PRINCIPLES OF MACROECONOMICS I

Delhi School of Economics · GE Code: ECON026 · Sem II / IV / VI / VIII

Complete Study Notes — Unit II, III & IV | Theory + Numericals

UNIT II: National Income Accounting

Abel, Bernanke & Croushore — Chapter 2

1. What is GDP?
GDP (Gross Domestic Product) is defined as the market value of all final goods and services newly
produced within a country's borders during a given time period. This is the most widely used measure of
economic activity. Each word in the definition is precise and important:
• Market value — goods and services are valued at the prices at which they are actually sold in the market.
This allows heterogeneous goods (cars, haircuts, medicines) to be added together into a single number.
• Final goods and services only — a final good is one purchased by the ultimate user. Intermediate goods
(e.g., steel used to produce a car, flour used to bake bread) are excluded. If we included them, we would be
double-counting because their value is already embedded in the final good's price.
• Newly produced — only goods produced in the current period count. The resale of a used car or an old
house does not add to current GDP because no new production has occurred. However, the broker's
commission on reselling a house is counted (it is a newly produced service).
• Within a country's borders — GDP is a geographic concept, not a citizenship concept. A Japanese
automobile factory located in India contributes to India's GDP, not Japan's. This is the key difference
between GDP and GNP.

■ KEY DISTINCTION: GDP (domestic) vs GNP (national). GNP = GDP + Net Factor Income from
Abroad (NFIA). NFIA = factor income earned by residents abroad minus factor income paid to
foreigners domestically.

2. Three Approaches to Measuring GDP

National income accounting provides three equivalent methods to measure GDP. In theory, all three yield the
same result because every rupee of output is simultaneously someone's income and someone's expenditure.

(A) Value Added / Product Approach

This approach adds up the value added at each stage of production across all producers in the economy. Value
added at any stage = (value of output at that stage) minus (value of intermediate inputs purchased). By
summing value added rather than total output, we avoid double-counting intermediate goods.

Value Added = Value of Output − Value of Intermediate Inputs

Why this works: Consider the chain — a cotton farmer sells to a thread maker, who sells to a cloth weaver,
who sells to a shirt manufacturer. If we summed all their sales, we would count the cotton multiple times.
Summing only value added gives us the final shirt's price exactly.

■ Numerical — Value Added Approach

Stage of Production Output Value (■) Intermediate Input (■) Value Added (■)

Cotton Farmer 500 0 500

Thread Maker 800 500 300

Cloth Weaver 1,200 800 400

Shirt Maker 1,800 1,200 600

GDP (Total) — — 1,800

■ GDP = ■1,800 = value of the final good (shirt). This exactly equals the sum of all value added. No
double counting.

(B) Expenditure Approach

This is the most commonly used approach. GDP is measured as the sum of all expenditures on final goods and
services by all sectors of the economy. It is broken into four components:

GDP = C + I + G + NX

Component What it Includes Important Exclusions

All household spending: food, clothing, rent,

healthcare, education, durable goods (cars,
C — Private appliances), non-durables (groceries), services Purchase of NEW residential housing
Consumption (haircuts) (this goes into I)

Business fixed investment (machinery,

equipment, buildings); Residential investment Purchase of financial assets — stocks,
I — Gross (new house construction); Inventory investment bonds, mutual funds are NOT
Investment (change in unsold stocks) investment in GDP terms

Transfer payments — pensions,

Government purchases of goods and services: subsidies, unemployment benefits.
G — Govt salaries of govt employees, military equipment, These are NOT purchases of output, so
Expenditure infrastructure excluded from G

Exports (foreign spending on our output, so

add) minus Imports (our spending on foreign
NX — Net Exports output, so subtract) —

■ INVENTORY INVESTMENT is crucial. If a firm produces goods but cannot sell them, the unsold
stock is recorded as the firm 'investing' in inventories. This ensures Production ≡ Expenditure at all
times, which is the fundamental identity of national accounts.

