Economics

“AE and the Multiplier”

"I'm a walking economy," a man was overheard to say.

"My hairline's in recession, my waist is a victim of
inflation, and together they're putting me in a deep
depression."

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Contents

Booklet Part A and Questions 5

Essential Terms 7
Macroeconomic Equilibrium 8
The Components and Determinants of Aggregate Expenditure (AE) 9
Consumption Function 9
Equilibrium and Why Points along the Aggregate Expenditure (AE) are Unsustainable 17
The Effect on Macroeconomic Equilibrium When There is A Change In AE 17
Why is AE Important? 18
Booklet (Part B) 19
Part B Questions 20
Consumption Function and the Savings Function 23
Algebraically calculating Equilibrium Level of Income using the Consumption Function 25
Changes in Autonomous Investment and Macroeconomic Equilibrium 26
Simple Multiplier and Formula 26
How the Multiplier Works 27
The Multiplier and Government Expenditure and Exports 30
Paradox of Thrift 31
Complex Multiplier 31
Business Cycle 32

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Essential Terms

Macroeconomics versus Microeconomics

Microeconomics
Behaviour of individual units (labour market, monopolies, oil market)

Macroeconomics
Behaviour of the economy as a whole and broad economic aggregates.
For example: Aggregate Expenditure, Aggregate Demand, Aggregate Supply, GDP,
Inflation, Unemployment, Macroeconomic Equilibrium

Nominal GDP
Current or market value of final goods and services produced in an economy over a
year.

Real GDP or Real Output

Constant value of final goods and services produced in an economy over a year.(GDP
adjusted for the effect of inflation)

Macroeconomic Equilibrium
Macroeconomic Equilibrium occurs when
Aggregate/Total Expenditure = Total Output = Total Income
ΣE = ΣO = ΣY
Σ =Sum of.

Total Income (Y)

Total payments made to the factors of production (rent, interest, profit, wages)
generated from production over a year. (National Income = NI or NY)

Total Output = Aggregate Supply (O)

Measured by GDP (P)
Total current/market value of all final goods and services produced in an economy
over a yr.

Total or Aggregate Expenditure or Aggregate Demand (E)

Aggregate Expenditure on goods and services produced in the economy .
Aggregate Expenditure = C (private consumption spending) + IP (planned investment
spending) + G (G1 - Govt current exp ie wages and G2 - Govt capital expenditure on
investment i.e. infrastructure spending) + X-M (exports minus imports).

Models used to analyse macroeconomic disequilibrium and equilibrium are

1. Keynesian Cross or Income / Expenditure Diagram
2. Circular Flow of Income (Leakages and Injections)
3. Aggregate Demand and Aggregate Supply Diagram

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Information
Macroeconomic Equilibrium Using a Keynesian Cross/Income and
Expenditure Diagram and the Circular Flow Diagram

1. Macroeconomic Equilibrium Using an Income/Expenditure or Keynesian Cross

Diagram

Macroeconomic Equilibrium – Income/Expenditure Graph (Keynesian Cross)

AE 450 line (AE= Y=O)

AE = C + Ip +G +X
AE- +C
M + Ip + G + (X-M)

AEe

Equilibrium occurs when Planned

AE = Real Income/Output

Ye Real Income/Output
Macroeconomic Equilibrium

2. Macroeconomic Equilibrium using a Five Sector Circular Flow

Equilibrium Level of Income and Output occurs when

 the total leakages = total injections or
 S + T + M = I + G + X and there is no tendency to change.

Macroeconomic equilibrium is rarely achieved as the spending plans of consumers,

investors, govts, exporters/importers are constantly changing and disequilibrium
occurs.

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 Aggregate Expenditure Using an Income and Expenditure or
Keynesian Cross Diagram

AE is the spending of household, business, government and overseas spending.

The components of aggregate expenditure (AE) are:
C+Ip+G+(X-M) or = C+Ip+G1 +G2 +(X-M)

G+X-M

+X

The Components of Aggregate Expenditure and the Determinants of

Aggregate Expenditure (AE)

1. CONSUMPTION

 Expenditure on durable goods (discretionary spending) (approx 15%), non

durable goods (non discretionary spending) (35%) and services (50%)

 Largest component of GDP (approx 50-60% of GDP)

 Most stable component of AE. Why? Spending on non durable goods or survival
level of consumption is fairly stable/ constant.
However, consumer spending on durable goods (discretionary spending) is less
stable, as it can be postponed.

The Consumption Function

Assume no Investment, no Govt and Overseas sector and Y = C + S (all income is spent or
saved)

1. The consumption function is the consumption line and shows the planned level of
consumption at each level of income.

2. The Equation that describes the Consumption Function

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 C =a+ b.Y or Autonomous Consumption (a) plus Induced Consumption (bY)

i. a = Autonomous Consumption – survival level of consumption and is not

determined by income but by factors other than income.

We assume autonomous consumption is constant irrespective of income (orange

rectangle).
In the diagram below, autonomous consumption is $100m at every level of income.
Then at zero income we still spend $100m (C) and this reflects the constant level of
autonomous consumption. So if we spend $100m and have 0 income then we are
drawing on savings or it is called dis-savings of $100m.

ii. bY = Induced Consumption – consumption that is determined by the level of

disposable income (blue triangle).

b= Marginal Propensity to Consume (MPC) is the Change in C/Change in Y

/Disposable Income (the rise over the run). It measures the slope of the C line.

bY= MPC x Y (income). As income rises consumption rises and the slope of the
consumption line is determined by the Marginal Propensity to Consume (MPC).

