introduction to economics  MACROECONOMIC EQUILIBRIUM



introduction to economics  MACROECONOMIC EQUILIBRIUM

As the aggregate expenditures increases, AD also increases and output will also increase. Change in expenditures is less but change in income is higher due to the multiplier effect. This is the case of horizontal portion of AS where prices are constant.


An increase in AD caused by an injection into the circular flow, e.g. higher government spending on wages paid to government employees, would lead to higher money wages held by government servants. Higher wages would translate into higher consumption expenditure on goods and services in the economy, leading to higher money incomes of sellers of goods and services. When firms see consumers more prosperous, they are incentivised to produce more, thus their demand for labour goes up. This triggers a second rise of income increases in the hands of workers (who are also consumers) leading to a further multiplied effect on consumption, production and hiring. And so on. The multiplier effect would not be infinite as there are leakages (saving, taxes, and imports) from the circular flow of incomes each time the workers receive wages from firms. The lower the leakages and the higher the marginal propensity to consume, the higher will be the multiplier effect.

introduction to economics  MACROECONOMIC EQUILIBRIUM

Inflationary Gap


introduction to economics  MACROECONOMIC EQUILIBRIUM

Yf1 Ye


The reverse multiplier effect can be illustrated in the context of Keynes’s paradox of thrift, which highlights the negative impact of higher saving in an economy in recession. As noted earlier, Classical economists thought the solution to the problem of low investment during the Great Depression was high real interest rates caused by low savings. If the latter could be increased, the real interest rate would fall and investment would pick up. However, Keynes said that such thrift (or conservative saving behavior) would accentuate the recession. As people save more, they will spend less. Firms will therefore produce less, and labour hiring will, as a result, fall, leading to a decline in incomes. This decline would also happen in a multiplied fashion, causing a huge decline in national income. The paradox lies in the fact that that saving, while usually considered good for any one individual, can actually be harmful to the overall economy if everyone started saving.

Figure: How higher savings lead to lower national income

introduction to economics  MACROECONOMIC EQUILIBRIUM


Ye3 Ye2 Ye1


The accelerator is a related concept which formalizes the investment response to output or income changes in an economy. The key observation here is that when an economy begins to recover from a slump, investment can rise very rapidly and, in percentage terms, the rise in investment may be several times the rise in income. Since investment is an injection into the circular flow of income, these changes in investment will cause multiplied changes in income and thus heighten a boom or deepen a recession. The formula for the accelerator is α = I/(∆Y), or (∆K)/(∆Y), noting that I = ∆K, where I is investment and K is capital (the stock of plants, buildings or machinery in the economy).

The reason why investment increases by much more than a change in income is as follows:

Suppose firms anticipate national income (and hence the demand for their products) to rise by 10% p.a. over the next 5 years. In response, firms will therefore normally look to undertake an investment (such as buying a machine) which will enable them to meet this new demand for the entire 5 year period. It is usually neither feasible nor possible to buy a machine that has a one year life! Thus, it is easy to see why a given annual change in output (10%) might prompt firms with a five year horizon to make an investment of over 50%. Reverting back to the formula, the size of the accelerator, α, depends on the marginal capital to output ratio: (∆K)/(∆Y). This is the cost of extra capital required to produce a Re.1 increase in national output. So if Rs.2 billion worth of capital is required to produce Rs.1 billion worth of output, then (∆K)/(∆Y) is

2. It is easy to see that, other things being equal the marginal capital-output ratio and the accelerator are essentially the same. α is likely to be greater than 1.


It is obvious that the interaction of the accelerator and multiplier can set off a chain reaction in the economy which can life output and income manifold. For e.g., if there is a rise in government expenditure, this will lead to a multiplied rise in national income. But this rise in national income will set off an accelerator effect: firms will respond to the rise in incomes (and the resulting rise in consumer demand) by investing more. But this rise in investment will constitute a further rise in injections and thus will lead to a second multiplies rise in income. And so on… The reason why such an interaction cannot raise output infinitely is because of two reasons i) the economy runs into the full-employment constraint, i.e. there is a fixed number of workers in the economy, and ii) output must grow at an increasing rate (something which is difficult to sustain for very long) in order for investment to continue rising. This is because the accelerator links investment to changes in output, not the level of output. So for e.g., if output rises in year 1 by Rs.3bn, in year 2 by Rs.2bn, and in year 3 by Rs.1bn, then with α = 2, investment will be Rs.6bn, Rs.4bn, and Rs.2bn in years 1, 2 and 3 respectively. As can be seen, I falls even though output is rising, leading to a reverse multiplier accelerator chain reaction to be set off effect will be reversed. The key point to remember, again, is that investment is related to “changes in income” not the “level of income”, and therefore “changes in income” have to increase in order for investment to increase. A mere increase in level is not important.


