Macroeconomics & The Global Economy

Session 4: National Income-where it comes

and where it goes?(Contd....)
Demand for goods & services
Components of aggregate demand:
C = consumer demand for goods & services
I = demand for investment goods
G = government demand for goods &
services
(closed economy: no NX )
 Consumption, C
• def: disposable income is total income minus total
taxes: Y – T
• Consumption function: C = C (Y – T )
Shows that (Y – T )  C
• def: The marginal propensity to consume is the
increase in C caused by a one-unit increase in disposable
income.
• Meaning: If MPC is 99%, then
• 1 unit (Y  T ) will cause 0.99 unit C
• MPC = C / (Y  T )
Or, C = MPC (Y  T )
 The consumption function
C

C ( Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T
 Investment, I
• Investment: firms + households
(Eg. Addition to stock of capital + new houses)
• Depends upon interest rate: cost of borrowing funds
to finance investment spending.
• Interest rates:
borrowing and lending
(since both interest rates work together, we assume
an average interest rate for simplicity)
 Investment, I
• Nominal interest rate: Interest rate in market value
• Real Interest rate: Interest rate in terms of
purchasing power (nominal interest rate corrected
for inflation)
• The true cost of borrowing is the real interest rate
not the nominal interest rate. Why?
Since, r  I
• The investment function is I = I (r ),
where r denotes the real interest rate
 The investment function
r
Spending on
investment goods
is a downward-
sloping function of
the real interest rate

I (r )

I
 Government spending, G
• G includes government spending on goods
and services raised by Tax revenue
• Classical theory assumes that government
spending and total taxes are exogenous:

G G and T T
 Budget surplus and deficit
• When T > G ,
budget surplus = (T – G )> 0 and public saving is
positive.
• When T < G ,
budget deficit = (T –G ) < 0
and public saving is negative.
• When T = G ,
budget is balanced and public saving = 0.
Equilibrium in the market for goods & services

 Agg. demand: C (Y  T )  I (r )  G

 Agg. supply: Y  F (K , L )

 Equilibrium: Y = C (Y  T )  I (r )  G
The
The real
real interest
interest rate
rate adjusts
adjusts
to
to equate
equate demand
demand with with supply
supply in
in the
the goods
goods
market.
market.
Equilibrium in the Financial Market: The
loanable funds market
A simple supply-demand model of
the financial system.
One asset: “loanable funds”
demand for funds: investment demands
supply of funds: savings (Public + Private)
 Supply of the fund: Saving
• private saving = (Y –T ) – C
• public saving = T –G
• national saving or Saving, S
= private saving + public saving
= (Y –T ) – C + T – G
S= Y – C – G
We know, Y = C + I + G such that S = C + I + G – C –G
S=I
(equilibrium condition goods market relating to
financial market)
Rewriting, S  Y  C (Y  T )  G = I (r )
 Loanable funds market equilibrium
r S  Y  C (Y  T )  G

National saving
does not
depend on r,
Equilibrium real so the supply
interest rate, r curve is
vertical.
I (r )
Equilibrium level S, I
of investment
 Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
An Increase in Government Purchases (G) by DG :

• Total demand for goods and services

• General price level and demand for money
(Since Total Output ( Supply) is fixed)
• Govt. spends more money from its savings.
• Savings
• Interest rate (Banks have less money for public)
• Investment level
Thus, government purchases are said to crowd out
investment
 The Crowd-out effect
1. The increase in the r S1
deficit reduces saving… S2

r2
2. …which causes the real
interest rate to rise…
r1

3. …which reduces the I (r )

level of investment.
I2 I1 S, I
 Macroeconomic Assumption on
Consumption and Saving
• Disposable income (Y-T) has two functions:
Consumption and Savings
• (Y  T ) = C + S
• (Y  T ) = C + S

• For any given amount of (Y  T),

Increase in ‘C’ leads to decrease in ‘S’

 Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
A Decrease in Taxes:
• Disposable (Y-T) income
• Consumption (C)
• Saving decreases

• Interest rate (r)

• Investment (I)
Like an increase in government purchases, tax cuts
crowd out investment and raise the interest rate.
 Two reasons: Technological changes and Tax Policy
Real An increase in the demand for
interest Saving, S investment goods shifts the investment
rate, r schedule to the right. At any given
interest rate, the amount of investment
is greater. The equilibrium moves
from A to B. Because the amount
B of saving is fixed, the increase in
investment demand raises
A the interest rate while leaving
I2 the equilibrium
I1 amount of investment
unchanged.
S Investment, Saving, I, S

But, what if interest rates are even higher?

 S(r)
Real
interest
rate, r

The higher Upward

Upward sloping
sloping savings
savings
interest rate
induces people
to decrease
consumption
and increase B
I2
saving, which A
I1
in turn allows
investment to Investment, Saving, I, S
increase.

When saving is positively related to the interest rate, it results in the

upward-sloping S(r) curve.
A rightward shift in the investment schedule I(r)
increases the interest rate (r) and the amount of investment (I).
Numerical Exercise
Consider an economy described by the following equations:
Y=C+I+G
Y = 5,000
G = 1,000
T = 1,000,
C = 250 + 0.75(Y − T)
I = 1,000 − 50r. Note: r is in %
a. In this economy, compute private saving, public saving and
national saving.
b. Find the equilibrium interest rate.
c. Now suppose that G rises to 1,250. Compute private saving,
public saving, and national saving.
d. Find the new equilibrium interest rate
Solution to Numerical Exercise
a) Private Saving = Y – T – C =
= 5,000 – 1,000 – (250 + 0.75(5,000 – 1,000)) = 750.
Public Saving = T – G = 1,000 – 1,000 = 0
S = S(private) + S(public) = 750 + 0 = 750.
b) S = I
750 = 1,000 – 50r. Therefore, r = 5%.
c) S(private) = 750 and S(public) = T – G = 1,000 – 1,250 = –250.
Thus, S = S(private) + S(public) = 750 + (–250) = 500.

d) S = I
500 = 1,000 – 50r. Therefore, r = 10%.
Thank You