the ratio of change in
income to the change in investment.
The multiplier concept explains the cumulative effect of change in investment
on income via their effect on consumption expenditures. It describes the fact
that additions to spending have an impact on income greater than the original
increase or decrease in spending itself. In other words, even small increments
in spending can multiply their effects.
Working of the multiplier – we can illustrate how a small investment increase
in the economy goes multiplied to propagate a large volume of income
ultimately.
Suppose an industrialist makes an investment of 10 million dollar to expand
his business. By this, those producing investment goods will get 10 million
dollar and this becomes the additional income for that group which would be

spending the amount. The quantity spent by them would depend on the
marginal propensity to consume. Let the MPC be 0.5, the group producing
investment goods would be spending 5 million dollars on consumption out of
the realized income of 10 million. Due to this, the group producing
consumption goods would get 5 million as their income. This additional income
would be paid out by way of wages, interest, etc. Those who have received the
income of 5 million would spend half of it i.e. 2.5 million since MPC = 0.5.
Consequently, the next group that had helped in catering to the needs of the
preceding group will get 2.5 million dollar and they will spend half of this. Thus
the process will continue till the entire sum gets exhausted. This is
summarized in the following table.
Table 3.2 investment and aggregate income multiplier
Multip Initial invest. Increase in consumption through Total increase in
lies (In million income aggregate income
period dollar) (In million dollar) (In million dollar)
0 10 -- 10
1 10 10+5 15
2 10 10+5+2.5 17.5
3 10 10+5+2.5+1.25 18.75
4 10 10+5+2.5+1.25+0.625 19.375
5 10 10+5+2.5+1.25+0.625+0.312 19.688
6 10 10+5+2.5+1.25+0.625+0.312+0.156 19.844
7 10 10+5+2.5+1.25+0.625+0.312+0.156+0. 19.922
075 etc
We can see from table 3.2 that the initial investment of 10 million reemerges
ultimately as nearly as 20 million. Here, the marginal propensity to consume
has been assumed to be 0.5 and hence, the investment doubles itself after a
series of emergence in different groups over a period. Since an investment of 10
million has become an aggregate income of 20 million the multiplier is 2.
Marginal propensity to consume and multiplier – In the above illustration,
the initial investment had multiplied two times to become the ultimate
aggregate income this is because the MPC has been assumed to be ½. The

value of the multiplier depends upon the consumption function and MPC.
Greater the volumes of consumption expenditure, larger the volume of
aggregate income as the value of the multiplier will be greater.
The formula for the multiplier is,
K= 1 or 1 …………………………………… (1)
1-MPC 1-c
Where, K stands for the multiplier and MPC (c) for marginal propensity to
consume.
Since the marginal propensity to save is 1-MPC the multiplier formula can also
be written as: K=1/MPS.
In our illustration stated above we have MPC= 0.5 hence the multiplier can be
calculated using the formula as follows.
K= 1/1-MPC = 1/1-0.5 = 2
Or MPS= 1-0.5 = 0.5 and K= 1/MPS = 1/0.5 =2
3.2. Government spending and taxation (Three Sector Model)
It is when the model of income determination is expanded to include government, aggregate

consumption, domestic investment and government expenditure for final product. The aggregate
flow of income is now allocated not only to consumption and private saving but in part of tax as
well.
In general, government can expand aggregate spending in any time period by increasing the
amount it adds to the stream of private spending through its purchase of goods and service or by
decreasing the amount it diverts from the stream of private spending through its net tax
collection. Government policy with respect to spending and taxing is known as fiscal policy.
To explain the mechanics of fiscal policy we will construct a series of three models, each of
which is built on the models developed for the two sector economy.
In the first, only tax receipts (T) and government purchases (G) are added to the two sector
model, government transfer payments are in effect assumed to be zero. In the second model,
government transfer payments are added. Both of these models assume that tax receipts are

independent of the level of income. In the third model, the breakdown of government
expenditures into purchases of goods and services and transfer payments is retained, but tax
receipts are recognized as being in part, dependent on the level of income.
Fiscal Policy– including taxes and government purchases
Recall the accounting identities in chapter two, the GNP identity for a three sector economy was
given as C+S+T= GNP= C+I+G.
Let; C+S+T= C+I+G
Form this we can find the saving-investment identity which is;
S+T-G = I
Where; T-G equals public saving
In the two sector economy, disposable personal income (Yd) was found to be equal to net
national product (Y), in the three sector economy, however, taxes absorb a portion of the income
generated by expenditures on net national product. Therefore, disposable personal income is less
than net national product by the amount of taxes. Algebraically, it can be putted as:-
Yd= Y-T
Or Y= Yd +T, where Yd is disposable income, Y is net national product and T is net tax.
And also the consumption function for the three sector model becomes:-
C= Ca+cYd
Or C = Ca+c(Y-T)
Investment is independent of income the equilibrium level of income is given by:-
Y= Ca+c(Y-T) + I+G……………… (1)