Graphing the Consumption Function Using and Income Expenditure Diagram

An Income/Expenditure Graph that illustrates the Consumption Function

AE(C)
450 line where C= Yd = O
MPC = Rise/Run =
$100m/$200m= 0.5 C = a + bY (autonomous C + induced C)
b = Marginal propensity to consume
Equilibrium (MPC)
Autonomous C is constant
$200m Induced
irrespective of income (orange).
Run =$200m Consumption (b.Y)
Induced Consumption rises as
Rise= $100m as income (Y) rises (b.Y) (blue).
Rise/Run = MPC E = equilibrium where E = C=Y/O
$100m Assumes income can only be
saved or spent (C).
dissavings Autonomous Consumption (a) At equilibrium would people
C>Y save? No - all income is spent C =
0 $200m Yd.
Real Disposable Income/Output

At Equilibrium Yd is $200m = C is $200m and savings is 0.

What is the MPC (b) in the graph page 10?

Change in C =$100m/Change in Yd $200m = 0.5. Therefore, the MPC or b or slope = 0.5

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 Determinants of Consumption
The consumption function consumption illustrates that consumption is determined by income
(induced) and other factors (autonomous) such as consumer confidence

1. Disposable Income or Induced Consumption

Disposable Income is the most important determinant of consumption)
Consumption is mainly determined by the level of income/ disposable income.
In the Keynesian Cross or Y/Ex model the Consumption line slopes upwards because
Consumption rises as real income/output rises

If people consume more as a proportion of their income, the marginal

propensity to consume is higher i.e. (0.6) and the C line will have a steeper
slope C1 increasing the equilibrium level of income. If the MPC falls (people
consume less as a proportion of their income) then the C line will be less steep
and the equilibrium level of income will fall.

450 line where C=Yd = O

AE (C) C1 = MPC steeper $150m/$250m = .6 and the
C=MPC = Rise/Run = equilibrium level of income is higher at $250m
$100m/$200m= 0.5
C = a +by (autonomous C + induced C)
b = Marginal propensity to consume (MPC) = slope
$250m of the C line.
Equilibrium
Induced Consumption (b.Y)
$200 Rise

Run Rise
$100m

dissavings Autonomous Consumption (a)

C>Yd
0
$200m $250m
Real Disposable Income/Output

Other Determinants of Consumption Shifts in the consumption function

Apart from Income that will shift the 450 line CF0 to CF1
CF1
consumption line from CF0 to CF1 or •Decrease in the
CF0
CF2) real interest
rate.
2. Consumer Expectations - If consumers CF2
•Rise in
expect a downturn in the economy and expected future
unemployment to increase, then this disposable
income.
Consumption (dollars)

may lead to consumption decreasing so

CF0 to CF2
the consumption line shifts downwards
•real interest
from CF0 to CF2 and equilibrium level rates rise
of Yd falls. Note income falls by a larger •fall in personal
amount than consumption – this is due 0
wealth

to the multiplier effect.

Disposable income (dollars)

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 3. Cost of Credit - if interest rates rise consumption will decrease
 due to repayments on borrowed funds increasing and/or
 savings increase as the opportunity cost of C rises
C shifts - decreases from CF0 to CF2 then the equilibrium level of Y (Ye) falls.
4. Govt/RBA Economic Policy i.e. monetary policy (interest rate policy) and fiscal
policy. (Federal Budgets). A decrease in interest rates due to expansionary
monetary policy would lead to an increase in CF0 from to CF2 and an increase in the
equilibrium Y (Ye).
5. Level of Consumer Debt
6. Holdings of Wealth/Assets or Shares - an increase in wealth will lead to an
increase in consumption.
7. Availability of Credit – reduced availability of credit will reduce consumption from
CFo to CF2
8. Distribution of Income - the more equal distribution of income the greater
consumption.

2. INVESTMENT (IP – PLANNED INVESTMENT)

Planned Investment – Planned private exp on capital goods used in the
production of final gds and services.

‘Investment’ on the Stock Exchange, or in government bonds is NOT investment

because it only involves the transfer of ownership of assets. Putting funds in banks or
building societies is saving. Unplanned investment is inventories or unsold stocks
and is not included in the aggregate expenditure line on the income expenditure graph.
The AE line includes only planned investment.

Private Investment includes:

1. Final purchases of machinery, tools etc by business.
2. All building and construction
3. Fixed Residential housing investment

Investment is:

 14-26% of GDP
 an important generator of economic activity and is used to explain the business
cycle
 is the most volatile component of Aggregate Expenditure as it concerns the future
which involves more risk and uncertainty.

Investment = Induced (determined by the level of income) and autonomous investment

(affected by changes in technology, population, taxation and real interest rates etc).
In the Y/Exp graph we assume investment is autonomous and has the same slope as the
C line.

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Why is Investment associated with risk and uncertainty?

 usually involves a long time period  increased uncertainty and risk

 can be affected by so many factors such as changing business expectations,
innovation/technology, durability of capital goods, the level of income/output and
future expectations of the level of income/output, domestic and international
political and economic factors such as interest rate changes, tax changes (carbon
tax, mining resource tax), international credit crisis. These factors affect the
availability of funds and profits and can lead to more uncertainty and risk.

Determinants of Investment

1. Real Rate of Interest (i) = (nominal interest rate - inflation rate)

Interest rates reflect the
a. the price of borrowed money
b. opportunity cost of money. For example, an increase in interest rates leads to an
increase in the opportunity cost of investment.
Investment Demand Curve - illustrates the relationship between investment and real
interest rate (real interest rate = nominal interest rate minus inflation rate).

