2. 5. Students Investigates Determining of
Macroeconomic Equilibrium.
2
5.1 Investigates the components of aggregate
expenditure.
5.2 Investigates the way of determinates
equilibrium in a two sector model.
5.3 Demonstrates the changes in equilibrium
level of income due to aggregate expenditure
components using the multiplier process.
5.4 Investigates determination equilibrium in a
closed economy.
5.5 Investigates determination equilibrium in
an open economy.
3. Introduction
3
In this chapter we introduce the concepts of
aggregate demand and supply, explaining
the shapes of the aggregate demand and
supply curves and forces causing them to
shift.
Aggregate demand is the total quantity of
goods and services demanded by
households, firms, government and
foreigners at different price levels.
Aggregate supply is the quantity of goods
and services that all the firms in the country
4. Macroeconomic Equilibrium
4
Equilibrium is a state in which the opposing forces
cancel one another and produce no overall change or
variation. An economy reaches equilibrium when its
aggregate demand equals to aggregate supply.
This occurs when the total demand for all gods and
services (AD) is equal to the total supply of these
goods and services (AS). That is, for the equilibrium
level of income to be achieved, we require that;
Aggregate Demand = Aggregate Supply
E = Y
Withdrawals (Leakages) = injections
W = J
5. Aggregate Demand (AD)
5
The aggregate demand of an economy is the
total of spending incurred by households,
firms, government and the rest of the world.
It consists of private consumption
(consumption expenditure), private
investment(investment expenditure),
government spending(government
expenditure) and net exports.
E = C + I + G + X [2.1]
Where,
E = Aggregate demand or spending.
C = Private consumption.
I = Private investment.
G = Government spending.
6. 6
Some of the components of aggregate
demand are relatively stable and change
only slowly over time (e. g. consumption
expenditure); others are much more
volatile and change rapidly, causing
fluctuations in the level of economic
activity (e. g. investment expenditure).
Aggregate demand interacts with
aggregate supply to determine the
equilibrium level of national income.
Governments seek to regulate the level of
aggregate demand in order to maintain full
employment, avoid inflation, promote
7. Aggregate Demand Schedule.
7
A schedule depicting the total
amount of spending on domestic
goods and services at various
levels of national income.
It is constructed by adding
together the consumption,
investment, government
expenditure and net exports
8. AGGREGATE DEMAND SCHEDULE; This
graph shows how AD varies with the
level of national income.
8
AGGREGATE
DEMAND
C + I + G + X
NATIONAL INCOME
TOTALEXPENDITURE
0
FIGURE - A
9. 9
A given aggregate demand
schedule is drawn up on the
usual CETERIS PARIBUS
conditions.
It will shift upwards or
downwards if some
determining factors
changes. See the below
graph B.
10. Shifts in the AD schedule due to determining factor
changes. E. g. if there is an increase in the propensity to
consume, the consumption schedule shifts upwards. A
reduction in government spending will shift the schedule
downwards.
10
AD1 (C + ∆C + I + G + X)
AD (C + C + I + G + X)
AD2 (C + I + G + ∆G + X)
NATIONAL INCOME0
TOTALEXPENDITURE
FIGURE - B
11. 11
Alternatively , the aggregate demand
schedule can be expressed in terms
of various levels of real national
income demanded at each price
levels as shown in below graph C.
This alternative schedule is also
drawn on the assumption that other
influences on spending plans are
constant. It will shift rightwards or
leftwards if some determining factors
change. See graph D.
12. The graph plots the quantity of
real national income demanded
against the price level.
12 FIGURE - C
AGGREGATE
DEMAND
C + I + G +X
REAL NATIONAL INCOME
PRICELEVEL
0
13. Shifts in the schedule due to determining factor changes,
if there is a increase in propensity to consume, the AD
will shift rightwards, a reduction in government spending
will shift leftwards.
13 FIGURE - DREAL NATIONAL INCOME
PRICELEVEL
0
AD
2
AD
AD1
14. Aggregate Supply (AS)
14
The aggregate supply is equivalent
to the total production or output of
the economy.
The economy generates income by
purchasing goods ad services.
