ECO 502

BRAC University,
Spring, 2006
Lectures 6 – 8

Lutfun N. Khan Osmani

Chapter 3
Spending, Income and the
Interest Rate
Contents
• Theory of income determination
• Economy in and out of equilibrium
• Determining equilibrium real GDP
• The multiplier effect
• Multiplier at work: fiscal policy
• Balanced budget multiplier
• Relation of autonomous spending to interest
rate
• The IS curve:
• Relation of the IS curve to the demand for
autonomous spending
• Shift in the IS curve
• What rotates the IS curve?
3-2
 Concepts
It is assumed that you know these
concepts clearly:

• Exogenous
• Endogenous
• Autonomous Consumption
• Induced consumption
• Induced savings
• Marginal propensity to consume

3-3
Business Cycle and the Theory of
Income Determination

• We know the goals of fiscal and monetary

policy is to dampen the business cycle so that
real GDP grows steadily from one year to the
next.

• The real world is much different from that

ideal world.

• What could be reason for this volatility?

3-4
Figure 3-1 Real GDP Growth
in the United States, 1950–2004

3-5
Business Cycle and the Theory of
Income Determination
• We know (and will also see later in the
lecture) that unstable ups and downs of real
GDP can be caused by changes in consumer
confidence, business optimism, government
spending and foreign events that influence
export and import (remember the Keynesian
Cross diagram).
• These shocks to aggregate demand (called
demand shock) are the basic source of
business cycle and economic volatility.

3-6
Business Cycle and the Theory of
Income Determination

• Shocks to aggregate demand can change

either real GDP or the price level (GDP
deflator), or both.

• Changes in aggregate supply depends on

costs of production for business firms
including the wages and prices of raw
materials such as oil. We shall learn about it
in chapter 7 & 8.

3-7
Business Cycle and the Theory of
Income Determination

• In order to focus on changes in aggregate

demand we assume price level to be fixed in
the short-run

• Therefore, changes in AD
• Changes in real GDP = --------------------------
» (Fixed) price level
» So, any change in AD automatically
cause change in real GDP.

3-8
Concepts

• Endogenous variables: those explained by an

economic theory, e.g., Q = f(P). Q is
endogenous P is exogenous.

• Exogenous variables: relevant for the model

but their behaviour not explained by the
model, e,g., price level (P).

3-9
Concepts

• The consumption function:

• C = Ca + c(Y – T)
• Ca  autonomous consumption
• c(Y – T)  induced consumption
• c  marginal propensity to consume
• ( Y – T)  disposable income

3-10
Concepts

• The consumption function:

• Numerical Example:
• C = 500 + 0.75(Y – T)

3-11
Planned Expenditure

• Planned expenditure:
E  C + I + G + NX

The consumption function:

C = Ca + c(Y – T)

3-12
Planned Expenditure

• Induced saving and marginal propensity to

save:

• Savings = personal disposable income minus

consumption
S = Y – T – C  savings function
S = Y – T - Ca - c(Y – T)
= (1 – c)(Y – T) – Ca

3-13
The savings function

• Numerical example:

S=Y–T–C
S = Y – T - 500 – 0.75(Y – T)
= (1 – c)(Y – T) – Ca
= (1 – 0.75)(Y – T) – 500
= 0.25(Y – T) – 500
= - 500 + 0.25(Y – T)

3-14
Figure 3-2 A Simple Hypothesis Regarding
Consumption Behavior

3-15
Economy in and out of Equilibrium

• In chapter 2 we learnt that actual expenditure

(E) and total income (Y) are always equal by
definition.
• But there is no reason why planned
expenditure (Ep) and income should be the
same. Only when the economy is in
equilibrium then income is equal to planned
expenditure.
•

3-16
Economy in and out of Equilibrium

• In equilibrium, households, firms, government

and the foreign sector want to spend exactly
the amount of income that is being generated
by the current level of production (remember
the KC diagram).

3-17
Economy in and out of Equilibrium

• When the economy is out of equilibrium,

production and income is out of line with
planned expenditure, and business firms will
be forced to raise or lower production (before
or above the crossing of the planned
aggregate expenditure line with the 450 line) .

3-18
Economy in and out of Equilibrium
• We know consumption depends on income,
but we don’t know what the level of income is
going to be.

• To construct the theory of income

determination we introduce extra element –
unplanned expenditure.