■ Numerical — Expenditure Approach

Private Consumption (C) = ■4,000 cr | Gross Investment (I) = ■1,200 cr

Govt Expenditure (G) = ■800 cr | Exports (X) = ■600 cr | Imports (M) = ■400 cr

NX = X − M = 600 − 400 = ■200 cr

GDP = C + I + G + NX = 4,000 + 1,200 + 800 + 200 = ■6,200 crore

(C) Income Approach
This approach measures GDP by summing all incomes earned in the process of production. Every rupee of
output produced must ultimately be paid out as income to some factor of production — wages, rent, interest, or
profit.

GDP = Compensation of Employees + Gross Operating Surplus + Gross Mixed Income

+ Net Indirect Taxes

• Compensation of employees — wages and salaries paid to workers, plus employer contributions to social
security and provident funds. This is the largest component in most developed economies.
• Gross Operating Surplus — the surplus accruing to corporations: essentially profits before depreciation
and taxes. 'Gross' because depreciation has not yet been deducted.
• Gross Mixed Income — income earned by self-employed individuals and unincorporated enterprises (e.g.,
a sole proprietor). It is 'mixed' because it combines both labour income and return to capital.
• Net Indirect Taxes = Indirect Taxes − Subsidies. These are included because market prices (at which
output is valued) include indirect taxes but exclude subsidies.

3. National Income Aggregates — The Full Chain

The syllabus specifically requires knowledge of 'related aggregates.' These form a chain of concepts derived
from GDP. Understanding the logic of each step is essential:

The starting point. Total market value of output produced within

GDP at Market Price (GDPMP) borders.

MINUS Depreciation (Capital Depreciation = wear and tear of capital. GDP is 'gross' because it has
Consumption Allowance) NOT deducted depreciation. NDP is 'net' because it has.

= NDP at Market Price Net Domestic Product at market prices.

MINUS Net Indirect Taxes (Indirect To go from market price to factor cost, remove the tax wedge. Indirect
Taxes − Subsidies) taxes inflate market prices; subsidies deflate them.

= NDP at Factor Cost = Domestic

Income Income actually earned by factors of production within borders.

PLUS Net Factor Income from Abroad NFIA = income earned by domestic residents abroad − income paid to
(NFIA) foreigners domestically. Can be positive or negative.

= NNP at Factor Cost = NATIONAL

INCOME (NI) The broadest measure of income earned by a nation's residents.

■ KEY FORMULAS: GNP = GDP + NFIA | NNP = GNP − Depreciation | NI = NNP at Factor Cost

■ Numerical — Full Aggregate Chain

Given: GDP at MP = ■8,000 cr | Depreciation = ■500 cr

Indirect Taxes = ■700 cr | Subsidies = ■200 cr | NFIA = −■100 cr (net outflow)

Step 1: NDP at MP = 8,000 − 500 = ■7,500 cr

Step 2: Net Indirect Tax = 700 − 200 = ■500 cr

Step 3: NDP at FC = 7,500 − 500 = ■7,000 cr (Domestic Income)

Step 4: National Income = 7,000 + (−100) = ■6,900 cr

Note: NFIA is negative because India pays more to foreigners than it earns abroad.
4. Nominal vs. Real GDP
GDP can be measured in two ways depending on which year's prices are used. This distinction is fundamental
to separating genuine economic growth from mere price increases (inflation).

Nominal GDP Real GDP

Prices used Current year's prices Base year's prices (constant prices)

Changes when Prices change OR quantities change Only when quantities (output) change

Reflects Both price and volume changes Only changes in actual production

Problem Overstates growth in inflationary times Requires choosing a base year

Best used for Measuring current economic size in ■ Comparing real growth across years

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

The GDP Deflator is an implicit price index. Unlike the CPI (which tracks prices of a fixed consumer basket), the
deflator covers all goods and services produced in the economy and uses a changing basket. It is broader than
CPI.

