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PAN African e-Network Project

Diploma in Business Management


Managerial Economics & Analysis
Semester - I
Session - 7

Ms. Tavishi

Macro Economics

Introduction to
Macroeconomics
Microeconomics examines the
behavior of individual decisionmaking unitsbusiness firms and
households.
Macroeconomics deals with the
economy as a whole; it examines the
behavior of economic aggregates
such as aggregate income,
consumption, investment, and the
overall level of prices.
Aggregate behavior refers to the
behavior of all households and firms
together.

Introduction to
Macroeconomics
Microeconomists generally
conclude that markets work
well. Macroeconomists,
however, observe that some
important prices often seem
sticky.
Sticky prices are prices
that do not always adjust
rapidly to maintain the
equality between quantity

Introduction to
Macroeconomics
Macroeconomists often
reflect on the
microeconomic principles
underlying macroeconomic
analysis, or the
microeconomic
foundations of
macroeconomics.

The Roots of
Macroeconomics
The Great
Depression was a
period of severe
economic contraction
and high
unemployment that
began in 1929 and
continued throughout
the 1930s.

The Roots of
Macroeconomics
Classical
economists
applied
microeconomic models, or market
clearing models, to economy-wide
problems.
However, simple classical models
failed to explain the prolonged
existence of high unemployment
during the Great Depression. This
provided
the
impetus
for
the
development of macroeconomics.

The Roots of
Macroeconomics
In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and
Money.
Keynes believed governments could intervene in
the economy and affect the level of output and
employment.
During periods of low private demand, the
government can stimulate aggregate demand to
lift the economy out of recession.

Recent Macroeconomic
History
Fine-tuning was the phrase used by
Walter Heller to refer to the
governments role in regulating
inflation and unemployment.
The use of Keynesian policy to finetune the economy in the 1960s, led
to disillusionment in the 1970s and
early 1980s.

1. Aggregate Output in the


Short Run
Potential output
the output the economy would produce
if all factors of production were fully
employed

Actual output
what is actually produced in a period
which may diverge from the potential
level

2. Initial Model
Prices and wages are fixed
At these prices, there are workers without a job
who would like to work and firms with spare
capacity they could profitably use
The actual quantity of total output is demanddetermined
this will be a Keynesian model
Government intervention to keep output close
to the potential output
For now, also assume:
no government
no foreign trade
Later topics relax these assumptions

3. Aggregate Demand
Given no government and no
international trade, aggregate demand
has two components:
Investment
firms desired or planned additions to physical
capital & inventories
for now, assume this is autonomous

Consumption
households demand for goods and services

so, AD = C + I

4. Consumption Demand
Households allocate their income
between CONSUMPTION and SAVING
Personal Disposable Income
income that households have for
spending or saving
income from their supply of factor
services (plus transfers less taxes)

Consumption and income in the


UK
at constant 1995 prices, 19891998

Income is a strong influence on consumption


expenditure but not the only one.

Consumption and Income in


Mauritius, current prices

5. The Consumption
Function
Consumption

The consumption function shows desired aggregate


consumption at each level of aggregate income

C = 8 + 0.7 Y

The marginal propensity


to consume (the slope of
the function) is 0.7 i.e.
for each additional 1 of
income, 70p is consumed.

With zero income,


desired consumption
is 8 (autonomous
consumption).

Income

5. Saving Function
Saving is income not consumed.
When income is zero, saving is -A
Since a fraction c of each extra
pound is consumed , a fraction of 1
c of income is saved
MPC + MPS = 1
S = -A + (1-C)Y

5. Saving Function
Saving

The saving function shows


desired saving at each
income level.

S = -8 + 0.3 Y

Income

Since all income is either


saved or spent on
consumption, the saving
function can be derived
from the consumption
function or vice versa.

6. Aggregate Demand
In the simple model, aggregate
demand is simply consumption
demand plus investment demand
AD: add I to the previous
consumption function
The slope of AD is the MPC

Aggregate demand

7. The Aggregate Demand


Schedule
AD = C + I

Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)

Income

8. Equilibrium Output:

output

expenditure approach

Wages and prices are fixed in the


model
AD < Potential Output, then firm
cannot sell as much as they would
like
Involuntary excess capacity and
involuntary unemployment

Desired spending

8. Equilibrium Output
45o line
E

AD

The 45o line shows the


points at which desired
spending equals output
or income.
Given the AD schedule,
equilibrium is thus at E.
This the point at which
planned spending equals
actual output and income.

