Course Code: ECO202/ ECO102

Chap 4 &5
Basic Macroeconomic relationships; The income
consumption and income saving,
Simple Keynesian Model
 Great Depression
• From 1929-1941, the United States (and
the world) was in a huge economic
depression, in the U.S. the official
unemployment rate was 25%.
• Economists and others began to ask the
question: why isn’t the economy
recovering, where is the self-adjusting
mechanism.
• Neoclassical theory says the economy will
recover in the long run, but how long is
that?
John Maynard Keynes

• Another famous economist

from Cambridge University
in England, he remarked:
“In the long run we’re all
dead.”
• Keynes, writing in the midst
of the Great Depression,
criticized neoclassical
theory, and put forward an
alternative way of looking at
the macroeconomy.
 Consumption function
• Short run Keynesian consumption function
is often written as: C=Ca+bYd
• Ca is autonomous consumption function.
This implies that Ca is not related to income
level (Yd) since a minimum level of
consumption is required just for survival
even if there is no income.
• And “b” is MPC/ Marginal Propensity to
consume
• Yd= ( Y- T)= Disposable income
 Marginal Propensity to
Consume
• Given the consumption function: C= f (Yd)
• The idea is that when the income
increases, consumption also increases but
less than proportionately. Alternatively,
marginal propensity to consume (MPC) is
positive but less than unity (0<MPC<1).

• MPC=∆C = Change in consumption

∆Yd Change in disposable income
• i.e. 0< =∆C <1
∆Yd
 Marginal Propensity to
Consume
• Suppose, initial income level is $1000 and consumption
demand is $800. When income level increases to $1500,
and consumption demand to $1200, MPC will be:
• =∆C/ ∆Yd =400/500=0.80
• This implies that when income increases by $ 100,
consumption demand increases by $ 80. And the
difference $20 is the saving.
• This means Yd = C+S
• i.e. Disposable income=Consumption+Saving
Average Propensity to Consume
• The fraction of total disposable income spent on
consumption demand is called the average propensity to
consume (APC).
• APC= Consumption demand = C
Disposable income Yd

• APC implies the average spending tendency of the

community or the people of a country.
C=Ca+bYd
APC=C/Yd
=Ca/ Yd+bYd/Yd
= Ca / Yd + b
=>APC > MPC
 Calculating APC and MPC

Yd C APC = C/Yd+ b MPC=b S=Yd-C

0 100 - - -100
100 175 1.75 0.75 -75
200 250 1.25 0.75 -50
300 325 1.08 0.75 -25
400 400 1 0.75 0
500 475 0.95 0.75 25
600 550 0.92 0.75 50
Consumption and Saving function
45°

Expenditur
e

C = a + bY
C<Y

a+I
S = - a + (1 – b) Y
C=Y→S=0

a
C>Y
I
S>0
0
S<
Y1 Yf Y
-a 0
“Dissaving”
 Saving Function
• The part of the disposable income not spent on
consumption is called saving. In this case, saving is the
difference between disposable income and consumption.