■ Numerical — Nominal, Real GDP and Deflator

Real GDP (Base 2020,
Year Qty (kg Rice) Price per kg Nominal GDP P=■20) GDP Deflator

2020 (Base) 500 ■20 ■10,000 ■10,000 100

2021 550 ■25 ■13,750 ■11,000 125

2022 600 ■30 ■18,000 ■12,000 150

Real GDP (2021) = 550 × ■20 (base price) = ■11,000

GDP Deflator (2021) = (13,750 / 11,000) × 100 = 125 → prices rose 25% since base year

Real growth 2020→2021 = (11,000 − 10,000) / 10,000 × 100 = 10%

Nominal growth 2020→2021 = (13,750 − 10,000) / 10,000 × 100 = 37.5% (inflated by prices)

5. Limitations of the GDP Concept

The syllabus explicitly includes 'limitations of the GDP concept.' GDP is a powerful summary statistic, but it has
well-known shortcomings as a measure of welfare or true economic activity:
• Non-market activities are excluded. Household work (cooking, childcare, cleaning), voluntary community
service, and subsistence farming all have genuine economic value but are not sold in markets, so they do
not enter GDP. This means GDP systematically underestimates economic activity in countries with large
non-market sectors.
• Underground and informal economy. In countries like India with large informal sectors, a significant
fraction of production goes unreported. Black market transactions, unregistered businesses, and undeclared
income are all excluded, making GDP an underestimate.
• Income distribution is ignored. GDP is an aggregate — two countries can have identical GDP per capita
but vastly different inequality. India and Norway may have the same average income on paper, but the lived
experience differs enormously. The Gini coefficient or HDI capture this better.
• Environmental degradation is not subtracted. When a factory pollutes a river or oil is extracted from the
ground, GDP rises. The depletion of natural resources and environmental damage are not counted as costs.
'Green GDP' attempts to correct for this.
• Quality improvements are hard to capture. A smartphone today costs ■50,000 and is vastly more
capable than a ■50,000 phone from 2005. GDP sees only the same nominal value. Statistical agencies use
'hedonic pricing' to partially address this.
• Leisure and well-being are excluded. If a country legislates a shorter working week, workers enjoy more
leisure but produce less output. GDP falls, but welfare may have risen.
• Composition of output is ignored. GDP treats ■1 spent on schools identically to ■1 spent on weapons or
cigarettes. It does not distinguish between productive and destructive activity.
 UNIT III: Determination of GDP

Dornbusch, Fischer & Startz — Ch.1 §1.2 (pp.14–16) & Ch.9 | Abel et al. — Ch.4

1. Actual and Potential GDP — The Output Gap

Textbook ref: Dornbusch Ch.1, Section 1.2, pages 14–16 — explicitly named in DSE syllabus

Potential GDP (Y*) is the level of real GDP the economy can produce when all resources (labour, capital, land)
are used at their normal, full-employment levels. It represents the economy's long-run productive capacity.
Potential GDP grows over time as the labour force grows, capital accumulates, and technology improves.
Actual GDP (Y) is what the economy actually produces in a given period. It fluctuates around potential due to
demand shocks, supply shocks, financial crises, and other disturbances. This fluctuation around the trend is
called the business cycle.

Output Gap = Actual GDP − Potential GDP

Type of Gap Output Gap Value Economic Meaning Policy Response

Economy is overheating. Firms

are hiring beyond normal Contractionary fiscal/monetary
Positive (Actual > capacity. Unemployment below policy — raise taxes, cut G, raise
Inflationary Gap Potential) natural rate. Inflation risk. interest rates

Full employment equilibrium.

Economy operating at
No Gap Zero (Actual = Potential) sustainable capacity. No intervention needed

Economy is underperforming.
Unemployment above natural Expansionary fiscal/monetary
Negative (Actual < rate. Idle factories. Deflationary policy — cut taxes, raise G,
Recessionary Gap Potential) pressure. lower interest rates

■ The business cycle (Dornbusch Ch.1): Actual GDP fluctuates around potential over time. A
recession is a period where actual GDP falls significantly below potential. The output gap measures
the severity of the recession or boom.

