PAPER 1: Macroeconomics and Economic Pursuits

MACROECONOMICS
Topic 1 – The circular flow model, national account aggregates and the
multiplier
Economics is defined as a study of how individuals, businesses, governments and other organisations
choose to use scarce resources to satisfy their numerous needs and wants in a manner that is efficient
and equitable.

A: The open economy circular flow

 The circular flow model shows the interdependence between households, businesses, government
and the foreign sector. It illustrates the process in which goods and services become available for the
satisfaction of wants.
 There is a difference between an open and a closed economy.
 A closed economy has no foreign sector, there is no international trading.
 An open economy means that a country trades with the rest of the world, through exports and
imports, it also includes payments for imports and the receipt of income for exports.

A.1: The four-sector diagram

Consumers/Households
Taxes
Goods &
services
Public

Expenditure Expenditure
Factor Government/Public Product
Market Sector Market
Factor services
Goods & services
Goods &
services

Taxes
Public

Producers/Firms/Business
Revenue

Sector
Expenditure

Imports
Exports

Money flow
Foreign Sector
Real flow
Figure 1.1: The circular flow model

Macroeconomics: Topic 1 1
A.2: Participants and their interactions
In the circular flow model of an open economy there are four economic participants:
1. Household sector/Consumers
 Households are the major consumers of economic goods and services – they use their income to
buy from producers/firms – in the product/goods market.
 Households are the primary economic participants because they are the owners of the four factors
of production (land, capital, labour and entrepreneurship).
 Households sell factors of production in the factor market to producers.
 Households receive remuneration/income from the firms. e.g. wages, rent, interest and profit.

2. Producers/Firms/business sector
 Firms purchase the factors of production from the household in the factor market.
 Firms use the factors of production to produce goods and services.
 Businesses sell goods and services to households, government and the foreign sector.
 Businesses receive an income from the other three participants (they try to earn sufficient income
to meet their operating costs).

3. The Government/state/public sector

 This refers to local, regional and national government.
 The state provides households and businesses with public goods (e.g. roads) and public services
(e.g. public hospitals).
 The state receives taxes from households, (e.g. income tax) and business sector, (e.g. company
tax), to enable them to provide the public goods and services.

4. Foreign sector
 This is a flow of goods/imports from the foreign sector and are paid for by households, businesses
and the public sector.
 Imports is an expenditure for households, businesses and the public sector.
 SA mainly imports machines, equipment and intermediate goods.
 There is also a flow of goods and services(exports) to the foreign sector from businesses.
 Exports is an income for households, businesses and the public sector.
 SA mainly exports primary, mineral and intermediate goods.
 The revenue/income earned from this process is foreign exchange, which is needed to pay for
imports.
 The foreign exchange market is located in the financial system.

A.3: Real flow and money flow

Transactions take place in markets. Every market transaction is a two-sided exchange in the sense that
for every sale, there is a purchase. Sales are in terms of goods and services, while purchases are in
terms of money.

Real flow:
 The sale of goods and services from producers to consumers via the product/goods market.
 The sale of factors of production from consumers to producers via in the factor market.
 Factors of production and goods and services flow from foreign countries to South Africa (imports).
 Factors of production and goods and services flow from South Africa to foreign countries (exports).

Money flow:
 Consists of income and expenditure
 Consumers income from the sale of factor of production, from the factor market.
 Consumers (including businesses, government and the foreign sector) use their income to purchase
(expenditure) goods and services, from the goods market.

*Note: Consumers in the broader sense refers to households, businesses, government and the foreign sector.

Macroeconomics: Topic 1 2
A.4: Leakages and injections
Leakages
Leakages/Withdrawals (L) refer to the outflow of money from the economy.
 As the money circulates within the economy, some of it leaks out of the circular flow of income and
expenditure.
 This reduces the size of the income and expenditure.
 For example,
o Households do not receive all the income that they earn because the government takes some of it,
in the form of direct taxation (income tax).
o Households do not spend all the money that they earn (income) on the output (goods/services)
produced by firms.
o Households may decide to save some of their income.