• It is based on the premise that Yd=C+S

• Then S=Yd - C
• S= Yd- (Ca+bYd)
• Or, S= -Ca+(1-b)Yd
Where, -Ca=Autonomous saving that is negative or that is
dissaving. A person must borrow in order to survive.
• 1-b is marginal propensity to save as we know b is
marginal propensity to consume.
 Marginal Propensity to save
• MPS is the change in saving as a result of
an additional unit of disposable income.
• MPS =∆S = Change in saving
∆Yd Change in disposable income
• APS is the ratio between total saving and
total disposable income.
• APS =S = Saving
Yd Disposable income
 savings function
S = Yd –C
= Yd – a - b Yd
= -a + (1 - b) Yd
What is the y intercept of the savings
function? –a (= autonomous savings)
What is the slope of the savings function?
(1 – b) ( = mps = marginal propensity to
save = ΔS/ΔYd = rise/run = slope)
APC, MPC and APS , MPS
 Practice
• Derive and draw C and S function
• Practice no 4 from McConnell Brue and
Flynn – Chapter 27 ( 19 e)
 Non income Determinants and
shifts of Consumption and Saving
function
• Amount of disposable income is the
main determinant
• Other determinants are
• Wealth
• Borrowing
• Expectations
• Real interest rates
LO2
 Non income Determinants
● Wealth: A household’s wealth is the dollar amount of all
the assets that it owns minus the dollar amount of its
liabilities (all the debt that it owes). The larger the stock of
wealth that a household can build up, the larger will be its
present and future consumption possibilities.
● An increase in wealth shifts the consumption schedule up
and the saving schedule down. In recent years, major
fluctuations in stock market values have increased the
importance of this wealth effect. Examples: In the late
1990s, skyrocketing U.S. stock values expanded the value
of household wealth by increasing the value of household
assets. Predictably, households spent more and saved
less.
 Non income Determinants

• Household debt/ borrowing: When a household

borrows, it can increase current consumption
beyond what would be possible if its spending
were limited to its disposable income. By
allowing households to spend more, borrowing
shifts the current consumption schedule upward.
 Non income Determinants
• Expectations: Changes in expected future prices or
wealth can affect consumption spending today.
Household expectations about future prices and
income may affect current spending and saving.
• For example, expectations of rising prices tomorrow
mayt trigger more spending and less saving today.
Thus, the current consumption schedule shifts up
and the current saving schedule shifts down. Or
expectations of a recession and thus lower income
in the future may lead households to reduce
consumption and save more today. If so the
consumption schedule will shift down and the
saving schedule will shift up.
 Non income Determinants
• Real interest rates: When real interest rates
(those adjusted for inflation) fall, households tend
to borrow more, consume more, and save less. A
lower interest rate, for example, induces
consumers to purchase automobiles and other
goods bought on credit. A lower interest rate also
diminishes the incentive to save because of the
reduced interest “payment” to the saver. At best,
lower interest rates shift the consumption
schedule slightly upward and the saving schedule
slightly downward. Higher interest rates do the
opposite.
Shift of C and S function
 Shift of C and S function
Shifts of the (a) consumption and(b) saving schedules.
Normally, if households consume more at each level of
real GDP, they are necessarily saving less. Graphically
this means that an upward shift of the consumption
schedule (C0 to C1) entails a downward shift of the
saving schedule (S0 to S1). If households consume less
at each level of real GDP, they are saving more. A
downward shift of the consumption schedule (C0 to C2)
is reflected in an upward shift of the saving schedule
(S0 to S2).
This pattern breaks down, however, when taxes change;
then the consumption and saving schedules move in
the same direction—opposite to the direction of the tax
change.
Shift of consumption function
 Other Important Considerations

• Simultaneous shifts
• Taxation

LO2
 Interest-Rate-Investment
Relationship
• Investment consists of spending on new plants, capital equipment,
machinery, inventories, construction, etc. The investment decision
weighs marginal benefits and marginal costs. The expected rate of
return is the marginal benefit and the interest rate (the cost of
borrowing funds) represents the marginal cost.
• The expected rate of return is found by finding the expected
economic profit (total revenue minus total cost) as a percentage of
the cost of investment. The text’s example gives $100 expected
profit on a $1000 investment, for a 10% expected rate of return.
Thus, the business would not want to pay more than a 10% interest
rate on the investment. Remember that the expected rate of return
is not a guaranteed rate of return. Investment carries risk.

LO3
 Interest-Rate-Investment
Relationship
• The real interest rate, i (nominal rate corrected for expected
inflation), determines the cost of investment.
• The interest rate represents either the cost of borrowed funds
or the opportunity cost of investing your own funds, which is
income forgone. If the real interest rate exceeds the
expected rate of return, the investment should not be made.
• The investment demand schedule: shows an inverse
relationship between the interest rate and the amount of
investment. As long as the expected return exceeds the
interest rate, the investment is expected to be profitable
Investment demand curve
 Shifts of Investment Demand

• Acquisition, maintenance, and operating

costs
• Business taxes
• Technological change
• Stock of capital goods on hand
• Planned inventory changes
• Expectations ( Refer to book for details)

LO4
 Determination of Equilibrium income in Simple Keynesian Model

Assumption of the model:

• In a two sector model, a simple but an imaginary assumption of no government and no

foreign trade is made.