Thus the aggregate supply is
synonymous with the concepts of
aggregate output and aggregate
15. 15
Aggregate income is used [1] to buy
consumer goods and services (= C), [2]
to meet import payments (=Z), (3) to
pay taxes and (4) to make savings (=S).
This relationship can be expressed as
follows:
Y = C + Z + T + S [2.2]
Where, Y = Total income
C = Consumption of domestic goods
and services
Z = Imports of goods and services
16. 16
Using the same argument, we can also say
that an economy reaches equilibrium when
aggregate demand (=E) is equal to
aggregate supply (=Y).
E = Y [2.3]
Substituting equations [2.1 and [2.2] in
equation [2.3],
C+I+G+X = C+Z+T+S [2.4]
Cancelling C (consumption ) from both sides,
I+G+X = Z+T+S [2.5]
17. 17
The left hand side of the above equation shows
the injections and the right side shows leakages
of the circular flow diagram. So the economy
reaches equilibrium when total injections are
equal to total leakages.
Total Injections = Total Leakages
I+G+X = S+T+Z
Rearranging equation [2.5], we get
(S-I) + (T-G) + (X-Z) [2.6]
The above equation shows the following 3 gaps in
the economy.
S-I = Gap between savings and investment.
T-G = balance on the government budget
X-Z = balance on the current account of the
18. 18
It shows us a very important macroeconomic
relationship. The sum of (S-I) and (T-G), which is
on the let side of the equation, is the domestic
savings gap. The term (X-Z) on the right side is the
foreign savings gap. This implies that a deficit in
domestic savings should be matched by a surplus
in foreign savings.
Simply, what it means is that a country should
borrow from abroad to finance its savings-
investments gap and budget deficit. We can draw
some useful conclusions from this relationship as
follows;
When I > S and G > T, the country faces a
current account deficit in the balance of
19. Aggregate Supply Schedule
19
Aggregate supply schedule is a schedule depicting
the total amount of domestic goods and services
supplied by business and government at various
levels of total expenditure.
The aggregate supply schedule is generally drawn
as a 45 angle line because business will offer any
particular level of national output only if they expect
total spending (aggregate demand) to be just
sufficient to sell all of that output.
Thus, in the below figure $100 million of
expenditure calls for $100 million of aggregate
supply, $200 million of aggregate supply calls worth
20. NATIONAL PRODUCT = NATIONAL INCOME
20
45
˚
AGGREGATE
SUPPLY
$ MILLIONYf20
0
100
10
0
20
0
$
MILLIONS
AGGREGATEDEMAND
(TOTALEXPENDITURE)
21. 21
However, for once an economy's
resources are fully employed in supplying
products then additional expenditure
cannot be meet from additional domestic
resources because the potential output
ceiling of the economy has been reached.
Consequently, beyond the full
employment level of national product, Yf,
the aggregate supply schedule becomes
vertical.
22. Components of Aggregate
Expenditure
22
Aggregate expenditure is
measure of national income. It
is defined as the value of
planned goods and services
produced in an economy and a
way to measure the gross
domestic product (GDP); a
measure of the level of
23. Personnel Disposable Income.
23
Consumption means spending on
consumer goods and services like food,
cloths, medicine or durable gods.
Consumption mainly depends on
personnel disposable income.
Disposable income is equal to
household income plus transfers from
the government to households minus
taxes paid by households to the
government.
24. 24
Disposable Income = Household
Income – Taxes.
So, disposable income is
spent for consumption, and
the balance is saved;
Disposable Income = Consumption + Saving
Yd = C + S
25. 25
Therefore, the privet consumption
expenditure depends on the
disposable income. This is
illustrated as follows;
C = f (Yd)
Where,
C = Consumption
F = Function
Yd = Disposable Income.
26. The Determinants of Private
Consumption.
26
Disposable income.
The wealth of
households.
Levy of taxes by the
government.
Loans of households.
27. The Components Of Aggregate
Expenditure.
27
Private Consumption
Government
Consumption
Expenditure
Investment Expenditure
Net Export
28. Private Consumption
Expenditure Comprises;
28
Buying durable consumer goods
Buying non durable consumer
goods
Buying services
The expenditure on capital goods
is, investment expenditure
Example: Machinery, tools,
housing and etc.