L=S+T+M
Leakages (L) = Net savings (S) + Net taxes (T) + Expenditure on imports (M)

The following are leakages/withdrawals from the circular flow:

Savings (S)
 Savings flow from households and producers to the financial system
 Net saving is very important. Net savings = Savings – Borrowings (loans) from households.
 Net savings leave the circular flow.
 If households borrow more than they save - it can result in price increases and therefore
inflation.
Taxation (T) (Direct or Indirect)
 Taxation is a leakage since it decreases the disposable income (the amount of money you can
spend).
 As the income decreases, households spend less and the flow of spending, production and
income decreases.
 Net taxes is important where transfer payments and subsidies are deducted (taken off).
Payment for Imports (M)
 Not all goods/services that are consumed (purchased) are produced domestically.
 Participants spend some of their income on imported goods and services and/or goods and
services that were produced with equipment using imported components.

Injections
Injections (J) refer to an inflow of money into the economy.
 With injections money is added to the circular flow.
 It increases the size of the income and expenditure.

J=I+G+X
Injections (J) = Investments (I) + Government expenditure (G) + Exports (X)

The following are injections/additions into the circular flow:

Investment (I)
 Money that firms or enterprises spend, which they borrow or obtain from various financial
institutions – either past savings or loans or through the issuing of shares.
 They may invest in property or equipment.
 They may also simply spend money loans on building up inventories, and/or buying intermediate
goods or raw materials.
Government expenditure (G)
 Government spends money on goods and services produced by businesses to produce social
and economic services and to provide infrastructure.
 Examples: spending on roads, hospitals and schools.
Payments for exports (X)
 Money flows into the circular flow from abroad when foreign residents buy our exports
Macroeconomics: Topic 1 3
Financial system
To explain leakages and injections we use the financial system in the circular flow.
Financial system:
 The financial system is in the factor market.
 Its function is to focus on the remunerations for the factor services of capital, in the form of interest
and dividends.
 It contains a number of markets e.g. capital market, money market, foreign exchange market
 Deposit-taking institutions (e.g. banks) and non-deposit taking institutions (e.g. insurance companies)
act as financial intermediaries in these markets.
 The savings of some consumers, producers and the government are made available as loans to
others.
 The South African Reserve Bank (SARB) is the most prominent financial institution in SA.

Figure 1.2 illustrates the circular flow of income and

spending. It shows the following:

The money flow:

 It is derived from the income earned and the
spending by consumers and producers.
 It decreases and increases because of leakages
and injections.

The four sectors:

 They show the relationship with the money flow
of income and spending.
 The government sector (right) and the foreign
sector (left) can impact on the money flow as a
result of their taxing and spending and their
export and import activities respectively.

The financial system:

 It accepts savings and surplus funds from consumers and producers and lends these to producers
(and the government, which is not indicated in the inner diagram) for investment in capital goods.

Model equations:
 The circular flow model can also be used to calculate aggregate spending (total spending).
 It shows how money is spent on goods and services.
 If we assume that the four sectors economy is in equilibrium, injections and leakages have
stabilised,
Leakages = Injections
L = J or S + T+ M = I + G + X
 In this equilibrium condition, the amount of income and expenditure equals the amount of production
(P).
Income (Y) and expenditure (E) = Production (P)
E = C + G + I + (X-M)
 But expenditure (E) is equal to income (Y) therefore:
Y = C + G + I + (X-M)

Mathematical Model (Calculation / Example)

C = R1 737 billion
+G = R 664 billion
+I = R 585 billion
+ (X – M) (854 – 872) = R –18 billion
Total = R2 964 billion

Macroeconomics: Topic 1 4
Graphical Model (Example)
We can convert our mathematical model into a graphical model.
Figure 1.3 shows expenditure and income.

 Expenditure is (E) and it is shown on the

Vertical axis.
 Income is (Y) and it is shown on the
Horizontal axis.
 E = Y and it is represented by a 45° line.

 Next, we enter the aggregate expenditure

(AE) curve C + I + G + (X – M).
 The curve shows the amount which
consumers, producers, the government
and the foreign sector plan to spend (that
is, expected expenditure) at every level of
income.
 The curve determines aggregate demand (AD).