If we were trying to get a ‘true’ measure of national production, which of the following activities would you include:

(a) washing-up;

(b) planting flowers in the garden;

(c) playing an educational game with children in the family;

(d) playing any game with children in the family;

(e) cooking your own supper;

(f) cooking the supper for the whole family;

(g) reading a novel for pleasure;

(h) reading a textbook as part of studying?

Is there a measurement problem if you get pleasure from the do-it-yourself activity itself as well as from its outcome?

The difficulty stems from separating production from consumption. In the paid-employment sector of the economy, the distinction is clear. With production, money flows from firms to households (as wages, etc.), and with consumption, money flows from households to firms. Many activities in the home, however, have both a production and consumption element. Although they all lead to a benefit when complete (e.g. washing-up leads to clean dishes), several, if not all, could give pleasure while they are actually being performed. If so, should two lots of benefits be recorded (or even three)? Playing an educational game with children can give pleasure to the children, future benefits to the children from the educational element, and pleasure to the parents. Then there is the cost element. Should this be deducted? It is not deducted for marketed output. In other words, the final value of goods and services sold is what is included, not the value minus the cost of producing them: costs such as the disutility (effort, boredom, etc.) experienced by workers. Ideally, a true measure of national welfare, as opposed to national production, should be only a net measure (i.e. benefits from consumption, minus costs of production). If this principle was used to measure welfare in the household, then all pleasurable activities should be included with a positive sign (including things such as reading a novel for pleasure) and anything causing displeasure should be recorded with a negative sign. Most of the above activities would have elements of both benefits and costs. However, when marketed national production is recorded, costs are ignored, and so for comparative purposes, household production should be recorded on the same basis, and only the benefits recorded. All the above items bring pleasure, either directly (such as reading a novel) or indirectly (such as doing the washing-up), and in this sense they should all be included, but whether activities that give direct pleasure should count as production or merely as consumption, is a question of definition.

Review this question after the balance of payments lectures. If the Malaysian ringgit is undervalued by 47 per cent in PPP terms against the US dollar, and the Swiss franc overvalued by 53 per cent, what implications does this have for the interpretation of Malaysian, Swiss and US GDP statistics?

The GDP figures understate the purchasing value of Malaysian national income by 47 per cent relative to US national income, and overstate the purchasing value of Swiss national income by 53 per cent relative to US national income. In other words, at the exchange rates in question, Malaysian national income seems 47 per cent lower relative US national income than it really is in purchasing terms, and Swiss national income seems 53 per cent higher relative to US national income than it really is in purchasing terms.

If there are no sales taxes, no net factor income from abroad and no depreciation, will the GDP at market prices and national income measures collapse to the same thing?


i. National income is NNP at factor cost = GNP at factor cost – depreciation. Since depreciation = 0, NNP at factor cost = GNP at factor cost.

ii. GNP at factor cost = GDP at factor cost + net factor income from abroad. Since net factor income from abroad = 0, GNP at factor cost = GDP at factor cost

iii. GDP at factor cost = GDP at market price – sales taxes. Since sales taxes = 0, GDP at factor cost = GDP at market price

iv. Therefore NNP at factor cost = GDP at market price.

If nominal GDP has increased by 10% over last year but real GDP has fallen by 2%, by what percentage must have prices risen?

12%. Real GDP growth rate = GDP growth rate – the rate of inflation. -2% = 10% +?;? = -12%.

Is population growth good or bad for a country’s economic welfare?

It depends. If the energies of the growing population (and labour force) can be usefully and efficiently employed towards productive activity, then the growth impact of the larger population may dominate the negative impact of the large denominator in the per capital income formula. However, if more and more people produce less and less (law of diminishing returns) and the quality of human capital created is generally poor, then it might well be that a large population leads to a decline in per capita income and hence average living standards. It also depends on the starting level of the population. In many African countries, centuries of slavery and migration to other countries, and decades of disease and wars, have led to the working populations in these countries to fall below the minimum threshold required for them to “take off” in an economic sense. By contrast, many South Asian and East Asian countries are quite heavily populated and could use a little cooling down of population growth rates.

How should one treat macroeconomic statistics?

With extreme caution, as such data is likely to be used and abused by different interest groups to support their respective stories. It is usually not the data which is misleading or not consistent with the truth but the manner in which it is presented which makes a certain interpretation of that data more likely. Objective analysis of data consists in stripping it off its particular dressings and looking at all the possible stories it can tell.

