UNIT 2: NATIONAL INCOME ACCOUNTING

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Gross National Product: Concept and Measurement
2.3 Approaches to Measuring GNP
2.4 Nominal and Real GNP
2.5 Summary
2.6 Key Words
2.7 Answers to Check Your Progress
2.8 References

2.0 AIMS AND OBJECTIVES

Aims
- This unit covers definition and measurements of the main macroeconomic variable.
- Introduce the major macroeconomic concepts of income raging from GNP to NNP
- Describes how the economists distinguish between two types of GNP concepts, nominal
GNP and real GNP and how GNP can be measured using product, income and
expenditure approach.
Objectives:
In studying this unit, you should be able to:
 state the purposes of national income accounting
 define GNP, and compute it using either the expenditure or the income approach
 adjust the nominal GNP, when you are given the relevant price index, to find the real
GNP
 To present several reasons why GNP is not an index of social welfare.

33
2.1 INTRODUCTION

The subject matter of this unit is national income accounting. This type of accounting measures
or estimates the size of the gross national product, the net national product, the national income,
the personal income and the disposable income of the economy.

This is national income accounting because it involves estimating output or income for the
nation society as a whole, rather than for an individual business firm or family.
The value of a nation’s output equals the total expenditure for this output, and those expenditure
become the income of those in the nation who have produced this output.

There are two equally acceptable methods, for obtaining each of the five income output
measures listed above. These two methods are the expenditures method and the income method.
In addition the unit discusses the purpose of social accounting and the short coming in using
these income – output measures.

National Income accounting: - is the measurement of aggregate economic activity, particularly

national income and its components.
National Income: is a measure of the money value of all final goods and services that are
produced in a country in one year. That means a national accounting system is a systematic
recording of the economic performance of a nation with in a given period of time. The
measurement of aggregate economic activity –national income accounting services how
functions. First, it enables us to identify the basic macro economic problems (inflation
unemployment). The second function of national income accounting system is to provide an
objective basis for evaluating economic policy. If national income accounts allow us to measure
the severity of a problem, they can also be used to determine how effective public policy has
been in solving it.

2.2 GROSS NATIONAL PRODUCT: Concept and measurement

Gross National Products (GNP): The total market value of all final goods and services produced
in a given time period. Each good and services produced and brought to market has a price.
That price serves as a measure of value for calculating the total output. Once we know the price

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of each final good and service, we can readily calculate the value of output produced in a given
time period. The total money value of final out put produced each year is what we refer to as
our Gross-National Product (GNP). The use of prices to value market output allows us to
summarize our out put activity and to compare the output of one period with that of another.
GNP accounting can also provide a basis for compassing one country economic performance
with another’s.
Two of the most important measure of the overall economy’s performance are GDP and GNP.
1. Gross Domestic Product (GDP) is the market monetary value of all final goods and
services produced in one year within the boundary of a given country, whether by
citizens or foreigners.
2. Gross National Product (GNP) is the market monetary value of all final goods and
services produce by resources owned and supplied by country citizens (Ethiopians)
irrespective of where the resources are produced and located (in or out of the country).
In other words, GNP=GDP+NFI (Net factor income)
NFI=(Factor Income received from Abroad)-(factor income paid abroad).
GNP may be greater, equal, or less than GDP.
1. If NFI>0, then GNP>GDP
2. If NFI=0, then GNP=GDP
3. If NFI<0, then GNP<GDP

 Net National Product (NNP): GNP less than depreciation.

 Depreciation: The consumption of capital goods in the production process, the wearing out
of plant and equipment.
National Income (NI): the total income earned by current factors of production.
NI=NNP-Indirect Business Taxes
Personal Income (PI): income received by households before payment of personal taxes. That
means National Income minus corporate taxes, minus retained earnings, minus social security
insurance plus transfer payments, plus net interest, equals personal income.
Disposal Personal Income (DI): Disposal income is the difference between personal income
and personal taxes i.e. PI-PT=DI

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 2.3 APPROACHES TO MEASURING GNP(GDP)

GNP (GDP) can be measured in three different ways:

1. The total product (value added approach)
2. The expenditure approach
3. The income approach
The total Product (Value Added Approach):

GNP is calculated by adding up all value added at each sector of the economy (I.e. agriculture,
industry, service and etc. value added: The increase in the market value or a product that takes
place at each stage of the production process.
National Income Accounting

Product Approach Expenditure approach Income approach

- Agriculture
- Personal expenditure - Wages and salaries
- Manufacturing - Gross private expenditure - Social insurance profits
- Construction - Government expenditure - Indirect Business Tax
- Exports - Net interest
- Transport - Imports - Rental income
- Distribution - Depreciation
- Bank & insurance
- Health & Education
etc.

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Table 1: Total output Approach (Product Approach)
NO. Economic Sector Value in million
1 Agriculture 1670
2 Industry (manufacturing) 1430
3 Mining 890
4 Construction 350
5 Transport and services 435
6 Whole sale trade 80
7 Other services 10.1
8 Government enterprises 500
9 Others 98
GNP (GDP) 5463.1
The most direct way of measuring the National Income is adding up the output figures of all the
firms in the country. In this method only the final goods and services are included. I.e. the cost
of intermediate goods must be excluded so that Double Counting is avoided. Double counting
arises because the output of some firms are inputs of other firms.

Table 2: Expenditure Approach

NO. Expenditure categories Million USD
1 Personal Consumption Expenditure (C) 3658.1
2 Gross Private Domestic Expenditure (I) 745
3 Gov. Purchases of goods & services (G) 1098
4 Export 670
5 Import 708
GNP (GDP) 5463.1
GNP= C+I+G+(X-M)+(NFIRA-NFIPA)

NOTE:

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  Personal Consumption Expenditure (C) includes expenditures by households on durable
consumer goods (automobiles, televisions, video etc) and non-durable consumer goods
(foods and others) and consumer expenditure of (labours, doctors, mechanics etc).
 Gross Private Domestic Investment (IQ) all investment spending by business firms (all
final purchases of machinery, equipment and tools by business enterprises; all
construction; changes in business inventories).
 Government purchases (spendings) on goods and services includes all governmental
spends on the finished products of business and all direct purchases of resources, transfer
payments and etc.
 Exports: goods and services purchased from foreign sources.

Ne Export: Is the difference between Exports and Imports i.e.: NX=X-M

GNP=C+I+G+(X-M)+[NFIRA-NFIPA]

Table 3: Income Approach

NO. Income Million USD
1 Compensation of employees 3244.2
2 Proprietor’s income 402.4
3 Rental income of persons 6.7
4 Corporate profits 297.1
5 Net interest 467.1
6 Depreciation 575.7
7 Indirect Business Taxes (IBT) 469.9
GNP (GDP) 5463.1

The income approach measures the GNP (GDP) in terms of income earned, it is the sum of all
incomes of all factors of production that contribute to the production process. The major
components of a national income accountings are:

1. Compensation of employee (wages and salaries) – W+S

2. Rental income (income earned from land) …. R
3. Interest Income ……….. I
4. Profits (proprietor’s and corporates) ……. ∏r

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 5. Indirect Business Taxes (un earned income) such as sales tax, excise tax, business
property tax ……….. IBT
6. Capital consumption allowance (depreciation) …….. D
GDP = W+S+R+I+∏+D+IBT=5463.1 million USD
Using the Expenditure Approach (table 2) calculate: -
a.GNIP
a.GNIP = C+I+G+(X-M)
= 3658.1 + 745 +1098 +(670-708) = 5463.1
b. NNP = GNP – D
= 5463.1-575.7 = 4887.4
c. NI = NNP-IBT =
4887.4-469.9 = 4417.5
d. NX = X-M
= 670-708 = -38(deficit trade balance)
Table 4: From GNP To Disposal Personal Income
NO. Expenditure Million USD
1 Gross National Product 5463.1
2 (-) depreciation 575.7
3 (=) Net National Product 4887.4
4 (-) Indirect Business Taxes (IBT) 469.9
5 (=) National Income 4417.5
6 - Undistributed Corporate Profits 29.1
- Corporate income taxes 134.1
7 - Indirect personal taxes 1206.7
8 + Gov. transfer payments to persons 694.6
9 + Government interest to persons 203.6
= DPI (Disposal Personal Income 2945.8

Government spending
Investment spending (G)
(I)
Product and Factor Market
(X-M)

Net export

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Consumer
Spending
(C)
Consumer Income Business Income Taxes
GNP= C+I+G+(X-M)

Where C = Consumption Expenditure

I = Investment Expenditure
G = Government Expenditure
X = Exports
M = Imports

Examples
1. Consider an economy with expenditure totals given by C = $ 1700 billion and I = $ 600.

a. What is the GNP?

b. How much does the capital stock increase during the period?

Answer:
Answer: a. Y = C+I = 1700+600 = $ 2300
b. S = Y-C = 2300-1700 = 600. The capital stock increased by $ 600, the amount of
investment.
2. Consider an economy with expenditure totals given by C = $ 12000 billion,
I = 400, G = 300, X = -100 F(Government transfer) = 200, N(Interest on the Government
debt) = 100 and T(Taxes) = $ 400 billion.
a. Calculate the GNP
GNP = C+I+G+NX = 1200+400+300-100 = $1800 billion.
b. What is Government Saving?
Government saving = Taxes-Government transfer-interest on the Gov. debt- Gov.
Spending.
Sg= T-F-N-G = 400-200-100-300= -200 billion USD.
c. Calculate Private Saving
Private Saving (Sp) = Disposal income-Consumption
Disposal Income = GNP + Government transfers + Interest on the Gov. debt – Taxes.
Sp = (Y+F+N-T) – C.

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 = (1800+200+100-400)-1200 = $500 billion
d. What is rest of world saving?
Rest of world saving = -Net Exports
Rest of world saving (Sr), = -X = $100 billion.
e. What is total saving? Show that it is equals investment?
Total saving = Private saving + Gov. saving + Rest of world Saving
S = Sp+Sg+Sr = 500-200+100 = $400 billion which equals investment.
3. Consider an economy with expenditure totals given by C = $2300 billion,
I = 700, G = 800, F = 100, N = 100 and T = $800 billion.
a. Calculate the GNP
b. What is Private Saving?
c. What is Government Saving?
d. What is total saving? Show that it equals investment.
e. What is the Government budget deficit?
Answer: a. Y = C+I+G+X
= 2300+700+800 = $3800
b. Sp = (Y+F+N-T)-C
= (3800+100+100-800)-2300 = $900
c. Sg = T-F-N-G
= 800-100-100-800 = $ - 200
d. S = Sp + Sg
= 900-200 = $700 = T
e. The government budget deficit is –Sg which equals $200.
Note: Inventories are goods produced, but not yet sold
 Identities of product GNP, Income GNP and Expenditure GNP.

Through Two counting rules including inventories in spending and computing profits as sales
minus expenses production GNP, Income GNP and spending GNP are always the same (equals).

2.4 NOMINAL AND REAL GNP

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NOMINAL GNP: The value of final output produced in a given period, measured in the prices
of that period (current prices)
REAL GNP: The value of final output produced in a given period, measured in the prices of a
base period (constant prices).
To distinguish increases the quantity of goods and services from increases in their prices, we
must construct a measure of GNP that take into account price level changes. Nominal GNP is
the value of goods and services measured in that year’s prices, where as REAL GNP is the value
of goods and services (output) measured in constant prices. To calculate REAL GNP, we value
goods and services at constant prices. Thus the distinction between nominal and real GNP is
important whenever the level of prices change.
REAL GNP = Nominal GNP x 100
CPI
Where CPI = is consumer price Index. Consumer
price Index (CPI): The device used to estimate the
percent change in the prices of a particular bundle of consumption goods.
Suppose a hypothetical nominal GNP of a country be 66 billion dollars in 2000 year and the
price index for that year was 110. Calculate the Real GNP for the given year.
Real GNP = Nominal GNP x 100
Price index (GNP deflator)
Real GNP = 66 x 100 = 60 billion dollars
100
A Laspeyers index uses a base year period market basket (for two commodities)

L = P1X0 + P1yY0, Where 0 – value of base year, 1 –value of later year

P0xX0 + P0yY0
The Laspeyers index compares the cost of a basket of goods purchased in some earlier-base-
period with the cost of the same basket in a later year. The consumer price index is an example
of a Laspeyers index. The cost of the market basket of goods has increased from the base period
(0) to time period (1) if the Lasperes index (L) has a value greater than one.
Example: Assume that a consumer buys 30 units of good X and 15 units of good Y in the base
period 1990. The price of X equals $8 and the price of Y equals $6 in the base period. If the
2000 prices Px1 = $7 and Py1 = $9, the Laspeyrs index will have a value of 1.045. This indicates
that the cost of the market basket of goods has increases by 4.5% from the base period to 2000.

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L = P1xX0 + P1yY0 = 7x30 + 9x15 = 345 = 1.045
P0xX0 + P0yY0 8x30 6x15 330
= 1.045x100-100 = 104.5-100 =4.5%
PER-CAPITA INCOME.
INCOME. The per capita Income (PCI) is a better measurement to compare
economic growth across countries, PCI = GNP, N-size of population
Annual growth rate = Real GNP(1 year-RGNP(t-1 year)
Real GNP (t-1 year)
Where , t year – current year
t-1 year – base year
Example: Suppose that, the gross national product of a country was 2000 million dollars in
2000 and 2130 million dollars in 2001. calculate the annual rate of growth of the economy.
Solution: Real GNP(2001) – Real GNP(2000) x 100
Real GNP(2000)
= 2130-2000 x 100 – 130 x 100 – 6.5%
2000 2000

INFLATION:
INFLATION: An increase in the average level of prices of goods and services, or decline in the
purchasing power of the national currency. A price index measures the general level of prices in
reference to a base year period. Annual rates of inflation are measured by the percentage
change. Such as the Consumer Price Index (CPI) from one year to the next.
Rate of inflation (year t) = CPI year t – CPI year t-1 x 100
CPI year t-1
Example: In 1992 the market basket price of a commodity was 144.5 birr, in 1993 the same
market basket costs 148.2. Calculate the rate of inflation.
RI (1993) = CPI 1993 – CPI 1992 x 100
CPI 1992
148.2 – 144.5 x 100 = 2.6%
144.5

Check Your Progress

Part I
Fill in the blank

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 1. A firm buys materials for $200 from other firms in the economy and product which sells
for $315. The 4115 is the _____________by the firm.
2. The total value added to a product at all stages of production equals the _________value
of the ____________product and the total value added to all products produced in the
economy during a year is the ________ product
3. In symbols, the GNP by the expenditures approach equals
________+_________+_______+_________
4. For several reasons the real GNP is not a measure of social welfare in an economy.
a. It does not induce the _________transaction that result in the production of goods and
services or the amount of ________________enjoyed by the citizens of the
economy.
b. It fails to record improvements in the ____________of the products produced,
changes in the composition of the products produced, changes in the composition
and distribution of the economy’s total ____________, the undesirable effects of
producing the GNP upon the _____________of the economy, the goods and services
produced in the _____________economy.
c. Because it is a measure of the total output of the economy, it does not measure the
___________output of the economy.
5. When the population of an economy grows at a more rapid rate than its real GNP grows, the
standard of living in that economy ____________(rises, falls, remains constant)

Part II
True or False
1. The total value added to a product and the value of the final product are equal.
2. In computing GNP, NNP and NI by the expenditure approach, transfer payments are
excluded because they do not represent payments for currently produced goods and
services.
3. In national income accounting any increase in the inventories of business firms is included
in gross private domestic investment.
4. If gross private domestic investment is greater than capital consumption during a given
year, the economy has declined during that year.

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 5. The net exports of an economy equals its exports of goods and services less its imports of
goods and services.
Part III
Below are NIA figures for X country
Billions of dollars
Exports---------------------------------------------------------------------------$367
Dividends------------------------------------------------------------------------ 60
Capital consumption allowance-----------------------------------------------307
Wages and salaries------------------------------------------------------------1442
Government purchases of goods and services------------------------------577
Rents------------------------------------------------------------------------------33
Indirect business taxes--------------------------------------------------------225
Wage and salary supplements-----------------------------------------------280
Gross private domestic investment-----------------------------------------437
Corporate incomes taxes------------------------------------------------------88
Transfer payments------------------------------------------------------------320
Interest-------------------------------------------------------------------------201
Proprietors’ income----------------------------------------------------------132
Personal consumption expenditures--------------------------------------1810
Imports-------------------------------------------------------------------------338
Social security contributions------------------------------------------------148
Undistributed corporate profits-----------------------------------------------55
Personal taxes------------------------------------------------------------------372
a. Compute each of the following
(1) Compensation of employees
(2) Net exports
(3) Net private domestic investment
b. Prepare an income statement for the economy
c. In this economy:
(1) Net national product is ______________
(2) National income is _________________
(3) Personal income is _________________

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 (4) Disposable income is _______________
_______________

2.5 SUMMARY

 The question of measurement of output comes under the heading of national income
accounting.
 There are three basic approaches to the measurement of the value of the economy’s total
output – the expenditure the income approach, and the product approach.
 Gross National Product is the value of output produced by factors of production owned by
residents of the country. GNP defers from GDP because some goods made in the country
are produced by foreign – owned factors of production and because our citizens receive
income from abroad, for example, if they own assets abroad.
 Spending on GDP is divided into consumption, investment, government purchases of
goods and services, and net exports.
 Real GDP is the value of the economy’s output measured in the prices of some base year.
Real GDP comparisons provide a better measure of the change in the economy’s physical
output than nominal GDP comparisons, which also reflect inflation.
 The GDP deflator is the ratio of nominal to real GDP. It provides one measure of the rise
in prices form the base date at which real GDP is valued.

2.6 KEY WORDS

2. Gross National Products (GNP): The total market value of all final goods and services
produced in a given time period.
3. Gross Private Domestic Investment: All investment spending by business firms (all final
purchases of machinery, equipment and tools by business enterprises; all construction;
changes in business inventories.
4. Net Export: Is the difference between Exports and Imports.
5. Nominal GNP: The value of final output produced in an given period, measured in the
prices of that period (current prices).
6. Real GNP: The value of final output produced in a given period, measured in the prices
of a base period (constant prices).

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2.7 ANSWERS TO CHECK YOUR PROGRESS

Part I
Fill in the blank questions
1. Value added
2. Market, final, gross national
3. C, I, G, NX
4. a) non market, leisure;
b) quality, output, environment, under ground;
c) per capital
5. Falls

Part II
True of False questions
1. True
2. True
3. False
4. False
5. False

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Part III
a. (1) 1,722 (2). 29 (3). 130
b. See table below
Receipts: expenditures Income
Approach Allocations: approach
Personal consumption capital consumption
expenditures $1810 allowance-----------------------$307
Indirect business
Gross private taxes 255
domestic investment 437 compensation of
Employees 1722
Government purchases Rents 33
of goods and services 577 Interest 201
Proprietors income--------------132
Net exports 29 Corporate income taxes---------88
Dividends--------------------------60
Undistributed corporate profit--55
Gross national _____ Gross national ____
Product 2853 Product 2853

c. (1). 2546 (2). 2291 (3). 2320 (4). 1948

2.8 REFERENCES

 Arnold, Roger; Economics 2nd ed,

ed, West publishing Co. 1992
 Colander, David; Economics 2nd ed.,
ed., Richard D. Irwin, Inc, 1995.
 Dr. Gupt, R.D; Keynes Post Keynesian economics,
economics, kalyani Publishers, 1998
 Ekelvnd, Robert, d. Tollison, Robert; Macro Economics,
Economics, Little Brown and company.
1986
 H. Branson, William; Macro Economic Theory and Policy 2nd edition, Printograph
(India)
 Jhingan, M.L; Macro Economic Theory 10th ed.,
ed., B.s Ashish company (virinda
publications (p) Ltd. 1997

48
 J. Ruffin, Roy, R. Gregory, Paul; Principles macro Economics 2nd ed.
ed. Scott, forsmand
and company. 1989.
 K Evans, Michael; Macro Economic Activity Theory, forecasting, and control, 1969.
 Luker, William, A. Martian, David; Economics for decision-making D.C Health and
company. 1998.

