CHAPTER 4

EQUILIBRIUM OUTPUT
AND THE MULTIPLIER EFFECT

Equilibrium Output
Equilibrium output happens
when aggregate expenditures
equal aggregate income.
Aggregate expenditures may
also be labeled as aggregate
demand., while aggregate
income may also be labeled as
aggregate supply. Hence,
equilibrium output may be
identified as the point where
Sa (aggregate supply)
intersects (aggregate demand)
in the expenditure and income
graph.

The Aggregate of Income and

Expenditure
Aggregate income (Y) is
calculated by adding all
incomes received in the
economy by all owners of
factor inputs within a one-year
period, hence, should equal
aggregate supply. On the other
hand, aggregate expenditure is
that part of income spent on
consumption and investment
(C + I). But since investment is
merely a part of saving (S), we
must understand in relation to
income.

The first general equation

that we need to be consider is
that Y = C + S, this equation
generally tells us that, given a
certain level of income, we can
only dispose it either by
spending (C) or saving (S),
nothing more, nothing less.
The money (Y) can only used
either way, so that Y can only
be the sum of C and S.
Corollarilly, if w want to
determine savings (S), the
equation is: S = Y C

Table 4.1
Income, Consumption and Savings
Y

160

320

-160

200

350

-150

400

500

-100

800

800

1200

1100

100

1600

1400

200

2000

1700

300

Table 4.1 shows that negative savings may happen because even at zero income
need to spend, e.g., food and minimal clothing in order o keep themselves alive.
Where do they get the money? Maybe from borrowing, spot from relatives,
subsidies from government welfare agencies.

Consumption and Savings

Propensities
In his general theory, Keynes argued that income
generally determines consumption, so that a functional
relationship exists between them, as C = f(Y), meaning
income determines the level of consumption.

An, since Y = C + S, income also naturally determines

savings. However, the numerical ratio is this functional
relationship varies from household to household. This
variation is captured by the consumption and saving
propensities model.

Consumption and Savings

Propensities
1. Average Propensity to
Consume (APC). A portion
of total income used for
consumption. It is
expressed as a percentage
income (Y). Algebraically.
APC = C / Y
2. Average Propensity to
Save (APS). A portion of
total income not used for
present consumption, and
therefore, saved.
Algebraically, APS = S / Y

Since Y = C + S, C / Y + S + Y
= 1, hence, APC + APS = 1
also, because income can
only be either spent or
saved. So adding two more
columns to Table 4.2 for
APC and APS, the result can
be seen as follows.

Table 4.2
Income, Consumption, Savings, Average Propensity to
Consume and Average Propensity to Save
Y
160
200
400
800
1200
1600
2000

C
320
350
500
800
1100
1400
1700

S
-160
-150
-100
0
100
200
300

APC
2
1.75
1.25
1
0.92
0.86
0.85

APS
-1
-0.75
-0.25
0
0.08
0.14
0.15

Adding each row in the APC and APS columns gives us a uniform sum of 1. Also
in table 4.2, we can see that APC and APS move in opposite directions, that is,
as APC decreases, APS increases. Conversely, as APC rises, APS moves down.
The APC and APS are useful tools in planning as they may be used by
planner (economists) to determine the spending and saving patterns of various
regions and localities of a country, which could guide decision makers in their
policy-making activities.

Consumption and Savings

Propensities
1. Marginal Propensity to Consume (MPC). A portion of
change in total income that is used for consumption.
It is expressed as the ratio of total change in
consumption C to change in income Y.
Algebraically. MPC = C / Y
2. Marginal Propensity to Save (MPS). A portion of the
change in income that is not used for spending, and
therefore, saved. It is expressed as the ratio of the
total change in the amount saved to the change in
income. Algebraically. MPS = S / Y

Table 4.3
Relationship of Income, Consumption, Savings,
APC , APS, MPC and MPS
Y
160
200
400
800
1200
1600
2000

C
320
350
500
800
1100
1400
1700

S
-160
-150
-100
0
100
200
300

APC
2
1.75
1.25
1
0.92
0.86
0.85

APS
-1
-0.75
-0.25
0
0.08
0.14
0.15

MPC
0.75
0.75
0.75
0.75
0.75
0.75

MPS
0.25
0.25
0.25
0.25
0.25
0.25

We can see that the first two row in the <PC and MPC are unfilled, because there are no
previous data on Y and C columns prior to Y = 160 and C = 320 date. Hence, MPC and
MPS cannot be calculated in this instance. We can also notice, that really, if we add the
two columns for each row, MPC + MPS = 1. Finally, we also see that the ratios of MPC
and MPS in relation to income and steady throughout. This kind of pattern has had
empirical validations in the several studies made in this direction in the past.
The MPC and MPS are very useful tools in economic planning as they give planners
and decision makers inputs that are necessary in formulating and implementing policies
related to wages and investment.

