CAPE ECONOMICS

UNIT 2: MACROECONOMICS
MODULE 1: MODELS OF THE MACROECONOMY

TOPICS COVERED
Topic 1: National Income Accounting
Topic 2: Classical Models of the Macroeconomy
Topic 3: Basic Keynesian Models
Topic 4: Investment

Study Notes | CXC A20/U2

 TOPIC 1: NATIONAL INCOME ACCOUNTING

SPECIFIC OBJECTIVES
1. Explain the circular flow of income
2. Explain the concept of National Income Accounting
3. Explain the different ways of deriving National Income Accounts
4. Interpret National Income statistics
5. Use National Income accounts to analyze the performance of an economy as a whole
6. Derive real GDP from nominal GDP
7. Explain the limitations of GDP

CONTENT
• Economic agents
• Gross Domestic Product (GDP), Gross National Product (GNP) and other measures
• Calculation of GDP, GNP and their components; avoidance of double counting
• GDP at market prices vs GDP at factor cost
• Use of National Income accounts to measure economic performance over time and inter-
country comparisons
• Calculation of real and nominal GDP using the price deflator
• Limits of National Income Accounts as a measure of well-being

1.1 — What Is National Income Accounting?

National income accounting is a record-keeping system used by governments to quantify the volume of
economic activity in a country over a specific time period. It tracks total revenues from domestic businesses,
salaries paid to workers, and taxes paid by corporations and individuals.
It is not an exact science, but it gives essential information about how effectively an economy operates and
where money is created and spent.

KEY CONCEPT: Economic growth is measured as an increase in real national income (real GDP, GNP,
or NNP). For growth to occur, there must be an actual increase in output, not just rising prices.

1.2 — Circular Flow of Income

The circular flow model shows how money moves between households, firms, government, and the foreign
sector.
 REAL FLOWS (goods/services/resources)
Households → Firms: Labour, land, capital
Firms → Households: Goods and services produced
Government → All: Public goods (roads, defence, schools)
Foreign ↔ Domestic: Actual goods traded

MONEY FLOWS (payments/income)

Households → Firms: Consumer spending
Firms → Households: Wages, rent, interest, profits
Households → Government: Income taxes
Government → Households: Welfare, salaries
Firms → Government: Business taxes
Government → Firms: Government purchases
Foreign Sector → Domestic: Export earnings
Domestic → Foreign Sector: Import spending

KEY RULE: Injections (I, G, X) add money to the circular flow. Withdrawals/Leakages (S, T, M)
remove money from it. When Injections > Withdrawals, national income rises. When Withdrawals >
Injections, national income falls.

1.3 — GDP, GNP and Other Measures

GDP (Gross Domestic Product): The total monetary value of all final goods and services produced within a
country's borders in one year, regardless of who owns the factors of production.
GNP (Gross National Product): The total value of all final goods and services produced by a country's citizens
(nationals), regardless of where they produce them — inside or outside the country.

GDP = C + I + G + NX where NX = (X − M)

GNP = GDP + Net Factor Income from Abroad

REMEMBER: Net Factor Income from Abroad = income earned by citizens abroad MINUS income
paid to foreign nationals in the country.

Other Key Measures

 Measure Formula What it means
NNP (Net National Product) GNP − Depreciation GNP after accounting for capital
that has worn out (capital
consumption allowance)
National Income (NI) NNP − Indirect Taxes + Total income earned by factors
Subsidies − Stock of production in the economy
Appreciation

Personal Income (PI) NI + Transfer payments Income actually received by

− Social Security households before income tax
contributions −
Corporate retained
earnings − Corporate
taxes

Disposable Income (DI) PI − Direct/Income Tax Income households can actually

spend or save
Per Capita Income National Income ÷ Average income per person;
Population used to compare living
standards

1.4 — Three Methods of Calculating GDP

IMPORTANT: All three methods should produce the same GDP figure when calculated correctly.

Method 1: Expenditure Approach

Adds up all spending in the economy on final goods and services.