29. Government Expenditure
29
Government expenditure spent to
purchase goods and services from
private sector to provide various
economic activities to the
consumers.
Example:
Provide public goods.
Provide merit goods.
National security.
33. Net Exports
33
This means the difference
between export income
and the import
expenditure. This may be
a deficit or a surplus.
Net Exports = Exports - Imports
34. Macroeconomic Equilibrium in a
Two Sector Economy (Simple
Economy).
34
Equilibrium is a state in which the opposing forces
cancel one another and produce no overall change or
variation. An economy reaches equilibrium when its
aggregate demand equals to aggregate supply.
This occurs when the total demand for all gods and
services (AD) is equal to the total supply of these
goods and services (AS). That is, for the equilibrium
level of income to be achieved, we require that;
Aggregate Demand = Aggregate Supply
E = Y
Withdrawals (Leakages) = injections
W = J
35. 35
As we noted earlier, the macroeconomic
equilibrium can be illustrated by 2 basic
methods.
Income - Expenditure Approach.
Total Expenditure = Total Output =
Total Income
∑E = ∑O = ∑ Y
Leakages – Injections Approach.
Leakages = Injections
W = J
36. Income - Expenditure Approach In
a Two Sector Economy.
36
In this approach, the total income equals
total expenditure. Therefore,
Total Income = Total Expenditure
Y = E
The total expenditure consists of private
consumption expenditure (C) and investment
expenditure(I). Therefore,
E = C + I
The total income also consists of private
consumption expenditure (C) and private savings
(S). Therefore,
Y = C + S
37. Leakages – Injections Approach In a
Two Sector Economy.
37
In this approach, savings equals leakages
and investment equals injections to the
economy. Therefore, with assuming the
earlier equations of total income and total
expenditures were given below. We must cut
off consumption (c) from both equations.
Y = C + S E = C + I
Y = E
C + S = C + I
38. Injections / Inflows (J)
38
Injections add to the total volume of the
basic circular flow of income model. That is ,
they “inject” revenue into the product market
that is, used for factor payments and
becomes households income. They are
considers as outside cash floes to the
income model. Following components can
be seen as injections.
Investment (I)
Government Purchases (G)
Exports (X)
39. Withdrawals/ Leakages (W)
39
Leakages subtract from the total volume of
the basic circular flow of income model. That
is, they “leak” income away from the product
markets, making less available for factor
payments and households income. Leakages
will shrink the income flow. Following
components can be seen as leakages.
Savings (S)
Personal Income Tax (T)
Imports (M)
W = S + T + M
40. The Consumption Function In a
Two Sector Economy.
40
The consumption function shows the
relationship between planned and
disposable income. This consumption
function indicates how much will be spent on
consumption at different level of income.
There is a direct or positive relationship
between planned consumption and
disposable income. i.e. as disposable
income rises planned consumption also
rises. The consumption function is a single
mathematical function to express consumers
41. 41
The consumption function can
be illustrated as follows.
C = a + bYd
Where,
C = Total Consumption.
a = Autonomous Consumption (a > 0 )
b = Marginal Propensity to Consume
(Induced Consumption, 0 < b <1)
y = Disposable Income.
42. 42
As we noted that there is no government in our two
sector economy, total national income can be
considered as disposable income. So we can
express the relationship between income and
consumption in the following example of a
consumption function;
C = 100 + 0.75 Yd [2.1]
Where, C = planned household consumption, and
Yd = disposable income.
The above equation indicate that households
maintain a basic autonomies consumption level of
100, irrespective of the income level. Autonomous
consumption does not depend on income.
(autonomous here means “independent of income”).
In other words, households are prepared to spend
say Rs. 100, even their income is zero. When
43. 43
For example, if the households
income rises by R. 1000 (= 1000
x 0.75), they use Rs. 750 of that
additional income to buy goods
and services. This coefficient
known as the marginal propensity
to consume.
45. Autonomous Consumption
45
This is a part of the consumption
expenditure that does not vary with changes
in national income or disposable income. In
the short term, consumption expenditure
consists of induced consumption
(consumption expenditure that varies
directly with income) and autonomous
consumption.
