MACROECONOMICS

INCOME EXPENDITURE APPROACH

(PART I)

10/3/2019 1
 Lecture Outline
 Behavior of Consumption, Savings and
Investment
• The Consumption Function
• The Savings Function
• The Investment Function
 Equilibrium in a Two–sector Model
 Equilibrium in a Three–sector Model
 Changes in Equilibrium

10/3/2019 2
 Intended Learning Outcomes
• Identify the main macroeconomic variables
and aggregate expenditure function
• Identify the determinants of national income
in goods and services market

10/3/2019 3
 BEHAVIOR OF CONSUMPTION,
SAVINGS AND INVESTMENT
The Consumption Function
The term consumption function describes the
relationship between consumption and the current
disposable income.
Ct = C0 + cYt
Where:
Ct = Consumption at time t
CO = Autonomous consumption (Level of
consumption at zero level of income)

10/3/2019 4
 CONSUMPTION…..

Induced Consumption (Cy)

 The part of consumption that varies with income.

 It is indicated by cY.

10/3/2019 5
 CONSUMPTION…..

The Marginal Propensity to Consume (MPC)

 The change in consumption per unit change in

income.
 It is the slope of the consumption function.

or

Where:
Y = Income at time t

10/3/2019 6
 CONSUMPTION…..

Average Propensity to Consume (APC)

Total consumption expenditure divided by total income.

Where:

10/3/2019 7
 CONSUMPTION…..

Consumption Function
Consumption

dC
dY

CO

0 Real National Income (Y)

10/3/2019 8
 The Savings Function
 The savings function describes the relationship
between savings and current disposable income.

• In a two-sector economy

 The intercept of the savings function is the level of

savings at a zero level of income, (-CO).

10/3/2019 9
 SAVINGS…..

The Marginal Propensity to Save (MPS)

 MPS is the change in savings per unit change in

income.
 It is the slope of the savings function.

 In terms of calculus,

10/3/2019 10
 SAVINGS…..

The Average Propensity to Save (APS)

 It is the proportion of disposable income that

households want to save.
 In a two sector economy

10/3/2019 Deparment of Business Economics-2017 11

 SAVINGS…..

The Savings Function

Savings

dS

dY

-CO Disposable Income

10/3/2019 12
 Investment
 Investment is an autonomous variable.

I = I0

 No relationship between investment and income

10/3/2019 Department of Business Economics-2017 13

 Relationship between Consumption and Savings
14
APC + APS =1

MPC + MPS =1

10/3/2019 14
 Graphical Relationship between Consumption and
Saving
Y =C

Consumption
and Savings

CO

Income (Y)
-CO

10/3/2019 15
 EQUILIBRIUM IN A TWO-SECTOR
ECONOMY
(INCOME-EXPENDITURE APPROACH)
At equilibrium, income is equal to aggregate
expenditure (AE).
Y = AE
AE = C + I
Where: C = C o + cYand I = Io

AE = Co + cY + Io
AE = Ao + cY
Where: Ao = Co+ Io.
10/3/2019 16
 TWO-SECTOR ECONOMY…..

Equilibrium Condition:
AE = Y
Y = Ao+ cY
Y – cY = Ao
Y (1-c) = Ao

Equilibrium Income:

10/3/2019 17
 Equilibrium National Income in a Three
Sector Economy
 Introduce the government sector into the model

 New Components
• Government Expenditure (G)
• Government Taxes (Tx)
• Transfer Payments (Tr)

10/3/2019 18
 THREE SECTOR ECONOMY…..

National Income Identity in a Three

Sector Economy
AE = C + I + G
Where;
C = C0 + cYd (Consumption function)
Yd= Y– Tx + Tr (Disposable income)
G = G0 (Government expenditure)
Tx= T0 + tY (Government tax revenue)
Tr = Tr0 (Government transfers)

10/3/2019 19
 THREE SECTOR ECONOMY…..

Aggregate Expenditure Function of a

Three Sector Economy
 AE = C0 + c (Y - Tx + Tr0) + I0 + G0
 AE = C0 + c (Y - T0 - tY + Tr0) + I0 + G0
 AE = C0 + cY – cT0 – ctY + cTr0 + I0 + G0
 AE = C0 + I0 + G0 + c Tr0 - cT0 + cY - ctY

A0

 AE = A0 + cY - ctY
 AE = A0 + c( 1- t ) Y (Aggregate Expenditure
Function)

10/3/2019 20
 THREE SECTOR ECONOMY…..

