 Financial institutions are medium between

household savings and investment for

industry.
 Government imposes taxes and collects
revenue and provides services for public.
 Transaction of goods, services and financial
assets within the countries as well as with
the foreigners are also considered in
National Accounting System (NAS).
 NAS provides a picture of economic
transactions.
Debit Credit
Factor Income Sales to Household
Retained Profit Sales to Government
Corporate Profit Tax Domestic Investment
Indirect Taxes Exports
Imports Subsidies from
Depreciation Government
Debit Credit
Consumption Income from domestic
Personal Income Taxes savings
Transfer to foreigners Income from Abroad
Personal Savings Transfer from Government
Transfer from Foreigners
Debit Credit
Wages and Salaries Corporate profit Tax
Purchase of goods and Indirect taxes
services Personal Income Tax
Transfer to foreigners
Subsidies to producers
Surplus
Debit Credit
Exports Imports
Transfer from foreigners Transfer to foreigners
Income from Abroad Income paid to foreigners
Deficit on Current
Account
Debit Credit
Personal Savings Fixed Investment
Business Savings Net Change in stocks
Government Savings
Deficit on Current
Account
 John Maynard Keynes : British economist
(1883-1946) who offered an explanation
of the Great Depression of the 1930’s.
 “The General Theory of Employment
Interest and Money”
 Keynes - The economy could tend towards
a less than full employment equilibrium.
 Classical economist (Prior to the 1930’s) -
The economy is always tending toward a
full employment equilibrium
 J. B. Say (Say’s law) : Supply creates its own
demand.
 Keynes believed that “Demand can be
forever inadequate for an economy to
achieve full employment”.
 What determines demand for goods and
services - Disposable income
 Consumption Function: shows the household
spending for goods and services at different
levels of disposable income.
 Consumption function
› Relationship between consumption and
disposable income
› Positive slope
 Autonomous consumption spending
› Part of consumption spending
› Independent of income
› Vertical intercept - consumption function
 Saving: Money earned but not spent.
 Dis-saving - The amount personal spending exceeds
disposable income.
 By taking money from personal savings.
 Autonomous Consumption: Consumption that is
independent of the level of disposable income
 What happens when disposable income is zero?
 Spending will be equal to autonomous consumption
because households will dissave for basic needs.
 Consumption spending increases when:
› Disposable income rises
› Wealth rises
› Interest rate falls
› Optimistic about the future
 Marginal propensity to consume (MPC)
› Slope of the consumption function
› Amount by which consumption spending
rises when disposable income rises.

ΔConsumption
MPC =
ΔDisposable income

0 < MPC < 1

 Representing the consumption with an
equation
C = a + b × (Disposable Income)

› C = consumption spending
› a = autonomous consumption spending
› b = MPC
 8,000 The consumption function shows the (linear)
Consumption Spending

relationship between consumption spending

7,000 and disposable income
6,000 Consumption
Function
5,000
4,000 600
3,000 1,000
and the slope of the line
2,000 The vertical intercept (2,000) (0.6) is the marginal
is autonomous consumption propensity to consume.
1,000
spending

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

Disposable Income
 Consumption–income line
› Aggregate consumption spending at each
level of income or GDP
› Slope = MPC
› If Tax is fixed, it shifts downward by

Tax × MPC
 Real Consumption
Consumption-
Spending
Income Line
5,600 B
2. The slope of the 5,000 A
consumption function
4,000

3,000 600
1,000
1. To draw the consumption- 2,000
income line, we measure 3. but a different
real income (instead of real 1,000 vertical intercept.
disposable income) on the
horizontal axis. 2,000 4,000 6,000 8,000
Real Income
 Move along
› Change in income - changes consumption
spending

Income ↑⇒ Disposable income ↑⇒

⇒ Consumptio n spending ↑⇒ Movement
rightward along the consumptio n - income line
 Shift
› Change in anything else except income –
changes consumption spending
 Real 8,000
Consumption-Income Line When
Consumption
Spending 7,000 Net Taxes = 500 billion
6,000
5,000
4,000
3,000
Consumption-Income Line When
2,000
Net Taxes = 2,000 billion
1,000

2,000 4,000 6,000 8,000

Real Income
 Investment Spending
› Given
 Government purchases
› Given
 Net
exports = Total exports - Total
imports
› Given
 Aggregate expenditure=C+Ip +G+NX
 Income increases
› Aggregate expenditure increases

