Macroeconomics

Week 3-4: Income and Spending

Fahmida Sultana
Associate Professor
Department of Development Studies
University of Dhaka
 Plan of Lecture
• Aggregate Demand and Equilibrium Output
• The Consumption Function and Aggregate
Demand
• The Multiplier
• The Government Sector
• Budget
• Balanced Budget Multiplier
• Life Cycle Hypothesis
 Aggregate Demand and
Equilibrium Output
• Aggregate Demand (AD) is the total amount of goods
and services demanded in an economy.
• Components:
1. Consumption (C)
2. Investment (I)
3. Government (G)
4. Net Export (NX)

So, AD=C+I+G+NX
 Aggregate Demand and
Equilibrium Output (cont..)
• Equilibrium Output- The level of output where quantity
of output produced equals the quantity of output
demanded.
AD 450

Y>AD
E

Y<AD

Y
Y0
 Aggregate Demand and
Equilibrium Output (cont..)
• When the amount output is not equal to the aggregate
demand- the amount that people want to buy, there is an
unplanned inventory or disinvestment:
IU = Y - AD
• Undesired/Unplanned/Unintended inventory
-If AD>Y => IU<0
-If Y>AD => IU>0
• Thus, at the level of equilibrioum, the value of IU=0
 The Consumption Function
and Aggregate Demand
• Consumption Function
C=C+cY; C >0, 0<c<1
• MPC(Marginal Propensity to Consume) is
the increase in consumption due to per unit increase in
income, denoted by c
• Why 0<MPC<1?
 The Consumption Function
and Aggregate Demand

• Savings Function
S= -C+ (1-c)Y
• MPS is the increase in savings due to per unit increase
in income, denoted by s.
• MPC+MPS=1
 The Consumption Function
and Aggregate Demand
• AD Function;
AD=Ā + cY; where Ā=C+I
• Equilibrium income and output : comes at the point
where AD=Y, so by solving it, we get:
• Y0=[1/(1-c)] Ā
• The higher the Ā and the higher the c, the higher the
equilibrium level of output.
• Saving and Investment: S=I (in equilibrium)
 The Multiplier
• Multiplier(α) refers to the amount by which the
equilibrium income changes due to a change in the
autonomous spending
• α=1/(1-c)
• The larger the MPC, the larger the multiplier
• The larger the MPC, the steeper the AD, and the larger
the income change.
 The Government Sector
• AD=Ā + c(1-t)Y; where Ā=C+I+G+cTR
• So,
– Ā is higher
– Slope is lower
– Thus, AD is flatter with a higher intercept
• Equilibrium income:
Y0= Ā[1/{1-c(1-t)}]
• Multiplier, αG=1/[1-c(1-t)]
 The Government Sector
• Income tax as an automatic stabilizer:
– Because the presence of income tax reduces the value of
multiplier, the equilibrium income fluctuates by a less amount.
So, the economy fluctuates less and the tax is thus called
automatic stabilizer.
• Effect of change in Government purchase (G) on
equilibrium:
– If G increases, Y0 increases and vice versa
• Effect of change in Tax (t) on equilibrium:
– If t increases, Y0 decreases and vice versa
 The Budget

• Budget Deficit : If earning<expenditure

BD=G+TR-TA
• Budget Surplus: If earning>expenditure
BS=TA-(G+TR)
 Balanced budget multiplier
• This is the special situation when the value of multiplier
becomes one.
• If an increase in government spending combined with an
increase in tax rate keeps the budget surplus unchanged,
the equilibrium output increases exactly by the same
amount by which the government spending was increased.
Naturally, the value of multiplier then becomes one .
∆Y0 = ∆G = ∆A
So, α =∆Y0/ ∆A=1(BBM)
• Mathematical proof
 Life Cycle Hypothesis
Main Idea:
• The theory views individuals as planning their
consumption and saving behavior over long periods with
the intention of allocating their consumption in the best
possible way over their entire lifetimes.
• Under this theory, consumption plans are made so as to
achieve a smooth or even level of consumption by saving
during periods of high income and dissaving during
periods of low income.
 Assumptions
• A person expects to live for NL years
• Work for WL years
• Earn income of YL each year of earning
• So, live in retirement for NL-WL years
• His year 1 is the first year of work
• No uncertainty about life expectancy or working
life
• no interest is earned on savings
• Prices are constant
 The Theory
• With life time consumption equal to life
time income, we can write
C x NL = YL x WL
From here, we can write:
C= WL/NL x YL
So, C=cYL
Where the factor of proportionality is, c or
WL/NL, the fraction of the lifetime spent
working
 The Theory
• Thus , the theory mainly tells us that the
individual consumes in each year of
working life a fraction of labour income and
that fraction is equal to the proportion of
working life in total life.
Figure
 Introducing wealth in the model
• Including the main assumptions, let us also
assume that the person is at a certain time
period, T, of his life with WR amount of
real wealth.

• So he will work another( WL-T) years and

will live another (NL-T) years.
 Introducing wealth in the model
• Thus, his lifetime consumption possibilities
now:
C x (NL-T) = WR + (WL- T) x YL
i.e, C = aWR + cYL
Where, a = 1/(NL-T) ; the marginal
propensity to consume out of wealth
And c = (WL-T)/(NL-T) ; the marginal
propensity to consume out of labour income.
• Numerical Examples and Practices
• Thank You