• Aggregate Income (Y) = Consumption(C) + Saving (S)

• Therefore, the AS schedule is usually called C + S schedule. The AS curve is also

named as Aggregate Expenditure (AE) curve.

Aggregate Demand:

• AD refers to the effective demand that is equal to the actual expenditure. AD involves

two items, namely, AD for consumer goods or consumption (C) and aggregate demand

for capital goods or investment (I).

• Aggregate demand = Consumption(C) + investment (I).

Solving for equilibrium income/ Y
Demand:Y = C + I (1)
C = a + bY (2)
I= Ia (3)
Substituting equation (2) and (3) into equation (1),
Y= a + bY +Ia
Subtracting bY from both sides:
Y - bY = a + Ia (4)
Factoring out the Y from the left hand side of equation (4)
Y (1 - b) = a + Ia (5)

Dividing both sides by (1 - b)

• Ye = 1 (a + Ia) (6)
(1-b)
Solving for equilibrium income/ Y
Equilibrium is
reached at less
than full
employment level.
 Keynesian Model
45°

Expenditur C+I
e

C = a + bY

a+I
S = - a + (1 – b) Y

a I
I

0
Y1 Y* Yf Y
-a
 Stability of equilibrium in SKM
Equilibrium is a situation in which there is no tendency for change. Unplanned
changes in inventory, equal to the difference between real GDP (Y) and aggregate
demand will cause firms to alter the level of production:
● When AD > Y, firms see that their inventories have dropped below the desired
level, so production increases to bring inventories up to desired levels. Real
GDP rises so that economy can reach equilibrium.
● When AD < Y, firms are unable to find buyers for all the goods they have
produced. These unsold goods pile up in firms' inventories. Firms will cut
back on production in order to sell off the excess inventories. Real GDP falls,
so they reach equilibrium.
● When AD = Y, firms are able to sell all of the goods they have produced.
Inventories are at the desired levels. Firms have no reason to increase or
decrease production. Real GDP will not change. The economy is in
equilibrium.
 Stability of equilibrium in SKM
Graphically, the economy is in equilibrium at the point where the AD
function intersects the 45 degree line. At this level of real GDP, AD
equals Y.
Equilibrium Conditions:
1. Y = AD
2. no unplanned changes in inventories
3. leakages = injections ( S = I)
Leakages are income that is not spent on domestic consumption. The
leakages are savings, taxes, and imports. Leakages cause real GDP
to fall. Injections are spending on domestic production other than
consumption spending. The injections are investment spending,
government spending, and exports. Injections cause real GDP to rise.
In equilibrium, real GDP does not change. So, the leakages must
balance out the injections.
 Savings, investment, and
equilibrium
• Note that the savings function intersects
the investment function at the same level
of income as the aggregate spending
function intersects the 45 degree line,
indicating that savings = investment at the
macro equilibrium.

• Note that this macro equilibrium occurs

below the full employment level of output,
Yf.
 Equilibrium under
fullemployment
• Refer book H. L Ahuza ~ page 98.
 Keynesian model – Practice
problem
Given:
Y=C+I
C = a + bY
Where:
a = 100
b = .75
I = 300
Solving for Ye, C, S

* Practice from book~ H. L Ahuza ~ page 102 and 103

 The Multiplier Model
• How much does a $ 1 initial increase in income
would be spent on consumption? Out of this, a
fraction ‘b’ is consumed. Assume that production
increases further to meet this induced expenditure,
i.e. output and income increases by 1+b.
• This will again create an excess demand because
the expansion in production and income by 1+b
will give rise to further induced spending. This
process goes on like this and is explained by the
multiplier model.
• Multiplier analysis is an important tool of income
expansion, and business cycle analysis.
 How does this multiplier work?