Expressed in terms of saving and investment, equilibrium will be found at that level of income
and output at which planned saving plus taxes equals planned investment plus government
purchases.
S+T= I+G………………………... (2)
If planned savings are equal to planned investment, then equilibrium is established by

government’s balanced budget i.e. taxation revenue being equal to government expenditure. But
government may use a budget deficit or surplus to influence the level of aggregate demand.
Since government expenditure is a component of AD, an increase in it, if not offset by a rise in
taxation, has a multiplier effect on incomes. The government instead of balanced budget will
start framing deficit budgets. Similarly, the lowering of rates of taxation without corresponding
fall in government expenditures provided higher disposable incomes to the people who will raise
their consumption expenditure, will cause a multiplier expansion of the level of income.
To show the multiplier effect, let us rewrite the aggregate spending equation (1)
Y= Ca+c (Y-T) + I+ G
This can be rearranged as;
Y = 1/1-c (Ca- cT+I+G)……… ……………… (3)
For instance, if we assume a change in investment, the other values remaining unchanged, the
new equilibrium level of Y is equal to the original level of Y plus the change in Y.
Y+ ∆Y = 1/1-c (Ca-cT+I+G) + 1/1-c ∆I
Subtracting Y from both sides of the equation, we have
∆Y = 1/1-c ∆I ………………………………. (4)
In the same way, we will find that

∆Y = 1/1-c ∆G ………………………………. (5)

∆Y = 1/1-c ∆Ca ……………………..………. (6)
∆Y = -c/1-c ∆T …………………………...….. (7)
Note – change in government expenditure and change in the amount of tax have different impact
on the level of income. To analyze this, we can compare the multipliers equation in (5) and (7).
∆Y = 1 ∆G or ∆Y = 1
1-c ∆G 1-c ……………. (8)
And ∆Y = -c ∆T or ∆Y = -c
1-c ∆T 1-c...……….….. (9)
From equations (8) and (9) we can see that the tax multiplier is less than the government
spending multiplier and they have different effect on income, the former has a negative impact
shown by the negative sign and the later a positive impact.
Regardless of the level of consumption (C), the government purchase multiplier is alwaysgreater
than the tax multiplier. This may be shown by combining the separate multiplier expressions for
∆G and ∆T.
∆Y + ∆Y = 1 + -c = 1-c = 1 ……………… (10)

∆G ∆T 1-c 1-c 1-c
The sum of the two multipliers is always unity. This is known as the balanced budget theorem or
the unit multiplier theorem.
3.2.2 Fiscal Policy–Including gross taxes, government purchases and transfer

payments.
In this model let us introduce a simple modification that brings out the essential difference
between the effects on income of changes in government purchases and transfer payments.
Net tax receipts (T) are equal to gross tax receipts minus government transfer payments thus
T= Tg –TR …………………………. (1)

Where, T is net tax and Tg is gross tax and TR is transfer payment (i.e amount of gross tax
receipts that is returned to individual through government transfer payments).
With the above equation (1) the net national income identity can be rewritten as:-
C+S+Tg-TR ≡ C+I+G ……………..……….. (2)
On the other hand the disposable income can be expressed as:-
Yd= Y-Tg+TR ……………………………… (3)
Hence, our consumption function will have the form of
C= Ca+c(Y-Tg+TR) …………………..…... (4)
Then the equilibrium level of income will become
Y= Ca+c(Y-Tg+TR) +I+G …………..…….. (5)
Which can be rewritten as:-

Y= 1 (Ca-cTg+cTR +I+G)…………………. (6)
1-c
This equation is identical to that for the first model except that Tg - TR is now substituted for T.
Hence, the two additional multiplier equations will have the following form.
∆Y = -c ∆Tg ……………………..…………. (7)
1-c
∆Y = c ∆TR ……………………….……..…… (8)