■ Numerical — Output Gap

Potential GDP (Y*) = ■10,000 crore | Actual GDP (Y) = ■9,200 crore

Output Gap = 9,200 − 10,000 = −■800 crore → Recessionary Gap

Gap as % of potential = (−800 / 10,000) × 100 = −8% → Significant recession

Interpretation: ■800 crore of potential output is being lost; unemployment is above the natural rate.

2. The Aggregate Expenditure (AE) Framework

Textbook ref: Dornbusch Ch.9 — Income and Spending

The AE model is a short-run model of GDP determination. The core idea, following Keynes, is that in the short
run, output is demand-determined. Firms produce what they expect to sell. The economy reaches equilibrium
when actual output equals planned aggregate expenditure.
In the simplest 2-sector model (only households and firms — no government, no trade):
 AE = C + I Equilibrium condition: Y = AE

If Y > AE: firms are producing more than people want to buy → unsold inventories rise → firms cut production →
Y falls toward equilibrium.
If Y < AE: firms cannot meet demand → inventories fall below desired levels → firms increase production → Y
rises toward equilibrium.

■ The equilibrium condition Y = AE is equivalent to Planned Saving = Planned Investment (S = I). This
is the saving-investment approach to equilibrium.

3. The Consumption Function

The consumption function is the relationship between household consumption spending and income. Keynes
proposed that consumption depends primarily on current income, and that as income rises, consumption rises
but by less than the rise in income.

C = C■ + cY where 0 < c < 1

• C■ (C-bar) = Autonomous consumption: the level of consumption that occurs even when income is zero.
Households borrow or run down savings to maintain a minimum consumption level. This is the intercept of
the consumption function.
• c = MPC (Marginal Propensity to Consume): the fraction of each additional rupee of income that is spent on
consumption. If MPC = 0.8, then for every ■1 of additional income, ■0.80 is consumed and ■0.20 is saved.
This is the slope of the consumption function.

Deriving the Saving Function (since all income is either consumed or saved, Y = C + S):

S = Y − C = Y − (C■ + cY) = −C■ + (1−c)Y = −C■ + sY

• −C■ = autonomous saving is negative: when income is zero, saving is negative (households dissave —
borrow or deplete assets) to fund autonomous consumption.
• s = MPS = 1 − MPC: Marginal Propensity to Save. The fraction of each extra rupee saved.

4. Key Propensities: MPC, MPS, APC, APS

Concept Formula Definition Key Property

Extra consumption per extra ■1 of income.

MPC ∆C / ∆Y Slope of the consumption function. 0 < MPC < 1 always

Extra saving per extra ■1 of income. Slope of

MPS ∆S / ∆Y = 1 − MPC the saving function. MPC + MPS = 1

Average fraction of total income spent on

consumption. Falls as income rises (since C■ >
0 means APC = C■/Y + c, and as Y rises, C■/Y
APC C/Y falls). APC > MPC when C■ > 0

Average fraction of total income saved. Rises

APS S / Y = 1 − APC as income rises. APC + APS = 1

■ MPC + MPS = 1 | APC + APS = 1 — These always hold because every rupee of income is either
consumed or saved. There is no third option in a simple economy.
■ Numerical — Computing Propensities
Given: C = 100 + 0.75Y

MPC = 0.75 | MPS = 1 − 0.75 = 0.25

At Y = ■1,000: C = 100 + 0.75(1000) = ■850

APC = C/Y = 850/1000 = 0.85 | APS = 1 − 0.85 = 0.15

At Y = ■2,000: C = 100 + 0.75(2000) = ■1,600

APC = 1600/2000 = 0.80 | APS = 0.20

Observe: APC falls from 0.85 to 0.80 as income rises (because autonomous component C■=100 becomes
smaller relative to total income)