GDP = C + I + G + (X − M)

Components
C (Consumption) — household spending on goods and services (largest component, ~60-70% of
GDP)
I (Investment) — business spending on capital goods, machinery, buildings, and inventory changes
G (Government Spending) — government purchases of goods and services (NOT transfer payments
like welfare)
X (Exports) — foreign spending on domestic output (injection)
M (Imports) — domestic spending on foreign output (withdrawal/leakage)
NX = X − M is called Net Exports
 GDP at Factor Cost = GDP at Market Prices − Indirect Taxes +
Subsidies

GNP at Factor Cost = GDP at Factor Cost + Net Factor Income

from Abroad

EXAM TIP: Statistical discrepancies should be added to GDP when using the expenditure approach
to get GDP at market prices.

Method 2: Income Approach

Adds up all factor incomes earned in the production of output.

GDI at Factor Cost = Wages + Rent + Interest + Profits

GDP at Market Price = GDI at Factor Cost − Stock Appreciation

+ Indirect Taxes − Subsidies

Factor Income Components

Wages and Salaries — payment for labour
Rent — payment for land
Interest — payment for capital
Profits — payment for enterprise
Mixed Income — self-employed income (combines labour + profit)
Deduct Stock Appreciation — rise in inventory value due to price increases (not real output)

Method 3: Output / Value-Added Approach

Adds up the value added at each stage of production. This avoids double counting by only counting the value
added at each stage, not the full sale price.

GDP = Sum of Value Added by each industry

Double Counting Example — Bread

Farmer sells wheat to baker: $2 → Value added = $2
Baker sells bread to store: $5 → Value added = $5 − $2 = $3
Store sells to consumer: $8 → Value added = $8 − $5 = $3
GDP contribution = $2 + $3 + $3 = $8 (NOT $2 + $5 + $8 = $15)
The final sale price ($8) equals the sum of value added at all stages.
 1.5 — Nominal vs. Real GDP

Nominal GDP: GDP measured at current year prices. It can rise just because prices increased (inflation), not
because actual output increased.
Real GDP: GDP measured at constant (base year) prices. Removes the effect of inflation to show the true change
in output.

Real GDP = (Nominal GDP ÷ GDP Deflator) × 100

GDP Deflator = (Nominal GDP ÷ Real GDP) × 100

REMEMBER: In the base year, the price index = 100, so nominal GDP = real GDP in that year. After
that, if nominal GDP rises faster than real GDP, the difference is inflation.

Worked Example
Nominal GDP = $480M | GDP Deflator = 115
Real GDP = ($480M ÷ 115) × 100 = $417M
This tells us that $63M of the nominal increase was due to inflation, not real growth.

1.6 — Limitations of GDP as a Measure of Well-Being

GDP measures the total value of output, but this does not necessarily reflect the quality of life or well-being of
citizens. Key limitations include:

1. Underground/Informal Economy
Cash transactions, illegal activities, and street vending are not reported to authorities and therefore
not counted in GDP. In the Caribbean, an estimated 20-30% of economic activity goes unrecorded.
This means GDP underestimates the true size of the economy.

2. Non-Market Activities
Unpaid work such as housework, childcare by family members, volunteer work, and home food
production are excluded from GDP, even though they contribute real value. If a parent pays a
babysitter, it counts. If they stay home, it doesn't — even for the same service.

3. Environmental Costs / Degradation

GDP counts the output from cutting down a forest (timber sales) but ignores the loss of
environmental value (clean air, biodiversity, carbon absorption). 'Green GDP' would subtract
environmental costs from standard GDP.

4. Income Distribution
GDP per capita shows average income, but does not reveal how income is distributed. Two
countries can have the same per capita GDP while one has extreme inequality and the other has
fairly equal distribution.

