Chapter one

Introduction To Macroeconomics
1. Introduction
1.1. Meaning of macro economics
Economics is the study of the economy and the behavior of people in the
economy. Traditionally, economics is divided into microeconomics, which
studies the behavior of individuals and organizations (consumers, firms and
the like) at a disaggregated level, and macroeconomics, which studies the
overall or aggregate behavior of the economy.

Macroeconomics is concerned with the behavior of the economy as a whole-

with booms and recessions, the economy’s total output of goods and services
and the growth of output, the rate of inflation and unemployment, the balance
of payments, and exchange rates.
Macroeconomics focuses on the economic behavior and policies that affect
consumption and investment, trade balance, the determinants of changes in
wages and prices, monetary and fiscal policies, the money stock, government
budget, interest rate, and national debt.

In macroeconomics, we do two things. First, we seek to understand the

economic functioning of the world we live in; and, second, we ask if we can do
anything to improve the performance of the economy. That is, we are concerned
with both explanation and policy prescriptions.

1.2. Macroeconomics goals and instruments

 Macro economics goals

1. Economic growth. The ultimate measure of a country’s economic success

is its ability to generate a high level of production of economic goods and
services for its population.

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2. Reducing Unemployment: Reducing or addressing unemployment,
particularly the cyclical unemployment, which is the outcome of poverty.
Poverty is the outcome of many factors. Some of the factors include socio-
economic backwardness, natural hazards, war, and poor governance
(administration) of a nation and policies. Frictional and structural
unemployment, which are caused due to poor or imperfect information
and change in technology respectively, can be addressed easily. Therefore,
their effect on an economy is temporary. As a result, economic policy
makers give due attention or emphasize to address the cyclical
unemployment, which could be permanent unless they are capable using
different macroeconomics instruments.

3. Stability of the economy. This refers to achieving low or stable inflation,

nominal interest rate (r), and exchange rate (USD to Birr ratio). One of the
stability objectives is ensuring stable prices because Prices stability
denotes that the overall price level does not rise or fall rapidly. Prices are
a yardstick where by economic values are measured. When the economic
yardstick changes quickly during periods of rapidly changing prices,
contracts and other economic agreements become distorted, and the price
system tends to become less valuable.
4. Foreign Economic Policy: The final goal of policy is to promote a proper
foreign economic policy. This aim has become increasingly important, as
the nations of the globe have become more closely tied by international
trade and finance. All economics are open. They import and export goods
and services, they borrow or lend money to foreigners; they imitate foreign
technologies or sell their inventions abroad.

Declines in the costs of transportation and communication have made

these international linkages even tighter than they were a generation ago.
Some economies today trade over half their national output.

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 Nations also keep a close eye on their foreign exchange rates, which
represent the price of their own currency in terms of the currencies of
other nations. When a nation’s exchange rate rises, its exports become
more expensive and therefore less competitive in world markets, causing
exports to shrink relative to imports. By contrast, when a nation’s
exchange rate falls, import prices rise and the inflation rate therefore tends
to increase. These and other impacts on the economy make the exchange
rate increasingly important for all nations.

 Macroeconomics instruments
To achieve the above objectives economic policy makers of countries use mix of
macroeconomics instruments such as:
1. Fiscal Policy. It consists of setting the levels of taxation and expenditure to
affect macro economic performance. Government expenditure affects the
overall level of spending in the economy and can thereby affect the level of
gross national product (GNP). In macroeconomics, taxation plays two key
roles. First, taxes reduce people’s incomes. By leaving households with less
spendable income, higher taxes tend to reduce their consumption
spending, lowering aggregated demand and actual GNP. In addition, taxes
help determine the prices that businesses and individuals face in markets
and thereby affect incentives and behavior.
2. Monetary policy: this policy comprises the management of a nation’s
money, credit and banking system by the nation’s central bank. By
speeding or slowing the growth of money supply, the central bank makes
interest rates lower or higher and induces or retards investment in houses,
plant, equipment etc.

3. Income policy: it is more accurately denoted wage-price policies. Income

policies are government actions that attempt to moderate inflation by direct
steps, whether by verbal persuasion or by legislated wage and price
controls.

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4. The Foreign connection: As economies become more and more open, their
policy makers devote increasing attention to managing their foreign
economic policies. The major tools fall in to two categories.

i. First, nations can affect their trade by trade policies. These consist of
tariffs, quotas, and other devices that restrict or encourage imports and
exports.

ii. A second set of policies specifically aimed toward the foreign sector is
exchange market management. There are a number of different systems
whereby nations can regulate their foreign exchange markets. Some
systems involve leaving exchange rates completely to the market place
(It’s called floating exchange rate). Others involve setting a fixed
exchange with other currencies.

1.3. The evolution of macro economics: Schools of thoughts in

Macroeconomics

Economic thinking has begun since the birth of mankind. This is because
archeological excavations evidenced that our ancestors were having some
economic thinking such as saving due to scarcity of resources and division of
labor even when gathering and hunting were their means of survival/basic
livelihood. Further studies made in ancient civilizations of Egypt, Babylon,
Persia, Axum, China, India, Byzantine, Greek, and Rome confirms that trade
and tax were the sources of their civilization. The above findings, therefore,
attest that people make economic decision since birth at different age levels
(child, youth, adult, and old) to death whether knowingly or unknowingly.
Available document suggest that economics is an old science like Art,
literature, Astronomy, Mathematics, Physics, Medicine, and the like.
Plato and Aristotle were the two prominent ancient Greek philosophers who
produced enormous economic articles on economics that served as
foundation/basis for further studies and advancement of economics. However,

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the studies of scholars conducted on economic issues and theories developed
up to the industrial revolution of the 18th century focus only on microeconomic
issues.
Macroeconomics as a branch of economics was emerged with the writing of
Adam Smith “The wealth of Nation” in 1776.
a. Classical school of thought (1776 – 1870): In this period the
distinction between micro and macro was not clear.
 The dominant idea of this school of thought was the invisible hand or
lassies fair, which means leave the market free (free market)
advocated by Adam Smith. The reason for their argument was that
because supply will create its own demand or price set by the private
sector alone will automatically correct/equilibrate any imbalance or
disequilibria created in the economy both in the short run and the
long run without government intervention. This law is called the “Says
law”.
 Adam Smith also described the government as evil and hence advocated
that the government should stay away or refrain from intervening in the
market. For Adam Smith and his followers any government policy is
ineffective to correct economic disorder or disequilibrium. In other words,
government intervention will distort the market rather than stabilizing.
 From the above arguments of the classical school of thought concepts
such as price, economy, and the government are macro concepts.
However, they did not have clear vision of how the economy should
operate.

b. Neo classical (1870 – 1936): Basically the neoclassical school is not

different from them classical school. The main distinction is the tool
of analysis, such as the marginal analysis and price determination of
goods and profit analysis.

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 c. The Keynesian macroeconomics (1936-1970s) :

Till 1930’s the classical line of thought dominated macroeconomics. It is

behaved that always the economy function at the full employment level and
there was neither over production nor underproduction. An automatic
functioning of the economic activity was assumed by the classical writers. A
flexible price system was recommended by them to maintain the general
balance. Classicalists gave importance to the supply side. They believed in the
say’s law of market “supply creates its own demand”. During the great
depression of 1929, the mass unemployment and over production disproved
the classical conclusions. That is An American economist called Keynes
challenged the classical wisdoms of macroeconomics based on the events or
episodes during the great economic depression of the early 1930s(1929 to
1935). The great depression was caused by excessive or overproduction of
wheat and coffee. Due to excess production than demanded the price of wheat
and coffee goes down, implying supply fails to create its demand as argued by
the classical.

Keynes rejected the automatic equilibrium. He tried to examine the causes of

unemployment, depression and stagflation. He argued that in a money using
economy, supply could not automatically create demand because the income
earners won’t spend their entire income. They hold a part of it as idle cash
balance this creates deficiency of demand and difficulty to sell all that is
produced. According to Keynes this is the basic cause of unemployment.
Because the amount of cash in the economy is fixed, an individual can increase
her cash holding by spending less, but she does so only by taking away cash
that other people had been holding.

As a result income falls along with spending. I try to accumulate cash by

reducing my purchases from you, and you try to accumulate cash by reducing
your purchases from me; the result is that both of our incomes fall along with

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our spending, and neither of us succeeds in increasing our cash holdings. If we
remain determined to hold more cash, we will react to this disappointment by
cutting our spending still further, with the same disappointing result; and so
on and so on. Looking at the economy as a whole, you will see factories closing,
workers laid off, stores empty, as firms and households throughout the
economy cut back on spending in a collectively vain effort to accumulate more
cash. The process only reaches a limit when incomes are so shrunken that the
demand for cash falls to equal the available supply.

Keynes and Economic Policy

For Keynes to do about recessions, the first and most obvious thing to do is to
make it possible for people to satisfy their demand for more cash without
cutting their spending, preventing the downward spiral of shrinking spending
and shrinking income. The way to do this is simple to print more money, and
somehow get it into circulation. So the usual and basic Keynesian answer to
recessions is a monetary expansion. But Keynes worried that even this might
sometimes not be enough, particularly if a recession had been allowed to get
out of hand and become a true depression. Once the economy is deeply
depressed, households and especially firms may be unwilling to increase
spending no matter how much cash they have; they may simply add any
monetary expansion to their hoarding.

Such a situation, in which monetary policy has become ineffective, has come to
be known as a “liquidity trap”. In such a case, the government has to do what
the private sector will not: spend. When monetary expansion is ineffective,
fiscal expansion must take its place. Such a fiscal expansion can break the
vicious circle of low spending and low incomes and getting the economy moving
again.

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1.4. Basic Concepts and Methods of Macroeconomic Analysis
As macroeconomics is concerned with the aggregate economic behavior factors,
the key macroeconomic concepts revolve around like national income
accounting, business cycle, inflation, unemployment, aggregate demand and
aggregate supply. The key market components of the macro economy in which
households, firms, the government, and the rest of the world all interact in
three different market areas as:

1. Goods-and-services market
2. Labor market (resources market)
3. Money (financial) market

Macroeconomic phenomenon can be analyzed using models (both

functional and graphically)
Macroeconomic analysis of the above and other related concepts is generally
aimed at maximizing the benefit from achievement of increase in output,
securing macroeconomic stability, increasing employment and economic
growth, and maintain elevated standard of economic performance with foreign
economies.

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THEORY OF MODEL BUILDING

The model illustrates the essence of the real object it is designed to resemble.
These models are far from realistic, but the model-builder learns a lot from
them nonetheless. Economists also use models to understand the world, but
an economist’s model is more likely to be made of symbols and equation.
Economists build their models to explain economic variables, such as GDP,
inflation, and unemployment. Economic models illustrate, often in
mathematical terms, the relationships among the variables. They are useful
because they help us to dispense with irrelevant details and to focus on
important connections.
Models have two kinds of variables:
1. endogenous variables
2. exogenous variables

Endogenous variables are those variables that a model tries to explain while
exogenous variables are those variables that a model takes as given. The
purpose of a model is to show how the exogenous variables affect the
endogenous variables. In other words, exogenous variables come from outside
the model and serve as the model’s input, whereas endogenous variables are
determined inside the model and are the model’s output.

Summery questions

1. Can you define macroeconomics?

2. Can you identify the main differences between the Keynesians and the
classical schools of thought?
3. Can you identify the main difference between microeconomics and
macroeconomics?
4. Discuss how the great depression of 1929 led to the emergence of new
economic thinking (Keynesian school of thought).

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 CHAPTER TWO
NATIONAL INCOME ACCOUNTING

2. National Income Accounting

Introduction: National income accounting is a systematic recording of the

economic performance of a nation within a given period of time. It can be done
(compiled) at different levels depending on the administrative structure of the
country.

2.1. The Concepts of Gross Domestic Product (GDP) and

Gross National Product (GNP)

Gross Domestic Product (GDP)

The most comprehensive available measure of the size of an economy is the

gross domestic product (GDP). GDP is the total market (money) value of all
final goods and services produced in a country during a specified period of
time, usually a year. GDP include the production of both factories of the
country and foreign-owned factories in the country. It includes only newly
produced goods and services within the borders of a country. Goods produced
by Ethiopians working in other countries are not part of GDP of the
Ethiopia. They are part of the other countries’ GDP. Goods and services
produced by foreigners working in Ethiopia are part of GDP of Ethiopia.

Gross National product (GNP) is defined as the total market value of all
final goods and services produced by nationals of a country in one year
regardless the place of the production. In case of Ethiopian GNP, it includes
goods produced by Ethiopians working abroad and excludes goods produced in
Ethiopia by foreigners. To measure total output accurately, all goods and
services produced in a given year must be counted once, but not more than

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once. GNP and GDP include only the market value of final goods and
services and ignore transactions involving intermediate goods.

By final goods, it is meant those goods and services which are being purchased
for final use and not for resale or further processing or manufacturing.
Transactions involving intermediate goods, on the other hand, refer to
purchases of goods and services for further processing and manufacturing or
for resale.

2.2. Approaches of measuring national income (GDP/GNP)

In this connection there are different approaches adopted by different

economists like:
1. The traditional approach,
2. The Keynesian approach and
3. The modern approach

1. Traditional Approach
a. Fisher’s definition. In the words of Fisher, “the national dividend or
income consists solely of services as received by ultimate consumers, whether
from their material or from their human environment. From this definition
fisher adopts consumption as the basis of national income. But it has the
following short comings.
- Net consumption cannot be estimated easily
- The value of services rendered by consumer durables year after year
cannot be measured
- Consumer durables also keep on changing hands and therefore the
change of ownership also creates difficulties.
b. Marshal’s definition. According to Marshes “the labor and capital of
country acting on its natural resources produce annually a certain net
aggregate of commodities, material and immaterial, including services of all

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 kind. This is the true net national income or revenue of the country or
national dividend.”

Hence, according to Marshal;

 All types of goods and services which are produced, whether they are
brought to the market or not, are included in the national income.

 The cost of wear and tear of the machinery should be deducted from the
total value of these goods and services. The reminder could be the
national income. That is why marshal has used the term net.

 Income from abroad has also to be taken into account while computing the
national income

But the goods and services produced in a country are so numerous that it is
not easy to make out a correct estimate of the total production. There is the
difficulty of double counting which implies that a particular commodity (as a
raw material as well as finished product) may get included in the national
income.

c. Pigou’s definition. In the words of Pigou; “National income is that

part of the objective income, of the commodity, including of course,
income derived from abroad, which can be measured in money” The
main points of this definition are given below.
 Only goods and services exchanged for money are included in the national
income.
 Income earned from investment in foreign countries has also to be counted
while computing national income.
services rendered to one self or the number of family or friends without any
payment are not to be included in the national income.

