07-09-2025

Introductory
Macroeconomics

Prof. Sunny Bhushan

ED 205
Module 2
BIT Mesra

Road ahead

• Income Determination in the short-run - Simple Keynesian System

• Multipliers
• Equilibrium in both closed and open economies and stability
• Autonomous expenditure
• Balanced budget
• Net exports
• Paradox of thrift

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The study of macroeconomics is organized around three models that describe the
world, each model having its greatest applicability in a different time frame.

Time Frame:
Very Long Run Long Run Short Run
• A snapshot of the very long • Fluctuations in demand
• Domain of growth theory determine how much of the
run model.
available capacity is used and
• Focuses on the growth of thus the level of output and
the economy’s capacity to • Capital and technology
remain largely fixed, except unemployment.
produce goods and services.
for short-term shocks.
• In the short run, prices are
• It centers on the historical fixed and output varies.
accumulation of capital and • Fixed capital and technology
improvements in determine the productive
capacity of the economy— It is in the realm of the short-run
technology. model that we find the greatest
this capacity is called as
“potential output.” role for macroeconomic policy.

The Keynesian Revolution: A

New Way to Understand the
Economy
“In the long run we are all dead.”

• Rejects classical idea that markets always clear

automatically.

• Focuses on short-run where prices are sticky and

output is demand-driven

• Justifies active government intervention (fiscal

policy)
AD = C + I + G + NX John Maynard Keynes

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What determines the Demand for Goods &

Services
Four components of GDP:-
• Consumption (C)
• Investment (I)
• Government (G)
• Net Exports (NX)

National Income Identity for:

• An Open Economy: Y = C + I + G + NX
• A closed economy: Y = C + I + G

Consumption

Consumption depends directly on the level of disposable income

C = C(Yd )
where; Yd = Y – T
Here; Yd stands for disposable income and T stands for tax

C = C(Y – T)
Consumption Function: is the relationship between consumption and disposable income

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Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC): is the amount by which
consumption changes when disposable income increases by one dollar

Consumption function: C = C (Y – T )

C = C(Yd)

written as: 𝐶 = 𝐶̅ + 𝑐𝑌

where; 𝑪 is a constant and c represents Keynes' psychological law (Marginal

Propensity to Consume (MPC)) 0 < c < 1
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The Consumption Consumption

Function Consumption
Function

0< MPC < 1 – any increment to

disposable income, the incremental
consumption resulting from this will be MPC
less than the incremental income
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Average Propensity to Consume

(APC): average consumption per unit
of disposable income.
Disposable income, Y - T

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Keynes’s Conjectures Consumption

𝐶 = 𝐶̅ + 𝑐𝑌

0 < MPC < 1

Average propensity to consume

(APC) falls as income rises. MPC

(APC = C/Y)
𝐶̅ APC

Income is the main determinant

of consumption.
Disposable income, Y - T

Income – Consumption Relationship

Income Approach
Y = C + S -------------(i)

where; C = 𝐶̅ + cY , where 𝐶̅ is an autonomous consumption; cY is induced consumption and c is marginal

propensity to consume

From eq. (i) S = Y- C

= Y – (𝐶̅ +cY)
= −𝐶̅ + (1 – c) Y
or,
S = 𝑆̅ + sY,
where 𝑆̅ = −𝐶̅ and s = 1-c
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• APC = C/Y

• Average Propensity to Save (APS) = Saving/Income [S/Y]

• Marginal Propensity to Consume (MPC) = change in consumption/change in income

• Marginal Propensity to Save (MPS) = change in saving/change in income

MPC (c) + MPS (s) = 1

• When you receive extra income, you have two choices: you can either spend it or save
it. The portion that you don’t spend is automatically saved.

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The Reference Line - 45° line Consumption 45° reference line

C = Yd
• At each point on the 45° line, consumption would
equal disposable income, or 𝐶 = 𝑌 .
C
• Therefore, the vertical distance between the 45°
line and any point on the horizontal axis measures
either consumption or disposable income. 𝑆𝑎𝑣𝑖𝑛𝑔𝑠

• The vertical distance between 𝑌 and the

consumption line labeled C represents the amount
of saving ( S) in that year. 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛

• Saving is the amount by which actual 𝟒𝟓°

consumption in any year falls short of the 45° line
i.e. (𝑆 = 𝑌 − 𝐶). Disposable income, Y - T

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(1) (2) (3) (4) (5) (6) (7)

Level of Consumption Saving (S) Average Propensity to Average Marginal Marginal
Output = (C) Consume (APC) Propensity to Save Propensity to Propensity to
Income (APS) Consume (MPC) Save (MPS)
(GDP = DI)
(1) – (2) (2)/(1) (3)/(1) ▵(2)/▵(1) ▵(3)/▵(1)

$370 $375 0.25

390 390 1.00
410 405 0.01
430 420 10
450 435 0.75
470 450 0.96
490 465 0.25
510 480 30 0.06
530 495 0.93
550 510 40 0.75

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Shift and Movement of the (a)

consumption and (b) saving schedules

• The movement from one point to another

on a consumption schedule – is solely
caused by a change in real GDP.

