Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-14

1
Discussion Points

1. Income-Expenditure Model

2. Equilibrium Income
3. Consumption Function

4. Multiplier
 The Income-Expenditure Model

➢ The income-expenditure model was originally

developed by the economist John Maynard
Keynes in the 1930s and later extended and
refined by many economists.
➢ The model is based on the idea that higher
expenditures are necessary to generate higher
levels of income in the economy.
➢ The model is useful for understanding
economic fluctuations in the very short-run
when prices do not change very much.
Great Depression
From 1929–1933

• Y fell by 26%

• P fell by 22%

• Unemployment rate rose from 3% to

25%
 The Income-Expenditure Model
aggregate output: The total quantity of goods and services produced (or
supplied) in an economy in a given period.

aggregate income: The total income received by all factors of production

in a given period.

In any given period, there is an exact equality between aggregate output

(production) and aggregate income. You should be reminded of this fact
whenever you encounter the combined term aggregate output (income)
(Y).

aggregate output (income) (Y) A combined term used to remind you of

the exact equality between aggregate output and aggregate income.

Also, we are taking as fixed for purposes of current discussion the

interest rate (r) and the overall price level (P).
A Simple Income-Expenditure Model

At any point on the 45E

line, the distance to the
horizontal axis is the same
as the distance to the
vertical axis.
Equilibrium Output

At equilibrium output
y*, output equals
planned expenditures,
C + I.
Adjustment to Equilibrium Output

If output were higher (y1), it

would exceed demand and
production would fall.
If output were lower (y2), it
would fall short of demand
and production would rise.

Table 11.1 Adjustments to Equilibrium Output

C+I Production Inventories Direction of Output
100 80 Depletion of inventories of 20 Output increases
100 120 Excess of inventories of 20 Output decreases
100 100 No change Output stays constant
The Keynesian Theory of Consumption

We all recognize that for consumption as a whole, as well as

for consumption of most specific categories of goods and
services, consumption rises with income.

While Keynes recognized that many factors, including wealth

and interest rates, play a role in determining consumption
levels in the economy, in his classic The General Theory of
Employment, Interest, and Money, current income played the
key role.

This simple observation plays a large role in helping us

understand the workings of the aggregate economy.
The Keynesian Theory of Consumption

consumption function: The relationship between consumption and

income.

A Consumption Function for a

Household
A consumption function
for an individual
household shows the
level of consumption at
each level of household
income.
The Keynesian Theory of Consumption

To explain aggregate spending behavior, economists

speculate that an increase in aggregate income in a given
period will result in an increase in aggregate consumption in
all of the following instances, except:
a. When household wealth increases.
b. When interest rates rise.
c. When households form positive expectations about the
future.
d. None of the above. In all of the cases above, aggregate
consumption will rise.
The Keynesian Theory of Consumption

To explain aggregate spending behavior, economists

speculate that an increase in aggregate income in a given
period will result in an increase in aggregate consumption in
all of the following instances, except:
a. When household wealth increases.
b. When interest rates rise.
c. When households form positive expectations about the
future.
d. None of the above. In all of the cases above, aggregate
consumption will rise.
The Keynesian Theory of Consumption
With a straight line consumption curve, we can use the following
equation to describe the curve:
C = a + bY

An Aggregate Consumption
Function
The aggregate consumption
function shows the level of
aggregate consumption at
each level of aggregate
income.
The upward slope indicates
that higher levels of income
lead to higher levels of
consumption spending.
The Keynesian Theory of Consumption
marginal propensity to consume (MPC)- That fraction of a change in
income that is consumed, or spent.

C
marginal propensity to consume  slope of consumption function 
Y

aggregate saving (S)- The part of aggregate income that is not

consumed.

S≡Y–C

The triple equal sign means that this equation is an identity, or something
that is always true by definition.

Identity- Something that is always true.

The Keynesian Theory of Consumption

When aggregate consumption is plotted along a straight line,

C = a + bY, an increase in income results in an increase in
consumption equal to:
a. b.
b. b times ΔY.
c. a times ΔY.
d. a + b.
The Keynesian Theory of Consumption

When aggregate consumption is plotted along a straight line,

C = a + bY, an increase in income results in an increase in
consumption equal to:
a. b.
b. b times ΔY.
c. a times ΔY.
d. a + b.
The Keynesian Theory of Consumption
marginal propensity to save (MPS)- That fraction of a change in income
that is saved.