5. Quality of Life
GDP does not measure: income equality, health/education quality, crime and safety levels,
happiness, or life satisfaction. Alternative measures include the Human Development Index (HDI),
Genuine Progress Indicator (GPI), and Gross National Happiness.
 TOPIC 2: CLASSICAL MODELS OF THE MACROECONOMY

SPECIFIC OBJECTIVES
8. Explain why within the classical model, all employment is voluntary
9. Explain how full employment is restored in the classical model
10. Explain the factors that influence aggregate demand
11. Explain the factors that influence aggregate supply
12. Interpret the classical long-run supply curve
13. Explain price level determination within the classical model
14. Use the classical AD/AS model to show changes in the price level and employment

CONTENT
• Flexibility of wages and prices
• The role of wage, price, and interest rate flexibility
• Factors influencing aggregate demand: consumer, investment, government, and net export
spending
• Factors influencing aggregate supply including changes in input prices and incomes
• The assumptions of the vertical aggregate supply curve
• The interaction of the classical aggregate demand and supply curves
• Shifts in the AD and AS curves

2.1 — Core Assumptions of the Classical Model

The classical model (associated with Adam Smith, David Ricardo, Alfred Marshall) believes that free markets, left
alone, will always return to full employment. The government should not intervene — intervention makes things
worse.

Core Classical Assumptions

Perfect competition in all markets
Perfect information — workers and firms know all available wages and prices
Flexible wages and prices — they adjust freely and quickly to clear markets
Rational behaviour — workers maximise utility; employers maximise profit
Say's Law: Supply creates its own demand — producing goods generates enough income to buy
them
Markets are self-correcting; government intervention is unnecessary
 2.2 — Why All Unemployment Is 'Voluntary' in the Classical Model

Voluntary Unemployment: Workers who choose not to work because they consider the prevailing market wage
too low by their standards (Bahaw 2007). In the classical model, if the wage is at the market-clearing level,
anyone who wants to work at that wage has a job.

Classical economists argue that since wages are perfectly flexible, the labour market always clears. If
unemployment exists, it is because workers are voluntarily choosing not to accept the equilibrium wage — not
because firms refuse to hire.

EXAMPLE: Caribbean example: In Barbados's tourism sector, during low season, wages fall and
some workers voluntarily exit the market (move to other sectors or take breaks). Classical
economists say this is voluntary, not involuntary unemployment.

2.3 — How Full Employment Is Restored: Three Adjustment Mechanisms

1. Wage Flexibility
• If unemployment rises, workers compete for jobs by accepting lower wages.
• Lower wages reduce firms' costs, making it profitable to hire more workers.
• Employment rises back to the full employment level.
• Labour market clears automatically — no government needed.

2. Price Flexibility
• If excess supply of goods builds up (unsold stock), firms lower prices.
• Lower prices increase consumer demand (goods become affordable).
• Firms produce more to meet rising demand, hiring more workers.
• Product markets clear automatically.

3. Interest Rate Flexibility (Loanable Funds)

• Say's Law works through the loanable funds market.
• If savings (S) > Investment (I): excess supply of funds → interest rates fall → investment
rises until S = I.
• If Investment (I) > Savings (S): excess demand for funds → interest rates rise → savings rise
until S = I.
• Financial markets clear automatically, ensuring income flows back into spending.
 CRITICAL EVALUATION: Real-world complication: Classical adjustment is slow because of wage
stickiness (contracts, unions), information imperfections, skills mismatches, and government
interventions like minimum wages and unemployment benefits.

2.4 — Aggregate Demand (AD)

Aggregate Demand (AD): The total quantity of goods and services that all sectors of the economy are willing and
able to purchase at different price levels, ceteris paribus.

AD = C + I + G + (X − M)

The AD curve slopes downward: as the price level falls, the purchasing power of money rises (Wealth Effect /
Real Balances Effect), so consumers can buy more, increasing quantity demanded.

Components of AD and Their Determinants

Component What it is Key Determinants

C — Consumption Household spending on final Disposable income, consumer
goods/services. The largest confidence, wealth (housing/stocks),
component. interest rates (borrowing costs)
I — Investment Business spending on capital goods Interest rates (key!), expected
(machinery, factories, equipment) profitability, business confidence,
and inventory changes. technology, taxes
G — Government Government purchases of Government policy decisions, fiscal
Spending goods/services. Does NOT include stance, economic cycle
transfer payments (pensions,
welfare).
(X−M) — Net Exports Exports bring money in (injection). Foreign incomes, exchange rates,
Imports take money out domestic income, trade policies,
(withdrawal). relative prices

2.5 — Aggregate Supply (AS)

Aggregate Supply (AS): The total quantity of goods and services that firms are willing and able to produce at
different price levels, ceteris paribus.