49
UNIT 3: CONSUMPTION, SAVING AND SIMPLE INCOME DETERMINATION (TWO
SECTOR MACRO MODEL)

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 The Consumption Function and its Derivation
3.3 The Saving Function and its derivation
3.4 Investment Demand and Investment Demand Curve
3.5 Equilibrium level of the GNP: The Keynesian Cross
3.6 The Paradox of Thrift
3.7 Summary
3.8 Key words
3.9 Answers to Check Your Progress
3.10 Model Examination Questions
3.11 References

3.0 AIMS AND OBJECTIVES

Aims
In this unit we are going to discuss about how the equilibrium level of income is determined in
the simple Keynesian Macro Model. Our scope of discussion will be limited to a two-sector
model that is one that includes only households and business. Since the equilibrium level of
income is determined solely by aggregate spending, consumption, saving and investment will be
the prime focus of the unit.

Objectives:
After learning this unit you will be able to:
 define the terms consumption, saving and investment.
 define the consumption function, the saving function and their derivation.
 explain the concepts of average and marginal propensity to consume and save and their
relationship with expenditure multiplier.

50
  show how the equilibrium level of national income is determined in the simple macro
model.

3.1 INTRODUCTION

There is a close relationship between aggregate consumption expenditures and the level of
disposable income. This relationship leads to one of the central propositions of the theory of
income determination. The consumption expenditure of a community is determined mainly by
its level of disposable income. So the determinants of consumption, the consumption function,
and other related theories regarding consumption will be discussed in this unit.

The simplest Keynesian model of the Macro economy is built on the foundation laid in the
consumption expenditures of domestic households and the investment expenditures of domestic
firms, and government expenditures on goods and services.

The level of income (output) and employment in an economy is composed of a number of

components, such as, consumption, investment and government expenditure. The level of an
income in an economy is, therefore, derived from the total of the various purchasing
components. That means Y = C+I+G

Where Y- National Income, C- Consumption Spending, I- Investment Spending and G-

Government Spending.

Consumption: Expenditure by consumers on the final goods and services. Macroeconomics

define Consumption demand (C), as the value of commodities (other human households) and of
services that households as a group are able and willingly to buy in a given period.

DETERMINANTS OF CONSUMPTION DEMAND

The determinant of consumption demand include people’s income after taxes (disposal personal
income their wealth, their expected income, the expected general level of prices, the actual level
of prices, interest rates, people’s age, prevailing attitudes towards thrift and others.
Paradox of Thrift: is a proposition that there is an inconsistency between the apparently virtuous
nature of household saving and potentially undesirable consequence of saving.

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Disposal Income (DI) is the amount of income consumers can actually choose to spend or not
spend (save) in a given time period, that is:
Disposal Income = Consumption + Saving

Saving: That part of disposal income not spent on current consumption

Disposal Income- Consumption = Saving
DI – C = S
Analyzing consumption and saving, Keynes interested how consumers divided up their disposal
income between current consumption and saving.
1. The Average Propensity to Consume (APC) – is the portion of total disposal spent on
consumption goods and services in a given time period. That means total consumption in a
given period divided by total disposal income.

Total Consumption = C/Yd

APC = Total Disposal Income
2. The Marginal Propensity to Consume (MPC) The fraction of each additional (marginal)
disposal income spent on consumption: The change in consumption divided by the change in
disposal income.

MPC = Change in Consumption = C = 2C

Change in Disposal Income Yd 2yd

3. The Marginal Propensity to Save (MPS): - The fraction of each additional (Marginal)
disposal income not spent on consumption.

MPS = S
Yd

MPC+MPS = 1

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 3.2. THE CONSUMPTION FUNCTION AND ITS DERIVATION

The Consumption function is a mathematical relationship indicating the rate of desired

consumer spending at various income levels. In other words the consumption function states the
relationship between income and Consumption.

The Consumption function equation (C) = C=f(DIa, W, DIe, Pa, Pc, i, a, t, …)

Where DIa- Disposal Income, W- Wealth, DI e- Expected disposal income, Pa- the actual price
level, Pe- the expected price level, i- Interest rate, a- age, t- thrift attitude, etc. In other words
C = a+byd, where a is the rate of consumer spending not dependent on current income, b is the
marginal propensity to consume. The amount of consumption indicated by a is often referred to
as Autonomous Consumption. This is the rate of Consumer Spending determined by forces
(Consumer wealth, interest rates expectations about the future, and a host of other factors, other
than current income. In theory, this amount of consumption would take place even if Yd
equated zero. Keynes used this simple equation with both autonomous and income dependent
(induced) consumption-to characterized consumer spending. Because of its unique focus on the
relationship of current consumption to current income, it is called the Keynesian consumption
function (Keynes focused on disposal income (Yd only).
DISSAVING: - Consumption expenditure in excess of disposal income (a negative saving flow)

450 Line
400 Saving
Consumption spending

300 C = yd
300
280 C D
200 Consumption function
180 (C = 50 per month + 0.75 yd)
100
50 dissaving

yd
0 50 100 150 200 250 300 350 400 450
Table 1: A hypothetical Consumption Function

Consumption (C = 50+0.75 yd)

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 Disposal income (yd) Consumption at their Additional Total C.
income spending
A 0 50 50 50
B 100 50 75 125
C 200 50 150 200
D 300 50 225 275
E 400 50 300 350
F 500 50 375 425

NB. The rate of consumer spending (C) is directly related to current disposal income (yd).

As income rises, so does consumption. In the above table, consumption increases by 100 (e.g.
from row B to row C). The marginal propensity to consume equals 0.75 (i.e. 200-125/200-100).

The difference between income and consumption equals dissaving (saving)

The slope of the consumption function equals the marginal propensity to consume (MPC. In
this case, when income increases from 100 to 200, consumption rises from 125 (point B) to 200
(point C). Thus the change in consumption ($75) equals three fourths of the change in income.
The MPC is still 0.75.

Derivation of The MPC from Consumption function

Given the consumption function:
C = a+by, if income increases by y, Consumption by C. thus, if C = a+by
Then C+C = a+b(y+y)
= a+by+by
C = C+a+by+by,
Since C = a+by, by substituting a+by for C, we get
C = -(a+by)+a+by+by
C = -a+-by+a+by+by
 C = b y
C = b
By dividing both sides of the equation by y, we get y
Thus “b” in consumption function C = a+by represents MPC.
According to the Keynesian theory of consumption, C/y is always less than Unity (one)
* The income identity for a closed economy states that income (y) equals the

54
 sum of consumption (C), Investment Spending (I), and government spending (G).
Y = C+I+G
* The Consumption function states that consumption depends on disposal income (yd), which is
equal to income minus taxes, C = a+byd
There is a subsistence level of consumption a, about which the individual has no choice. If the
individual’s income is less than “a”, he borrows. At income levels above “a”, he has a choice
between consumption and saving. The coefficient “b” is the marginal propensity to consume
(MPC). For example, if we set “b” equal to 0.8, we are saying that 80 cents of each additional
disposal income is spent on consumption. The other 20 cents is saved.
* If the Tax rate is the constant t, total tax payments are the tax rate multiplied by income, ty.
Disposal income yd = Income-taxes = y-ty = (1-t)y. By replacing the disposal income yd
with (1-t)y, the consumption function can be written as:
C = a+b(1-t)y
* Spending Balance in a closed economy occurs at levels of consumption C and
income y that obey both the consumption and the income identity.
We substitute the consumption function into the income identity.
Y = C+I+G, and solve for income to obtain
Y = a+b(1-t)y+I+G
Y = a+(b=bt)y+I+G
Y = a+b(1+t)y+I+G
Y = a+(b-bt)y+I+G
Y = by-byt+a+I+G
Y = by(1-t)=a+I+G
Y(1-b(1-t)
Y(1-b(1-t) = a+I+G
1-b(1-t) 1-b(1-t)

Y = 1/1-b(1-t) [a+I+G]

Example 1. Consider an economy described by the following equations

C = 500+0.6 yd
I = 300

55
 G = 500
t = 0.2
Find the level of income when spending balance occurs.
Solution: Y = 1 (C+I+G)
1-b(1-t)
Y= 1 (500+300+500)
1-0.6(1-0.2)
Y= 1 (1300)
1-(0.6-0.12)
Y= 1 (1300)
1-0.48
= 1 (1300) =
0.52

 1.923 (1300) = 2499.9 = 2500

To solve for consumption, substitute back into the consumption function the value of income
when spending balance is attained. Because they can be determined inside the model, in this
case, income and consumption are called ENDOGENOUS VARIABLES. Investment and
government spending cannot be determined inside the model-yet-so they are called
EXOGENOUS VARIABLES, determined outside the model. The multiplier for a closed
economy measures how much a change in investment or government spending change income.
The formula for the multiplier when both investment and government spending are exogenous is
1/(1-b(1-t)). It is greater than one because both “b” and “t” are between Zero and one,
indicating than an increase in either investment or government spending will have a more than
proportional effect on income.

The Income identity for an open economy says that income (y) equals the sum of
consumption(C), investment (I), government spending (G), and net exports (x).
Y = C+I+G+X, where net exports, equal to exports minus imports, are positive if there is a trade
surplus and negative if there is a trade deficit.
The Net Export Function relates net exports income X = g – my
Where “g” is a constant and “m” is a constant. The coefficient m is called the marginal
propensity to import, and measure how much of an additional income is spent on imports.

56
Now substitute the net export function, as well as the consumption function, into the income
identity,
Y = C+I+G+X and solve for income to obtain
Y = a+b(1-t)y+I+G+g-my
Y = by-byt + a+I+G+g-my
y-by+byt+my = a+I+G+g
y-by(1-t)+my = a+I+G+g
y(1-b(1+t) = a+I+G+g
(1-b(1-t)+m) (1-b(1-t)+m

Y= 1 (a+I+G+g)
1-b(1-t)+m

The open economy multiplier, which measures the impact of a change in government spending
or investment on output in an open economy,
is
1
1-b(1-t)+m

The open economy multiplier is smaller when the marginal propensity to import “m” is larger.
If “m” were zero. So that increases in income did not affect imports, the open and closed
economy multiplier would be the same. With “m” greater than zero, the open economy
multiplier is smaller than the closed economy multiplier.
We can now analyze the relation between trade deficits and government budget, or fiscal
deficits. Increases in government spending (G), it not matched by tax increases, cause fiscal
deficits. According to the multiplier, increases in G also cause income y to rise. When y
increases, imports rise and trade deficits occur.

3.3. THE SAVING FUNCTION AND ITS DERIVATION

Like consumption, saving too is the function of Income. At the aggregate level of income, Y =
C+S. Therefore, S = Y-C.
Y-C. Saving is thus a part of income which is not consumed. Saving
function is a counter part of the consumption function. Saving function may therefore, be
derived from the consumption function.

57
 S = Y-C, and C = a+by

By substituting a+by for C in equation S = Y-C;

S = Y-(a+by)
= Y-a-by
= -a+y-by
S = -a+(1-b)y  Saving function

Remember that b = C/y = MPC. Therefore 1-C/y = 1-b and 1-b is marginal propensity to
save (MPS). Let the consumption function be given as C = a+by and the saving function as S =
-a+(1-b)y
Assume a = 100 and b = 0.75, we can rewrite consumption and saving function C = 100+0.75y
And S = -100+0.25y

Saving C
Y=C+S

C=100+0.75y S
250
Expenditure

200 Dissaving
150
100
50 S= -100+0.25y

450
0

(-) Disposal Income (y)

The 450 line shows income-consumption relationship on te assumption that the total income is
consumed; nothing is saved. The schedule C = 100+0.75y gives the income-consumption
relationship-consumption being a linear function of income. The schedule S = -100+0.25y is

58
the saving function derived from the consumption function. The saving schedule shows the
income saving relationship.

EQUILIBRIUM OF NATIONAL INCOME: Two-sector model

Aggregate Demand = Aggregate Supply
C+I = C+S
Since “C” is common to both sides, the equilibrium condition may be expressed as I=S that is
C+I = C+S
 C-C+I = S
 I =S

Equilibrium and Disequilibrium National Income in a four-sector model of economy

AD = C+I+G-T+x-M
Disequilibrium condition apply if when
Y<C+I+G-T+X-M, y tends to rise
And Y>C+I+G-T+X-M, y tends to fall

Rearranging this equilibrium as

Y-C+T+M = I+G+X and making use of the identity:
Y-C = S
That is S+T+M = I+G+X
Planned Planned
Withdrawals /Leakages/ Injection

3.4. INVESTMENT DEMAND AND INVESTMENT DEMAND CURVE

Macroeconomists define INVESTMENT DEMAND, I*, as the desired change during a

specified period in the nation’s capital stock, which is the value of newly produced structures
and equipment that firms are then able and willingly to buy, plus the value of new residual
houses demanded by households, plus the desired change positive or negative of business
inventories of raw materials, semi finished goods, and finished goods that are ready for sale.

59
Given future streams of revenues, costs, and profits that investment projects are likely to bring,
investment demand I* varies with the prevailing interest rate i. A lower interest rate encourages
investment demand: a higher investment rate discourages it.

20
Interest rate i (% per year)

15

10 Investment demand curve

5 100 200 300 400 500

Investment demand, I*
As shown by the investment demand curve, there is an inverse relationship between investment
and interest rates.

Determinants of Investment other than i

1. Elements of uncertainty  Business expectations are very uncertain, rumours news of
technological development, events.
2. Existing stock of capital goods  large capital goods discourage. Potential investors.
3. Consumer demand  present and future demands
4. Level of income  if the level of income rises in the economy, the demand for goods will
rise due to the rise in money wage rates.
5. Liquid assets  if investors possess large liquid assets, the inducement to invest is high.
6. Inventions and innovations  absence to invest
7. Population growth.
8. State policy  investment and economic policies of the government.
9. New products  if the sale prospects of a new products are high, it encourages
investment.
10. Political climate  political stability of the country.

60
Algebraic Expression on consumption, saving and investment
1. Consider a closed economy without a government with expenditure totals given by C =
$1200 billion and I = 400 billion.
a. What is gross national product?
b. Show that saving equals investment.
Solution: a. GNP = C+I
Using Y to denote GNP, Y = C+I = 1200+400 = $1600
b. Saving(s) = Income-Consumption = GNP-consumption.
Using S to denote saving S= Y-C
= 1600-1200 = $400 billion, which equals Investment  S=I

2. Consider a closed economy with expenditure totals given by

C = $1200, I = 400, G = 300
F = 200 (Government transport)
N = 100 (Interest on the government debt)
T = 400 (Taxies)
a. What is GDP? B. What is private saving (Sp)?
c. What is government saving (Sg)?
d. What is total saving? Show that it equals investment.

Solution: a. GDP = C+I+G = 1200+400+300 = $1900 billion

b. Sp = Disposal income - Consumption
DI = (y+F+N-T)-C = (1900+200+100-400)-1200 = $600
c. Sg = T-F-G = 400-200-100-300 = $200 billion
d. Total saving(s) Sp+Sg = 600+(-200) = $400 billion
Which equals investment (S = I

3. Consider an open economy with expenditure totals given by:

C = $1200 billion, I=400, G=300
X = -100 (Net exports)
F = 200 (government transfers)
N = 100 (Interest on government debt)
T = 400 (taxes)

61
a. What is GNP? b. What is private saving (Sp)?
c. What is government saving (Sg)?
d. What is the rest of world saving (Sr)?
e. What is total saving(s)? show that it equals investment(I).
Solution: a. GNP = C+I+G+X = 1200+400+300-100 = $1800
b. Sp = Disposal income - consumption
DI = (Y+F+N-N)-C
= (1800+200+100-400)-1200 = $500 billion
C. Sg = T-F-N-G
= 400-200-100-300 = -$200 billion
d. Rest of world (Sr) = -x
= 1-(-100) = $100 billion
e. Total saving(s) = Sp+Sg+Sr
= 500-200+100 = $400 billion
Which equals investment (S=I)
Exercise
4. Consider an economy with expenditure totals given by:
C = $2300 billion; I=700, G=800
F = 100 (government transfers)
N = 100 (Interest on government debt)
T = 800 (taxes)
a. What is GDP? B. What is private saving (Sp)?
c. What is government spending (Sg)?
d. What is total saving? Show that it equals investment?
e. What is the government budget deficit?
f. Suppose that money equals $600 and government bonds $800 at the start of
the year. If 80 percent of the government deficit is financed by issuing bonds, calculate the
new levels of bond and money holdings.
Solutions
a. Y = C+I+G
= 2300+700+800 = $3800 billion

62
b. Sp = (Y+F+N-T)-C
= (3800+100+100-800)-2300 = $900 billion
c. Sg = T-F-N-G
= 800-100-100-800 = -$200 billion
d. S = Sp + Sg
= 900+(-200) = $700 billion = I:(S=I)
e. The government budget deficit is –Sg, which equals $200 (i.e. –(-200) =
200))
f. The change in bonds is 80 percent of the 200 government budget deficit, or
160 (80/100x200 = 100), so the new level of bond is 960 (i.e. 800+160). The change in
money is 20 percent of 200, or 40 (i.e. 20/100x200 = 40), so the new level of money is
640 (600+40 = 640).
5. Consider an economy with expenditure totals given by:
C = $2300, I=700, G=$800
F = 100 (Gov. transfers)
N = 100 (interest on the government debt)
T = 800 (taxes)
X = -$200 (Net exports)
a. What is GNP? b. What is private saving (Sp)?
c. What is government saving (Sg)?
d. What is rest of world saving (Sr)?
e. What is total saving (S)? Show that it equals investment (I)?
f. What percentage of the government budget deficit is financial by the
current account deficit?

Solution
a. Y = C+I+G+x
= 2300+700+800-200 = $3600 billion
b. Sp = (Y+F+N-T) - C
= (3600+100+100-800)-2300 = $700

63
c. Sg = T-F-N-G
= 800-100-100-800 = -$200 billion
d. Sr = -X
= -(-200) = $200 billion
e. S = Sp+Sg+Sr
= 700-200+200 = $700 billion = I
S=I
f. Since the current account deficit $200, is the same as the government budget
deficit, the entire budget deficit is financed through the current account deficit. That means
foreigners have acquired $200 billion bonds or many.

3.5 EQUILIBRIUM LEVEL OF THE GNP: THE KEYNESIAN CROSS

Keynes postulated that the nominal value of the gross national product, y, that will be supplied
by firms in one year and therefore can be called the Aggregate Nominal Supply (ANS) will be
from any innate tendency to change and will thus be in EQUILIBRIUM only if the nominal
value of national output that people are able and will to buy in that year the Aggregate Nominal
Demand (AND), is equal to the nominal GNP being supplied. If the aggregate nominal demand
ever exceeds the Aggregate Nominal Supply (AND>ANS), Keynes figured, an
EXPANSIONARY GAP. Exists. If on the other hand, the Aggregate nominal demand falls
short of the Aggregate supply (AND<ANS), a CONTRACTIONARY GAP exists.

To Summarize:

1. If AND = ANS, then y is in equilibrium and will not change.

2. If AND>ANS, then an Expansionary gap exists and y will rise as production is
increased in response to unplanned inventory declines.
3. If AND<ANS, then a contractionary gap exists, and y will fall as production is
decreased in response to unplanned inventory build-ups.

It is known that Aggregate nominal demand and Aggregate nominal supply are equal only at one
level of GNP-where the AND and ANS lines cross, which is why a graph of AND and ANS

64
 lines that shows how the equilibrium level of nominal GNP is determined is often called the
KEYNESIAN CROSS.