Output, Income

Desired spending

8. Adjustment towards
Equilibrium
Suppose the economy
begins with a lower
output, AD > Y

45o line
E

AD
If firms have stock, they
can sell more by
unplanned

B
C

No stock, they must turn


away customers

Output, Income

Either way, the firm


should increase outputs

9. An Alternative
Approach
S, I

An equivalent view of
equilibrium is seen by
equating
S
planned investment (I)
E

I
to planned saving (S)

Output, Income

again giving us
equilibrium at E

The two approaches are equivalent.

10.

Effects of a Fall in Aggregate

Demand

autonomous consumption or investment


Desired spending

45o line AD
0
AD1

Suppose the economy


starts in equilibrium
at Y0.
a fall in aggregate
demand to AD1
Leads the economy
to a new equilibrium
at Y1.

Y1

Y0

Output, Income
Notice that the change in equilibrium output is
larger than the original change in AD.

10. Effects of a Fall in Aggregate


Demand a change in MPC
Desired spending

45o line AD
0

AD1

Suppose the economy


starts in equilibrium
at Y0.
There is a change in
MPC
Leads the economy
to a new equilibrium
at Y1.

Y1

Y0
Output, Income

11. The Multiplier


The multiplier is the ratio of the change in
equilibrium output to the change in autonomous
spending that causes the change in output.
It tells us how much output change after a shift in
demand; K = Y/ AD
K = 1/ (1- MPC) = 1/MPS
The larger the marginal propensity to consume,
the larger is the multiplier.
The higher is the marginal propensity to save, the more
of each extra unit of income leaks out of the circular
flow.

11. The Paradox of


Thrift
Earlier, we analyse a shift in AD caused by
changed in autonomous investment
Now consider a parallel shift in the AD schedule
caused by a change in autonomous part of
planned consumption and savings
An autonomous consumption increase of 10 will
cause an upward shift in AD
This is equivalent to a fall in autonomous saving,
thus a parallel downward shift in saving function

11. The Paradox of


Thrift
In equilibrium, planned saving equals planned
investment and the latter is unaltered.
Thus, planned saving cannot change
S

Y*

In equilibrium,
planned saving = planned
investment; A fall (rise) in
desire to save induces
a rise (fall) in output to
keep planned saving equal
to planned investment

11. The Paradox of


Thrift
A change in the amount households wish to save
of each levels of income leads to a change in
equilibrium income, but no change in equilibrium
saving, which must equal planned investment.
This is the paradox of thrift
If all households decide to increase saving, this
will lead to a fall in AD, employment, income but
no rise in saving

Three-Sector Model
With the introduction of the
government sector (i.e. together with
households C, firms I), aggregate
expenditure E consists of one more
component, government expenditure
G.
E=C+I+G
Still, the equilibrium condition is
Planned Y = Planned E

Three-Sector Model
Consumption function is positively
related to disposable income Yd
C = f(Yd)
C= C
C= cYd
C= C + cYd

Three-Sector Model
National Income Personal Income
Disposable Personal Income
w/ direct income tax Ta and transfer
payment Tr
Yd Y
Yd = Y - Ta + Tr

Three-Sector Model
Transfer payment Tr can be treated as
negative tax, T is defined as direct
income tax Ta net of transfer payment
Tr
T = Ta - Tr
Yd = Y - (Ta - Tr)
Yd = Y - T

Tax Function
Autonomous Tax T
this is a lump-sum tax which is independent
of income level Y

Proportional Income Tax tY


marginal tax rate t is a constant

Progressive Income Tax tY


marginal tax rate t increases

Regressive Income Tax tY


marginal tax rate t decreases

Consumption Function
C = f(Yd)
C = C
C = C
C = cYd
C = c(Y - T)
C = C + cYd
C = C + c(Y - T)

T = T

Consumption Function
C = C + c(Y - T)

C = C + c(Y - T) C = C- cT + cY
slope of tangent = c
T = tY
C = C + c(Y - tY) C = C + (c - ct)Y
slope of tangent = c - ct
T = T + tY
C = C+c[Y-(T+tY)]C = C - cT + (c - ct) Y
slope of tangent = c - ct