By what would we need to divide GDP in order to get a measure of labour productivity per hour?

The total number of hours worked in the year throughout the country.

Is the size of the underground or black economy likely to increase or decrease as the level of unemployment rises?

It could rise or fall depending on which of two effects is the larger. On the one hand, if a certain proportion of unemployed people claim unemployment benefit and work in the underground economy, then, with a higher official level of unemployed, the size of the underground economy is likely to be bigger. On the other hand, if the economy is in recession, it is likely that the size of the underground economy will shrink along with the rest of the economy.

Name some external benefits that are not included in GDP statistics?

Three examples are: the pleasure people get from seeing other people’s attractive houses and gardens, aesthetically pleasing architecture, improved health from a better diet.

Are worries about the consequences of economic growth a ‘luxury’ that only rich countries can afford?

This is a very cynical way of looking at the issue. The point is that the marginal benefit of increased output in a poor country is likely to be much higher than in a rich country (given the diminishing marginal utility of income). Thus if a cost–benefit study were done of specific growth policies, the benefits would probably enter with a higher value per unit in a poor country than in a rich country. This does not mean that the cost should be ignored. It is just that people may be prepared to make bigger sacrifices for increased output in poor countries than in rich countries. We must be careful with these arguments, however. They could be used to ‘justify’ policies that are highly damaging to the environment by governments which have little long-term interest in the welfare of the people, or by firms which are unconcerned about the environmental consequences of their activities. The point is that costs should still be taken into account: it is just that the benefits should possibly be given a higher weighting.

If a retailer buys a product from a wholesaler for £80 and sells it to a consumer for £100, then the £20 of value that has been added will go partly in wages, partly in rent and partly in profits. Thus £20 of income has been generated at the retail stage. But the good actually contributes a total of £100 to GDP.

Where then is the remaining £80 worth of income recorded?

At the wholesale stage and earlier. Each stage adds value – value that is partly in wages, partly in rent, etc. When the values added at all the stages are summed, this gives the final value of the good.

An index called the index of sustainable economic welfare (ISEW) has been developed by certain economists to measure sustainable development in different countries. The index takes account of factors like depletion of natural resources which reduces the likelihood of growth being sustained. Make out a case against using ISEW.

How would an advocate of the use of ISEW reply to your points?

There are three major criticisms of ISEW. The first concerns its use as a substitute for GDP. GDP is not meant to be a true measure of living standards, both now and sustainable into the future. Instead it is primarily a measure of output that involves exchange, an important measure when attempting to understand the relationship between aggregate demand (as expressed through exchange relationships) and aggregate supply. The second criticism concerns the selection of items that should be included. Any list could be criticized for including too many or too few items. For example, it could be argued that various forms of public expenditure should be included (other than on health and education, which are already included). On the other hand, various forms of ‘services of household labour’ are not clearly production. They could be seen as a form of consumption. For example, does time spent gardening constitutes work or pleasure? We would not include watching television or sitting relaxing as production, so should be include gardening or any other hobbies as production which generates pleasure when consumed or merely as pure consumption? Similarly, do relationships between people constitute the ‘provision of services’ or is it rather mere joint consumption? The third and perhaps the most serious criticism concerns measurement. How, for example, should the depletion of non-renewable resources or long-term environmental damage be measured? Such measurement entails various value judgments about the relationship between present and future costs. In fact, the value placed on all non-marketed items is likely to be highly controversial (more so than marketed items, where corrections for market distortions could relatively easily be made). An advocate of ISEW would reply that ISEW, as its name says, is meant to be a measure of sustainable economic welfare, and not a measure of marketed output and is thus doing something different from the conventional use of GDP. If GDP is used, not for its original purpose, but as a measure of welfare, then ISEW is superior. As far as the selection of items and their measurement is concerned, there will be inevitably be disagreement, because people have different values. But here the advocate of ISEW would reply with the last two sentences of the box.

What are the conditions for macroeconomic equilibrium in the economy.

i. Injections (governemnt spending, exports, investment) into the circular flow of incomes must equal the withdrawals (saving, taxes, imports) from the circular flow; or

ii. Aggregate demand must equal aggregate income must equal aggregate supply. The two approaches are equivalent. Note, however, that the equilibrium of an economy, at least in a Keynesian world, does not imply the full-employment equilibrium. It is possible for inflationary and deflationary gaps to exist.

What are the major macroeconomic variables involved in the determination of national income?

C, I, G, X, M, T, S, prices, exchange rate, interest rate and money supply. We focus on the first seven in this part of the course, but will enrich our analysis with the remaining four later in the context of the ISLM approach to equilibrium determination and international finance considerations.