Table1: The equilibrium GNP(in million USD per year

Y=ANS C=500+0.6y I*=300 AND=C+I* Unplanned Effect on nominal GNP

inventors
change
0 500 300 800 -800
500 800 300 1100 -600
Rises
1000 1100 300 1400 -400
1500 1400 300 1700 -200
2000 1700 300 2000 0 equilibrium
2500 2000 300 2300 +200
3000 2300 300 2600 +400
Falls
3500 2600 300 2900 +600
4000 2900 300 3200 +800

Figure 1. The Keynesian Cross

ANS

4000 h AND=C+I*
3500

65
 2900 C=500+0.6y

Billions of USD per year 2600 Equilibrium Contractionary gap:

2000 e AND<ANS
1700

a
1100 b Expansionary gap:
800 c AND>ANS
500 450 d g
m
0 Y
500 2000 3500
Nominal GNP in billion of USD per year

From the above diagram, to the left of point e, AND exceeds ANS and expansionary gaps exist:
to the right of e, AND falls share of ANS and contractionary gaps exist.
An Expansionary Gap
At Y=500 (0d), ANS equals 500 as well (cd); but AND=1100(ad). Thus, an expansionary gap
exists. Unplanned inventory change of 500-1100 = -600 occurs (ac). Y will tend to rise. In the
mean time, GNP accountants will record C=800 plus actual I=-300 summing to y=500. The
planned investment of I*=300 by some firms (ab) plus the unplanned investment of –600 by the
same or other firms (the unexpected inventory decline ac) yields a total actual investment of –
300 by all firms combined (bc). Firms are eager to step up production; their plans have not
worked out.
A Contractionary Gap
At Y = 3500 (om), ANS equals 3500 as well (hm); but AND = 2900 (im). Thus, a
contractionary gap exists. An unplanned inventory change of 3500-2900 = +600 occurs (hi). Y
will tend to fall. In the meantime, GNP accountants record C=2600 plus actual I=900 summing
to 3500. The planned investment of I*=300 by some firms (ik) plus the unplanned investment
of +600 by the same or other firms (the unexpected inventory build up in) makes for a total

66
actual investment of +900 by all firms combined (hk). Under the circumstances, firms curtail
production; their inventories are rising out of control.
Examples
1. Consider an economy described by the following wing equations
C = 500+0.9y 1
Equilibrium condition = 1  mpc (c  I )
I* = 500
Autonomous consumption .
AND = C+I*
a. Calculate the equilibrium value of Y.
b. Who buys what part of output?
c. What is the size of multiplier?
Solution
a. Y = 1/1-MPC (C+I*)
= 1/1-0.9 (500+500) = 1/0.1(1000) = 10(1000) = 10,000
b. Consumers buy C = 500+0.9y
= 500+0.9(10,000) = 500+900 = 9500
Investors buy I = 10,000-9500 = 500
c. The size of multiplier is 1/1-MPC = 1/1.09 = 10

2. Consider an economy described by the following equations

C = 1000+0.54
I* = 500; AND = C+I*
a. Calculate the equilibrium value of Y
Solution Y = 1/1-MPC(C+I*) = 1/1-0.5 (1000+500) = 2(1500) = 3000

b. Who buys what part of output?

Solution Consumers buy C=1000+0.54 1000+0.5(3000)=2500
1000+0.5(3000)=2500
Investors buy I = 3000-2500 = 500

c. What is the size of multiplier?

Solution = 1/1-MPC = 1/1-0.5 = 1/0.5 = 2
3. Consider an economy described by the equations

67
 c = 1000+0.9y
I* = 200
AND = C+I*
a. Calculate the equilibrium value of y.
b. Who buys what part of output?
c. Calculate the size of the multiplier.
Solution
a. Y = 1/1-MPC(C+I*)
= 1/1-0.9(1000+200)
= 1/0.1(1200) = 10(1200) = 12,000
b. Consumer buys 1000+0.9(12,000) =
= 1000+10,800 = 11,800
Investors buy 12,000-11,800 = 200
c. The size of multiplier is
K = 1/1-MPC = 1/1-0.9 = 1/0.1 = 10
3.6 THE PARADOX OF THRIFT

The paradox of Thrift is the proposition that there is an inconsistency between the apparently
virtual nature of household saving and the potentially undesirable consequences of such saving.
If most households decide to save a larger proportions of their incomes, then they will consume
less and this reduced expenditure will lower aggregate demand and so lead to lower level of
national income.

Thriftiness or saving is beneficial to the investment goods. However, if households attempt to

save more than business plan to invest at a given level of income (i.e; “Widramals” exceeds
“injection” in the circular flow of the national income model) this will cause the equilibrium
level of national income to decline, reducing also the actual amount saved and invested.

x S2 = 0.4y
b S1 = 500+0.4y

68
 a e
I*

0 y
2250 3500
y* y

Nominal GNP in billions of USD/year

Consider an original equilibrium at ‘e’, based on saving function of S=-500+0.4y and
investment demand of I* = 900. Because in equilibrium personal saving (and actual investment)
must equal investment demand, we can figure that in equilibrium S=I*.
Calculation of the equilibrium level of y using S = I approach

-500+0.4y = 900
0.4y = 900+500
0.4y/0.4 = 1400/0.4
y = 3500

Let S1 become S2 = 0.4y

If I* is constant, a new equilibrium will be reached at point ‘a’ where total saving equals 900
just as it did at point ‘e’. In the process, the equilibrium GNP will have fallen by over a third.

S2 = I*
0.4y/0.4 = 900/0.4
Y= 2250

Check Your Progress

Part I
Multiple Choices

69
 1. Which of the following specifies the level of consumption for each level of personal
disposable income?
A. Saving function
B. Consumption function
C. Marginal Propensity to consume
D. Marginal propensity to save
2. _______is the function of a dollar by which consumption increases when income rises by
a dollar?
A. Consumption function
B. Investment
C. Marginal propensity to consume
D. Saving function
3. When the multiplier is more than 1, which of the following is true?
A. A one unit change in AD produces a small change in equilibrium output.
B. A one unit change in AD produces a larger change in equilibrium output.
C. A large change in AD does not produce any change in equilibrium output.
D. The multiplier change has no effect on the equilibrium output.
2. When investment demand is reduced.
A. Output is reduced.
B. Output is increased.
C. It has a total effect on spending
D. A and C
3. Which of the following is not true about the 45o diagram?
A. The values in the x axis and y axis are always equal
B. The slope of the consumption of function equals to MPC
C. When income increases consumption decreases
D. The difference between income and consumption equals dissaving or saving.

Part II
Fill in the blank

70
 1. Shows the income consumption relationship on the assumption that the total income is
consumed, nothing is saved.
2. is the counter part of the consumption.
3. If AND exceeds ANS there exists gap.
4. When the AND and ANS lines cross, the equilibrium level of nominal GNP is called
.
5. does not desend upon the current disposal
income

3.7 SUMMARY

 Macroeconomics defines consumption demand, C, as the value of commodities (other than

houses) and of services that households as a group are able and willing to buy in a period.
 The consumption demand is influenced by many variables, notably people’s disposable
personal income but also by their wealth, expected income, and much more.
 The consumption function is an expression that shows how consumption demand varies
with disposal personal income and ultimately, with the GNP, other things being equal.
 Macroeconomics define investment demand (I) as the desired change during a specified
period in the nation's capital stock, which is the value of newly produced structures and
equipment that firms are then able and willing to buy, plus the value of new residential
houses demanded by households, plus the desired change-positive or negative-or business
inventories of raw materials, semi finished goods and finished goods that are ready for
sale.
 All else being equal, investment demand varies inversely with the prevailing interest rate,
i. A lower interest rate encourages investment demand; a higher rate discourages it.
 In simple model of macro economy, the nominal GNP is determined entirely by the
spending decisions of domestic households and domestic firms (Keynesians approach)

71
3.8 KEY WORDS

2. Consumption: Expenditure by consumers on the final goods and services.

3. Average Propensity to Consume: The portion of total disposable income spent on
consumption goods and services in a given time period.
4. Marginal Propensity to Consume: The fraction of each additional (marginal) disposable
income spent on consumption.
5. Marginal Propensity to Save: The fraction of each additional (Marginal) disposable
income not spent on consumption.

3.9 ANSWERS TO CHECK YOUR PROGRESS

Multiple Choice
1. B 4. D
2. C 5. C
3. B

Fill in the blank

1. The 450 line
2. The saving function
3. Expansionary gap
4. Keynesian cross
5. Autonomous consumption

3.10 MODEL EXAMINATION QUESTION

1. Explain the statement that consumption depends up on current disposable income

2. Explain the component of the equation: C = $20 + 0.90Yd

3.11 REFERENCES

 Rudiger Donbusch, Stanley Fischer (1989), Macro Economics,

Economics, McGraw Hill, USA.
 Edward Shapro, Macroeconomics.
 Thomas F. Dernburg and Dencan M, Mc Daugall (1972), Macroeconomics, U.S.A.

72
UNIT 4: THE CLOSED AND OPEN MACRO MODELS

Contents
4.0 Aims and objectives
4.1 Introduction
4.2 Government Purchase and Lump-Sum Taxes
4.3 The Balanced Budget Multiplier
4.4 The Four Sector Economic Model
4.5 The Macro Model and Fiscal Policy
4.6 Summary
4.7 Answers to Check Your Progress
4.8 Key Words
4.9 Model Examination Question
4.10 References

4.0 AIMS AND OBJECTIVES

Aims
In this unit analysis of an economy will be discussed by incorporating the government and the
rest of the world. First the model is expanded to include government (three sector model) and its
actions in varying its spending, transfers and taxes to affect the level of income. The focus will
be on the Keynesian demand management policy and the details to devise the set of fiscal policy
action that would enable best the government to achieve varying targeted levels of output.
In addition to this the unit examines an open economy, a four-sector economy, by including the
monetary policy and the way that the foreign trade multiplier affects the economy’s income
level.
Objectives
After learning this unit, you will be able to:
- Explain the three-sector macro model.
- Know the four-sector macro model.
- Understand what the Keynesian demand management policy and monetary policy are.

73
 - Know what expanded open (foreign trade) macro multipliers and the balanced
multipliers are.

4.1 INTRODUCTION

The basic Keynesian model here is expanded to include the government sectors in order to
explain the nature of fiscal policy- the deliberate manipulation government demand for
commodities and services, of government transfer payments and of tax collections to influence
the size of the nominal gross national product (GNP) and ultimately, the levels of real GNP,
prices, employment and unemployment. This is illustrated using numerous examples of fiscal
policy action and worked out problems.

In addition to the above the macro economic implications of an economy involved in trading
commodities, services and financial assets with other countries (open economy) will be explored
and the extent of a country’s economic involvement with the rest of the world is periodically
summarized by its balance of payments, a systematic record of all economic transactions that
have occurred, during a specific period of time.

As an instrument of macro economic policy, fiscal policy has been very popular with modern
government to influence the size and components of national product, employment, industrial
production, Taxation, Prices, etc.

Government expenditure and tax income acts as important levels of influence the aggregate out
lag, employment and the level of prices in the economy.

Fiscal policy: - The use of government taxes and spending to alter macroeconomic outcomes. A
given change increases or decrease in aggregate government expenditure causes a change
increase or decrease in the aggregate demand thereby increasing or decreasing factor incomes.
Government expenditure incurred on wages and salaries of its employees, interest paid on
government debt, social security and old age pension payments all tend to increase the disposal
personal income of people as a consequence of which the aggregate demand for consumer
goods increase. Thus, an increase in the total expenditure of government tends to expand the
aggregate economic activity in the economy. On the other hand, taxes levied on the people to
finance government expenditure reduce the disposal personal and corporate incomes, which

74
could have been, either spent on consumption or devoted to capital formation. Thus, taxes tend
to reduce the aggregate demand and income in the economy.

The government expenditure and revenue can be combined in several ways in order to stimulate
or depress the aggregate demand and economic activity in the economy.

Fiscal Guidelines
The primary goal of fiscal policy is to make equilibrium GNP equal to full-employment GNP.
The fiscal mechanism for attaining that goal is the government Budget. By changing taxes
transfers, or government spending, the government can alter the rate of Leakage or Injection.
These changes in turn, may increase or decrease aggregate spending.
Leakage: - Saving, Taxes, Imports
Injection: - Investment, Government spending, Exports.
Equilibrium GNP: The rate of output at which desired spending equals the rate of production.
In equilibrium injections and leakages are exactly equal. This implies:
1. In a closed, private economy: desired I=desired S.
2. In a closed, mixed economy: desired I+G=desired S+I
3. In an open economy: desired I+G+x = desired S+I+M

Full Employment GNP: The total value of final goods and services that could be produced in a
given period at full employment; potential GNP.

NB. In a fiscal strategy:

 Desired new injection = recessionary gap.
 Desired New leakage = inflationary gap.

Definition:
Definition: the word “Budget” is said to have its origin from the French word “Bougette”
which means “a small leather bag”. The bag contains an economic “Bill” presented by the
finance minister in the parliament every year. In this way budget can be defined to be the
detailed financial statement containing minutes of income and expenditures of the government
in every fiscal year.

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4.2 GOVERNMENT PURCHASE AND LUMP-SUM TAXES

The inclusion of government into the two-model economy (C+I), affects aggregate demand
through government Expenditures and Taxation. The government expenditure (purchase) and
taxation affect the national income to the extent of their net multiplier.
Multiplier:
Multiplier: The ratio of an induced change in the equilibrium level of national income to an
initial change in the level of spending. The value of the multiplier (K) is given by the formula:

K = 1/1-MPC or 1/MPC

Aggregate Demand in the three-sector model is defined as:

AD = C+I+G and aggregate supply (AS) as: -
AS = C+S+T
The equilibrium of national income will take place at a level where
C+S+T = C+I+G
Or Y = C+I+G
Where C = a+bYd
Where yd = Y=T
Where T = Lump-sum tax
By substituting a+bYd for C and Y-T for yd
Y = a+b(Y-T)+I+G
Y = a+bY-bT+I+G
Y = by-bT+a+I+G
Solving for y, we get the equilibrium level of national income
Y-bY = a-bT+I+G
Y(1-b)
(1-b) = a-bT+I+G
1-b 1-b
Y = 1/1-b (a-bT+I+G)
Example: let assume that a consumption function and an investment function as follows:
C = 100+0.75Y
I = 100
G = T=50

76
Find the equilibrium level of the national income
Y = 1/1-0.75 (100-0.75x50+100+50)
= 1/0.25(100-37.5)+100+50
= 4(62.5+100+50)

Y = 850

The Government Budget and the Multiplier

Given the equilibrium condition
Y = 1/1-b(a-bT+I+G)
Let the government expenditure increase by G. This will increase aggregate demand by y
through the process of multiplier. The equilibrium level of national income can then be
expressed as.
Y+y = 1/1-b(a-bT+I+G+G)

Let C = 700+0.60y
I = 350, G=400 T = 150
Find the equilibrium level of nation income and the multiplier.
Y = 1/1-60(700-0.60(150)+350+400
1/0.40(700-90)+750  2.5(610+750)=25(1360) = 3400

The effect of G on the level of national income can be obtained by subtracting

Y = 1/1-b(a-bT+I+G) from Y+y = 1/1-b(a-bT+I+G+G). That is
y = 1/1-b(G)
By dividing both sides of the equation by G
y/G = 1/1-b(G/G)  Y/G = 1/1-b

We get the government expenditure multiplier (Gm) as Gm = Y/G = 1/1-b

The impact of change in taxes on the level of national income
The impact of change in tax(T), i.e. its multiplier effect, is smaller than the impact of
G(orI), if T = G or T = I

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A change in tax by T will result in a change in Y. By incorporating T and Y in equation Y
= 1/1-b(a-bT+I+G), the equilibrium level of national income may be expressed as Y+ Y = 1/1-
b(a-b(T+T)+I+G
Y+Y = 1/1-b(a-bT-bT+I+G)

Now subtract the equation Y = 1/1-b(a-bT+I+G)

from Y+Y = 1/1-b(a-bT-bT+I+G)
i.e. Y+Y = 1/1-b(a-bT-bT+I+G) = (Y = 1/1-b(a-bT+I+G)
Y = 1/1-b(-bT) -bT/1-b = -b/1-b T
The tax multiplier (Tm) can be obtained by dividing both sides of –b/1-bT by T.

Thus Tm = y/T = -b/1-b. T/T  Y/T = -b/1-b

We may compare the Tm and Gm. Since b = MPC and MPC<1,

[Tm = -b/1-b] < [Gm = 1/1-b]

By way of comparison, two points are important to note:

1. T-multiplier is smaller than G-multiplier.
2. The effect of taxation on the level of national income is negative whereas that of
government expenditure is positive.

4.3 THE BALANCED BUDGET MULTIPLIER

When G = T, the government budget is said to be BALANCED. The effect of balanced
budget on the national income is analyzed by balanced budget theorem or balanced budget
multiplier effect. The balanced budget theorem states that the Balanced Budget Multiplier is
Always Equal to One. That is why the balanced budget theorem is also called unit multiplier.

Proof:
Y = 1/1-b[a-bT+I+G]
By incorporating G and T (while G = T) and the resulting combined change in income
(y) the equilibrium level of income can be expressed as:
Y+Y = 1/1-b[a-b(T+T)+I+G+G]
Y+Y = 1/1-b[a-bT-bT+I+G+G]

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By subtracting Y = 1/1-b(a-bT+I+G) from the equation
Y+Y = 1/1-b[a-bT-bT+I+G+G]
 Y = 1/1-b[bT+G)
Since T = G, by substitution, we can rewrite
Y = 1/1-b(-bT+G) as Y = 1/1-b(-bG+G)
By multiplying both sides of the equations by 1-b, we get y(1-b)=-bG+G
 Y(1-b)/1-b = G(1-b)/1-b
Y = G

We can obtain a balanced budget multiplier (Bm) by dividing both sides of the equation ( y =
G) by G. That is Bm = Y/G G/G
3.
Y/G = 1
The balanced budget multiplier can also be obtained by adding up the G-multiplier and T-
multiplier. That is
Gm = 1/1-b, and Tm = -b/1-b
Bm = Gm+Tm = 1/1-b + -b/1-b = 1-b/1-b = 1
Thus the balanced budget multiplier (Bm) is equal to unity. It implies that if G=T, national
income increases exactly by the amount of increase in government expenditure.
Proportional Income Tax and the Balanced Budget Multiplier
Taxation system consists of the lump-sum and proportional taxes. The effect of balanced budget
with a lump sum and a proportional tax: -
T = T + ty
Where T = autonomous tax and t=the rate of proportional income tax, also called “marginal
propensity to tax” (MPT).

Y = a+b(Y-T)+I+G
By substituting this equation for T we can get
Y = a+b[Y-(T+(y)+I+G
= a+by-bT=b+y+I+G
= by-b+y+a-bT+I+G

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Y = y(b-bt)+a-bT+I+G
y-y(b=bt) = +a-bT+I+G
y(1-b+bt) = a-bT+I+G
1-b+bt 1-b+bt
Y = 1/1-b+bt [a-bT+I+G]

Now let the government expenditure increase by G causing increase in the national income by
y. The new equilibrium level of national income will be y+y=1/1-b+bt[a-bT+I+G+G]
Subtract the equation 1/1-b+bt[a-bT+I+G]
From 1/1-b+bt[a-bT+I+G+G]
y = 1/1-b+bt[G]
divide both sides of the equation by G. we can get the balanced budget multiplier with
proportional tax as:
y/G = 1/1-b+bt(G/G)

4 y/G = 1/1-b+bt

4.4 THE FOUR SECTOR ECONOMIC MODEL

The inclusion of foreign trade (Export-Import) to the three-sector makes the model a complete
four-sector economic model.
Export Function (x)
Export – a good service or capital asset which is sold to foreign
1. A good which is produced in the home country and which is then physically
transported to and sold in, an overseas market earning foreign exchange for the home
country is called a VISIBLE EXPORT.
2. A service which produced for foreigners either in the home country (for example,
visits by tourists) or overseas (for example, banking insurance) which likewise
generates foreign exchange for the home country is called an INVISIBLE EXPORT.
3. capital which is placed abroad I the forms Portfolio investment, foreign direct
investment (FDI) in physical and banking deposits is called a CAPITAL EXPORT.

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Export of a country depends on a number of factors including:
a. Prices of domestic goods in relation to those in other countries.
b. Tariffs and trade policies of importing countries.
c. Export subsidies.
d. Income-elasticity for imports in the importing countries.
e. Level of imports by the domestic economy and etc.

IMPORT FUNCTIONS (M)

Import – a good or (service) which produced in a foreign country and which is then physically
transported and sold in the “home market” leading to an outflow of foreign exchange from the
country is called “VISIBLE” Import. Imports of a country, like its exports, are determined by a
number of similar factors,
1. Import prices in relation to domestic prices;
2. The level of domestic tariffs;
3. Domestic trade policy and foreign economic relation;
4. Income-elasticity of imports;
5. The level of incomes (domestic income (y) and MPM;
6. The level of exports.