• An upward or downward shift of the

entire schedule – is a shift of the
consumption schedule and is caused by
changes in any one or more of the Non-
income determinants of consumption.

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Investment

• Quantity of investment goods demanded depends on the interest rate

• Therefore, it measures the cost of the funds used to finance investment

• Investment project to be profitable: its return (the revenue from increased future
production of goods and services) must exceed its cost (the payments for borrowed
funds)

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Nominal vs Real Interest Rate

• The nominal interest rate: it is the rate of interest that investors pay to borrow money

• The real interest rate is the nominal interest rate corrected for the effects of inflation

Real Interest Rate = Nominal Interest Rate – Inflation Rate

𝒓= 𝒊 −𝝅

Nominal interest rate = 8%

Inflation rate = 5%
Real interest rate = 3%
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Real Interest Rate

Investment Function (r)

Real interest rate measures the true cost of

borrowing and, thus, determines the quantity of
investment
I=I(r)

𝐼 = 𝐼 ̅ − 𝑏𝑟
• 𝑏>0
• 𝑟 is the real rate of interest and
• the coefficient b measures the responsiveness of Investment
investment spending to the interest rate Function, I(r)
It slopes downward because as the interest rate
rises, the quantity of investment demanded falls
Investment, (I)

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Shifts in Investment Real Interest Rate

Demand Curve
Factors that lead to greater rates of returns
• shifts the investment demand curve
towards rightward direction

I1
Factors that lead to lower rates of returns I0
I2
• shifts the investment demand curve
towards leftward direction Investment

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Government Purchases
• Government purchases include: buying goods for Rewrite the consumption function here;
defense services, building schools, roads, etc.

Yd = Y – T (previously)
• Transfer Payments
are not made in exchange for some of the economy’s Now,
output of goods and services.
Yd = Y + Tf – T;
• Therefore, they are not included in the variable G;
but increase the HH's income. where Tf stands for transfer payments

Therefore;
• Transfer payments are the opposite of Taxes
C = C(Y + Tf – T)

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Net Exports
• The item “Net exports” accounts for domestic spending on foreign goods and foreign spending
on domestic goods.

• When foreigners purchase goods we produce, their spending adds to the demand for
domestically produced goods.

• Correspondingly, that part of our spending that purchases foreign goods has to be subtracted
from the demand for domestically produced goods.

• Accordingly, the difference between exports and imports, called net exports , is a component of
the total demand for our goods.

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Aggregate Demand and Equilibrium Output

• Aggregate demand is the total amount of goods demanded in the economy.
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
• Output is at its equilibrium level when the quantity of output produced is equal to the quantity
demanded.
𝑌 = 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
• When aggregate demand—the amount people want to buy—is not equal to output, there is
unplanned inventory investment or disinvestment.
IU = Y – AD
IU is unplanned additions to inventory
• IU > 0  Excess inventory investment: Output is greater than aggregate demand,
• IU < 0  Output is below than aggregate demand

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Consumption, Aggregate Demand, and Autonomous Spending

𝑌 =𝑌 −𝑇+𝑇

Here, 𝑌 is the disposable income, T is tax and 𝑇 is the transfer payment

Consumption Function: 𝐶 = 𝐶̅ + 𝑐𝑌
= 𝐶̅ + 𝑐 𝑌 − 𝑇 + 𝑇

Aggregate Demand: 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
= 𝐶̅ + 𝑐 𝑌 − 𝑇 + 𝑇 + 𝐼 ̅ + 𝐺̅ + 𝑁𝑋
= 𝐶̅ − 𝑐 𝑇 − 𝑇 + 𝐼 ̅ + 𝐺̅ + 𝑁𝑋 + 𝑐𝑌
= 𝐴̅ + 𝑐𝑌

Where, 𝐴̅ is the autonoumus spending i.e. it is independent of income

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Equilibrium in Income and Output