• A hypothetical example: 
-- First off, suppose everyone has the same MPC, 0.75 
-- I withdraw $100 from my savings acct and spend it all on a leather
jacket 
-- Biff, the leather jacket salesman, since he has MPC = 0.75, spends
$75 (on a hat) 
-- Cheryl, the hat salesperson, spends 0.75*$75 = $56 (on a puppy) 
-- Ralph, the dog breeder, spends (0.75)2*$75 = $42 (on a haircut) 
-- Olga, the hairstylist, spends (0.75)3*$75 = $32 ... 
-- and so on. Note that each subsequent amount spent is 75% of the
previous amount.
• After many more iterations the amount spent will be so tiny (75% of a
fractional cent) that we can forget about it. But by then the total
increase in spending will have been quite large.
 How does this multiplier work?
• Numerically, let's keep track of the total, cumulative increase in spending
that results from an injection of $100 into the spending stream. We have
assumed MPC = 0.75 and that it's the same for everyone. 

-- I spend $100 on a leather jacket. The leather jacket vendor spends

$75 (.75*$100) on a hat, and so on... ->    Increase in equilibrium GDP 
        = Increase in total spending 
        =  $100 + (.75)($100) + (.75)(.75)($100)+ (.75)(.75)($100) + ... 
        = $100 * (1 + .75 + .752 + .753 + ...)
(GEOMETRIC SERIES -- converges to a finite number, according to a simple
formula)
        = $100 * [1/(1-.75)]          
        = $400
• Note that in this example .75 is the MPC.
 The Dynamic Multiplier process
Round Increase in Increase in Total increase in
demand production income (all
this round in this rounds)
round
1 ∆Ā ∆Ā ∆Ā
2 b∆Ā b∆Ā (1+b) ∆Ā
3 b2∆Ā b2∆Ā (1+b+b2) ∆Ā
4 b3∆Ā b3∆Ā (1+b+b2+b3)∆Ā
…. ….. ….. 1 ∆Ā
(1-b)
 Comparative static multiplier
• For equilibrium level of income:
• Y=C+I
• In multiplier analysis we are concerned
with change in income by change in
investment
• ∆Y=∆C+∆I
• ∆Y/∆I=1/1-MPC=1/MPS
 Comparative static multiplier
∆Y=∆C+∆I ...... 1
C= a + b Y
∆C = b ∆Y...... 2
Substituting the value of equation 2 into 1
∆Y = b ∆Y + ∆I
∆Y (1 -b) = ∆I
∆Y / ∆I = 1/ 1-b
Investment multiplier = 1 / 1 - MPC = 1/ MPS
∆Y = ∆I x 4 when MPC = .75
∆Y = ∆I x 1.3 when MPC = .25
 The Effect of Multiplier
C

E2 C+I+I'
C+I
E1 C

0.5
C
45º
O Y1 Y2
Y

I rises hence C+ I shifts parallely upward. Equilibrium income rises from Y1 to Y2.

Y1 increased to Y2 because of the multiplier effect and a new equilibrium is attained.

 Worked out - Practice problem

Given:
Y=C+I
C = a + bY
Where:
a = 100
b = .75
I = 300
1. Solving for Ye, C, S
2. I increases by 100. What is the Value of Investment Multiplier.
3. Find the new equilibrium Ye, C, S.

