Macroeconomics
Session 6
Dr. Jithin P
IIM Raipur
Savings function
• Savings function defines the relationship between savings
and income where savings value can be derived at each level
with the use of income value.
• Goods market equilibrium condition: saving
leakages (S)=investment injections (I)
𝑌 ≡𝐶+𝑆
𝑆≡𝑌−𝐶
𝑆 ≡ 𝑌 − 𝐶ҧ − 𝑐𝑌
𝑆 ≡ − 𝐶ҧ + 1 − 𝑐 𝑌
• If a 1-unit increase in disposable income leads to an increase
of c units in consumption, the remainder (1 - c) is the
increase in savings.
• This increment to saving per unit increase in disposable
income (1 - c) is called the marginal propensity to save (MPS)
• Important : The sum of marginal propensity to consume and
marginal propensity to save is equal to one (MPC + MPS = 1).
Investment (I)
• Like C, Investment (I) also depends on various factors.
• However, for the time being, I is assumed to be given or constant.
• I is autonomously or exogenously determined.
• It does not depend on the level of output/ production / GDP.
Now C and I can be specified as follows:
𝐶 = 𝐶ҧ + 𝑐𝑌
𝐼 = 𝐼ҧ
𝐴𝐷 = 𝐶 + 𝐼
𝐴𝐷 = 𝐶ҧ + 𝑐𝑌 + 𝐼 ҧ
𝐴𝐷 = 𝐴ҧ + 𝑐𝑌
Equilibrium Income
and Output
• Output is at its equilibrium level when
the quantity of output produced (Y) is
equal to the quantity demanded
(AD=C+I)
𝑌 = 𝐴ҧ + 𝑐𝑌
Solve for Y to find the equilibrium level of
output:
𝑌 − 𝑐𝑌 = 𝐴ҧ
(1 − 𝑐)𝑌 = 𝐴ҧ
1
𝑌= 𝐴ҧ
(1 − 𝑐)
Equilibrium Income and Output
• Equilibrium occurs where Y=AD, which is illustrated by
the 45° line → point E
• This is equilibrium level of output because At 𝑌0,
output/production/income equals aggregate demand
(Y=C+I). firms’ actual inventories are equal to target
inventories.
• At any level of output below 𝑌0, aggregate demand(C+I)
is more than production/output (Y), firms’ inventories
decline, and they increase production.
• At any level of output above 𝑌0, aggregate demand(C+I)
is less than production /output (Y), firms’ inventories
increase, and they decrease production.
CONSUMPTION, AGGREGATE
DEMAND, AND AUTONOMOUS
SPENDING
• We just assume that investment is 𝐼,ҧ government
spending is 𝐺ҧ , taxes are 𝑇𝐴, transfers are 𝑇𝑅, and net
exports are 𝑁𝑋. Consumption now depends on disposable
income
𝑌𝐷 = 𝑌 + 𝑇𝑅 − 𝑇𝐴
𝐶 = 𝐶ҧ + 𝑐𝑌𝐷 = 𝐶ҧ + 𝑐(𝑌 + 𝑇𝑅 − 𝑇𝐴)
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝐴𝐷 = 𝐶ҧ + 𝑐 𝑌 + 𝑇𝑅 − 𝑇𝐴 + 𝐼 ҧ + 𝐺ҧ + 𝑁𝑋
𝐴𝐷 = 𝐴ҧ + 𝑐𝑌
CONSUMPTION, AGGREGATE
DEMAND, AND
AUTONOMOUS SPENDING
• aggregate demand also depends on the
level of income. It increases with the
level of income because consumption
demand increases with income.
• The aggregate demand schedule is
obtained by adding (vertically) the
demands for consumption, investment,
government spending, and net exports
at each level of income.
CONSUMPTION, AGGREGATE DEMAND, AND
AUTONOMOUS SPENDING
• At any income level below 𝑌0 , firms find that demand exceeds output and inventories
are declining, and they therefore increase production.
• Conversely, for output levels above 𝑌0 , firms find inventories piling up and therefore cut
production.
𝑌 = 𝐴𝐷
𝑌 = 𝐴ҧ + 𝑐𝑌
Solve for Y to find the equilibrium level of output:
𝑌 − 𝑐𝑌 = 𝐴ҧ
(1 − 𝑐)𝑌 = 𝐴ҧ
1
𝑌= 𝐴ҧ
(1 − 𝑐)
Effect of a • The last equation shows that the level of output as a function of the
MPC and autonomous spending (A)
change in • The equilibrium level of output is higher the larger the MPC, and the
higher the level of autonomous spending.
autonomous ∆𝑌 =
1
∆𝐴ҧ
expenditure (1 − 𝑐)
• An increase in production leads to an increase income . An increase in
on income further leads to an increase in consumption as consumption
depends on income .
equilibrium • The change in total output is multiplier times change in initial
demand/ investment. This is called multiplier effect.
output
The Multiplier (Algebra)
• By how much does a Rs.1000 increase in autonomous
spending raise the equilibrium level of income?
• This increase in output and income would in turn
give rise to further induced spending as
consumption rises because the level of income has
risen.
• Out of an additional Rs.1000 of income, a fraction
c is consumed.
• Assume, then, that production increases further
to meet this induced expenditure, that is, that
output and thus income increase by 1 + c.
• Expansion in output and income results in further
increases.
The Multiplier (Algebra)
• If we write out the successive rounds of increased spending, starting
with the initial increase in autonomous demand, we obtain
• The multiplier is the amount by which equilibrium output changes
when autonomous aggregate demand increases by 1 unit.
1
𝛼≡
1−𝑐
THE MULTIPLIER IN PICTURES
• Effect of an increase in autonomous spending on
the equilibrium level of output:
• The initial equilibrium is at point E, with income
at 𝑌0
• If autonomous spending increases, the AD curve
shifts up by ∆𝐴ҧ , and income increases to Y’
• The new equilibrium is at E’ with income at
∆𝑌0 = 𝑌0′ − 𝑌0
• The magnitude of income change required to
restore equilibrium depends on two factors
1. Autonomous spending
2. MPC
THE GOVERNMENT
SECTOR
• The government directly affects the level of equilibrium
income in two separate ways.
1. Government purchases of goods and services, G , are a
component of aggregate demand.
2. Taxes and transfers affect the relation between output and
income, Y , and the disposable income
• Fiscal policy is the policy of the government with regard to
the G, TR, and TA.
• Assume G and TR are autonomously determined or
constant, and that there is a proportional income tax
structure , i.e., TA= tY
