Introduction

• A key objective of Macroeconomics is to explain GDP growth and its fluctuations • Therefore, need to understand the forces that determine GDP (“National Income”)

• John Maynard Keynes in his “General Theory of Employment, Interest and Money” (1936) developed a model of income determination • Known as Keynesian Theory of Income Determination • Aggregate spending / demand determines the level of aggregate output

Concepts and Functions

Actual vs. Planned Expenditure

• Actual expenditures are expenditures actually incurred by the economic entities in the economy • Planned expenditures are expenditures intended to undertake by the economic entities • Macroeconomic equilibrium (as proposed by Keynes) occurs when the actual Aggregate Demand (expenditure) equals the planned Aggregate Demand (expenditure) • i.e., the planned (intended) AD should equal the actual level of output, which is the equilibrium level of output

Components of Aggregate Demand Two-sector Model

AD = C + I

Consumption Function (C)

• A functional statement of the relationship between disposable income (Y) and consumption expenditure (C)

C = f(Yd)

• Consumption is a positive linear function of income

C = a + bYd

Note: In a two-sector model Y = Yd. (Why?)

a is a positive constant, (a>0) showing the level of consumption at zero level of income, also known as autonomous consumption b represents the slope of the consumption function 0 excess demand (ED) If AD < Output => excess supply (ES)

Equilibrium Output

Desired AD > output spending

E

AD < output

AD = C + I

45o

Output, Income

Planned Investment = Planned Savings

Saving, Investment S = -a + (1-b)Y

-a

E

I

Income (Y)

Planned investment < planned saving i.e. households planned consumption is less than firms’ investment plans; firms build up stocks and/or reduce output

Planned investment > planned saving i.e. households planned consumption is greater than firms’ investment plans; firms deplete stocks and/or raise output

Equilibrium Output, Income

Desired spending

AD > output

AD = C + I

E

C = a + bY

AD < output

(a I )

a

0

S = -a + (1-b)Y E

45o

I

Output, Income

Planned investment < planned saving

-a

Planned investment > planned saving

Y*

Equilibrium level of Income, Output

Value of output should equal aggregate spending Planned savings should equal planned investment

Y CI

SI

Substituting in for S

substituting in for C

Y a bY I

and solving for Y

(a (1 b)Y ) I

and solving for Y

Y bY a I

a I Y

1 b

(1 b)Y a I (a I ) Y (1 b)

a I Y (1 b) (1 b)

Exercise 1

Suppose the household sector’s planned consumption is C = 50 + 0.80Y, and intended investment is Rs.50. (a) Derive an equation for the saving function? (b) What is the equilibrium level of income and aggregate consumption?

Aggregate Spending – The Multiplier

Effect of Changes in Autonomous

Changes in autonomous aggregate spending (a I ) causes parallel shifts of the consumption function

Thus, a change in investment demand leads to a shift in the aggregate demand schedule

Aggregate Spending – The Multiplier

A change in investment demand

Effect of Changes in Autonomous

Suppose there is an increase in the autonomous investment (I ) because firms become optimistic about future demand conditions for their products –

What happens to our analysis?

A change in Investment demand

Aggregate Demand E’ AD’ AD

I

E

45o

Y

Output, Income

A change in Investment demand

We know that

a I Y (1 b) (1 b)

If investment (I) changes, the effect on output is given by: Y 1 b = marginal propensity to consume (MPC) I (1 b) E.g. if investment were to change by one unit, and if the MPC=0.75, then Y 1 4 1 (1 0.75) Thus, a one unit change in...