ECONOMICS 2B

WEEK 1: LECTURE NOTES

1. What macroeconomics is all about?

Macroeconomics deals with the functioning of an economy as a whole and is usually

concerned with aggregate variables such as growth, employment, price stability and external
transactions. Macroeconomics seeks to explain the determinants of these variables in terms
of trends and variations in the short - and long-run, and debates the appropriateness of
policy actions in response to apparent or perceived macroeconomic instability (Blanchard &
Johnson, 2013).

Unemployment, inflation, interest rates, exchange rates, the balance of payment, the gold
price, the budget, public debt, taxation, Reserve Bank policy – these issues are what
macroeconomics is all about. They deeply affect all our lives whether as a student,
household consumer, investor, business manager, employee, labour union member or
government official.

As a first step towards understanding the operation of the economy we consider, in this
chapter, the simple Keynesian theory of income determination. This theory was designed
originally to explain recessions and periods of sustained unemployment, and emphasises
the causes of fluctuations in real national income and employment. It helps in understanding
the nature and causes of short-run changes in income and employment.

Short run period: Is thought to span for a period of up to 3 years.

Medium term period: A time frame between 3 to 7 years.

Long run period: A time frame that is usually in decades.

The simple model focuses on the so-called real sector of the economy, where real economic
activities like production, consumption, saving, investment, imports and exports occur. The
theory can, therefore, help us understand the course of the South African economy,
especially the course of gross domestic product (GDP).

The price level, which is essential for an analysis of inflation, is a prominent variable in more
modern version of Keynesian theory.

This difference will bring in the concept of nominal and real values. Nominal GDP is the total
value of productivity measured at current market prices whereas real GDP is the value of
total output that is expressed at base year prices (constant prices).

In the simple Keynesian model we assume, for the time being, that the average price level
remains constant. While obviously unrealistic, it does not affect the results of the analysis
materially.
In this unit we focus, therefore on the determination of total production and income in the
real sector. This is measured in terms of GDP. Changes in GDP are reflected in the
business cycle (upswings and downswings in the economy), as well as changes in the rate
of economic growth (the growth in GDP over the longer term). Except where explicitly
indicated otherwise, we will be concerned with real GDP and real national income.

2. The basic framework reviewed

The crux of the Keynesian approach is that the explanation of changes in production and
income is to be found in fluctuations in total expenditure in the economy. Total expenditure in
the economy is at the centre of the action. If that can be explained, the decision that lead to
(or are reflected in) the macroeconomics state of the economy can be understood.
Therefore, the basic Keynesian model is an expenditure- or demand-determined model.

The idea of an income-expenditure circular flow is very useful to illustrate the Keynesian
approach. It shows the circular flow of expenditure and income between two key groups of
role players in a simple economy: households (consumers) and business enterprises
(producers). In a more complete diagram one will also indicate a public sector (state), a
monetary sector and foreign sector.

Three types of transactions that occur in this sector are:

(a) The goods market transaction- where producers sell their goods in the goods market
in exchange for income.
(b) The labour market transactions – where labour is employed by firms and gets income
for its services.
(c) Financial market transaction – deficit spending units (firms) access loans from
savings by surplus spending units (households)

3. A Basic circular flow

Our main concern is the amount of income that ends up in the pockets of households and
individuals in the bottom half of the circle. The volume of income flowing in the bottom half of
the circular ‘tube’ depends on the volume of expenditure in the top half. If the flow
expenditure increases, for example, it is likely to induce decisions to increase production to
meet the increased expenditure. This implies a corresponding adjusted level of sales and
real income Y. Figure 1.1 shows the circular flow of income and expenditure between firms
and households.
Figure 1.1 Circular Flow of Income and Spending

This reasoning provides us with the first and basic chain reaction: changes in expenditure
cause adjustments in production and income. When production has adjusted fully to a
change in total expenditure, a situation of macroeconomic equilibrium occurs. At such an
equilibrium, the following condition is satisfied:

Total expenditure = Total production

In Keynesian theory fluctuations and trends in real national income Y basically are
interpreted as shifts in this equilibrium, or at least movements towards a new equilibrium
point. Therefore, it is an equilibrium approach. Changes in the equilibrium level of income
are caused and explained by changes total expenditure.

A more complete chain reaction would run as follows:

Suppose total expenditure increases. At existing production levels, production is less

than the new level of expenditure. This will be apparent in a decrease in the stocks of
producers. This is a sign and inducement for producers to decide to adjust their
production levels to the new expenditure levels. When (and if) they decide to do so,
total production will increase (as measured in terms of real GDP) and so will
employment. The income from the increased sales flows to the different factors of
production – managers, workers, land owners, shareholders, other input suppliers,
etc – and national income Y increases correspondingly. This increase is bound to
continue until production is equal to the new, higher level of total expenditure – i.e.
until a new and higher equilibrium level of income Y is reached. An economic
upswing occurs.

In brief:

Total Expenditure↑ → stocks are depleted → production↑ → Real GDP and Real Y↑

The entire Keynesian approach centres on this fundamental chain reaction. It enables one
to identify the likely causes of fluctuations in income Y, or the likely consequences of
fluctuation in expenditure. In this way one can gain some insight into the causes of upswings
or downswings in the economy, or of increases or decreases in the real economic growth
rate.
The rest of the theory consists of a refined focus on expenditure. It focuses on two aspects:
(a) To understand and explain trends and fluctuations in expenditure as such, and
(b) To relate and translate all other disturbances and shocks in the economy – changes in
interest rates, the money supply, taxation, VAT, the gold price, the exchange rate, the
balance of payments (BoP), etc – into one or another impact on expenditure.