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2. Keynesian Approach

According to Keynes three approaches can be adopted to compute national

income. These are;
A. Expenditure approach
B. Income approach, and
C. Sale – minus Cost approach.

A. Expenditure Approach

According to this approach national income is equal to total consumption

expenditure and total investment expenditure systematically it can be
expressed as under

Y=C+I
Where
Y - Is national income
C- Is consumption expenditure and
I- is investment expenditure.

B. Income approach.

According to this approach national income is the total income of all the
factors of production symbolically it can be expressed as under

Y= F+EP

Where, y is the national income, F is the payments received by owners of

factors of production and EP represents entrepreneurial profits.

C. Sale – minus-Cost approach.

According to this approach, national income is equal to the total sale of

proceeds in us user cost. Symbolically it can be expressed as under.

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 Y=A-U

Where, y is the national income, A is gross national product, and U is aggregate

user cost.

3. Modern Approach
Modern approach has considered the concept of national income in its three
aspects;

i) Product aspect (output)

ii) Income aspect and

iii) Expenditure aspect.

And they stress up on the existence of fundamental identity between them.

They view national income as a flow of output, income and expenditure, when
goods are produced by firms the owners of various inputs receive income in the
form of wages, profits, interest, remaining is saved. The amount saved by the
households is mobilized by the produces for investment spending. Thus, there
is a circular flow of production, income and expenditure. These three flows are
always equal per unit of time. Hence, total output = total income = total
expenditure.

I. The Output Approach

This is the method of measure of GDP/GNP by adding up the market value of
output of all firms in the country. In this method of measuring GDP/GNP, it is
important to include only final goods and services in order to avoid double
counting. Double counting will arise when the output of some firms are used as
the inputs of other firms. There are two possible ways of avoiding double
counting: These are:
1. Taking only the value of final goods and services and
2. Taking the sum of the value added by all firms at different stages of
production.

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Example 1

This example will enable you to compute the gross domestic product of a
country using output approaches.

Sector Value of output (in million birr )

1.Agriculture and allied activities 8000
 forestry 1000
 Agriculture 1500
 Fishing 5500

2.Industry 12,200
 mining and quarrying
 large and medium scale 1200
manufacturing 5000
 electricity and water 4000
 construction 2000

3.distribution 20,000
 banking and insurance 10,000
 Defense 2250
 Education 3250

 Health 2000

 Other services 2000

4.capital consumption allowance 6200

5. Net income from a broad 4000

On the basis of the information available in the above table determine GDP

Solution
GDP will be given as: 8000+ 12200+20000= 40200, taking only the value of
final goods and services method
The sum of the value added methods
To avoid double counting, it is also necessary to use value added method.
Value added is the market value of firm’s output less the value of the inputs

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purchased from others. Thus, by summing the values added by all firms in the
economy, GNP can be determined.
Example 2

This example helps you to identify the method of computing GDP using the
sum of value added method.

1. A farmer produces oil seeds and sells it to edible oil factory for birr
10,000.
The oil factory uses the oil seeds to produce edible oil, which it sells to
retailers for birr 15,000 Retailers buy the oil and sell it for birr 24,000 using
the value added method compute the value of the final product.
Solution
1. let’s summarizes the stages of production as fallows
Stages of production Value of output Cost of intermediate goods Value added
Farmer 10000 0 10000
Oil factory 15000 10000 5000
Retailers 24000 15000 9000
Total 24000

As you observe in the above table, the sum of value added is equal to the final
value (24000).

2. Expenditure approach
To determine GDP using expenditure approaches, we must add up all types of
spending on final goods and services. Expenditures can be categorized into 4
groups depending on who buys the goods or services. We examine these
categories as follows:
 personal consumption Expenditure (C)
 Gross private Investment (Ig)
 Government purchase of goods and services (G)
 Net export (NE)

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Personal consumption Expenditure(C)
Personal consumption expenditure includes expenditures by households on
durable goods like cars, refrigerators, video records, automobiles etc, non-
durable goods like bread, beer, cigarettes, pencil, tea et c and for services like
barber, restaurant, lawyer, mechanics etc.
Gross private Investment (Ig)
It refers to all investment spending by business firms. Investment includes all
purchases of machinery, equipment and tools by business enterprise, all
construction like building of a new factory and change in inventories.
Investment also includes residential construction. This is because like
factories, residential house are income-earning assets. That means they can be
rented to yield money income as a return.
N.B. Gross private investment includes added investment and depreciation. If
we take only the added investment, which has occurred in the current year,
then we get net private investment.
Net private investment = Gross private investment – depreciation

Where, depreciation is the allowance made for tear and wear out of capital.

Government purchases of goods and services (G)

It includes all government spending at different layers of the government like at
federal, state and local, on final goods and services. However, it excludes all
government transfer payments because such payments don’t reflect current
production.
Net export (NE)
Net export (NE) = Export –Import
Spending by foreigners in a certain country may contribute just as spending
by the citizens. Hence, we have to add the value of net export in determining
GNP. On the other hand, the value of import (produced a broad and do not
reflect productive activity of a country) should be subtracted. Net export is the

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difference between the amounts by which foreigner spending on a certain
country and the amount by which citizens spending on foreign country. In
other words, net export is the difference between export and import
In general, the value of gross domestic product of any economy will be given as:
GDP = C + Ig + G + NE
A country may own resources in foreign country, which leads to a flow of
income from a broad in to the country, denoted by I1, resources owned by
foreigners in a country may lead to outflow of income to a broad from the
country, denoted by I0 the difference between income inflow (I1) and income
outflow (I0) is known as net factor income from abroad.
Net I = I1 – I0
Hence, the relationship between GNP and GDP is given as:
GNP = GDP + net income from a broad
GNP = GDP + (I1 – I0 )
You can observe the following relationship:
 when I1 > I0 , GNP exceeds GDP
 when I1 = I0 , GNP equals GDP
 when I1 < I0 , GNP is less than GDP
Example 3
Value in billion birr
1. Capital consumption allowance (depreciation) 1220
2. Personal consumption expenditure 6320
3. Government spending on goods and services 5000
4. Transfer payment 650
5. Income earned by foreigners in the country 500
6. Net investment 5780
7. Income earned by citizens a broad 800
8. Export 500
9. Import 750

Using the expenditure method, calculate GDP and GNP

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Solution
GDP= C + Ig + G + NE
= C + net investment + depreciation + G + NE
Where GNP = Gross national product
C= personal consumption expenditure
Ig = Gross private investment
G= Government purchases of goods and services
NE = net export
GDP = 6320 + 5780+ 120+5000+500-750
GDP = 18070 billion birr
GNP = GDP + (I1 – I0)
= 18070 +800-500
GNP = 18370 billion birr
3. The Income Approach
According to this method, payments received by all citizens of the counter that
have contributed in the current year production are added to get gross national
product. Hence, gross Domestic product using income approach includes
compensation to employees, rent, interest, profit, depreciation and indirect
business tax and subsides.
Compensation to employees (w)
It includes wages and salaries and their supplements like employer’s
contributions in social security, pension, health and welfare funds, which are
paid by business firms and government to suppliers of labor.
Rents (R): are payments to households that supply property resources.

Interest (I): refers to payments by private firms to household which supply

capital. However, interest payment made by government is excluded.

Profit (Π) : includes proprietors’ income (profit of unincorporated business) and

corporate profit. Proprietors’ income refers to the net income of sole
proprietors, partnerships and cooperatives. While corporate profits include

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corporate income taxes (part flow to government), dividends (part divided to
stock holders) that are payment flow to households and undistributed
corporate profits that are retained as corporate earnings.

Depreciation (capital consumption allowance) (D)

The annual payment, which estimates the amount of capital equipment used
up in each year’s production, is called depreciation. It represents a portion of
GNP that must be used to replace the machinery and equipment used up in
the production process.
Indirect business tax (IBT)
The government imposes indirect taxes on business firms. These taxes are
treated as cost of production. Therefore, business firms add these taxes to the
prices of the products they sell. Indirect business tax includes sales taxes,
excise taxes and custom duties etc.
Therefore, GDP and GNP using income approaches are given as follows:
GDP = C+ R+ I+ II+ D+ IBT – subsidy
GNP=GDP + net income from a broad

Example 4
In this example, you will learn the skill of computing GNP and/or GDP using income
approach using the following hypothetical data of a certain country, answer the
question below.
Types of income Amount (in billion birr)
Compensation of employees 10,800
Proprietor’s income 400
Rental income 600
Corporate profit 4000
Net interest 170
Deprecation 1600
Indirect business taxes 200
Income earned by foreigners in the country 500
Income earned by citizens abroad 800

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 1. Compute GDP using income approach
2. Compute GNP using income approach

Solution

1. GDP using income approach is determined as follows:

GDP = C + R +I + II + D + IBT
GDP = 108100+ 600+ 170 + 400 + 4000 + 1600 + 200 = 17770 billion birr
2. GNP = GDP + Net income from a broad
GNP = 17770 + 800 – 500 = 18070 billion birr

2.3. Other Social Accounts (NNP, NI, PI and DI)

In the previous section, we have discussed GNP as measure of the economy’s
annual output. However, there are also other social accounts, which can be
derived from GNP and has equal importance such as:
 Net national Product (NNP)
 National Income (NI)
 Personal income (PI)
 Personal disposable income (PDI)
Net National product (NNP)

GNP as a measure of the economy’s annual output may have defect because it
fails to take into account capital consumption allowance, which is necessary to
replace the capital goods used up in that year’s production. Hence, net national
product is a more accurate measure of economy’s annual output than gross
national product and it is given as:

Net National product = Gross National product – Capital consumption

allowance

National income (NI)

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National income is the income earned by economic resource (input) suppliers
for their contributions of land, labor, capital and entrepreneurial ability, which
involved in the given year’s production activity. It measure the income received
by resource supplier for their contributions to current production. However,
from the components of NNP, indirect business tax, which is collected by the
government, does not reflect the productive contributions of economic
resources because government contributes nothing directly to the production.
Hence, to get the national income, we must subtract indirect business tax from
net national product.
National income = Net National product – indirect business tax + subsidies

Personal income (PI)

Part of national income like social security contribution (payroll taxes), and
corporate income taxes are not actually received by individuals. Therefore, they
should be subtracted from the national income. On the other hand, transfer
payment, which include welfare payments, veterans’ payments, and
unemployment compensation, are not currently earned. Therefore, in order to
get personal income (PI) which is a measure of income received by individuals,
we must subtract from national income those types of income which are earned
but not received and add those types of income which are received and but not
currently earned.

Personal income (PI) =National income (NI) - social security contribution

(SSC) -corporate profits -Net interest + transfer payment + Dividend +
personal interest income

Personal Disposable Income (PDI)

Personal disposal income is the difference between personal income and

personal income taxes. It is the amount of income which households divided it

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as saving and consumption. Personal taxes include personal income taxes,
personal property taxes and inheritance taxes.

Personal Disposable Income = personal income –

personal income taxes

2.4. Nominal vs Real Gross Domestic product

Nominal GDP (NGDP) measures the money value of all finished goods and
services according to price during the year in which the goods and service are
produced. That means it measures the value of current production in terms of
current prices. This type of measurement can be influenced by both changes in
the price and production (output)

Real GDP (RGDP) measures the money value of all finished goods and services
using a certain base year price. Real GDP is nominal GDP adjusted to eliminate
inflation. it is important for analyzing production condition.

Real GDP = Nominal GNP for the given year X 100

GNP deflator for that year

2.5. The GDP Deflator and the Consumer Price Index

The GDP deflator, also called the implicit price deflator for GDP, is defined as
the ratio of nominal GDP to real GDP.
GDP deflator = Nominal GDP X 100%
Real GDP

The GDP Deflator reflects what’s happening to the overall level of prices in the
economy.

23
To better understand this, consider again an economy with only one good, then
nominal GDP is the total number of dollars spent on bread in that year, PXQ.
Real GDP is the number of loaves of bread produced in that year times the
price of bread in some base year, p base x Q. The GDP deflator is the price of
bread in that year relative to the price bread in the base year, P.P base.

The definition of the GDP deflator allows us to separate nominal GDP in to two
parts, one part measures quantities (real GDP) and the other measures prices
(the GDP deflator) that is,

Nominal GDP = Real GDP X GDP deflator.

Nominal GDP measures the current dollar value of the output of the economy.
Real GDP measures output valued at constant price and the GDP deflator
measures the price of output relative to its price in the base year.

Consumer’s price index (CPI)

Inflation or deflation is derived from a price index; a price index is a number
that shows how the average level of prices has changed over time. To create a
price index assign one year as the base year. We determine all changes in
prices from that base year then weight the change in price for each good by the
year as assigned a value of 100. the price index for years other the base year
indicates the change in the average level of prices between any year and the
base year, which can be expressed as percentage changes.
CIP = Current prices x fixed market basked quantity
Base year prices x fixed market basket quantity
Inflation rate = CPI of current yr- CPI of base yr x 100%
CPI base yr
2.6. GDP and Welfare

National income statistics are of great importance, with their help, one can
know the actual state of the economy’s performance. These statistics are also

24
very useful for providing direction to the future policy formulation. The
importance of national income statistics has grown over the years and now in
almost every country they are providing very handy to the policy makers. The
reasons for the growing importance of national income statistics are as follows.

1. Indices of economic warfare. National income statistics are useful indices of

the economic welfare of the people. With their help one can very easily draw
a comparison between the economic conditions of the people living in
different countries and of those living with in the country at different
periods of time these statistics are very useful for knowing the changes in
the standard of living of the people all over the world.

2. Aid to economic policy and planning. National income statistics are a

pointer to the changes in the economic activity taking place in the economy
under the impact of various policies of the government. Whether a
particular policy has yielded the desired results or not can be known by the
national income statistics. And on the basis of the studies and researches
conducted with the help of these statistics, the policy makers can bring
about suitable changes in their policies, they also provide important tools
for economic planning.

3. Index of economic structure national income statistics are a very useful

index of the economic structure of a country. They provide useful knowledge
about the performance of various sectors of the economy. Thus, one can
have a clear idea of the sectors which are lagging behind in economic
development and the sectors which hare advancing in economic growth.

