MACROECONOMICS

Chapter : 4

Income and Expenditure

 A Scenario
Imagine……….
• a home builder decides to spend an extra $100 on home construction
Direct effect……..
• Income of construction workers, material suppliers, electricians etc.
increases worth $100
Process doesn’t stop here……….
• Increase in households’ disposable income leads to rise in consumer
spending
• This, in turn, induces firms to increase output yet again
• This generates another rise in disposable income
• Which leads to another round of consumer spending increase
• So there are multiple round of increase in aggregate output
How large is the total effect on aggregate output (income) if we sum the
effect from all these rounds of spending increases?
To answer, study multiplier…………
 The Multiplier: An Informal Introduction
What is Multiplier?
The multiplier is the ratio of the total change in real GDP
caused by an autonomous change in aggregate spending to the
size of that autonomous change.
The Multiplier: An Informal Introduction
Marginal Propensity to Consume (MPC)
MPC is the increase in consumer spending when disposable
income rises by $1.

Marginal Propensity to Save (MPS)

MPS is the increase in household savings when disposable
income rises by $1.
MPS= 1 - MPC
 The Multiplier: An Informal Introduction
Increase in investment spending = $100 billion

+ Second-round increase in consumer spending = MPC × $100 b

+ Third-round increase in consumer spending = MPC2 × $100 b
+ Fourth-round increase in consumer spending = MPC3 × $100 b

Total increase in real GDP = (1 + MPC + MPC2 + MPC3 + . . .) × $100b

The Multiplier: An Informal Introduction
• So the $100 billion increase in investment spending sets off
a chain reaction in the economy .
• The net result of this chain reaction is that a $100 billion
increase in investment spending leads to a change in real
GDP
• i.e., a multiple of the size of that initial change in spending.

• How large is this multiple?

The Multiplier: Numerical Example
Rounds of Increase of Real GDP when MPC = 0.6
The Multiplier: Numerical Example

1/(1 − 0.6) × $100 billion

= 2.5 × $100 billion
= $250 billion

In the end, real GDP rises by $250 billion as a consequence of

the initial $100 billion rise in investment spending.
 Consumption Function
The consumption function is an equation showing how an
individual household’s consumer spending varies with the
household’s current disposable income.

C= consumption spending
yd= disposable income
MPC = marginal propensity to consume
a = constant term

MPC= slope of consumption function

The Consumption Function
The Consumption Function
• Deriving the slope of the consumption function
Aggregate Consumption Function
• The aggregate consumption function is the relationship for
the economy as a whole between aggregate current
disposable income and aggregate consumer spending.

Shifts in Aggregate Consumption Function

Causes:
• Changes in expected future disposable income
• Changes in aggregate wealth
Aggregate Consumption Function

The aggregate consumption function shifts in

response to changes in expected future
income and changes in aggregate wealth.
Aggregate Consumption Function
Aggregate Consumption Function
Investment Function
Classification of Investment Spending :
a) Planned b) Unplanned
• Planned investment spending is the investment spending that
businesses plan to undertake during a given period.
• It depends negatively on:
▪ interest rate
▪ existing production capacity
and positively on:
▪ expected future real GDP.
Accelerator Principle
• According to this principle, a higher expected future growth
rate in real GDP leads to higher planned investment spending.
• A lower expected future growth rate in real GDP leads to lower
planned investment spending.
Inventories and Unplanned Investment Spending

• Inventories are stocks of goods held to satisfy future sales.

• Inventory investment is the value of the change in total

inventories held in the economy during a given period.

• Unplanned inventory investment occurs when actual sales

are more or less than businesses expected, leading to
unplanned changes in inventories.
Inventories and Unplanned Investment Spending

• Actual investment spending is the sum of planned

investment spending and unplanned inventory investment.
Planned Aggregate Spending and GDP

GDP = C + I
YD = GDP
C = a + MPC × YD
I = I planned+ I unplanned

Planned aggregate spending is the total amount of planned

spending in the economy.

AEPlanned = C + Iplanned
 Planned Aggregate Spending and GDP
AEPlanned $4,000
consumer
spending
(billions
of dollars) 3,000
AE Planned
AEPlanned = C + IPlanned
CF
2,500

2,000

Planned
aggregate
spending is C = 300 + 0.6 ×YD
equal to
consumer 800
spending plus
Iplanned,
$500 billion. 300

0 $500 1,000 1,500 2,000 2,500 3,000 3,500 4,000

Real GDP (billions of dollars)
Income–Expenditure Equilibrium
• The economy is in income–expenditure equilibrium when
aggregate output, measured by real GDP, is equal to
planned aggregate spending.

GDP= AE Planned

• Income–expenditure equilibrium GDP is the level of real

GDP at which real GDP equals planned aggregate spending.
Income–Expenditure Equilibrium

If real GDP > AE Planned, then IUnplanned will be positive

If real GDP < AE Planned, then IUnplanned will be negative

Firms will act by increasing or decreasing production to

adjust.
• Positive unplanned inventory investment: there is
an unanticipated increase in inventories and firms
reduce production, leading to fall in real GDP
• Negative unplanned inventory investment: there is
an unanticipated reduction in inventories and firms
increase production, leading to rise in real GDP
 Income–Expenditure Equilibrium
Planned
aggregate $4,000 AEPlanned = GDP
45-degree line
spending,
AEPlanned
(billions of AE
dollars) 3,000 IUnplanned = $200 Planned

AEPlanned = C + IPlanned =
2,000 E
IUnplanned = –$400 A + MPC × GDP + IPlanned

1,400
The Keynesian cross is a diagram that
1,000 identifies income–expenditure
800 equilibrium as the point where a
planned aggregate spending line
crosses the 45-degree line.
0
$500 1,000 1,500 2,000 2,500 3,000 3,500 4,000
Y* Real GDP (billions of dollars)

IUnplanned is negative and GDP rises IUnplanned is positive and GDP falls
The Multiplier Process and Inventory Adjustment
 The Multiplier
$4,000
Planned AEPlanned after
aggregate autonomous AEPlanned
spending, change 2
AEPlanned
(billions of E2 AEPlanned
1
dollars) 3,000 IUnplanned = –$400

X AEPlanned before
2,400 autonomous change
2,000
E1

Autonomous
1,200
increase of
$400 in ΔY* = Multiplier × ΔAAEPlanned =
800
aggregate 1 / (1 – MPC) × ΔAAEPlanned
spending

0 $500 1,000 1,500 2,000 2,500 3,000 3,500 4,000

Y*1 Y*2 Real GDP
(billions of dollars)
The Paradox of Thrift

• In the paradox of thrift, households and producers

cut their spending in anticipation of future tough
economic times.

• These actions depress the economy, leaving

households and producers worse off than if they
hadn’t acted virtuously to prepare for tough times.

• It is called a paradox because what’s usually “good”

(saving to provide for your family in hard times) is
“bad” (because it can make everyone worse off).
The Paradox of Thrift