5. Equilibrium GDP — Full Derivation

With investment assumed to be autonomous (I = I■, does not depend on income), we derive equilibrium income
algebraically:

Equilibrium condition: Y = C + I

Substitute C = C■ + cY and I = I■:

Y = C■ + cY + I■

Y − cY = C■ + I■

Y(1 − c) = C■ + I■

Y* = (C■ + I■) / (1 − c)

Alternative derivation via Saving = Investment (S = I):

Saving function: S = −C■ + sY

Set S = I■:

−C■ + sY = I■

sY = C■ + I■

Y* = (C■ + I■) / s [same result, since s = 1 − c]

■ Both methods give the same answer. The S=I method is elegant: equilibrium is where the saving
leakage exactly equals the investment injection.

6. The Concept of the Multiplier

Textbook ref: Dornbusch Ch.9 — central concept of the chapter

The multiplier is one of the most important concepts in macroeconomics. It captures the idea that an initial
increase in autonomous spending generates a larger total increase in GDP through successive rounds of
spending and re-spending in the economy.

Multiplier (α) = 1 / (1 − MPC) = 1 / MPS

∆Y = α × ∆(Autonomous Expenditure)

The Round-by-Round Logic (Dornbusch's mechanism):

Suppose investment increases by ■100 crore and MPC = 0.8. This initial injection sets off a chain of spending:
 New Consumption (MPC × Cumulative ∆Y
Round New Income Generated (■) Income) (■) (■)

1 (Initial ∆I) 100.00 80.00 100.00

2 80.00 64.00 180.00

3 64.00 51.20 244.00

4 51.20 40.96 295.20

5 40.96 32.77 336.16

… … … …

Total (Sum of infinite

geometric series) 500.00 — 500.00

Total ∆Y = 100 / (1 − 0.8) = 100 / 0.2 = ■500 crore. The original ■100 crore injection is multiplied 5 times.

■ KEY INSIGHT: A higher MPC → higher multiplier → larger GDP response to any demand shock.
This is because a higher MPC means each round of spending generates more re-spending.
Conversely, a higher MPS (more leakage into saving) → smaller multiplier.

■ Full Numerical — Equilibrium + Multiplier

Given: C = 200 + 0.75Y, I = ■300 crore (autonomous)

Part 1 — Find Equilibrium Y*:

Y = 200 + 0.75Y + 300

Y − 0.75Y = 500

0.25Y = 500 → Y* = ■2,000 crore

Part 2 — Compute Multiplier:

α = 1 / (1 − 0.75) = 1 / 0.25 = 4

Part 3 — Investment increases by ■100 crore (∆I = +100):

∆Y = α × ∆I = 4 × 100 = ■400 crore

New Y* = 2,000 + 400 = ■2,400 crore

Part 4 — Verify via S = I:

Original: S = −200 + 0.25(2000) = −200 + 500 = ■300 = I ✓

After shock: S = −200 + 0.25(2400) = −200 + 600 = ■400 = New I (300+100) ✓

7. Autonomous Expenditure
Autonomous expenditure is any component of aggregate expenditure that does not depend on the current
level of income (Y). It is determined by factors outside the income-expenditure model — interest rates, animal
spirits, government decisions, foreign demand, etc.
In the basic model, autonomous components include:
• Autonomous consumption (C■) — subsistence level of consumption, financed by borrowing or
dis-saving if necessary.
• Autonomous investment (I■) — investment decisions driven by profit expectations and technology, not
by current income levels.
 • Government expenditure (G) — determined by fiscal policy, not by income.
• Exports (X) — determined by foreign income and exchange rates, not domestic income.
A change in any autonomous component shifts the AE curve vertically by the amount of the change. The new
equilibrium is found by multiplying that shift by the multiplier.
 UNIT IV: National Income Determination — Open Economy with
Government

Dornbusch Ch.9 | Abel, Bernanke & Croushore — Ch.5, §5.2 (pp.214–215)