1-c
Note: regardless of the value of c, the government transfer multiplier is less than government
purchases multiplier by one. that is
(1/1-c) - (c/1-c) = 1

Example
a) Calculate the change in the level of income due to change in government expenditure and
transfer payments by the same amount of 10, assume that MPC = 2/3
b) What is the amount of multiplier for ∆G and ∆TR?
C) Interpret the result in b.
Solution
Given ∆G = ∆TR = 10
MPC = c = 2/3
a) ∆Y = 1/1-c∆G = [1/(1-2/3)]x10 = 30
∆Y = c/1-c ∆TR = [2/3/(1-2/3)] x10 =20
b) ∆Y = 1 = 1 =3
∆G 1-c 1-2/3
∆Y = c = 2/3 = 2
∆TR 1-c 1-2/3
c) The above result shows us that ∆G exert a greater expansionary effect than ∆TR does.
3.2.3 Fiscal Policy–including gross tax receipt as a function of income,

government purchases and transfer payments.
In this model for the sake of simplicity we assume that investment expenditure and government
expenditure are autonomous.
In the previous model we assumed that tax receipts would remain constant in the face of a
change in income however here, on the third fiscal model we will make one modification, that is
any change in income will typically affect tax receipt and hence tax receipts vary with change in
income level. With this we will have the following tax function in linear form.
Tg = Ta +tY………..(1) where
Tg- gross tax receipt
Ta – autonomous tax
t- Marginal propensity to tax (MPT)
Y- Income

As a result net tax will be given as
T= Ta +tY –TR …….(2)
Where T is net tax
Substituting the tax function, Ta+tY, for Tg we can have:-
C+S+Ta+tY-TR= C+I+G …………..(3)
Now disposable personal income can be rewritten as;
Yd= Y-(Ta+tY-TR) or
Yd = Y-Ta-tY+TR …………….(4)
by substituting equation (4) the consumption will be written as
C= Ca+c (Y-Ta-tY+TR)……………………….(5)
With this the equilibrium level of income will be
Y= Ca+c(Y-Ta-tY+TR)+I+G or
Y= Ca+cY-cTa-ctY+cTR+I+G………………(6)
Equation 6 can be re written as:-
Y= 1(Ca – cTa +cTR+I+G)
1-c(1-t)
Hence, we derive the multiplier equations as follows:-
∆Y = 1…………………….………………..(7)
∆Ca 1-c(1-t)
∆Y = -c……………………………………..(8)
∆Ta 1-c(1-t)
∆Y= -c………………………………………(9)
∆TR 1-c(1-t)
∆Y = ∆Y = 1…...………………………..(10)
∆I ∆G 1-c(1-t)
Example 1
Given MPC= ¾ , t= 1/5 determine the change in the level of income when ∆G =10,

Solution
∆Y = 1 ∆G = 1 x 10
1-c(1-t) 1 -3/4(1-1/5)
∆Y = 25
Government budget
Budget refers to the planned expenditure and revenue of a government over a given period of
time, usually one year.
The first important concept is the budget surplus, which is the excess of the government’s
revenues consisting of taxes, over its total expenditures and transfer payment.
It can be written as:-

BS= T-G-T
R………………………………………….. (1)
where
BS -Budget surplus
T- Net tax
G-Government expenditure
TR- Transfer payments
An excess of government expenditure over its taxes is a budget deficit (negative budget surplus).
If we assume a proportional income tax it will yield a tax revenue of T=tY which gives BS= tY-
G-TR
budget
BS=tY-G-TR
0 Y(income output)
- (G+R)
Fig 3.4: The budget surplus and deficit

In figure 3.4, we plot the budget surplus as a function of the level of income for given
government expenditure (G), transfer payments (TR) and tax rate (t). At low level of income, the
budget is deficit, because government spending (G+TR) exceeds income tax collection (tY). By
contrast, the budget shows a surplus for high levels of income, since income tax collection
exceeds expenditure (in the form of government purchase and transfers).
Government Purchases, Tax and Budget Surplus
An increase in government purchases has a positive impact on budget surplus. At first sight
increased government purchases are reflected in a reduced budget surplus. However, the
increased government purchases will also cause an increase in income and therefore, increased
income tax collection. This raises the interesting possibility that government tax collection might
by more than government purchases since tax multiplier exceeds the government purchase
multiplier.
Mathematically:
∆Y = 1
∆G 1- c(1-t)
A fraction of increase in income is collected in the form of tax. Assuming the transfer payments
remain constant the change in budget surplus can be written as;
∆BS = ∆T - ∆G………..(a)
But ∆T = t∆Y and ………….(b)
∆Y= 1 ∆G ……………….(c)
1-c(1-t)
Substituting equation (c) into (b) we will have:-
∆T = t (1 ∆G )………………(d)
1-c(1-t)
Substituting equation (d) into (a) we will have