Equilibrium National Income in a

Three Sector Economy
At Equilibrium, AE = Y

Where:

Equilibrium National Income:

Where:

10/3/2019 21
 THREE SECTOR ECONOMY…..

Equilibrium State of Three Sector Economy

AE

Y =AE
AE = A0 + c (1-t) Y
E

A0
45o
0 Income
Y*

10/3/2019 22
 CHANGES IN EQUILIBRIUM

 Changes in Autonomous Expenditure

 Changes in Induced Expenditure

10/3/2019 23
 CHANGES IN EQUILIBRIUM.....

Changes in Autonomous Expenditure

Change in C0, I0, G0, Tr0 and T0,

 Change the intercept of AE line

 Upward or downward parallel shift in the AE line

 Change the initial equilibrium

10/3/2019 24
 CHANGES IN EQUILIBRIUM - Change in A0…..

AE
AE = Y
E1 AE1= A10 + c(1-t)Y

AE = A0 + c(1-t)Y
A1 E0
ΔG0
A0

0 Y Y1 Income

10/3/2019 25
 CHANGES IN EQUILIBRIUM - Change in A0…..

AE = A0 + c( 1- t ) Y

AE = (C0 - cT0 + c Tr0 + I0 + G0) + c( 1- t ) Y

A0
If G0 changes, only the intercept changes, but not the
slope.
AE = (C0 - cT0 + c Tr0 + I0 + ΔG0 + G0) + c( 1- t )Y

A0
AE = (A0 + ΔG0 )+ c( 1- t ) Y

10/3/2019 26
 CHANGES IN EQUILIBRIUM - Change in A0…..

At equilibrium,
Y = AE
Y = (A0 + ΔG0) + c( 1- t ) Y

New equilibrium income,

10/3/2019 Department of Business Economics-2017 27

 CHANGES IN EQUILIBRIUM …..

Changes in Induced Expenditure

This will arise due to,

 Changes in Income Tax Rate (t)

 Changes in MPC (c)

10/3/2019 28
 CHANGES IN EQUILIBRIUM - Change in Induced Expenditure…..

A Change in Tax Rate

AE
Y = AE

E1 AE1 = A0 + c (1-t)1Y
AE = A0 + c (1-t)Y

E0

0
Y Y1 Income
10/3/2019 Department of Business Economics-2017 29
 CHANGES IN EQUILIBRIUM - Change in Induced Expenditure (Tax Rate)…..

A change in tax rate changes only the slope of the AE

line.
AE = A0 + c( 1- t ) Y (AE function)
AE = A0 + c( 1- t + Δt ) Y
At equilibrium, Y = AE
Y = A0 + c( 1- t + Δt) Y

New equilibrium income

10/3/2019 30
CHANGES IN EQUILIBRIUM - Change in Induced Expenditure…..

A Change in MPC
A change in MPC changes both the intercept and the
slope of the AE line.

AE
Y = AE
E2 AE1 = A01 + c (1-t)1Y
AE = A0 + c (1-t)Y

A01 E1
A0

Y Y1 National Income
10/3/2019 31
 CHANGES IN EQUILIBRIUM - Change in Induced Expenditure (MPC)…..

AE = A0 + c( 1- t ) Y (AE function)

If MPC (c) changes,

AE = C0+ c(Y –T0 – tY + Tr0) + I0 + G0

AE = C0 + (c+Δc)(Y - T0 – tY + Tr0) + I0 + G0
AE = C0 + (c+Δc)Y - (c+Δc)T0 - (c+Δc)tY + (c+Δc)Tr0 + I0 + G0

AE = [C0 - (c+Δc)T0 + (c+Δc)Tr0 + I0 + G0] +[(c+Δc)Y -(c+Δc)tY ]

Slope
A0 = intercept

10/3/2019 32
 CHANGES IN EQUILIBRIUM - Change in Induced Expenditure (MPC)…..

10/3/2019 Department of Business Economics-2017 33

 Injections and Withdrawal in a Three
Sector Economy
In a three-sector model, national income is either
consumed, saved or taxed by the government.
Y = C + S +Tx
Given AE = C + I + G
In equilibrium, Y = AE
C + S + Tx = C + I + G
 S + Tx = I + G

10/3/2019 34
10/3/2019 35