 At an income of Y the AE intersects the vertical axis at E.

 If AE increases to E1.
 This means more money is injected into the economy (a bigger amount of money will be injected
into the economy than what will leak out).
 This causes total income to increase from Y to Y1.

The economy is in equilibrium if leakages = injections

The economy will be out of equilibrium if L > J or L < J.
The process to restore equilibrium causes changes to national income (Y) as follow:
 National income will rise/increase when: I+G+X > S+T+M.
o Injections are more than leakages and therefore: Y<C+I+G+(X-M)
o The amount of injections in excess of leakages,
 increases demand,
 to satisfy the additional demand,
 more goods and services will be produced and
 more income will be generated.
 National income will fall when: I+G+X < S+T+M.
o Injections are less that leakages and therefore: Y > C+I+G+(X-M)
 The amount of leakages in excess of injections,
 reduces demand and then
 less goods and services will be produced and
 less income will be generated.
 Their effects are simultaneous. An increase in injections will increase income until the injections are
equal to leakages.

A.5: Markets
We identify four markets in the open economy circular flow model:
 Goods/Product market (goods and services)
 Factor market (factors of production)
 Financial market (Capital and Money markets)
 Foreign exchange market

Product and factor markets

The factor and product market are related because the demand for factor services is a derived demand.
Only if there is a demand for a product will there be a demand for the factors of production.

Macroeconomics: Topic 1 5
Product (goods and services) markets:
 The product market are all the markets for consumer goods and services.
 The market produces all the goods/services that are bought or sold.

Factor (resource) markets:

 Factors of production are traded in these markets.
 E.g. labour is hired, capital is borrowed, property is rented and entrepreneurs offer their services.
 Includes the labour, financial and property markets.

Financial markets
The financial market serves those who wish to save and those who wish to borrow.
The money, capital and foreign exchange markets are part of the financial market.

Money markets:
 The market is for short-term and very short-term savings and loans (three years and shorter).
 It exists when parties (mainly consumers and producers) want to market short-term deposits or short-
term loans.
 Examples: banks, insurance companies
 Traded items include; bank debentures, treasury bills, government bonds
 The SARB is a key institution in the money market. It controls the supply of money in SA.
Capital markets:
 The market exists for when consumers and producers make long-term deposits or borrow over a long
period of time.
 Example: mortgage bond
 The Johannesburg Securities Exchange (JSE) is a key institution in the capital market.
 At the JSE shares and other debts that are listed are traded.
 The JSE allows for company shares and other debts that are listed to be traded.

Foreign exchange markets

The foreign exchange market exists when a person buys foreign currency (e.g. dollars) and/or traveller’s
cheques;
1. to travel abroad, and
2. when businesses buy foreign exchange to pay for imports or receive foreign exchange in
exchange for exports.
 The foreign exchange market is multinational in scope.
 The leading centres for foreign exchange dealings are London, New York and Tokyo, where the SA
rand is exchanged or traded freely.
 The SARB has no control over it.
 Foreign currencies can be bought at any commercial bank, or through enterprises such as American
Express or Thomas Cook.

A.6: Flows through different markets

In the four-sector open economy model on page 1:
 The flows of private and public goods and services (products) are real flows and they are
accompanied by counter flows of expenditures and taxes.
 Factor services are real flows and they are accompanied by counter flows of income.
 Imports and exports are real flows and they are accompanied by counter flows of expenditure and
revenue.

Macroeconomics: Topic 1 6
 In the four-sector open economy model, the real flow
represents production.
 Production earns income for those who sell the services
of their factors of production.
 Income is used to purchase the goods and services that
are produced.

 This ensures that the production, income and

expenditure amounts are, ceteris paribus, equal to one
another. This is illustrated in the figure alongside.

Figure 1.4 shows the three major flows in the economy

B: National account aggregates and conversions

Measuring macroeconomic performance is very important as it gives the government and society the
opportunity to understand how variables (such as economic growth, employment and inflation) have
performed and then to make informed decisions.