∆BS= t ( 1 ∆G) - ∆G or
1-c (1-t)
∆BS = ( t - 1) ∆G
1-c (1-t)
( t- (1-c(1-t) ) ∆G = ( t-1+c – ct ) ∆G = ( -1 (1-t) + c(1-t) ) ∆G = ( (1-t) + (c-1) ) ∆G

1-c(1-t) 1-c(1-t) 1-c(1-t) 1-c(1-t)

= -1(1-t) ∆G
1-c (1-t)
∆BS= - (1/1-c)∆G………………(2)
In equation (2) we have shown that an increase in government purchases will definitely reduce
the budget surplus.
However, the increased government purchases will also cause an increase in income and increase
income tax collection. Hence, its impact on budget surplus will be positive.
3.3. Money, Interest and Income (Extended Model)

3.3.1. Money Supply
Supply of money means the total quantity of money available with the public for spending. The
term public includes individuals and business firms.
Since the money hold by the government, central bank and commercial banks is not in spendable
form, it is not included in the definition of money supply.
Money supply is a stock concept when viewed with reference to a particular point of time. And it
is a flow concept when viewed over a period of time. As a stock, it consist the total currency
notes, coins and demand deposits with the banks, held by the public. Since money supply can be
used and spent several times during a period of time it is a flow concept.
The number of times a unit of money changes hands during a given period of time is its velocity
of circulation. Thus, for a given period of time, the flow of money supply can be known by
multiplying the given stock of money by its velocity of circulation. Algebraically, this can be
expressed as:
MS= MV,
Where:
MS = Money supply
M- Total stock of money
V- Velocity of circulation
Approaches to Measure Money Supply

Broadly speaking, there are four alternative approaches regarding the measures of money supply.
These are given below:
1. Classical and Neoclassical Approach
This approach was based on the basic function of money as medium of exchange and therefore,
only currency and demand deposits with bank were included in the total money supply. This is
considered as a narrow definition of money supply but it is analytically superior because it
provides the most liquid and exact measure of money supply. Hence, the central bank can have a
better control over it.
M1= C+DD
NB: A demand deposit consists of funds held in an account from which deposited funds can be
withdrawn at any time from the depository institution, such as a checking or savings accounts,
accessible by a teller, ATM or online banking.
2. Monetarist Approach
Milton Friedman and his disciples have included currency, demand deposits and time deposits in
total money supply. They have included fixed deposits with the commercial banks in the money
supply because it can be withdrawn before the expiry of that period by paying a penal rate of
interest. That is fixed deposits possess liquidity like currency in this sense.
M2=C+DD+TD
M2=M1+TD
NB: A time deposit (fixed deposit) is an interest-bearing bank deposit account that has a
specified date of maturity, such as a certificate of deposit (CD). The deposited funds must
remain in the account for the fixed term to receive the stated interest rate. Time deposits are an
alternative to the standard savings account, and will usually pay a higher rate of interest.
3. Gurley and Shaw Approach

They further extend the scope of money supply by including the liabilities of non- banking
intermediaries i.e., the saving bank deposits, shares, bonds, etc., which are close substitutes to
money.
M3=M2+non- banking intermediaries
NB: Shares are units of ownership interest in a corporation or financial asset that provide for an
equal distribution in any profits, if any are declared, in the form of dividends. And A Bond is a
fixed income instrument that represents a loan made by an investor to a borrower (typically
corporate or governmental).
4. Radcliffee Committee approach
It is the widest definition of money supply .It is based on the general liquidity of the economy.
According, to this approach money supply covers the whole liquidity position that is relevant to
the spending decisions. It, therefore, includes cash, all types of bank deposits, and deposits with
none banking financial institutions (NBFI), near money assets and the borrowing avenues
available to the public. Although this approach provides broad definition of money supply, it is
not easily controlled by the central bank.
3.3.2. Demand for Money
There are different approaches adopted by various groups of economists to define money and to
determine why people want to hold money. Hence, in this section we will try to see the different
theories of money demand.
1. Classical Theory of Demand for Money
The classical theory of demand for money or the quantity theory of money was propounded by
Fisher. According to this theory, the demand for money arises for the fact that money is a
medium of exchange. People spend their incomes on transactions. Therefore, the demand for
money is determined by the total quantity of goods and services transacted during a given period