4. Useful pace for the formulation of budgetary policies. National income

statistics provides a very useful and important base for the formulation of
government budgets it is on the basis of these figures that the finance
minister is able to have a comparative idea of the importance of different
taxation measures, public borrowing or deficit financing and other fiscal

25
 measures. They also help the finance minister in preparing the budget,
particularly in formulating proposals for a federal government they are a
useful guide for determining the amount of granting aid and subsidies to be
provided to the various units.

5. Significance for defense and development national income statistics enable

the government to make proper allocation of the national product between
defense and development programs of the economy.

6. Significance for deciding the role of public sector with the help of national
income statistics the government can very well find out the relative
significance of public and private sectors in the economy. The government
can also formulate policies for regulating the role of both the sectors for
future growth of the economy.

7. Importance in developing countries national income statistics are of special

importance to the developing countries like ours. We can know the relative
usefulness of various sectors of the economy and formulate policies
accordingly.

2.7. The Business Cycle

The business cycle is the cycle of short-term ups and downs in the economy.

- An expansion, or boom, is the period in the business cycle from a trough up to a peak, during
which output and employment rise.

- A contraction, recession, or slump is the period in the business cycle from a peak down to a
trough, during which output and employment fall.

26
Summery questions
Part I short answer questions
1. Why countries prepare national income accounts?
2. What is the difference between nominal GDP and real GDP?
3. Do you think that a change in nominal GDP reflects a similar change in economic
well being? Why?
4. Assume that an economy with a population of 100 people produces iPod and cell
phone in three successive years of 2002, 2003 and 2004 at the given price levels.
Year Item Item and Price per item population
Quantity
2002 Items: iPod 500 $70 100
Items: Cell phone 1000 $50
2003 Items: iPod 500 $80 120
Items: Cell phone 1000 $50
2004 Items: iPod 700 $55 150
Items: Cell phone 800 $80

Now answer the following questions:

1. Calculate the nominal GDP for each year.
2. Choose base year and use base year’s price calculate real GDP for each year Base year’s
Nominal GDP = Base year’s Real GDP.
3. Calculate growth rate of real GDP.
4. Calculate real GDP per capita.

27
CHAPTER 3: INCOME DETERMINATION MODEL IN A CLOSED ECONOMY
The objective of this chapter is to enable the students to have in-depth
knowledge regarding the income determination models in a closed economy; in
order to achieve this goal the students will cover the following main topics.
 Two sector income determination model
 Three sector income determination model
 Extended model of income determination (i.e. including money and
interest)
 Equilibrium in the commodity and money markets (IS LM model)
3.1. Consumption and Investment spending (two sector model of income
determination)
3.1.1 Aggregate demand and equilibrium output
Aggregate demand is the total amount of goods demanded in the economy.
Distinguishing among goods demanded for consumption (C), for investment (I),
by the government (G) and net exports (NX) aggregate demand is given by:-
AD= C + I + G + NX
In general the quantity of goods demanded, depends on the level of income in
the economy. But for now we shall assume that the amount of goods demanded
is constant, independent of the level of income.
To discuss the equilibrium output we use a graphical depiction as follows.
Fig 3.1 Equilibrium with constant AD
AD
AD = Y
M
N E IU>0
A

IU< 0
45o Y1 Y2 Y
Output

28
In the above diagram AD represents aggregate demand, the 45o line labeled
AD =Y Shows that aggregate demand is equal to the level of output. This line is
used as a reference line that translates any horizontal distance into an equal
vertical distance.
At point “M” total output produced is greater than quantity demanded. Firms
would be unable to sell all they produce and would find their warehouses filling
with inventories of unsold goods. Hence, they will reduce there as at point “N”
output demand exceeds total output produced; as a result firms produce more.
Point “E” shows equilibrium level of output. Firms are selling as much as they
produce, people are buying the amount they want to purchase, and there is no
tendency for the level of output to change.
Equilibrium output and the national income identity
we defined equilibrium output as that level of output at which aggregate
demand for goods is equal to output given as:-
AD = C+I+G+NX = Y
Here recall the definition of AD, it is the total amount of goods people want and
able to buy, where as investment and consumption in the national income
accounts are the amounts of the goods actually bought. In particular, the
investment measured in the national accounts includes involuntary or
unintended (or undesired), inventory changes, which occur where firms find
themselves selling more or fewer goods than they had planned to sell.
We thus distinguish between the actual aggregate demand measured in
accounting context and the economic concept of planned (desired, intended)
aggregate demand.
Take a look at fig 3.1 and see that at point M, the planned aggregate demand is
greater than the actual demand; the excess output should be added to the
firm’s inventories. In the national income accounts additions to inventories are
counted as investment. This is shown as:-
IU = Y-AD

29
Where
AD - Aggregate demand
Y – Total output
IU- Unplanned investment
At equilibrium level of income there is no involuntary inventory accumulation
or rundown. The planned spending is equal to actual output, thus Y= AD and
IU = 0
Note – At point “N” actual demand is greater than planned AD as a result firms
rundown their inventories and IU becomes negative as shown in the diagram.
3.1.2 The Consumption Function
The “fundamental psychological law” forwarded by Keynes states that “men are
disposed, as a rule and on the average, to increase their consumption as their
income increases but not by as much as the increase in their income”. In other
words as income increases, consumers will spend part but not all of the
increase, choosing instead to save some part of it. Therefore, the total increase
in income will be accounted for by the sum of the increase in consumption
expenditures and the increase in personal saving.
1. Average propensity to consume (APC)
The average consumption- income relationship is defined by the ratio of
consumption to income for different levels of Y. Symbolically;
APC= C/Y .......................................(1)
Where
APC- Average propensity to consume
C-Consumption
Y-Income
As you can see from table 3.1 at Y of 40, we have C of 50, hence APC= C/Y
=50/40 =1.25. You can calculate APC for any level of income by the same
method and notice that as Y increases APC declines .In other words C
increases less than proportionally with increase in Y and vice versa.
2. Marginal propensity to consume (MPC)

30
Shows how a given change in the level of income will be divided between a
change in consumption and saving. It is given as
MPC= ∆C/∆Y ......................................(2)
Where
MPC- Marginal propensity to consume
ΔC- Change in consumption
ΔY-Change in income
MPC is the slope of the consumption function. For instance take Yo= 120, Y1 =
160 then ∆Y= 40 and also consider Co= 110, C1 = 140 and then ∆C = 30 hence
MPC = ∆C/∆Y = 30/40 = ¾. In figure 3.2 for any point the slope is calculated
to be ¾ therefore the slope of the consumption function is the geometric
representation of the MPC.

The consumption function equation

A general equation for a linear consumption function is given as
C=Ca + cY -------------------------------------------- (1)

Where
C- Consumption
Ca- autonomous consumption
cY- induced consumption and
Y- is level of income.
If we consider the above diagram Ca= 20, C= MPC =3/4 hence the
consumption function equation will have the form of: - C= 20+ ¾ y
If we divide the consumption function equation by Y then we will have the
general equation of APC given as:
APC = C/Y = Ca/Y + C------------------------------- (2)
Where
APC-Average propensity to consume
C- Consumption

31
Ca- autonomous consumption
Y- is level of income.
3.1.3. The Saving Function
Panel (B) of figure 3.2 shows the saving function, which is the counterpart of
the consumption function shown in panel (A). In panel (A) the amount of saving
at any level of income is the difference between the consumption function and
the level of income when income is 40, consumption is 50 and saving is -10
saving function lies below the x-axis. When income is 160 consumption is 140
and saving is 20 and saving function is above the x-axis.
1. Average propensity to save (APS)
It is the saving counter part of APC and is given by
APS=S/Y--------------------------------------- (1`)

Where
APS-Average propensity to save
S-Saving
Y-Income Level
For instance when Y= l20, S=10, hence APS =S/Y= 100/120 = 0.83. As you can
see on table 3.1 APC can be calculated for different levels of income. Here one
thing you have to note is that, since income is either consumed or saved the
sum of APC and APS should be one. Hence,
APC + APS= 1 or
APS= 1-APC ------------------------------------ (2`)
2. Marginal propensity to save (MPS)
There is also the saving counterpart of MPC and it is denoted as
MPS = ∆S/∆Y ------------------------------------- (3`)
Where
MPS- Marginal propensity to save
ΔS- Change in saving
ΔY-Change in income

32
Since ∆Y must be devoted to either ∆C or ∆S, the two ratios ∆C/∆Y and ∆S/∆Y
must add up to one. That is:
MPC + MPS = 1 or MPS = 1-MPC------------------------- (4`)
On table 3.4 you recall that MPC= ¾ for all levels of output hence MPS= 1-
3/4= ¼
The Saving function equation
The general equation for a linear saving function is given as;
S=Sa + sY
Where
S- Total saving
Sa- Autonomous saving
Y- Income
sY – induced saving
If we divided the saving function equation by Y, then we will have the general
equation for APS. That is
APS= S/Y = Sa/Y + s
Note: by definition saving is equal to income minus consumption, algebraically
S=Y-C,
But according to equation (1) above C= Ca + cY, substituting on the equation
we have S=Y-(Ca +cY) = Y-Ca-cY this can be rearranged as;
S= - Ca+ (1-c) Y
Note: 1-c =s since c+s=1
The relationship between income, consumption and saving is shown by using
the following hypothetical income, consumption and saving schedule.

33
Table 3.1 income consumption and saving schedule
No income consumption saving APC MPC APS MPS
(Y) (C) (S)
1 0 20 -20 - - - -
2 40 50 -10 1.25 0.75 -0.25 0.25
3 80 80 0 1 0.75 0 0.25
4 120 110 10 0.92 0.75 0.83 0.25
5 160 140 20 0.87 0.75 0.125 0.25
6 200 170 30 0.85 0.75 0.15 0.25
7 240 200 40 0.83 0.75 0.167 0.25
8 280 230 50 0.82 0.75 0.217 0.25

Graphically
C+S
280
260
220
200
180
160
140 C+S
120
100 (+S) C
80 Panel (A)
60 S=0
40 (-S) C
20 C C
0
0 20 40 60 80 100 120 140 160 180 200 240 260 Y

S
60 Panel B
40
20 S
0
-20 80 Y
Fig 3.2 consumption and saving function

34
As we can see from figure 3.2 when level of income of the consumer is zero
consumption is given as 20 and this consumption level independent of the level
of income is referred to as autonomous consumption. The amount is shown by
negative saving (dis-saving) of 20. As the level of income increase and reaches
80 it is exactly equal to amount of consumption which is the break even point.
If we further increase income to 160, we will have consumption of 40 and a
positive saving amount of 20.
From table 3.1 we found that Sa=-20 and S= ¼ which the saving function can
be represented as: - S= (-20) + ¼ Y
3.1.4. Planned investment and aggregate demand
We have now specified one component of aggregate demand, consumption
demand. The other component planned investment spending is assumed to be
constant at the level of investment for our present discussion. Since we are
considering two sector model i.e. government spending and net exports each
assumed to be equal to zero, aggregate demand is the sum of consumption and
investment demands. That is
AD= C+I, but C= Ca +cY
Hence, AD = Ca + I +cY,
let Ca+ I= A
AD= A+cY -------------------------- (1)
The aggregate demand function above is shown in figure 3.3 part of aggregate
demand. A = C+I, is independent of the level of income or it is autonomous. But
aggregate demand depends on the level of income. It increases with the level of
income since consumption demand increases with income.

35
 C AD=Y
IU>0
AD=A+CY
AD
I C=C2+CY

A IN<0

C2

450
Yo income, output

Fig 3.3 the consumption function And Aggregate demand

3.1.4. Equilibrium income and output
The equilibrium level of income is maintained when the aggregate demand
equals output which in turn equals income. The 45o line, AD=Y in figure 3.3
shows points at which output and aggregate demand are equal only at point E,
and the corresponding equilibrium levels of income and output (Yo), aggregate
demand exactly equal output. At that level of output and income planned
spending precisely matches production.
The arrows in figure 3.3 indicate how the economy reaches equilibrium. At any
income level below Yo, firms find that demand exceeds output and that their
inventories are declining. They therefore increase production; conversely, for
output levels above Yo, firms find inventories piling up and therefore cut
production as the arrows show. This process leads to the output level Yo, at
which current product exactly matches planned aggregate spending and
unintended inventory changes are therefore equal to zero.
The equilibrium level of income can be algebraically derived as follows.
The consumption function is given as: - C=Ca+cY, at equilibrium aggregate
demand is equal to total output produced. That is AD=Y, but in equation (3),
we have AD= A+cY
Hence Y= A+cY, solving for Y, we have
Y= (1/1-C) A ----------------------------------- (1)

36
As you can see from the above formula the equilibrium level of output is
higher, the larger the marginal propensity to consume(c) and the higher the
level of autonomous spending (A) is.
There is a useful alternative formulation of the equilibrium condition that
aggregate demand is equal to output. In equilibrium, planned investment
equals saving this applies only in a closed two sector economy.
At equilibrium Y= AD,
But Y= C+S and AD= C+I
Hence C+S= C+I
S= I
On figure 3.3 you can see that the distance between the 45o line and the
consumption function is the saving function. And also the distance between
the AD function and the consumption function is the planned investment.
These two distances are equal only at point “E”. With Yo level of income (S=I)
any point above Yo shows saving exceeding investment and any point below Yo
depict investment greater than saving.
3.1.5 The Multiplier
The concept of “multiplier” was first introduced by R.F Kahn, a colleague of
Keynes and this was used as an employment multiplier i.e. finding the effect of
an increase in investment in an employment. Keynes borrowed this concept
and developed another type of multiplier called the income multiplier or the
investment multiplier.
Definition –a multiplier is the ratio expressing the relationship between the
increase in national income and the increase in investment which induces the
rise in income. Precisely the multiplier can be defined as the ratio of change in
income to the change in investment.
The multiplier concept explains the cumulative effect of change in investment
on income via their effect on consumption expenditures. It describes the fact
that additions to spending have an impact on income greater than the original