Autonomous consumption represents some
minimum level of consumption that is
necessary to sustain a basic standard of
46. Consumption Schedule/
Function more Illustrated Curve.
46
A schedule depicting the relationship between
consumption expenditure and the level of
national income or disposable income, also
called consumption function.
At low levels of disposable income,
households consume more than their current
income,
Drawing on past savings, borrowings or selling
assets in order to maintain consumption at
some desired minimum level (autonomous
consumption).
47. Consumption Function Curve
47
Consumption schedule; a simple consumption
schedule that takes the linear form C = a + bY ,
where C is consumption and “a” is the minimum
level of consumption expenditure at zero-disposable
income (autonomous consumption).
Thereafter, consumption expenditure increases as
income rises (induced consumption), and “b” is the
proportion of each extra currency (Rs. or $) of
disposable income that is spent.
The 45 degree line 0 E shows what consumption
expenditure would have been had it exactly matched
disposable income.
The difference between 0 E and the consumption
expenditure schedule indicates the extent of
dissavings or savings at various income levels. The
slope of the consumption schedule is equal to the
marginal propensity to consume.
48. 48
45
˚
E
Consumption
Schedule
C = a + bYd
Induced
Consumption
Autonomous
Consumption
Disposable Income
Consumption/Savings
0
Dissavings
Savings
49. Marginal Propensity to Consume
(MPC)
49
The fraction of any change in national income that
is spent on consumption, alternatively the change
in consumption can be expressed as a proportion
of the change in disposable income.
In other words, the MPC is equal to the ratio of
change in consumption to change in income. The
MPC measures change in consumption as a
proportion of the change in income. Where “b” is
equal to MPC. Symbolically,
MPC = ∆C / ∆Y
MPC = Change in Consumption
50. The MPC
50
∆ C
∆ Y
Autonomous Consumption
C = a + bY
0 Income (Rs.)
Consumption
(Rs.)
51. The Saving Function in a Two
Sector Economy.
51
This is a mathematical relationship between
saving and income by the household sector.
The saving function can be stated as an
equation, usually a simple linear equation, or
as a diagram designated as saving line. This
indicates the saving income relationship.
The level of savings is equal to
national income minus
consumption expenditure;
S = Y – C [2.2]
52. 52
By substituting the earlier consumption
function in the above expression, we can
derive the following savings function (Since
C = 100 + 0.75Y);
S = Y – (100 + 0.75Y)
= Y – 100 – 0.75Y
(Y – 0.75) = - 100 + 0.25 Y
The above equation tells us that households
save 0.25 of their increased income. In the
earlier example, households save Rs. 250
(=1000 x 0.25) of their additional income of
Rs. 1000. the coefficient 0.25 is called the
53. Marginal Propensity to Save
(MPS)
53
The MPS defines the relationship between change in
saving and change in income. It is the change in
saving divided d by the change in income.
MPS = ∆ S / ∆ Y
MPS = Change in Saving
Change in Income
We can show the relationship between MPC and
MPS as follows;
C + S = Y [2.3] see equation 2.2
∆ C + ∆ S = ∆ Y
(∆ C / ∆ Y) + (∆ S / ∆Y) = 1
MPC + MPS = 1
54. Continued…….MPS
54
Where,
∆ = Change
∆ Y = Change in income
∆ C = change in consumption
∆ S = change in saving
The MPC and MPS, will always be constant at
all the levels of income in our examples. The
MPS + MPC must always to be equal to 1.
because any change in income is either
consumed or saved, that balance share of
additional income that is not consumed, it
must be saved.
55. Saving Function (Algebraic)
55
Saving function also can be illustrated as
S = -a + (1-b) yd
Where,
S = Savings
-a = Autonomous Savings
(1-b) = Marginal Propensity to Save
(MPS)
57. Continued………..Savings
57
The saving schedule is a schedule that depicts
the relationship between savings and the level
of income. In the simple two sector model, all
consumption and savings accounted for by
households.