of time. Again the total demand for money also depends upon its velocity of circulation that is
why Fisher expressed this in the form of the following equation.
PT =MV
Where: P- General Price level
T- Total volume of goods transacted
M-Total stock of money
V- Velocity of circulation
The money demand equation of Fisher is given as:
M d =k *PY
Where: k is the fraction of the real money income (PY) which people wish to hold in cash and
demand deposits or the ration of money stock to income, p is the price level, and Y is the
aggregate real income.
Because k is a constant, the level of transaction generated by a fixed level of nominal income PY
determines the quantity of money Md that people demand. Therefore, Fisher’s quantity theory of
money suggests that the demand for money is purely a function of income, and interest rates
have no effect on the demand for money.
2. Neo- Classical Theory (Cambridge Approach) of Demand for Money
The Neo-classical theory of demand for money was propounded by Cambridge economists,
Marshall and Pigou.
Similar to fisher, for this approach, the demand for money is the function of income only and no
other factor intervenes. However, the Cambridge approach did not rule out the effects of interest
rates on the demand for money.
Symbolically, it can be explained as;
Md= kY
Where: k is the reciprocal of V in the Fisher equation and it is constant
Md- amount of money demanded
Y- Money value of national income

3. Keynes Theory of Demand for Money
Keynes theory is contained in his famous book, the general theory of employment, interest and
money. According to Keynes, the demand for money arises because of its liquidity or ‘liquidity
preference’ as he referred to it.
For Keynes, there are three motives for holding money (i) transaction motive (ii) precautionary
motive and (iii) speculative motive. According to him, the total demand for money means total
cash balances which may be of two types (i) active and (ii) idle, the former comprising
transactions demand and precautionary demand for money and the latter comprising of
speculative demand for money. Let’s see each of them in detail.
a. Transaction Motive: Keynes emphasized that this component of the demand for money is
determined primarily by the level of people’s transactions. The transactions demand for money
arises from the lack of synchronization (harmonization) of receipts and disbursements. In other
words, people aren’t likely to get paid at the exact instant you need to make a payment, so
between paychecks people keep some money around in order to buy stuff. But the transactions
here are routine and predictable (usual) transactions. Keynes believed that these transactions
were proportional to income, like the classical economists, he considered the transactions
component of the demand for money to be proportional to income.Like the classical economists,
he considered the transactions component of the demand for money to be proportional to income.
The rate of interest has no role to play in determining the transaction demand for money.
Keynes shown this algebraically as follows.
Lt= f(Y)
Where: Lt= Liquidity for transaction
Y= income
b. Precautionary Motive: Precautionary demand arises primarily because of the uncertainty of
future receipts and expenditures. People hold money for some unexpected contingences such as
unemployment, sickness, accidents etc.
Algebraically it is expressed as:

Lp= f(Y)
Where: Lp = liquidity for Precautionary
Y= income
According to Keynes, both transaction and Precautionary motive are function of income and
interest inelastic. He referred to the sum for these two as the active cash balances.
c. Speculative Motive: According to Keynes, the money held for speculative motive is idle cash
balance. Speculative demand for money is the demand for holding cash for making speculative
gains from the purchase and sale for bond and securities owing to changes in the rate of
interest /dividend. Obviously, this demand is determined by the rate of interest and bond prices.
The rate of interest and the bond price are inversely related. High bond prices indicate low rate of
interest and low bond prices indicate high interest rate.
In order to make a decision, whether should be hold in the form of money or bonds, an individual
compares the current rate of interest with the future rate of interest. If people expect the future
rate of interest to rise, they will anticipate capital losses, for avoiding which will sell their bonds
and keep cash holdings to lend it in future at a higher rate of interest.
When people expect the future rate of interest to fall in comparison with the current rate of
interest, their demand for money for speculative motive decrease for buying bonds and sell them
in future to make capital gains.
As you can see from figure 3.4 there is an inverse relationship between the speculative demand
for money and the current interest rate. When the interest rate rises, the speculative demand for
money falls and vice versa.
Interest rate Msp =H(r)