B.1: Deriving the national account aggregates

The national account aggregates are methods that are used to determine the value of economic activity.
Three methods used to measure economic activity (calculate the GDP):
 Production method
 Income method, and
 Expenditure method

They are all used at different times and for different purposes

Production method Income method Expenditure method

Add the final values of all goods Add all the income earned Add the spending of
and services produced in the by the owners of the factors of the four main sectors of the
primary, secondary and tertiary production economy – households (C),
sector government (G),
businesses (I) and foreign
sector (X – M).

Production method
Businesses and other enterprises, government and the foreign sector all participate in the production
process.
Production takes place in the primary, secondary and tertiary sectors where they focus on agricultural,
mining, manufacturing, construction and services production.

 If we only add up the market values of all outputs of all participants, we would obtain a total that is
much bigger than the value of the economy’s actual output.
 This calculation would amount to double counting or “multiple counting”.
 Intermediate inputs must be subtracted (minus) from final outputs.
 Thus GDP includes only final goods and services and not intermediate goods to avoid double
counting.
 This will then give the value that was added by each sector.

 If the three sectors compared over time, increases or decreases, it indicates a structural change
(long-term change) in the economy.
 Cyclical changes are short-term changes.
 GDP is a gross measurement as it includes the total amount of goods and services produced, it also
includes depreciated goods.
 GDP measures goods and services produced by both citizens of a country and foreigners.

Macroeconomics: Topic 1 7
 Total value is measured by expressing the value of production in terms of the prices of the goods and
services.
 GDP is usually valued at market prices but it is possible to value GDP by using basic prices or factor
cost.
 Real GDP measures the actual volume of production.

The following table indicates the values that were added in each sector of the SA economy of 2011:
Value added in R billion 2011

1. Primary sector 324

2. Secondary sector 557

3. Tertiary sector 1 789

4. Gross value added at basic prices 2 670

4.1 +Plus taxes on products 313

4.2 – Less subsidies on products -19

5. Gross domestic products at market prices 2 964

Table 1.1: GDP at market prices

 The GDP at market prices is the amount made up of the prices paid by consumers - as in the
circular flow.
 This method of calculating GDP is indicated as GDP(P).

The following table indicates GDP by kind of economic activity at current prices (R millions).
GROSS VALUE ADDED BY KIND OF ECONOMIC ACTIVITY, 2000
Economic activity Gross value Gross value added
added %
Primary sector 76938 9,7
 Agriculture, forestry and fishing 25375 3,2
 Mining and quarrying 51563 6,5
Secondary sector 194 022 24,4
 Manufacturing 148 875 18,8
 Electricity, gas and water 22 995 2,9
 Construction 22 152 2,8
Tertiary sector 523 033 65,9
 Wholesale and retail trade, catering and 103 923 13,1
accommodation
 Transport, storage and communication 80 063 10,1
 Finance, banking, insurance and real estate 160 954 20,3
 Community, social and personal services 178 093 22,4
Gross value added at basic prices 793 993 100
(Source: South African Reserve Bank, Quarterly Bulletin, June 2001)

Income method
Gross domestic income is calculated by adding the incomes earned by the owners of the factors of
production.
In the production of goods and services income is earned in the form of wages and salaries, rent,
interest and profit.

Macroeconomics: Topic 1 8
 Income in R billion 2010
1. Compensation of employees (labour costs) 1 318
2. Net operating surplus (profit) 937
3. Consumption of fixed capital (depreciation) 376
4. Gross value added at factor cost 2 631
5. +Plus other taxes on production (indirect, VAT) 50
6. –Less other subsidies on production (exports) -11
7. Gross value added at basic prices 2 670
8. +Plus other taxes on products and imports (stamp duties) 313
9. -Less subsidies on products (no pollution, employ disabled) -19
10. Gross domestic product at market prices (or GDI) 2 964
11. Primary income from the rest of the world 38
12. Less primary income to the rest of the world 104
13. Gross national income at market prices (GNI) 2 898
14. Current transfers from the rest of the world 11
15. Less Current transfers to the rest of the world 26
16. Gross national disposable income at market prices 2 883