1. Adding Government to the Model

When we introduce government into the simple Keynesian model, two new variables appear: G (government
expenditure on goods and services) and T (taxes). Government expenditure is treated as autonomous — it is a
policy variable set by the government, independent of income. Taxes reduce households' disposable income.
Disposable Income: Households do not consume out of total income Y, but out of after-tax income:

Disposable Income: Yd = Y − T

The consumption function now becomes:

C = C■ + c(Y − T) = C■ + cY − cT

Deriving Equilibrium with Government (closed economy):

Y=C+I+G

Y = C■ + c(Y − T) + I■ + G

Y = C■ + cY − cT + I■ + G

Y − cY = C■ − cT + I■ + G

Y(1 − c) = C■ + I■ + G − cT

Y* = (C■ + I■ + G − cT) / (1 − c)

■ Taxes (T) appear as '−cT' in the numerator (not −T) because taxes reduce disposable income by T,
but this only reduces consumption by c×T (the MPC fraction). The rest (s×T) comes from reduced
saving.

2. Fiscal Policy — Impact of Changes in G and T

Fiscal policy refers to the use of government expenditure and taxation to influence the level of economic
activity. The AE model allows us to precisely calculate the impact of fiscal policy changes on equilibrium GDP
through multiplier analysis.

(A) Government Expenditure Multiplier

When government increases its spending by ∆G, holding taxes constant:

From Y* = (C■ + I■ + G − cT) / (1 − c)

Differentiating with respect to G:

∆Y / ∆G = 1 / (1 − c) = 1 / s

Government Expenditure Multiplier: αG = 1 / (1 − c) = 1 / s

Mechanism: ■1 of government spending directly adds ■1 to aggregate expenditure. This raises income by ■1,
which induces c×■1 of additional consumption, which raises income further, and so on. The total effect is the full
multiplier — identical to the basic investment multiplier.
(B) Tax Multiplier
When government increases taxes by ∆T, holding G constant:

From Y* = (C■ + I■ + G − cT) / (1 − c)

Differentiating with respect to T:

∆Y / ∆T = −c / (1 − c) = −c / s

Tax Multiplier: αT = −c / (1 − c) = −MPC / MPS

Why is the tax multiplier smaller in absolute value than the G multiplier? A ■1 increase in G adds ■1
directly to AE — the full rupee enters the spending stream immediately. A ■1 increase in taxes reduces
disposable income by ■1, but households spread this reduction between lower consumption (c × ■1) and lower
saving (s × ■1). Only the consumption part (c × ■1) actually reduces AE. Hence |αT| = c/(1−c) < 1/(1−c) = αG
always.

(C) Balanced Budget Multiplier — Haavelmo's Theorem

What if the government increases both G and T by the same amount ∆B? Intuitively one might expect zero net
effect. Haavelmo showed this is wrong:

∆Y = αG × ∆B + αT × ∆B

∆Y = [1/(1−c) + (−c/(1−c))] × ∆B

∆Y = [(1 − c)/(1 − c)] × ∆B

∆Y = 1 × ∆B

Balanced Budget Multiplier = 1 (always, regardless of MPC)

Intuition: The G increase raises AE by the full ■1. The T increase reduces AE by only c × ■1 (the saving part is
also reduced, but saving is a leakage, not expenditure). Net effect on AE = ■1 − c × ■1 = (1 − c) × ■1.
Multiplying by 1/(1−c) gives ∆Y = ■1. So even a fully balanced-budget expansion raises GDP by the amount of
the spending increase.