Msp
Money demand
Fig 3.5: Speculative Demand for Money
Here after we will discuss the other important contribution of Keynes, which is the liquidity trap.
It represents the subjective minimum level of interest rates. When the current rate of interest
becomes very low people have no desires to spend money but they want to keep the whole
money with them. In this situation, the yield of bonds becomes so low and the risk becomes so
high that the people do not want to keep bonds and decide to sell them for cash and the money of
the country will be trapped in the hands of the people.
According to Keynes, for an economy in the liquidity trap, monetary policy is not effective since
it cannot influence the interest rate. He recommended the use of fiscal policy.
Total Demand for Money
The total demand for money is the sum effect of the three motives; therefore the equation can be
formulated as:
Md= K(y) + H(r)
The total demand for money curve is scathed by horizontally summing the transaction demand,
Precautionary demand and the speculative demand for money.
3.3.3. Equilibrium
Given the money supply and the income level, at some particular interest rate, the sum of the
transactions and speculative demand for money will be equal with the supply of money. The
interest rate that equates the supply of and demand for money is the equilibrium interest rate.
You can see from the figure below that money supply is a perfectly inelastic curve, since it is
determined by actions of the monetary authority irrespective of interest rate; however the money
demand curve is a negatively sloped curve. On the diagram, point “E” gives the point of
intersection between money demand and supply curves, hence is at the equilibrium interest rate.

r Ms
rx Md E
Md > Ms Md
M
Figure 3.6, Equilibrium of interest rate
On the above figure, any point above the equilibrium interest rate will give us excess money
supply over money demand. In this situation, people use the excess cash on their hands to buy
bonds, which will raise price of bonds and reduce their yield. This process continues until bond
prices have been pushed up by the amount necessary to reduce their yield to equilibrium interest
rate.
In contrast, at any point below the equilibrium interest rate, money demand will be greater than
the money supply. In this case, people would prefer to hold less bonds and more money.
Therefore, they try to sell bonds and get money. The increase in supply of bonds drives their
prices down and the yields will be high. This process continues until bond prices have fallen by
the amount necessary to raise their yield to equilibrium interest rate.
Changes in Money Supply
The monetary authority of a country can reduce the level of interest rate by increasing the total
money supply. As it is shown graphically on fig 3.7, the monetary authority can either increase
or decrease money supply by using one or more of the credit creation control methods. For

instance, central bank can use the open market operation i.e., the purchase and sale of
government securities. As long as they can find either buyers or sellers depending on the
situation they can control the money supply.
R ms1 ms2 ms3 ms4

interest
rate
r*
r1
r2 md
Money
Fig 3.7 Changes in money supply and interest rate
One thing you have to note here is that once the economy is in the liquidity trap region, increased
money supply doesn’t affect the interest rate, here interest rate reaches minimum point and it will
not decline further. In this case, nobody wants to buy government securities or bonds; hence the
central bank can not affect the money supply through the open market operation.
Changes in the Level of Income
Assuming the money supply and speculative demand for money remaining constant, if there is
increase in the level of income, the money demand curve will shift outward, causing a rise in the
equilibrium interest rate, as shown in Fig. 3.8.
As you can see on fig 3.8, when money demand increase due to rise in the level of income from
Md1 to Md2, the equilibrium interest rate increases from r* to r1 .
Md1 Md2 Ms
r1 E1
r* E

money
Figure 3.8 Change in money demand
3.4. Goods Market and IS Curve
In this section, we derive a goods market schedule, the IS curve. The IS curve shows a
combination of interest rates and the levels of output such that planned spending equals income.
The goods market equilibrium schedule is an extension of income determination with a 45 0 line
diagram. Now investment is no longer fully exogenous but also is determined by the interest rate.
The equilibrium in the goods market requires that Y=C-I and S=I, all the factor that cause the
change in consumption, saving or investment functions influence the determination of
equilibrium.
From the C +I approach, we have :

