Macroeconomics II Chapter one .pptx

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1. MACROECONOMICS II CHAPTER ONE EQUILIBRIUM INCOME DETERMINATION Prepared by : Dagim F. Department of economics, mizan-tepi university

2. 1.1.Components of income In order to know more about the components of income, let us understand first the meaning of aggregate demand . In very simple terms, aggregate demand (AD) is the total amount of goods demanded in an economy . The economy, however, can be taken as the combination of several sectors. These sectors can be household sector, business sector, government sector and foreign sector . All of these sectors demand goods and services from the economy. The aggregate demand, therefore, for all of them is known as aggregate demand. 11/18/2022 [email protected] 2

3. Cont… As it is defined above, aggregate demand of an open economy (the realistic one) It is composed of private consumption spending (C), business firm spending (I), Government spending (G) and foreign spending (NX). Therefore , each component determines the aggregate demand. It is the determinants of these aggregates that form the basis for aggregate demand analysis. 11/18/2022 [email protected] 3

4. Cont… i. Consumption Spending: Consumption is the first component of AD, and it share the maximum of AD. Consumption spending or consumption expenditure refers to the total amount of income used for or spent on either durable or non-durable consumption goods such as food, shelter (rent), clothes and cars or transportation. For Keynes, there is positive relationship between consumption spending and disposable income, and hence if their real income increases more than increase in consumption. However , how much to spend on goods and services and save depends on their income after tax (disposable income); i.e., on real personal disposable income (Y-T). 11/18/2022 [email protected] 4

5. Cont… As a result, consumption is a function of income and expressed as: C = a + b (Y-T), Where ; b is MPC and 0<b<1 a>0; and’ a’ is autonomous consumption. Tax revenue (T) is assumed to be simple positive function of income, as income increase, tax revenue also increase. Thus tax function can be specified. T= T=t(y ) Where - represents marginal propensity to tax and - autonomous tax. Autonomous tax is the tax income that is independent of income. It is negative tax revenue such as paid to households as a social benefit. 11/18/2022 [email protected] 5

6. Cont… ii. Investment spending (I): Private investment spending is the second element of aggregate demand. It is the amount of spending made by firms on capital goods to add to their stock of capital and to replace existing capital as it wears out. In other words, investment is the demand for capital goods that are used to produce other goods and services. Investment is a function of interest rate and inversely related. 11/18/2022 [email protected] 6

7. Cont… Interest rate measures the cost of borrowed funds used to finance investment funds. Thus if interest rate increases, cost of investment increase so that the investment becomes less profitable and these would cause decline in the quantity of investment demand. Thus , we can expressed investment function in general as I=I(r). This can be represented by the equation: Where; I = investment demand spending; Io = Autonomous investment which is independent of interest rate and r= Real interest rate. 11/18/2022 [email protected] 7

8. Cont… iii. Government spending (G): Government spending (G) represents public sector’s demand for goods and services. It is the spending made by both federal and local government for their employee, on infrastructure, transfer payments and other public spending. Government spending is assumed to be determined by the government independently of the state of macro economy. It is exogenous and denoted by 11/18/2022 [email protected] 8

9. Cont… iv. Foreign spending –Net export (NX): Net export (NX) is the final component of aggregate demand, which represent demand for domestic goods and services by the rest of the world. The home country will sell goods to foreign residents that are called export, denoted by X. While some of domestic income will be spent on foreign products. These goods are called imports, denoted by M. Net export therefore the difference between the demand for domestic products by the rest of the world and demand for foreign product by domestic consumer (NX=X-M). 11/18/2022 [email protected] 9

10. Factors that affect export and import. Demand for domestic goods by foreign residents will depend on two factors; the level of foreign consumer’s income and the price competitiveness of domestic goods in foreign market. Other things held constant, the higher the level of foreign income the greater will be the demand for domestic goods. Thus there would be a positive relation between export and foreign real income (Y*). Price competitiveness of domestic product in foreign market can be measured by real exchange rate, “e” that is defined as: e = Ep/p E -nominal exchange rate p */p- the ratio of foreign price to domestic output price 11/18/2022 [email protected] 10