A rise in the real interest rate  fall in quantity of investment and vice versa.
Real interest rate Factors that Shift Investment Demand Curve
10% 1. changes in technology
2. new resources discovered
3. changes in law i.e. environmental
5% regulations
Investment Demand Curve
4. changes in taxation
5. changes in expectations
quantity of investment 6. changes in the level of economic activity

John Maynard Keynes argued that Investment was interest inelastic (investment was
not as responsive to interest rate changes)

Note - Interest rates are affected by the Reserve Bank through Monetary Policy

2. Expected Net Rate of Profits

If the expected net rate of profit was greater than the market rate of interest then
investment is worthwhile.
If the expected net rate of profit was less than the market rate of interest then
investment is not worthwhile.

Other Determinants that will affect Investment and the Net

Rate of Profit

3. Cost of purchasing capital, maintaining capital and operating capital.

4. Govt Policies (carbon tax, mining resource rent tax)
 Fiscal Policy (subsidies, tax and Govt investment projects i.e. infrastructure)
 Microeconomic Reform to improve competition which may  increase in
investment if profitability increases investment
 Reserve Bank Monetary Policy that affects interest rates.
5. Capital Stocks and Productivity

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6. Technology
7. Growth of Demand and Capacity Utilisation.
8. Business Expectations
Graphing Investment using an Income and Expenditure (Keynesian
Cross) Graph
In this model we assume investment is constant irrespective of income (autonomous),
there is no govt spending and net exports. Therefore we can add investment to the
consumption function as indicated below:

Aggregate. 45 degree The Effects of a Change in

Exp C + Ip C + Ip + increase in Ip Autonomous Investment
C + Ip
C Assume autonomous Ip
increases by $10m due to fall
in real interest rates and/or
Consumption an increase in producer
expenditure confidence. This will lead to a
Increase in Ip $10m
larger increase in Ye. Ye
increases by $50m.
Change in Ip $10m/$50m the
change Ye. A $1 increase in Ip
Real Income/Output leads to a $5 change in Ye.
Increase in Ye $50m

3. GOVT EXPENDITURE (G)

 Approx 20-25% of GDP

 Govt Expenditure (Relatively Stable over the longer term)
 G1= current exp (=< a year time period) i.e. wages salaries ,submarines defence
weapons
 G2= exp that adds to the stock of capital (exp > a year time period) i.e. hospitals,
infrastructure.
Note -capital expenditure is difficult to change in the short term i.e. build1/2 a
highway?

Determinants of Government Expenditure

Political Ideology, Economic Theories and the level of economic activity domestically
and internationally will determine the level of Govt Expenditure (i.e. the Federal Govt
stimulus program in 2008/9 due to the GFC) or due to unforeseen events such as the
floods in Queensland, Iraq War, Drought, Bushfires).

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In the model below we are assuming that investment and government expenditure
are constant irrespective of income (autonomous) and there is no net exports. The
slope of the C + Ip + G line is determined by the MPC.

Therefore, we can add government expenditure to the consumption and the investment
line as indicated below:

The Effects of Changes in

Aggregate. 45 degree Autonomous Government
Exp C + Ip C + Ip + G + Expenditure.
+G increase in G C + Ip + G
C + Ip Assume G increases by $5m
C due to the federal govt
spending on an
infrastructure project will
lead to a larger increase in
Consumption
expenditure
Ye. Ye increases by $25m.
Ip/YE = $5m/$25. The
Increase in G $5m multiplier is 5. An
increase in $1 of
government expenditure
increases the equilibrium
level of income by $5.
Increase in Ye $25m

Real Income/Output

4. NET EXPORTS OR XN (EXPORTS – IMPORTS)

 Net Exports (Xn or X – M: Negative and is more volatile than G and C)

 Approx negative 2% of GDP in Australia

Factors that affect X and M.

Some of the factors that affect X and M’s are:

1. The level of economic activity in Australia (increases in Aust’s Economic growth

increases imports) and Overseas (increases in O/S economic growth  increase
exports).

2. Australian and Major Trading Partner Govt Policies eg AANZ Free Trade Agreement

3. Terms of Trade

4. Aust's International Competitiveness which is affected by:

a) Australia's inflation rate compared to major trading partners.
b) Australia's relative productivity – labour and multi factor productivity

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 c) Exchange Rate changes
d) Unforeseen circumstances i.e. drought, war.

In this model we assume investment, government expenditure and exports are constant
irrespective of income (autonomous) and we add exports to the consumption,
investment and govt expenditure line. Export, Govt Expenditure and Investment have
the same slope as the C line. The slope is determined the MPC.
However, imports are assumed to be negative and are affected by income.
Therefore, the AE line falls and the slope of the AE line changes.

The slope of the final AE line is determined by the marginal propensity to spend
( spending/Yd) on domestically produced goods and services as in the
diagrams below.

All of the Components of Aggregate Expenditure (C + Ip + G + X- M)

Combined Into One AE Line

p+G+X

An alternative
way of drawing
all the
components of
Aggregate Expenditure (not drawn to scale).

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O

+X

What happens if the economy is operating at disequilibrium points

B or A on an Income Expenditure Diagram?

WHY ARE POINTS A AND B ON THE AE LINE UNSUSTAINABLE ?

At E
AE=Total
Output
Inventories 0

AE 45 degree = Real Income/Real GDP = AE

AE>Total AE
Output B
Inventories Points A and B are unsustainable –
Fall E disequilibrium using the Y/Exp
A AE < Total diagram
Output
Inventories
At A= AE > Real Y/output inventories
Rise (unsold stock) are reduced until
income rises to Ye where Σ Exp = Σ O
= Σ Y and inventories are 0.

