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Essential Terms
Microeconomics
Behaviour of individual units (labour market, monopolies, oil market)
Macroeconomics
Behaviour of the economy as a whole and broad economic aggregates.
For example: Aggregate Expenditure, Aggregate Demand, Aggregate Supply, GDP,
Inflation, Unemployment, Macroeconomic Equilibrium
Nominal GDP
Current or market value of final goods and services produced in an economy over a
year.
Macroeconomic Equilibrium
Macroeconomic Equilibrium occurs when
Aggregate/Total Expenditure = Total Output = Total Income
ΣE = ΣO = ΣY
Σ =Sum of.
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Information
Macroeconomic Equilibrium Using a Keynesian Cross/Income and
Expenditure Diagram and the Circular Flow Diagram
AE = C + Ip +G +X
AE- +C
M + Ip + G + (X-M)
AEe
Ye Real Income/Output
Macroeconomic Equilibrium
4
Aggregate Expenditure Using an Income and Expenditure or
Keynesian Cross Diagram
G+X-M
+X
1. CONSUMPTION
Most stable component of AE. Why? Spending on non durable goods or survival
level of consumption is fairly stable/ constant.
However, consumer spending on durable goods (discretionary spending) is less
stable, as it can be postponed.
1. The consumption function is the consumption line and shows the planned level of
consumption at each level of income.
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C =a+ b.Y or Autonomous Consumption (a) plus Induced Consumption (bY)
bY= MPC x Y (income). As income rises consumption rises and the slope of the
consumption line is determined by the Marginal Propensity to Consume (MPC).
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Determinants of Consumption
The consumption function consumption illustrates that consumption is determined by income
(induced) and other factors (autonomous) such as consumer confidence
Run Rise
$100m
7
3. Cost of Credit - if interest rates rise consumption will decrease
due to repayments on borrowed funds increasing and/or
savings increase as the opportunity cost of C rises
C shifts - decreases from CF0 to CF2 then the equilibrium level of Y (Ye) falls.
4. Govt/RBA Economic Policy i.e. monetary policy (interest rate policy) and fiscal
policy. (Federal Budgets). A decrease in interest rates due to expansionary
monetary policy would lead to an increase in CF0 from to CF2 and an increase in the
equilibrium Y (Ye).
5. Level of Consumer Debt
6. Holdings of Wealth/Assets or Shares - an increase in wealth will lead to an
increase in consumption.
7. Availability of Credit – reduced availability of credit will reduce consumption from
CFo to CF2
8. Distribution of Income - the more equal distribution of income the greater
consumption.
Investment is:
14-26% of GDP
an important generator of economic activity and is used to explain the business
cycle
is the most volatile component of Aggregate Expenditure as it concerns the future
which involves more risk and uncertainty.
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Why is Investment associated with risk and uncertainty?
Determinants of Investment
A rise in the real interest rate fall in quantity of investment and vice versa.
Real interest rate Factors that Shift Investment Demand Curve
10% 1. changes in technology
2. new resources discovered
3. changes in law i.e. environmental
5% regulations
Investment Demand Curve
4. changes in taxation
5. changes in expectations
quantity of investment 6. changes in the level of economic activity
John Maynard Keynes argued that Investment was interest inelastic (investment was
not as responsive to interest rate changes)
Note - Interest rates are affected by the Reserve Bank through Monetary Policy
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6. Technology
7. Growth of Demand and Capacity Utilisation.
8. Business Expectations
Graphing Investment using an Income and Expenditure (Keynesian
Cross) Graph
In this model we assume investment is constant irrespective of income (autonomous),
there is no govt spending and net exports. Therefore we can add investment to the
consumption function as indicated below:
Political Ideology, Economic Theories and the level of economic activity domestically
and internationally will determine the level of Govt Expenditure (i.e. the Federal Govt
stimulus program in 2008/9 due to the GFC) or due to unforeseen events such as the
floods in Queensland, Iraq War, Drought, Bushfires).
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In the model below we are assuming that investment and government expenditure
are constant irrespective of income (autonomous) and there is no net exports. The
slope of the C + Ip + G line is determined by the MPC.
Therefore, we can add government expenditure to the consumption and the investment
line as indicated below:
Real Income/Output
2. Australian and Major Trading Partner Govt Policies eg AANZ Free Trade Agreement
3. Terms of Trade
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c) Exchange Rate changes
d) Unforeseen circumstances i.e. drought, war.
