Macroeconomic Identities

Income and spending

Session 4
 Outline
• Consumption and savings

• Investment

• Aggregate expenditure

• Simple economy equilibrium

– Mathematical Analysis

– Graphical Analysis
Gross Current
Year
Domestic Market
price
value
 Why? To measure overall performance of the
economic activities

What? Value of final goods and services

Quantity X Price= Value of GDP2014 Quantity X Price = Value of GDP 2015

500 50 2500
500 X 30 1500
Units X Rs
= Rs
Units Rs = Rs
GDP in Real Terms and Nominal Terms
• GDP in Real Terms
It reflects only the physical value of goods and
services added to the economy during the
specified period of time

• GDP in Nominal Terms

It reflects both the physical value of goods and
services added to the economy and Price changes
experienced during the specified period of time
 GDP Deflator
• GDP in Real Terms
“GDP deflator can be used to measure “Inflation or
price changes”

GDP Deflator = Nominal GDP

Real GDP

Inflation Rate = GDP Deflator (t)

-1 X100%
GDP Deflator (t-1)
 • Assume in a hypothetical economy rice production in three
years has given where both production and prices have
increased during this time, while production technology has
remained without any change
Factor prices per one unit Cost of Production
of production (one kilo)
Factors of 2010 2011 2012 2011 2012
production 20 Kilo 25 Kilo 30 kilo 25 kilo 30 kilo
2010 2011 2012
2010 2011 2012 2010 2010
prices prices prices prices prices
Land 100 110 115.5
Labour 30 33 34.65
Capital 75 82.5 86.63
Entrepreneur 190 209 219.45
Depreciation 5 5.5 5.78
GDP
 Factor prices per one Cost of Production
unit of production (Rs.
one kilo)
Factors of 2010 2011 2012 2011 2012
production
20 Kilo 25 Kilo 30 kilo 25 kilo 30 kilo
2010 2011 2012
2010 2011 2012 2010 2010
prices prices prices prices prices

Land 100 110 115.5 2000 2750.00 3465.00

Labour 30 33 34.65 600 825.00 1039.50

Capital 75 82.5 86.63 1500 2062.50 2598.90

Entrepreneur 190 209 219.45 3800 5225.00 6583.50

Depreciation 5 5.5 5.78 100 137.50 173.40

GDP
 Factor prices per one Cost of Production
unit of production (Rs.
one kilo)
Factors of 2010 2011 2012 2011 2012
production
20 Kilo 25 Kilo 30 kilo 25 kilo 30 kilo
2010 2011 2012
2010 2011 2012 2010 2010
prices prices prices prices prices

Land 100 110 115.5 2000 2750.00 3465.00

Labour 30 33 34.65 600 825.00 1039.50

Capital 75 82.5 86.63 1500 2062.50 2598.90

Entrepreneur 190 209 219.45 3800 5225.00 6583.50

Depreciation 5 5.5 5.78 100 137.50 173.40

GDP 8000 11000 13860.3

 Factor prices per one Cost of Production
unit of production (Rs.
one kilo)
Factors of 2010 2011 2012 2011 2012
production
20 Kilo 25 Kilo 30 kilo 25 kilo 30 kilo
2010 2011 2012
2010 2011 2012 2010 2010
prices prices prices prices prices

Land 100 110 115.5 2000 2750.00 3465.00 2500 3000

Labour 30 33 34.65 600 825.00 1039.50 750 900

Capital 75 82.5 86.63 1500 2062.50 2598.90 1875 2250

Entrepreneur 190 209 219.45 3800 5225.00 6583.50 4750 5700

Depreciation 5 5.5 5.78 100 137.50 173.40 125 150

GDP 8000 11000 13860.3 10000 12000

 GDP Deflator
2010 2011 2012
Deflator= 1 1.1 1.16

Inflation = 10% 5.4%

 What is an identity?
• “Something which is true by mathematical definition
and this identity is hold because of the way the
variables are defined”
• GDP = C + I + G + NX
– C = consumption spending by households
– I = Investment spending by Business
– G = Government spending on goods and services
– NX = Net Export (Export – Import)
 Consumption Spending (C)
• Consumption is an act of using goods and services