Consumption function C=C(y)
Investment function I = I(r)
Equilibrium condition S(y) = I(r)
In order to derive the IS curve we use the following three diagrams. The relation between interest
rate and income level is explained in figure 3.9 part A. It shows the inverse relationship between
investment and interest rate. The straight line in part B is drawn at 45 0 angle from the origin.
Whatever the amount of planned investment measured along the horizontal axis of part B,
equilibrium requires that planned saving measured along the vertical axis of part B by the same.
Therefore, all points along the 450 line in part B indicate equality of saving and investment. Part
C, brings in the saving function, showing that saving varies directly with income.
The IS curve in part D is derived from the other parts of the figure. For example, assume an
interest rate of nine percent in part A, indicating that investment is 20. In part B, to satisfy the
equality between saving and investment, saving must also be 20, as shown on the vertical axis. In
part C, saving will be 20 only at an income level of 120. Finally bringing together Y of 120 from

part C and r of nine percent from part A yields one combination of Y and r at which S=I and Y=
C+I.
The IS curve is the schedule of combinations of the interest rate and level of income such that the
goods market is in equilibrium. It is negatively sloped because an increase in the interest rate
reduces planned investment spending and therefore reduces aggregate demand, thus reducing the
equilibrium level of income. At points to the right of the curve, there is excess supply in the
goods market, at points to the left of the curve, there is excess demand for goods.
S S
100 100
80 80
60 60
40 40
20 20
Y
40 80 120 160 200 20 40 60 80 100 I
(c) saving function (B) saving investment
S =S(Y) equality S= I
r r
10 10
9 9
8 8
7 7
6 6
5 5
4 4
3 IS 3
2 2
40 80 120 140 160 200 Y 20 30 60 80 100 I
(D) goods market equilibrium (A) investment function
S(Y) = I(r) I=I(r)
Figure 3.9 Derivation of IS curve

If we reduce interest rate to 5 percent, investment increase to 30.yielding an income level of 140
in part C. Therefore, we have 5 percent interest rate and 140 income combined in part B.
We can apply the same procedure to all levels of interest rate and thereby generate all the points
that make up the IS curve. They have in common the property that they represent combinations
of interest rate and income at which the goods market clears.
3.5. Money Market and LM Curve
As you might recall, the Keynesian theory of the demand for money makes the transactions
demand (here combined with the precautionary demand) a direct function and makes the
speculative demand an inverse function of the interest rate.
Then, Md, the total money demand has been given as Md= K(y) +h(r). The supply of money
(Ms) is determined outside the model, it is exogenous. This gives us three set of equations
Demand for money Md= K (Y) + h(r)
Supply of money Ms = M/P
Equilibrium condition Md=Ms
On figure 3.10, the LM graph has been derived based on the above three equations. Part A shows
the speculative demand for money as a function of r; part B is drawn to show total money supply
of 100, all of which must be held in either transactions or speculative balances. The points along
the line indicate all the possible ways in which the given money supply may be divided between
Mt (transaction demand for money) and Msp(speculative demand for money). Noting that,
Msp=h(r). Part C shows the amount of money required for transactions purpose at each level of
income and is derived from the other parts as follows.
Assume in part A an interest rate of 6 percent, at which the public will want to hold 40 in 100
leaving 60 for transactions balances, an amount consistent with an income level of 120 as shown
in part C. Finally in part D, bringing together Y of 120 from part C and r of 6 percent from part
A yields one combination of Y and r at which Md= MS/p or at which there is equilibrium in the

money market. We can repeat the above process for each level of interest rate and income level
and we will come up with the upward sloping LM as shown in part D.
Mt Mt
100 100
80 80 Ms= 1100
60 60
40 40
20 20
0 Y 0 Msp
40 80 120 160 200 20 40 60 80 100
C) transaction’s demand B) supply of money
Mt= K(Y) Ms/P = Mt +Msp
r r
LM
10 10
8 8
6 6
5 5
4 4
2 Y 2
40 80 120 160 200 0 20 40 60 80 100 Msp
D) money market equilibrium A) speculative demand
Ms= K(y) + H (r) Msp = h(r)
Fig 3.10 Derivation of LM curve
The LM curve is the schedule of combinations of interest rates and levels of income such that the
money market is in equilibrium. It is positively sloped given the fixed money supply, because an
increase in the level of income, which increases the quantity of money demanded, has to be
accompanied by an increase in interest rate. This reduces the quantity of money demanded and