11. Cont… A rise in “e” means domestic goods are relatively cheaper compared with locally produced goods, demand for domestic export increases. Similarly , a rise in domestic output prices will make domestic goods more expensive in foreign markets. Other things held constant, increase in domestic goods price reduce export demands. Hence , there is a positive relationship between X and e and negative relationship between export demand and domestic price. This relationship between export demand and real exchange rate as well as foreign income (Y*) level could be represented by the following export function . 11/18/2022 [email protected] 11

12. Cont… On the other hand, domestic demand for foreign goods and services (M) depends on the price of foreign goods relative to domestic goods as well as the domestic income (Y). Import (demand for foreign goods and services), are usually assume to be depend positively up on domestic income. Nevertheless, it inversely related to real exchange rate (domestic price of foreign currency ). This is because a rise in real exchange rate makes import more expensive in terms of domestic currency in relation to domestically produced local substitutes. Thus, the import function can be expressed as 11/18/2022 [email protected] 12

13. Cont… Where; mo an autonomous import which represents import that is independent of domestic income and real exchange rate. This implies net export is a function of foreign income, domestic income and real exchange rate. Combining these behavioral relations of consumption, investment, exports and imports together gives aggregate demand function as: 11/18/2022 [email protected] 13

14. 1.2 . Determining equilibrium income By now we are familiar with the different component of aggregate demand and factors which determine each component of aggregate demand. At this time, however, we will see how equilibrium level of output and price of an economy determine by putting together aggregate demand. The analysis of determining equilibrium income can be seen differently in closed economy and open economy separately . The analysis of equilibrium income determination under closed economy begins from Keynesian cross model which refers to output determination in goods market with the assumption of exogenous investment demand. However , as it elaborate in-depth in Macroeconomic-I, here only some points will be presented as re-polishing. 11/18/2022 [email protected] 14

15. 1.2.1.Equilibrium income determination in Closed economy In closed economy , based on Keynesian cross model, the economy is in equilibrium when actual aggregate demand equals planned aggregate demand. Actual expenditure is the amount households, firms and government spend on goods and services. It is equal to GDP of an economy (Y). On the other hand, planned expenditure is the amount households, firms and government would like to spend on goods and services . This implies planned expenditure is the same as aggregate demand of closed economy : 11/18/2022 [email protected] 15

16. Cont… To simplify the analysis let us assume planned investment is exogenous and tax is also assumed to be fixed Thus Planned expenditure is a positive function of income for a certain level of planned investment, Government expenditure and tax. This can be represented by upward sloping curve with MPC (marginal propensity to consume) slope and intercept autonomous spending, where as actual expenditure is represented by a 45 degree line from the origin. Putting together planned expenditure and actual expenditure curve we construct a Keynesian cross model as shown below in figure 2.1. 11/18/2022 [email protected] 16

17. Cont… Figure 2.1. The Keynesian cross model 11/18/2022 [email protected] 17

18. Cont… In Keynesian cross model, the economy reach equilibrium when actual expenditure equals planned expenditure (Y=AD). It is a point when the idea of economic agents realizes. That is where quantity demand equal to quantity of output produced. Any deviation from this equilibrium level causes change in unplanned inventory investment or disinvestment (IU ). It is represents the difference between planned expenditure and actual expenditure. This value acts as signal for firms to induce production or decreases production of goods and services accordingly. 11/18/2022 [email protected] 18

19. Cont… IU = Y – AD =0 at equilibrium and IU ≠ when the economy is not at equilibrium. If output produced (actual expenditure) is greater than aggregate demand (planned expenditure), firms are selling less than their production. Under such condition firms add the unsold goods to their stock of inventories resulting in increase in inventory investment. This increase in inventories act as signal for firms to cut production of output until planned expenditure is equal to actual expenditure . Similarly , if the output is less than equilibrium level, planned expenditure is greater than actual expenditure. 11/18/2022 [email protected] 19