In this model we assume investment, government expenditure and exports are constant
irrespective of income (autonomous) and we add exports to the consumption,
investment and govt expenditure line. Export, Govt Expenditure and Investment have
the same slope as the C line. The slope is determined the MPC.
However, imports are assumed to be negative and are affected by income.
Therefore, the AE line falls and the slope of the AE line changes.
The slope of the final AE line is determined by the marginal propensity to spend
( spending/Yd) on domestically produced goods and services as in the
diagrams below.
p+G+X
An alternative
way of drawing
all the
components of
Aggregate Expenditure (not drawn to scale).
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O
+X
13
What happens when there is an autonomous change in AE and how
does it affect the
Macroeconomic Equilibrium?
Macroeconomic Equilibrium – Income/Expenditure Graph (Keynesian Cross)
1. Assuming that the price level is constant, Aggregate Expenditure determines the
level of economic activity/income and output in the economy in the short run
(John Maynard Keynes). This is why the Income Expenditure Diagram is also
called the Keynesian Cross after the economist J. M. Keynes.
If Aggregate Expenditure increases (or any of the components of AE increase) the
equilibrium level of income and output increases (Output or real GDP increases).
If Aggregate Expenditure decreases (or any of the components of AE decrease) the
equilibrium level of income and output decreases (Output or real GDP decreases).
3. The aggregate expenditure model is also used to explain the turning points in the
business cycle.
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How many Keynesian economists does it take to change a light bulb? All of them,
because then you will generate employment, more consumption, increasing
expenditure and income, generating more employment and consumption.....................
In this section we discuss the multiplier; a concept developed by John Maynard Keynes that
highlighted the importance of spending in generating an increase in income/output in an
economy. This is a really interesting concept that is of considerable significance when
discussing the effects of projects such as the Gorgon Gas Development, economic stimulus
policies or infrastructure spending. Basically, it is the theory that a change in spending
(that is not due to a change in income) will have ultimately a bigger effect on the
equilibrium level of income and real GDP. For example, due to an increase in consumer
confidence, Robert Pattison spends $100 in a vampire shop. The vampire shop owner,
Kristen Stewart saves 20% ($20) and then spends $80 in Lady Gaga’s clothes shop (male or
female?). Lady Gaga saves 20% ($16) and then spends $74 in Pink’s music shop. Pink saves
$14.80 and then spends $59.20 in.......... and so it goes. Therefore, Robert Pattison’s
spending has led to multiple spending and increase in the equilibrium level of income.
Questions
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6. According to the Income Expenditure Diagram how does a rise in income affect the
average propensity to consume (APS)? (Define APS)
7. Define the multiplier and write the simple multiplier formula?
8. According to the simple multiplier, if the MPS = 0.2 then the multiplier = ___ if the
MPS is 0.2 then a $1 increase in autonomous investment will lead to a $ __________
change (increase or decrease? Circle) in Ye and a $1 decrease in autonomous
investment will lead to a $ __________ change (increase or decrease? Circle) in Ye.
9. According to the simple multiplier then if the MPC = 0.5 then the multiplier = ___ and
a $1 decrease in autonomous investment will lead to a $ __________ change (increase
or decrease) in Ye and a $1 increase in autonomous investment will lead to a $
__________ change (increase or decrease)
10. What determines the size of the simple multiplier?
11. Using the Income Expenditure diagram explain the multiplier effect of an increase
in business confidence assuming a 3 sector economy?
12. Define the complex multiplier – using the complex muliplier explain the effect of a
decrease in exports on the equilibrium level of income assuming no price level
changes and C, I and G are constant) the MPS =.1 and MPT = .1 and MPM=.1
13. Draw and label the business cycle diagram?
14. List the characteristics of each stage of the business cycle.
15. Explain the turning points in the business cycle using an income expenditure
diagram?
16. Complete the following Multiple Choice.
Multiple Choice
1. The value of the multiplier will be higher, the higher the
2. According to the ‘paradox of thrift’ society’s attempts to save more may result in
3. An investment is the
(a) consumption
(b) private investment
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(c) government expenditure on goods and services
(d) government expenditure on transfer payments
5. In an economy with no taxes, fixed prices and where consumers spend three quarters of their
income, investment rises by $40m. The equilibrium level of income will tend to increase by
(a) $30m
(b) $40m
(c) $120m
(d) $160 m
Consider the following data for a simple economy which has no government or overseas sector.