Factors That Shift the AS Curve

 Input Prices (shift AS left when they rise, right when they fall)
Labour costs — minimum wage increases, union negotiations → higher wages = higher costs = AS
shifts left
Raw material prices — e.g. oil prices (crucial for Caribbean island economies)
Capital costs — interest rates on business loans
Exchange rate — depreciation raises the cost of imported inputs

Technology & Productivity (shift AS right when improved)

Automation and digitalisation reduce costs and increase output
Infrastructure improvements (better ports, roads, internet) reduce costs
Human capital — better-educated, better-trained workforce increases productivity

Government Policies
Corporate taxes — higher taxes reduce profitability, shifting AS left
Subsidies — lower costs, shifting AS right
Regulations — stricter environmental/labour rules raise costs (AS left)
Trade policies — import tariffs on raw materials raise costs

2.6 — The Classical Long-Run Aggregate Supply (LRAS) Curve

In the classical model, the LRAS is perfectly vertical (perfectly inelastic) at the full employment level of output
(Yfe). This is because in the long run, output is determined by real factors — labour, capital, technology, and
natural resources — not by the price level.

Y = f(K, L, A, N) where K=Capital, L=Labour, A=Technology,

N=Natural Resources

Assumptions Underlying the Vertical LRAS

Full employment — all resources (labour, capital, land) are fully utilised
Flexible prices and wages — markets clear; no involuntary unemployment
Perfect information — no money illusion
Technology is given in the long run
The economy operates at its productive capacity (potential output)

SHIFTS: Shifting LRAS RIGHT (increased potential output): discovery of new resources, technological
advancement, increase in labour force, improved infrastructure, education improvements. Example:
 Jamaica discovering oil reserves would shift LRAS right.

2.7 — Price Level Determination in the Classical Model

Price level is determined by the intersection of the AD curve and the vertical LRAS curve. Since LRAS is vertical:

Classical AD/AS Conclusions

Increases in AD (AD shifts right) only raise the PRICE LEVEL — output stays at Yfe.
Decreases in AD (AD shifts left) only lower the PRICE LEVEL — output stays at Yfe.
Only supply-side changes (shifts in LRAS) can change the level of real output in the long run.
Short-run: AD and SRAS intersection determines short-run equilibrium; SRAS is upward sloping.
Long-run: Economy automatically returns to LRAS via wage/price adjustments.

EXAM CRITICAL: CRITICAL: In the classical model, fiscal stimulus (increasing G) cannot increase real
output long-term — it just causes inflation. Only supply-side policies can raise potential output.

CARIBBEAN CONTEXT: Caribbean reality check: Classical full employment is unrealistic in the
Caribbean because of structural unemployment (skills mismatches), seasonal unemployment
(tourism), significant informal sector underemployment, and geographic immobility between
islands.
 TOPIC 3: BASIC KEYNESIAN MODELS

SPECIFIC OBJECTIVES
15. Explain the consumption function
16. Explain the relationship between saving and consumption
17. Calculate the simple multiplier
18. Explain the effect of changes in investment on national income
19. Explain the effect of government spending on national income
20. Describe the effect of withdrawals and injections on national income
21. Explain the relationship between net exports and national income
22. Determine the equilibrium level of national income
23. Explain inflationary and deflationary gaps

CONTENT
• Autonomous and induced consumption
• Income = Consumption + Saving; MPC and MPS; APC and APS
• Simple multiplier
• Relationship between changes in investment and national income
• Government expenditure and its effects on national income
• Concepts of injections and withdrawals; small multipliers in the Caribbean due to leakages
• Relationship between net exports (X−M) and national income; exports as injection, imports
as withdrawal
• Determination of equilibrium income using: 45° line (E=Y), withdrawals=injections,
Keynesian AD/AS curves
• Full employment output, actual output, inflationary and deflationary gaps

3.1 — The Keynesian Revolution

John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936. He challenged
classical economics by arguing that markets do NOT always self-correct, particularly during recessions.