Table 1.2: Gross national income

Explanation of table:
 Compensation of employees (line 1) mainly consists of gross salaries and wages.
 The net operating surplus (line 2) includes mainly the total value of goods and services that are
produced, less the costs.
Costs consist of three elements:
o cost of intermediate goods and services
o cost of remuneration of employees
o cost of consumption of fixed capital
 The net operating surplus shows profits and surpluses of enterprises and businesses before taxation.
It therefore includes mainly:
o rent on land
o interest on capital
o entrepreneurial profits
 The above incomes are understated by the amount provided for the consumption of fixed capital.
o This provision indicates the amount of fixed capital assets and can therefore be regarded as part of
the income earned by capital as a factor of production.

 After adjustments for indirect taxes and subsidies, that South Africa’s GDP(I) flow amounted to R2
964 billion in 2011.
 This is an amount similar to that of the production and expenditure flows in Tables 1.1 and 1.3
respectively.

 After line 10 in the section GDP(I) is converted to GNI.

This is done by:
o Adding primary income from the of the world (“Primary” implying income from the factors of
production)
o Subtracting primary income to the rest of the world.

 Even though adjustments are made in the table above not all personal incomes are included in the
national income.
Macroeconomics: Topic 1 9
 Only incomes which have been earned for services rendered are included.
 Transfer payments is not included in the GNI because they are not payment for a compensatory
service rendered.
 e.g. state pensions, disability grants, child support grants and foster care grants.
 This is a major shortcoming of GNI.

Expenditure method
Expenditure on GDP measures total expenditure on final goods and services produced within the
borders of the country.
It is calculated by adding together the expenditures of the four main participants in the circular flow
model (namely households, government, businesses and other enterprises) and the foreign sector.

Expenditure on: (in R billion) 2011

1. Final consumption expenditure by households 1 737
2. Final consumption expenditure by general government 636
3. Gross capital formation 585
4. Residual item 24
5. Gross domestic expenditure 2 982
6. Exports of goods and services 854
7.- Less imports of goods and services -872
8. Expenditure on GDP at market prices 2 964
Table 1.3: Expenditure on GDP

Explanation of table:
 The table below shows that South Africa was importing more goods and services than it was
exporting in 2011.
 This caused a leak from the circular flow to the value of about R18 billion in 2011.
 When taking into account the amount of the leak, expenditure at R2 964 billion was similar to the
value of the total production in Table 1.1.
 GDP calculated in terms of expenditures is indicated as GDP(E).
 It amounts to C + G + I + (X – M).
 Embedded in consumer spending by the government are children grants and foster parent grants.

B.2: National account conversions

The aim of our national accounts is to provide a systematic and comprehensive record of national
economic activity.
SA uses the system of National Accounts (SNA) recommended by the United Nations and therefor our
figures comply with international standards.
Macroeconomic measurement (GDP, GDE and GDI) has to do with the prices we use such as real and
nominal prices, and before and after tax prices.

GDP can be calculated;

 In terms of basic prices
 In terms of constant prices or at factor cost and
 In terms of current prices also known as market prices.

 Real GDP or GDP at constant prices is a measure of GDP in which quantities produced are valued
at the prices in a base year rather than at current prices.
 For the calculation of constant figures, 2010 had been chosen as the new base year.
 The purpose is to take inflation into account.
 Real GDP measures the actual physical volume of production.
 The base year is the year used to compare all the other years against.
Macroeconomics: Topic 1 10
Indirect taxes have the effect of making the market prices of goods and services higher than their basic
prices or factor cost, where the latter is equal to factor income (i.e. the income earned by the relative
factors of production)
Subsidies have the effect of making the market prices of goods and services lower than their basic
prices or factor cost.

Taxes on product indicates any tax that is levied per unit of the good or services and includes value
added tax (VAT), import duties, other tax on imports and tax on exports.
Other taxes on production refer to taxes on production that are not linked to a specific good or service
and include payroll taxes, business licenses and tax on land and buildings.
Subsidies on products refer to direct subsidies that are made per unit of the good and service. These
subsidies are always linked to a specific product, for example, a government subsidy on bread.
Other subsidies on production refer to subsidies that are not linked to specific goods and services, for
example, a subsidy made on employment.