( Hint work out MPC and MPS)
Possible Levels of National Consumption Spending $b
Output and Income $b
320 320
330 327
340 334
350 341
360 348
370 355
6. The value of the multiplier is closest to
(a) 1.43
(b) 3
(c) 3.33
(d) 7
(a) 0.3
(b) 0.5
(c) 0.7
(d) not possible to calculate because income (Y) is not known
9. Assuming a 3 sector economy (no changes to price levels and the economy is operating at less
than full capacity) where Ye = C ($100m + 0.8Y) plus Ip ($50m) then the equilibrium level of
income is equal to
(a) $7,500
(b) $150
(c) $15,000
(d) $750
10. Assuming a 3 sector economy (no changes to price levels and the economy is operating at less
than full capacity) where Ye =C ($100m + 0.5Y) plus Ip ($50m) then a rise in autonomous
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investment of $10m is going to lead to a change in the equilibrium level of income of
(a) $10m
(b) $5m
(c) $20m
(d) $50m
AE 45 degree
C + Ip
A
$500m
Real Y (O)
11. If the economy is operating at A and real GDP is $500m, then we can expect
Information
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Marginal Propensity to Consume
(MPC) change in C/ change in Yd
(disposable), MPC measures the 45 Degree line where
slope of consumption line and is planned C = real Yd/O
calculated by the change in C or planned real
expenditures equal real
$24,000 divided by the change in Yd
GDP
$30,000 (blue dotted line) in Figure
1.
What is the consumption
function?
Consumption Function = planned
MPC = Rise/Run
consumption at each level of = $24,000/$30,000
disposable income. = .8
Figure 1 Consumption Function
Formula = a + b.Y or
$6,000 X .8Y
a = $6000 autonomous consumption
which is independent of the level of
income.
b = MPC slope of the C line.
b.Y = MPC (.8) x Y (Induced
Consumption determined by
income)
SAVINGS AND THE SAVINGS Dissaving - Negative saving; a situation in which
spending exceeds income (HH borrow or sell assets).
FUNCTION
What is the Marginal Propensity
to Save?
Marginal Propensity to Save (MPS)
change in S/change in Yd
MPS measures the slope of the
savings line.
From Figure 1 the MPS
=$6000/$30,000 = .2
What is the Savings Function?
Savings Function = planned savings
at each level of disposable income
S= -a + MPS.Y or –a + (1-b)Y –the equation that describes the Savings line. From Figure 1 the
Savings function = -$6000 + .2Y.
Dissaving - Negative saving; a situation in which spending exceeds income (HH borrow or sell
assets).
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able
You can convert the information
from the graphs on the left to the
Table 1 below.
The table shows the figures for MPC,
MPS, APC and APS.
What is the Average Propensity to
Save (APS) and the Average
Propensity to Consume (APC)?
APS = The average propensity to
savings is savings divided by
disposable income (S/Yd)
APC = The average propensity to
consume. It is consumption divided
by disposable income (C/Yd).
Points to Note
MPC stays at .8 irrespective of
income.
MPS stays at .2 irrespective of
income.
APC falls as income rises (from
1.8 to .9).
APS rises as income rises (from -
.8 to .1).
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Algebraically Calculating the Equilibrium Level of Income Using the
Consumption Function
Assuming no investment, no Govt and Overseas sector and Y = C + S (all income is spent or
saved).
How could you calculate Equilibrium level of GDP/Ye if you were only given the values for
autonomous C ($6000) and the MPC (.8) and no diagram?
At Equilibrium level of Income (Ye) = C
Ye= a+b.Y
Ye = $6000+.8Y
At Y =Ye
Ye – 0.8Ye = $6000
Ye (1-0.8) = $6000
0.2Ye = $6000
Ye= $6000/.2 Therefore Ye = $30,000
C1 = MPC -.8
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The Business cycle is mainly explained by changes in Investment. To explain the
effects of a change in autonomous investment we must first understand the theory
of the multiplier.
The multiplier equation gives govt, businesses and economists a figure that tells us how much a
change in autonomous expenditure will affect the equilibrium level of income and in economy.
“One person’s spending is another person’s income” or an autonomous change in any
component of AE (C + Ip + G + X – M) will lead to a greater change in income Ye or Output.