• Total expenditure that people want to make is

the planned expenditure (Ep). The rest of the
expenditure (E - Ep) is the unplanned and
undesired.
3-19
Economy in and out of Equilibrium

• To simplify, we assume that only investment

expenditure contains unplanned component,
consumption (C), government expenditure
(G), and net export (NX) are always equal to
the planned amount. So,

3-20
Economy in and out of Equilibrium

• Planned expenditure (or planned aggregate

expenditure or PAE)
Ep = C + Ip + G + NX, or
Ep = Ca + c(Y – T) + Ip + G + NX
Ep = Ca + cY – cT + Ip + G + NX

• Take all the elements of the above equation

that do not depend on total income (Y), we
can call them autonomous planned
expenditure (Ap)
3-21
Economy in and out of Equilibrium
• T usually has two parts: Ta and tY
• Where Ta is autonomous tax (does not
depend on income, e.g. council tax, poll tax,
etc.) and t is the rate of tax. tY rises as Y
rises.

• Autonomous planned expenditure:

Ap = Ca – cTa + Ip + G + NX

• Therefore,
Ep = Ap + cY
3-22
Economy in and out of Equilibrium

• Numerical example:
• Autonomous planned expenditure:
Ap = Ca – cTa + Ip + G + NX

• Assume: Autonomous consumption is 500, as before;

MPC = 0.75; Ip = 1,200; NX = -200; govt. spending
and autonomous tax = 0.
• Therefore,
Ap = 500 – 0.75(Ta) + 1200 + 0 – 200 = 1,500

3-23
Economy in and out of Equilibrium

• So, total planned expenditure (Ep) has two

parts; autonomous spending (Ap) and
induced consumption cY.

• Ep = Ap + cY or
• Ep = 1,500 + 0.75Y

3-24
 Figure 3-4
How Equilibrium Income Is Determined

Equilibrium
occurs at B. At
any other point
economy is out
of equilibrium
causing
pressure on
business firms
to increase or
reduce
production and
income.
3-25
Economy in and out of Equilibrium
• Equilibrium is a situation in which there is no
pressure for change

• In the figure equilibrium occurs at B where

planned expenditure (Ep) is equal to real
income (Y)

• At any other point the economy is out of

equilibrium

• Firms will have to either reduce or expand

production
3-26
Determining Equilibrium Real GDP

• At equilibrium, Y = Ep (PAE)

• Subtract cY from both sides

• Y – cY = Ep – cY but
• Ep = Ap + cY
• Ep – cY = Ap

• Therefore,
• Y – cY = Ap, or
• (1 – c)Y = Ap

3-27
Determining Equilibrium Real GDP

• (1 – c)Y = Ap

• MPS×Y = Ap; or sY = Ap or
• Y = Ap/s

• Numerically,
• sY = Ap or
• 0.25Y = 1,500 (since MPC = 0.75)

• Y = Ap/s, or
• Y = 1,500/0.25 = 6,000  Eqm. income (Y)

3-28
 The multiplier effect
• The multiplier is the ratio of the change in
output (Y) to the change in autonomous
planned spending that causes it.

• It is 1.0 divided by (1 – MPC)

• It is also 1.0 divided by the marginal

propensity to save (s)

• Y 1 1
• Multiplier (k) = -------- = ----------- = ------
•  Ap 1 - MPC s
3-29
 The multiplier effect
• 1 1
• Multiplier (k) = ----------- = -----
• 1 - MPC s
• Y 1
• Multiplier (k) = ------ = ----- or Ys = Ap
•  Ap s
•
 Ap
 Y = --------------
» s

3-30
The Multiplier Effect

Numerically,

• Y 1
• Multiplier (k) = ------ = -------- = 4.0
•  Ap 0.25

• Increase in autonomous planned spending

(Ap) by £500 billion raises income by $2,000
(500 × 4) billion because of multiplier effect.
3-31
Figure 3-5 The Change in Equilibrium
Income Caused by a $500 Billion Increase in
Autonomous Planned Spending

3-32
The Multiplier Effect

• An increase in autonomous planned spending

(Ap) by $500 billion ($1500 - $2000) has
moved the Ap line up
• The new equilibrium is at J with income (Y)
equal to $8,000.
• The multiplier effect has increased income
from $6,000 billion to $8,000 billion

3-33
Multiplier at Work: Fiscal Policy

• Any change in govt. expenditure or tax

revenue has consequences for govt. budget.

• It follows from magic equation (S + T  I + G +

NX) that
• T – G = I + NX – S
• So, change in the left-hand side must be
balanced by change in right hand side.

