Macroeconomics Lecture 2 Notes: GDP Determination

A Basic Model of GDP Determination in the Short Run

GDP Calculation: Firm Examples

  • Example 1:

    • Firm A (Asparagus): Pays £5M to workers, sells £4M to Firm B, £3M to Firm C, and £1M to consumers.
    • Firm B (Processed Food): Sells £9M to households, pays £5M to workers.
    • Firm C (Quiches): Sells £8M to consumers, pays £5M to workers.
    • GDP Calculation: Sum of sales to final consumers = £1M (A) + £9M (B) + £8M (C) = £18M.

  • Example 2 (Closed Economy, No Government):

    • Industry X (Raw Materials & Energy): Pays £7000M to workers, sells £6000M to Y, £3000M to Z, and £3000M to consumers.
    • Industry Y (Manufactured Goods): Sells £14000M to households, pays £7000M in wages.
    • Industry Z (Services): Sells £16000M to consumers, pays £10000M in wages.
    • GDP Calculation: Sum of sales to final consumers = £3000M (X) + £14000M (Y) + £16000M (Z) = £33000M.

Lecture Outline

  • Assumptions in building a macro model.
  • Key relationships: Consumption and Investment.
  • GDP determination.
  • The multiplier effect.
  • The “big idea”: The Keynesian revolution.

Simplified Macro Model Assumptions

  • Economy as one big industry.
  • Final spending is demand for the industry's output.
  • Government purchases, consumption, investment, and exports drive demand.
  • Factors: Labor, output of goods, consumer spending, investment, government purchases, exports-imports.

Model Assumptions (Temporary)

  • Price level is constant (real terms).
  • Excess capacity exists, so output is demand-determined.
  • Closed economy, no government.
  • Focus: GDP = C + I [+ G + (X-M)], where Y symbolizes GDP.
  • C (Consumption) is endogenous; I (Investment) is exogenous.

Circular Flow of Income

  • Flow between domestic households, the financial system, the government, domestic producers, and abroad.
  • Total income generated = Total final spending.
  • Saving and investment are key components.
  • Payments for factor services, income for goods and services.

Consumption and Saving

  • Change in personal disposable income leads to changes in consumption and saving.

  • Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS): Both are positive and sum to one (MPC + MPS = 1).

  • All disposable income is either spent or saved.

  • Equations:

    • Consumption: C = a + bY, where:

      • a = Autonomous consumption (consumption when income is zero).
      • b = MPC.

    • Saving: S = -a + (1-b)Y

UK Consumption and Income (1955-2022)

  • Graphical representation of UK consumption and personal income over time.

Paradox of Thrift

  • Savings rate rises in recessions, falls in booms.
  • The household saving ratio peaked at 27.4% during the COVID-19 pandemic (UK, Quarter 1 2024).

Empirical Example: Consumption and Saving

  • Consumption: C = 100 + 0.8Y
    • Autonomous consumption = 100.
    • MPC = 0.8.
  • Saving: S = -100 + 0.2Y
    • MPS = 0.2.

Consumption and Saving Functions (Graphical)

  • Illustrations of consumption and saving functions.

Consumption and Saving Schedules

  • Table showing disposable income, desired consumption, and desired saving at different income levels.

Investment

  • Investment treated as an exogenous variable.
  • Later, investment will depend on interest rates and expectations of future demand growth.
  • Numerical example: Investment is constant at 250.

Aggregate Expenditure Function

  • Aggregate Expenditure (AE) = C + I in a closed economy with no government.
  • Table showing GDP, desired consumption, desired investment, and desired aggregate expenditure.

Aggregate Expenditure Function (Graphical)

  • Graph of AE as a function of Real GDP.

Equilibrium GDP

  • Equilibrium GDP: Purchasers buy the exact amount of national output produced.
  • Above equilibrium GDP: Desired expenditure < National output (output decreases).
  • Below equilibrium GDP: Desired expenditure > National output (output increases).
  • In a closed economy with no government, desired saving = desired investment at equilibrium GDP.
  • Graphically: AE curve intersects the 45° line; saving function intersects the investment function.

Equilibrium GDP Determination

  • Graphs illustrating equilibrium GDP using aggregate expenditure and saving/investment functions.

Equilibrium GDP Table

  • Table showing GDP, desired aggregate expenditure, and pressure on Y (GDP).

Achieving Equilibrium

  • For GDP to remain unchanged, injections of spending and leakages must be equal.
  • Analogy: A bath with the tap running and no plug; inflow must equal outflow for a stable water level.

Model Solution

  • Model: Y = C + I and C = a + bY
  • Solving for Y:
    • Y = a + bY + I
    • Y - bY = a + I
    • Y = {\a + I}{1-b}

Equilibrium Example

  • Equilibrium: Y = C + I and S = I

  • Numerical Example:

    • C = 100 + 0.8Y and I = 250
    • Y = 100 + 0.8Y + 250
    • Y = {100 + 250}{1 - 0.8} = 350 \times 5 = 1750

  • If Y = 1750:

    • C = 100 + 0.8(1750) = 1500
    • S = -100 + 0.2(1750) = -100 + 350 = 250
    • Saving = Investment.

Changes in GDP

  • Equilibrium GDP increases with a rise in exogenous spending (injections) or a fall in withdrawals.
  • Equilibrium GDP decreases with a fall in injections or a rise in withdrawals.
  • Multiplier: Magnitude of the effect on GDP from shifts in autonomous expenditure.
    • Multiplier = {1}{1-b}, where b is the MPC (without taxes and foreign trade).
    • If b = 0.8, multiplier = 5.

Simple Multiplier

  • Graphical representation of the multiplier effect.

Multiplier: Detailed Graph

  • Illustration on how a change in autonomous spending affects equilibrium income.

New Equilibrium with Increased Investment

  • Investment rises from 250 to 350.
  • Old GDP: 1750.
  • New GDP:
    • Y = 100 + 0.8Y + 350
    • Y - 0.8Y = 450
    • Y = 450 \times 5 = 2250
  • Increase in Y = change in I \times multiplier = £100 \times 5 = £500.
  • New saving level: S = -100 + (0.2 \times 2250) = 350

Multiplier Intuition

  • £100 increase in exogenous spending generates £100 of extra income, £80 of which is spent.
  • This £80 generates £80 of extra income, and 0.8 (64) of this is spent, creating £64 of extra income, and so on.
  • Total income generated converges to £500.

Multiplier: Numerical Example Table

  • Cumulative spending over multiple rounds of spending, illustrating how the multiplier effect converges.

The “Big Idea”: Keynesian Revolution

  • Economy can get stuck with GDP below potential due to “aggregate demand failure”.
  • Aggregate spending is inadequate to generate GDP at its potential (full-employment) level.
  • Caused by consumer caution, low investment, or low world demand.
  • Solution: Government spending and tax changes to increase demand.
  • Budget becomes a tool for managing the economy, not just funding government spending plans.

Keynesian Revolution Graph

  • Graphical representation of how government intervention can shift the economy to full-employment GDP.