Ye At B = AE < Real Y/output and

inventories will occur until income
Real Y, O (Real GDP) decreases to Ye where Σ Exp = ΣO =
ΣY and inventories are 0.

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 What happens when there is an autonomous change in AE and how
does it affect the
Macroeconomic Equilibrium?
Macroeconomic Equilibrium – Income/Expenditure Graph (Keynesian Cross)

Example 1 450 line (AE= Y=O)

AE
An increase in planned AE, from AE
to AE1 will lead to a larger change
AE +C + Ip + G + (X-M)
(increase) in Income/Output from
1

Ye to Ye1. (Higher Macroeconomic

AEe
Equilibrium)
Example 2 Equilibrium occurs when Planned
AE = Real Income/Output
A decrease in planned AE, from AE
to AE2 will lead to a larger change
(decrease) in Income/Output from
Ye to Ye2. (Lower Ye
Macroeconomic
Real Income/Output
Equilibrium)Macroeconomic Equilibrium

Why is Aggregate Expenditure Important?

1. Assuming that the price level is constant, Aggregate Expenditure determines the
level of economic activity/income and output in the economy in the short run
(John Maynard Keynes). This is why the Income Expenditure Diagram is also
called the Keynesian Cross after the economist J. M. Keynes.
If Aggregate Expenditure increases (or any of the components of AE increase) the
equilibrium level of income and output increases (Output or real GDP increases).
If Aggregate Expenditure decreases (or any of the components of AE decrease) the
equilibrium level of income and output decreases (Output or real GDP decreases).

2. Changes in the components of Aggregate Expenditure may have a multiplier

effect on the equilibrium level of income/GDP.

3. The aggregate expenditure model is also used to explain the turning points in the
business cycle.

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How many Keynesian economists does it take to change a light bulb? All of them,
because then you will generate employment, more consumption, increasing
expenditure and income, generating more employment and consumption.....................

In this section we discuss the multiplier; a concept developed by John Maynard Keynes that
highlighted the importance of spending in generating an increase in income/output in an
economy. This is a really interesting concept that is of considerable significance when
discussing the effects of projects such as the Gorgon Gas Development, economic stimulus
policies or infrastructure spending. Basically, it is the theory that a change in spending
(that is not due to a change in income) will have ultimately a bigger effect on the
equilibrium level of income and real GDP. For example, due to an increase in consumer
confidence, Robert Pattison spends $100 in a vampire shop. The vampire shop owner,
Kristen Stewart saves 20% ($20) and then spends $80 in Lady Gaga’s clothes shop (male or
female?). Lady Gaga saves 20% ($16) and then spends $74 in Pink’s music shop. Pink saves
$14.80 and then spends $59.20 in.......... and so it goes. Therefore, Robert Pattison’s
spending has led to multiple spending and increase in the equilibrium level of income.

Questions

1. Explain the difference between autonomous and induced expenditure?

2. Define the MPS?
3. Explain the difference between the savings function and the C function?
4. The MPC and MPS in a 3 sector economy = ___?
5. Draw an income /expenditure (Keynesian Cross) diagram to illustrate and explain
how the size of the MPC affects the slope of the consumption line and the
equilibrium level of income?

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6. According to the Income Expenditure Diagram how does a rise in income affect the
average propensity to consume (APS)? (Define APS)
7. Define the multiplier and write the simple multiplier formula?
8. According to the simple multiplier, if the MPS = 0.2 then the multiplier = ___ if the
MPS is 0.2 then a $1 increase in autonomous investment will lead to a $ __________
change (increase or decrease? Circle) in Ye and a $1 decrease in autonomous
investment will lead to a $ __________ change (increase or decrease? Circle) in Ye.
9. According to the simple multiplier then if the MPC = 0.5 then the multiplier = ___ and
a $1 decrease in autonomous investment will lead to a $ __________ change (increase
or decrease) in Ye and a $1 increase in autonomous investment will lead to a $
__________ change (increase or decrease)
10. What determines the size of the simple multiplier?
11. Using the Income Expenditure diagram explain the multiplier effect of an increase
in business confidence assuming a 3 sector economy?
12. Define the complex multiplier – using the complex muliplier explain the effect of a
decrease in exports on the equilibrium level of income assuming no price level
changes and C, I and G are constant) the MPS =.1 and MPT = .1 and MPM=.1
13. Draw and label the business cycle diagram?
14. List the characteristics of each stage of the business cycle.
15. Explain the turning points in the business cycle using an income expenditure
diagram?
16. Complete the following Multiple Choice.

Multiple Choice
1. The value of the multiplier will be higher, the higher the

(a) marginal propensity to save

(b) marginal propensity to consume
(c) level of autonomous investment
(d) level of income

2. According to the ‘paradox of thrift’ society’s attempts to save more may result in

(a) decreased exports

(b) increased aggregate savings
(c) increased aggregate supply
(d) decreased total income and savings

3. An investment is the

(a) purchase of a government bond

(b) the exchange of $A for $US
(c) the purchase of a capital good
(d) the deposit of a firms profit in an interest bearing account

4. The largest component of aggregate demand in 2010-2011 was

(a) consumption
(b) private investment

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(c) government expenditure on goods and services
(d) government expenditure on transfer payments

5. In an economy with no taxes, fixed prices and where consumers spend three quarters of their
income, investment rises by $40m. The equilibrium level of income will tend to increase by
(a) $30m
(b) $40m
(c) $120m
(d) $160 m