■ Full Fiscal Policy Numerical

Given: C = 100 + 0.8Yd, I = ■250 cr, G = ■200 cr, T = ■150 cr

Equilibrium Y*:

Y = 100 + 0.8(Y−150) + 250 + 200

Y = 100 + 0.8Y − 120 + 450

Y = 430 + 0.8Y

0.2Y = 430 → Y* = ■2,150 crore

Multipliers: αG = 1/0.2 = 5 | αT = −0.8/0.2 = −4 | BBM = 5 + (−4) = 1

Case 1 — ∆G = +■100 (T unchanged):

∆Y = 5 × 100 = +■500 → New Y* = ■2,650

Case 2 — ∆T = +■100 (G unchanged):

∆Y = −4 × 100 = −■400 → New Y* = ■1,750

Case 3 — Balanced Budget: ∆G = ∆T = ■100:

 ∆Y = (5 − 4) × 100 = +■100 → New Y* = ■2,250 (Multiplier = 1 ✓)

3. The Net Exports Function

Textbook ref: Dornbusch Ch.9 | Abel Ch.5, §5.2 (pp.214–215)

When we open the economy to international trade, we add the Net Exports component. Net Exports (NX) =
Exports (X) − Imports (M).

Exports (X):
Exports are treated as autonomous — they are determined by foreign incomes, world prices, exchange rates,
and foreign tastes, none of which depend on domestic income Y. An increase in foreign income or a
depreciation of the domestic currency raises exports.

Imports (M):
Imports rise with domestic income. As the domestic economy grows and incomes rise, households and firms
buy more goods — including imported ones. This gives us:

M = M■ + mY where m = MPM (Marginal Propensity to Import), 0 < m < 1

• M■ = autonomous imports (imports that occur regardless of income level — essential raw materials, for
instance).
• m = MPM: of each extra ■1 of income, m rupees are spent on imports. This is a crucial leakage from the
domestic circular flow.

Combining exports and imports:

NX = X■ − M = X■ − M■ − mY

NX is a downward-sloping function of domestic income Y. As Y rises, imports rise, so NX falls. At a

sufficiently high level of income, the trade balance turns negative (trade deficit). This is a key prediction of the
open-economy model.

■ Trade Deficit when NX < 0 (M > X). Trade Surplus when NX > 0 (X > M). In equilibrium, a
fast-growing economy tends to run a trade deficit.

4. Equilibrium GDP in the Open Economy

Textbook ref: Abel, Bernanke & Croushore, Chapter 5, Section 5.2, pp. 214–215

In the full 4-sector model (households, firms, government, foreign sector), aggregate expenditure is:

AE = C + I + G + NX

Substituting all components and solving for equilibrium Y:

Y = C■ + c(Y − T) + I■ + G + X■ − M■ − mY

Y = C■ + cY − cT + I■ + G + X■ − M■ − mY

Y − cY + mY = C■ − cT + I■ + G + X■ − M■

Y(1 − c + m) = A0 [where A0 = all autonomous expenditure]

Y* = (C■ + I■ + G − cT + X■ − M■) / (1 − c + m)

5. The Open Economy Multiplier

 Open Economy Multiplier: α = 1 / (1 − c + m) = 1 / (s + m)

Why is the open economy multiplier smaller than the closed economy multiplier?
In the closed economy, the only leakage from the circular flow is saving (s). Each round of spending, a fraction
s leaks into saving and does not return as further spending.
In the open economy, there is a second leakage: imports (m). When income rises, a fraction m of each rupee is
spent on foreign goods — this spending does not generate domestic income for the next round. Total leakage
per round = s + m.

Economy Type Leakages Multiplier Formula Effect

2-sector closed Saving (s) 1/s Largest multiplier

Same as 2-sector (G doesn't add

Closed with Govt Saving (s) 1/s leakage)

Smaller — foreign leakage

Open Economy Saving (s) + Imports (m) 1 / (s + m) reduces multiplier

■ As MPM (m) rises, the open economy multiplier falls. More import-dependent economies are less
responsive to demand stimulus.

