INDIAN INSTITUTE OF MANAGEMENT LUCKNOW
Post-Graduate Programme in Management
Course: Macroeconomic Environment
The Algebra of Macroeconomic Equilibrium-I
While discussing the Keynesian model of income determination we relied primarily on graphs to
illustrate the aggregate expenditure model (i.e., Y=C+I+G+X-M) of short-run real GDP. Graphs help
us understand economic change qualitatively. When we write down an economic model using
equation, we make it easier to make quantitative estimates. When economists forecast future
movements in GDP, they often rely on econometric models. An econometric model is an economic
model written in the form of equations, where each equation has been statistically estimated. We can
use the following equations to represent the aggregate expenditure model.
C C MPC(Y) Consumptionfuntion
II Planne dinvestment function
GG Government spending function
NX NX Net export (X - M) funtion
Y C I G NX Equilibrium condition
The letters with “bars” represent fixed or autonomous values. So C represents autonomous
consumption. Now solving for equilibrium we get:
Y C MPC (Y ) I G NX ,
or , Y MPC (Y ) C I G NX ,
or , Y (1 MPC ) C I G NX ,
1
or , Y C I G NX
1 MPC
1
Remember that is the multiplier, and all four variables in the numerator of the equation
1 MPC
represent autonomous expenditure. Therefore an alternative expression for equilibrium GDP is:
Equilibrium GDP = Autonomous expenditure × multiplier.
Now consider the following hypothetical data for an economy.
1. C = 1000 + 0.65Y Consumption function
2. I = 1500 Planned investment function
3. G = 1500 Government spending function
4. NX = -500 Net export function
5. Y = C + I + G + NX Equilibrium condition
The first equation is the consumption function. The MPC is 0.65 and 1000 is autonomous
consumption, which is the level of consumption that does not depend on income. If we think of the
consumption function as line on the 450 – line diagram, 1000 would be the intercept and 0.65 would
be the slope. The “functions” for the other three components of planned aggregate expenditure are
very simple because we have assumed that these components are not affected by GDP and, therefore,
are constant. Economists who use this type of model to forecast GDP would, of course, use more
realistic investment, government, and net export functions. The parameters of the functions – such as
the value of autonomous consumption and the value of the MPC in the consumption function – would
be estimated statistically using data on the values of each variable over a period of years.
In this model, equilibrium GDP occurs where GDP is equal to planned aggregate expenditure.
Equation 5 – the equilibrium condition – shows us how to calculate equilibrium in the model: To
calculate equilibrium, we substitute equation 1 through 4 into equation 5. This gives us the
following:
Y = 1000 + 0.65Y + 1500 + 1500 – 500
We need to solve this expression for Y to find equilibrium GDP. The first step is to subtract 0.65Y
from both sides of the equation:
Y – 0.65Y = 1000 + 1500 + 1500 – 500
Y(1 - 0.65) = 1000 + 1500 + 1500 – 500
Then we solve for Y:
0.35Y = 3500
Or, Y = (3500/0.35) = 10000.