 The figures in Tables 1.1, 1.2 and 1.3 are all at current prices.
 The SARB also calculates these aggregates in real figures.

Conversions can be made from GDP at factor cost to GDP at basic prices or GDP at market prices,
using the equations below:

GDP at market prices = GDP at basic prices + tax on products - subsidies on products.
GDP at factor cost = GDP at basic prices - other taxes on production + other subsidies on production.
GDP at market prices = GDP at basic prices + tax on products - subsidies on products = GDP at factor
cost + other taxes on production - other subsidies on production.

Net figures indicate that some amount has been taken away.
Net operating surplus = after tax surplus. Net income = after tax income.
Net fixed capital formation = after consumption of fixed capital (depreciation).
Net exports = after deduction of imports.

National figures (GNI) relate to the aggregated income or production by the citizens of the country
wherever they may be economically active (abroad or in SA).
Domestic figures (GDI) relate to the aggregated income or production produced with in the boarders of
SA by SA and foreign citizens.
Primary income is made up of incomes earned by the factors of production.

The table below shows the conversion

GDP at market prices R billion R2 964
Plus Primary income from the rest of the world R38
Less Primary income to the rest of the world R104
GNI at market prices R2 898
Table 1.4 Conversion of GDP to GNI – 2011
GNI at market prices can be taken one step further to find gross national disposable income at market
prices.
Disposable household income is a term used to describe household income after taxes.

C: The Multiplier
C.1: Definition of the multiplier
The “multiplier effect” is when a small initial increase in spending (ΔE) produces a proportionately
larger increase in aggregate income (ΔY).
 A multiplier is a number we multiply with.
 In national income the multiplier is the ratio of a change in the equilibrium level of income (ΔY) to an
initial change in the level of spending (ΔE).
 For example, if ΔE is R25 and ΔY= R100 the multiplier 100 / 25 = 4.

Macroeconomics: Topic 1 11
C.2: Explanation of the multiplier process
The concept of the multiplier is that one person’s spending becomes another person’s income.
The multiplier effect is cumulative rather than instantaneous. It is a process.

For example:
 A South African entrepreneur, starts a new coal mine near Rustenburg.
 He hires workers and employs the services of an excavating business.
 His expenditures become the income (salaries) of the workers and income of the contracted
business.
 The workers and business spend that income and a second round of recipients receives income.
 They then spend their incomes.
 And so the process goes on and on, until it eventually comes to an end.

The value of the multiplier depends on the fraction of the extra income that is spent on consumption (the
marginal propensity to consume – mpc) at each successive round.
For example:
 Assume that an analysis of South Africans’ spending behaviour shows that they are inclined to
spend 75% or R0,75 out of each rand straightaway.
 The marginal propensity to consume (MPC) will be 75 ÷ 100 = 0,75. (75/100 = 0.75)

If we don’t know the spending habits (percentage spent), one looks at the amount of money the new
receipts spent.
For example:
 Assume that we find the entrepreneur spent R10 billion and the recipients spent R7,5 billion of
their income.
 The mpc = ΔC / ΔE = 0,75.

C.3: Calculating the multiplier

To keep things simple, it is assumed recipients will either consume or save their income.
 The receivers of income are inclined to spend part of their incomes and save the balance.
Therefore, marginal prosperity to consume (mpc) + marginal prosperity to save (mps) = 1

Multiplier formula

The larger an increase in consumption from an increment of income, the larger the multiplier.
 If mpc is 0,8 and the mps is 0,2, the multiplier value is 5;
 If mpc is 0,75 and mps is 0,25, the multiplier value is 4 (1/0,25).