Import function is defined as M=M+gy. Where M=autonomous imports, g=M/y; factor g,

the marginal propensity to import (MPM), is assumed to be a constant.
The foreign trade multiplier
Y = C+I+G+(X-M)
Where C = a+by
I=I
G=G
X=x
M = m+gy
Yd = Y-T
By substitution, the equation Y = C+I+G+(X-M)
May be written as:
Y = a+b(Y-T)+I+G+X-(M+gy)

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 = a+by-bT+I+G+X-M-gy
Y = by-gy+a-bT+I+G+X-M
 Y-by+gy = a-bT+I+G+X-M
 Y(1-b+g) = a-bT+I+G+X-M
a-bT+I+G+X-M
1-b+g 1-b+g

Y = 1/1-b+g[a-bT+I+G+X-M]
The term 1/1-b+g is the foreign trade multiplier, when consumption and imports are both linear
function of domestic income.
Proof: Let exports (X) increase by X, while other variables remain constant. The equilibrium
level of national income will then be: -
Y+y = 1/1-b+g[a-bT+I+G+X-M+X], and subtract the equation
Y=1/1-b+g[a-bT+I+G+X-M]

From the equation y+y = 1/1-b+g[a-bT+I+G+X-M+X], y = 1/1-b+g[X], and divide both

sides of the equation, we get the foreign trade multiplier y/x as
5. y/x = 1/1-b+g[X/x]  y/x = 1/1-b+g

The equation y/x = 1/1-b+g shows that if b = g, then the foreign trade multiplier will be equal
to unity.

Foreign Trade Multiplier with Taxes Function (T)

Y = C+I+G+(X-M) Y = C+I+T+G+(X-M)
Where T = T+tyd, C = a+by
Y = a+b(y-T-ty)+I+G+X-(M+gy)
= a+by-bT-bty+I+G+X-M-gy

y = by-bty-gy+a+I+G+X-M-bT
y-by+bty+gy = a-bT+I+G+X-M
y(1-b(t-t)+g = a-bT+I+G+X-M
a-bT+I+G+X-M
1-b(1-t)+g 1-b(1-t)+g

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y = 1/1-b(1-t)+g [a-bT+I+G+X-M]

Let X increase by X, so y will also increase to y

Y+y = 1/1-b(1-t)+g [a-bT+I+G+X-M]

By subtraction y = 1/1-b(1-t)+g) from the above equation, we can get

y = 1/1-b(1-t)+g [X]
divide both sides of the equation by X

6. Y/X = 1/1-b(1-t)+g[X/x] = y/x = 1/1-b(1-t)+g

This is the foreign trade multiplier for a four-sector model economy in which consumption tax
and exports are linear functions of income.

The Government Budget Summary

Government budget is a financial statement of the government’s planned revenues and
expenditures for the fiscal year (usually one year).
The main sources of current revenues of the government are TAXATION principally income
and expenditure taxes, and National insurances contributions and etc.
The main current outgoings of government expenditure are the provisions of goods and services
principally wage payments to health, education, police and other public service employed) and
transfer payments (old age pensions etc.)

The use of the government budget

The main uses of the government budget are the following:
1. The government budget forms the basis of government’s long-run (term) financial
planning of its own economic and social commitments.
2. The government budget is the main instrument of fiscal policy in regulating the level and
composition of aggregate demand in the economy.
3. A budget shows (for a given year) the planned expenditures and exported receipts that
government’s spending and tax programs would yield. In a given fiscal year
governments usually run either budgetary surpluses or budgetary deficits. A BUDGET
SURPLUS occurs when all taxes and other revenues Exceed government expenditures.

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 A BUDGET DEFICIT is run when expenditures Exceed tax collections. When taxes and
other revenues.

4.5 THE MACRO MODEL AND THE FISCAL POLICY

According to the Keynesian View, fluctuations in aggregate demand are the major source of
economic disturbances. If demand could therefore be stabilized and maintained at a level
consistent with the economy’s full employment productive capacity, the major source of
economic instability would be eliminated. The Keynesian theory highlights the potential of
fiscal policy as a tool capable of reducing fluctuations in demand. When an economy is
operating below its potential output, the Keynesian model suggests that governments should
institute EXPANSIONARY FISCAL POLICY. In other words, the government should either
increase its purchases of goods and services and/or cut taxes. In a basic Keynesian model, a
reduction in current taxes financed by borrowing increases the current disposal income of
households. Given their additional disposal income, households increase their current
consumption. New classical economists argue that this analysis is incorrect because it ignores
the impact of the higher future taxes implied the budget deficit. The new classical economists
believe that there are strong forces pushing a market economy toward full employment
equilibrium and that macroeconomic policy is an ineffective tool with which to reduce
economic instability.

Automatic Fiscal Policy

Automatic Stabilizers: Built in features that tend automatically to promote a budget deficit
during a recession and a budget surplus during an inflationary boom. [Even without a change in
policy]. The automatic stabilizers are automatic in that, with out any new legislation action,
they tend to increase the budget deficit (or reduce the surplus) during a recession and increase
the surplus (or reduce the deficit) during an economic boom.

The major advantage of automatic stabilizers is that they institute counter cyclical fiscal policy
without the delays the inevitably accompany legislation. When unemployment is rising and
business conditions are slows these stabilizers automatically reduce taxes and increase
government expenditures, giving the economy a shot in the arm. On the other hand, automatics

84
stabilizers help to apply the brakes to an economic boom, increasing tax revenues and
decreasing government spending.

Methods of Automatic Stabilization (built-in-stabilizers)

1. Unemployment compensation. When unemployment is high, the receipts from the
unemployment compensation tax will decline because of the reduction in employment.
When the unemployment rate is low, tax receipts from program will increase because more
people now working. The amount paid in benefits will decline because fewer people are
unemployed. The program will automatically tend to run a surplus during good times.
2. Corporate Profit Tax. Under recessionary conditions corporate profits will decline sharply
and so will corporate tax payments. This sharp decline in tax revenue will tend to enlarge
the size of the government deficit.
During economic expansion, corporate profits typically increase much more rapidly than
wages income, or consumption. This increase in corporate profits will result in a rapid
increase in the tax take from the business sector during expansion. Thus, corporate tax
payments will go up during an expansion and fall rapidly during a contraction if there is no
change in tax policy.
3. Progressive Income tax. When income grows rapidly, the average personal income tax
liability of individuals and families increases. During an economic expansion, revenue
from the personal income tax increases more rapidly than income. Other things remain
constant, the budget moves toward surplus (or smaller deficit), even though the economy’s
tax rate structure is unchanged. On the other hand, when income declines, many
individuals will be taxed at a lower rate or not at all.
Income tax revenues will fall more rapidly than income, automatically enlarging the size
of the budget deficit during a recession.

Discretionary Fiscal Policy

Discretionary fiscal policy: - A change in laws or appropriation levels that alters government
revenues (Taxation) and/or expenditure. Keynesians urge the government to engage in
Discretionary Fiscal Policy, which involves conscious deliberate change in government demand
(G) and in tax rates(t) to achieve desired macroeconomic goals. Discretionary fiscal policy
requires changes in tax laws and government expenditure programs. It takes time to institute

85
 such changes; congress must act. Congressional committee must meet, hear testimony, and draft
legislation.
The principal weapons of discretionary fiscal policy programs which involve explicit public
decision making are: -
a. Public works and other expenditure programs
b. Public employment project programs
c. Tax rates varying tax rates can be sued to either stimulate or restrain an economy.
NB. Discretionary (active) fiscal policies occur when policy makers carefully watch trends,
forecast future developments, and change policies when the economy is not performing in a
satisfactory manner.

CONTRACTIONARY FISCAL POLICY – is a consciously designed decrease in government

demand or increases in the tax collections that aim to move the nominal GNP from its current
equilibrium level to a lower target level.

Table: Macro economics policy dilemmas

Policy Option Advantages Disadvantages
Monetary Expansionary 1. Interest rates may fall 1. Inflation may worsen
Policy 2. Economy may grow 2. Exchange rate may fall
3. Decreases unemployment 3. Capital out flow
4. Trade deficit may increase
Contractionary 1. Exchange rate may rise 1. Risks recession
2. Helps fight inflation 2. Increases unemployment
3. Trade deficit may decrease 3. Slows growth
4. Capital in flow 4. May help cause short-run
political problems
5. Interest rate may rise
Fiscal Expansionary 1. May be growth will continue 1. Budget deficit worsen
Policy (borrow and 2. May help solve short-term 2. Hurts country’s ability to
spend) political problems borrow in the future
3. Decrease unemployment 3. Trade deficit may increase
4. Upward pressure on interest
rate
Contractionary 1. May help fight inflation 1. Risks recession
(reduce deficit 2. May allow a better monetary 2. Increase unemployment
(fiscal mix 3. Slows growth
3. Trade deficit may decrease 4. May help cause short-run
4. Interest rate may fall political problems
Source David C. Colander: Economics
2nd ed. 1995 U.S.A. page 425

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Lowering Government Demand (G)

Example: Assume that an economy settled at an equilibrium nominal GNP of $2,500 billion per
year, but a desired GNP target of only $2,000 billion per year.
Consider an economy illustrated by these equations (in billions of dollars per year):
C = 500+0.6Dl
I* = 300
G = 500
DI = Y-NT
NT = 500

The Economy’s equilibrium GNP can be calculated as Y = 1  mpc c  mpc.NT  I  G 

1

Y = 1/1-MPC (C-MPC.NT+I*+G)
Y = 1/1-0.6[500-0.6(500)+300+500] =
Y = 2.5(1000) = 2500

To lower the nominal GNP to Y = 2,000, or by 500. Government demand must be cut by
500/2.5 = 200 because
y = 2.5(G)
-500 = 2.5(-200)

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RAISING THE INCOME TAX RATE, (t)
Consider the economy described by these equations (in billions dollars per year)
C = 500+0.6 DI
I* = 300
G = 500
DI = Y-NT
NT = 0.2y
The economy’s equilibrium GNP can be calculated as
Y= 1 [C+I+G]
1-MPC(1-t)

Y= 1 [500+300+500]
1-0.6(1-0.2)
Y = 1.923(1300)  1.923076923 (1300) = 2500
Y = 2499.9 = 2500

Given a target level of y = 2,000, we need, 2,000 = new multiplier (1,300) and, thus, a new
multiplier, of 2000/1,300 or our solution requires
1.5384615 = 1 = 1
1-MPC(1-t) 1-0.6(1-t)
= 1
0.4t.bt

The forgoing requires that

1.5384615(0.4+0.6t) = 1
 0.6153846+0.9230769t =1
 0.9230769t = 0.3846154
 t = 0.4166
To achieve its goal through tax rate changes alone, the government will have to raise the original
20 percent income tax rate (t = 0.2) to 41.67 percent (t=0.4166). if it does, the equilibrium GNP
changes to equal to
Y= 1 [C+I*+G)
1-MPC(1-t)

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Y= 1 [500+300+500]
1-0.6(1-0.4166
Y = 1 (1300)
0.65
Y = 1.538(1300) = 2000.05 = 2000.

Algebraic Expressions
1. Assume that the GNP of a country in the initial year is $3200 billion, and the
potential growth rate is 3.5% per year. Find the GNP of the country after 5 years.
Answer. 320 x3.5 x 5years = 560+3200 = $3760
$3760
100
2. Consider a closed economy described by the following equations:
Y = C+I+G
C = 400+0.9yd
With investment I=$400. government spending G=$100, and the tax rate (t) = 0.5.
a. What is the level of income when spending occurs?
Answer: Y = 400+0.9(y-0.5y)+400+100
900+0.9-0.45y
900+0.45y
 y-045 = 900
 y(1-0.45) = 900
 0.55y = 900
y = 1.818(900) = $1636
The multiplier is 1/1-0.45 = 1/0.55 = 1.818 = 2.00
b. Suppose the government spending increases to $200 billion. What is the new
level of income?
Answer. Y = 400+0.9(y-0.5y) + 400+200
= 1000+0.9y-0.45y
= y-0.45 = 1000
y(1-45) = 1000
 0.554 = 1000
y = $1818
$1818

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 1818-1636 = $182 income is increased by 182 billion USD.

3. Given that
Y = C+I
C = 500+3/4y
I = 300
Calculate the equilibrium value of y and find the size of the multipliers.
Answer: Y = 1/1-MPC .(C+I)
1/1-3/4 (500+300) = 1/1-0.75 (800)
Y = 1/0.25(800)  4(800) = $3200 = $3200
The multiplier is 4
4. Let the consumption function be given as
C = a+by and the saving function S=-a(1-b)y assuming that a=300 and b=0.65 Derive
the equations for C and S.
Answer: C = 200+0.65y
S = -200+0.35y
5. Enumerate the factors that influence the consumption demand
1) Disposal Personal income
2) People’s wealth
3) People’s expected income
4) The expected general level of price
5) The actual level of prices
6) Interest rates
7) People’s age
8) The prevailing attitudes towards thrifts and etc.

Check Your Progress

1. Consider a world described by the following equations:

C = 800 + 0.8 DI (Disposable income)
I = 500
DI = Y – NT (Net tax, Dump-sum)
NT = 800

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 a. Compute the equilibrium value of Y
b. Determine the value of the multiplier.

4.6 SUMMARY

 In three-sector model, the basic Keynesian model includes the government sector. Its
purpose is to explain the nature of fiscal policy, the deliberate manipulation of
government demand for commodities and service, G, of government transfer payments,
Tr and tax collections T, to influence the size the nominal GNP and ultimately, the
levels of real GNP, prices, employment and unemployment.
 Two sector Keynesian models that incorporate a government sector introduced. In
the first place the government impose the so-called lump sum taxes on private income,
which are taxes that are fixed at a given level independently of people’s income, and
that do not vary with the level of this income. The second introduces income taxes-
taxes that are sensitive to and vary with the level of income.
 The Keynesian income-tax model contains a built in tendency to moderate fluctuations
in the GNP. When a government collects income taxes from people and makes income-
related transfer payments to them, any decline in income causes an automatic decrease
in income tax collections and an automatic increase in transfer payments such as
unemployment benefits and public assistance. Any increase in income has precisely
opposite effects.
 The theory of fiscal policy is easy enough to understand, but fiscal policy must not be
expected to work perfectly and with precision. Its practical application is inevitably
hampered by the recognition lag, the administrative lag and the operational lag.
 In an open economy that is integrated with the rest of the world through regular trade in
goods and financial assets, the Keynesian theory of nominal GNP determination must
be modified to take account of export and import demands. The difference between the
two, net export demand, corresponds to the balance of current account in the country’s
balance of payments.
 The effectiveness of both fiscal and monetary policy in an open economy differs from
that in a closed economy. In an open economy with flexible exchange rates, fiscal
policy is less, effective and monetary policy is more effective than a closed economy.

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 This is so because fiscal and monetary policies affect interest rates, which, in turn affect
the exports and imports of financial assets and thus, exchange rates and net export
demand.

4.7 ANSWERS TO CHECK YOUR PROGRESS

a. In equilibrium
Y= 1 ( c – MPC . NT + I +G)
1-MPC
Where C – autonomous consumption
MPC - Marginal propensity to consume
NT – Lump sum tax (fixed)
I - Investment spending
G - Government spending
Y= 1 (800 – 640 + 500 + 600)
1-8
Y= 5 (1, 260) = 6300
Proof C = 800 + 0.8 (6300-800)
= 800 + 4400 = 5200
I = 500 G = 600  C + I + G = 5200 + 500 + 600 = 6300
b. The multiplier
Multiplier = 1
1-0.8
= 5

4.8 KEY WORDS

1. Fiscal Policy: The use of government taxes and spending to alter macroeconomic
outcomes.
2. Equilibrium GNP: The rate of output at which desired expending equals the rate of
production.
3. Government budget: a financial statement of the government’s planned revenue and
expenditures for the fiscal year.

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4.9 MODEL EXAMINATION QUESTION

1. Consider the following information and answer the question below

C = 500 + 0.6DI
I = 300
G = 500
NT = 0.2y
a) Calculate the economy’s equilibrium GNP
b) Find the multiplier

4.10 REFERENCES

 Edward Shapiro, (1999) Micro Economic Analysis Galgotia Publications, New Delhi.
 William H. Branson (1998), Macroeconomic Theory and Policy, A.I.T.B.S. Publishers, New
Delhi.
 Gupta, R.d. and Rana, A.S., (1993), Keynes, Part-Keynesian Economics, Kalijanti
Publishers, New Delhi.

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UNIT 5: INTEREST AND MONEY

Contents
5.0 Aims And Objectives
5.1 Introduction
5.2 Evolution of Money
5.2.1 Barter Economy
5.2.2 Primitive Money
5.2.3 Commodity Money and Representative Commodity Money
5.3.4 Types of Money
5.3 Function of Money
5.4 Demand for Money
5.4.1 Transitive Motive
5.4.2 Primitive Motive
5.4.3 Speculative Motive
5.5 Supply of Money
5.5.1 Determinant of Money Supply
5.6 The Role of Interest Rate in an Economy
5.6.1 Determining Interest Rate
5.6.2 Nominal Rate
5.6.3 Interest rate in an Economy
5.6.4 Income and Interest Rate
5.7 Summary
5.8 Answers to Check Your Progress
5.9 Key Words
5.10 Model Examination Question
5.11 References

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5.0 AIMS AND OBJECTIVES

Aims
In this unit the meaning evolution and functions of money in a modern economy will be
explained. The concepts of the demand and the supply of money will also be discussed. As we
shall see, this is an area which has been central to the most fundamental controversies in
macroeconomics. The unit assesses the field of monetary theory and policy that many of the
differences between Keynesians and monetarists are debated.

Objectives
After learning this unit, you will be able to:
- explain the concept of money and describe the functions of money.
- outline the functions of a central bank.
- outline the Keynesian theory of money and identify the factors that influence the
transactions precautionary and speculative demands for money.
- analyze the effect of change in money supply on the equilibrium rate of interest in the
Keynesian model
- analyze the monetarist vies of the effects of a change in money supply on the rate of
interest and level of money national income.
5.1 INTRODUCTION

Money is any generally accepted commodity chosen by common consent to serve as a medium
or instrument of exchange of goods and services among people. Money is widely accepted in
payments and in settlement of debts. It is accepted customary without special test of its quality
and quantity.

A money economy is the alternative to a barter economy. The genesis of money lies in the
extreme inefficiency of barter system of exchange in an economy that develops beyond the most
primitive methods of production. Barter, of course, is a system wherein one good is exchanged
directly for another.

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5.2 EVOLUTION OF MONEY

5.2.1 Barter Economy

In a primitive economics, wherein families provide most of their own needs and the exchange of
goods is held to a minimum, a barter system may be quite appropriate. However, the production
developed there was an increasing division and specialization of labor, and hence increasing
trade or exchange of goods and services. A system of barter becomes increasingly wasteful of
time and effort, complicated, and naturally inhibitory of many kinds of (financial) transactions.
The disadvantages of barter may be grouped as follows:

a) Lack of double coincidence of needs in markets.

b) Absence of a common unit or a common denominator, in terms of which the prices of
the various items to be traded can be expressed.
c) Lacks of credit sales and purchases due to disagreement in future payments.
d) Difficulty of holding wealth or generalized purchasing power to storage costs to be paid
and the possibility of deterioration.

5.2.2 Primitive Money

There have been almost as many different symbols used as money as there have been societies
using them. The most familiar in history are animal bones and giraffe tails, gunpowder and salt,
and stones and strings of shells.

What do all these symbols have in common? Certain characteristics are common to all money in
some degree. For a substance to serve as money it must be relatively rare, it should be easily
carried and stored without spoiling; and it should be divisible into smaller portions for making
small payments. The commodity that best exemplifies these characteristics is precious metal.

5.2.3 Commodity Money and Representative Commodity Money

Money that is valuable is itself apart form its value as money is called commodity money. Using
gold, silver, and tobacco in exchange is an example of commodity money. Desirable commodity
money should possess several characteristics:
a) It should be easily verifiable

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 b) It should be intrinsically useful
c) It should be conveniently transportable
d) It should be divisible

5.2.4 Types of Money

Fiat Money – Something that has little value as a commodity but, because of law or tradition, is
accepted as a medium of exchange. A yap stone is accepted in exchange for useful goods and
services solely because its recipients are confident that they will also be able to exchange the
stone for goods and services. Another example of Fiat Money could be paper money. The paper
they are printed on has almost no value. But the government says that this paper money is legal
tender, suitable for paying its bills and collection of taxes.