The well-known income-expenditure diagram or ‘45° diagram’ is the basic graphical aid of
the simple Keynesian approach.

Figure 1.2 Income Determination in the Keynesian Model

This shows the real sector of the economy, and illustrates the interaction between total
expenditure (E) and total production to determine the equilibrium level of real income Y. The
graphical indication of this level is where the total expenditure line intersects the 45° line.
Only at that level of Y (Y◦) will total production (measured horizontally) be equal to total
expenditure (measured vertically). Any other Y level is a disequilibrium level, since
production can be seen to be either higher or lower than expenditure.

In others words, only at Y◦ is the condition for macroeconomic equilibrium satisfied:

Total expenditure = Total production

4. The real sector

The basic thrust of the Keynesian approach is to understand, explain and anticipate the
behaviour of total expenditure. This is done by dividing total expenditure into different
components of expenditure. Each of these components can then be analysed as indicated in
(a) and (b) above.

The main components or types of expenditure are consumption expenditure (C), capital
formation (or investment) (I), government expenditure (G), and net exports, i.e. exports (X)
less imports (M). Therefore:
 Total expenditure = C + I + G + (X – M)

4.1 Consumption: a summary

Consumption (C) pertains to expenditure by households on consumable items and services

such as clothing, food, sport, movies, transport, medical services, books, pencils, computers,
fridges, lawnmowers and vehicles. Expenditure on imported items is included in total
consumption expenditure.

It includes anything from spending on refrigerators to medical services to movie tickets to

food. In the national accounts of South Africa, final consumption expenditure by households
is classified in terms of durable goods, semi-durable goods, non-durable goods and
services. If you would like to know more about how South African households spend their
income, you will find valuable information in the Quarterly Bulletin of the South African
Reserve Bank on
(https://www.resbank.co.za/PUBLICATIONS/QUARTERLYBULLETINS/Pages/QuarterlyBull
etins-Home.aspx).

Total consumption expenditure usually is a very stable component of aggregate expenditure.

Consumption C depends on (or, is a function of) real disposable income (YD), wealth, the
average price level, expectations, habits, etc.

C = f (real disposable income (YD); wealth; expectations; habits;

demographic factors, etc)

This means that the decisions to spend income on consumption goods largely are
determined (or caused) by these factors. Some of these factors have a positive impact on
consumption expenditure, others a negative impact.
 Of all these factors the most important is the level of real disposable income (YD).
Disposable income is the part of income Y that remains after taxation T has been paid
or subtracted (YD = Y – T). This indicates the importance of the government when it
comes to determine the level of consumption in an economy. If taxation is reduced, this
can be seen as expansionary fiscal policy as households will have more disposable
income to spend leading to a growth in national income. On the other hand, an increase
in taxation will be considered as a contractionary fiscal policy because it diminishes the
level of consumption.
 If real disposable income increases, individuals and households are likely to increase
their consumption spending.
 The part of disposable income that is not spent on consumption is saved. (Therefore
saving also depends on disposable income.)
 The essence of the relationship between real consumption and real disposable income
can be found in the marginal propensity to consume (MPC).
 A tax increase will decrease disposable or after-tax income, which should discourage
consumption spending. Here one finds a negative or inverse relationship between taxes
and consumption.
 If levels of wealth increase, people are better off, this will encourage consumption
spending. It is reasonable to expect a positive relationship between wealth and
 consumption. A prominent example is the positive effect of rising stock market prices on
wealth and thus on consumption.
 In chapter 5 we shall encounter arguments that consumption is also determined by the
average price level. If the average price level increases, the real value of assets will
decrease. This decreases the wealth of people and discourages consumption. In this
way the average price level can have a negative impact on consumption.

The consumption function

The relationship between consumption and real income, i.e. the consumption function, can
be expressed in mathematical term as:

C = a + bY + ….
 a represents autonomous consumption
 b is the marginal propensity to consume (MPC)
 Y is the disposable income

This function can be depicted graphically on the income-expenditure diagram. The

consumption line shows, for each level of Y (real income), the corresponding level of real
consumption expenditure in the country (e.g. Y1 and C1). It depicts the overall behaviour of
consumers and largely explains the level of consumption in terms of real income. Figure 1.3
shows the Keynesian Consumption function

Figure 1.0.3 Keynesian Consumption Function. Source: Fourie (2015)

The positive slope indicate the positive relationship between consumption and real income:
as income Y increase, an increase in consumption C is induced. When income decreases,
consumption should decrease.
 The slope of the consumption function is directly related to the marginal propensity to
consume. (How?)

 Graphically, any change in consumption due to a change in Y is indicated by a

movement on or along the line.
 A change in one of the other factors that determines consumption implies, graphically, a
shift of the C line. If wealth levels increase, for example, the C line is shifted upwards. If
taxation is increased, the C line is shifted down.

After Keynes, a number of economists have suggested more complex relationships between
income and consumption.
 Relative income: Consumption is not determined by absolute income but by relative
income (that of friends and neighbours).Households do not necessarily reduce
consumption when their income increases.
 Permanent income: Household consumption not determined by current income but by
what they expect to earn normally.
 Life-cycle income: Spending by households is planned according to what they expect to
earn over their lifetime.
 The distribution income: Compares consumption patterns between the rich and the
poor. The mpc (marginal propensity to consume) is higher for the poor with a lower
(Marginal Propensity to Save) mps, whereas the rich have a lower mpc but their mps is
high

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