37
increase or decrease in spending itself. In other words, even small increments
in spending can multiply their effects.
Working of the multiplier – we can illustrate how a small investment increase
in the economy goes multiplied to propagate a large volume of income
ultimately.
Suppose an industrialist makes an investment of 10 million dollar to expand
his business. By this, those producing investment goods will get 10 million
dollar and this becomes the additional income for that group which would be
spending the amount. The quantity spent by them would depend on the
marginal propensity to consume. Let the MPC be 0.5, the group producing
investment goods would be spending 5 million dollars on consumption out of
the realized income of 10 million. Due to this, the group producing
consumption goods would get 5 million as their income. This additional income
would be paid out by way of wages, interest, etc. Those who have received the
income of 5 million would spend half of it i.e. 2.5 million since MPC = 0.5.
Consequently, the next group that had helped in catering to the needs of the
preceding group will get 2.5 million dollar and they will spend half of this. Thus
the process will continue till the entire sum gets exhausted. This is
summarized in the following table.
Table 3.2 investment and aggregate income multiplier
Multipl Initial invest. Increase in consumption through income Total increase in
ies (In million (In million dollar) aggregate income
period dollar) (In million dollar)
0 10 -- --
1 10 5 5
2 10 5+2.5 17.5
3 10 5+2.5+1.25 18.75
4 10 5+2.5+1.25+0.625 19.375
5 10 5+2.5+1.25+0.625+0.312 19.688
6 10 5+2.5+1.25+0.625+0.312+0.156 19.844

38
7 10 5+2.5+1.25+0.625+0.312+0.156+0.75 etc 19.922
We can see from table 3.2 that the initial investment of 10 million reemerges
ultimately as nearly as 20 million. Here, the marginal propensity to consume
has been assumed to be 0.5 and hence, the investment doubles itself after a
series of emergence in different groups over a period. Since an investment of 10
million has become an aggregate income of 20 million the multiplier is 2.
Marginal propensity to consume and multiplier – In the above illustration,
the initial investment had multiplied two times to become the ultimate
aggregate income this is because the MPC has been assumed to be ½. The
value of the multiplier depends upon the consumption function and MPC.
Greater the volumes of consumption expenditure, larger the volume of
aggregate income as the value of the multiplier will be greater.
The formula for the multiplier is,
K= 1 or 1 ……………………………………(1)
1-MPC 1-c

Where, K stands for the multiplier and MPC (c) for marginal propensity to
consume.
Since the marginal propensity to save is 1-MPC the multiplier formula can also
be written as: K=1/MPS.
In our illustration stated above we have MPC= 0.5 hence the multiplier can be
calculated using the formula as follows.
K= 1/1-MPC = 1/1-0.5 = 2
Or MPS= 1-0.5 = 0.5 and K= 1/MPS = 1/0.5 =2

3.2 Government spending and taxation (The three sector model)

It is when the model of income determination is expanded to include
government, aggregate consumption, domestic investment and government
expenditure for final product. The aggregate flow of income is now allocated not
only to consumption and private saving but in part of tax as well.
In general government can expand aggregate spending in any time period by
increasing the amount it adds to the stream of private spending through its

39
purchase of goods and service or by decreasing the amount it diverts from the
stream of private spending through its net tax collection. Government policy
with respect to spending and taxing is known as fiscal policy.
To explain the mechanics of fiscal policy we will construct a series of three
models, each of which is built on the models developed for the two sector
economy.
In the first only tax receipts (T) and government purchases (G) are added to the
two sector model, government transfer payments are in effect assumed to be
zero. In the second model, government transfer payments are added. Both of
these models assume that tax receipts are independent of the level of income.
In the third model, the break down of government expenditures into purchases
of goods and services and transfer payments is retained, but tax receipts are
recognized as being in part, dependent on the level of income.
3.2.1 Fiscal Policy– including taxes and government purchases
Recall the accounting identities in chapter two, the GNP identity for a three
sector economy was given as C+S+T= GNP= C+I+G.
Let; C+S+T= C+I+G
Form this we can find the saving-investment identity which is ;
S+T-G = I
Where ; T-G equals public saving
In the two sector economy disposable personal income (Yd) was found to be
equal to net national product (Y), in the three sector economy, however, taxes
absorb a portion of the income generated by expenditures on net national
product. Therefore, disposable personal income is less than net national
product by the amount of taxes. Algebraically, it can be put as:-
Yd= Y-T
Or Y= Yd +T, where Yd is disposable income, Y net national product and T is
net tax.
And also the consumption function for the three sector model becomes:-
C= Ca+cYd

40
Or C = Ca+c(Y-T)
I = Ia (investment is independent of income) the equilibrium level of income is
given by:-
Y= Ca+c(Y-T) + I+G……………… (1)
Expressed in terms of saving and investment, equilibrium will be found at that
level of income and output at which planned saving plus taxes equals planned
investment plus government purchases.
S+T= I+G………………………... (2)
If planned savings are equal to planned investment, then equilibrium is
established by governments balanced budget i.e taxation revenue being equal
to government expenditure. But government may use a budget deficit or
surplus to influence the level of aggregate demand. Since government
expenditure is a component of AD, an increase in it, if not offset by a rise in
taxation, has a multiplier effect on incomes. The government instead of
balanced budget will start framing deficit budgets. Similarly, the lowering of
rates of taxation without corresponding fall in government expenditures,
provided higher disposable incomes to the people who will raise their
consumption expenditure and there will be a multiplier expansion of the level
of income.
To show the multiplier effect, let us rewrite the aggregate spending equation (1)
Y= Ca+c (Y-T) + I+ G
This can be rearranged as ;
Y = 1/1-c (Ca- cT+I+G)……… ……………… (3)
For instance if we assume a change in investment, the other values remaining
unchanged, the new equilibrium level of Y is equal to the original level of Y plus
the change in Y.
Y+ ∆Y = 1/1-c (Ca-cT+I+G) + 1/1-c ∆I
Subtracting Y from both sides of the equation, we have
∆Y = 1/1-c ∆I ………………………………. (4)
In the same way we will find that

41
 ∆Y = 1/1-c ∆G ………………………………. (5)
∆Y = 1/1-c ∆C2 ……………………..………. (6)
∆Y = -c/1-c ∆T …………………………...….. (7)
Note – change in government expenditure and change in the amount of tax
have different impact on the level of income. To analyze this we can compare
the multipliers equation in (5) and (7).
∆Y = 1 ∆G or ∆Y = 1
1-c ∆G 1-c ……………. (8)
And ∆Y = -c ∆T or ∆Y = -c
1-c ∆T 1-c...……….….. (9)
From equations (8) and (9) we can see that the tax multiplier is less than the
government spending multiplier and they have different effect on income, the
former has a negative impact shown by the negative sign and the later a
positive impact.
Regardless of the level of consumption ( C ), the government purchase
multiplier is always greater than the tax multiplier. This may be shown by
combining the separate multiplier expressions for ∆G and ∆T.
∆Y + ∆Y = 1 + -c = 1-c = 1 ……………… (10)
∆G ∆T 1-c 1-c 1-c
The sum of the two multipliers is always unity. This is known as the balanced
budget theorem or the unit multiplier theorem.
2.3.1. DERIVING THE IS CURVE (EQUILIBRIUM IN THE GOODS MARKET)

Investment Demand and Interest Rate

INTRODUCTION:
 This involves finding the equilibrium values of the interest rate, r, and output
demanded, y, by consumers, business, and government, given the price level. In
the demand side, we have two equations expressing equilibrium conditions in the
product market and money market, in three variables: the level of income (real
national product), y, the interest rate, r, and the price level, p.

42
 In the previous section, we used the Keynesian cross (simplest income-
expenditure subsystem of our model) of income determination, in which both the
price level and the level of planned investment are taken (assumed) as
exogenously give (fixed). Thus, total expenditure as a function of income equals
income. That is
c (y – t(y)) + і + g = y = c (y – t(y)) + s (y – t(y)) + t(y) ---------------------- (1),
where,
- y is real GDP,
- c is real households’ consumption expenditure as a function of
disposable income,
- і is real planned investment demand by firms,
- g is real government expenditure (purchases) of goods and services,
- s is real households savings as a function of disposable income,
- t is real tax revenue as a function of disposable income.

In equation 1 above, each element is at a planned (or ex-ante) level. Thus, і is the
level of planned expenditure fixed investment (і) plus inventory investment (Δv).
The Keynesian cross is useful because it shows what determines the economy’s
income for any given level of planned investment. Yet it makes unrealistic
assumption that the level of planned investment is fixed (exogenous).

Now we return to the question of what determines і? To begin with, we can speculate
(guess or expect) that the level of fixed planned investment by a firm might depend
on the market interest rate, r, in addition to the profitability and riskiness of the
business. Intuitively, this expectation seems reasonable because in order to invest
a firm either borrow or use its own funds. In either case, the cost of borrowing can
be measured by the interest rate the firm has to pay or forgone receiving in case
it uses its own funds.

To add this relationship interest rate and investment to our model, we write the level
of planned investment as

43
 і = i (r) ------------------------------------------------------------------ (2)

d і= і ’dr ---------------------------------------------------------------- (3)

Where і ’< 0, implying the interest elasticity of investment is negative. That is,
increasing interest rate, r, from r0 to r1, reduces the level of planned
investment, і, from і0 to і1. Graphically,

і0

і1

і ’(r)

r0 r1 r

Fig 1: The investment demand function

A. Derivation of the IS curve

 Conventional assumptions are made about the determinants of these
components of expenditure (c, і, and g) for analytical convenience. These
include:
1. Exogenously given price level characterizes the real world (which shall
be relaxed in due course),
2. Consumption is thought of as being increasing function of disposable
income but a decreasing function of tax rate and MPC is less than 1,
3. Investment is thought of negatively related to the rate of interest, r,
4. Government expenditure (purchase) is treated as exogenous, that is a
variable that can affect but is not affected by other variables in the
model. We can derive the IS function (curve) and analyze its slope in
several ways.

44
 First mathematically: Substituting the investment equation (2) into the
original equilibrium equation gives us the equilibrium condition in the product
market. That is, the IS function (curve)
IS = y = c (y – t (y)) + і (r) + g = c (y – t (y)) + s (y – t (y)) + t (y) ---------- (4)

 Equation 4 describes pairs of y and r-values, which will maintain equilibrium

in what we call the “ product market”
 The slope of IS can also be derived mathematically by differentiating equation
4, holding g constant. That is,
dy = c’(dy – t’dy) + і’dr = c’(dy – t’dy) + s’(dy – t’dy) + t’dy-------------- (5)

 Equation 5 does not represent a movement away from equilibrium but rather
gives change in y and r that can occur simultaneously and keep the product
market in equilibrium.
 Subtracting c’(dy – t’dy) from each part of equation 5 gives
dy - c’(dy – t’dy) = і’dr = s’(dy – t’dy) + t’dy--------------------------------(6)

 Isolating terms containing dy and dr from equation 6 and rearranging it gives

(1 - c’ (1 - t’)dy + і’dr = (s’(1 - t’) + t’)dy------------------------------ (7)

 Finally, the slope of the IS curve is given by

dr = (1 - c’ (1 - t’) = (s’(1 - t’) + t’) ------------------------------- (8)
dy і’ і’

 Since the numerator (1 - c’ (1 - t’) = (s’ (1 - t’) + t’) > 0 and the denominator
і’< 0, it is clear that dr/dy < 0. This implies that the slope of the IS curve,
which represents the product market equilibrium condition is negative.
 Second, the derivation of the IS curve graphically
 Equilibrium income with fixed level of government expenditure, and s + t
increasing with the level of real income but planned investment decreases
following the increase in the rate of interest, r, is

45
 S+ t (s+ t (y)) 0
i+g i(r0)+g0

dy di i(r1)+g0

y1 y0

Fig 2: Equilibrium income with an increase in r in the Keynesian cross

 From figure 2, we know that an increase in r from r0 to r1 reduces planned

investment from і0 to і1. This in turn implies a downward shift in the і(r) + g
line from і(r0) + g0 to і(r1) + g0 by the amount dі = і0 - і1. At the original level of
і(r) + g0 with r = r0, equilibrium income was at y0. With the increase in r to r1,
equilibrium income reduces to y1 1 due to the drop in planned investment.
This relationship between r and y is depicted in figure 3 by deriving it from
the above two figures.

і s +t

і0 і(r0) + g0

і1 і(r1) + g0

dr і(r) dy

r0 r1 r r y0 y1 y

Fig 1 I Fig 2

r1 dr

r0 dy s

1
Note that the reduction in y is greater than the drop in і due to the multiplier effect of і on c and s (indirect effect).

46
 y1 y0 y

Fig 3: The IS curve: Equilibrium r and y in the product market.

 The above 3 graphs show that as interest rate, r rises in figure 1, the level of
planned in investment, і, in figure 1 and 2 falls. The drop in і in turn
reduces the equilibrium income, y, in figure 2 and 3, more through the
multiplier effect it has on the consumption behavior of individuals. Thus,
the line describing equilibrium pairs of r and y (i.e. (r1, y1) and (r0, y0)) must
be negatively sloped as shown in figure 3. This curve showing equilibrium
points of interest rate, r, and income, y, in the product market is labeled
(called) IS2. It describes the r, y combination that maintain equality between
і + g and planned s + t.
3.4.5. The money market and the LM curve
Money, interest and income
The supply of money
Supply of money means the total quantity of money available with the public
for spending. The term public includes individuals and business firms. Since
the money hold by the government, central bank and commercial banks is not
in spend able form it is not included in the definition of money supply.

Money supply is a stock concept when viewed with reference to a particular

point of time. And it is a flow concept when viewed over a period of time. As a
stock, it consists the total currency notes, coins and demand deposits with the
banks, held by the public. Since money supply can be used and spent several
times during a period of time it is a flow concept.

The number of times a unit of money changes hands during a given period of
time is its velocity of circulation. Thus, for a given period of time, the flow of

47
money supply can be known by multiplying the given stock of money by it’s
velocity of circulation. Algebraically this can be expressed as:
MS= MV,
Where
MS – Money supply
M- Total stock of money
V- Velocity of circulation

Approaches to the measure of money supply

Broadly speaking, there are four alternative approaches regarding the

measures of money supply. These are given below.
1. Classical and Neoclassical approach – this approach was based on the
basic function of money as medium of exchange and therefore, only currency
and demand deposits with bank were include in the total money supply. This is
considered as a narrow definition of money supply but it is analytically
superior because it provides the most liquid and exact measure of money
supply. Hence, the central bank can have a better control over it.
M1= C+DD

2. Monetarist approach – Milton Friedman and his disciples have included

currency, demand deposits and time deposits in the total money supply. They
have included fixed deposits with the commercial banks in the money supply
because it can be withdrawn before the expiry of that period by paying a penal
rate of interest. That is fixed deposits posses liquidity like currency in this
sense.