What does the 45 degree line in expenditure-income space represent?

It represents all the points at which the economy is in equilibrium, i.e. the expenditure on domestic goods and services is equal to the supply of domestic goods and services is equal to the incomes distributed to factors used in the production of those goods and services

Are the following net injections, net withdrawals or neither?

If there is uncertainty, explain your assumptions.

i. Firms spend money on research.

ii. The government increases personal tax allowances.

iii. The general public deposits more money in banks.

iv.Pakistani investors earn higher dividends on overseas investments.

v.The government purchases US military aircraft.

vi. People draw on their savings to finance holiday trips abroad.

vii. People draw on their savings to finance holidays within Pakistan.

viii.The government runs a budget deficit (spends more than it receives in tax revenues) and finances it by borrowing from the general public.

ix.The government runs a budget deficit and finances it by printing more money.

i.Increase in injections (investment).

ii. Decrease in withdrawals (taxes).

iii. Increase in withdrawals (saving).

iv.Fall in withdrawals (a reduction in net outflow abroad from the household sector).

v.Neither. The inner flow is unaffected. If, however, this were financed from higher taxes, it would result in an increase in withdrawals.

vi. Neither. The inner flow is unaffected. The consumption of domestically produced goods and services remains the same.

vii. Decrease in withdrawals (saving).

viii.Neither. An increase in government expenditure (or decrease in taxes, or both) is offset by an increase in saving (i.e. people buying government securities).

ix. Net injections. An increase in government expenditure (or decrease in taxes, or both) is not offset by changes elsewhere. Extra money is printed to finance the net injection.

It is possible that as people get richer they will spend a smaller and smaller fraction of each rise in income (and save a larger fraction). Why might this be so? What effect will it have on the shape of the consumption function?

It is likely that the rich will feel that they can afford to save a larger proportion of their income than the poor. The consumption function will slope upwards, but get less and less steep. This means mpc will fall as incomes rise.

What effect will the following have on the mpc:

a) a rise in the rate of income tax;

b) people anticipate that the rate of inflation is about to rise;

c) the government redistributes income from the rich to the poor?

a) The mpc will fall. Note that here we are relating consumption to gross income. For any given

gross income, a rise in taxes will cause a fall in disposable income and hence a fall in consumption.

b) The mpc will rise as people spend a larger fraction of any rise in income, for if they wait to consume, their incomes will be worth less in the enxt period in urchasing power terms.

c) The mpc will increase, because the poor have a higher mpc than the rich.

What would be the impact of changing the determinant variables given in the first column (below) on consumption and saving. Must saving always fall if consumption falls?

Determinant Consumption Saving
Income (rise) rise rise
Assets held (increase in) rise fall
Taxation (fall) rise rise
Cost of credit (lower interest rates) rise fall
Expectations (that prices will rise) rise fall
Redistribution of income (becomes more equal) rise fall
Tastes and attitudes (people want to consume more) rise fall
The average age of durables (increases) rise fall

Thus there are two determinants of consumption (namely income and taxation, which will not cause saving to rise if consumption is caused to fall.

Why, if the growth in output slows down (but is still positive), is investment likely to fall (i.e. be negative)?

Because firms will require a smaller increase in capital. They will thus buy fewer extra machines and other equipment: i.e. investment will fall. The underlying concept is that of Keynes’s investment accelerator which relates induced investment to changes in output rather than the level of output.

Give some other examples of changes in one injection or withdrawal that can affect others.

  • A rise in government expenditure on infrastructure projects may encourage firms to invest, or, on the other hand, may replace private investment.
  • A rise in taxation will reduce savings and imports as well as consumption of domestic goods and services.
  • A depreciation of the exchange rate will lead to increased exports (an injection) and decreased imports (a withdrawal). This could encourage increased investment in the domestic economy.
  • Higher savings will mean less total consumption, including less expenditure on imports.

Keeping Keynes’s paradox of thrift arguments in mind, is an increase in saving ever desirable?


  • If there is a problem of excess demand, an increase in savings will reduce inflationary pressures.
  • If investment increases over time, an increase in savings will allow these increases to be financed without problems of rising interest rates or inflation, problems which would have the effect of curtailing the investment.

The present level of a country’s exports is £12 billion; investment is £2 billion; government expenditure is £4 billion; total consumer spending (including on imports) is £36 billion; imports are £12 billion and expenditure taxes are £2 billion. The economy is currently in equilibrium. It is estimated that an income of £50 billion is necessary to generate full employment. The marginal propensity to save is 0.25.

a) Is there an inflationary or deflationary gap in this situation?

b) What is the size of the gap? (Don’t confuse this with the difference between Ye and Yf.)

c) What would be an appropriate government policy to close this gap?