MPC + MPS ≡ 1

Because the MPC and the MPS are important concepts, it may help to
review their definitions.

The marginal propensity to consume (MPC) is the fraction of an increase

in income that is consumed (or the fraction of a decrease in income that
comes out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in

income that is saved (or the fraction of a decrease in income that comes
out of saving).
The Consumption Function

The consumption function shows the

relationship between desired
spending and the level of income.
C = Ca + by
Ca = autonomous consumption, does
not depend on the level of income.
by = the part of consumption that is
dependent on income:
b = marginal propensity to consume
(MPC), or the fraction of additional
income that is spent.
y = level of income in the economy.
Changes in the Consumption Function

An increase in autonomous An increase in the MPC from b to b’

consumption from C0a to C1a increases the slope of the consumption
shifts up the entire function.
consumption function.
Changes in the Consumption Function
Factors that cause autonomous consumption to change
are:
Increases in consumer wealth.
Nobel Laureate Franco Modigliani found that consumer
wealth, or the value of stocks, bonds, and consumer
durables held by the public, will lead to increases in
autonomous consumption.
Increases in consumer confidence.
Changes in consumer confidence affect consumer
spending.
The Keynesian Theory of Consumption
The Aggregate Consumption
Function Derived from the Equation
C = 100 + .75Y
In this simple consumption
function, consumption is 100
at an income of zero.
As income rises, so does
consumption.
For every 100 increase in
income, consumption rises by
75.
The slope of the line is .75.

Aggregate Aggregate
Income, Y Consumption, C

0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850
The Keynesian Theory of Consumption
Deriving the Saving Function from the
Consumption Function
Because S ≡ Y – C, it is easy to derive
the saving function from the
consumption function.
A 45° line drawn from the origin can be
used as a convenient tool to compare
consumption and income graphically.
At Y = 200, consumption is 250.
The 45° line shows us that consumption
is larger than income by 50.
Thus, S ≡ Y – C = −50.
At Y = 800, consumption is less than
income by 100.
Thus, S = 100 when Y = 800.
Y − C = S
AGGREGATE AGGREGATE AGGREGATE
INCOME CONSUMPTION SAVING

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
The Keynesian Theory of Consumption

Fill in the blanks. Where the consumption function is below

the 45° line, consumption is ________ than income, and
saving is ________.
a. more; positive
b. more; negative
c. less; positive
d. less; negative
The Keynesian Theory of Consumption

Fill in the blanks. Where the consumption function is below

the 45° line, consumption is ________ than income, and
saving is ________.
a. more; positive
b. more; negative
c. less; positive
d. less; negative
Other Determinants of Consumption

The assumption that consumption depends only on income is obviously

a simplification.

In practice, the decisions of households on how much to consume in a

given period are also affected by their wealth, by the interest rate, and by
their expectations of the future.

Households with higher wealth are likely to spend more, other things
being equal, than households with less wealth.

Lower interest rates are likely to stimulate spending.

If households are optimistic and expect to do better in the future,

they may spend more at present than if they think the future will be
bleak.
Planned Investment (I) versus Actual Investment

A firm’s inventory is the stock of goods that it has awaiting sale.

planned investment (I) Those additions to capital stock and

inventory that are planned by firms.

actual investment The actual amount of investment that takes

place; it includes items such as unplanned changes in inventories.

If a firm overestimates how much it will sell in a period, it will end up with
more in inventory than it planned to have.

We will use I to refer to planned investment, not necessarily actual

investment.
Planned Investment and the Interest Rate (r)

Increasing the interest rate, ceteris paribus, is likely to reduce the level of
planned investment spending. When the interest rate falls, it becomes
less costly to borrow and more investment projects are likely to be
undertaken.
Planned Investment Schedule

Planned investment
spending is a negative
function of the interest rate.
An increase in the interest
rate from 3 percent to 6
percent reduces planned
investment from I0 to I1.
Other Determinants of Planned Investment

The decision of a firm on how much to invest depends on, among other
things, its expectation of future sales.