AD
AD = Y
• Equilibrium level of income: AD = Y
• The 45° line, AD = Y, shows points at 𝐼𝑈 > 0
E 𝐴𝐷 = 𝐴̅ + 𝑐𝑌
which output and aggregate demand
AD0
are equal. 𝐼 ̅ + 𝐺̅ + 𝑁𝑋
• Only at point E and at the 𝐼𝑈 < 0
𝐴̅
corresponding equilibrium levels of 𝐶 = 𝐶̅ − 𝑐 𝑇 − 𝑇 + 𝑐𝑌
income and output ( Y0), does
aggregate demand exactly equal 𝐶̅ − 𝑐(𝑇 − 𝑇 )
output.
• The arrows on the horizontal axis 𝟒𝟓°
indicate how the economy reaches Y
Y0
equilibrium.

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Multiplier Effect
• A change in spending, say, investment, ultimately changes output and income by more
than the initial change in investment spending, this is called as the multiplier effect.

• The multiplier determines how much larger that change will be; it is the ratio of a
change in GDP to the initial change in spending (in this case, investment).

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐺𝐷𝑃
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔

• By rearranging this equation, we can also say that:

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐺𝐷𝑃 = 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 × 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔

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• If investment in an economy rises by $30 billion and GDP increases by $90 billion as a
$
result, we then know from the equation that the multiplier is 3 ( ).
$

• Note these three points about the multiplier:

1. The “initial change in spending” is usually associated with investment spending
because of investment’s volatility.
2. But changes in consumption (unrelated to changes in income), net exports, and
government purchases also lead to the multiplier effect.
3. Implicit in the preceding point is that the multiplier works in both directions. An
increase in initial spending will create a multiple increase in GDP, while a
decrease in spending will create a multiple decrease in GDP.

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Intuition behind Multiplier

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The Multiplier Process (MPC .75)

• An initial change in investment spending of $5 billion
creates an equal $5 billion of new income in round 1.

• Households spend $3.75 ( .75 × $5) billion of this new

income, creating $3.75 of added income in round 2.

• Of this $3.75 of new income, households spend $2.81 (

.75 × $3.75) billion, and income rises by that amount
in round 3.

• Such income increments over the entire process get

successively smaller but eventually produce a total
change of income and GDP of $20 billion.

• The multiplier therefore is 4 ( $20 billion / $5 billion).

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The Multiplier and the Marginal Propensities

The MPC and the multiplier are directly related

Multiplier =

Recall, too, that MPC = 1 - MPS.

Therefore MPS = 1 - MPC, which means we can also write the multiplier formula as

1
Multiplier =
𝑀𝑃𝑆
The equilibrium level of output is higher the larger the marginal propensity to consume, c .

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Derivation of the Autonomous Expenditure Multiplier

• Each point means AD is higher by an amount AD
∆𝐴̅ ≡ 𝐴′ − 𝐴̅ 𝐴𝐷 = 𝑌

• Inventories run down

• Production has to increase, say upto level 𝑌 . This 𝐴𝐷′ = 𝐴′ + 𝑐𝑌

Aggregate Demand
give rise to induced expenditure, giving rise to 𝐸
AD upto level 𝐴 G
𝐴
• Balance will be resotred at equilibrium 𝐸 and the ∆𝐴̅ 𝐴𝐷 = 𝐴̅ + 𝑐𝑌
corresponding level of income increases to 𝑌 𝐴′ F
Q
• The magnitude of the income change required to ∆𝐴̅ E
restore equilibrium depends on two factors: P
∆𝑌
• The larger the increase in autonomous spending, 𝐴̅
i.e. by the parallel shift in the aggregate demand
schedule, the larger the income change.
• Furthermore, the larger the marginal propensity to
consume—that is, the steeper the aggregate Y
𝑌 𝑌 𝑌
demand schedule—the larger the income change. Income, Output

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Autonomous Expenditure Multiplier

• The autonomous expenditure multiplier (also called the expenditure multiplier or
Keynesian multiplier) measures how much total output (GDP or income) changes in
response to a change in autonomous expenditure — that is, spending that does not
depend on the level of income (like government spending, investment, or exports).