there by maintains money market equilibrium. At points to the right of the LM curve, there is an
excess demand for money and at points to its left; there is an excess supply of money.
3.6. IS – LM Equilibrium
Equilibrium between the supply of and demand for goods is possible at all combinations of Y
and r indicated by the IS curve; similarly, equilibrium between all combinations of Y and r
indicated by the LM curve.However, there is only combination of Y and r at which the supply of
goods equals the demand for goods and the supply of money equals the demand for money. This
combination is defined by the intersection of IS and LM curves as shown on diagram 3.11.
r LM
IV I
r* E II
III
IS
Y* Y
Fig 3.11Equilibrium in the goods and money market
One might want to know what would happen in the IS-LM model if interest rate, other than the
equilibrium interest rate prevails in the economy. In this case, disequilibrium will arise in the
markets. Any combination of r and Y to the right of the IS curve gives us S>I and Y>(C+I). The
opposite is true for any combination of Y and r anywhere to the left of the IS curve. Similarly,
any combination of Y and r anywhere to the right of the LM curve is a combination at which
Md>Ms. Here, the opposite is also true for any combination to the left of the LM curve. This can
be summarized by the following table taking the four areas labeled by roman number on figure
3.11.
Table 3.1. Disequilibrium areas on the IS – LM Model
Area AR/e/d/s Goods market Money market

Area I I<S, (C+I) <Y Md<Ms
Area II I<S, (C+I) <Y Md>MS
Area III I>S, (C+I)>Y Md>Ms
Area IV I>S, (C+I)>Y Md<Ms
From our analysis of the goods market, we know that a situation in which I>S or (C+I) >Y will
head to a rise in income and vice versa. Similarly we know that when Md>Ms interest rate tends
to rise and vice versa.

Chapter 3 Macro

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 3 Macro

Uploaded by

Copyright:

Available Formats

Adigrat University Dep.

t of AcFn Macroeconomics 2019

3. Income Determination Model in Closed Economy

3.1. Consumption and Investment spending (Two Sector Model)

Aggregate demand and equilibrium output

AD= C+I+G ………………………………….. 3.1

To discuss the equilibrium output we use a graphical depiction as follows.

Fig 3.1 Equilibrium with constant AD

Chapter III Page 1 of 35

Equilibrium Output and National Income Identity

UI = Y-AD …………………………………………….. 3.3

At equilibrium level of income, there is no involuntary inventory accumulation or rundown. The

Chapter III Page 2 of 35

The Consumption Function

1. Average propensity to consume (APC)

2. Marginal propensity to consume (MPC)

MPC= ∆C/∆Y …………………………………………… 3.5

Where MPC= Marginal propensity to consume, ΔC = Change in consumption and

Chapter III Page 3 of 35

C=Ca + cY………………………………………………… 3.6

APC = C/Y = Ca/Y + C------------------------------- (2)

1. Average Propensity to Save (APS)

It is the saving counter part of APC and is given by

Chapter III Page 4 of 35

2. Marginal propensity to save (MPS)

There is also the saving counterpart of MPC and it is denoted as

MPS = ∆S/∆Y ------------------------------------- (3`)

MPC + MPS = 1 or MPS = 1-MPC------------------------- (4`)

Saving Function Equation

The general equation for a linear saving function is given as;

Chapter III Page 5 of 35

APS= S/Y = Sa/Y + s

Note: by definition saving is equal to income minus consumption, algebraically

Chapter III Page 6 of 35

Fig 3.2 consumption and saving function

Chapter III Page 7 of 35

3.1.4. Planned investment and aggregate demand

Fig 3.3 the consumption function And Aggregate demand

Chapter III Page 8 of 35

3.1.4. Equilibrium income and output

Chapter III Page 9 of 35

Chapter III Page 10 of 35

Chapter III Page 11 of 35

3.2. Government spending and taxation (Three Sector Model)

It is when the model of income determination is expanded to include government, aggregate

Chapter III Page 12 of 35

Fiscal Policy– including taxes and government purchases

Let; C+S+T= C+I+G

Form this we can find the saving-investment identity which is;

Where; T-G equals public saving

Investment is independent of income the equilibrium level of income is given by:-

Y= Ca+c(Y-T) + I+G……………… (1)

Chapter III Page 13 of 35

S+T= I+G………………………... (2)

If planned savings are equal to planned investment, then equilibrium is established by

This can be rearranged as;

Y = 1/1-c (Ca- cT+I+G)……… ……………… (3)

Y+ ∆Y = 1/1-c (Ca-cT+I+G) + 1/1-c ∆I

Subtracting Y from both sides of the equation, we have

∆Y = 1/1-c ∆I ………………………………. (4)

In the same way, we will find that

Chapter III Page 14 of 35

∆Y + ∆Y = 1 + -c = 1-c = 1 ……………… (10)

3.2.2 Fiscal Policy–Including gross taxes, government purchases and transfer