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LECTURE 2LECTURE 2

Keynesian Income Keynesian Income DeterminationDetermination

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Aggregate ExpenditureAggregate Expenditure

Defined as the total amount that firms Defined as the total amount that firms and households and households plan to spend on goods plan to spend on goods and servicesand services at each level of income. at each level of income.

It can also be seen that the aggregate It can also be seen that the aggregate expenditure is the sum of expenditures expenditure is the sum of expenditures on consumption, investment, on consumption, investment, government expenses and net exports.government expenses and net exports.

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Consumption Consumption Government Government

SpendingSpending

GDP = C + I + G + NXGDP = C + I + G + NX

Investment Net Investment Net ExportsExports

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Income, Savings and their Income, Savings and their DeterminantsDeterminants

A household can do 2 things with A household can do 2 things with income:income:

(a) consume – buy goods and services.(a) consume – buy goods and services.

(b) save.(b) save. Saving is the part of its income that a Saving is the part of its income that a

household does not consume in a given household does not consume in a given period.period.

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ConsumptionConsumption

The consumption The consumption function shows the function shows the relationship between relationship between total consumer total consumer expenditures and total expenditures and total disposable income in the disposable income in the economy, holding all economy, holding all other determinants of other determinants of consumer spending consumer spending constant.constant.

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Marginal Propensities and Marginal Propensities and the Multiplierthe Multiplier

The slope of the consumption function is The slope of the consumption function is known as the known as the marginal propensity to marginal propensity to consume (MPC)consume (MPC)..

The MPC tells us how much more consumers The MPC tells us how much more consumers will spend if disposable income rises by RM1.will spend if disposable income rises by RM1.

MPC = MPC = Change in Disposable IncomeChange in Disposable Income

Change in ConsumptionChange in Consumption

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Consumption FunctionConsumption Function

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ExampleExample

Calculate the MPC for the graph Calculate the MPC for the graph below. What does the value imply?below. What does the value imply?

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Factors that Shift the Factors that Shift the Consumption FunctionConsumption Function

Any change in disposable income Any change in disposable income will cause a will cause a movement alongmovement along the the same consumption function, where same consumption function, where else a change in other determinants else a change in other determinants will will shiftshift the consumption function. the consumption function.

Wealth Wealth Price levelPrice level Real interest rateReal interest rate Future income expectationFuture income expectation

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WealthWealth

A source of purchasing power in A source of purchasing power in addition to income.addition to income.

Eg. A wealthy retiree with a huge bank Eg. A wealthy retiree with a huge bank balance may earn little current income balance may earn little current income when interest rates are low. But a high-when interest rates are low. But a high-flying investment banker who spends flying investment banker who spends every penny of high income she earns every penny of high income she earns will not accumulate much wealth.will not accumulate much wealth.

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PricePrice LevelLevel

People hold a great deal of wealth in forms that People hold a great deal of wealth in forms that are fixed in money terms. Bank accounts are the are fixed in money terms. Bank accounts are the most obvious example, but government and most obvious example, but government and corporate bonds also have fixed values in money corporate bonds also have fixed values in money terms.terms.

The purchasing power of such money-fixed assets The purchasing power of such money-fixed assets obviously declines whenever the price level rises, obviously declines whenever the price level rises, which means that the asset can buy less.which means that the asset can buy less.

Eg. If the price level rises by 10%, a RM1,000 Eg. If the price level rises by 10%, a RM1,000 government bond will buy 10% less than it could government bond will buy 10% less than it could when prices were lower. when prices were lower.

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Real Interest RateReal Interest Rate A higher real rate of interest raises A higher real rate of interest raises

the rewards for saving and vice the rewards for saving and vice versa.versa.

Future Income ExpectationFuture Income Expectation When consumers expect income to When consumers expect income to

increase in the future, current increase in the future, current consumption will also increase and consumption will also increase and vice versa.vice versa.

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Equilibrium GDP Equilibrium GDP DeterminationDetermination

Equilibrium GDP is that output level Equilibrium GDP is that output level at which the total amount of goods at which the total amount of goods and services produced, GDP, is just and services produced, GDP, is just equal to the total amount of goods equal to the total amount of goods purchased. purchased.