Example 1
Assumptions:
1. Price level does not change.
2. The economy is not working at full capacity.
3. No govt or overseas sector. (3 sector economy)
The Ye = k(multiplier) x Ia therefore the Ye= 10 (k) X $10m =$100m
Ye - $100m so a $10 million change in autonomous investment leads to a $100m change in the
equilibrium level of income/output ($10m/$100m).A $1 change in autonomous investment
leads to $10 change in Ye!!
Why? Money spent becomes another person’s income which will be respent and respent and
respent…
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How the Multiplier Works When Spending is Investment
Figure 4 Flow of Income (Y) and Spending (Exp)
Example 2
Consider a $300 million increase in business 1. Autonomous Increase in Expenditure (Ip) due to a decrease in
interest rates)
investment due to fall in interest rates. This will
set off a chain reaction of increases in spending
and expenditures. Capital equipment will be
purchased and those who produce the capital 3. Leads to an induced 2. Leads to an increase Y
goods necessary for the investment will change in Exp
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Example 3 Using an Income/Expenditure Diagram
An Increase in Autonomous Investment ,the Multiplier and the effect on National
Income and Output (Ye)
Assume MPS = .5 therefore the MPC =0.5
K = 1/ 1- MPC or 1/.5 = 2
Assume Ia increases by $40m therefore Ye will increase by k (2) x change in Ia
($40m) = $80m. The new Ye will be increased by $80m.
45 degree
Exp C+ I+ change in Ia (rise in$40m) Assume 3 sector economy,
(C+I) C+I
C =$200 +.5Y and
$40m Ip was $40m but increased by
$40m. Ip is now $80m.
Can we algebraically calculate the
Ye Ye* (increase by $80m) new Ye? Yes.
Ye= C + Ip
Real Yd,O Ye =a +b.Y + Ip (Including the in Ip)
Ye = $200m +.5Y + ($40 m + the
increase in Ip if $40m)$80m
So an increase in Ia of $40m leads to a larger At Y =Ye
increase in Ye (increases by $200m) Ye – 0.5Ye = $280m
Ye (1-0.5) = $280m
0.5Ye = $280m
Ye = $280/0.5 Therefore the new Ye1
= $560m
Can the Multiplier work in reverse if autonomous investment falls? Yes.
The Effect of a Decrease in Autonomous Investment on
Ye=the Equilibrium
$6000/.2 level
Therefore of$30,000
Ye =
Income (Ye) Output Using the Simple Multiplier
Using different figures, a decrease in Autonomous Investment (due to a fall in business
expectations), will lead to a multiplier and the effect on National Income (Ye)
Assume MPS = .1 therefore the MPC =0.9
K = 1/1-MPC or 1/MPS or 1/.1 = 10
Assume Ia decreases by $40m therefore Ye will decrease by k (10) x change in Ia
($40m) = $400m. The new Ye will decrease by $400m.
45 degree
C+ I
Exp C+ I+ change in Ia (Fall in Ia of $40m)
(C+I) C
So a decrease in Ia of $40m
leads to a larger decrease in
Ye/O (Ye decreases by
$400m).
$180m
$140m
$120m
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Can We Algebraically Calculate the New Ye?
Assume 3 sector economy, C =$120 +.9Y and Ip was $60m but decreased by $40m now
Ip = $20m
Ye= C + Ip
Ye =a +b.Y + Ip
Ye = $120m +.9Y + ($60 m subtract the decrease in Ip if $40m)$20m
At Y =Ye
Ye – 0.9Ye = $140
Ye (1-0.9) = $140
0.1Ye = $140
Ye = $140/0.1. Therefore the new Ye = $1,400. The previous equilibrium level of income
was $1,800. As the multiplier is 10 a $40m fall in Ip would lead to a $400m fall in
income.
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The Multiplier Effect of Other Components of AE – Govt Expenditure
and Exports
If the MPC = 0.8 and the MPS = 0.2 then the Multiplier = 1/0.2 ( 1 /MPS) so an increase
Govt exp of $5 million will lead to an increase in Ye of $25m. The multiplier can also
work in reverse if Govt expenditure falls assuming other factors remain constant.
45 degree
Aggregate.
Exp C + Ip C + Ip + G +
+G increase in G C + Ip + G
C + Ip
C
Consumption
expenditure
Increase in G $5m
Increase in Ye $25m
Real Income/Output
Changes to Exports.