Consider the following data for a simple economy which has no government or overseas sector.
( Hint work out MPC and MPS)
Possible Levels of National Consumption Spending $b
Output and Income $b
320 320
330 327
340 334
350 341
360 348
370 355
6. The value of the multiplier is closest to

(a) 1.43
(b) 3
(c) 3.33
(d) 7

7. If other things are equal a fall in interest rate will

(a) shift the investment demand curve to the right

(b) shift the investment demand curve to the left
(c) discourage planned investment
(d) encourage planned investment

8. If C = 50 + 0.7Y then what is the MPS

(a) 0.3
(b) 0.5
(c) 0.7
(d) not possible to calculate because income (Y) is not known

9. Assuming a 3 sector economy (no changes to price levels and the economy is operating at less
than full capacity) where Ye = C ($100m + 0.8Y) plus Ip ($50m) then the equilibrium level of
income is equal to

(a) $7,500
(b) $150
(c) $15,000
(d) $750

10. Assuming a 3 sector economy (no changes to price levels and the economy is operating at less
than full capacity) where Ye =C ($100m + 0.5Y) plus Ip ($50m) then a rise in autonomous

17
 investment of $10m is going to lead to a change in the equilibrium level of income of

(a) $10m
(b) $5m
(c) $20m
(d) $50m

Refer to the diagram below to answer the following question;

AE 45 degree

C + Ip
A

$500m
Real Y (O)

11. If the economy is operating at A and real GDP is $500m, then we can expect

(a) consumption and investment to rise to $500m

(b) inventory levels to rise
(c) the Reserve Bank of Australia to raise interest rates to reduce production
(d) the inflation rate to rise.

Information

Recap - Aggregate Expenditure, Consumption and the Consumption Function

Aggregate Expenditure on goods and services produced in the economy or C+Ip+G+(X-M)
To understand the multiplier you will need to recap consumption and the consumption
function. Assume Y = disposable income in the following explanations.

CONSUMPTION AND THE CONSUMPTION FUNCTION.

Assuming no investment, no Govt and Overseas sector and Y = C + S and all income is spent or
saved), then the MPC + MPS = 1 If the MPC was 0.8 then the MPS would be 0 .2.

What is the Marginal Propensity to Consume? Figure 1

18
Marginal Propensity to Consume
(MPC) change in C/ change in Yd
(disposable), MPC measures the 45 Degree line where
slope of consumption line and is planned C = real Yd/O
calculated by the change in C or planned real
expenditures equal real
$24,000 divided by the change in Yd
GDP
$30,000 (blue dotted line) in Figure
1.
What is the consumption
function?
Consumption Function = planned
MPC = Rise/Run
consumption at each level of = $24,000/$30,000
disposable income. = .8
Figure 1 Consumption Function
Formula = a + b.Y or
$6,000 X .8Y
a = $6000 autonomous consumption
which is independent of the level of
income.
b = MPC slope of the C line.
b.Y = MPC (.8) x Y (Induced
Consumption determined by
income)
SAVINGS AND THE SAVINGS Dissaving - Negative saving; a situation in which
spending exceeds income (HH borrow or sell assets).
FUNCTION
What is the Marginal Propensity
to Save?
Marginal Propensity to Save (MPS)
change in S/change in Yd
MPS measures the slope of the
savings line.
From Figure 1 the MPS
=$6000/$30,000 = .2
What is the Savings Function?
Savings Function = planned savings
at each level of disposable income
S= -a + MPS.Y or –a + (1-b)Y –the equation that describes the Savings line. From Figure 1 the
Savings function = -$6000 + .2Y.
Dissaving - Negative saving; a situation in which spending exceeds income (HH borrow or sell
assets).

19
able
You can convert the information
from the graphs on the left to the
Table 1 below.
The table shows the figures for MPC,
MPS, APC and APS.
What is the Average Propensity to
Save (APS) and the Average
Propensity to Consume (APC)?
APS = The average propensity to
savings is savings divided by
disposable income (S/Yd)
APC = The average propensity to
consume. It is consumption divided
by disposable income (C/Yd).

Relationships between MPC and

MPS and APS and APCS
MPC + MPS = 1
If the MPC = 0.5 then the MPS = 0.5
or if the MPC = 0.9 then the MPS = 0.1
APC + APS = 1

Points to Note
 MPC stays at .8 irrespective of
income.
 MPS stays at .2 irrespective of
income.
 APC falls as income rises (from
1.8 to .9).
 APS rises as income rises (from -
.8 to .1).

Table 1 (Derived from the graphs above)

20
Algebraically Calculating the Equilibrium Level of Income Using the
Consumption Function
Assuming no investment, no Govt and Overseas sector and Y = C + S (all income is spent or
saved).
How could you calculate Equilibrium level of GDP/Ye if you were only given the values for
autonomous C ($6000) and the MPC (.8) and no diagram?
At Equilibrium level of Income (Ye) = C
Ye= a+b.Y
Ye = $6000+.8Y
At Y =Ye
Ye – 0.8Ye = $6000
Ye (1-0.8) = $6000
0.2Ye = $6000
Ye= $6000/.2 Therefore Ye = $30,000

Algebraically Calculating the New Macroeconomic Equilibrium When There Is

a Change in the MPC.
What will be the effect of a change in the MPC on the Equilibrium Level of Income (Ye)
Output? Calculating the New Ye Algebraically.
What happens when there is an increase in the MPC from .8 to .9 and the MPS falls from .2
to .1. What will be the new equilibrium level of income?
Finding the new equilibrium level of income using the consumption function:
Ye = a +b.Y
Ye = $6000 +.9Y
At Y =Ye
Ye (1-0.9) = $6000
0.2Y = $6000
Ye - 0.9Y= 6000
0.1Ye = $6000
Ye = $6000/.1
Ye = $60,000 A change in the MPC from .8 to .9 has led to an increase in Ye from $30,000 to
$60,000. See the figure 3 below:

Figure 3 Income/Expenditure Keynesian Cross

Diagram (Consumption only)
When the MPC is
higher (.9 light blue
dotted line) and the
MPS is lower the C1 = MPC -.9
equilibrium level of
income is higher.

