Bule Hora University

College of Agricultural science

Department of Agricultural Economics

Course title: Macroeconomics II
Program: Regular 3rd year
Course Load: 3 Cr. Hrs.

March, 2024
1 Gelgelo B. (MSc.)
Bule Hora, Ethiopia
 Assessment Methods

Quizzes 10
Test 20
Assignment with 20
Presentation
Final Exam 50
Total 100
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 CHAPTER ONE. EQUILIBRIUM INCOME DETERMINATION

1.1. The Components of Income

 GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the
economy’s output of goods and services.
 Generally, the GDP or income has three components: consumption (C), investment (I), government purchases
(G) in closed economy which expressed in the national income accounts identity as: Y=C+I+G.
 Consumption: When we eat food, wear clothing, or go to a movie, we are consuming some of the output of the
economy.
 Households receive income from their labor and their ownership of capital, pay taxes to the government, and then
decide how much of their after-tax income to consume and how much to save.
 The income after payment of all taxes ( Y-T) is called disposable income and households divide their disposable
income between consumption (C) and saving (S). S= Y-C.
 The relationship between consumption and disposable income is called the consumption function and expressed
as C = C(Y-T) = a + b(Y-T).
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  The slope (b) of the consumption function is called marginal propensity to consume (MPC) and is the amount by

which consumption changes when disposable income increases by one Birr.

 Investment: Both firms and households purchase investment goods. Firms buy investment goods to add to their

stock of capital and to replace existing capital as it wears out and households buy new houses, which are also part of
investment.
 The quantity of investment goods demanded depends on the interest rate, which measures the cost of the funds used

to finance investment.
 Government Purchases: The government sector basically does two major things or national economic activities.
 Making expenditure on goods and services, which is denoted by (G)
 Government earns income through tax, which is denoted by (T)

 These purchases are only one type of government spending. The other type is transfer payments (TR) to households,

such as welfare for the poor and Social Security payments for the elderly.
 Transfer payments (TR) do affect the demand for goods and services indirectly.

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  Transfer payments (subsidies) are the opposite of taxes: they increase households’ disposable income,

just as taxes reduce disposable income.

 We can now revise our definition of T to equal taxes minus transfer payments (T-TR).

 If government purchases equal taxes minus transfers, G = T-TR, then the government has a balanced

budget.

 If G+TR>T, the government runs a budget deficit, which it funds by issuing government debt-that is, by

borrowing in the financial markets.

 If G +TR< T, the government runs a budget surplus, which it can use to repay some of its outstanding

debt.

 The budget surplus (BS) can be defined as the excess of government revenue, consisting of taxes, over

its total expenditure including transfers and is given by the equation as: BS=T-G-TR
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 1.2. Keynesian Cross and the Economy in Equilibrium
 In the simple Keynesian model, there are three ‘fundamental assumptions’. These are:

 The flow of output produced by an economy (GDP) in a given time period is identically equal to income (Y) generated.

 Output is demanded by three types of agents: consumers, firms, and the government (assume a closed economy)

 The price level is constant, i.e., there is no inflation. Therefore, the nominal values of Y, C, I, and G are also their real values.

 Derivation of the Keynesian cross is started by drawing a distinction between actual and planned expenditure.

 Planned expenditure or aggregate demand is the amount of households, firms and the government plan to spend on

goods and services.

 Actual expenditure is the amount households, firms, and the government spend on goods and services, and it equals

the economy’s gross domestic product (GDP).

 Assuming that the economy is closed, so that net exports are zero, we write aggregate demand (or planned

expenditure) AD as the sum of consumption (C), planned investment (I) and government purchase (G) AD = C + I +
G
 Individual consumers’ demands for products can be aggregated and represented by a consumption function
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  In other words, consumption is determined by disposable income  Note that the two curves differ only in their intercept. The intercept of

(Yd) which is total income (Y) minus taxes (T) i.e. Yd=Y-T. consumption function or curve is ‘a’ whereas it is ‘a+I+G’ for the
aggregate demand since I and G are also constant by assumption.
 Then, we can write: C = a + b(Y-T), and 0<b<1, hence, C=a+bYd.
 Under these particular assumptions, both aggregate demand and
 Where, ‘a’ is the intercept of the consumption function
consumption function have the same slope given by marginal
(sometimes called autonomous consumption) - represents the
propensity to consume (MPC)
level of consumption when income is zero and the ‘b’ is the
 This can be proved by taking the first order derivative of both functions
marginal propensity to consume (MPC).
since the first order derivative is the slope of a function.
 By substituting the values of consumption functional (C),

autonomous investment (I) and autonomous government

expenditure (G) into the AD equation, we obtain: AD=a+ b(Y-T̅ )
+I̅ +G̅ .

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  Equilibrium will be found when the desired amount of output demanded by all the agents in the

economy exactly equals the amount produced in a given time period.

 Actual aggregate demand = Planned aggregate demand Y = AD.

 The graphical representation of the equilibrium is known as the "Keynesian cross" because of the

crossing of the upward sloping AD curve and the 45 0 line.

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 Illustrative Example
 Suppose the consumption function and the investment is given as follows with no government intervention:

C=100+0.75Y; I=150, Where, the investment (I) is autonomous.

a) Find the aggregate demand function.

b) Find the equilibrium level of income.

c) Find the equilibrium level of aggregate demand

d) Find the equilibrium level of consumption.