At low levels of disposable income ,
households consume more than their current
income (dissavings). At higher levels of
disposable income, they consume only a part
of their income and save the rest, see the
above graph.
58. Investment Function in a Two
Sector Economy
58
Investment means spending on capital goods
( plant, equipment, inventory) that are used
in the production of other goods and
services. Business investment depends on
various factors such as interest rates,
expectations and future rates of return.
However, the relationship between business
investment and current level of income is
generally weak. Therefore we assume that
investment is autonomous. As a function of
income, autonomous investment is drawn as
60. 60
The Equilibrium in a simple
economy can be computed with,
a schedule
graphical presentation
Equations
Let us see how the equilibrium in
a simple economy (2 sector
economy) by a hypothetical
schedule and according to that
table we can present the graphical
curve.
62. 62
10
0
20
0
30
0
40
0
500
600
700
100 200 300 400 500 600 700
E = Y
C + I
C
I
E
Aggregate
Expenditure [E]
Aggregate Income [Y]0
According to the
diagram, the
equilibrium national
Income is illustrated
with the point E.
63. The Changes in Equilibrium Level
of Income due to Aggregate
Expenditure Components Using
the Multiplier Process.
63
The Change in equilibrium in a
simple economy depends on the
following components.
Change in consumption function.
Change in investment.
64. 64
The Change in consumption
function depends on two
factors.
1. Change in Autonomous
Consumption.
2. Change in Marginal
Propensity to Consume
(M.P.C).
65. The Change in consumption function
can be illustrated as a change in
Autonomous Consumption.
65
C
Yd
50
0
100
C1 = a1 + by
C = a + by
A
C
66. In the above diagram we can see how the
consumption curve shifts when the
autonomous consumption changes. As a
result of this the aggregate expenditure
curve also shifts. Therefore the equilibrium
point changes (see the diagram below).
66
10
0
50
120 1500
Y = E
E1 = C1 + I
E = C + I
A
B
67. The change in equilibrium due to the
change in Marginal Propensity to
Consume MPC.
67
C1 = a +b1y
C = a + b y
Y10000
200
300
C
68. The slop of the consumption curve changes as a
result of the change in MPC. Due to this , the slope
of the aggregate expenditure also changes leading
to a change in the equilibrium level of output.
68
Y = E
C1
C
E
A
B
Y
1000 12000
1200
1500
The Equilibrium point also
changes from A to B.
69. The change in investment will
affect the equilibrium of a simple
economy.
69
E 1 = C + I1
E = C + I
I 1
I
Output Y
Expenditure
100
50
0
70. When the investment changes the investment curve
shifts. Then the aggregate expenditure curve also
shifts. As a result of this, equilibrium output and
the points also will change.
70
Y = E
E1
E
C
D
0
Expenditure
Output Y
71. The Multiplier Effect in a
Simple Economy.
71
The multiplier principle states that with
an injection of money into the circular
flow income, the national income, thus
generated would be many times more.
The value of the multiplier can be given
as;
k = ∆ Y
∆ J
And the increase in the level of income
can be calculated by the formula;
72. 72
Thus an injection of money cause a multiple
increase in the income and a withdrawal of
money from the circular flow of income
cause a multiple decrease in the national
income. Here the multiplier works reverse.
In a two sector economy, i. e. an economy
which has no government and foreign trade,
investments would be the only injection and
savings is the only withdrawal. Due to this
reason the multiplier is weakened by only
one factor, savings. The multiplier is
calculated by below formula.
k = 1 1
1- MPC or MPS
73. 73
If there is a change in autonomous
expenditure, the change in the output
can be calculated as follows.
∆ Y = 1
[1-b] x ∆ I
Where,
∆ Y = change in income
∆ I = change in autonomous
investment
b = MPC
74. Example
74
Assuming Marginal Propensity to consume is
0.75 when investment (I) is increased from 50
to 100. find the change in the level of output.
∆Y = 1 x ∆ I
(1-b)
∆Y = 1 x [100 – 50]
(1 – 0.75)
∆Y = 1 x 50
(0.25)
∆Y = 4 x 50 = 200.