Credit Money (Bank Money) – Almost side by side with paper money credit money emerged.
Modern monetary systems are not based on a useful commodity like gold or silver, but on credit.
Credit money has no value apart from its value in exchange. It is accepted by sellers because
they know it will be accepted by other sellers with whom they trade.

Commodity Money – Used as a medium of exchange and also in bought and sold as an ordinary
good. Eg. Cocoa, gold

Token Monies – Those means of payments whose value or purchasing power as money exceeds
the cost of production and the value in alternative uses. Eg. Dollar bills and coins

Legal tender (Fiat money)– money that the government has declared acceptable in exchange
and as a lawful way of paying off debts. Eg. Means of payment accepted by the government;
pay taxes; own currency.

5.3 THE FUNCTIONS OF MONEY

Money is used as a link between the world’s producers and the world’s consumers. It enables
people to consume or own things they did not produce, and it encourages people to produce
things they do not intend to consume.

It is generally agreed that money performs four functions:

a) Functions as a medium of exchange

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 b) It serves as a unit of account or measure of economic value.
c) Serves as a standard of deferred payments, i.e., payments that are deferred to the future.
d) Money can be held as a store of value; a store of liquid wealth.

Different measures of money and near-monies

Money Broader monetary
Aggregates
M1 M2 M
 Currency X X X
 Checkable deposits at banks X X X

 Traveler’s checks X X X

 Saving and small time deposits* X X

X X
 Money market mutual fund shares
X
 Large time deposits
X
 Treasury securities, bonds, other

IOU monies – a medium of exchange based on the debt of a privates firm or person.

5.4 DEMAND FOR MONEY

Demand for Money arises from the need to satisfy the necessities. Commodities are demanded
because these goods have utilities. Money has no utility. Why is the money demanded?

Money is demanded for two reasons:

a) To help in exchange of goods and services
b) To be held as an asset (as wealth)

The first is called transact demand for money, and the second is called asset demand for money.

The 1st is the volume of money needed during a given period of time to serve as a medium of
exchange of goods and services and the 2nd is also needed as a form of wealth and it can be
conveniently converted to any form of wealth.

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Keynes calls it as “liquidity preference”. Keynes and other economists state three major reasons
for people to demand or hold money: -
- Transactions Motive
- Precautionary Motive, and
- Speculative Motive

5.4.1 Transactions Motive

The transactions motive for holding money refers to the amount of money demanded for the
day-to-day (normal) transactions.

The total volume of money needed for transactions purposes during a given period of time by an
economy depends on:
- The level of national income and employment
- The general price level

5.4.2 Precautionary Motive

In addition to the normal (day-to-day) transactions, money is also needed for unforeseen
(unexpected) transactions.

These are sums of money to provide protection in the event of emergency. The volume of
money required to satisfy precautionary purpose varies from business to business depending on:
- The nature of their business
- Their access to the credit market
- The case with which they can convert their securities to cash when emergencies arise.

In the event of war or rumor of war, the precautionary demand for money increases. In general
the volume of money demanded for transportation purpose depends on the level of national
income and is a stable function of the latter.

Lt and P = K(Y) – Where Lt and P is transactions and precautionary demand for money,
Y – is national income
K – represents a fraction of national income to be kept for Lt and P.
L = Demand K = Fraction

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T = Transaction P = Precautionary

5.4.3 The Speculative Motive (Asset Motive)

Keynes defines the speculative motive as “the desire of earning profit by knowing better than
the market, what the future will bring forth.”

People like to hold those assets, which they expect their prices to increase in the future and
hesitate to hold those securities that they expect their prices to decline in the future. People who
like to hold their wealth in the form of either securities or money are influenced by:
a) The rate of interest
b) Their anticipation regarding the present and future prices securities.

How much money people will hold depends on:

a) The present rate of interest
b) The future rate of interest
c) The present and future prices of securities

The speculative demand for money is a negative function of the rate of interest. That is Ls = L(r)

Ls = Speculative demand for money

r = Rate of interest
5.5 SUPPLY OF MONEY

The supply of money is a stock at a particular point of time. The supply of money at any
moment is a total amount of money in the economy.

The three alternative views regarding the definition of money supply is associated with the
traditional and Keynesian thinking

a) The medium of exchange function of Money

- Currency with the public, and demand deposit with commercial banks (M1)
Demand Deposit with Commercial Bank includes:
- Saving Accounts
- Current Accounts that is deposited in commercial bank.
b) By Friedman and associated by modern quantity theorists, the supply of money includes:

100
 - Number of dollars people carrying around in their pockets.
- The number of dollars they have to their credit at the banks in the term of demand
deposit and time deposit in a commercial bank.

M1 + Time deposit = M2
M2 in America
M3 in Britain

N.B. It is verbal expression for M1 + Time deposit in different countries.

It is stated that the supply of money includes M2 + Deposit of saving banks building societies.
- Loan Association
- Deposit of other credit and financial association.

N.B. M2 includes M1 + Time deposit

5.5.1 Determinants of Money Supply

Money supply is determined by the following factors:

a) The required reserve ratio

The required reserve ratio or the minimum cash reserve ration on the reserve deposit ratio on the
reserve deposit ratio is an important determinant of the money supply. An increase in the
required reserve ration reduces the supply of money with commercial banks and a decrease in
required reserve ration increases the money supply. The reserve ration is the ratio of cash to
current and time deposit liabilities, which is determined by law.

Commercial bank is required to keep a certain percentage of these liabilities in the form of
deposit with the central bank of the country.

b) The Level of Bank Reserve

The level of bank reserve consists of reserve on deposit with the central bank and currency in
their vaults. It is influenced by central bank because the central bank required all commercial
bank to hold reserve equal to a fixed percentage of both time and demand deposit that is set by
the central bank.

101
The bank reserve is determined by the required reserve ratio. Thus, the higher reserve ration, the
higher the required reserve to be kept by a bank and vise versa. But the supply of money is
determined by the excess reserve that is kept by the commercial bank. It is the difference
between total reserve and required reserve. How you know the required reserve is the result of
the fixed percentage ration that must be kept in the central bank. When the required reserve
decreases, excess reserve will increases as the result of the supply of money increases and vice
versa.

c) Open Market Operation (OMO)

When the central bank buys the securities, bonds, the result will be an increase in the level of
bank reserve. It also increases money supply and the sell of securities, and bonds by central
bank decreases the level of bank reserve.

The Discount Rate: A high discount rate means commercial bank gets less amount by selling
securities to central bank. Thus, there will be contraction of credit and the level of commercial
bank reserve.

d) Publics’ desire to hold currency and deposit

If people are in the habit of keeping less in cash and more in deposit with commercial bank, the
money supply will be large. This is because banks can create more money with larger deposit.
The vise versa holds the reserve.

High Powered Money – It is the sum of commercial bank reserve and currency (notes and coins)
held by the public. High-powered money is the base for the expansion of bank deposits and
creation of money supply.

Alternative Demand for Money

A) Quantity theory of money: -

This theory holds that the supply of money in any given economy has a direct relationship with
the price level. The value of money fluctuates whenever price levels rise or fall. This theory also
states that the value of money depends upon the supply of money in the economy. For instance
whenever the quantity of money is doubled all other things being constant, the price level also

102
doubled. This theory is an extension of the original quantity theory, which is an attempt to
explain and predict the changes in velocity of circulation of money.

B) Income theory of money: -

Income theory of money states that other factors which govern the change in the price level
other than the quantity of money like income, consumption, savings and expenditure. For
example as income increases, the expenditure and effective demand will increase bringing about
an increase in the general price level of an economy.

The same is true for savings. The larger the volume of saving the lower is the volume of
expenditure thus a decrease in demand and a fall in the price will occur. On the other hank,
investment means a rise in expenditure, increase in demand and a rise in the price levels.

The price level or the value of money depends more up on the levels of income and expenditure
in the economy rather than upon the quantity of money. Therefore, it can be concluded that this
is the main reason why fiscal policy, which uses expenditure and tax for economic stability is
more effective than monetary policy, which uses interest and money supply as controlling
instrument.
5.6 THE ROLE OF INTEREST RATE IN AN ECONOMY

Interest rate is the price paid for the use of money. It refers to the amount of money that must be
paid for the use of one Birr for a period of one year. It is mostly stated as percentage of the
amount of the initial money used called principal.

5.6.1 Determining Interest Rate

Interest rate is an extremely important economic indicator that simultaneously affects both the
level and composition of investment goods production. The following curves show how the
demand for and the supply of money determine the equilibrium interest rate, that in turn
aggregate investment expenditures.

103
 Expected rate of net profit, r%
Sm

Real rate of interest, i and

Real rate of interest, i %

9
7

6 7
Dm
6

Investment
3

3
Demand
0

1 2 3 4 5 0.5 1.0 1.5 2.0 2.5

Amount of money Demanded and Amount of investment
Supplied (Bill. Birr) (Bill. Birr)
(a) Money Market (a) Investment Demand
Fig.1: Money market and investment spending of a certain model economy.

The intersection between Sm and Dm at 3 billion Birr i.e., at their equilibrium, the market
interest rate at 7%, Fig 1(a). This equilibrium interest rate in turn determines the amount of
investment demand, 1.0 billion Birr, Fig 1 (b).

The total demand for money Dm curve is down ward slopping while the supply of money, Sm
curve is a vertical line on the assumption that the monetary authorities determine some stock of
money independent of the rate of interest. The intersection of demand for money curve and the
money supply curve determines the equilibrium rate of interest, which is 7% in this particular
case.

5.6.2 Nominal and Real Interest Rates

The above discussion of the role of interest rate in the investment decision assumes no inflation.
The nominal interest rate is the rate of interest expressed in the current value of money. The real
interest rate, on the other hand, is the rate of interest expressed in constant or inflation adjusted
value of money.

5.6.3 Interest Rate in an Economy

104
Fig. 1(b) shows that, other things being equal, a change in the equilibrium rate of interest will
move business along the aggregate investment demand curve, changing the level of investment
and the equilibrium level of GDP.

The monetary authorities purposely manipulate the money supply to influence the interest rate
and thereby levels of out put, employment and prices. Low interest rate monetary policy
increases investment and expands the economy while a high interest rate monetary policy
chokes off investment and constrains the economy.

Interest rate is a device to the process of allocation of money capital and thereby physical capital
to various firms and investment projects. It rations the available supply of money to investment
demands whose expected profitability is sufficiently high to warrant payment of the interest rate.
If the expected rate of net profits of additional physical capital is greater than the interest rate to
secure the required funds, then the firm, in terms of profit, will be able to borrow and expand its
physical facilities. In such a way, interest rate allocates money, and ultimately physical capital to
chose industries in which it will be most productive and therefore most profitable.

5.6.4 Income & Interest Rate (Demand side equilibrium)

Demand side equilibrium refers to the equilibrium values of interest rate and of output
demanded by consumers, business firms and government at a given price level. This can be
mathematically expressed using two equations expressing equilibrium conditions in the product
market and money market, in three variables: the level of income, Y; the interest rate, r; and the
price level, P.

Check Your Progress

Part I. Fill in the black

1. __________is means of payments whose value or purchasing power as money exceeds the
cost of production and the value exceeds in alternative users.
2. __________ is a medium of exchange based on the debt of a private form or person.
3. __________, __________and __________ are the major reasons for people to hold money.
4. __________ is the ratio of cash to current and time deposit liabilities.

105
5. __________theory states that the supply of money in an economy has a direct relationship
with the price level.

Part II. Choose

1. The reserve ratio is determined by

a. Demand and Supply
b. Law
c. Commercial bank
d. IMF
2. The sum of commercial bank serve and currency held by the public is called _________
a. Fiat money
b. Precautionary motive
c. The discount rate
d. High Powered money
3. Which of the following is not the characteristics of commodity money.
a. It should be intrinsically useful
b. It should be conveniently transportable
c. It should be indivisible
d. None of the above
4. The total volume of money needed for transactions by an economy in a given period of
time depends on
a. the general price level
b. Token monies
c. The level of national income & employment
d. A and C
e. B and C
5. When the central bank buys bonds the result will be-
a. Decrease in the level of bank reserve
b. Increase in the level of bank reserve
c. The rate of interest decreases

106
5.7 SUMMARY

 Money can be defined as an asset that is generally acceptable a means of payment for
goods and services. In a developed financial system, there is a range of financial assets
that may be used as a means of payment.
 A central bank performs a number of important functions, including the implementation
of monetary policy and the control and supervision of the banking system.
 Keynes divides the demand for money into three types: The transactions, precautionary
and speculative demands for money. In the Keynesian liquidity preference theory,
interaction of the demand and the supply of money determine the equilibrium rate of
interest.
One of the main differences between monetarists and Keynesian concerns their analysis of the
effect of an increase in the money supply. In the Keynesian model, wealth holders attempt to
spend excess money balances on bonds, and so force down interest rates. In the monetarist
model, wealth holders attempt to spend their excess balances on all types of assets, including
goods: this causes both a fall in interest rates and an increase in either the output or prices of
goods and services.

5.8 ANSWERS TO CHECK YOUR PROGRESS

Fill in the blank

1. Token money
2. OIU monies
3. Transaction, Speculative, Precautionary
4. Reserve ratio
5. Quality theory of money.
Choose
1. B
2. D
3. C
4. C
5. C

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5.9 KEY WORDS

 Money – Anything generally accepted in exchange for other things within more or less
definite areas; hence a customary medium of exchange.
 Money demand (MD) – the dollar amount of their assets that people wish to hold in the form
of money
 Money supply (MS) often referred to as M1, merely includes coins and paper bills – jointly
referred to as cash or currency – and checking accounts. The wider definition includes a
number of other items to M1 on the grounds that they are similar to checking accounts or
can easily be converted to such accounts with only little delay (Eg. Savings deposits, time
deposits, money market mutual fund balances etc.)
 Interest – A sum paid or calculated for the use of capital. The sum is usually expressed in
terms of a rate or percentage of the capital involved.
 Nominal interest rate – the rate of interest expressed in the current value of money.
 Real interest rate – the rate of interest expressed in constant or inflation adjusted value of
money.

5.10 MODEL EXAMINATION QUESTIONS

1. Discuss the main disadvantages of an economy in which incomes are paid in kind and
transactions are carried out by barter.
2. Describe the methods available to a central bank to control the supply of money in an
economy.

5.11 REFERENCES

 C. R. McConnel, S. L. Brue (1996), Economics: Principles, Problems and Policies, 13 th

Ed., McGraw Hill INC. USA.
 John Sloman (1994), Economics, 2nd Ed., Harvester Wheatsheaf, U. K.
 Lioyd G. Reynolds (1997), Macroeconomics: Analysis and Policy, 6 th Ed., Universal
Book Stall, India.
 William H. Branson (1996), Macroeconomics Theory and Policy, 2 nd Ed., Universal
Book Stall, India.

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UNIT 6: GENERAL EQUILIBRIUM OF PRODUCT AND MONEY MARKETS

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Equilibrium of the Product Market
6.3 Equilibrium in Money Market
6.4 General Equilibrium of Product and Money Market
6.5 Shift in the IS Curve
6.6 Shift in the LM Curve
6.7 Simultaneous Shifts in the IS and LM Functions
6.8 Worked Example
6.9 Summary
6.10 Answers to Check Your Progress
6.11 Key Words
6.12 Model Examination Questions
6.13 References

6.0 AIMS AND OBJECTIVES

Aims
This unit combines the theory of income and output and theory of money and interest in a two
market equilibrium model pulls together the various stands that have been described so far and
integrate into a coherent general model in which the equilibrium level of income and the
equilibrium rate of interest are determined simultaneously. The unit demonstrates the derivation
of IS and LM curves step-by-step using graphic illustration. Algebraic derivation of the
equations of IS and LM curves, calculation of the equilibrium rate of interest and the
equilibrium of level of national income are discussed with worked out examples.

OBJECTIVES
After learning this unit, you will be able to:
 Explain what goods markets and asset markets and their interaction.

109
  Define and know the core of modern macroeconomics that is the IS-LM curves and their
derivations as well as the calculations of the general equilibrium in the IS-LM model.

6.1 INTRODUCTION

This unit integrates money, interest and income into a general equilibrium model of product and
money markets in the Hicks-Hansen diagrammatic framework known as the 15 – LM model.
The term 15 is the short hand expression of the equality of investment and saving which
represents the product market equilibrium. On the other hand, the term LM is the short hand
representation of equality of money demand (L) and money supply (M) and represents the
money market equilibrium. In order to analyze the general equilibrium of product and money
markets, it is instructive to study the derivation of the 15 and LM function and their slopes for
the understanding of the effectiveness of monetary and fiscal policies.

The general equilibrium approach is used to build a theory explaining movements in output,
employment and price. So product market for goods and services and money market jointly
determine the equilibrium level of output, price or interest rate. Product market is a market
where the households exchange money for goods and services provided by the firms. On the
other hand, money market is also a market in which a financial asset with maturity of less than
one year are bought and sold.

In general, these two markets interact with each other and what happens in our market affects all
markets in a general equilibrium framework.

6.2 EQUILIBRIUM OF THE PRODUCT MARKET

1. Equilibrium in the product market

Product Market: - are the forces created by buyers and sellers that establish the prices and
quantities of goods and services.

The product market is in equilibrium when the desired saving and investment are equal. Saving
is a direct function of the level of income, S = f(y) --- (1),
Investment is a decreasing function of the interest rate, I = f(R) --- (2)
From (1) and (2), we have S=I

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So product market equilibrium is defined by an equality between saving and investment. At the
level of income at which S = I (in a simple two sector model) the leakage in the form of
investment – aggregated demand for goods is Just equal to the aggregate supply. For some
purpose an economy is divided in two sectors. These are the monetary sector and the good or
product sector. The two sectors are inter related but for the general equilibrium of the economy
they must also be separately in equilibrium. For the monetary sector the rate of interest in
equilibrium and the level of income must be such that the supply of money equals the demand
for it (M=L). The product sector is in equilibrium at a condition when saving equal to
investment (S=I) realizing the rate of interest and the level of income. We can also see this inter-
relationship through what HICKS call the IS curve.

The IS curve reflects the equilibrium of the product market. It shows the combination of interest
rate and income levels where saving, investment equality takes place so that the product market
of the economy is in equilibrium.

It is also known as “real Sector” equilibrium. Saving and investment are always equal but only
when the full multiplier effects has been reached and saving and investment in equilibrium. At
this point actual saving equal normal saving as determined by the normal propensity to save.

Derivation of the IS curve

The term IS is the short hand expression of the equality of investment and saving, which
represents the product market equilibrium. In order to analyze the general equilibrium of
product and money market, it is instructive to study derivation of the IS and LM function and
their slopes for understanding of effectiveness of monetary and fiscal polices. The derivation of
the IS curve is shown in the figure panel (A). The saving curve S in relation to income is drown
in a fixed position on the Keynesian assumption that the rate of interest has little effect on
saving. The saving curve shows that saving increases as income increases.

Investment on the other hand, depends on the rate of interest and the level of income. Given a
level of interest rate, the level of investment rises with the level of income. At a 5 percent rate of
interest, the investment curve is I2
If the rate of interest is reduced to 4 percent the investment curve will shift upward to I3

111
 S
(A)

Saving/Investment
E3 I3 (r = 4%)
E2 I2 (r = 5%)
E1
I1 (r = 6%
0 Y1 Y2 Y3
Income
Y
A
6
B
5
Rate of interest

C
4

IS

0 Income
100 200 300

(B)
Thus, the investment curve I3 shows more investment at high level of income. Similarly when
the rate of interest raised to 6 prevent, the investment curve will shift down ward to I 1. The
reduction in the rate of investment is essential to raise the marginal efficiency of capital to
equality with the higher interest rate. In panel (B) we drive the IS curve by marking the level of
income at various interest rate. Each point on this IS curve represents a level of income at which
saving equals investment at various interest rates. The rate of interest is represented on the
vertical axis and the level of income on the horizontal axis. If the rate of interest is 6 percent.
The S curve intersects the I1 curve at E1 which determines OY1 income. From this income level
which equals RS 100 croves we drawl a dashed line down ward to intersect the extended line
form 6 percent at point A. At interest rate 5 percent the S curve intersects the I 2 curve at E2 so as
to determine OY2 income (RS 200 croves). In the lower figure, the point B corresponds 5
percent interest rate and RS 200 covers income level. Similarly, the point C corresponds to the
equilibrium of S and I, at 4 percent interest rate by connecting these points A, B and C with a
line. We get IS curve. The IS curve slopes down ward from left to right because as the interest
rate falls, investment increases and so does income. In other words, there is a negative
relationship between income and interest rate in the real sector of the economy.