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Expenditure ScheduleExpenditure Schedule

Real Expenditure (RM billions)Real Expenditure (RM billions) C + I + GC + I + G

6,1006,100 6,000 6,000

4,8004,800

3,9003,900

0 6,000 Real GDP (RM billions)0 6,000 Real GDP (RM billions)

C + I + G + NX

C + I

C

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The 45The 45o o line shows all the points at which output line shows all the points at which output and spending are equal.and spending are equal.

Real Expenditure (RM billions)

45o

C + I + G + NX

Equilibrium

Spending exceeds output

0 6,000 Real GDP (RM billions)

6,000 E Output exceeds spending

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The MultiplierThe Multiplier

The multiplier is the ratio of the The multiplier is the ratio of the change in equilibrium GDP divided by change in equilibrium GDP divided by the original change in spending that the original change in spending that causes the change in GDP.causes the change in GDP.

Multiplier = Multiplier = Change in GDPChange in GDP

Change in Change in SpendingSpending

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The remarkable thing about the The remarkable thing about the multiplier is that it shows that a multiplier is that it shows that a change in spending will bring about change in spending will bring about an an even larger changeeven larger change in equilibrium in equilibrium GDP on the demand side.GDP on the demand side.

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Eg. The expenditure Eg. The expenditure schedule (values are in RM schedule (values are in RM

billion)billion)GDPGDP ConsumptConsumpt

ionionInvestmeInvestme

ntntGovernmeGovernme

ntnt

SpendingSpending

Net Net ExportsExports

Total Total ExpendituExpenditu

rere

4,8004,800 3,0003,000 900900 1,3001,300 -100-100 5,1005,100

5,2005,200 3,3003,300 900900 1,3001,300 -100-100 5,4005,400

5,6005,600 3,6003,600 900900 1,3001,300 -100-100 5,7005,700

6,0006,000 3,9003,900 900900 1,3001,300 -100-100 6,0006,000

6,4006,400 4,2004,200 900900 1,3001,300 -100-100 6,3006,300

6,8006,800 4,5004,500 900900 1,3001,300 -100-100 6,6006,600

7,2007,200 4,8004,800 900900 1,3001,300 -100-100 6,9006,900

2020

Total expenditure after a Total expenditure after a RM200 billion increase in RM200 billion increase in

investment spendinginvestment spendingGDPGDP ConsumptConsumpt

ionionInvestmeInvestme

ntntGovernmeGovernme

nt nt

SpendingSpending

Net Net ExportsExports

Total Total ExpendituExpenditu

rere

4,8004,800 3,0003,000 1,1001,100 1,3001,300 -100-100 5,3005,300

5,2005,200 3,3003,300 1,1001,100 1,3001,300 -100-100 5,6005,600

5,6005,600 3,6003,600 1,1001,100 1,3001,300 -100-100 5,9005,900

6,0006,000 3,9003,900 1,1001,100 1,3001,300 -100-100 6,2006,200

6,4006,400 4,2004,200 1,1001,100 1,3001,300 -100-100 6,5006,500

6,8006,800 4,5004,500 1,1001,100 1,3001,300 -100-100 6,8006,800

7,2007,200 4,8004,800 1,1001,100 1,3001,300 -100-100 7,1007,100

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Referring the tables above, assume Referring the tables above, assume that firms now want to invest RM200 that firms now want to invest RM200 billion more than previously – for a billion more than previously – for a total of RM1,100 billion. total of RM1,100 billion.

The multiplier principle says that The multiplier principle says that GDP will rise by more than the GDP will rise by more than the RM200 billion increase in investment.RM200 billion increase in investment.

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Multiplier = Multiplier = Change in GDPChange in GDP Change in Spending (I)Change in Spending (I) = = RM800 billionRM800 billion RM200 billionRM200 billion = = 44

Implication: Each additional RM1 of investment Implication: Each additional RM1 of investment demand will add RM4 to equilibrium GDP.demand will add RM4 to equilibrium GDP.

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Illustration of the Illustration of the MultiplierMultiplier

Real Expenditure (RM billions) 45o

C + I + G + NX

C + I + G + NX

RM 200 billion

0 6,000 Real GDP (RM billions)6,800