3-34
Multiplier at Work: Fiscal Policy
 T – G =  I +  NX – S
• When govt. boosts its spending by $500
billion as in the earlier diagram, it was
assumed that autonomous consumption,
investment and net export are fixed. ( Ca = 
I =  NX = 0) and tax revenue remains
constant, i.e., T = 0.
• The only element that changes is G – creating
a budget deficit of $500 billion
• When G changes Y changes  C changes
• Therefore, S changes
3-35
Multiplier at Work: Fiscal Policy

 T – G =  I +  NX – S

• We saw G was 500

• What is the value of S?
• We know, saving changes by the marginal
propensity to save times the disposable
income,

 S = s(Y – T)

3-36
Multiplier at Work: Fiscal Policy

• We know when G changes by G, Y changes

by
 G x multiplier (k) = 500 × 4 = 2,000

• So the value of S
•
 S = s(Y – T)
= 0.25( 2,000 – 0)
= 500

3-37
Multiplier at Work: Fiscal Policy

• The $2,000 billion increase in output induces

$500 billion of extra saving. Each extra dollar
of saving is available for households to buy
bonds that govt. must sell to finance its $500
billion budget deficit.

3-38
Multiplier at Work: Fiscal Policy

• An alternative could be to reduce autonomous taxes

by $667 billion.
Use a tax cut to eliminate the gap

Change in spending (500) = tax cut x MPC (0.75)

Tax cut = change in spending / MPC = 500/0.75 =
$667

A tax cut of $667 will raise PAE by 500; (500 x

0.75) = $667

• It will have exactly same effect on Y

3-39
Multiplier at Work: Fiscal Policy

• We know, change in income (Y) is equal to

change in autonomous planned spending
(Ap) times the multiplier [k = 1/(1 – MPC) =
1/MPS = 1/s].
•

3-40
Multiplier at Work: Fiscal Policy

• We already know,
Ap = Ca – cTa + Ip + G + NX
• And from the above equation only autonomous
tax (cTa) part is changing. So, we can write:

• Ap - cTa
• (Y) = ------ = -----------
• s s

3-41
Multiplier at Work: Fiscal Policy

• Numerically,

• Ap - cTa
• (Y) = ------ = -----------
• s s

• -(0.75)(-667) 500
• (Y) = ------------------ = -------- = 2,000
• 0.25 0.25

3-42
Multiplier at Work: Fiscal Policy

• What would happen if the govt. increased

taxes instead of reducing it?

• The multiplier for an increase in taxes is the

income change in the earlier equation divided
by Ta:

• Y Ap - cTa -c
• ------ = ----------- = ---------- = ------
 Ta s Ta s Ta s

3-43
Multiplier at Work: Fiscal Policy

• Numerically,

• Y -0.75
• ------ = ----------- = - 3.0
 Ta 0.25

• This implies, for every unit increase in tax the

output will fall by a multiple of 3 (667 x 3 =
2,000)

3-44
Multiplier at Work: Fiscal Policy

• Balanced budget multiplier:

Govt., thus could boost income by $2,000
billion either by raising spending by $500 or
by cutting taxes by $667 billion.

• Either method, however, could create large

govt. deficit which is undesirable.

• However, govt. can still boost the economy

even if it has to maintain a balanced budget.

3-45
Multiplier at Work: Fiscal Policy

• Balanced budget multiplier:

In order to maintain balanced budget, any

additional govt. expenditure must be
balanced by equal amount of additional taxes

3-46
Multiplier at Work: Fiscal Policy
• Balanced budget multiplier:

• To see this, we can use the multiplier for govt.

spending (k = 1/s) and for a change in taxes
(tax multiplier = - c/s)

3-47
Multiplier at Work: Fiscal Policy
• Balanced budget multiplier:
1 -c 1-c
• ------ + ----------- = ---------- = 1.0
• s s s
• Numerically,
•
• 1 - 0.75 1 – 0.75
• ------ + ----------- = ---------- = 1.0
• 0.25 0.25 0.25

3-48
Multiplier at Work: Fiscal Policy
• Balanced budget multiplier:
That is, multiplier for a balanced budget fiscal
expansion is always 1.0.
It happens because

(1) One dollar of govt. spending raises

autonomous planned expenditure by exactly one
dollar.
(2) But extra dollar of tax reduces autonomous
planned expenditure by c times one dollar. (Recall
c is less than one).

3-49
Multiplier at Work: Fiscal Policy

• Thus positive effect of $1 of expenditure on Y is

larger than the negative effect of $1 tax increase.
• Therefore, on balance, there is a positive effect
on the economy.
• Balanced budget multiplier:
Thus govt. can achieve desired income and real
GDP by sufficiently large increase in govt.
spending accompanied by exactly same increase
in tax rates

3-50
The Relation of Autonomous planned
Spending to the Interest Rate

• Thus far autonomous consumption and

planned investment have been assumed to be
exogenously given.

• In fact they depend on interest rate, which in

turn depends on monetary policy.

• To understand the effect of monetary policy,

we first have to understand the relationship
between interest rate and planned aggregate
spending.