Classical View (Before Keynes) Keynesian View

Markets always clear themselves Aggregate demand determines national income
Supply creates its own demand (Say's Law) Economy can be stuck below full employment
Economy self-corrects to full employment Government intervention is necessary and
effective
 Wages and prices are perfectly flexible Wages are 'sticky downwards' — they resist
falling

3.2 — The Consumption Function

Keynes argued that the primary determinant of household consumption is current disposable income. The
relationship is captured by the consumption function.

C = a + bYd

Breaking Down C = a + bYd

C = Total Consumption Spending
a = Autonomous Consumption — spending even at zero income (financed by savings or borrowing).
Covers basic necessities like rent, food, utilities.
b = Marginal Propensity to Consume (MPC) — the fraction of each additional dollar of income that
is consumed.
Yd = Disposable Income (income after taxes)
bYd = Induced Consumption — the portion of spending that depends on income

KEYNES'S LAW: Keynes's Fundamental Psychological Law: As income rises, consumption rises, but
by LESS than the rise in income. Therefore MPC (b) is between 0 and 1.

CARIBBEAN LINK: Caribbean context: Autonomous consumption tends to be HIGHER in the

Caribbean than in developed economies because a large proportion of basic goods (food, fuel,
medicine) is imported and costly, and social safety nets are weaker.

3.3 — Marginal and Average Propensities

Propensity Formula Key Relationship Meaning

MPC ΔC / ΔY MPC + MPS = 1 Fraction of EXTRA
income spent on
consumption
MPS ΔS / ΔY MPS = 1 − MPC Fraction of EXTRA
income saved
MPM ΔM / ΔY MPC + MPS + MPM + Fraction of EXTRA
MPT = 1 income spent on
 imports
MPT ΔT / ΔY (part of the 1 above) Fraction of EXTRA
income paid in taxes
APC C / Y APC + APS = 1 Fraction of TOTAL
income spent on
consumption
APS S / Y APS = 1 − APC Fraction of TOTAL
income saved

KEY OBSERVATION: Keynesian observation: As income rises, the APC falls (people save a larger
proportion of their total income). But the MPC stays relatively constant — every extra dollar
earned, the same fraction (MPC) is spent.

Worked Example
Income rises from $1.5M to $2.0M JMD
Consumption rises from $1.3M to $1.7M JMD
MPC = ΔC/ΔY = (1.7−1.3)/(2.0−1.5) = 0.4/0.5 = 0.8
MPS = 1 − 0.8 = 0.2
This means: for every extra dollar earned, 80 cents is consumed and 20 cents is saved.

3.4 — The Saving-Consumption Relationship

Since all income is either consumed or saved, the saving function is derived directly from the consumption
function.

Y = C + S (income identity — always true)

S = −a + (1−b)Y = −a + sY where s = MPS

Interpreting the Saving Function

−a = Dissaving: when income = 0, households draw on savings to fund autonomous consumption
(1−b) = MPS: for every extra dollar of income, (1−MPC) is saved
Breakeven point: where the consumption line crosses the 45° line — at this income, all income is
consumed and savings = 0
Below breakeven: households are dissaving (S < 0)
Above breakeven: households are saving (S > 0)
 3.5 — The Multiplier Effect

The multiplier explains how an initial injection of spending into the economy leads to a larger overall increase in
national income. An initial injection ripples through the economy as each recipient spends a fraction (MPC) of
the income they receive.

k = 1/(1−MPC) = 1/MPS

ΔY = k × ΔJ (where J = injection: I, G, or X)

How the Multiplier Works — Step by Step

Step 1: An injection occurs (e.g. J$100M hotel investment)
Step 2: Construction workers receive J$100M income
Step 3: With MPC = 0.8, they spend J$80M on goods/services
Step 4: Those sellers earn J$80M and spend J$64M (80% of 80M)...
...This process repeats, with each round smaller than the last
Total ΔY = k × ΔI = [1/(1−0.8)] × J$100M = 5 × J$100M = J$500M

CARIBBEAN CRITICAL POINT: Caribbean Reality: The effective multiplier is MUCH smaller than the
theoretical multiplier because of high leakages from the open Caribbean economies.