∆𝑌 1
𝛼 = =
∆𝐴 1 − 𝑀𝑃𝐶

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AD
𝐴𝐷 = 𝑌
Government Expenditure
𝐴𝐷 = 𝐴̅ + 𝑐𝑌 + 𝐺
Multiplier B

AD2
• Government purchases affect the ∆𝐺
economy.
𝐴𝐷 = 𝐴̅ + 𝑐𝑌 + 𝐺
∆𝐴𝐷
A
• If G increases by ∆𝐺, then the AD curve
shifts upward by ∆𝐺 AD1

Govt. Exp. Multiplier:

∆
𝛼 = =
∆ 45°
Y1 Y2
∆𝑌
Income, Output, Y

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Tax Rate Multiplier AD

𝐴𝐷 = 𝑌
• A decrease in taxes of ΔT immediately raises
disposable income Y−T by ΔT and,
therefore, increases consumption by 𝐴𝐷
MPC×ΔT. F
AD2 𝑀𝑃𝐶
× ∆𝑇 𝐴𝐷
Just as an increase in government purchases has
a multiplied effect on income, so does a ∆𝐴𝐷
decrease in taxes.
1. A tax cut
E shifts aggregate
AD1
demand….
Tax Rate Multiplier:
∆𝑌 𝑀𝑃𝐶
𝛼 = =
∆𝑇 1 − 𝑀𝑃𝐶

Y1 Y
2. …which increases Y2
equilibrium income ∆𝑌

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Identity: Y = C + I + G + NX ……..(i)
i.e. total spending on the domestic goods (Y) is equal to spending by the domestic resident and net demand for
domestic goods by foreigners
• Derving relation between output and disposable income:
Yd = Y + Tf – T………. (ii)
where, Tf is transfer payment and T is tax.
• Disposable income in turn is allocated to consumption and savings
Yd = C + S………..(iii)
• Rearranging the equations (ii) and (iii) and inserting the value of eq (i)
Yd – Tf + T = C + I + G + NX…….(iv)
• Putting identity (iii) into (iv), we get:
C + S – Tf + T = C + I + G + NX
• By making some rearrangements, we get:
S – I = (G + Tf – T) + NX

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Saving, Investment, Government Budget and Trade

S – I = (G + Tf – T) + NX
• The identity suggests that excess of saving over investment (S – I) in the private sector is equal
to the government budget deficit plus the trade surplus.

• This means that if the private sector's saving is equal to investment, then the government’s
budget deficit (surplus) is reflected in an equal external deficit (surplus).

The term (G + Tf – T) is called government budget deficit.

• G + Tf indicate total government expenditure (government purchases + transfer payments)
• T indicate the amount of taxes (revenue) received by the government

If:
• G + Tf > T -- Budget Deficit
• G + Tf = T -- Balanced Budget
• G + Tf < T -- Budget Surplus
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Balanced Budget Multiplier

Government Budget: B = T – G – Tf

Suppose, ∆𝐺 = ∆𝑇 , ∆𝑌 = ? [assuming ∆𝑇 f = 0]
Recall, Y = 𝐴̅ + c(Y – T + 𝑇f) + G
𝐴̅ = 𝐶̅ + 𝐼 ̅ + 𝑇f
∆𝑌 = 0 + 𝑐 ∆𝑌 − ∆𝑇 + ∆𝐺
As, ∆𝐺 = ∆𝑇, therefore;
∆𝑌 = 𝑐∆𝑌 − 𝑐∆𝐺 + ∆𝐺
∆𝑌 1 − 𝑐 = ∆𝐺 1 − 𝑐
∆
= =1
∆

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We know: AD = C + I + G + NX

And consumption depends upon disposable income:

𝐶 = 𝐶̅ + 𝑐𝑌

We also know: 𝑌 = 𝑌 −𝑇+𝑇

Taxes are two types:

1. Lumpsum Taxes: T = T0
2. Proportional Taxes: T =tY

Hence, the disposable income, now can be written in form of:

1) Lumpsum Tax: 𝑌 =𝑌 −𝑇 +𝑇

2) Proportional Tax: 𝑌 = 𝑌 − 𝑡𝑌 + 𝑇
𝑌 = 𝑌 1−𝑡 +𝑇

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Paradox of Thrift
“The propensity to save may defeat its own purpose.” ---[Link]
Core Idea:
While saving is good for an individual, it can be bad for the economy if everyone increases their saving
at the same time.
Explanation:
1. Suppose households decide to increase their saving (i.e., reduce consumption).
2. This leads to a fall in aggregate demand, because consumption is a major component.
3. Firms respond to reduced demand by cutting production and laying off workers. This causes a fall
in income (Y).
4. Since S = Y– C, and income falls sharply, actual saving may not rise — it might even fall.
5. So, the economy ends up worse off, and people don’t actually save more overall.

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