3-51
The Relation of Autonomous planned
Spending to the Interest Rate

• We start by the question why planned

investment depends on interest rate?

• Firms borrow funds to buy investment goods

• They can stay in business only if earnings of

investment goods are enough to pay the
interest on borrowed funds.

3-52
The Relation of Autonomous planned
Spending to the Interest Rate
• Note: The rate of return on an investment
project is its annual earnings divided by its
total cost.

• An increase in planned investment reduces

the rate of return (diminishing marginal
productivity of capital)

• So, interest rate must fall to induce firms to

undertake more investment. (See next
diagram.)

3-53
Figure 3-6

An increase in
planned
investment
reduces the rate
of return.

3-54
The Relation of Autonomous planned
Spending to the Interest Rate

• Rate of interest influences business

investment as well as household
consumption.

• (Other things remaining the same) A

decrease in the rate of interest increases
autonomous planned spending (Ip + Ca) and
vice versa.

3-55
Figure 3-7 Effect on Autonomous Planned Spending of
an Increase in Business and Consumer Confidence

3-56
The Relation of Autonomous planned
Spending to the Interest Rate

• If the level of business and consumer

confidence were to increase, the return line
would shift to the right – at the same interest
rate autonomous planned spending would be
higher.

3-57
Figure 3-8 Relation of the Various Components of
Autonomous Planned Spending to the Interest Rate

3-58
The IS Curve

• We now have seen that autonomous planned

spending (Ap) depends on the interest rate

• And real GDP and real income depends on

autonomous planned spending

• It follows logically that real GDP and real

income must depend on interest rate

3-59
The IS Curve

• We shall derive a graphical schedule that

shows the different possible combinations of
interest rate and real income that are
compatible with equilibrium.
• That schedule is called the IS curve
• In doing so we assume that business and
consumer confidence, the MPS (s), the level
of govt. spending (G), taxes (T) and net
export (NX) as given.

3-60
IS Curve

• The IS curve connects all combinations of {r,

Y} for which the goods or product market is in
equilibrium

• The IS curve is based on the idea that as

interest rate falls investment rises and
therefore planned aggregate spending rises,
real GDP rises.

3-61
Figure 3-9 Relation of the IS Curve to the
Demand for Autonomous Spending

3-62
 The IS Curve
• Ap is the demand schedule in the left frame
showing that demand for autonomous
planned spending depends on interest rate.
• For example, at 10% interest rate level of Ap
is $1,500 billion (point C).
• Taking multiplier to be 4.0, the equilibrium
level of income is $6,000 billion and plotted on
the right frame (point C)
• Higher interest  lower Ap  lower income
and vice versa

3-63
The IS Curve in Equations
• Product market equilibrium:

Y = E = C + I + G + NX
Y = Ca + c(Y – T) – hr + G + NX
Y = Ca + cY – cT – hr + G + NX
Y - cY = Ca – cT – hr + G + NX
Y(1 – c) = (Ca – cT + G + NX) – hr
Y(1 – c) = Apn – hr
hr = Apn - Y(1 – c)
r = Apn/h - {(1 – c)/h}Y  the IS equation
• Intercept = Apn/h > 0

• Slope = - (1 – c)/h < 0

3-64
Effect on the IS Curve of a Rightward Shift in
the Demand for Autonomous Planned Spending

3-65
Shift in the IS curve

• Anything that shifts the Ap demand schedule

will shift the IS curve in the same direction.
• The factors that shift the IS curve to the right
include an increase in business confidence or
consumer confidence, an increase in govt.
expenditure or net exports, and a decrease in
taxes.
• Opposite change will shift the IS curve to the
left

3-66
Shift in the IS curve

• For example, an increase in govt. purchases

raises the planned expenditure.

• For any given interest rate, the upward shift of

planned expenditure of G leads to an
increase in income of G/(1 – MPC)

• The IS curve shifts outward.

3-67
Shift in the IS curve

• A decrease in taxes also expands

expenditure and income, the IS curve shifts
outward.
• A decrease in govt. expenditure or increase in
taxes reduces income and therefore IS curve
shifts inward.

3-68
Shift in the IS curve

• Let A′p is the value of autonomous planned

spending that takes place at zero rate of
interest.
• In the figure Ap line intersects the horizontal
axis(at zero rate of interest) at $2,500 billion.
• So, A′po = 2, 500.
• The IS curve always lies at a horizontal
distance 4.0 times the Ap line (since multiplier
is equal to 4.0).

3-69
Shift in the IS curve

• So the IS curve crosses the horizontal line at

income 10,000

• With the new demand curve

A′p1 = 3, 000 and the corresponding IS curve
crosses the horizontal line at income 12,000

3-70