Consumption Function
C = C + c (Y - T)
Y-intercept = C - cT
slope of tangent = c = MPC
slope of ray APC when Y

Consumption Function
C = C + c (Y - tY)
Y-intercept = C
slope of tangent = c - ct = MPC (1-t)
slope of ray APC when Y

Consumption Function
C = C + c [Y - (T + tY)]
Y-intercept = C -cT
slope of tangent = c - ct = MPC (1-t)
slope of ray APC when Y

Consumption Function
C = C - cT + (c - ct)Y
C OR T
y-intercept C - cT C shift
upward
t
c(1-t) C flatter
c
c(1-t) C steeper
y-intercept C - cT C shift
downward

Government Expenditure Function


G only includes the part of
government expenditure spending on
goods and services, i.e. transfer
payments Tr are excluded.
Usually, G is assumed to be an
exogenous / autonomous function
G = G

Government Expenditure Function


Y-intercept = G
slope of tangent = 0
slope of ray when Y

Aggregate Expenditure
Function
E =C+I+G
given C = C + cYd
T = T + tY
I = I
G = G
E = C + c[Y - (T+tY)] + I + G
E = C - cT + I+ G + (c-ct)Y
E = E + c(1-t) Y

Aggregate Expenditure
Function
E = C - cT + I + G + (c - ct)Y
E = E + (c - ct)Y
given E = C - cT + I + G
E is the y-intercept of the aggregate
expenditure function E
c - ct is the slope of the aggregate
expenditure function E

Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T
E = C - cT + I + G + cY
y-intercept = C - cT + I + G
slope of tangent = c

Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = tY
E = C + I + G + (c-ct)Y
y-intercept = C + I + G
slope of tangent = (c-ct)

Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T and I = I + iY
E = C - cT + I + G + (c + i)Y
y-intercept = C - cT + I + G
slope of tangent = (c + i)

Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = tY and I = I +iY
E = C + I + G + (c - ct +i )Y
y-intercept = C + I + G
slope of tangent = (c - ct +i )

Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T + tY and I = I
+iY
E = C - cT + I + G + (c - ct +i)Y
y-intercept = C - cT + I + G
slope of tangent = (c - ct +i)

Output-Expenditure Approach
w/ T = T + tY
w/ C = C + cYd
C

2-Sector

C = C + cYd = C + cY

Slope of tangent = c = MPC =C/Yd

Slope of tangent = c (1-t) = (1-t)*MPC MPC


3-Sector
C

C = C - cT + c(1-t)Y

C -cT
Y

I, G, C, E, Y

Y=E

Y
Planned Y = Planned E

Output-Expenditure Approach
I = I exogenous function

E = E + (c - ct) Y [slide 21-22]


In equilibrium, planned Y = planned E
Y = E + (c - ct) Y
(1- c + ct) Y = E
Y = E 1
1 - c + ct

E = C - cT + I + G
kE=
1
1 - c + ct

Output-Expenditure Approach
I= I+iY endogenous function

E = E + (c - ct + i) Y [slide 27]
In equilibrium, planned Y = planned E
Y = E + (c - ct + i) Y
(1- c + ct - i) Y = E
Y = E
1

1 - c - i + ct

E = C - cT + I + G
kE=

1
1 - c - i + ct

Output-Expenditure Approach
T = T exogenous function
I = I + iY

E = E + (c + i) Y [slide 25]
In equilibrium, planned Y = planned E
Y = E + (c + i) Y
(1 - c - i) Y = E
Y = E
1

1-c-i

E = C - cT + I + G
kE=

1
1-c-i

Factors affecting Ye
Ye = k E * E
In the Keynesian model, aggregate
expenditure E is the determinant of Ye
since AS is horizontal and price is rigid.
In equilibrium, planned Y = planned E
E = C - cT + I + G + (c - ct + i) Y
Any change to the exogenous variables
will cause the aggregate expenditure
function to change and hence Ye