ΔAE = MPC × ΔGDP

 Real 8,000
Aggregate
Expenditure 7,000 5. to get the aggregate expenditure line.
C + IP + G + NX
6,000 C + IP + G
4. and net exports (NX) C + IP
5,000
C
4,000

3,000
3. government purchases (G) . . .
2,000
2. then add planned investment (IP)
1,000

1. Start with the

consumption- 2,000 4,000 6,000 8,000
income line, Real GDP
 Equilibrium GDP in the short run
› Output = aggregate expenditure
 Change in inventory
› ΔInventories = GDP - AE

AE < GDP ⇒ ∆Inventories > 0 ⇒ GDP ↓

AE > GDP ⇒ ∆Inventories < 0 ⇒ GDP ↑
AE = GDP ⇒ ∆Inventories = 0 ⇒ No change in GDP
 1. Using a 45° line …

3. into an equal vertical

distance (BA).
2. we can translate
Any horizontal
distance (such as
0B) …
45°
0 B
 If AE line – below the 45° line
› AE<GDP
› Reduce output in the future
 If AE line – above the 45° line
› AE>GDP
› Increase output in the future
 A C+IP+G+NX
12,000
H

E
8,000

Total
K Aggregate
Output
Expenditure
4,000 J
Aggregate
Total Expenditure
Output
45°
4,000 8,000 12,000
 Equilibrium GDP
› AE line intersects the 45° line
› Produce the same level of output in the
future
 Equilibrium GDP
› Not necessarily full employment
 Cyclical unemployment – low spending
› Low production
› High unemployment
 Overheat economy – too high spending
› Production > potential output
› Unusually low unemployment
 Aggregate When the aggregate Real GDP
Expenditure expenditure line is
low . . .
AELOW Aggregate
Production
F B Function
10,000 10,000
E 8,000 cyclical
A unemployment
equilibrium output = 50
(8,000) is less than
potential output,
45°
10,000 Real GDP 150 Number of
Potential GDP Workers
8,000 Full Employment
and equilibrium employment 100
is less than full employment.
 When the aggregate
expenditure line is high . . . and equilibrium employment is
Aggregate Real GDP greater than full employment.
Expenditure
AEHIGH
Aggregate
E' H Production
12,000
10,000 10,000 B Function
F

10,000 Real GDP 150 Number of

Potential GDP Workers
12,000 Full Employment
200
equilibrium output (12,000) is
greater than potential output,
 Increase investment spending
› Sales revenue increases
› Income/disposable income increases
› Consumption spending increases
 Expenditure multiplier
› Change in equilibrium real GDP
› For 1 change in C, IP, G, or NX

1
Multiplier =
(1 − MPC)
 Increase in 2,500
Annual GDP 2,306
2,176
1,960

1,600

1,000

Initial After After After After After

Rise in Round Round Round Round All
IP 2 3 4 5 Rounds
 Increase investment spending
› GDP increases by more than the initial
increase in investment
 Decrease investment spending
› GDP falls by more than the change in
spending

 1  P
ΔGDP =   × ΔI
 (1 − MPC) 
 An increase in C, IP, G, or NX
› Shift the AE line upward by the initial
increase in spending
› Equilibrium GDP rises:

 1 
ΔGDP =   × ΔSpending
 (1 − MPC) 
Real Aggregate AE2
Expenditure 12,000 F
AE1

8,000
$1,000 E

Increase in
4,000 Equilibrium GDP

2,500

45°
4,000 8,000 12,000 Real GDP
 Automatic stabilizers
› Reduce the size of the multiplier
› Diminish the impact of spending changes
 Taxes.
Transfer payments
Interest rates
Imports
Forward-looking behavior
 Long-run: Multiplier = 0
  Finding Equilibrium GDP Algebraically

C = a + bYD 
 ⇒ C = a + b(Y − T )
YD = Y − T 
C = (a − bT ) + bY 
 a − bT + I + G + NX
P
AE = C + I + G + NX  ⇒ Y =
P

 1 − b
Y = AE 
 Tax multiplier = -(Spending multiplier-
1) - MPC
Tax Multiplier =
1 - MPC
- MPC
∆GDP = × ∆T
1 - MPC