6.3 EQUILIBRIUM IN MONEY MARKET

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What is money market?

Money market is a market in which financial assets with maturity of less than one year are
bought and sold. Like all markets, the money market has two sides a demand side and a supply
side.

The demand for money

Demand for money is the quantities of money people are willing and able to hold at alternative
interest rates, other things remain constant. The decision to hold money balance is called a
portfolio Decision.
Decision. There are many good reasons to hold money balance that pays little or no
interest rate. Such as:
 Money hold for the purpose of making everyday market purchases so money is needed
either in cash a positive checking account balance form called transaction demand
 Money hold for emergencies or an unexpected market transactions called precautionary
demand and
 Many hold for speculative proposes for later financial opportunities.

These three reasons for holding money combine to create a market demand for money. For
example the person who holds $1,000 in cash gives up the opportunity to purchase a 1,000 asset
(for example Bond) that yields interest. Thus, the interest rate is the opportunity cost of holding
money.

Therefore, to illustrate the demand course for money balance. As the interest rate increase, The
opportunity cost of holding money increases and individuals choose to hold less money as the
interest rate decreases, the opportunity cost of holding money decreases, and individual choose
to hold more money.

Demand curve for money

i2
Interest Rate

i1

0
The Supply for
M2 Money
M1

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The supply/or nominal quantity, of money (M) is determined by central bank. So we take it as
given at the level M (constant) Central Bank is responsible for regulation of the nation’s
financial system, its primary responsibility is to secure the integrity of the money supply – not to
allow the money supply to grow so quickly that the value of money declines ant inflation ensure
or not allow a too slow growth of the money supply to constrain the growth of the real economy.
Interest Rate

Supply curve for money

Quantity of money

The Money Market Equilibrium

Money market is in equilibrium when the demand and supply of money are equal.

Since the supply of money is fixed, if the demand for money is higher or lower than the supply
of money, then the adjustment has to take place in money demand. If there is less or more
money demanded than available, the actions of money holders in trying to acquire or get rid of
money will bring about change in the rate of interest and hence in the quantity of money
demanded so as to have money holders satisfied with holding the fixed amount of money
available.

In the money market, the interest rate adjusts to bring money demand into equilibrium with
money supply.

The following graph shows money market equilibrium. The money supply is set by the central
bank, so it is shown as a vertical line money demand is shown as depending on the interest rate,
with the level of income, Yo taken as given. The graph shows that the supply of money and the
demand for money are equal at the interest rate (point A).

Excess supply of money

Money demand < Money supply

r2
C C
r0
r1 A
Interest Rate

B 114
B Excess demand of money
Money demand > Money supply
Money supply and demand Y0
 Money supply is fixed and money demand is for a given level of income (Yo). When the
interest rate is r1 (lower than r0), the amount of money demanded exceeds the amount of money
supplied (point B to point B1), at the level of income (Yo). We have an excess demand for
money because the interest rate is too low. When the amount of money demanded exceeds the
amount of money available, every one wants more money than is available.

Households and companies try to readjust their portfolios to increases the amount of money they
have and reduce the amount of bonds. They can do this by selling bonds or by buying fewer
bonds. But since no more money is available, the only effect of this attempted readjustment is
that the interest rate in bonds will rise.

LM CURVE
The LM curve shows all combinations of interest rate and levels of income at which the demand
for and supply of money are equal. In other words, the LM schedules show the combination of
interest rates and levels of income where the demand for money (L) and the supply of money
(M) are equal such that the money market is in equilibrium. The LM schedule (curve) is upward
sloping because the higher the level of income, the greater has to be the interest rate that will
bring money demand back down into equilibrium with a fixed money supply.

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 B Money supply = Money demand at r2 and y2
r2
A Money supply = Money demand at r0 and y0
r0
C
r1
Money supply = Money demand at r1 and y1

Income
Y1 Y0 Y2

The money market at all points along the LM curve

There are three levels of income (Yo, Y1, and Y2) associated with three different interest rate (ro,
r1, and r2) In all case, the demand for money equals the supply of money. The diagram shows the
pairs of equilibrium income and interest rate (point A, B, C) along a line called the LM curve.

Deriving the LM Curve

The LM curve is derived from the Keynesians formulation of liquidity preference schedules and
the schedule of money, A family of liquidity preference curves L 1 Y1, L2 Y2 and L3 Y3 is drown
at income levels of Rs 100 crores, Rs 200 crores & Rs 300 crores respectively in figure “A”
These curves together with the perfectly inelastic money supply curve M given as the LM curve.
The LM curve consists of a a series of points, each point representing an interest income level at
which the demand for money (2) equals the supply of money (M). If the income level is Y 1,
demand for money equals the money supply at interest rate R 1. At Y2 income level, and the QM
curves equal at R2 interest rate, salary at Y3 income level, the L3 Y3 and QM curve equal at R3
interest rate. By extend a dashed line horizontally to the right so as to meet the drown upward
from Y1 and K in figure “B” point S and T can also be determined in similar manner. By
connecting these points S & T. We can get LM curve. This curve relates different income levels
to various interest rates.

LM
L3

L2 T
Rate of Interest

R3 Y3(300)
E3 S
R2 L1
Y2(200) K
E2
R1 E1
Y1(100) 116
 Y1 Y2 Y3
Demand and supply of money
Income
Fig. “A”
Fig. “B”
The LM curve slopes up ward from left to right because given the supply of money, an increase
in the level of income increases the demand of money which leads to higher rate of interest.

6.4 GENERAL EQUILIBRIUM OF PRODUCT AND MONEY MARKET

The general equilibrium is existed only when the equilibrium pairs of interest rate and income of
the IS curve equal the equilibrium pairs of interest rate and income of the LM, curve. In other
words when there is a single pair of interest rate and income level in the production and money
markets, the two markets are in equilibrium. On figure – the equilibrium position is where the IS
and LM curves intersect at point E relating Y level of income to R interest rate. This pair of
income level and interest rate shows a simultaneous equilibrium in the real or good (saving
investment) market and the money (demand and supply of money) market. This general
equilibrium position persists at a point of time and given price level. If there is any deviation
from this equilibrium position, certain force will act and react in such a manner that the
equilibrium will be restored.

R1 B
D
E
R
Interest Rate

R2 A C

117
 Income
Y1 Y Y2

On point A on the Lm curve the money market is in equilibrium at Y 1 income level and R2
interest rate but not product market because of the lower interest rate R 2. The product market
will become in equilibrium at Y1 income level when there is a higher interest rate R1 at point B
on the IS curves a result there is excess of investment than saving at point A Since point A lies to
the left of the IS curve. Also when there is excess of investment (I) over saving (S) there will be
excess demand of goods and it increases the level of income. This increase rises the needs for
transactions purposes and it will rise the interest rate, This moves the LM – equilibrium from
point A upward to point E which is a combination of higher interest rate R and higher income
(level Y exists).

This point also refers rising interest rate reduces investment and an increase in income rise
saving and help to reach the equality of I and S where the general equilibrium is reestablished
by the equality of IS and LM.

On the other hand when we come to point C on the IS curve in the above figure it is a product
market equilibrium at R2 interest rate and Y2 income level. But the money market is not in
equilibrium (its equilibrium is at Y2 income level and only at a higher interest rate R 1 at point D
on the LM curve). Point C is a point where the demand for money at R 2 than required to
equalize L and M. Therefore, there is excess demand for money at R 2 interest rate and will
introduce people to sell bonds while there is less demand for bonds.

So that it tends to rise the interest rate and the product market will become disequilibrium
because of the investment decline. This will result the falling of income and saving so the
equilibrium of product market will be at point E when I=S also the decrease of income reduces
the transaction demand for money and leads to the equality of LM at point E where the
equilibrium is restored by the equality of IS and LM curves of R interest rate and Y income
level.

Change in General Equilibrium

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The general equilibrium of the product and money market mentioned on the above section is
based on static equilibrium analysis.

However, the general equilibrium combination of Y level of income and R interest rate may
vary due to a shift in IS function of shift in LM function or shift of both functions. The IS
function may shift due to changes in the saving or investment functions. Where as the shifts in
the LM function may caused by changes in the money supply or liquidity preference (demand
for money) functions.

According to the following figure, the shift of the IS curve to the right (from IS to IS 1) is
because the autonomous investment increase (or reduction in saving) and the new equilibrium
will be at point E1. The new equilibrium point shows a higher level of income Y 1 at a higher
interest rate R1. The increase of interest rate from R to R1 can exist when there is a low interest
rate, investment will rise and also income from Y to Y 2. But this much increase of income is
impossible because of the increase in investment will rise the demand for transaction purposes
that the interest rate will also increase form R to R 1 and the equilibrium point will be E1 where
LM and SI become equal. Due to this reason, the expansionary effect of increase in investment
will be decreased by the increase of the interest rate the income rises by less than the full
multiplier. On the contrary when investment falls (or saving increases), the IS will shift to the
left (form IS to ISo) and the equilibrium point become at point E o where there is a lower level of
income Yo and interest rate Ro.

LM

R1 E1
R
Interest Rate

R0 E
Eo IS1
IS
IS0
0 Income
yo y y1

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On the other hand, the increase of the money supply or the decrease of money demand shifts the
LM curve to the right as LM, shown on the following figure. So the economy will also move to
the new equilibrium point E1 where the IS curve intersects the LMo curve. The rise of money
supply or the decrease of money demand leads to the decrease of interest rate to R 1 in the money
market. As a result investment and income will increase and the income level will be Y 1. This
shows that the new equilibrium is established at a lower interest rate and higher income level.
The increase on the income level depends on two conditions. This are
1. How much the interest rate falls which in turn depends on the elasticity of speculative
demand for money, and
2. How much investment rises as a result of any given fall in the interest rate which in turn
depends on the interest – elasticity of investment demand function.

LMo
LM
LM1
Ro
Eo
R
E
R1
E1
Interest Rate

Income
yo y y1

On the reverse, a decrease in the money supply or an increase in money demand will increase
the interest rate to Ro so that investment and income will decline. Thus the LM curve shifts to
the left as LMo which moves the economy to the new equilibrium point Eo. This is the point that
the Lmo and the IS curve interest with the higher interest rate Ro and low level of income Y o.
The decrease of income level depends on: -
1. How much the interest rate rises which in turn depends on the elasticity of speculative
demand for money, and
2. How much investment declines as a result of any given rise in the interest rate which in
turn depend on interest elasticity of investment demand function.

6.5 SHIFT IN THE IS CURVE

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The IS function can shift to the right due to two factors. The first factor which brings the shift of
the IS curve to the right is that of the reduction in saving and the second factor is that of increase
in autonomous investment. Either of these two factors may cause a shift in the IS curve to the
right.

The first equation which can be raised here is that how the reduction in saving can be considered
as a factor. First of all, a reduction in saving can be caused due to one or more factors such as
due to the increase in consumption decrease in interest rate, etc Here, we don’t have to forget
that in the Keynesians assumptions the rate of interest has little effect on saving. By any means
when saving reduces, the IS curve shifts to the right.

As we can see on the above figure, the IS curve shifts from IS 1 to IS2 as saving decreases from
S1 to S2.

The second factor which leads to a shift in the IS curve to the right is that of increase in
autonomous investment. The increase in investment can be caused as a result of expectations of
higher profits in the future of from innovation or from expectations concerning increase in the
future demand for the product or from a rise of optimism in general. In addition, expenditure
and tax policies have effect on the shifting of the IS curve.

In relation to this, at the time the interest rate increases, it is clear that the investment will
decline. Because, more people prefer to save their money in bank, to get more money rather
than investing.

In all these cases, the IS function will shift to the right equal to the decrease in the supply of
saving times the multiplier or the increase in the investment times the multiplier.

E2
R2
Interest Rate

E1
R1 IS2

IS1
Income
Y1 Y2

121
The above figure shows us that with the increase in autonomous investment (or reduction
saving) the IS curve shifts form IS 1, to IS2 and the new equilibrium is established at point E 2
which indicates a higher level of income Y2 at a higher interest rate.

6.6 SHIFTS IN THE LM CURVE

Like the IS function, the LM function can shift to right due to the conditions. The first condition
is at the time there is an increase in the money supply given the demand for money and the
second condition is at the time there is a decrease in the demand for money, given the supply of
money.

If the central bank follows an expansionary monetary policy, it will buy securities in the open
market. As a result, money supply with the public increases for both transactions and
speculative purposes. This shifts the LM curve to the right

A decrease in the demand for money means a reduction in the quantity of balances demanded at
each level of income and interest rate. Such a decrease in the demand for money balances
creates an excess of the money supplied over the money demanded. This is equivalent to an
increase in money supply in the economy which has the effect shifting the LM curve to the
right. This can be shown in the figure below.

LM1

R1 E1
Interest Rate

LM2

E2
R2

Income
Y1 Y2

As we can understand form the above figure, with the increase in the money supply, the LM 1
curve shifts to the right as LM 2 This moves the economy to a new equilibrium point (E 2). The
increase in the money supply brings down the interest rate to R 2 in the money market. Thus, in

122
 turn increases investment there by raising the level of income to Y 2 thus the effect of the
increase in money supply is to shift the LM curve to the right and a new equilibrium is
established at a lower rate, R2 and higher income level, Y2. In contrast, when there is a decrease
in the money supply or an increase in money demand the LM curve shifts to the left and a new
equilibrium will be established a higher interest rate and lower income level.

6.7 SIMULTANEOUS SHIFTS IN THE IS AND LM FUNCTIONS

As we have seen above, with the increase in investment when the IS curve shifts to the right,
both the rate of interest and the level of the income tend to rise, given the LM curve on the other
hand, when an increase in money supply shifts the LM curve to the right, it lowers the rate of
interest and raises the income level, given the IS. Here, let’s assume that both the IS and LM
curves shift to the right simultaneously as a result of the increase in investment and money
supply respectively. The figure presented below illustrates how will these expansionary fiscal
and monetary policies affect the level of income and the rate of interest where the increase in
investment shifts the IS curve to IS and the increase in the money supply shifts the LM curve to
LM1as a result, the IS1 & LM2 curves intersect at point E1 which is the new equilibrium position.
This new equilibrium position is achieved at a rate of interest, R 1, which is remained the same.
However, the level of income has changed from Y to Y2.

LM

R2 E2
LM1
Interest Rate

R1 E E1

IS1

IS Income

y y y
Given the money supply1 with
2
no change in the LM curve, an increase in investment would raise
both income and the rate of interest. This is also shown in the above figure when the IS 1 curve
intersects the LM curve at E2 and the interest rate rise to R2 and income to Y1 But the rise in
income is slowed down because of the rise in the interest rate. If the money supply increases by
so much as to prevent the rise in the interest rate, the interest income will be equal to the full

123
expansionary effect of the rise in investment. The figure shows this by shifting the LM curve to
the right as LM1 which intersects the IS, cover at E1.

5. The IS curve is shifted by change in autonomous spending. An increase in autonomous

spending, such as investment spending or government expenditure shifts the IS curve to
the right.

Worked Examples;
Determine aggregate demand and goods market equilibrium, autonomous expenditure and the
multiplier on in a simple economy the consumption function is given.

C = 600 + 0.7y y = income

C = Consumption
Investment function = I250 + 0.1y – 10r
R = the interest rate is expressed in annual percentage
A. If the interest rate is 5 percent what is the value of autonomous expenditure?
B. What is value of multiplier?
C. Solve the level of income that gives goods market equilibrium. What is the level of
income that gives good market equilibrium? What is the level of consumption and
investment?
D. If the MPC were increased 0.75 what would be the new multiplier and the new
equilibrium?
Solution
a) Autonomous expenditure is 800
b) The multiplier is 1/0.2 = 5
The level of consumption and planned investment are found by substituting to consumption and
investment function
C = 600 + 0.7y
600 + 0.7 (4000) = 3400
I = 250 + 0.1y – 10r
= 250 + 0.1 (4000) – 10(5)
= 250 + 400 – 50
= 600

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 c) The level of consumption = 3400
The level of investment = 600
d) Of the question asks about the effect of increasing the MPC. This means there is a new
consumption function
C = 600 + 0.7y
Substituting this equation rather than the original ones given:
Y = 600 + 0.75y + 250 + 0.1y – 10r
= 600 + 0.7y + 250 + 0.1y – 10(5)
= 800 + 0.85y
0.15y = 800
Y= 1/0.15 (800)
Y= 5333
The new multiplier is (1/0.15) = 6.6 the new income (y) level is 5333.

Example 2
The effect of changes in autonomous expenditure
From the previous example we will look mpc = 0.7 the consumption and investment schedules
and equilibrium income were
C = 600 + 0.7y
I = 250 + 0.1y – (10x5)
= 200 + 0.1y
Y = 4000
We are assuming the interest rate as 5%
a) What is the effect on equilibrium income of a decrease in autonomous consumption (c)
form 600 to 550?
b) What is the effect on equilibrium income of an increase in autonomous investment (I)
form 250 to 300?
Solution:
a) We will do this problem two ways. The long way is to solve for the new equilibrium
income.

125
 Y = 550 + 0.7y + 250 + 0.1y – 10(5)
Y = 750 + 0.8y
0.2y = 750
Y = 3750
The equilibrium income falls to 3750. Now we do the problem in another way.
 Y = Multiplier  C
= 5 (550 – 600)
= 5(-50)
= 250
So the level income goes form 4000 to 3750
b) Finding the effect of an increase 50 in autonomous part of investment.
Y = multiplier (I)
= 5(300 – 250)
= 5(50)
= 250
Equilibrium income increase by, 250

WORKED EXAMPLE
Finding IS schedule
We will use the same investment and consumption function that we used earlier example.
C = 600 + 0.7Y
I = 250 + 0.1Y – 10r
We will now let the interest rate vary rather than being fixed at 5%
Question:
a) With the relations just shown what is the Is schedule?
b) What is the slope of this schedule?
Solution:
a) Out put equals aggregate demand gives the following.
Y = 600 + 0.7Y + 250 + 0.1Y – 10r
10r + 850 + (0.7Y + 0.1Y) – Y
10r = 850 + 0.8Y – Y
r = 85 – 0.02Y
It is IS schedule
b) The slope of Is schedule is – 0.02.
So the level of income goes from 4000 to 3750

126
 B) Finding the effect of an increase 50 in autonomous investment.
Ye = multiplier x Io
= 5x (300 – 250) = 250
Equilibrium income increases by 250
Worked example finding IS schedule
We will use the same investment and consumption function that we used earlier example.
C = 600 + 0.7Y
I = 250 + 0.1Y – 10r
We will now let the interest rate vary rather than being fixed at 5%
What is the slope of this schedule?
Solution out put equals aggregate demand gives the following
Y = 600 0.7Y + 250 = 0.1Y – 10r
R = 85 – 0.02Y it is IS schedule
b) IS that the slope of IS schedule is = 0.02

6.8 WORKED EXAMPLE

How the velocity of money is affected by the rate of Interest?

Question: Consider the following demand for money schedule, where the interest rate is
calculated in percentage.
Md = 0.4Y – 80r

a) what is the demand for money income is 4000 and the interest rate is 5%?
b) When interest rate changes in the economy income often changes. Also suppose income
is 5000 when the interest rate is 10%. What is the velocity of money now?
Solution:
If we substitute the value for income and the rate of interest we get the following Md/p = o.4 x
4000 – (80 x 5) = 1200
The demand for money is 1200. The velocity is the ratio of income to money.
Velocity = v = 4000/1200 = 3.33
If the rate of interest rate is raised to 10%, income increases to 5000. The demand for money
remains constant.