The multiplier effect will eventually come to an end after successive rounds of income receipts and
induced consumption expenditure.
For example:
 Assume the entrepreneur’s autonomous investment increases aggregate income by 10 billion.
 We can summarise it as follows:
1. = R10 billion
2. R10 billion × 0,75 = R7,5 billion
3. R7,5 billion × 0,75 = R5,63 billion
4. R5,63 billion × 0,75 = R4,22 billion
5. Etc = R --------------
R40,00 billion
= 1/0,25 = 4 × R10 billion

Macroeconomics: Topic 1 12
 Evidence shows that the mpc declines as income increases.
o Meaning, although consumption rises as income increases, the rate of increase of consumption
tends to decline.
o As an economy becomes more affluent, people spend more on consumer goods and services, but
they spend a smaller proportion of their income on such items.

 The paradox of thrift is a situation where the decision to save more, by reducing spending, results in a
fall in output and therefore employment.
o It states that individuals try to save more during an economic recession, which essentially leads to
a fall spending and therefore in aggregate demand and hence a fall in economic growth
(production output and employment).

C.4: The multiplier in the circular flow

In a four-sector flow module there is more leakages than merely savings.
 This means that 1-mpc is not equal to mps.
 In the circular flow: 1 - mpc = that proportion if any increase in income that leaks out of the circular
flow.
 This leakage = mps + mrt + mpm
 mpm = marginal propensity to import;
 mrt = marginal rate of taxation
 Imports make the multiplier smaller than it would otherwise be.
 Income taxes makes also make the multiplier smaller than it would otherwise be
The formula for the multiplier in a four-sector economy is:

The multiplier takes effect:

o When there is a change in the planned rate of spending.
o When there is a change in spending that is independent of changes in income e.g.
autonomous expenditure by G or I. It must be new money borrowed.

C.5: Graphical representation

 Aggregate expenditure AE = C + I + G +
(X – M) shows the initial equilibrium R10
billion at point B.
 New investments of R0,5 billion (I) are
made.
 This raises the AE curve to AE1.

 The AE1 curve intersects with the 45°

scale line at point D1 and is R12 billion.
 At this level, aggregate expenditure equals
aggregate income.
 The increase in investments (ΔI) of R0,5
billion increased equilibrium income by R2
billion.
 The increase in expenditure therefore
leads to an amplified change in equilibrium
income.
 The amplified change is the multiplier
effect. Equilibrium income increases by
more than the increase in initial Figure 1.5 The multiplier
expenditure.
Macroeconomics: Topic 1 13
 The multiplier is therefore greater than 1.

Suppose that the economy is in a recovery.

Profit prospects start to look better and businesses are making plans for large increases in investment.
The world economy is also heading towards recovery and exports are increasing.
The question on everyone’s lips is: How strong will the recovery be?
This is a hard question to answer.
But an important ingredient in finding the answer is working out the size of the multiplier.

To calculate the multiplier in Figure 1.5:

 Expenditure (autonomous injections [J]) increases by R0,5 billion and equilibrium income increases
by R2 billion to R12 billion.
 The multiplier is R2 billion ÷ R0,5 billion = 4.

C.6: Applications
 J.M. Keynes was an English economist used the variables that underpin the multiplier to explain how
governments could manage employment and growth by manipulating the levels of leakages and
injections.
 Fiscal policy that focuses on taxes and spending was the primary tool.
 Some of the policies that he recommended are still used today, including in South Africa.

 Demand-side policies are more recent versions of Keynesian policies.

 They seek to promote economic growth by ensuring that aggregate demand rises at a smooth rate.
 The policies involve active (also called discretionary) demand management, for example the
government manipulates aggregate demand by means of fiscal policy.

 The multiplier find application in the creation of employment through autonomous investment.

 South Africa has a dualistic economy, with a large proportion of poor people.
 Some analysts, using a sort of relative poverty approach, estimate the proportion as high as 42%.
 In terms of the World Bank’s absolute $1,25 the proportion is nevertheless much less.
 The main reason for the high poverty levels is unemployment.
 At 25% it is extremely high, even compared to some Africa countries.
 As a result, savings rates for the population are extremely low.
 The mpc is in excess of 90%.
 Investments, therefore, have strong multiplier effects.

Macroeconomics: Topic 1 14