Factors affecting Ye
Change in E
If C I G E E Y
If T C - c T E by - c TE Y

Change in k E / slope of tangent of E


If c i E steeper Y
If c C - c T E E Y
If t E steeper Y

Y=E

I, G, C, E, Y

I, E, Y I

E = I

I
Y
Ye = k E E

G
G, E, Y

C
C, E, Y

T
C, E, Y

C by -cT

i
I, E, Y

Digression

Differentiation
y = c + mx
differentiate y with respect to x
dy/dx = m

Expenditure Multiplier k
Y=k
kE=
k
k

=
=

* E
1

E = C - cT + I + G
if I=I & T=T+tY

1 - c + ct
1

if I=I+iY & T=T+tY

1 - c + ct - i

1
1-c-i

if I=I+iY & T=T

Expenditure Multiplier k

Whenever there is a change in the


autonomous spending C I or G the
national income Ye will change by a
multiple of k E.
It actually measures the ratio of the
change in national income Ye to the
change in the autonomous
expenditure E
Ye/E = k E

Tax Multiplier k T
Y=k
kT =
k
k

=
=

* ( C - cT + I + G)
-c
if I=I & T=T+tY

1 - c + ct
-c

if I=I+iY & T=T+tY

1 - c + ct + i

-c
1-c-i

if I=I+iY & T=T

Tax Multiplier k T
Any change in the lump-sum tax T
will lead to a change in the national
income Ye by a multiple of k T in the
opposite direction since k T takes on
a negative value
Besides, the absolute value of k T is
less than the value of k E.

Balanced-Budget Multiplier
kB
G E E Ye by k E times
T E E Ye by k T times
If G = T , the change in Ye can be
measured by k B
Y/ G = k E
Y/ T = k T
kB=kE+kT
kB= + =1
1

-c

1-c

1-c

Balanced-Budget Multiplier
kB

The balanced-budget multiplier k B =


1 when t=0 & i=0
What is the value of k B if t 0 ?
If k B = 1 an increase in government
expenditure of $1 which is financed
by a $1 increase in the lump-sum
income tax, the national income Ye
will also increase by $1

Injection-Withdrawal
Approach
In a 3-sector model, national income
is either consumed, saved or taxed
by the government
Y=C+S+T
Given E = C + I + G
In equilibrium, Y = E
C+S+T=C+I+G
S+T=I+G

Injection-Withdrawal
Approach

Since S + T = I + G
SI
TG
I>ST>G
I<ST<G
(Compare with 2-sector model)
In equilibrium S = I

Injection-Withdrawal
Approach

T = T + tY
S = -C + (1-c) Yd
S = -C + (1 - c)[Y -_(T + tY)]
S=
S=
S=
S=
ctY

-C
-C
-C
-C

+
+
+
+

(1 - c)[Y - T - tY]
Y - T - tY - cY + cT + ctY
cT -T - tY + Y - cY + ctY
cT - (T + tY) + Y - cY +

Injection-Withdrawal
Approach
S + T = -C + cT -(T+ tY) + Y - cY + ctY
+T
S + T = -C + cT + Y - cY + ctY
In equilibrium, S + T = I + G
-C + cT + Y - cY + ctY = I + G
(1- c + ct)Y = C - cT + I + G
Ye = k E * E
E = C - cT + I + G
[slide 30]

Use the Injection-Withdrawal


Approach to solve for Ye if T=T

Fiscal Policy
The use of government expenditure and
taxation to achieve certain goals, such as
high employment, price stability.
Discretionary Fiscal Policy
Expansionary Fiscal Policy (when Yf > Ye)
Contractionary Fiscal Policy (when Yf < Ye)

Automatic Built-in Stabilizers


Proportional / Progressive Tax System
Welfare Schemes

Expansionary Fiscal Policy


Recessionary/Deflationary Gap Yf-Ye
Y-line

G E E Y

E=

E + (c-ct) Y

E = E + (c -ct) Y
G

Y= k E * E

Recessionary Gap

Ye

Yf

Expansionary Fiscal Policy


Recessionary/Deflationary Gap Yf-Ye
T E by -c T E Y

Y-line
E=

E + (c-ct) Y

E = E + (c -ct) Y

-cT

Y= k E * E = k T * T

Recessionary Gap

Ye

Yf

Contractionary Fiscal Policy


Inflationary Gap Ye - Yf
Y=E
G E E Y
E = E + (c-ct) Y

E=

E + (c-ct) Y

Y= k E * E
Yf

Ye

Nominal Y>Yf Inflationary Gap

Contractionary Fiscal Policy


Inflationary Gap Ye - Yf
Y=E
T E by -c T E Y
E = E + (c-ct) Y

E=

-cT

E + (c-ct) Y

Y= k E * E = k T * T
Yf

Ye

Nominal Y>Yf Inflationary Gap

Automatic Built-in
Stabilizers
Proportional /Progressive Tax System
Recession: governments tax revenue
Boom: governments tax revenue

