Macro economic equilibriumUNIT 05

Prepared by; RASHAIN PERERA077 059 37 52rashainperera@gmail.com

What is macro economic equilibrium?

Macro economic equilibrium is determined by aggregate demand (aggregate expenditure) and aggregate supply (total output).

Macro economic equilibrium could be shown in terms of a graph simply as shown below.

At the equilibrium

AD = ASY = EW = J

Price

Quantity

S

D

Y = E condition

Y represents the income E represents the expenditure As explained in chapter 04, Y

= E

Y = C + S + T + ME = C + I + G + X

(Y) Aggregate income/ supply

Aggregate supply is the total amount of goods and services supplied or produced by an economy in a given period of time usually a year at a given overall price level. In other words it is the total output of the economy

Y = C + S + T + M

Consumption ; the amount that is spend on day to day activities from the disposable income is simply known as the consumption expenditure

Yd. = income – direct taxes (T) + state benefits (Tr)

Yd.

Consumption Savings

Consumption function Consumption function shows the

relationship between planned consumption and disposable income. There is a direct or positive relationship between planned consumption and disposable income.

C = a + b (Yd) a- autonomous consumption

Marginal propensity to consume This is the proportion of the extra income which is

spent on consumption. In other words it is the extra spending on consumption out of the additional income.

MPC = change in consumption / change in income

Average propensity to consume This can be calculated by simply dividing

consumption by income.

Factors influencing consumption or MPC other than income

Distribution of incomeThe rate of interestThe availability of creditTaxationWealthexpectations

Y = C + S + T + M

Savings ; It is the balance income part, after paying for consumption and taxes. Savings could be defined as income minus consumption

S = Yd – C

Yd.

Consumption Savings

Savings function Savings function shows the relationship

between planned savings and disposable income. The savings function is the converse or opposite of consumption function.

S = -a + b(Y)

Marginal propensity to save This is the proportion of the extra income which is

saved. In other words it is the percentage change in income which will go to savings. It is equal to change in planned savings divided by change in disposable income.

MPS = change in S / change in Y

Average propensity to save This is the proportion of disposable income which is

saved.

APS = savings / income

The factors determining savings other than income

interest ratesinflationexpectations

The relationship between MPC and MPS Consumption plus savings must equal

income. Thus the change in disposable income is either consumed or saved.

MPC + MPS = 100% of the change

MPC + MPS = 11 – MPC = MPS1 – MPS = MPC

The relationship between APC and APS

APC + APS = 100% of the totalAPC + APS = 1

1 – APC = APS1 – APS = APC

(E) Aggregate Exp./ Demand

Aggregate demand is the sum of all planned expenditures in the economy. The aggregate demand shows the amount of goods and services in the whole economy that are demanded by all macro economic agents at any given price level.

E = C + I + G + X Investment; is the addition to the capital stock. In other

words it is the expenditure incurred by business firms for investments.

Investment functionI = I0

The planned level of investment varies inversely with the rate of interest in i.e. higher the rate of interest; lower will be the level of planned investment and vice versa

The determinants of planned investment the relative price of capital and labor technological changesgovernment policiesattractiveness of the country for foreign investments

W = J condition

W represents the Withdrawals J represents the injection W = J

W = S + T + MJ = I + G + X

(W) Withdrawals

Leakages subtract from the total volume of the basic circular flow of income. That is they leak income away from the product markets.

W = S + T + M

(J) Injections

Injections add to the total volume of the basic circular flow of income. That is they inject revenue into the market

J = I + G + X

Circular flow of incomePRESENTATION OF EQUILIBRIUM

Simple economy-2 sector

Bank

S I

Closed economy-3 sector

Bank

S I

State S

T

Open economy-4 sector

Bank

S I

State S

T

M X

Equation methodTO PRESENT THE EQUILIBRIUM

Simple economy

Y = EY = C + I

W = JS = I

Closed economy

Y = EY = C + I + G

W = JS + T = I + G

Open economy

Y = EY = C + I + G + NX

W = JS + T + M = I + G + X

Schedule methodTO PRESENT MACRO EQUILIBRIUM

Simple economy

Y C(MPC=.8)

S/W I/J E

500 400 100 200 600600 480 120 200 680700 560 140 200 760800 640 160 200 840900 720 180 200 9201000 800 200 200 10001100 880 220 200 1080

Closed economy

Y C(MPC=.8)

S I G E W J

500 400 100 100 40 540 100 140600 480 120 100 40 620 120 140700 560 140 100 40 700 140 140800 640 160 100 40 780 160 140900 720 180 100 40 860 180 1401000 800 200 100 40 940 200 1401100 880 220 100 40 1020 220 140

Open economy

Y C(MPC=.8)

S I G X M E W J

500 400 100 100 40 1000 960 600 1060 1140600 480 120 100 40 1000 960 660 1080 1140700 560 140 100 40 1000 960 740 1100 1140800 640 160 100 40 1000 960 820 1120 1140900 720 180 100 40 1000 960 900 1140 11401000 800 200 100 40 1000 960 980 1160 11401100 880 220 100 40 1000 960 1060 1180 1140

Graphical methodTO PRESENT MACRO EQUILIBRIUM

Multiplier effect

Multiplier

Tax multiplier Investment multiplier

= MPC/MPS = 1 / MPS

Investment rounds