75. This is illustrated in a diagram.
75
Y = E
E = C + I 1
E = C + I
1000 1200
100
50
0
Y
E
∆ Y
∆ I
76. Determining the Equilibrium
in a Closed Economy.
76
As the government enters to our simple economy, it
changes into a closed economy or 3 sector
economy. Therefore, the aggregate income and
expenditure components include Taxes (T), Government
purchases (G) and transfers (Tr). Here only autonomous
taxes are considered as taxes.
The following components are used to compute the
equilibrium in the closed (3 sector) economy.
Consumption (C)
Savings(S)
Autonomous taxes (T)
Government Purchases (G)
Transfers (TR)
Investment (I).
77. 77
By using the above components the equilibrium can
be explained with two approaches.
Income - Expenditure Method.
Aggregate expenditure in a closed economy can be
explained as the sum of private consumption
expenditure (C) Investment (I) and government
purchases.
E = C + I + G
Y = E
Y = C + I + G
Aggregate income (Y) in a closed economy equal
the sum of expenditure on private consumption (C)
Personal savings (S) and Autonomous taxes (T).
Y = C + S + T
78. 78
Withdrawals - Injections Method.
E = C + I + G
Y = C + S + T
Y = E
C + I + G = C + S + T
I + G = S + T
Where,
S = Savings.
T= Autonomous taxes.
I = Investment
G = Government purchases. Injections
Leakages
79. The consumption function in a
closed economy can be
illustrated as,
79
C = a + b ( Y-T+TR )
Where ,
a = Autonomous consumption
b = Marginal Propensity to consume
T = Autonomous taxes
TR = Transfers
80. 80
Output
Y
C S T I G E Y - E
585 460 115 10 45 95 600 -15
630 500 120 10 45 95 640 -10
675 540 125 10 45 95 680 -5
720 580 130 10 45 95 720 0
765 620 135 10 45 95 760 5
810 660 140 10 45 95 800 10
855 700 145 10 45 95 840 15
• Consider the example table below.
81. The point “A” is the Equilibrium in
the Closed Economy
81
Y = E
E = C + I + G
C = a + b [Y – T + Tr]
S + T
I + G
OUTPUT [Y]
C,I,S,T,G,E
EXPENDITURE
0
A
82. Determining the Equilibrium in
an Open Economy [4 Sector].
82
When a closed economy (3 sector
economy) is changing into a 4 sector
economy, by introducing international
trade, it is called an open economy.
The basic model of an open economy
is the same as that of a closed
economy and we should add exports
(X) and imports (M); due to
international trade.
83. The components that are used to compute
the equilibrium in an open economy are as
follows.
83
Consumption (C)
Savings (S)
Investment (I)
Government purchases (G)
Transfers (Tr)
Autonomous taxes (T)
Imports (M)
Exports (X)
84. The Equilibrium in an Open
Economy under Income-
Expenditure Approach.
84
Y = C+I+G+ (X-M)
Where,
Consumption = (C)
Investment = (I)
Government purchases = (G)
Imports = (M)
Exports = (X)
85. The Equilibrium in an Open
Economy under Withdrawals -
Injections Approach.
85
Withdrawals = S + T + M
Injections = I + G + X
W = J
S + T + M = I + G + X
Savings (S), autonomous taxes (T) and Imports
(M) are considered as withdrawals.
Investment (I) Government purchases (G) and
Exports ( X) are considered as injections.
87. Bibliography
87
David. W. Pearce," The Dictionary of Modern
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Anderton, Alain, ”Economics”,3rd Edition,
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Lipsy G, Richard, Harbury. Colin," First
Principles of Economics”, 2nd Eds, (1992 ),
Butler & Tanner Ltd, London.
88. 88
Colombage. S. S. ”Principles of
Macroeconomics”, (2006), The Open
University Press, Nugegoda, Sri Lanka.
Richard G. Lipsy, ”An Introduction to Positive
Economics”, 7th Low Price Edition ,(1989),
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Robert J. Gordon," Macroeconomics” 3rd
Edition, (1984), Little Brown & Company
Canada Ltd, USA.
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of Macroeconomics”, (2001), McGraw-Hill
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89. 89
Begg, David K. H., et al, Economics, 4th Eds.
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