C1 = MPC -.8

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The Business cycle is mainly explained by changes in Investment. To explain the
effects of a change in autonomous investment we must first understand the theory
of the multiplier.

The Effect of an Increase in Autonomous Investment on the

Equilibrium level of Income (Ye) Output Using the Simple Multiplier

Any change in autonomous spending may lead to a multiplier effect on the

Equilibrium level of Income.

What is the Simple Multiplier?

The multiplier equation gives govt, businesses and economists a figure that tells us how much a
change in autonomous expenditure will affect the equilibrium level of income and in economy.
“One person’s spending is another person’s income” or an autonomous change in any
component of AE (C + Ip + G + X – M) will lead to a greater change in income Ye or Output.

Formula for the Simple Multiplier (k)

k= 1/MPS or 1/1- MPC.

Or What is not Spent is Consumed

The Simple Multiplier (k) in Action

Example 1
Assumptions:
1. Price level does not change.
2. The economy is not working at full capacity.
3. No govt or overseas sector. (3 sector economy)

If autonomous investment increased by $10m due to an increase in producer expectations of

profit and the MPC is 0.9 then the change in Ye or real GDP will be equal to the autonomous
Investment (Ia) multiplied by the multiplier or Ye – k x Ia

k (multiplier) = 1/1-MPS = 1/1-0.1 =10

The Ye = k(multiplier) x Ia therefore the Ye= 10 (k) X $10m =$100m
Ye - $100m so a $10 million change in autonomous investment leads to a $100m change in the
equilibrium level of income/output ($10m/$100m).A $1 change in autonomous investment
leads to $10 change in Ye!!

Why? Money spent becomes another person’s income which will be respent and respent and
respent…

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23
How the Multiplier Works When Spending is Investment
Figure 4 Flow of Income (Y) and Spending (Exp)
Example 2
Consider a $300 million increase in business 1. Autonomous Increase in Expenditure (Ip) due to a decrease in
interest rates)
investment due to fall in interest rates. This will
set off a chain reaction of increases in spending
and expenditures. Capital equipment will be
purchased and those who produce the capital 3. Leads to an induced 2. Leads to an increase Y
goods necessary for the investment will change in Exp

experience an increase in their incomes. Workers

4 . Y
will be hired and also paid an income. This
increase in income will induce more spending
5. Leads to an induced change in Exp
and if they collectively spend about 3/5 of that
additional income (MPC = 0.6) then $180m will
be added to the incomes of others who will then
spend 3/5 of that additional income (MPC = 0.6). 7. Leads to an induced change 6.. Y
At this point, total income has grown by ($300m in Exp

+ (0.6 x $300m) + (0.6 x $180m). The sum will

8. Y
continue to increase as the producers of the
additional goods and services realise an increase
in their incomes, of which they in turn spend 60% on even more goods and services. The
process continues, until the $300m change in autonomous investment (assuming no
change to price levels and the economy is not working to full capacity)leads to an increase
in income/output (k X Ia or 1/.4(MPS) X $300m or 2.5 x $300m ) of $750m. The
multiplier can work in reverse if autonomous investment or aggregate
expenditure falls – it will lead to a larger fall in Ye.
Example 2
Assume an Increase in autonomous investment due to a fall in interest rates.

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Example 3 Using an Income/Expenditure Diagram
An Increase in Autonomous Investment ,the Multiplier and the effect on National
Income and Output (Ye)
 Assume MPS = .5 therefore the MPC =0.5
 K = 1/ 1- MPC or 1/.5 = 2
 Assume Ia increases by $40m therefore Ye will increase by k (2) x change in Ia
($40m) = $80m. The new Ye will be increased by $80m.
45 degree
Exp C+ I+ change in Ia (rise in$40m) Assume 3 sector economy,
(C+I) C+I
C =$200 +.5Y and
$40m Ip was $40m but increased by
$40m. Ip is now $80m.
Can we algebraically calculate the
Ye Ye* (increase by $80m) new Ye? Yes.
Ye= C + Ip
Real Yd,O Ye =a +b.Y + Ip (Including the  in Ip)
Ye = $200m +.5Y + ($40 m + the
increase in Ip if $40m)$80m
So an increase in Ia of $40m leads to a larger At Y =Ye
increase in Ye (increases by $200m) Ye – 0.5Ye = $280m
Ye (1-0.5) = $280m
0.5Ye = $280m
Ye = $280/0.5 Therefore the new Ye1
= $560m
Can the Multiplier work in reverse if autonomous investment falls? Yes.
The Effect of a Decrease in Autonomous Investment on
Ye=the Equilibrium
$6000/.2 level
Therefore of$30,000
Ye =
Income (Ye) Output Using the Simple Multiplier
Using different figures, a decrease in Autonomous Investment (due to a fall in business
expectations), will lead to a multiplier and the effect on National Income (Ye)
 Assume MPS = .1 therefore the MPC =0.9
 K = 1/1-MPC or 1/MPS or 1/.1 = 10
 Assume Ia decreases by $40m therefore Ye will decrease by k (10) x change in Ia
($40m) = $400m. The new Ye will decrease by $400m.

