This section discusses macroeconomic equilibrium, focusing on how to measure and analyze the overall economy.
Key Concepts
National Income Equilibrium: The point where aggregate demand equals aggregate supply.
Leakages (W): Withdrawals of money from the circular flow of income (savings, taxes, and imports).
Injections (J): Additions of money into the circular flow of income (investment, government spending, and exports).
National Income and Expenditure
National income can be measured using the expenditure approach:
Y = C + I + G + NX where:
Y = National Income
C = Consumption
I = Investment
G = Government Spending
NX = Net Exports (Exports - Imports)
Components of Aggregate Expenditure
Consumption (C): Spending by households on goods and services. It's a major driver of economic activity.
Influenced by disposable income.
A significant portion is spent on essential items.
It is the largest component of aggregate expenditure. Consumption is determined by disposable income, where an increase in income generally leads to increased consumption.
Equilibrium Condition
Equilibrium occurs when total leakages equal total injections: W = J
S + T + M = I + G + X
Savings (S) + Taxes (T) + Imports (M) = Investment (I) + Government Spending (G) + Exports (X)
Consumption Function
The consumption function relates consumption expenditure to disposable income.
Equation: C = a + bY_d
C = Consumption
a = Autonomous Consumption (consumption independent of income)
b = Marginal Propensity to Consume (MPC)
Y_d = Disposable Income
MPC (Marginal Propensity to Consume): change in consumption / change in disposable income \frac{\Delta C}{\Delta Y_d}
Savings Function
Relates savings to disposable income.
Equation: S = -a + (1-b)Y_d
-a = Dissaving (when consumption exceeds income)
(1-b) = Marginal Propensity to Save (MPS)
MPS (Marginal Propensity to Save) = change in savings / change in disposable income \frac{\Delta S}{\Delta Y_d}
Key Relationships
MPC + MPS = 1
APC + APS = 1
APC (Average Propensity to Consume) = \frac{C}{Y_d}
APS (Average Propensity to Save) = \frac{S}{Y_d}
Important Considerations
As disposable income increases, the MPC generally decreases while the MPS increases.
In a basic macroeconomic model, autonomous consumption (a) should be greater than zero.
Investment Expenditure (I)
Investment includes spending on new plants, equipment, and inventory.
It is a crucial injection into the economy.
Fluctuations in investment can significantly impact economic output.
Simple Model
Model: Y = C + I
Where:
C = 450 + 0.6Y
I = 150
Equilibrium Condition: Y = E
Y = 450 + 0.6Y + 150
0.4Y = 600
Y = 1500
Leakages and Injections: W = J
-450 + 0.4Y = 150
0.4Y = 600
Y = 1500
Consumption = 450 + 0.6Y, savings = −450 + 0.4Y.
Graphical Representation
The equilibrium point can be shown graphically where the aggregate expenditure line intersects the 45-degree line.
Government Sector
Introducing government spending (G) and taxes (T) to the model.
New Variables
Net Taxes (NT = Taxes - Transfers).
Disposable Income (Yd = Y - NT).
New Equilibrium Condition: Y = C + I + G
Which can be written as Y = C + S + NT
Therefore at equilibrium: C + I + G = C + S + NT
I + G = S + NT
Leakages (W) = S + NT
Injections (J) = I + G
Disposable income
Y_d = Y - NT
Multipliers
Simple Multiplier
K = \frac{1}{1-MPC} = \frac{1}{MPS}
With Income Tax
K = \frac{1}{MPS + MPT}
Interpretation
The multiplier effect shows how a change in autonomous expenditure can lead to a larger change in national income.
Example: If investment increases by x, national income increases by a multiple of x.
Open Economy
In an open economy, trade and international capital flows are considered.