1. Ye= 1600, C =1300, S = 300

2. DI= 100,

DY/ DI= 1/ 1-b

= 1/ 1- .75
=4

3. DY = 4 x 100 = 400

Y1 = 1600 + 400 = 2000

C = 1600, S = 400
 Keynesian model - numerical
example
Given:
Y=C+I
C = a + bY
Where:
a = 100
b = .75
I = 300
1. Solving for Ye, C, S
2. I increases by 100. What is the Value of Multiplier.
3. Find the new equilibrium Ye, C, S.
Inflationary gap
It is created due to the
effective demand being in
excess of the full
employment level. It is the
difference between
equilibrium income and full
employment income
(potential income) when
equilibrium income exceeds
the full employment
income.
Recessionary gap
Deflationary gap is also called recessionary
gap. When there is an insufficient demand for
goods and services in the economy, the
equilibrium will occur at the lower level of full
employment income and to the left of full
employment line.

The deflationary gap is the difference of

amount by which aggregate expenditure falls
short of the level needed to generate
equilibrium national income at full
employment without inflation.
PARADOX OF THRIFT
Who coined the term paradox of thrift?
Keynes first popularised the term as it fitted in neatly with his concept that
recessions were caused by falls in aggregate demand. It also justified higher
government borrowing to offset the private sector savings. He mentioned it in
his General Theory.
"For although the amount of his own saving is unlikely to have any
significant influence on his own income, the reactions of the amount
of his consumption on the incomes of others makes it impossible for
all individuals simultaneously to save any given sums. Every such
attempt to save more by reducing consumption will so affect incomes
that the attempt necessarily defeats itself. It is, of course, just as
impossible for the community as a whole to save less than the amount
of current investment, since the attempt to do so will necessarily
raise incomes to a level at which the sums which individuals choose to
save add up to a figure exactly equal to the amount of investment.
— John Maynard Keynes,
The General Theory of Employment, Interest and Money, Chapter
7, p. 84
 Who coined the term paradox of thrift?

This rather long-winded statement was shortened by Paul

Samuelson, who used the term 'paradox of thrift' in his influential
post-war macroeconomics text book.
The idea was also in use before Keynes. In 1893, in the The Fallacy
of Saving, John M. Robertson writes on the potential problem of
many individuals saving at once.
"Had the whole population been alike bent on saving, the
total saved would positively have been much less, in as much
as (other tendencies remaining the same) industrial paralysis
would have been reached sooner or oftener, profits would be
less, interest much lower, and earnings smaller and more
precarious. This ... is no idle paradox, but the strictest
economic truth."— John M. Robertson, The Fallacy of Saving,
pp. 131–132
 S, I & the paradox of thrift
• Paradox of thrift
If society attempts to save more, it may end up actually
saving the same amount or even less, as a result of the
multiple decline in equilibrium GDP caused by the
withdrawal of aggregate expenditure
• An increase in saving by the household sector necessarily
goes hand-in-hand with a simultaneous decrease
in consumption expenditures, and thus a decrease
in aggregate expenditures. This decrease in aggregate
expenditures then triggers the multiplier process and
subsequently leads to a decrease in aggregate production.

6-52
Paradox of thrift
Practice:
Mc Connell & Brue 17th Edition
figure 10.7
Pg 180/187
Application: The U.S. Recession of 2001
Pg 578 : The Aggregate Expenditure Theory Emerged as a Critique of
Classical Economics and as a Response to the Great Depression.

Given:
Y=C+I
C = a + bY
Where:
a = 100
b = .75
I = 300
Solving for Ye, C, S
i) If full employment equilibrium is at 5000 then find the Investment
required to achieve that level. What is the new C and I.
 Practice

2. Consider a simple economy in which whole investment is constant and equal to

$50 billion.

There are no government or foreign sectors, and the price level is constant.

Assume that consumption behavior can be described as C = $40 billion + .8Y.

A. What is the value of the marginal propensity to consume? Ans: .8

B. What would be the value of consumption if Y = $500 billion? Ans: 440

C. What is the equilibrium level of GDP in this model? Ans: 450

D. What is the value of the multiplier in this model? What determines the size of the
multiplier?Ans: 5, MPC

E. Suppose that desired investment were to call to $40 billion. What would happen
to equilibrium income?

DI = -10
DY = -50
Y2 = 450 - 50 = 400
Practice