127
Md/p = (0.4 x 5000) – (80 x 10) = 1200

The velocity of money has now risen from 3.33 to 4.17. The velocity of money falls as the
interest rate falls because corporation and individual have less incentive to reduce their money
holding.

WORKED EXAMPLE:

Money market equilibrium

Suppose that money demand relation is the following Md/p = 0.4y – 80r
What is the rate of interest when the money market is in equilibrium? As before we assume that
income is 4000. suppose that the supply of money is 1200, what is the rate of interest?
Ms/p = 1200 = Md/p = 0.4 x 4000 – 80r

The solution is that is the interest rate is 5%. Suppose that the interest rate is lower to 3% the
quantity of money demand will be
Md/p = (0.4 x 4000) – (80 x 3)
There would then be an excess demand for money fo 160.
Md/p = 1360 > Ms/p = 1200
Worked example
Income and money market equilibrium:
The LM Schedule
By considering the above example but we let income go up to 4300.
Md/p = (0.4 x 4300) – (80 x 5)
= 1720 – 400 = 1320 since the supply of money is only 1200, there is excess demand for money.
Md/p > Ms/p. this means that the interest rate must rise when the interest rate has risen to 6.5%.
the money market is in equilibrium again.
Md/p = (0.4 x 4300) – (80 x 6.5)
1720 – 520 = 1200
We have now found two points on the LM schedule
1 y = 4000 Md/p = Ms/p = 1200, r = 5%
2. Y = 4300 Md/p = Ms/p = 1200r = 6.5 percent

128
If income falls from 4000 to 3800 this drop income of 200 causes the quantity of money
demanded to fall by 80 with a rate of interest of 5%. There is an excess supply of money of 80.
As cash manager try to buy bonds, the interest rate falls until it drops from 5% to 4%. At the
new level of interest rate, the amount of money demanded once more equals the amount
supplied. This gives us a 3rd point on the LM schedule.
3. Y = 3800 = Md/p = Ms/p = 1200, r = 4%.
So there has been full income expansionary effect of the increase in investment as a result of the
simultaneous increase in money supply by just the amount necessary to prevent the rise in the
interest rate.
Solving the equilibrium with is and lm curve
Combining consumption and investment demands into aggregate demand equal to income gives
on is schedule as shown in previous exercise.
Y=C+I
C = 600 + 0.7Y
I = 250 + 0.1Y -10r
The is schedule is
R = 85 – 0.02Y
The money market relations in the preview worked example where as follows
MS/P = MD/P
0.4y – 80r = 1200
r = 0.005y – 15
the point of intersection of IS and LM is found by
85 – 0.02y = .005y – 15
y = 4000

Check your progress

PART I
Choose
1. to reach on the general equilibrium of product and money market first there msut be
a. equilibrium of product market only
b. equilibrium of money market only

129
 c. separate equilibrium of the two markets
d. none
2. In keynessian’s assumption the rate of interest has
a. no effect on saving
b. little effect on saving
c. more effect on saving
d. none
3. The money demand is less than the money supply when interest rate
a. increases
b. decreases
c. constant
d. none
4. In the LM diagram when the level of income increases the money demand
a. decreases
b. increases
c. does not change
d. none
5. When the IS function shifts to the right
a. interest rate increases
b. level of income decrease
c. level of income increases
d. a and c
e. a and b

PART II
Fill in the blank
1. _____________ is responsible to determine the supply (nominal quantity) of money.
2. _____________ reflects the equilibrium of the product market.
3. the decision to hold money balance is called
4. shift on the IS function may caused by ____________ or ________
5. when LM curve shifts to the right, it lowers __________ and raises ___________

130
6.9 SUMMARY

 The IS-LM model consists of two parts: the first draws together the determinants of
equilibrium in the market for goods, and the second draws together in determinants of
equilibrium in the market for money.
 For the two sector economy the goods market equilibrium is found at that level of at
which the sum of C + I is just equal to that level of Y. Goods market equilibrium can also
be defined by an equality between saving and investment. At that level of Y at which S =
I, the leakage from income stream into S is exactly offset by I.
 Money market equilibrium is defined by an equality between the supply of and the
demand money Ms = Md the condition that gives the equilibrium interest rate. In other
words, at the interest rate at which Ms = Md there is money money market equilibrium.
A combination of Y and r (interest rate) at which the supply of goods equals the demand for
goods and the supply of money equals the demand for money is defined by the intersection of
the IS and LM curves. At this point the equilibrium in both markets occurs.

6.10 ANSWERS TO CHECK YOUR PROGRESS

Choose
1. c 4. b
2. b 5. d
3. a
Fill in the blank
1. Central bank
2. IS curve
3. Portfolio decision
4. saving or investment
5. Interest rate and level of income

6.11 KEY WORDS

131
  Product market – the forces created by buyers and sellers that establish the price and
quantities of goods and services.
 Money market – a market which financial assets with maturity of less than one year are
bought and sold.
 Product market equilibrium (IS) – an expression of the equality of investment and
saving. It is also known as real sector equilibrium. The combination of interest rate and
income levels where saving – investment equality takes place.
 Money market equilibrium (LM) – a condition where the demand and supply of money
are equal. The LM curve shows all combinations of interest rate and levels of income at
which the demand for and supply of money are equal.
 The general equilibrium – a condition where the equilibrium pairs of interest rate and
income of the IS curve equal the equilibrium pairs of interest rate and income of the LM
curve.

6.12 MODEL EXAMINATION QUESTIONS

1. Using illustrative diagrams explain:

 The IS curve
 The LM curve
 The general equilibrium in the product and money market.

6.13 REFERENCES

 Baily, Martin Neil (1995), Macro Economics; Financial Markets and the International sector.
Rechard D. Irwin, INC. USA.
 M.L Jhingan (1997) Macro Economic Theory; Vrindo Publications (p) Ltd. New Delhi.
 Robert B. (1986) Macro economics; McGraw Hill comp; USA
 Roy J.,R. (1986) Principles of Macro Economics. London: forenamed and comp.
 Steven E., L. (1997). Macro economics, Mc Graw Hill co. USA

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UNIT 7: ECONOMIC FLUCTUATIONS: INFLATION AND UNEMPLOYED

Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Inflation
7.3 Unemployment
7.4 Unemployment in Ethiopia
7.5 Macroeconomic Stabilization
7.6 Summary
7.7 Key Words
7.8 Answers to Check Your Progress
7.9 Model Examination Questions
7.10 References

7.0 AIMS AND OBJECTIVES

Aims
In this unit the business cycle more as leas regular movements of the real GNP with
corresponding changes in levels of employment, unemployment and prices will be explained.
Types and causes of unemployment and inflation and what such terms mean: natural rate of
unemployment, full employment cost push and demand pull inflation... will be discussed. the
social consequences of the causes and cures of unemployment and inflation will also be
included.
Objectives
After learning this unit you will be able to:
 understand what a business cycle is.
 explain the meanings of unemployment and inflation in terms of the harmful affects they
can have on individuals and on the society as a whole.
 analyze the alternatives policy options, which may be sued in attempt to reduce the rates
of unemployment and inflation.

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7.1 INTRODUCTION

The world economy is not stable, it changes from time to time due to several factors. When
these factors bring negative impact on the economy, the economy will be characterized by
macro economic problems such as inflation and unemployment.
Inflation is a continual and ongoing rise in general price level on a specific period of time.

Unemployment is an involuntary idleness of a person willing to work at a prevailing rate of pay

out but unable to find it.

In this unit we will discuss briefly about factors that contribute to inflation and unemployment
and their consequences.

In addition we will discuss how to manage these macro economic problems according to
policies suggested by the two major schools of economic thought, Keynesians and monetarists.

Finally, the stabilization of the macro economic problems will be discussed.

7.2 INFLATION

It is not easy to give a precise and yet generally acceptable definition of inflation. Different
monetary experts define it is different ways. Among these Ackley (Year, pp) defines “inflation
as a persistent and appreciable rise in general or average of prices.”

There are two types of increases in the price level. Because of this, we divide inflation into tow.
1. One-shot-inflation-Occurs when the price level changes in one year and becomes
constant in the coming years.
2. Continued inflation – Occurs when the price level changes (increase) continuously from
year to year.

I. Cause of Inflation

Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and
services.

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 Factors affecting demand
Both Keynesians and monetarists believe that the aggregate demand affects inflation. These
factors are discussed below.
1. Increase in money supply – When the money supply increases, individuals are holding
“too much” money relative to other goods, so they spend the money. This increases
aggregate demand and therefore prices will rise and inflation occurs.
2. Increase in disposable incomes – When the disposable income of the people incases, it
raises their demand for goods and services. Because of this prices will increase and
inflation occurs. Disposable income may increase with the rise in national income or
reduction in taxes or reduction in saving of the people.
3. Cheap monetary policy – Cheap monetary policy or the policy of credit expansion also
leads to increase in the money supply which raises the demand for goods and services in
the economy. When credit expands, it raises the money income of the borrowers which,
it turn, raises aggregate demand relative to supply, thereby, leading to inflation.
4. Deficit financing – In order to meet its high expenses, the government reports to deficit
financing by borrowing from the public and even by printing more notes. This raise
aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in
prices.
5. Black money – the existence of black money due to corruption, tax evasion etc. Increase
the aggregate demand. People spend such unearned money extravagantly, there by
creating unnecessary demand for commodities. This tends to raise the price level further.

Factors Affecting Supply

1. Shortage of factors of production such as labor, raw material, power supply, capital etc. Will
decrease the supply of products. Because of this shortage, prices will increase in the market.
Therefore inflation occurs.
2. Natural calamities like drought or flood is a factor that affects the supplies of agricultural
products. This creates shortage of food products and raw materials, there by increasing
inflationary pressure.

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3. Increase in export – when a country produces more goods for export than for domestic
consumption this creates shortages of goods in the domestic market. Which leads to inflation
in the economy.
4. Law of diminishing returns – if industries in a country are using old machines and out
molded methods of production, the law of diminishing returns operates. This raises cost per
unit of production. Therefore the prices of products will increase.
5. International factors – when prices rise in the major industrial countries, their effects spread
to almost all countries with which they have trade relations.

II. Effects of Inflation

Inflation affects different people differently. This is because of the fall in the value of money.
When the value of money falls, some group of the society gain, some lose and some stand in
between. The reason is that the price movements in the case of different goods and services is
not the same.

Inflation can be anticipated or unanticipated. Anticipated inflation in that all groups and
individuals are able to predict. Therefore they are able to protect themselves against it.

An anticipated inflation is that groups and individuals in the economy are not able to predict.
Therefore they are not able to protect themselves against it.

We will briefly discuss how anticipation of inflation affects people and the economy below.

1. Inflation and people who hold money

With inflation, the purchasing power of money declines. As a result, people who hold their
assets in a liquid form will experience a decrease of their purchasing power during periods of
inflation.
For example
If inflation rate is 10% this year, then it takes $110 this year to buy what $100 bought last year.

2. Inflation and savers

Inflation may also decrease the value of money set aside in savings. To offset inflation effects,
interest rates are adjusted for the expected rate of inflation. So that the actual interest rate paid
(the nominal interest rate) equal to the real interest plus expected inflation rate.

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That is,
Nominal interest rate = Real interest rate + expected inflation rate
Interest rates attempt to adjust for expected inflation does not necessarily mean that savers will
not lose purchasing power. That will depend upon how well the market does at anticipating
inflation rate.

3. Inflation and lenders and borrowers

Inflation affects both lenders and borrowers. But it depends upon how well anticipated the
inflation is. If there is an anticipated inflation, borrowers will gain purchasing power at the
expense of lenders, Since they will be paying back the loan with money that is worthless than
the money they borrowed. If inflation is less than anticipated, then lenders gain at the expense of
borrowers.

4. Inflation and past decisions

Inflation often turns past decisions into “Mistakes”, by changing the underlying conditions that
were presumed when the decision was made.
For example – A contractor agreed to construct a building with a contract price of $ 10 million.
Because of inflation the prices of materials risen and the 10 million dollar could not cover his
expenses. Therefore, his past decision become mistaken.

5. Inflation and uncertainty

Inflation brings uncertainty because people don’t know whether the inflation rate rises or fall in
the future. Therefore they will be uncertain to engage in long-term contracts. Causing mutually
advantageous exchanges to be forgone.

6. Inflation and hedging against inflation –

Individuals in an inflation – prone economy need investments that offer the best protection
against inflation, rather than those investments which the most productive potential. “Resources
are expended in the search for “inflation-proof” investments, and resource expansion is forgone
by choosing a defensive position over an aggressive one.”

7. Inflation and international competitiveness

Inflation rate will affect a countries international competitiveness. Suppose X country’s and Y
country’s inflation rates were the same. Because of the increase in inflation rate of X, goods

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become expensive and Y’s cheap. Now consumers buy Y’s Goods. There fore X become less
competitive than Y.

8. Other effects
Inflation leads to a number of other effects. As the money income of the people increases,
government collects that in the form of taxes on incomes and commodities. So the revenues of
the government increase during prices are rising. But its expenses also increase. “On the whole,
the government gains under inflation for rising wages and profits spread an illusion of
prosperity within the country.”

Inflation also affects the balance of payments of a country. When prices rise, more racially,
domestic goods become more expensive than the foreign goods.

This tends to increase imports and reduce exports. Because of this the balance of payments of
the country will be unfavorable.

This happens if the country follows a fixed exchange rate policy. But if the country follows
flexible exchange rate, there will not be such effect.

III. Anti-inflationary policies

1. Keynesian demand management

Keynesian economists say that it is possible to influence the equilibrium level of national
income and to increase the level of employment by using fiscal and/or monetary policies.

Keynesians believes that monetary change will only affect real national income indirectly that is
an increase in money supply leads to a fall in interest rate and then to an increase in spending.
Here, if investment and consumption are responsive to interest rate changes the possible interest
in elasticity of investment and consumption is one of the main reasons why Keynesians favored
fiscal rather than monetary policy.

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The Keynesians demand management policy is explained below using inflationary gap diagram.

Full employment

Aggregate AD
demand
x1 x = Inflationary gap

0
r1 re National Income

The equilibrium level of income (Oye) is above the full employment level and so cannot
actually be attained. Appropriate fiscal policies to change this demand-pull inflation would be a
cut in government spending, or an increase in taxation. The objective is to shift AD line by the
full amount of inflationary gap.

Limitations of the Keynesian theory

Keynesian demand management polices were used by the governments of western countries to
decreases unemployment. This was after the Second World War. But in the periods of high
unemployment, the government would expand aggregate demand, this reduce unemployment
but at the same time it created inflationary pressure. Therefore Keynesian model is only short-
term and in the short run.
run. Because it is not easy to predict the effects of policy changes and the
management of the economy.

Another criticism of the Keynesian model is that if understate the influence of money on the real
variables in the economy. A change in money supply according to monetarists will only affect
national income through its effect on the rate of interest.
interest. But monetarists argue that in a close
relationship between changes in the money supply and national income.

Finally monetarists criticize that without government interferences the economy will tend
towards its natural rate of unemployment.

2. Monetary policy during inflation

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The aim of monetary policy is to decrease the rate of expansion of money, to effect the increase
in its velocity, to decrease the volume of liquid assets, to reduce consumption and spending by
means of higher interest rates.
rates.
The effectiveness of monetary policy depends upon the changes in the velocity of circulation of
money. Because these changes may completely neutralize the restrictions imposed by money
(David C. Calendar).

3. Wage and Price control

It is a legal limitation on the prices and wages that can be set. There are two kinds of price
control mechanisms. These are price ceiling and price floor.
Price Ceiling – Government imposed limit on how high a price may be set (charged). This
political pressure prevented the price of good from rising to the full new supply or demand
equilibrium.

For example
The price of fuel was $ 16, now government set price ceiling of $ 10. As shown below in the
graph.
Price
16 D S
14 E1
12
10
8
6 Price ceiling

4
2
0 0.5 1.5 2.0 2.5

The result was an oil shortage, the quantity demand for oil was greater than quantity supply of
oil. When the government prevents form rising to the equilibrium price, the invisible hands will
place up ward pressure on price. In this case the invisible hands won out, and the price ceiling

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were eliminated, allowing to increase substantially. And the increase in price eliminated the
shortage.

Price floor – Government imposed limit on how low a price may be set, these price control
mechanism are not always efficient methods of preventing inflation. Because the supply and
demand always win and remove the fixed price.

7.3 UNEMPLOYMENT

Unemployment is defined as involuntary idleness of a person willing to work at the prevailing

rate of payout unable to find it. It implies that only those persons are to be regarded as
unemployed who are prepared to work at the prevailing rate of pay, but they do not find work.

Voluntarily unemployed persons who do not want to work like the idle rich are not considered
unemployed.

Unemployment rate – the percentage of the labor force that is unemployed. The unemployed
are those people over 18 years old who are not able to work and are looking for work who do
not have a job or who are on layoff.

Unemployment rate = Number of unemployed people x 100

Labor force

When unemployment is rising the solution is to increase the aggregate demand for goods and
services as companies supply their goods and services, they will hire more workers and create
more jobs.

The economy theory of job search

This theory deals about how long should an unemployed person search for job and what factors
affect the search.
A. The rational search for job – when the economy is operating at the natural rate of
unemployment, there is a rough balance between the number of people seeking jobs and the
number of unfilled jobs for which job seekers are qualified. But when unemployment is above
the natural rate of unemployment, this balance is broken; the result is cyclical unemployment.

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 1. The wage offer curve – most job searches do not accept the first job they are offered, on
the assumption that something better might be available. We assume that the more time
someone spends looking, the better offers they will find.
2. The reservation wage curve – When individuals are searching for jobs realize that the
search is costly for them. The main cost is wages forgone while the search is being
carried out. For this reason, each searcher has in mind a minimum wage/salary that will
be sufficient to stop the job search and accept the offer. The minimum wage is called the
reservation wage.
3. The optimal search time – is the point where the reservation wage curve meets the wage
offer curve, or a searcher should take the first job offer that meet his/her reservation
wage at the time of the offer.

B. Optional search time and the unemployment rate

An increase in optimal search time will increase the unemployment rate

C. Inflation expectations and optional search time

A worker’s inflation expectations affect how long he/she search for job. If job searchers have
“too high” or (“too low”) an expected inflation rate, wage offers will seem to have less
purchasing power (more purchasing power) than they actually have and therefore affect their
perception of the wage offer curve and the optional search time.

D. Job hunting on the information supper high way

When individuals and firms are using the information superhighway and computers to search for
jobs and to hire people. There are also electronic databases, which list companies hiring in your
area of expertise. Finally, some firms are using computer interviews to screen applicants for jobs
before the applicants are allowed to talk with a real person.

I. Types of unemployment
Individuals are unemployed for different reasons. The primary types of unemployment which
economists separate people into include:

1. Frictional unemployment
2. Structural unemployment

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 3. Cyclical unemployment
4. Seasonal unemployment
5. Technological unemployment

1. Frictional unemployment – Arises because of the continual movement of people

between regions and jobs.
For example – someone may leave one computer job and get hired by another computer
firm due to changes in demand. The intervening period is frictional unemployment. In a
dynamic economy there will always be some frictional unemployment because demand
for goods is constantly changing.
2. Structural unemployment – Occurs when there is a mismatch between the supply and
the demands for workers. Mismatches can occur because the demand for one kind of
labor is falling, and supplies do not quickly adjust. Thus, we often see imbalances
between occupations as certain sectors grow while others decline.
3. Cyclical unemployment – It arises due to cyclical fluctuations in the economy. They
may also be generated by international forces. It is during the down sing of the business
cycle that income that income and output fall leading to wide spread unemployment.
4. Seasonal unemployment – Results from seasonal fluctuations in demand. For example-
employment in ice factories in only for the summer and agricultural workers who remain
employed during harvesting and sowing recourse remain idle for the rest of the year.
5. Technological unemployment – Modern production process is essentially dynamic
where innovations lead to the adoption of new machines and inventions thereby
displacing existing workers. For example-when there is displacement of old technology
by a new one requiring less workers than before, technological unemployment.