20. Cont… Similarly, if the output is less than equilibrium level, planned expenditure is greater than actual expenditure. This means the output produced is below aggregate demand. Therefore to meet the high demand in the economy firms run down their stock of inventory (unplanned inventories disinvestment) takes place. The running down of inventory investment gives signal for firms to put more resources under production to increase output production up to point of equilibrium. Hence through adjustment of inventories, the equilibrium level of Keynesian cross model is maintained when the economy is not in equilibrium. Therefore , it is the domestic spending (AD) of the economy that determines the equilibrium output/income level. 11/18/2022 [email protected] 20

21. 1.2.2 . Equilibrium income determination in open economy By now, we are familiar with how equilibrium of national income is determined in closed economy. It is domestic spending (aggregate demand) of the economy, which determines the equilibrium output/income level. In this section equilibrium, income determination will be considered under open economy setup. As we have seen in the preceding section, the demand for domestic output may not be the same as output produced in the economy. There is reduction and addition to domestic demand through export and import. This will cause difference in the analysis of equilibrium output/income determination between closed and open economy. 11/18/2022 [email protected] 21

22. Cont… For open economy, the equilibrium level of national income is determined when internal balance is equals to external balance. Let us begin with open economy national income accounting identity to identify equilibrium condition for open economy. Y = C + I + G + X – M or (NX) Where; C-consumption spending, I-investment spending, G-government spending, X is foreign spending on domestic goods and M-domestic consumer spending on foreign goods. 11/18/2022 [email protected] 22

23. Cont… consumption spending is partially autonomous (Ca) and partly determined by the level of national income. Also import demand is partly autonomous and partly an increasing function of income. Assuming that both import and consumption functions are linear, that is : 11/18/2022 [email protected] 23

24. Cont… Where; Ca and Ma are autonomous consumption and autonomous import respectively, m is the marginal propensity to import. It measures the proportion of additional national income spent on import. For instance if m = 0.1 it means if the national income of the country increases by a certain unit, 10 percent of it will be spend on import. As in the case of Keynesian cross model I and G are assumed to be exogenous. Also export is assumed to be exogenous (it is independent of the national income of a country as it is import for other countries). 11/18/2022 [email protected] 24

25. Cont… Now let us incorporate the above stated assumption in to the national income accounting to identify the relationship between income and internal balance; income and external balance. Where ; AD is domestic aggregate demand which is equal to and is net export or external balance. 11/18/2022 [email protected] 25

26. Cont… The rearranged national income accounting identity show that the economy reaches equilibrium when domestic balance (Y-AD(Y)) is equals to external balance (NX). To identify graphically the equilibrium level of national income, first let us determine whether the curves representing internal and external balance are upward sloping or downward sloping. When we see internal balance, it contains two components: the autonomous part which represents its intercept and the part which depend on income as it is indicated below 11/18/2022 [email protected] 26

27. Cont… To find the slope of internal balance, take the first derivative of internal balances with respect to income . Since b represents marginal propensity to consume, 1-b is marginal propensity to save . It is the proportion of additional income that consumers save from their additional income. So 1-b is positive which implies internal balance curve is upward sloping curve with vertical intercept equals to the sum of autonomous spending. 11/18/2022 [email protected] 27

28. Cont… On the other hand the slope of external balance is equals to m as indicated below. But m is the proportion of additional income that spent on import (marginal propensity to import ). As we have seen it is negative because an increase in national income increases the demand for import and makes net export negative. As a result net export (external balance) curve has negative slope which can be indicated by downward sloping curve. 11/18/2022 [email protected] 28

29. Cont… Since , m > 0, -m < 0 Once we determine the slope of the curves, let us put together both in the same quadrant to identify the equilibrium point of open economy. That is, the intersection point of internal and external balance curve (where internal balance is equal to external balance) that gives the equilibrium level of income as indicated in figure 2.2 by . This point represents open economy equilibrium point, which is achieved through the interaction of both internal and external sector 11/18/2022 [email protected] 29

30. Cont… Figure 2.2: Equilibrium of open economy 11/18/2022 [email protected] 30

31. Cont… The concept of internal and external balance also helps to illustrate inflow and outflow of capital to finance capital accumulation (investment) in addition to flow of goods and services. For this purpose, once again consider the open economy national income accounting identity . Y = C + I + G + NX Y – ( C + G ) = I + NX 11/18/2022 [email protected] 31