M2=C+DD+TD+ST

M2=M1+TD+SD
3. Gurley and Shaw approach – they further extend the scope of
money supply by including the liabilities of non- banking intermediaries that is
the saving bank deposits, shares, bonds, etc which are close substitutes to
money.
M3=M2+ non- banking intermediaries

48
4. Radcliffee Committee approach – it is the widest definition of money
supply – it is based on the general liquidity of the economy. According to this
approach money supply covers the whole liquidity position that is relevant to
the spending decisions. It, therefore, includes cash, all types of bank deposits,
and deposits with none banking financial institutions (NBFI), near money
assets and the borrowing avenues available to the public. Although this
approach provides broad definition of money supply it is not easily controlled
by the central bank.

3.4.2 Demand for money

There are different approaches adopted by various groups of economists to
define money and to determine why people want to hold money. Hence, in this
section we will try to see the different theories of money demand.
1.) Classical theory of demand for money
The classical theory of demand for money or the quantity theory of money was
propounded by Fisher. According to this theory, the demand for money arises
for the fact that money is a medium of exchange. People spend their incomes
on transactions. Therefore, the demand for money is determined by the total
quantity of goods and services transacted during a given period of time. Again
the total demand for money also depends upon its velocity of circulation that is
why Fisher expressed this in the form of the following equation.
PT =MV
where
P- General price level
T- Total volume of goods transacted
M-Total stock of money
V- Velocity of circulation
The money demand equation of Fisher can be given as
M d =k *PY
Because k is a constant, the level of transaction generated by a fixed level of
nominal income PY determines the quantity of money Md that people demand.

49
Therefore, Fisher’s quantity theory of money suggests that the demand for
money is purely a function of income, and interest rates have no effect on the
demand for money.
2. Neo- classical theory (Cambridge approach) of demand for money
The Neo-classical theory of demand for money was propounded by Cambridge
economists, Marshall and Pigou.
Similar to fisher for this approach, the demand for money is the function of
income only and no other factor intervenes. However, the Cambridge approach
did not rule out the effects of interest rates on the demand for money.
Symbolically it can be explained as;
Md= kY
where
k is the reciprocal of V in the Fisher equation and it is constant
Md- amount of money demanded
V- in the fisher equation
Y- Money value of national income
3.) Keynes Theory of demand for money
Keynes theory is contained in his famous book, the general theory of
employment, interest and money. According to Keynes the demand for money
arises because of it’s liquidity or liquidity preference’ as he referred to it.
For Keynes there are three motives for holding money (i) transaction motive (ii)
precautionary motive and (iii) speculative motive. According to Keynes the total
demand for money means total cash balances which may be of two types (i)
active and (ii) idle, the former comprising transactions demand and
precautionary demand for money and the latter comprising of speculative
demand for money.
a). Transaction motive – Keynes emphasized that this component of the
demand for money is determined primarily by the level of people’s transactions.
The transactions demand for money arises from the lack of synchronization
(harmonization) of receipts and disbursements. In other words, people aren’t

50
likely to get paid at the exact instant you need to make a payment, so between
pay checks people keep some money around in order to buy stuff. But the
transactions here are routine and predictable (usual) transactions. Keynes
believed that these transactions were proportional to income, like the classical
economists, he considered the transactions component of the demand for
money to be proportional to income. Keynes emphasized that this component
of the demand for money is determined primarily by the level of people’s
transactions. The transactions demand for money arises from the lack of
synchronization (harmonization) of receipts and disbursements. In other words,
people aren’t likely to get paid at the exact instant you need to make a
payment, so between pay checks people keep some money around in order to
buy stuff. But the transactions here are routine and predictable (usual)
transactions. Keynes believed that these transactions were proportional to
income, like the classical economists, he considered the transactions
component of the demand for money to be proportional to income.
The rate of interest has no role to play in determining the transaction demand
for money.
Keynes, shown this algebraically as
Lt= f(Y)
Where Lt- Liquidity for transaction
Y= income
b).Precautionary motive– Precautionary demand arises primarily because of
the uncertainty of future receipts and expenditures. People hold money for
some unexpected contingences such as unemployment, sickness, accidents
etc.
Algebraically it is expressed as:-
Lp= f(Y)
where Lp- liquidity for Precautionary
Y= income

51
According to Keynes both transaction and Precautionary motive are function of
income and interest inelastic. He referred to the sum for these two as the active
cash balances.

c). Speculative motive

According to Keynes the money hold for speculative motive is idle cash balance.
Speculative demand for money is the demand for holding cash for making
speculative gains from the purchase and sale for bond and securities owing to
changes in the rate of interest /dividend. Obviously, this demand is determined
by the rate of interest and bond prices. The rate of interest and the bond price
are inversely related. High bond prices indicate low rate of interest and low
bond prices indicate high interest rate.

In order to make a decision, whether should be hold in the form of money or

bonds, an individual compares the current rate of interest with the future rate
of interest. It people expect the future rate of interest to rise, they will
anticipate capital losses, for avoiding which will sell their bonds and keep cash
holdings to lend it in future at a higher rate of interest.

When people expect the future rate of interest to fall in comparison with the
current rate of interest, their demand for money for speculative motive
decrease for buying bonds and sell them in future to make capital gains.

As you can see from figure 38 there is an inverse relationship between the
speculative demand for money and the current interest rate when the interest
rate rises the speculative demand for money falls and vice versa.

interest rate Msp =H(r)

Msp
Money demand

52
Fig 3.8 speculative demand for money

Here we will discuss the other important contribution of Keynes, which is

the liquidity trap.

Liquidity trap – represents the subjective minimum level of interest rates.

When the current rate of interest becomes very low people have no desires to
spend money but they want to keep the whole money with them. In this
situation the yield of bonds becomes so low and the risk becomes so high that
the people do not want to keep bonds and decide to sell them for cash and the
money of the country will be trapped in the hands of the people.

According to Keynes, for an economy in the liquidity trap, monetary policy is

not effective since it can not influence the interest rate. He recommended the
use of fiscal policy.

The total demand for money

The total demand for money is the sum effect of the three motives; therefore the
equation can be formulated as

Md= K(y) H(r), summing the transaction demand, Precautionary demand

and the speculative demand for money.

3.4.3 Equilibrium

Given the money supply and the income level, at some particular interest rate
the sum of the transactions and speculative demand for money will be equal
with the supply of money. The interest rate that equates the supply of and
demand for money is the equilibrium interest rate.

You can see from fig 3. that money supply is a perfectly inelastic curve, since it
is determined by we actions of the monetary authority irrespective of interest
rate, however the money demand curve is a negatively sloped curve as shown
in our earlier discussion on the diagram point “e” gives the point of intersection
between money demand and supply curves, hence the equilibrium interest
rate.

53
 r Ms

rx M d E

Md > Ms Md

M
Figure 3.10 equilibrium interest rate

On the above figure any point above the equilibrium interest rate will give us
excess money supply over money demand. In this situation people use the
excess cash on their hands to buy bonds, which will raise price of bonds and
reduce their yield. This process continues until bond prices have been pushed
up by the amount necessary to reduce their yield to equilibrium interest rate.

In contrast, at any point below the equilibrium interest rate, money demand
will be greater than the money supply. In this case, people would prefer to
hold less bonds and more money. Therefore, they try to sell bonds and get
money. The increase in supply of bonds drives their prices down and the yields
will be high. This process continues until bond prices hove fallen by the
amount necessary to raise their yield to equilibrium interest rate.

Changes in money supply

The monetary authority of a country can reduce the level of interest rate by
increasing the total money supply. As it is show graphically on fig 3.11 the
monetary authority can either increase or decrease money supply by using one
or more of the credit creation control methods. For instance, central bank can
use the open market operation i.e. the purchase and sale of government
securities. As long as they can find either buyers or sellers depending on the
situation they can control the money supply.
R ms1 ms2 ms2 ms3
interest

54
rate
r*
r1
r2 md

Money

fig 3.11 changes in money supply and the rate of interest

One thing you have to note here is that once the economy is in the liquidity
trap region, increased money supply doesn’t affect the interest rate, here
interest rate reaches minimum point and it will not decline further. In this case
nobody wants to buy government securities or bonds; hence the central bank
can not affect the money supply through the open market operation.

Changes in the level of income

Assuming the money supply and speculative demand for money remaining
constant, if there is increase in the level of income, the money demand curve
will shift outward, causing a rise in the equilibrium interest rate, as shown in
Fig. 3.12
As you can see on the fig 3.12 when money demand increase due to rise
in the level of income from Md1 to Md2 the equilibrium interest rate increases
from r* to r1 .
Md1 Md2 Ms

r1 E1

r* E

money
Figure 3.12 change in the

Equilibrium in the money market requires an for money. As you recall from our
earlier discussions, the Keynesian theory of the demand for money makes the

55
transactions demand (here combined with the precautionary demand) a direct
if makes the speculative demand an inverse function of the interest rate alone,
or (it needs formal definition of money market)

Msp=h(r).

Then Md the total money demand has been given as Md= K(y) +h(r). The supply
of money (Ms) is determined outside the model, it is exogenous. This gives us
three set of equations

Demand for money Md= K (Y) + h(r)

Supply of money Ms = M/P

Equilibrium condition Md=Ms

On figure 3.14 the LM graph has been derived based on the above three
equations. Part A shows the speculative demand for money as a function of r
part B is drawn to show total money supply of 100, all of which must be held
in either transactions or speculative balances. The points along the line
indicate all the possible ways in which the given money supply may be divided
between Mt (transaction demand for money) and Msp(speculative demand for
money). Part C shows the amount of money required for transactions purpose
at each level of income on is derived from the other parts as follows.

Assume in part A an interest rate of 6 percent, at which the public will want to
hold 40 in 100 leaves 60 for transactions balances, an amount consistent with
an income level of 120 as shown in part C. Finally in part D, bringing together
Y of 120 from part c and r of 6 percent from part A yields one combination of Y
and r at which Md= MS/p or at which there is equilibrium in the money
market. We can repeat the above process for each level of interest rate and

56
income level and we will come up with the up ward sloping LM as shown in
part D.

Fig 3.14 derivation of LM curve

Mt Mt
100 100
80 80 Ms= 1100
60 60
40 40
20 20
0 Y 0 Msp
40 80 120 160 200 20 40 60 80
100
C) transactions demand B) supply of money
Mt= K(Y) Ms/P = Mt +Msp
r r
LM
10 10
8 8
6 6
5 5
4 4
2 Y 2
40 80 120 160 200 0 20 40 60 80 100 Msp
D) money market equilibrium A) speculative demand
Ms= K(y) + H (r) Msp = h(r)

3.4.6 IS – LM equilibrium (The Short Run Equilibrium)

Equilibrium between the supply of and demand for goods is possible at all
combinations of y and r indicated by the IS curve; similarly, equilibrium
between all combinations of Y and r indicate by the LM curve however, there is
only combination of y and r at which the supply of goods equals the demand
for goods and the supply of money equals the demand for money. This
combination is defined by the intersection of IS and LM curves as shown on
diagram 3.16

r LM

57
 r* E

IS

Y* Y

Fig 3.16 equilibrium in the goods and money mkt

One might want to know what would happen in the IS-LM model if interest
rate, other than the equilibrium interest rate prevails in the economy. In this
case disequilibrium will arise in the markets. Any combination of r and y to the
right of the IS curve gives us S>I and Y>(C+I). The opposite is true for any
combination of Y and r anywhere to the left of the IS curve. Similarly, any
combination of Y and r anywhere to the right of the LM curve is a combination
at which Md>Ms. Here, the opposite is also true for any combination to the left
of the LM curve.

ISLM equilibrium and the aggregate demand curve

Derivation of AD curve and Determination of the Equilibrium price and
output levels
As we have seen the LM curve plots the relationship between the interest rate
and the level of income that arises in the market for money balances. In the
short run price is fixed. If the federal government suddenly decreases the
money supply, a fall in M reduces M/P and if money supply increases, arise in
M increases M/P. This is true only if price is fixed. Now let us see the effect of
change in price on LM curve.
Change in the price level
If money supply is constant, the real money supply can change if there is a
change in price. If M3 remained at its initial level but price is reduced, then the
real money supply will increase and it results for the shift in LM curve to the

58
right. On the other hand f price is increased, then the real money supply will
decrease and it results for the shift in LM curve to the left.
In the following figure, consider the effect of a fall in the price level from P5 to
P1 assuming that the nominal money supply remains unchanged. This
reduction in the price level increases the real money stock and the equilibrium
level of output.

fig 5.1 i LM5 LM4

i5 E1 LM3

E2 LM2

i4 E3

E4 LM1

Panel A E5

IS

Y0 Y1 Y2 Y3 Y4 Y5 Y

P5 E1 AS
P4 E2
P3 E3
P2 E4
Panel B P1
E5
AD

Y
Y1 Y2 Y3 Y4 Y5

 The intersection of LM with IS., results in equilibrium point E, and

equilibrium level of output Y.

59
 The reduction in price from P5 to P4, results in the shift in equilibrium
point from E1, to E2 and an increase in equilibrium level of output from Y1
to Y2

 A shift in price from P4 to P3 results in the shift in equilibrium from E2 to

E3, and an increase in equilibrium level of output from Y2 to Y3

 A decline in price from P3 to P2 and P2 to P1, results in a shift in

equilibrium from E3 to E4 and E4 to E5 and an increase in equilibrium
output from Y3 to Y4 and Y4 and Y5 successively.

Thus successive reduction in price from P5 to P4 to P3 to P2 and P1 will result

in an increase in real money balance. This will increase the LM curve,
proportional Y and consequently to LM4, LM3, LM2, and LM1 i.e. the LM
curves shifts down ward to the right with a decrease in price.

On the other hand, successive increase in money balance shift the LM curve to
right, and intersected with IS curve yielding the shift in equilibrium to E2, E3,
E4 and E5 and equilibrium level of output to Y2 , Y3, Y4 and Y5 which
corresponds with price levels P4, P3, P2 and P1. The connection of all these
points in panel B results in a down ward sloping AD curve.