The optimism or pessimism of entrepreneurs about the future course of

the economy can have an important effect on current planned investment.
Keynes used the phrase animal spirits to describe the feelings of
entrepreneurs.

For now, we will assume that planned investment simply depends on the
interest rate.
Equilibrium Output and the Consumption Function

Equilibrium output is
determined where the C + I line
intersects the 45E line. At that
level of output, y*, desired
spending equals output.
The Determination of Equilibrium Output (Income)

Equilibrium- Occurs when there is no tendency for change.

In the macroeconomic goods market, equilibrium occurs when planned
aggregate expenditure is equal to aggregate output.

planned aggregate expenditure (AE)- The total amount the economy

plans to spend in a given period. Equal to consumption plus planned
investment:

AE ≡ C + I.

Because AE is, by definition, C + I, equilibrium can also be written:

Equilibrium: Y = C + I
Y>C+I
aggregate output > planned aggregate expenditure

C+I>Y
planned aggregate expenditure > aggregate output
Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. The
Figures in Column 2 Are Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
Planned Unplanned
Aggregate Aggregate Inventory
Output Aggregate Planned Expenditure (AE) Change Equilibrium?
(Income) (Y) Consumption (C) Investment (I) C+I Y − (C + I) (Y = AE?)

100 175 25 200 − 100 No

200 250 25 275 − 75 No
400 400 25 425 − 25 No
500 475 25 500 0 Yes
600 550 25 575 + 25 No
800 700 25 725 + 75 No
1,000 850 25 875 + 125 No
The Determination of Equilibrium Output (Income)

Equilibrium Aggregate Output

Equilibrium occurs when

planned aggregate
expenditure and aggregate
output are equal.
Planned aggregate
expenditure is the sum of
consumption spending and
planned investment
spending.

The planned aggregate

expenditure function crosses
the 45° line at a single point,
where Y = 500. (The point at
which the two lines cross is
sometimes called the
Keynesian cross.)
Adjustment to Equilibrium

The adjustment process will continue as long as output (income) is below

planned aggregate expenditure.

If firms react to unplanned inventory reductions by increasing output, an

economy with planned spending greater than output will adjust to
equilibrium, with Y higher than before.

If planned spending is less than output, there will be unplanned increases

in inventories. In this case, firms will respond by reducing output. As
output falls, income falls, consumption falls, and so on, until equilibrium
is restored, with Y lower than before.

As the Figure shows, at any level of output above Y = 500, such as Y =

800, output will fall until it reaches equilibrium at Y = 500, and at any level
of output below Y = 500, such as Y = 200, output will rise until it reaches
equilibrium at Y = 500.
Savings and Investment

Savings equals output minus consumption.

S = y −C

• Output is determined by demand, C + I, or

y =C + I
• Subtracting consumption from both sides of the
equation results in:
y −C = I
• The left side shows that y – C equals savings, S,
therefore:
S=I
Savings and Investment

Saving and Investment are equal at all levels of income as

they are derived from an identity.
However, savings and investment are in equilibrium at the
Equilibrium level of income.
The level of savings in the economy is not fixed, and how it
changes depends on the real GDP.
However, saving and Investment are in equilibrium only at
the equilibrium level of income as there are no
unwanted inventory accumulation or depletion.
The savings function is the relationship between the level
of income and the level of savings.
The fraction that the consumer saves is determined by his
or her marginal propensity to save (MPS).
The Saving/Investment Approach to Equilibrium
Because aggregate income must be saved or spent, by definition, Y ≡ C +
S, which is an identity. The equilibrium condition is Y = C + I, but this is
not an identity because it does not hold when we are out of equilibrium.
By substituting C + S for Y in the equilibrium condition, we can write:
C+S=C+I
Because we can subtract C from both sides of this equation, we are left
with:
S=I
Thus, only when planned investment equals saving will there be
equilibrium.
The S = I Approach to
Equilibrium
Aggregate output is
equal to planned
aggregate expenditure
only when saving equals
planned investment (S =
I).
Saving and planned
investment are equal at Y
= 500.
 Alternate Characterisation of Equilibrium Income

• It depicts the income where planned expenditure and

income are equal.

• It depicts the income level where saving and

investment are not only equal but also in
equilibrium.

• It also depicts the income where actual investment is

equal to planned investment.