45 degree
C+ I
Exp C+ I+ change in Ia (Fall in Ia of $40m)
(C+I) C

So a decrease in Ia of $40m
leads to a larger decrease in
Ye/O (Ye decreases by
$400m).
$180m
$140m
$120m

Ye1 Ye $1, 800M Ye decreases by $400m to Ye1 ($1,400m)

Real Yd,/O

25
Can We Algebraically Calculate the New Ye?

Example 4 (Using the following assumptions)

Assume 3 sector economy, C =$120 +.9Y and Ip was $60m but decreased by $40m now
Ip = $20m
Ye= C + Ip
Ye =a +b.Y + Ip
Ye = $120m +.9Y + ($60 m subtract the decrease in Ip if $40m)$20m
At Y =Ye
Ye – 0.9Ye = $140
Ye (1-0.9) = $140
0.1Ye = $140
Ye = $140/0.1. Therefore the new Ye = $1,400. The previous equilibrium level of income
was $1,800. As the multiplier is 10 a $40m fall in Ip would lead to a $400m fall in
income.

What have you learned so far?

The Equilibrium level of Income is affected by:

1. changes in the slope of the AE line

2. changes (increases or decreases)in the autonomous components of AE ( such

as investment )

3. the size of the Multiplier or the size of the MPC or MPS

The smaller the MPS or the larger the MPC, the larger the simple multiplier value
(the change in the autonomous AE will be have a more expansionary affect on
Ye/O.
If MPC = 0.9 and MPS = 0.1 then the multiplier= 1/1-0.9 = 10
If MPC = 0.6 and MPS = 0.4 then the multiplier= 1/1-0.6 = 2 ½
If MPC = 0.5 and MPS = 0.5 then the multiplier= 1/1-0.5 = 2

26
The Multiplier Effect of Other Components of AE – Govt Expenditure
and Exports

Do exports and government expenditure also lead to a multiplier effect on the

equilibrium level of income? Yes.

Changes to Government Expenditure

If we assume Govt expenditure is autonomous and the slope of the C+ Ip + G line is
determined by the MPC (autonomous) then an increase in G will lead to a multiplier
effect on income assuming other factors remain constant.

If the MPC = 0.8 and the MPS = 0.2 then the Multiplier = 1/0.2 ( 1 /MPS) so an increase
Govt exp of $5 million will lead to an increase in Ye of $25m. The multiplier can also
work in reverse if Govt expenditure falls assuming other factors remain constant.

45 degree
Aggregate.
Exp C + Ip C + Ip + G +
+G increase in G C + Ip + G
C + Ip
C

Consumption
expenditure

Increase in G $5m

Increase in Ye $25m

Real Income/Output

Changes to Exports.
If we assume exports are autonomous (0 imports) and the slope of the C+ Ip + G + X line
is determined by the MPC then a decrease in X of $2b will lead to a multiplier effect on
income assuming other factors remain constant.

If the MPC = 0.8 and the MPS = 0.2 then the Multiplier (k) = 1/0.2 (1 /MPS) =5. So a
decrease in Exports of $2 million will lead to an decrease in Ye of $10m ( 5 X 2). The
multiplier can also work in reverse if X’s rise, assuming other factors remain constant.

27
 What if the slope of the AE (C+ Ip + G +X – M) changes? (5 sector
model including all the components of AE)

The Effect of a Change in the Slope of the AE line on the Equilibrium Level of
Income (Ye) Output and The Paradox Of Thrift
As you can see in the diagram below the slope of the AE line affects (relationship between
planned spending and income) the equilibrium level of income/GDP.
Diagram 1
AE 45 degree Diagram 1 (Assume other factors remain constant
AE and an increase in the MPS or a fall in the MPC)
When the AE slope is less steep (AE to AE1), the
equilibrium level of income (red dot) is
significantly lower (red lines).
AE1
If we spend a smaller proportion of our income,
the level of income and output in the economy
falls!!!!

This is called the “Paradox of Thrift”. The more

Real Yd /O we save or the higher the MPS (lower MPC) the
lower the equilibrium level of income/output!!!

Complex Multiplier

However, in reality the slope of the AE line is going to be determined by

1. the marginal propensity to save, the marginal propensity to tax and the
marginal propensity to import
or
2. the marginal propensity to spend .

This means we need a more complex multiplier.

Any change (increase or decrease) in
 autonomous consumption, investment, government expenditure or exports
will a larger change in the equilibrium level of income/output due to the
multiplier.
 leakages ( withdrawals) will a larger change in the equilibrium level of
income/output due to the multiplier.

Complex Multiplier (5 Sector Economy) Formula

k = 1/marginal propensity to save + marginal propensity to tax + marginal

propensity to import or 1/ MP Leakages
Assume the complex multiplier=1/0.1 (MPS) + 0.2(MPT) + 0.1(MPM)
k =1/0.4 = 2 ½

A $1 autonomous change in exports will lead to a $2.50 change in Ye/0.

The size of the Complex Multiplier is determined by size of the Marginal Propensity
of the leakages (MPS, MPT and MPM) or the Marginal Propensity to Spend whereas

28
the size of the Simple Multiplier is determined by the MPS or the Marginal
Propensity to Consume.