 Numerical example: the following equation describes an economy , where

C,I,G etc are being measured in billions and r as percentage ( a 5
percent interest rate implies r=5 ) and given
C= 0.8 (1-t)y
T= 0.25
I= 900-50r
G= 800
Md= 0.25Y+ 62.5r
M/P = 500

a). what is the equation that describes IS and LM curves.

a) What are the equilibrium levels of r and y

Solution

60
 a. I. Y = C+I+G=AD -> IS equation
Y= 0.8(1-t)Y+900-50r+800
Y= 0.8(1-t)y-50r+1700 …………(1)
Ii Md=Ms
0.25Y+62.5r=0.25y+500
62.5 62.5
R= 0.25y+500 ………………(2)
62.5
b. substitute r on equation (1
y= 0.8(1-t)y -50 {0.25y+500 +1700, t= 0.25
62.5
Y= 0.6y-0.25-400+1700
Y= 1300 = 2166.6
0.6
R= 0.25 (2166.6)+500 = 16.6
62.5

61
 CHAPTER FOUR
Aggregate Demand in the Open Economy
International flows of Capital Goods
The key macroeconomic difference between open and closed economies is that,
in an open economy, a country’s spending in any given year need not equal its
output of goods and services. A country can spend more than it produces by
borrowing from abroad, or it can spend less than it produces and lend the
difference to foreigners. To understand this more fully, let’s take another look
at national income accounting, Consider the expenditure on an economy’s
output of goods and services. In a closed economy, all output is sold
domestically, and expenditure is divided into three components: consumption,
investment, and government purchases. In an open economy, some output is
sold domestically and some is exported to be sold abroad. We can divide
expenditure on an open economy’s output Y into four components:
Consumption of domestic g&s …………………………………………….(Cd)
Investment spending on domestic g&s ……………………………………………(Id)
Government purchase of domestic g&s ………………………………………….(Gd)
Export of domestic g&s ……………………………………….………………………Ex
The division of expenditure into these components is expressed in the identity
as:

𝑌=⏞ ⏞
𝐶 𝑑 + 𝐼 𝑑 + 𝐺 𝑑 + 𝐸𝑥
Where, the first components stand for domestic spending on domestic g&s
and the second component (EX) indicates foreign spending on domestic g&s.
Domestic spending on all g&s is the sum of domestic spending on domestic
g&s and on foreign g&s
i.e. 𝐶 = 𝐶 𝑑 + 𝐶 𝑓 , 𝐺 = 𝐺 𝑑 + 𝐺 𝑓 , 𝐼 = 𝐼 𝑑 + 𝐼 𝑓
Thus, from equation one, we can obtain
𝑌 = (𝐶 − 𝐶 𝑓 ) + (𝐼 − 𝐼 𝑓 ) + (𝐺 − 𝐺 𝑓 ) + 𝐸𝑋
𝑌 = 𝐶 + 𝐼 + 𝐺 − [𝐶 𝑓 + 𝐼 𝑓 + 𝐺 𝑓 ] + 𝐸𝑥
Where, variables in bracket shows imported goods and services

62
 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑅𝑋 − 𝐼𝑀
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝐸𝑋
NEX – is foreign spending on domestic g&s minus domestic spending on
foreign g&s.
N.B. 𝑁𝐸𝑋 = 𝑌 − (𝐶 + 𝐼 + 𝐺), 𝑤ℎ𝑒𝑛 𝑌 > (𝐶 + 𝐼 + 𝐺), 𝐸𝑋 > 𝐼𝑀
International Capital Flows and the Trade Balance
Recall the national income accounts identity can be written in terms of saving and
investment relationships: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝐸𝑋

Subtract C and G from both sides to obtain: 𝑌 − 𝐶 − 𝐺 = 𝐼 + 𝑁𝐸𝑋

But, 𝑌 − 𝐶 − 𝐺 is national savings(S), (the sum of private saving(Y-T-C), and public
saving, (T- G)). Therefore, S = I + NX
Subtracting I from both sides of the equation, we can write the national income
accounts identity as:
S -I = NEX(trade balance)
The left-hand side of the identity is the difference between domestic saving and
domestic investment, S − I, which we call net capital outflow. (It’s sometimes
called net foreign investment.) If net capital outflow is positive, our saving
exceeds our investment, and we are lending the excess to foreigners. If the net
capital outflow is negative, our investment exceeds our saving, and we are
financing this extra investment by borrowing from abroad. Thus, net capital
outflow equals the amount that domestic residents are lending abroad minus
the amount that foreigners are lending to us. It reflects the international flow of
funds to finance capital accumulation.
The national income accounts identity shows that net capital outflow always
equals the trade balance. That is, Net Capital Outflow = Trade Balance
S − I = NX
If S − I and NX are positive, we have a trade surplus. In this case, we are net
lenders in world financial markets, and we are exporting more goods than we
are importing. If S − I and NX are negative, we have a trade deficit. In this
case, we are net borrowers in world financial markets, and we are importing

63
more goods than we are exporting. If S − I and NX are exactly zero, we are said
to have balanced trade because the value of imports equals the value of
exports.

Saving and Investment in the Small Open Economy

Since the trade balance equals the net capital outflow, which in turn equals
saving minus investment, our model focuses on saving and investment. To
develop this model, we do not assume that the real interest rate equilibrates
saving and investment. Instead, we allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend to other
countries.
We are assuming a small open economy with perfect capital mobility. By
“small’’ we mean that this economy is a small part of the world market and
thus, by itself, can have only a negligible effect on the world interest rate. By
“perfect capital mobility’’ we mean that residents of the country have full access
to world financial markets. In particular, the government does not impede
international borrowing or lending.
Because of this assumption of perfect capital mobility, the interest rate in our
small open economy, r, must equal the world interest rate r*, the real interest
rate prevailing in world financial markets: r = r*(the world interest rate
determines the interest rate in our small open economy) and the small open
economy takes the world interest rate as exogenously given.
Assumption to develop a model for the small open economy
1. The economy’s output Y is fixed by the factors of production and
the production function.
𝑌 = 𝑌̅ = 𝐹(𝐾
̅ , 𝐿̅)
2. Consumption C is positively related to disposable income Y -T.
C = C(Y -T)
3. Investment I is negatively related to the real interest rate r.
I = I(r)

64
We can now return to the accounting identity and write it as
NX = (Y - C - G) - I
NX = S - I
Substituting all the assumptions and the condition that the interest rate equals
the world interest rate, we obtain
𝑁𝐸𝑋 = [𝑌̅ − 𝐶(𝑌̅ − 𝑇) − 𝐺] − 𝐼(𝑟 ∗ )
𝑁𝐸𝑋 = 𝑆̅ − 𝐼(𝑟 ∗ )
Remember that saving depends on fiscal policy: lower government purchases G
or higher taxes T raise national saving. Investment depends on the world real
interest rate r*: high interest rates make some investment projects
unprofitable. Therefore, the trade balance depends on these variables as well.
The trade balance is determined by the difference between saving and
investment at the world interest rate.

Effects of policies on trade balance

Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate, investment
I equals saving S, and net exports NX equal zero. Let’s use our model to predict the effects of government
policies at home and abroad.
a. Fiscal Policy at Home

65
b. Fiscal Policy Abroad

c. Shift in investment demand

66
 Exchange rates
The exchange rate between two countries is the price at which exchange
between them takes place.
a. The nominal exchange rate
It is the relative price of the currency of two countries. For example, if the
exchange rate between the U.S. dollar and the Ethiopian birr is 20 birr
per dollar, then you can exchange one dollar for 20 birr in world markets
for foreign currency.
b. Real exchange rate: is the relative price of the goods of two countries. That
is, the real exchange rate tells us the rate at which we can trade the goods
of one country for the goods of another. The real exchange rate is
sometimes called the terms of trade.
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠
𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 ∗
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑𝑠
𝑝
𝐸 = 𝑒 ∗ ⁄𝑝∗

The real exchange rate between two countries is computed from the nominal
exchange rate and the price levels in the two countries. If the real exchange rate
is high, foreign goods are relatively cheap, and domestic goods are relatively
expensive. If the real exchange rate is low, foreign goods are relatively
expensive, and domestic goods are relatively cheap.
The Real Exchange Rate and the Trade Balance (NEX)

67
If the real exchange rate is low, domestic goods are relatively cheap, domestic
residents will want to purchase few imported goods and net export become
high. The real exchange rate is related to net exports. When the real exchange
rate is lower, domestic goods are less expensive relative to foreign goods, and
net exports are greater. The trade balance (net exports) must equal the net
capital outflow, which in turn equals saving minus investment. Saving is fixed
by the consumption function and fiscal policy; investment is fixed by the
investment function and the world interest rate.

In the following graph, the vertical line, S - I, represents the net capital outflow
and thus the supply of domestic currency to be exchanged into foreign
currency and invested abroad. The downward-sloping line, NX, represents the
net demand for domestic currency coming from foreigners who want domestic
currency to buy our goods. At the equilibrium real exchange rate, the supply of
domestic currency available from the net capital outflow balances the demand
for domestic currency by foreigners buying our net exports.

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Effects of fiscal policy on exchange rates

The Mundell-Fleming model

69
It is an open economy version of IS-LM models via assuming fixed price level
and show what causes fluctuation in aggregate demand. It stresses on the
interaction between goods market and money markets.
Components of M-F model
Y = C(Y -T) + I(r) + G + NX (e) ……………………….. Goods market
𝑀⁄ = 𝐿(𝑟, 𝑌)…………………………………………... Money market
𝑃

It implies that, r=r*, the economy is too small relative to the world economy
that it can borrow or lend as much as it want without affecting world interest
rate(r*).
The model on the Y-r graph
The rise in ‘e’ makes domestic goods more expensive relative to foreign goods
which reduce NEX. Hence an increase in ‘e’ shifts IS curve to the left as IS (e).
That is ‘e’ adjusts to ensure that IS curve crosses the point where LM curve
intersects the horizontal line that represents the world interest rate(r*).

LM
r
r*
IS(e)

Y
- If r>r*, i.e. IS=LM>r*, foreign investors would invest their funds in the
country and in the process they rid up domestic currency which reduces
NEX and shifts IS curve down until r = r*.

The model on the Y-e graph- this graph is drawn holding r constant at the
world interest rate.
The two equations in this graph are:
Y = C(Y -T) + I(r*) + G + NX (e) ……………………….. IS
𝑀⁄ = 𝐿(𝑟 ∗, 𝑌)…………………………………………... LM
𝑃

70
LM -is vertical because the exchange rate doesn’t enter into the LM equation.
The higher the level of r* the further to the right the LM summery is.

71
Both , IS and LM curves

72
4.5. Fiscal and monetary policies in an open economy with perfect capital
mobility

Floating exchange rate

The exchange rate is allowed to fluctuate in response to changing economic
conditions.
Fiscal policy- Expansionary fiscal policy shifts the IS* curve to the right, and
the exchange rate appreciates, whereas the level of income remains the same.
Because in open economy the reduction in national saving due to fiscal
expansionary causes net foreign investment to fall and exchange rate to
appreciate which reduces NEX that offsets the expansion in domestic demand
of g&s.

73
 Monetary policy
Suppose an increase in money supply, Because the price level is assumed to
be fixed, the increase in the money supply means an increase in real balances
and hence it shifts the LM* curve to the right. Hence, an increase in the money
supply raises income and lowers the exchange rate. Although monetary policy
influences income in an open economy, as it does in a closed economy, the
monetary transmission mechanism is different. In a closed economy an
increase in the money supply increases spending because it lowers the interest
rate and stimulates investment.

In a small open economy, the interest rate is fixed by the world interest rate. As
soon as an increase in the money supply puts downward pressure on the
domestic interest rate, capital flows out of the economy as investors seek a
higher return elsewhere. This capital outflow prevents the domestic interest
rate from falling. In addition, because the capital outflow increases the supply
of the domestic currency in the market for foreign-currency exchange, the
exchange rate depreciates. The fall in the exchange rate makes domestic goods
inexpensive relative to foreign goods and, thereby, stimulates net exports.

74
Hence, in a small open economy, monetary policy influences income by altering
the exchange rate rather than the interest rate.

Monetary and fiscal policy under Fixed exchange rate

A fixed exchange rate dedicates a country’s monetary policy to the single goal of
keeping the exchange rate at the announced level. The central bank is
committed to allow the money supply to adjust to whatever level to ensure that
the equilibrium exchange rate equals the announced exchange rate.

Fiscal policy

75
Monetary policy

Chapter five
Aggregate Supply
Introduction: aggregate supply function shows the varying amounts of aggregate
output that business as a whole is ready to offer at each possible price level.
The supply curves we seek to derive are all short-run curves because an aggregate
supply curve is, in a sense, a summation of the supply curves of all the industries in
the economy. We can better understand the nature of the aggregate supply curve if we
look behind it at the industry’s supply curve and firm’s supply curve. Thus, this part
of the chapter requires revision of your microeconomics course, so please refer it
before dealing with aggregate supply.
There are 3 types of aggregate supply curves
1. The upward sloping aggregate supply curve (classical aggregate supply curve)

76
 2. Perfectly elastic aggregate supply curve( Keynesian aggregate supply curve)
3. Perfectly inelastic aggregate supply curve. And we will discuss the first two in
detailed in this module.
The classical View:
The classical economists believed that there is always full employment in the economy. In case of
unemployment, a general cut in money wages would take the economy to full employment. In a
competitive economy when money wages are reduced, they lead to a reduction in the cost of production
and consequently to the lower price of products. When prices fall, demand for products will increase and
sales will be pushed up. Increased sales will necessitate the employment of more labor and ultimately full
employment will be attained.

The Keynesian View:

Keynes stated his views the relationship between wages and employment by accepting the classical
postulates that both the Law of Diminishing Returns and the Theory of Marginal Productivity operate.
Since every worker is paid the wage equal to the marginal product and the law of diminishing returns
operates in industry, real wages must decline for employment to increase.

But this does not mean that unemployment is due to refusal of workers to accept wages equal to their
marginal product. According to Keynes, unemployment results from the lack of aggregate demand.
Keynes believed that money wages are not flexible, they are sticky. This rigidity or stickiness of money
wages may be due to a number of institutional and other factors such as:

 Powerful labor unions which are able to prevent money wages from falling
 Statutory provisions, such as minimum wage laws
 Failure of employers to reduce wages due to a desire to retain loyal and experienced employees,
etc.
Models of Aggregate Supply
In this chapter, we will examine three prominent models of aggregate supply. These are:
a. The sticky-wage model
b. The imperfect information model
c. The sticky-price model
In all the models, some market imperfection (that is, some type of friction) causes the output of the
economy to deviate from the classical benchmark. Although each of the three models takes us down a
different theoretical route, each route ends up in the same place. That final destination is a short-run
aggregate supply equation of the form:

77
 Y Ŷα (P Pe), α0

Where Y is output, Ŷ is the natural rate of output, P is the price level, and Pe is the expected price level.
This equation states that output deviates from its natural rate when the price level deviates from the
expected price level. The parameter α indicates how much output responds to unexpected changes in the
price level; 1/ α is the slope of the aggregate supply curve.

Each of the three models tells a different story about what lies behind this short-run aggregate supply
equation. In other words, each highlights a particular reason why unexpected movements in the price
level are associated with fluctuations in aggregate output.