Caribbean Effective Multiplier: k = 1/(MPS + MPM + MPT)

Why Caribbean Multipliers Are Small — The Leakage Problem

High MPM (imports): 60-80% of goods are imported. New income quickly leaks abroad when spent
on foreign goods.
Tourism revenue repatriation: Foreign-owned hotels send profits back to their home country.
Remittances: Workers send money to family abroad.
Tax leakages: MPT reduces the amount flowing back into domestic spending.
Example — Jamaica: MPS = 0.2, MPM = 0.3, MPT = 0.1 → k = 1/(0.2+0.3+0.1) = 1/0.6 = 1.67 (vs
theoretical k = 5)

3.6 — Injections, Withdrawals, and National Income

Injections (J): Additions of spending into the circular flow from outside the current cycle of income and
consumption: Investment (I), Government Spending (G), Exports (X).
Withdrawals / Leakages (W): Income removed from the circular flow that is not spent on domestic goods:
Saving (S), Taxation (T), Imports (M).

Equilibrium Condition: I + G + X = S + T + M

Effect on National Income

If J > W (Injections > Withdrawals): National income RISES — more spending enters the economy
than leaves
If W > J (Withdrawals > Injections): National income FALLS — more leaks out than comes in
At Equilibrium (J = W): National income is stable — no pressure to expand or contract

NET EXPORTS: Net Exports and National Income: As national income rises, imports rise (people
spend more on foreign goods), so net exports fall. Exports are an injection; imports are a
withdrawal. For the Caribbean, high import dependence means significant income constantly leaks
out.

3.7 — Determining Equilibrium National Income

There are three approaches to finding equilibrium national income. All three give the same answer.

Approach 1: 45° Line (E = Y) Approach 2: J = W Approach 3: Keynesian AD/AS

AE = C + I + G + (X−M). Plot Injections (J) line Uses the Keynesian AS curve

Equilibrium where the (horizontal — autonomous) and (horizontal → upward sloping
Aggregate Expenditure (AE) line Withdrawals (W) line (upward → vertical). Equilibrium where
crosses the 45° line. At this sloping — rises with income). AD intersects AS. Different
point, AE = Y (planned spending Equilibrium at intersection: I + sections of the AS curve give
= output). G + X = S + T + M. different price/output
combinations.

Disequilibrium: If AE > Y, firms' If J > W at current income, Keynesian short-run AS has

inventories fall → they increase income rises. If W > J, income three ranges: horizontal
production → Y rises. If AE < Y, falls. Income adjusts until (recession/unemployment),
inventories pile up → firms cut balance is restored. upward-sloping (approaching
production → Y falls. capacity), vertical (full
employment).

3.8 — Output Gaps: Inflationary and Deflationary Gaps

Full Employment Output (Yf / Potential Output): The maximum sustainable level of real GDP when all resources
are fully utilised. Note: does NOT mean zero unemployment — frictional and structural unemployment still exist
at Yf.
Actual Output: The real GDP the economy is currently producing (can be above or below Yf).

DEFLATIONARY (RECESSIONARY) GAP INFLATIONARY GAP

Actual output (Ye) is BELOW full employment Actual output (Ye) is ABOVE full employment
output (Yf) output (Yf)
Unemployment is above the natural rate Labour shortages; overtime; capacity constraints
Deflationary pressures (prices stagnant or falling) Inflationary pressures (prices rising)
Gap = Yf − Ye (the shortfall in output) Gap = Ye − Yf (excess demand beyond capacity)
Policy: Reflationary/Expansionary — increase G, Policy: Deflationary/Contractionary — reduce G,
cut T, cut interest rates (shift AD right) increase T, raise interest rates (shift AD left)
Caribbean example: Jamaica 2010-2016 — debt Caribbean example: A tourism boom can create
crisis created a large deflationary gap with 15%+ inflationary pressures as spending exceeds
unemployment productive capacity

POLICY LINK: The government can close a deflationary gap by increasing G or cutting T
(expansionary fiscal policy — shift AD right). It can close an inflationary gap by reducing G or
increasing T (contractionary fiscal policy — shift AD left).
 TOPIC 4: INVESTMENT

SPECIFIC OBJECTIVES
24. Explain the concept of investment
25. Differentiate between the investment demand curve and the investment curve
26. Explain the accelerator theory
27. Outline the factors that account for the volatility of investment

CONTENT
• Investment: induced and autonomous
• Marginal Efficiency of Capital (MEC) — investment demand as a function of expected rate of
return
• Marginal Efficiency of Investment (MEI) — non-interest rate determinants: taxes, costs,
capital stock, expectations
• Accelerator theory of investment
• Determinants of investment: the accelerator, durability, irregularity of innovation,
variability of profits, expectations, and interest rates

4.1 — What Is Investment?