• There are three sub-categories in consumption spending

• Consumption function explains the relationship between

consumption and disposable income

• Disposable Income in simple economy is equal to the

consumer income

• With government, the disposable income is consumer

income + Transfer payments – Direct tax
 Consumption function

C = C0 + c Yd
C = Consumption Spending by households

C0 = Autonomous Consumption

c = MPC = Marginal Propensity to Consume

Yd = Disposable income
 Autonomous consumption C0
• The term autonomous explains “a variable
which does not vary with another factor or
variable”
• Autonomous consumption refers to the
consumption which does not depend on
disposable income
• It is an independent value
 Autonomous consumption
• Assume you have recently become ill; and now you have to
consume more medicines even though your disposable income
does not changed

• OR you might be consuming more car maintenance service

because your car just broke down

• What ever the reason you are consuming more of various goods
and services even though your disposable income has not
changed at all
 Marginal Propensity to Consume (MPC) c
• It is the ratio of the change in consumption to the change in
disposable income

• c (MPC) = Change in consumption

Change in disposable income

• c (MPC) = ∆C
∆ Yd

• The Greek symbol delta (∆) stands for “Change in”

• MPC is depending on disposable income

Graphical Representation of Consumption
function

Disposable income
Average Propensity to Consume (APC)

“Proportion of consumption spent on income”

• APC = Consumption expenditure

Disposable Income

• APC = C0 + c Yd
Yd
 Savings function
• Consumers will not spend their total disposable income on
consumption

• They have savings which is disposable income not used for

consumption

• The relationship between savings and disposable income, when

every things remain the same is called the savings function

Yd - C = S

• Disposable income – Consumption = savings

 Marginal Propensity to Saving (MPS)
• S = - C0 + Yd ( 1- c)
• S = - C0 + Yd ( MPS)
– MPS = 1-c
– MPC = c
– MPS = 1 – MPC
– MPS + MPC = 1

Average Propensity to Saving (APS)

• APS = S / Yd
 Savings function
S = Yd - C
S = - C0 + Yd ( 1- C)
Example
1. Suppose that the consumption function is given by C = 150 +
0.8Y . Calculate savings function

2. Assume John’s Marginal Propensity to Consume (MPC) is 0.8.

He has to borrow a sum of Rs. 2000/= to be spent in order to
maintain his subsistence level. Illustrate John’s consumption
function and the savings function.
Graphical Representation of Savings
Function

S = - C0 + Yd ( 1- c)
1-c
∆S
∆Yd
 APC and APS
• APC = C / Y
• APS = S / Y
• When Y = C + S,
Divide both sides by Y
Y / Y = C / Y + S/Y
1 = APC + APS
And,
1 = MPC + MPS
 Problem 3
MPC = 0.8
MPC
C0 = 2000
C = C0 + c Yd
C = 2000 + 0.8 Yd

S = - C0 + (1-c) Yd
S = - 2000 + (1-0.8) Yd
S = -2000 + 0.2Yd
MPS
 Problem 4
Graphically illustrates the consumption and savings
function C= 2000 + 0.8Yd
C/S

S= -2000 + 0.2Yd
2000

Yd
-2000
 Problem5
• Calculate average propensity to consume
(APC) and average propensity to savings (APS)
C = 2000 + 0.8Yd
APC = C
Y
APC = 2000 + 0.8Yd
Yd
 Problem5
• Calculate average propensity to consume
(APC) and average propensity to savings (APS)
S = -2000 + 0.2Yd
APS = S
Y
APS = -2000 + 0.2Yd
Yd
Relationship between APC and APS
S = Yd – C
S + C = Yd
S + C = Yd
Yd Yd Yd
APS + APC = 1
 Investment
• Investment is autonomous which does not changed when
change in income
• Investment = I0
• In a simple two sector economy total income is spent on
consumption and savings
Y=C+S
And all the output either consumed or invested
AE = C + I
Where I = S
Relationship between consumption and
saving