Note, if MP Leakages increase or MP Spending decreases the complex multiplier

decreases.
k = 1/MPS + MPT + MPM or 1/ MP Leakages
k =1/0.2 + 0.3 + 0.3
k =1/0.8 = 1.2
A $1 autonomous change in exports will lead to a $1.20 change in Ye/0.

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Business/Trade Cycle

Time

The Business/Trade Cycle

1. Describes the cyclical pattern of economic activity (output/real GDP)
2. Consists of Troughs, Upswing, Peak/Boom, Downswing
3. Illustrates the key role of expenditure (most importantly investment)in
determining economic activity.
4. Business cycle explained in terms of Changes in AE, Aggregate Demand and
Aggregate Supply
5. The severity and length of the business cycles vary. on average from 1951 to
1997 the Length of Business Cycle was 53 months (Downswing 21 months,
upswing – 32 months) However, up to 2008 Aust had 16 /17 years of Economic
Growth
6. The general trend of economic activity/ real GDP/O over time is increasing.
7. Recession is literally defined as 2 consecutive quarters of negative
economic growth , however this definition has come under criticism
recently.

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 The Stages, Characteristics and the Role of Changes in AE and the Multiplier
Effect in Explaining the Business Cycle.

Stages Features Stages Explained in Terms of

Changes in Aggregate Expenditure
and the Multiplier Effect
Trough Low levels of output, high cyclical level of Diagram 1:
1990/1 unemployment, falling sales and profits low
45 degree
1997 business consumer expectations/confidence A. Exp
(Period of low therefore decrease in AE (C, I) and a multiplier
levels of effect reducing the equilibrium level of income.
Aggregate Exp / Low imports ,interest rates and levels of inflation AE
Demand) fall. (Economic Growth Negative)
AE1

Real Y/O
Upswing Firms need to replace worn out capital, lower Diagram 2:
(Increased levels interest rates Increased I and C  multiplier
of Aggregate effect on income increase in output (GDP) and A. Exp
45 degree
Exp/ Demand) employment. Note increase in income will lead to
1992 an improvement in business and consumer AE1
1998 confidence also leading to an increase C and I and AE
2010 -12 a multiplier effect on income.

Real Y/O

Peak Economy near full employment, capacity Diagram 3:

1995 constraints, high participation rates, labour 45 degree
1999/2000 shortages (wage pressures) high levels of output A. Exp
2008 (near/ full capacity), high consumer and business AE1
Period of high confidence, high C especially on consumer
level of durables and luxuries and an increase in imports, AE
Aggregate Exp / high level of borrowing, a fall in productivity,
Demand inflationary pressure CAD worsens. Multiplier
effect is reduced due to inflation and the fact that
the economy is operating at full capacity
Real Y/O

Downswing 2009 A fall in productive investment due to inflationary Diagram 4:

2013 pressures, a fall in business expectations and a 45 degree
(Decreased fall in expenditure on C durables/luxuries A. Exp
levels of decrease –> multiplier effect fall in level of AE
Aggregate Exp/ income, output and expenditure - unemployment
Demand) increases, lower inflation, lower CAD and AE1
economic growth rate falls.

Real Y/O

CAD = Current Account Deficit

31
 Questions:

1. Complete the following table on Aggregate Expenditure = C + Ip + G+ X – M

Aggregate Expenditure Definition of the Approx Characteristics Determinants
Draw Y/Exp or Keynesian Components % of GDP i.e. volatile or
Cross model and include stable
the 45 degree line
Consumption (C)
Draw C function Diagram

Investment
Draw C+Ip

Government Expenditure
Draw C+Ip+G

Exports Minus Imports

Draw C+Ip+G + X-M

32
2. Define and give an examples of Macroeconomics and Microeconomics?
3. Define and explain the difference between GDP and Real GDP and identify the better
measure of Economic Growth?
4. Define total income, total output and total expenditure.
5. According to Keynes the main determinant of economic activity/output is...............
...................?
6. Using a circular flow diagram explain what is meant by macroeconomic
equilibrium?
7. What does the 45 degree line illustrate in an Income Expenditure/Keynesian Cross
diagram?
8. Explain the equation C = a + b.Y?
9. Define and give the formula for Marginal Propensity to Consume?
10. Explain the terms autonomous and induced?
11. Draw an income expenditure diagram and illustrate autonomous consumption,
induced consumption, equilibrium level of income, savings and dissavings?
12. Define dis-savings?
13. Using an income expenditure diagram, illustrate how a fall in the MPC from .9 to .6
will affect the consumption line and the macroeconomic equilibrium (equilibrium
level of income)?
14. Using Income Expenditure diagram show how a increase in consumer expectations
may affect consumption and the equilibrium level of income. (Assume all income is
spent or saved, AE = C)?
15. In the 3 sector Income Expenditure diagram (AE = C+Ip) is investment assumed to
be autonomous and/ or induced. How can you tell this from the model?
16. Using a 3 Sector Income Expenditure diagram explain how a fall in business
confidence will affect the equilibrium level of income?
17. When imports are added to AE why does the slope of the AE line change?
18. What is unplanned investment and is it included in planned aggregate expenditure?
19. Draw an income expenditure diagram using the full aggregate expenditure model
and indicate on the diagram macroeconomic equilibrium?
20. What determines the slope of the AE curve for domestically produced goods and
how would you measure it?
21. Using the diagram on page 17 of this information, explain why points a and b are
unsustainable? In your explanation refer to inventories (unsold stock).
22. Identify the factors that are currently affecting consumption and draw a full income
expenditure (AE= C + Ip + G + X – M) diagram to illustrate a fall in consumer
confidence on the equilibrium level of income, assuming other factors remain
equal?

33