The Sticky-Wage Model:

To explain why the short-run aggregate supply curve is upward sloping, many economists stress the
sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term
contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not
covered by formal contracts, implicit agreements between workers and firms may limit wage changes.
Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons,
many economists believe that nominal wages are sticky in the short run.

The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To preview the
model, consider what happens to the amount of output produced when the price level rises:
 When the nominal wage is stuck, a rise in the price level lowers the real wage, making labor
cheaper.
 The lower real wage induces firms to hire more labor.
 The additional labor hired produces more output.
This positive relationship between the price level and the amount of output means that the aggregate
supply curve slopes upward during the time when the nominal wage cannot adjust.
To develop this story of aggregate supply more formally, assume that workers and firms bargain over and
agree on the nominal wage before they know what the price level will be when their agreement takes
effect. The bargaining parties—the workers and the firms—have in mind a target real wage.

The target may be the real wage that equilibrates labor supply and demand. More likely, the target real
wage is higher than the equilibrium real wage: as union power and efficiency-wage considerations tend to
keep real wages above the level that brings supply and demand into balance.
The workers and firms set the nominal wage W based on the target real wage ώ and on their expectation
of the price level Pe. The nominal wage they set is:

78
 W  ώ ×Pe

Nominal Wage Target Real Wage ×Expected Price Level

After the nominal wage has been set and before labor has been hired, firms learn the actual price level P.
The real wage turns out to be:

W/P  ώ ×(Pe/P)
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐏𝐫𝐢𝐜𝐞 𝐋𝐞𝐯𝐞𝐥
𝐑𝐞𝐚𝐥 𝐖𝐚𝐠𝐞 = 𝐓𝐚𝐫𝐠𝐞𝐭 𝐑𝐞𝐚𝐥 𝐖𝐚𝐠𝐞 × 𝐀𝐜𝐭𝐮𝐚𝐥 𝐩𝐫𝐢𝐜𝐞 𝐥𝐞𝐯𝐞𝐥

This equation shows that the real wage deviates from its target if the actual price level differs from the
expected price level. When the actual price level is greater than expected, the real wage is less than its
target; when the actual price level is less than expected, the real wage is greater than its target.

The final assumption of the sticky-wage model is that employment is determined by the quantity of labor
that firms demand. In other words, the bargain between the workers and the firms does not determine the
level of employment in advance; instead, the workers agree to provide as much labor as the firms wish to
buy at the predetermined wage. We describe the firms’ hiring decisions by the labor demand function:
L Ld(W/P), which states that the lower the real wage, the more labor firms hire.

a. Labor demand
Real wage,

W/P1

W/P2 L Ld(W/P)

Labor, L
L1 L2

b. Production function
Income, Output, Y
Y = F(L)

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 Y2

Y1

L1 L2 Labor,

c. Aggregate supply

Price level, P
Y Ŷα(P Pe)

P2

P1

Y1 Y2 Income, Output, Y

The labor demand curve is shown in panel (a) of the figure above. Output is determined by the
production function:
Y F(L), which states that the more labor is hired, the more output is produced. This is shown
in panel (b) of the figure. Panel (c) shows the resulting aggregate supply curve. Because the
nominal wage is sticky, an unexpected change in the price level moves the real wage away from
the target real wage, and this change in the real wage influences the amounts of labor hired and
output produced.

The aggregate supply curve can be written as Y Ŷα (P Pe). Output deviates from its natural level
when the price level deviates from the expected price level.

The Imperfect-Information Model:

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The second explanation for the upward slope of the short-run aggregate supply curve is called
the imperfect-information model. Unlike the sticky-wage model, this model assumes that
markets clear—that is, all wages and prices are free to adjust to balance supply and demand. In
this model, the short-run and long-run aggregate supply curves differ because of temporary
misperceptions about prices.

The imperfect-information model assumes that each supplier in the economy produces a single
good and consumes many goods. Because the number of goods is so large, suppliers cannot
observe all prices at all times. They monitor closely the prices of what they produce but less
closely the prices of all the goods they consume. Because of imperfect information, they
sometimes confuse changes in the overall level of prices with changes in relative prices. This
confusion influences decisions about how much to supply, and it leads to a positive relationship
between the price level and output in the short run.

Consider the decision facing a single supplier—a wheat farmer, for instance. Because the farmer
earns income from selling wheat and uses this income to buy goods and services, the amount of
wheat she chooses to produce depends on the price of wheat relative to the prices of other goods
and services in the economy.

If the relative price of wheat is high, the farmer is motivated to work hard and produce more
wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more
leisure and produce less wheat. Unfortunately, when the farmer makes her production decision,
she does not know the relative price of wheat. As a wheat producer, she monitors the wheat
market closely and always knows the nominal price of wheat. But she does not know the prices
of all the other goods in the economy. She must, therefore, estimate the relative price of wheat
using the nominal price of wheat and her expectation of the overall price level.

Consider how the farmer responds if all prices in the economy, including the price of wheat,
increase. One possibility is that she expected this change in prices. When she observes an
increase in the price of wheat, her estimate of its relative price is unchanged. She does not work
any harder.

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The other possibility is that the farmer did not expect the price level to increase (or to increase by
this much).When she observes the increase in the price of wheat, she is not sure whether other
prices have risen (in which case wheat’s relative price is unchanged) or whether only the price of
wheat has risen (in which case its relative price is higher).The rational inference is that some of
each has happened. In other words, the farmer infers from the increase in the nominal price of
wheat that its relative price has risen somewhat. She works harder and produces more.

Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the
economy observe increases in the prices of the goods they produce. They all infer, rationally but
mistakenly, that the relative prices of the goods they produce have risen. They work harder and
produce more.

To sum up, the imperfect-information model says that when actual prices exceed expected
prices, suppliers raise their output. The model implies an aggregate supply curve that is now
familiar:
Y Ŷα(P Pe)

Output deviates from the natural rate when the price level deviates from the expected price level.

The Sticky-Price Model:

Our third explanation for the upward-sloping short-run aggregate supply curve is called the
sticky-price model. This model emphasizes that firms do not instantly adjust the prices they
charge in response to changes in demand. Sometimes prices are set by long-term contracts
between firms and customers. Even without formal agreements, firms may hold prices steady in
order not to annoy their regular customers with frequent price changes. Some prices are sticky
because of the way markets are structured: once a firm has printed and distributed its catalog or
price list, it is costly to alter prices.

To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first
consider the pricing decisions of individual firms and then add together the decisions of many

82
firms to explain the behavior of the economy as a whole. Notice that this model encourages us to
depart from the assumption of perfect competition.

Perfectly competitive firms are price takers rather than price setters. If we want to consider how
firms set prices, it is natural to assume that these firms have at least some monopoly control over
the prices they charge. Consider the pricing decision facing a typical firm. The firm’s desired
price p depends on two macroeconomic variables:

 The overall level of prices P. A higher price level implies that the firm’s costs are
higher. Hence, the higher the overall price level, the more the firm would like to charge
for its product.
 The level of aggregate income Y. A higher level of income raises the demand for the
firm’s product. Because marginal cost increases at higher levels of production, the
greater the demand, the higher the firm’s desired price.
The firm’s desired price is written as:

p P a(Y  Ŷ)

This equation says that the desired price p depends on the overall level of prices P and on the
level of aggregate output relative to the natural rate Y - Ŷ. The parameter a (which is greater than
zero) measures how much the firm’s desired price responds to the level of aggregate output.

Now assume that there are two types of firms. Some have flexible prices: they always set their
prices according to this equation. Others have sticky prices: they announce their prices in
advance based on what they expect economic conditions to be. Firms with sticky prices set prices
according to:
p Pe a(Ye  Ŷ e),
Where, a superscript “e’’ represents the expected value of a variable. For simplicity, assume that these
firms expect output to be at its natural rate, so that the last term, a (Ye  Ŷ e), is zero. Then these firms set
the price:

p Pe

That is, firms with sticky prices set their prices based on what they expect other firms to charge.
We can use the pricing rules of the two groups of firms to derive the aggregate supply equation.

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To do this, we find the overall price level in the economy, which is the weighted average of the
prices set by the two groups. If s is the fraction of firms with sticky prices and 1 s the fraction
with flexible prices, then the overall price level is:

P sPe (1 sP a(Y Ŷ )]

The first term is the price of the sticky-price firms weighted by their fraction in the economy, and
the second term is the price of the flexible-price firms weighted by their fraction. Now subtract
(1 s)P from both sides of this equation to obtain:

sP sPe (1 sa(Y  Ŷ )]

Divide both sides by s to solve for the overall price level:

P Pe [(1 sa/s]( Y Ŷ )]

The two firms in this equation are explained as:

 When firms expect a high price level, they expect high costs. Those firms that fix prices in
advance set their prices high. These high prices cause the other firms to set high prices also.
Hence, a high expected price level Pe leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their
prices high, which leads to a high price level. The effect of output on the price level depends
on the proportion of firms with flexible prices.

Hence, the overall price level depends on the expected price level and on the level of output.
Algebraic rearrangement puts this aggregate pricing equation into a more familiar form:

Y Ŷα (P Pe),

Where α s/[(1 s)a]. Like the other models, the sticky-price model says that the deviation of output

from the natural rate is positively associated with the deviation of the price level from the expected price
level.

Chapter six

Behavioral Foundations: Theories of consumption

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How do households decide how much of their income to consume today and how much to save
for the future? This is a microeconomic question because it addresses the behavior of individual
decision makers. Yet its answer has macroeconomic consequences. As we have seen in previous
chapters, households’ consumption decisions affect the way the economy as a whole behaves
both in the long run and in the short run.

The consumption decision is crucial for long-run analysis because of its role in economic
growth. The consumption decision is crucial for short-run analysis because of its role in
determining aggregate demand. Consumption is two-thirds of GDP, so fluctuations in
consumption are a key element of booms and recessions. The IS–LM model shows that changes
in consumers’ spending plans can be a source of shocks to the economy, and that the marginal
propensity to consume is a determinant of the fiscal-policy multipliers.

In previous chapters we explained consumption with a function that relates consumption to

disposable income: C C(Y T).This approximation allowed us to develop simple models for
long-run and short-run analysis, but it is too simple to provide a complete explanation of
consumer behavior. In this chapter we examine the consumption function in greater detail and
develop a more thorough explanation of what determines aggregate consumption.

John Maynard Keynes and Consumption Function

Keynes made the consumption function central to his theory of economic fluctuations, and it has
played a key role in macroeconomic analysis ever since. Let’s consider what Keynes thought
about the consumption function, and then see what puzzles arose when his ideas were confronted
with the data.

Keynes’s Conjectures
Today, economists who study consumption rely on sophisticated techniques of data analysis.
With the help of computers, they analyze aggregate data on the behavior of the overall economy
from the national income accounts and detailed data on the behavior of individual households
from surveys. Because Keynes wrote in the 1930s, however, he had neither the advantage of
these data nor the computers necessary to analyze such large data sets. Instead of relying on

85
statistical analysis, Keynes made conjectures about the consumption function based on
introspection and casual observation.

First and most important, Keynes conjectured that the marginal propensity to consume—the
amount consumed out of an additional dollar of income—is between zero and one. He wrote that
the “fundamental psychological law, upon which we are entitled to depend with great
confidence, . . . is that men are disposed, as a rule and on the average, to increase their
consumption as their income increases, but not by as much as the increase in their income.’’ That
is, when a person earns an extra dollar, he typically spends some of it and saves some of it.The
power of fiscal policy to influence the economy—as expressed by the fiscal-policy multipliers—arises
from the feedback between income and consumption.

Second, Keynes posited that the ratio of consumption to income, called the average propensity
to consume, falls as income rises. He believed that saving was a luxury, so he expected the rich
to save a higher proportion of their income than the poor. Although not essential for Keynes’s
own analysis, the postulate that the average propensity to consume falls as income rises became a
central part of early Keynesian economics.

Third, Keynes thought that income is the primary determinant of consumption and that the
interest rate does not have an important role. This conjecture stood in stark contrast to the beliefs
of the classical economists who preceded him. The classical economists held that a higher
interest rate encourages saving and discourages consumption. Keynes admitted that the interest
rate could influence consumption as a matter of theory. Yet he wrote that “the main conclusion
suggested by experience, I think, is that the short-period influence of the rate of interest on
individual spending out of a given income is secondary and relatively unimportant. On the basis
of these three conjectures, the Keynesian consumption function is often written as:

C ĆcY,  Ć0, 0 c 1,

Where C is consumption, Y is disposable income, Ćis a constant, and c is the marginal

propensity to consume.

Notice that this consumption function exhibits the three properties that Keynes posited. It
satisfies Keynes’s first property because the marginal propensity to consume c is between zero

86
and one, so that higher income leads to higher consumption and also to higher saving. This
consumption function satisfies Keynes’s second property because the average propensity to
consume APC is:

APC C/Y Ć/Y c,

As Y rises, Ć/Y falls, and so the average propensity to consume C/Y falls. And finally, this
consumption function satisfies Keynes’s third property because the interest rate is not included in
this equation as a determinant of consumption.

The Early Empirical Successes

Soon after Keynes proposed the consumption function, economists began collecting and
examining data to test his conjectures. The earliest studies indicated that the Keynesian
consumption function is a good approximation of how consumers behave.

In some of these studies, researchers surveyed households and collected data on consumption
and income. They found that households with higher income consumed more, which confirms
that the marginal propensity to consume is greater than zero. They also found that households
with higher income saved more, which confirms that the marginal propensity to consume is less
than one.

In addition, these researchers found that higher-income households saved a larger fraction of
their income, which confirms that the average propensity to consume falls as income rises. Thus,
these data verified Keynes’s conjectures about the marginal and average propensities to
consume.

In other studies, researchers examined aggregate data on consumption and income for the period
between the two world wars. These data also supported the Keynesian consumption function. In
years when income was unusually low, such as during the depths of the Great Depression, both
consumption and saving were low, indicating that the marginal propensity to consume is between
zero and one.

In addition, during those years of low income, the ratio of consumption to income was high,
confirming Keynes’s second conjecture. Finally, because the correlation between income and

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consumption was so strong, no other variable appeared to be important for explaining
consumption. Thus, the data also confirmed Keynes’s third conjecture that income is the primary
determinant of how much people choose to consume.

Secular Stagnation, Simon Kuznets, and Consumption Puzzle

Although the Keynesian consumption function met with early successes, two anomalies soon
arose. Both concern Keynes’s conjecture that the average propensity to consume falls as income
rises.
The first anomaly became apparent after some economists made a dire and, it turned out,
erroneous—prediction during World War II. On the basis of the Keynesian consumption
function, these economists reasoned that as incomes in the economy grew over time, households
would consume a smaller and smaller fraction of their income.