32. Cont… Add and subtract tax (T) to the left hand side of the above equation and rearrange as follow : Saving of the economy(S ) S = I + NX S – I = NX S – I = X – M S-I indicates international flow of capital while X-M represents the flow of goods and services. 11/18/2022 [email protected] 32

33. Cont… According to the equation (S-I) = (X-M), if saving exceeds investment, the excess is used to make loan abroad or owner of the fund invest in some other country, that is there is outflow of capital . If saving is less than investment, there is excess demand for fund that it is not available in the domestic economy in the form of saving. This excess can be financed through borrowing from other external source, which results in inflow of capital. 11/18/2022 [email protected] 33

34. Cont… 11/18/2022 [email protected] 34

35. 1.3.The expenditure multiplier The Keynesian cross, in closed economy, shows how an income Y is determined for any given levels of planned investment (I), and fiscal policy variables (G and T ). Hence, one can easily use this model to show how income changes when one of these exogenous variables changes; for instance, as part of government macroeconomic policy instrument. In fact any change in government fiscal policy (government purchase and government tax revenue) has a multiplied effect on real factors such as output. 11/18/2022 [email protected] 35

36. Cont… The factor which shows the relationship between the changes in the instrument and the effect are known as multipliers. Thus , the corresponding multipliers are known as government purchase multiplier and tax multiplier . Here, we will see only the effect of government expenditure on income (government purchase multiplier) in closed and open economy. 11/18/2022 [email protected] 36

37. Cont… In any economy, for a given level of income, high government purchase implies higher planned aggregate demand . The ratio of ∆Y/∆G, in either of the economy, is called the government purchase multiplier; and it tells us the factor by which income rises in response to a unit increase in government purchase. By using the national income identity or the aggregate demand model, we can derive the closed economy multiplier as follow: Y = a + b (Y – T ) + I + G 11/18/2022 [email protected] 37

38. Cont… Assuming other autonomous variable remains constant (i.e., T and I), and by taking total differentiation of the above identity, we would get 11/18/2022 [email protected] 38

39. Cont… The government expenditure multiplier (1/s) proves that a change in ‘G” will lead a greater change in ‘Y’. Which means, if government purchase increase by ∆G it leads to an even greater increase in income (∆Y >∆G) (It is also possible to show using Keynesian cross model, in closed economy). Like in the case of closed economy, government affects the national income by changing its expenditure and its taxation. Since import depend on income, the government can also use fiscal policy (G and T) to affect trade balance. 11/18/2022 [email protected] 39

40. Cont… Now by assuming other autonomous variable remain constant, government expenditure multiplier of open economy can be derived using the expression from equilibrium income in differential form . dY = 11/18/2022 [email protected] 40

41. Cont… Since marginal propensity to save and import is positive the government expenditure multiplier is also positive. This implies an increase in government expenditure has expansionary effect on equilibrium level of income. The magnitude of the effect depends on the magnitude of marginal propensity to save and marginal propensity to import. If we compare it with closed economy government expenditure multiplier, open economy multiplier is less than closed economy multiplier since there is additional positive term (m) in the denominator. 11/18/2022 [email protected] 41

42. Cont… Impliedly ; , in open economy, part of any increase in income goes to purchase of an import; that is foreign goods rather than domestic good and generate foreign income rather than domestic income. That means the total amount of spending made by government shared between domestic and foreign goods and services in case of open economy. There is leakage of aggregate demand from the economy to other’s country. 11/18/2022 [email protected] 42

43. Cont… In contrast, all expenditure made by government in closed economy goes to boosting of domestic demand only and initiate domestic production, which results in more expansion of output compared to open economy case . 11/18/2022 [email protected] 43

44. Cont… Exercise Given an economy described by the following functions Find; The equilibrium level output and consumption if tax revenue is equal to 100. Determine the value government purchase and tax multiplier and interpreter your result. Calculate the change in equilibrium output if government purchase (G) increase by 100 units. 11/18/2022 [email protected] 44