Solutions :-

a) AD = C + I. but C=100+0.75Y and I=150. by substituting these values,

AD=C+IAD=100+0.75Y+150 =250+0.75Y
b) The equilibrium level of income is obtained by equating output or income (Y) to aggregate demand (AD) given as follows:

Y=ADY=250+0.75YY-0.75Y=2500.25Y=250Y=1,000

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 c) The equilibrium level of aggregate demand is again obtained by substituting the equilibrium income level into the
aggregate demand function

AD=250+0.75Y and Y=1,000 substituting this in the aggregate demand function we obtain:

AD=250+0.75Y =250+0.75(1000) =250+ 750 =1000. This answer fulfills the equilibrium condition given by: Y=AD
since the values of both the variables are 1000.
 d) Equilibrium level of consumption is also obtained by substituting the equilibrium income into the consumption

function. C=100+0.75Y; but Y=1000(in equilibrium). So, C=100+0.75Y C =100+0.75(1000) =100+ 750 = 850

e) Graph showing the consumption function, the aggregate demand function and the equilibrium values with correct
labeling.

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 QUIZ (10%)

Given consumption function (C), investment (I) and government

expenditure (G) as follows (the values are in millions birr): C=50+0.8Y
I=200, G=150. Then:
a.Find the aggregate demand function. (2.5pts)
b.Calculate the equilibrium level of income. (2.5pts)
c.Calculate the equilibrium level of aggregate demand. (2.5pts)
d.Calculate the equilibrium level of consumption. (2.5pts)

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 1.3. Fiscal policy and Multipliers

 Government purchase and government tax revenue are the two major government fiscal policy instruments in

the commodity market.

 Any change in these variables has a multiplied effect on real factors such as output. The factors, which show the

relationship between the changes in the instrument and the effect, are known as multipliers.
A. Government Purchase multiplier
 If government purchases rise by ∆G, then the planned aggregate demand schedule shifts upward by ∆G, as shown

in the figure below.

 The graph shows that an increase in government purchases

leads to an even greater increase in income, i.e., ∆Y>∆G.

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 1.3. Fiscal policy and Multipliers Cont.…

 It is easy to compare the change in the government spending (∆G) and the change in output (∆Y).

Since the line ‘Y = AD’ is a 450 line, the triangle ‘ABC’ is an isosceles triangle with side AC and side
BC being equal.

 The change in output (∆Y) is equal to the distance BC, since BC is equal to AC. But the change in

government expenditure (∆G) is equal to distance BD.

 Thus, the change in output (∆Y) exceeds the change in government expenditure (∆G) by the distance

DC.
 The ratio ∆Y/∆G is called the government purchase multiplier; and it tells us the factor by which
income rises in response to a unit increase in government purchases.
 An implication of the Keynesian cross is that the government purchases multiplier given by ∆Y/∆G is
larger than one.
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 1.3. Fiscal policy and Multipliers Cont.…
 Why does fiscal policy have a multiplier effect on income?
 The reason is that, according to the consumption function, higher income causes higher consumption.
Because an increase in government purchases raises income, it also raises consumption, which further
raises income of producers of the consumption goods, and so on.
 The impact affects the income and consumption values of different parties for several times. Therefore,
in this model, an increase in government purchases causes a greater increase in income.

 The process of the multiplier begins when expenditure rises by ∆G, which implies that income rises by
∆G, as well. This increase in income in turn raises consumption by MPC times ∆G, where MPC is the
marginal propensity to consume.
 This increase in consumption raises aggregate demand and income once again. This second increase in
income of MPC (∆G) again raises consumption by MPC(MPC.∆G), which again raises aggregate
demand and income, and so on. We can, thus, write this process compactly as follows:

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 1.3. Fiscal policy and Multipliers Cont.…


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 1.3. Fiscal policy and Multipliers Cont.…


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 1.3. Fiscal policy and Multipliers Cont.…
B. Tax multiplier
 The government uses the tax regulation for two major
purposes or objectives.
 The first one is that tax is a major source of government
revenue (by increasing tax).
 The second one is used to motivate producers and consumers
(by decreasing tax)
 Thus, the government increases the tax to meet the first
objective whereas the government decreases the tax to
meet the second objective
 For instance, a decrease in tax by T immediately raises
disposable income (Y-T) by T and, therefore,
consumption by MPCxT. For any level of income Y,
aggregate demand is now higher.
 As shown in the figure below, the aggregate demand
schedule shifts upward by MPCxT. The equilibrium of
the economy moves from point A to point B.

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 1.3. Fiscal policy and Multipliers Cont.…


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 1.3. Fiscal policy and Multipliers Cont.…

C. The Balanced Budget Multiplier

 We know that government spending increases the aggregate demand and taxes reduces the aggregate
demand.
 If government is planning to increase spending by 100 million birr and at the same time, government
wants to increase the tax collection by 100 million birr, what would be the impact on aggregate
demand?

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 Illustrative Example:

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 Illustrative Example Cont.…

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 Illustrative Example Cont.…

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 Illustrative Example Cont.…

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 Illustrative Example Cont.…

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 END OF CHAPTER ONE

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