They feared that there might not be enough profitable investment projects to absorb all this
saving. If so, the low consumption would lead to an inadequate demand for goods and services,
resulting in a depression once the wartime demand from the government ceased. In other words,
on the basis of the Keynesian consumption function, these economists predicted that the
economy would experience what they called secular stagnation—a long depression of indefinite
duration—unless fiscal policy was used to expand aggregate demand.

Fortunately for the economy, but unfortunately for the Keynesian consumption function, the end
of World War II did not throw the country into another depression. Although incomes were
much higher after the war than before, these higher incomes did not lead to large increases in the
rate of saving. Keynes’s conjecture that the average propensity to consume would fall as income
rose appeared not to hold.

The second anomaly arose when economist Simon Kuznets constructed new aggregate data on
consumption and income dating back to 1869.Kuznets assembled these data in the 1940s and
would later receive the Nobel Prize for this work. He discovered that the ratio of consumption to
income was remarkably stable from decade to decade, despite large increases in income over the
period he studied. Again, Keynes’s conjecture that the average propensity to consume would fall
as income rose appeared not to hold.

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The failure of the secular-stagnation hypothesis and the findings of Kuznets both indicated that
the average propensity to consume is fairly constant over long periods of time. This fact
presented a puzzle that motivated much of the subsequent work on consumption. Economists
wanted to know why some studies confirmed Keynes’s conjectures and others refuted them. That
is, why did Keynes’s conjectures hold up well in the studies of household data and in the studies
of short time-series, but fail when long time-series were examined?

For the household data or for the short time-series, the Keynesian consumption function
appeared to work well. Yet for the long time series, the consumption function appeared to have a
constant average propensity to consume.

Economists needed to explain how these two consumption functions could be consistent with
each other. In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of
these seemingly contradictory findings. Both economists later won Nobel Prizes, in part because
of their work on consumption. But before we see how Modigliani and Friedman tried to solve the
consumption puzzle, we must discuss Irving Fisher’s contribution to consumption theory. Both
Modigliani’s life-cycle hypothesis and Friedman’s permanent-income hypothesis rely on the
theory of consumer behavior proposed much earlier by Irving Fisher.

Irving Fisher and Intertemporal Choice

The consumption function introduced by Keynes relates current consumption to current income.
This relationship, however, is incomplete at best. When people decide how much to consume
and how much to save, they consider both the present and the future. The more consumption they
enjoy today, the less they will be able to enjoy tomorrow.

In making this tradeoff, households must look ahead to the income they expect to receive in the
future and to the consumption of goods and services they hope to be able to afford.

The economist Irving Fisher developed the model with which economists analyze how rational,
forward-looking consumers make intertemporal choices— that is, choices involving different
periods of time. Fisher’s model illuminates the constraints consumers face, the preferences they
have, and how these constraints and preferences together determine their choices about
consumption and saving.

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 The Intertemporal Budget Constraint
Most people would prefer to increase the quantity or quality of the goods and services they
consume—to wear nicer clothes, eat at better restaurants, or see more movies. The reason people
consume less than they desire is that their consumption is constrained by their income. In other
words, consumers face a limit on how much they can spend, called a budget constraint. When
they are deciding how much to consume today versus how much to save for the future, they face
an intertemporal budget constraint, which measures the total resources available for
consumption today and in the future. Our first step in developing Fisher’s model is to examine
this constraint in some detail.

To keep things simple, we examine the decision facing a consumer who lives for two periods.
Period one represents the consumer’s youth and period two represents the consumer’s old age.
The consumer earns income Y1 and consumes C1 in period one, and earns income Y2 and
consumes C2 in period two. (All variables are real—that is, adjusted for inflation.) Because the
consumer has the opportunity to borrow and save, consumption in any single period can be either
greater or less than income in that period.

Consider how the consumer’s income in the two periods constrains consumption in the two
periods. In the first period, saving equals income minus consumption. That is, S Y1 C1,
where S is saving. In the second period, consumption equals the accumulated saving, including
the interest earned on that saving, plus second-period income. That is, C2 (1 r)S Y2, where
r is the real interest rate. For example, if the interest rate is 5 percent, then for every $1 of saving
in period one, the consumer enjoys an extra $1.05 of consumption in period two. Because there
is no third period, the consumer does not save in the second period.

Note that the variable S can represent either saving or borrowing and that these equations hold in
both cases. If first-period consumption is less than first period income, the consumer is saving,
and S is greater than zero. If first-period consumption exceeds first-period income, the consumer
is borrowing, and S is less than zero. For simplicity, we assume that the interest rate for
borrowing is the same as the interest rate for saving.

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To derive the consumer’s budget constraint, combine the two preceding equations. Substitute the
first equation for S into the second equation to obtain C2 (1 r)(Y1 C1) Y2.

To make the equation easier to interpret, we must rearrange terms. To place all the consumption
terms together, bring (1 r) C1 from the right-hand side to the left-hand side of the equation to
𝐶2 𝑌2
obtain (1 r)C1 C2 (1 r)Y1 Y2.Now divide both sides by 1 r to obtain C1 + 1+𝑟 = Y1 + 1+𝑟

This equation relates consumption in the two periods to income in the two periods. It is the
standard way of expressing the consumer’s intertemporal budget constraint.

The consumer’s budget constraint is easily interpreted. If the interest rate is zero, the budget
constraint shows that total consumption in the two periods equals total income in the two
periods. In the usual case in which the interest rate is greater than zero, future consumption and
future income are discounted by a factor 1 r. This discounting arises from the interest earned
on savings. In essence, because the consumer earns interest on current income that is saved,
future income is worth less than current income. Similarly, because future consumption is paid
for out of savings that have earned interest, future consumption costs less than current
consumption. The factor 1/(1 r) is the price of second period consumption measured in terms
of first-period consumption: it is the amount of first-period consumption that the consumer must
forgo to obtain 1 unit of second-period consumption.

Keynes posited that a person’s current consumption depends largely on his current income.
Fisher’s model says, instead, that consumption is based on the resources the consumer expects
over his lifetime.

Franco Modigliani and Life-Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani and his collaborators Albert Ando
and Richard Brumberg used Fisher’s model of consumer behavior to study the consumption
function. One of their goals was to solve the consumption puzzle—that is, to explain the
apparently conflicting pieces of evidence that came to light when Keynes’s consumption
function was brought to the data.

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According to Fisher’s model, consumption depends on a person’s lifetime income. Modigliani
emphasized that income varies systematically over people’s lives and that saving allows
consumers to move income from those times in life when income is high to those times when it
is low. This interpretation of consumer behavior formed the basis for his life-cycle Hypothesis.

The Hypothesis
One important reason that income varies over a person’s life is retirement. Most people plan to
stop working at about age 65, and they expect their incomes to fall when they retire. Yet they do
not want a large drop in their standard of living, as measured by their consumption. To maintain
consumption after retirement, people must save during their working years. Let’s see what this
motive for saving implies for the consumption function.

Consider a consumer who expects to live another T years, has wealth of W, and expects to earn income Y
until she retires R years from now. What level of consumption will the consumer choose if she wishes to
maintain a smooth level of consumption over her life?

The consumer’s lifetime resources are composed of initial wealth W and lifetime earnings of R
Y. (For simplicity, we are assuming an interest rate of zero; if the interest rate were greater than
zero, we would need to take account of interest earned on savings as well.) The consumer can
divide up her lifetime resources among her T remaining years of life. We assume that she wishes
to achieve the smoothest possible path of consumption over her lifetime. Therefore, she divides
this total of W RY equally among the T years and each year consumes: C (W RY )/T. We
can write this person’s consumption function as: C(1/T) W (R/T) Y.

For example, if the consumer expects to live for 50 more years and work for 30 of them, then T
50 and R 30, so her consumption function is C 0.02W 0.6Y. This equation says that
consumption depends on both income and wealth. An extra $1 of income per year raises
consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year.

If every individual in the economy plans consumption like this, then the aggregate consumption
function is much the same as the individual one. In particular, aggregate consumption depends
on both wealth and income. That is, the economy’s consumption function is C aW bY, where

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the parameter a is the marginal propensity to consume out of wealth, and the parameter b is the
marginal propensity to consume out of income.

Implications
Notice that the intercept of the consumption function, which shows what would happen to
consumption if income ever fell to zero, is not a fixed value. Instead, the intercept here is aW
and, thus, depends on the level of wealth. This life-cycle model of consumer behavior can solve
the consumption puzzle.

According to the life-cycle consumption function, the average propensity to consume is C/Y
a(W/Y ) b. Because wealth does not vary proportionately with income from person to person
or from year to year, we should find that high income corresponds to a low average propensity to
consume when looking at data across individuals or over short periods of time. But, over long
periods of time, wealth and income grow together, resulting in a constant ratio W/Y and thus a
constant average propensity to consume.

To make the same point somewhat differently, consider how the consumption function changes
over time. For any given level of wealth, the life-cycle consumption function looks like the one
Keynes suggested. But this function holds only in the short run when wealth is constant. In the
long run, as wealth increases, the consumption function shifts upward.

This upward shift prevents the average propensity to consume from falling as income increases.
In this way, Modigliani resolved the consumption puzzle posed by Simon Kuznets’s data.

The life-cycle model makes many other predictions as well. Most important, it predicts that
saving varies over a person’s lifetime. If a person begins adulthood with no wealth, she will
accumulate wealth during her working years and then run down her wealth during her retirement
years. According to the life-cycle hypothesis, because people want to smooth consumption over
their lives, the young who are working save, while the old who are retired dissave.

Milton Friedman and Permanent-Income Hypothesis

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In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to
explain consumer behavior. Friedman’s permanent income hypothesis complements
Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue that
consumption should not depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent-
income hypothesis emphasizes that people experience random and temporary changes in their
incomes from year to year.

The Hypothesis

Friedman suggested that we view current income Y as the sum of two components, permanent
income YP and transitory income YT.That is , Y YP YT.

Permanent income is the part of income that people expect to persist into the future. Transitory
income is the part of income that people do not expect to persist. Put differently, permanent
income is average income, and transitory income is the random deviation from that average.

Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption in response to transitory changes in
income. For example, if a person received a permanent raise of $10,000 per year, his
consumption would rise by about as much. Yet if a person won $10,000 in a lottery, he would
not consume it all in one year. Instead, he would spread the extra consumption over the rest of
his life. Assuming an interest rate of zero and a remaining life span of 50 years, consumption
would rise by only $200 per year in response to the $10,000 prize.

Thus, consumers spend their permanent income, but they save rather than spend most of their
transitory income. Friedman concluded that we should view the consumption function as
approximately C aYP, where a is a constant that measures the fraction of permanent income
consumed. The permanent-income hypothesis, as expressed by this equation, states that
consumption is proportional to permanent income.

Implications

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The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong variable. According to the permanent-income
hypothesis, consumption depends on permanent income; yet many studies of the consumption
function try to relate consumption to current income. Friedman argued that this errors-in-
variables problem explains the seemingly contradictory findings. Let’s see what Friedman’s
hypothesis implies for the average propensity to consume. Divide both sides of his consumption
function by Y to obtain APC C/Y aYP/Y.

According to the permanent-income hypothesis, the average propensity to consume depends on

the ratio of permanent income to current income. When current income temporarily rises above
permanent income, the average propensity to consume temporarily falls; when current income
temporarily falls below permanent income, the average propensity to consume temporarily rises.

Now consider the studies of household data. Friedman reasoned that these data reflect a
combination of permanent and transitory income. Households with high permanent income have
proportionately higher consumption. If all variation in current income came from the permanent
component, the average propensity to consume would be the same in all households. But some of
the variation in income comes from the transitory component, and households with high
transitory income do not have higher consumption. Therefore, researchers find that high-income
households have, on average, lower average propensities to consume.

Similarly, consider the studies of time-series data. Friedman reasoned that year-to-year
fluctuations in income are dominated by transitory income.

Therefore, years of high income should be years of low average propensities to consume. But
over long periods of time—say, from decade to decade—the variation in income comes from the
permanent component. Hence, in long time-series, one should observe a constant average
propensity to consume, as in fact Kuznets found.

Robert Hall and Random-Walk Hypothesis

The permanent-income hypothesis is based on Fisher’s model of intertemporal choice. It builds
on the idea that forward-looking consumers base their consumption decisions not only on their

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current income but also on the income they expect to receive in the future. Thus, the permanent-
income hypothesis highlights that consumption depends on people’s expectations.

Recent research on consumption has combined this view of the consumer with the assumption of
rational expectations. The rational-expectations assumption states that people use all available
information to make optimal forecasts about the future.

The Hypothesis
The economist Robert Hall was the first to derive the implications of rational expectations for
consumption. He showed that if the permanent-income hypothesis is correct and if consumers
have rational expectations, then changes in consumption over time should be unpredictable.
When changes in a variable are unpredictable, the variable is said to follow a random walk.
According to Hall, the combination of the permanent-income hypothesis and rational
expectations implies that consumption follows a random walk.

Hall reasoned as follows. According to the permanent-income hypothesis, consumers face

fluctuating income and try their best to smooth their consumption over time. At any moment,
consumers choose consumption based on their current expectations of their lifetime incomes.
Over time, they change their consumption because they receive news that causes them to revise
their expectations.

For example, a person getting an unexpected promotion increases consumption, whereas a

person getting an unexpected demotion decreases consumption. In other words, changes in
consumption reflect “surprises” about lifetime income. If consumers are optimally using all
available information, then they should be surprised only by events that were entirely
unpredictable. Therefore, changes in their consumption should be unpredictable as well.

Implications
The rational-expectations approach to consumption has implications not only for forecasting but
also for the analysis of economic policies. If consumers obey the permanent-income hypothesis
and have rational expectations, then only unexpected policy changes influence consumption.
These policy changes take effect when they change expectations.

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For example, suppose that today Congress passes a tax increase to be effective next year. In this
case, consumers receive the news about their lifetime incomes when Congress passes the law (or
even earlier if the law’s passage was predictable). The arrival of this news causes consumers to
revise their expectations and reduce their consumption. The following year, when the tax hike
goes into effect, consumption is unchanged because no news has arrived.

Hence, if consumers have rational expectations, policymakers influence the economy not only
through their actions but also through the public’s expectation of their actions. Expectations,
however, cannot be observed directly. Therefore, it is often hard to know how and when changes
in fiscal policy alter aggregate demand.

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