The more progressive the tax system, the


greater is its stabilizing effect. But there will
be greater dis-incentives to earn income
With t, k E With proportional tax, the
multiplying effect of a discretionary change
in government expenditure G reduces

Automatic Built-in
Stabilizers
Welfare Schemes
Unemployment benefits, public
assistance allowances, agricultural
support schemes
Recession: governments expenditure
Boom: governments expenditure

Again, if the welfare schemes are


generous, the incentives to work will
be weakened.

Discretionary Fiscal Policy v.s.


Automatic Built-in Stabilizers
If the economy is close to Yf, built-in stabilizers
are useful as they can stabilize the economy
around Yf or potential income level.
However, if the economy is far below Yf,
discretionary fiscal policy is still necessary
(Simple Keynesian model).
Another drawback of the built-in stabilizers is
they may reduce the speed of recovery as
k E Y = k E * E

Discretionary Fiscal Policy


Government expenditure G? Tax
T?
Location of effects
If a recession is localized in a
particular industry G
Tax cut will have its impact on the
entire economy

Discretionary Fiscal Policy


Government expenditure G? Tax T?
Duration of the time lag
Decision lag : time involved to assess a
situation & decide what corrective actions
should be taken
Executive lag : time involved to initiate
corrective policies & for their full impact to
be felt

tax cut has a much shorter executive


lag

Discretionary Fiscal Policy


Government expenditure G? Tax T?
Reversibility of the fiscal policy
Government expenditure can easily be increased
but are not so easy to cut as the civil servants who
have vested interests in the present allocation of
government expenditure will resist
Tax is easier to be changed as the civil servants
who administer income tax is independent of the
rate being levied. Of course, voter resistance
should also be considered.

Discretionary Fiscal Policy


Government expenditure G? Tax
T?
Public reaction to short-term changes
A temporary tax cut raises Yd.
Households, recognizing this situation,
may not revise their current
consumption. Instead, they save a
large part of the tax cut.

Financing the Government Budget


Increasing Taxes
By increasing taxes, the government transfers
purchasing power from current taxpayers to
itself
Current taxpayers bear the cost
If the revenue is spent on some investment
project, (current / future) taxpayers may
benefit when the project is completed.
How about the revenue is spent on transfer
payment?

Financing the Government Budget


Printing more Money
This will create inflationary pressure.
Households and firms will be able to
buy less with each unit of money. Fewer
resources are available for private
consumption and investment.
Those whose incomes respond slowly to
changes in price levels will bear most of
the cost of the government activity

Financing the Government Budget


Internal Debt
The government can transfer purchasing
power from any willing lenders to itself in
return for the promise to repay equivalent
purchasing power plus interest in future.
Since, repayment of the debt are made from
tax revenue, future taxpayers will suffer.
However, if the debt raised today is spent on
creating capital assets, the burden on future
generation will be lighter.

Financing the Government Budget


External Debt

Borrowing from abroad transfers


purchasing power from foreigners to
the government.
The burden on future generations will
once again depend on how the debt
raised is used (investment project /
transfer payment)

The Problems of the Simple


Keynesian Multiplier k E
Y = k E * G
There are several problems with this
method of analysis, i.e., Y may be
less
Sources of financing G
Effects on private investment I
Productivity of government projects

The Problems of the Simple


Keynesian Multiplier k E
Sources of financing G
Increasing Tax
will exert a contractionary effect on the economy

Increasing Money Supply


will generate an inflationary pressure

Increasing Debt
will increase the demand for loanable fund as
well as interest rate affect private investment

The Problems of the Simple


Keynesian Multiplier k E
Effects on Private Investment I
Private investment may be crowded out
when government increases its expenditure
It is questionable that the government can
really produce something which is desired by
the consumers
Besides, government investment projects
are usually less productive than private
investment projects

The Problems of the Simple


Keynesian Multiplier k E
Productivity of Government Projects
Government projects may not yield a
rate of return (MEC / MEI) exceeding
the market interest rate.

Thank You
Please forward your query
To: tavishie@amity.edu