Injections (J) = £12bn + £2bn + £4bn = £18bn

Domestic consumption (Cd) = £36bn – £12bn – £2bn = £22bn

∴ Expenditure on domestic goods, E = Cd + J = £18 + £22 = £40bn

Multiplier = 1/mps = 1/0.25

= 4 a) Deflationary gap. If the economy is in equilibrium, then Y = E. Thus Ye = £40bn. But full employment is achieved at an income of £50bn. There is thus a deflationary gap.

b) £2.5bn. This is the amount that must be injected (given a multiplier of 4) in order to increase national income by £10bn from the current £40bn to the full-employment level of £50bn.

c) Increase government expenditure by £2.5bn.

Why does investment in construction and producer goods industries tend to fluctuate more than investment in retailing and the service industries?

Because demand for the output of these industries (which are ‘investment’ goods industries) fluctuates much more as a result of the accelerator effect.

Give some examples of single shocks and continuing changes on the demand side. Does the existence of multiplier and accelerator effects make the distinction between single shocks and continuing effects more difficult to make on the demand side than on the supply side?

Examples of single shocks include government expenditure on a specific project, a surge in consumer spending in anticipation of a rise in taxes and a temporary movement in the exchange rate (a depreciation causing a rise in aggregate demand through increased exports and decreased imports, and an appreciation causing a fall in aggregate demand). Examples of continuing changes include a sustained increase in consumer or business confidence, which builds over time, and changes in interest rates that then remain for a period of time. The multiplier and accelerator will amplify single shocks on the demand side and the process will last for several months. Aggregate demand will not go on and on rising, however, unless there are continuing changes on the demand side, which then continue to be amplified by the multiplier and accelerator. Thus the effects are somewhat less clear cut than with changes on the supply side, but it is still possible to distinguish between single shocks on the demand side and continuing changes (even if the single shocks do cause multiplier and accelerator effects).

Draw an injections and withdrawals diagram, with a fairly shallow W curve. Mark the equilibrium level of national income. Now draw a second steeper W curve passing through the same point. This second W curve would correspond to the case where the mps is higher.

W, J


Y0 Y2 Y1

introduction to economics  MACROECONOMIC EQUILIBRIUM

Economies with different marginal rates of taxation

Assuming now that there has been an increase in injections, draw a second J line above the first. Mark the new equilibrium level of national income with each of the two W curves. You can see that national income rises less with the steeper W curve. The higher mps has a dampening effect on the multiplier. A higher tax rate has the same dampening effect as well by reducing the size of the multiplier (by increasing the size of the term in the denominator). Multiplier with taxes = 1/[1-{mpc(1-t)}];as t increases, (1-t) falls,, therefore 1-{.} rises, causing the multiplier to fall.

What effects will government investment expenditure have on public-sector debt

(a) in the short run;

(b) in the long run?

a) Increase. Unless financed by extra taxation, an increase in government expenditure (for whatever purpose) will lead to an increase in public-sector debt.

b) Possibly decrease. If the investment leads to extra output and income, then the extra tax revenue from the extra incomes and expenditure could more than offset the cost of the investment, thereby leading to a fall in public-sector debt.

If cuts in interest rates are not successful in causing significant increases in investment, how can they lead to economic recovery?

What, in these circumstances, determines the magnitude of the recovery?

They can lead to recovery if they cause consumers to borrow more. The increased spending causes a multiplied rise in national income. The magnitude of the recovery depends on

(a) the amount of extra consumer spending;

(b) the size of the multiplier;

(c) whether there is any subsequent increase in investment (through the accelerator effect).

How do people’s expectations influence the outcome?

People’s expectations will reinforce whatever it is they expect (self-fulfilling expectations). If firms expect a rise in government expenditure to lead to

a) higher interest rates,

b) a reduction in private-sector investment and hence

c) no expansion of the economy, they will reduce their investment plans, thus bringing about the effect (i.e. economic stagnation) that they had anticipated.

If the government increases spending by Rs.10bn and finances it totally from taxes, will there be any expansionary impact on output?

Yes. The increase in spending is an injection of Rs.10 bn. The withdrawal, however, is less than Rs.10bn, as saving (a withdrawal from the system falls). Why does saving fall? Because higher taxes reduce disposable income and therefore given a fixed mps out of disposable income, saving will fall. The concept is called balanced budget multiplier, i.e. the fact that tax-financed spending (which has no effect on the fiscal balance) can still be expected to have a multiplied (albeit much smaller) effect on equilibrium output and income.

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