Investment (I): Expenditure on capital goods that are not consumed today but used for future production.
Investment represents the economy's addition to its productive capacity.

Gross Investment = Gross Fixed Capital Formation + Changes in

Inventories

Net Investment = Gross Investment − Capital Consumption

(Depreciation)

Components of Investment
Fixed Capital Investment (Planned): spending on plant, machinery, equipment, buildings (e.g.
Appleton Estate buying new rum distillation equipment)
Inventory Investment (Unplanned): changes in stocks of raw materials and finished goods (e.g.
Wisynco storing water before hurricane season)
→ If AE < Y: inventories rise (unplanned positive investment — firms slow production)
→ If AE > Y: inventories fall (unplanned negative investment — firms increase production)
 Residential Investment: construction of new housing units

4.2 — Autonomous vs. Induced Investment

Autonomous Investment (I₀) Induced Investment (Iᵧ)

Independent of the level of national income (Y) Depends on changes in national income (Y) or
Driven by government policy, technology, output
population growth Rises when income rises; falls when income falls
Remains relatively constant regardless of GDP Directly related to the level of economic activity
changes Example: Sandals Resort expands rooms after
Example: GOJ's North-South Highway continues record tourism arrivals increase national income
regardless of current GDP — driven by long-term
development goals

Total Investment: I = I₀ + Iᵧ

4.3 — Marginal Efficiency of Capital (MEC) vs. MEI

MEC (Marginal Efficiency of Capital): The expected rate of return on an additional unit of capital investment.
Firms invest in a project if the expected rate of return > cost of borrowing (interest rate). The investment
demand curve is derived from MEC — it slopes downward because as more capital is invested, returns diminish.

MEC RULE: Investment Rule: Invest in all projects where Expected Rate of Return > Interest Rate
(r). As interest rates fall, more projects become viable, so investment rises. This is why the
investment demand (MEC) curve is downward sloping.

MEI (Marginal Efficiency of Investment): A broader concept that recognises investment depends on MORE than
just the interest rate. It captures the non-interest rate determinants that shift the entire investment demand
curve.

Non-Interest Rate Determinants of Investment (MEI Shifters)

Business Taxes / Incentives

Higher corporate taxes reduce after-tax returns → MEI curve shifts LEFT (less investment at every
interest rate). Tax holidays and investment credits → MEI shifts RIGHT. Example: Trinidad's 10-year
tax holiday for manufacturing firms increased MEI, boosting investment.
 Costs of Capital Goods
Higher machinery/equipment prices or import duties raise investment costs → MEI shifts LEFT.
Exchange rate depreciation makes imported capital more expensive. Example: Jamaican dollar
depreciation in 2023 raised imported machinery costs 20%, reducing MEI.

Stock of Capital Goods on Hand (Excess Capacity)

If firms have excess capacity (underutilised capital), additional investment is less attractive → MEI
shifts LEFT. Example: After COVID-19, Caribbean hotels had low occupancy — despite low interest
rates, they postponed expansion because existing capital was underutilised.

Expectations About Future Economic Conditions

Optimistic expectations about future sales/profitability → MEI shifts RIGHT. Pessimism or political
instability → MEI shifts LEFT. Example: When the Bank of Jamaica signals stable macroeconomic
conditions, business confidence improves → MEI shifts right.

MEC MEI
Focus: expected rate of return vs interest rate Focus: broader investment determinants
Primary variable: interest rate Multiple variables: taxes, costs, expectations,
capital stock
Investment function: I = f(r) Investment function: I = f(r, T, C, K, E)
Movement along the curve when r changes Curve shifts when non-interest factors change

4.4 — The Accelerator Theory of Investment

Accelerator Principle: The level of investment spending is driven by the RATE OF CHANGE of national income
(output), not the level. A small change in consumer demand causes a proportionally larger change in investment
demand.