7.4 UNEMPLOYMENT IN ETHIOPIA

In Ethiopia the challenge of employment generation is tantamount to achieve the objectives of

sustained growth and reduction of poverty. In fact they are inseparable and interdependent long-
run development goals. Thus in the face of the rapid rate of population growth and its very
young age structure with a median age of around 19 years, the economically active population
of Ethiopia has been increasing at accelerating pace.

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Unemployment is said to occur when persons actively seeking for jobs could not find it. This
partly takes place when the economy fails to generate adequate and well paying job
opportunities for the labor force. The availability of job opportunities in turn depends upon the
overall economic performances.

Although scarcity of a well disaggregated employment/unemployment statistics has prevented

from establishing reliable indicators on the magnitude, structure, and nature of unemployment is
a characteristic feature of urban areas while underemployment is believed to be rural
phenomenon.

Underemployment may vary among regions and households with in a given locality depending
up on the pattern of labor allocation and the availability of cultivated land (per capita land
availability). The declining trend in per capita land availability particularly in the highlands is
believed to have aggravated the underemployment problem in rural areas of the country.

With regard to open unemployment, the only available reasonable statistics to measuring
unemployment are the results of the 1984 and 1994 population and Housing Census Statistics.
As indicated the table below, open unemployment is more of an urban phenomenon. For
instance, in 1994, the rate of unemployment in the urban phenomenon. For instance, in 1994,
the rate of unemployment in the urban areas was about 22% while that of the rural areas stood at
less then 1%. The sex-wise distribution of unemployment indicates that unemployment is sever
among women population than that of men. Urban open unemployment has become critical as
reflected in the substantial increase of the unemployment rate from 7.9% to 22% during the
1984-1994 periods.

Major Causes for Unemployment in Ethiopia

1. Land Reform: Revisiting the public Vs private ownership. One of the central policy
challenges facing Ethiopia’s economy is the issue of land ownership. This importance
emanates from the fact that economic growth; employment and basic survival of the
majority of the population depend on the productive efficiency of agricultural sector. The
redistribution of rural land and nationalization of manufacturing industries was the
fundamental policy changes made in 1974. The land reform changed both land ownership
and the administration of its distribution.

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 Productivity and the weather factor:
factor: For long it has been customary to attribute production
variation in general and agricultural production in particular weather factor: bumper
production for good weather season and a fall in production for drought. There is a
tendency to attribute high productivity to a successful extension package program but poor
production to the usual drought factor.

While weather condition is obviously a factor, it is neither the only nor the major determinant of
productivity variations in all regions of the country. What follows from this is that the impact of
rainfall variation (weather condition) on crop productivity is largely felt in drought prone areas,
and to a lesser extent in other non-surplus areas. In surplus producing regions although rainfall
could vary from year to year, that may lead to major moisture shortages to the level that affects
the production level significantly.

Debt burden and sustainability of debt;

External borrowing has had two important effects on Ethiopia’s economy and on the welfare of
the people:
It has the volume of resources available both for consumption and investment;
The negative effect of external debt is the growth of the volume of repayments (interest and
principal) beyond the country’s capacity, which has resulted in the gradual build-up of arrears.

It is clear that the debt burden needs to reduce, if only for want of resources to meet debt service
obligations. Faced with the impossibilities of meeting scheduled payments, the government
pursued two basic coping strategies:

i. To increase foreign exchange earnings to be able to service external debt as well as import
necessities. To this end, the government implemented reforms that would have a positive
impact on the tradable sector.
ii. To negotiate with creditors for debt reduction. In view of reducing the country’s external
debt service obligations and the debt over-hang, debt-reduction measures have already
been taken.

II. Unemployment and output (Okun’s law)

Social costs

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The aggregate loss of income and output due to cyclical unemployment in the social cost of
cyclical unemployed resource.

Economist Arthur okun measured the social cost of unemployment in terms of the loss of output
for search percentage point increase in the unemployment rate.
Unemployment rate = Number of persons unemployed
Number of persons in the civilian labor force

The relationship that okun found between changes in the unemployment rate and change in
output is called okun’s law.
Okun’s law – states that for every percentage point increase in the unemployment rate there is a
2.5 percent drop in real GNP.

Okun’s law measures the short-run losses of output due to a cyclical increase in the
unemployment rate above the natural rate. It assures that cyclical increase in employment, rising
hours worked per person and increased productivity. Thus, in the short-run there is substantial
output gain when people return to productive employment. Idle capital will be utilized
efficiently and people doing Parr-time work will return to fulltime jobs.

The private costs of unemployment are not events distributed across society. The long-term
employed with the minimum unemployment insurance protection bear substantial burden or the
private unemployment cost, especially if they place a low value on their leisure. The
unemployment suffers less.

Social benefits
The effect of unemployment are not all negative, especially when the economy is operating at
the natural rate of unemployment.

Job turnover allows workers to seek out better job. As workers move into jobs in which they are
more productive, real GNP increases. If unemployed worker were to accept the first job that
they are offered even if were below the salary and skill level to which they were accustomed.

III. Trade off between inflation & unemployment

It is a situation in which the attainment of something desirable necessarily implies the loss of
something else desirable. Over the short-run there is sometimes a trade off between

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unemployment and inflation. That is if one rises the other falls, or they move in opposite
direction. And this is one problem of achieving economic goals because economic goals may
seem to conflict with each other. Unfortunately, the solution of one economic goal, such as full-
employment, create higher inflation rate.

This trade-off occurs because an increase in the aggregate demand for goods and services will
increase the employment of all resources, including human resources, and will lead to full
employment. As resource supplies become scarce, price of input begin to rise. Further, as full
employment is approached, less adaptable resources are used. For these reasons, attainment of
the goal of full employment creates higher inflation rate.

On the other side, unemployment will increase when inflation is controlled. Aggregate demand
may be restrained through either monetary of fiscal policy to hold back up ward pressures on
prices. Often this monetary and fiscal policies are accompanied by high interest rates, that may
create a recession in output and resource employment.

The Phillips curve: a graphical representation of the presumed inverse relationship between
unemployment & inflation. The relationship between unemployment and change in the
price level can be seen more clearly in the following figure.

IR2
Where: -
L1= Unemployment
IR1 IR = Inflation Rate

L1 L2

- Change in the price level are indicated by the inflation rate shown in the verticals axis and
- Unemployment rate is obtained by dividing the number of unemployed workers by the
total number of workers, as shown in the horizontal axis.
The graph shows that an inflation rate of IR2 is consistent with an unemployment rate U1, the
inflation rate IR1 is consistent with an unemployment rate U2. To achieve a lower

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unemployment rate, U1 the inflation rate must rise to IR2. Early Keynesian argued the fiscal
policy should be directed toward achieving some desire combination of unemployment and
inflation rates as shown on the Phillips curve.

Long-run Phillip curve – A curve showing the trade off (complete lack of trade off) when the
expectations of inflation equal actual inflation.

Classical View of Phillip Curve Trade off

Natural rate of unemployment: - the rate of unemployment to which the economy naturally
gravitates.

This natural rate of unemployment is independent of the inflation rate and expectations of
inflation. It is the unemployment rate that will exist in long run equilibrium when expectations
of inflation equal the actual level of inflation. The long-run Phillips curve is vertical at this
natural rate of unemployment.

Unemployment rate below the natural unemployment rate would lead to actual inflation higher
than expected inflation, which brings about a future increase in expectations of inflation and
an upward shift of the shut-run Philips curve. This is shown by the graph below.

E = Expected inflation
Inflation L-R Phillips Curve
rate equals Actual inflation
B
E
A
A = Actual inflation below

expected

D Unemployment rate
B = Actual inflation above

Monetarists believe that maintaining unemployment rate below theexpected

natural rate would cause an
over increasing acceleration of inflation.
inflation. And the combination of high and accelerating
inflation and high unemployment is known as stagflation.
stagflation.

Finally, monetarist believe government expansionary policy causes stagflation. Therefore,

inflation will stop when the accepts the natural rate of unemployment as inevitable.

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 The Keynesian view of the Phillips curve Trade-off
Keynesians believes that in the short-run social forces, the invisible hands play a major role in
determining inflations, and that expected inflation need not precisely equal inflation.

“Within a limited range of inflation rates around the actual inflation rate, many Keynesians
believe that the short-run Phillips curve can be relatively stable, and not shift up even though
actual inflation exceeds expected inflation.”

Critiques of Phillips Curve

“Many economists do not agree with an explanation of inflation, which gives less considerations
about monetary conditions. They argue that changes in prices are at least as important as
unemployment in determining changes in wage rates. But this is not included in the Philip
curve.

“Economists like Milton Friedman and Edmund Phelps have mounted one of the theoretical
attacks on the Phillip curve property of trade off between inflation and unemployment”. They
argue that there is no trade off in the long run.
run. However, for short run trade off similar to those
specified by Phillips curve. This is called the accelerationist theory.
theory. It agrees that in the short
run an anticipated increases in the inflation rate will lower real wages and reduce
unemployment. But in the long run there may no trade off.
off.

7.5 MACRO ECONOMIC STABILIZATION

The basis for the establishment of built-in stabilizer is variation in both taxes and transfer
payment. These built-in stabilizers play a significant role in the working of an economy.

They are named stabilizers because they operate in a manner that counteracts fluctuation in
economic activities.

They are called built-in because they come into play automatically as the income level changes.
In other words, their operation does not depend upon the discretionary actions of the monetary
and fiscal policy.

It involves the automatic adjustment of the expenditure and in relation to cyclic ups and downs
within the economy without deliberate action on the part of the government. The various

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economic stabilizers are corporate profits tax, income tax, excise taxes, old age, survivors and
unemployment insurance and unemployment relief payment. These stabilize the economy by
changing directly (tax) for indirectly (government expenditure). When the national income
declines, tax will reduce and government expenditure decreases. Thus, there would be an
automatic budget deficit in the first condition and by the second condition budget surplus would
happen so the economy will be stabilizer.

Limitation: The effectiveness of built-in stabilizer will depend on the elasticity of tax receipt,
the level of taxes and flexibility of public expenditure the greaser the elasticity of tax receipts
the greater will be the effectiveness of the built-in stabilizer but:
 The elasticity of tax receipt is not so high as to act as an automatic stabilizer even in
advanced countries.
 With low level of taxes then a high elasticity of tax receipts would not be very
significant as an automatic stabilizer during a down swing.
 The built-in stabilizers do not consider the secondary effects of stabilizers on after tax
business income and consumption spending on business expectation.
 This device keeps silent about the stabilizing influence of local bodies, state
governments and of the private sector economy.
 They cannot eliminate the business cycle, at most they can reduce its severity.
 Their effects during recovery from recession are unfavorable.

Therefore economists suggested that built-in stabilizers should be supplemented by

discretionary fiscal policy.

One of the practical difficulties of government expenditure and taxation to compensate for
deficiencies of excesses in private spending is making the fiscal tools flexible enough for
prompt and effective use. Everything in life is in change so we have to make our policy as
flexible as possible.

A fiscal system with built-in flexibility is one where change in employment and output in
economy brings about, because of the very character of expenditures and taxes already in
operations, marked compensating change in the government’s fiscal position. Unemployment,

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old age insurance schemes, etc. are notable in this regard because they have built-in flexibility
on both the spending and taking sides.

II. Discretionary Fiscal Policy

It is a deliberate action of the government in order to control inflation and deflation by changing
tax or government spending or both.

Discretionary fiscal policy has three forms of controlling inflation and deflation.

1. Changing taxes with government expenditure constant

When taxes are reduced while keeping government expenditure then household’s and
businessmen’s disposal income will increase, raising private spending. But the amount of
increase will depend on whose taxes are cut, to what extent, and on whether the taxpayers
regard the cut temporally oar permanent.

For e.g. If the reduction of tax is for higher and middle-income group, the aggregate demand
will increase much and will have a significant effect. However if it is fore low-income group,
the aggregate demand will increase much and will have a significant effect. However if it is for
low-income group, the aggregate demand will not increase significantly. It they are businessmen
with little capital, tax reduction will not induce them to invest more. In addition if the tax payers
regard tax reduction as temporary, this policy will again be less effective. Thus, this policy is
more effective in controlling inflation by raising taxes because high rates of taxation will reduce
disposal income of individuals and business there by decreasing aggregate demand.
Changing government expenditure with taxes constant
This method is more useful in controlling deflationary tendencies.
- When government increases its expenditure on goods and services, keeping taxes constant.
Aggregate demand will increase by the same amount as the increase in government
spending.
- Reducing government expenditure during inflation is not so effective because of high
business expectations in the economy, Which are not likely to reduce aggregate demand.

2. Changing both expenditures and taxes simultaneously

- This policy is the most effective of all.
- To control inflation, taxes may be raised and government expenditure will be reduced.

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 - To control deflation, taxes may be decreased and government expenditures will be raised
too.
Limitation – The discretionary fiscal policy depends on proper timing and accurate forecasting
but, since economics is not and exact sciences, accurate forecasting is not possible, mostly,.
Moreover the policy is subjected to two-time lags.
- “Decision lag” It is a time span required for studying the problem and making decision.
- “Execution lag” – it is a time span needed after the decision is made in order to convert
the decision into practice.

It involves expenditure, which is to be allocated for the execution of the program. Both time
lags may need long period of time. In addition to this certain public projects are so cumbersome
that it is not possible to accelerate or slow the down for the purpose of raising or reducing
spending on them.

Therefore in order to control emphasis must be given to taxation as the best fiscal device.
1. The tax system
The amount of tax revenue the government collects depends on the income of the taxable unit.
Simple multiplier on the other hand depends on marginal propensity to consume, which is
change in consumption divided to change in income. Therefore the higher the tax rate, the lower
the multiplier. Thus the tax system acts as an automatic stabilizer by moderating the effect of
cyclical disturbances. If there is a sudden drop in autonomous investment spending, the
multiplier effect on output will be smaller the higher is the tax rate because when investment
increases, income goes up so does taxes. Thus consumption rise by less than it would if taxes of
cyclical disturbances on output and employment will be lessened.
2. Unemployment compensation and welfare payment
Unemployment compensation is a kind of assistance given from the government for people who
has got no employment in the time of recession while welfare payment are payments given to
people whose incomes have decline but still in work. So government spending tends to rise
automatically during recession as more people become eligible for entitlement programs.
Government spending therefore acts as automatic stabilizer.
But there are two problems with the functions of automatic stabilizer:

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- They do not eliminate fluctuations but only moderate them, automatic destabilize counteract
them.

Check Your Progress

Part I. True or False

________1. Inflation is caused when the aggregate supply of goods and services exceeds the
aggregate demand.
________2. Increase in money supply is one of the factors which causes inflation.
________3. Inflation will not affect both lenders and borrowers.
________4. Keynesians believe that an increase in money supply leads to an increase in interest
rate.
________5. The Keynesian demand management policies were used to decrease unemployment.
________6. Monetarists believe that without government interferences the economy will tend to
its natural rate of unemployment.
________7. Price ceiling is a limit imposed by the government on how low the price should be.
________8. Unemployment is defined as involuntary and voluntary idleness of a person willing
to work.
________9. When unemployment is rising the solution is to increase the aggregate demand.
________10. Cyclical unemployment arises because of the continual movement of people from
one region to another.
________11. The Philips curve represents the direct relationship between inflation and
unemployment.
________12. The natural rate of unemployment is independent of inflation rate and expectations
of inflation.
________13. The combination of high and accelerating inflation and high unemployment is
known as stagflation.
________14. Government spending like unemployment compensation and welfare payment can
as automatic stabilizer.
________15. The effectiveness of built-in stabilizers will not depend on the level of taxes.

Part II. Choose

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1. Inflation can be caused when
a. Money supply increases
b. Disposable income decreases
c. There is no credid expansion
d. There is black money
e. a and d
2. Anticipation of inflation affects
a. Savers
b. Lenders and borrowers
c. Past decisions
d. Balance of Payments
e. All of the above
3. The aim of monetary policy is
a. to increase the rate of expansion of money
b. to decrease the volume of liquid assets
c. to increase consumption
d. to decrease interest rates
4. The type of unemployment caused by the down swing of the business cycle is called
a. Frictional unemployment
b. Structural unemployment
c. Cyclical unemployment
d. Technological unemployment
5. Structural unemployment is called when
a. people ore from one area to another
b. there is placement of old technology by new one
c. there is a mismatch between supply and demand for workers
d. there is seasonal fluctuations
6. A curve showing the complete lack of trade off is
a. Short-run Phillips curve
b. Long-run Phillips curve
c. Wage offer curve

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 d. The reservation wage curve
7. Which of the following is not true about the natural rate of unemployment?
a. It is independent of the inflation rate and expectation of inflation’
b. It exists in the short run
c. The lengwn Phillips curve is vertical at the natural rate of unemployment
d. It is the rate of unemployment to which the economy gravitates
8. In a discretionary Fiscal policy government controls inflation and deflation by: -
a. changing taxes with government expenditure constant
b. changing government expenditure with taxes constant
c. changing both government expenditure and taxes simultaneously
d. all of the above
e. none
9. The limitations of discretionary fiscal policy are:
a. It depends on proper timing
b. It depends on accurate forecasting
c. It is subjected to time lags
d. None of the above
10. Which of the following is not true about built-in stabilizers.
a. Their effect during recovery from session are favorable
b. The elasticity of tax receipt is not so high as to an automatic stabilizer
c. It keeps silent about stabilizing influence of local bodies
d. All of the above.

7.6 SUMMARY

In this section we have seen about inflation, unemployment and the stabilization of an economy.
And the interrelationship center on the trade off between inflation and unemployment.
 The monetarists and Keynesian views of inflation and the Phillip curve reflect two
consistent world views.
 Classical argue that the only way to stop inflation is to stop increasing the money supply.
 Keynesians argue that supplemental policies like income policy are needed.

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7.7 KEY WORDS

 Inflation – a situation in which the general level of price rises continuously overtime.
 Inflationary gap – denotes the amount by which actual private spending and government
expenses exceed the theoretical amount of spending necessary to maintain full
employment or exceed the theoretical amount of spending adequate to absorb all the
available goods and services without appreciably raising the price level.
 Unemployment – involuntary idleness of a person willing to work at the prevailing rate
of payout unable to find it.
 Unemployment rate – the percentage of the labor force that is unemployed.
 Full employment – the employment level associated with the natural rate of
unemployment.
 Okun’s Law – states that for every percentage point increase in the unemployment rate
there is a 2-5 percent drop in real GNP.
 The Phillip’s curve – a graphical representation of the presumed inverse relationship
(trade-off) between unemployment and inflation.

7.8 ANSWERS TO CHECK YOUR PROGRESS

Part I. True or False

1. F 6. F 11. F
2. F 7. F 12. T
3. F 8. T 13. T
4. T 9. F 14. T
5. T 10. F 15. F
Part II. Choose

1. e 6. b
2. e 7. b
3. b 8. d
4. c 9. d
5. c 10. a

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7.9 MODEL EXAMINATION QUESTIONS

1. During this period, Ethiopian unemployment rate seems much higher than many
countries in the developing world, Try to find out why?
2. "A nation cannot become richer by creating more money, just as the owner of theater can
not increase its seating capacity by printing more tickers" explain.
3. Using illustrative diagram discuss the unemployment-inflation link (the Phillips curve)
7.10 REFERENCES

 Arnold, Roger; Economics 2nd ed,

ed, West publishing Co. 1992
 Luker, William, A. Martian, David; Economics for decision-making D.C Health and
company. 1998.
 Ekelvnd, Robert, d. Tollison, Robert; Macro Economics,
Economics, Little Brown and company.
1986
 Colander, David; Economics 2nd ed.,
ed., Richard D. Irwin, Inc, 1995.
 Dr. Gupt, R.D; Keynes Post Keynesian economics,
economics, kalyani Publishers, 1998
 H. Branson, William; Macro Economic Theory and Policy 2nd edition, Printograph
(India)
 Jhingan, M.L; Macro Economic Theory 10th ed.,
ed., B.s Ashish company (virinda
publications (p) Ltd. 1997
 J. Ruffin, Roy, R. Gregory, Paul; Principles macro Economics 2nd ed.
ed. Scott, forsmand
and company. 1989.
 K Evans, Michael; Macro Economic Activity Theory,
Theory, forecasting, and control, 1969.

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