■ Full Open Economy Numerical

Given: C = 150 + 0.75Yd, T = ■100 cr, I = ■200 cr, G = ■250 cr

X = ■180 cr (autonomous), M = 50 + 0.15Y

Step 1 — Equilibrium Y*:

Y = 150 + 0.75(Y−100) + 200 + 250 + 180 − 50 − 0.15Y

Y = 150 + 0.75Y − 75 + 580 − 50 − 0.15Y

Y = 605 + 0.60Y

0.40Y = 605 → Y* = ■1,512.5 crore

Step 2 — Open Economy Multiplier:

s = 1 − 0.75 = 0.25, m = 0.15

α = 1 / (0.25 + 0.15) = 1 / 0.40 = 2.5

(Compare: closed economy multiplier = 1/0.25 = 4 — imports reduce it from 4 to 2.5)

Step 3 — Trade Balance at equilibrium:

M = 50 + 0.15 × 1512.5 = 50 + 226.9 = ■276.9 cr

NX = 180 − 276.9 = −■96.9 cr (Trade Deficit)

Step 4 — If exports rise by ■100 cr (∆X = +100):

∆Y = α × ∆X = 2.5 × 100 = ■250 cr → New Y* = ■1,762.5 cr

6. Net Exports and Equilibrium National Income — Key Relationships

Understanding how changes in trade variables affect the equilibrium is central to Unit IV:

Change (Shock) Direct Effect on AE Effect on Equilibrium Y Effect on NX

 NX improves initially; but rising Y
raises M, so NX improvement is less
↑ Exports (X) AE shifts up by ∆X ↑ Y by α×∆X (open multiplier) than ∆X

↑ Autonomous
Imports (M■) AE shifts down ↓ Y by α×∆M■ NX worsens directly

No immediate shift, Y less responsive to all Trade balance more sensitive to

↑ MPM (m) but multiplier falls shocks income changes

↑ Govt Expenditure ↑ Y → ↑ M → NX worsens ('twin

(G) AE shifts up by ∆G ↑ Y by αG×∆G (open) deficits')

Foreigners buy more

↑ Foreign Income of our goods → ↑ X ↑ Y via export multiplier NX improves
 MASTER FORMULA & CONCEPT REFERENCE — All Three Units

Concept Formula / Key Result

UNIT II — NATIONAL INCOME ACCOUNTING

GDP (Expenditure Approach) C + I + G + NX

Value Added Output − Intermediate Inputs

GDP Deflator (Nominal GDP / Real GDP) × 100

NDP at Market Price GDP − Depreciation

NDP at Factor Cost NDP at MP − Net Indirect Taxes

National Income (NI) NDP at FC + NFIA = NNP at FC

GNP GDP + NFIA

MPC + MPS = 1 | APC + APS = 1

UNIT III — GDP DETERMINATION (SIMPLE MODEL)

Consumption Function C = C■ + cY

Saving Function S = −C■ + sY where s = 1 − c

Equilibrium (2-sector) Y* = (C■ + I■) / (1−c)

Output Gap Actual GDP − Potential GDP

Basic Multiplier α = 1/(1−MPC) = 1/MPS

Change in Y ∆Y = α × ∆(Autonomous Expenditure)

UNIT IV — OPEN ECONOMY WITH GOVERNMENT

Disposable Income Yd = Y − T

Equilibrium (with G, T) Y* = (C■ + I■ + G − cT) / (1−c)

Equilibrium (open economy) Y* = (C■ + I■ + G − cT + X■ − M■) / (1−c+m)

Imports Function M = M■ + mY where m = MPM

Net Exports NX = X■ − M■ − mY (downward sloping in Y)

Govt Expenditure Multiplier αG = 1/(1−c) = 1/s

Tax Multiplier αT = −c/(1−c) = −MPC/MPS

Balanced Budget Multiplier = 1 always (Haavelmo's Theorem)

Open Economy Multiplier α = 1/(s+m) = 1/(MPS+MPM)

Prepared strictly per DSE GE ECON026 syllabus (meeting 26/11/2024) — Abel/Bernanke/Croushore Ch.2, Ch.4, Ch.5§5.2 |
Dornbusch/Fischer/Startz Ch.1§1.2, Ch.9