Net Investment = a × (Yt − Yt-1) where a = Capital-Output

Ratio

Capital-Output Ratio (a): The amount of capital stock needed to produce a given level of output. E.g. a ratio of
5:1 means $5M of capital is needed to produce $1M of output per year. Assumed fixed in the short run.

The Bike Factory Example — How the Accelerator Works

 You have 10 machines; each makes 100 bikes/year; capacity = 1,000 bikes.
1 machine wears out/year (replacement investment only).

Year 1: Demand = 1,000 bikes → need 10 machines → Total investment = 1 (replacement)

Year 2: Demand jumps 20% to 1,200 → need 12 machines → buy 2 new + 1 replacement = 3
machines
→ A 20% rise in sales caused a 200% rise in investment! That's the accelerator.
Year 3: Demand grows only 5% to 1,260 → need 13 machines → buy 1 new + 1 replacement = 2
machines
→ Sales still rising, but investment FELL because the rate of growth slowed.

ACCELERATOR KEY POINT: KEY TAKEAWAY: Investment depends on the CHANGE in output, not the
level. Even if output is still growing, a slowdown in growth can cause investment to fall —
potentially triggering a recession. This makes investment the most volatile component of AD.

4.5 — Why Investment Is Volatile

Investment is the most unstable component of GDP. The following factors explain its volatility:

Determinants of Investment Volatility

The Accelerator: Small changes in output growth cause large swings in investment (as shown
above).
Durability of Capital: Capital goods last a long time (machines, buildings). Firms can delay
replacement, making investment lumpy and irregular.
Irregularity of Innovation: New technologies trigger investment booms (e.g. digitisation, renewable
energy), but innovations come in waves — not steadily.
Variability of Profits: If current profits are low, firms have less retained earnings to fund investment.
Firms are also cautious when profits are uncertain.
Expectations: Investment depends heavily on business confidence about the future. If firms expect a
recession, they cut investment even if current conditions are fine.
Interest Rates: Higher interest rates raise the cost of borrowing for investment. Lower rates make
more projects profitable.
Caribbean-specific: Foreign Direct Investment is especially volatile — global recessions, hurricanes,
and political instability cause sudden swings in FDI inflows.

EXAM LINK: Investment volatility means it can amplify both booms and recessions. A fall in
investment triggers the negative multiplier effect → falling national income → more
unemployment. Caribbean economies are especially vulnerable due to reliance on FDI.
 FORMULA & KEY CONCEPT SUMMARY — MODULE 1

Formula / Concept Meaning / Notes

GDP = C + I + G + (X−M) Expenditure approach. NX = X−M. Result is GDP at market
prices.
GNP = GDP + Net Factor Adds citizens' income earned overseas; subtracts foreigners'
Income from Abroad income from home.
NNP = GNP − Depreciation Removes worn-out capital from GNP.
GDP at Factor Cost = GDP at Strips out taxes to show what factors of production actually
Market Prices − Indirect earn.
Taxes + Subsidies
Real GDP = (Nominal GDP ÷ Removes inflation. Base year deflator = 100.
GDP Deflator) × 100
C = a + bYd Consumption function. a = autonomous; b = MPC.
S = −a + (1−b)Y Saving function. Derived from Y = C + S.
MPC = ΔC/ΔY Fraction of extra income consumed. MPC + MPS = 1.
MPS = ΔS/ΔY Fraction of extra income saved.
APC = C/Y | APS = S/Y APC + APS = 1. As income rises, APC falls.
Simple Multiplier k = 1/MPS Theoretical multiplier; ignores all leakages except saving.
= 1/(1−MPC)
Effective Multiplier k = Caribbean multiplier; accounts for high import and tax
1/(MPS+MPM+MPT) leakages.
ΔY = k × ΔJ Change in national income from any injection (I, G, or X).
Equilibrium: J = W → I+G+X OR: AE = Y (45° line). Two equivalent equilibrium conditions.
= S+T+M
Accelerator: I = a × (Yt − Net investment from change in output. a = capital-output
Yt-1) ratio.