If we assume exports are autonomous (0 imports) and the slope of the C+ Ip + G + X line
is determined by the MPC then a decrease in X of $2b will lead to a multiplier effect on
income assuming other factors remain constant.
If the MPC = 0.8 and the MPS = 0.2 then the Multiplier (k) = 1/0.2 (1 /MPS) =5. So a
decrease in Exports of $2 million will lead to an decrease in Ye of $10m ( 5 X 2). The
multiplier can also work in reverse if X’s rise, assuming other factors remain constant.
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What if the slope of the AE (C+ Ip + G +X – M) changes? (5 sector
model including all the components of AE)
The Effect of a Change in the Slope of the AE line on the Equilibrium Level of
Income (Ye) Output and The Paradox Of Thrift
As you can see in the diagram below the slope of the AE line affects (relationship between
planned spending and income) the equilibrium level of income/GDP.
Diagram 1
AE 45 degree Diagram 1 (Assume other factors remain constant
AE and an increase in the MPS or a fall in the MPC)
When the AE slope is less steep (AE to AE1), the
equilibrium level of income (red dot) is
significantly lower (red lines).
AE1
If we spend a smaller proportion of our income,
the level of income and output in the economy
falls!!!!
Complex Multiplier
The size of the Complex Multiplier is determined by size of the Marginal Propensity
of the leakages (MPS, MPT and MPM) or the Marginal Propensity to Spend whereas
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the size of the Simple Multiplier is determined by the MPS or the Marginal
Propensity to Consume.
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Business/Trade Cycle
Time
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The Stages, Characteristics and the Role of Changes in AE and the Multiplier
Effect in Explaining the Business Cycle.
Real Y/O
Upswing Firms need to replace worn out capital, lower Diagram 2:
(Increased levels interest rates Increased I and C multiplier
of Aggregate effect on income increase in output (GDP) and A. Exp
45 degree
Exp/ Demand) employment. Note increase in income will lead to
1992 an improvement in business and consumer AE1
1998 confidence also leading to an increase C and I and AE
2010 -12 a multiplier effect on income.
Real Y/O
Real Y/O
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Questions:
Investment
Draw C+Ip
Government Expenditure
Draw C+Ip+G
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2. Define and give an examples of Macroeconomics and Microeconomics?
3. Define and explain the difference between GDP and Real GDP and identify the better
measure of Economic Growth?
4. Define total income, total output and total expenditure.
5. According to Keynes the main determinant of economic activity/output is...............
...................?
6. Using a circular flow diagram explain what is meant by macroeconomic
equilibrium?
7. What does the 45 degree line illustrate in an Income Expenditure/Keynesian Cross
diagram?
8. Explain the equation C = a + b.Y?
9. Define and give the formula for Marginal Propensity to Consume?
10. Explain the terms autonomous and induced?
11. Draw an income expenditure diagram and illustrate autonomous consumption,
induced consumption, equilibrium level of income, savings and dissavings?
12. Define dis-savings?
13. Using an income expenditure diagram, illustrate how a fall in the MPC from .9 to .6
will affect the consumption line and the macroeconomic equilibrium (equilibrium
level of income)?
14. Using Income Expenditure diagram show how a increase in consumer expectations
may affect consumption and the equilibrium level of income. (Assume all income is
spent or saved, AE = C)?
15. In the 3 sector Income Expenditure diagram (AE = C+Ip) is investment assumed to
be autonomous and/ or induced. How can you tell this from the model?
16. Using a 3 Sector Income Expenditure diagram explain how a fall in business
confidence will affect the equilibrium level of income?
17. When imports are added to AE why does the slope of the AE line change?
18. What is unplanned investment and is it included in planned aggregate expenditure?
19. Draw an income expenditure diagram using the full aggregate expenditure model
and indicate on the diagram macroeconomic equilibrium?
20. What determines the slope of the AE curve for domestically produced goods and
how would you measure it?
21. Using the diagram on page 17 of this information, explain why points a and b are
unsustainable? In your explanation refer to inventories (unsold stock).
22. Identify the factors that are currently affecting consumption and draw a full income
expenditure (AE= C + Ip + G + X – M) diagram to illustrate a fall in consumer
confidence on the equilibrium level of income, assuming other factors remain
equal?
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