Consumption Function
At equilibrium, income (Y) is equal to expenditure (C + I),
and between C and I, C always comprises the larger share
of Y. This logical flow is an extension of Keynes observation
that saving is just a residual fund after an individual or
household had already satisfied his consumption needs,
and that investment (Y) is merely a portion of (S), and at
equilibrium S = I.

From the equilibrium equation Y = C + I, we can see that

both C and I are functions of Y. But because C comprises the
more significant portion of Y, we need to study it more
closely in relation to Y. Hence, we will state that C = f(Y),
meaning the value of C depends on the value of Y.

Consumption Function
From this graph, we can see
the value of C at any point
along the C curve is C = a + bY.
So that we can forecast the
consumption behavior if we
are able to establish the ratio
of C and Y (change in C for
every change in Y). In this
assumed linear relationship
between C and Y, a = origin or
starting value of C and b =
slope of the curve or C line.

Consumption Function
Revisiting the date we generated
in Table 4.1, we will validate the
linear relationship of C and Y by
calculating its slopes are every
paired rows:
1. At Y = 160 and C = 320
Y = 200 and C = 350
Solve for B.
DC
b=
DY
350 - 320
b=
200 -160
30
b=
40
b = 0.75

2. At Y = 200 and C = 350

Y = 400 and C = 500
Solve for B.
DC
b=
DY
150
b=
200
b=0.75

Consumption Function
3. At Y = 400 and C = 500
Y = 800 and C = 800
Solve for B.
DC
DY
300
b=
400
b=0.75
b=

4. At Y = 800 and C = 800

Y = 1200 and C = 1100
Solve for B.
DC
DY
300
b=
400
b=0.75
b=

5. At Y = 1200 and C
=1100
Y = 1600 and C = 1400
DC
DY
300
b=
400
b=0.75
b=

6. At Y = 1600 and C
=1400
Y = 2000 and C = 1200
DC
DY
300
b=
400
b=0.75
b=

Consumption Function
Since the slope of s straight
line is the same at any paired
points along the line, we are
able to prove the linear
relationship between Y and C
in our sample date. With this
linearity, we can forecast the
value of C at any level of Y.

Example:
Y = 900
a = 200
Solve for C. C = ?

Solution:
C = a + bY
C = 200 + 0.75 (900)
C = 100 + 675
C = 875

Planned Investments
And Its Multiplier Effect

The second component of aggregate spending (aggregate demand) is

planned investment; I. Planned investment is the type of investment made
by the firm voluntarily of intentionally. This is differentiated from
unplanned investment, which has a negative effect on output because it
occurs due to weakness in demand, therefore, is undesirable.

Unplanned investment happens when inventories rise because of the fall

in demand. For example, San Miguel Corporation expects to sell 100
million bottles of beer for the year, but because of a change in consumer
preference, it is only able to sell 90 million bottles. So, without wanting it,
SMC will have increased its investment (trough increase inventory) by the
amount equivalent to 10 million unsold beers. This kind of investment
(unplanned) definitely has a negative effect on output. It is for this reason
that we will only consider planned investment as relevant to our present
analysis.

Planned Investments
And Its Multiplier Effect
With this clarification, henceforth, we will
consider planned investments as investment
Investment may be defined as that part of
savings used to create future value, e.g.,
sewing machine to create clothes I the future,
beer mixing machines to crease future beers,
buildings to create more space foe
warehousing, etc.

Planned Investments
And Its Multiplier Effect
Planned investment is normally not
dependent on income. Firms do not normally
alter its investments expenditures as planned
for a given year. Why? Because a capital
expenditure plans which was made in prior
years is very costly for the firm to change in
terms of additional man-hour cost, which will
rework the plan, and for cost opportunities in
doing other things rather than reworking plan

Planned Investments
And Its Multiplier Effect
Figure 4.3 shows a perfectly
elastic I curve showing that
the level of investment by
firms is not dependent on the
level of income (Y).

Now, what happens if an

unexpected rise in demand
occurs? Of course, the firm has
to respond by producing
additional output by
increasing investment. That is
the only way that the firm can
cope with increase in demand.

Planned Investments
And Its Multiplier Effect

If for example, a typhoon damaged the facilities of

Meralco so, say in Manila. Meralco will have no choice but
to increase its investment to rehabilitate its facilities
immediately. They cannot wait for the next budget cycle
before repairing its facilities. Otherwise, they will be in big
trouble from its customers.

After deducting the reduction in income brought about by

the damaged facilities, will a 100 million increase in
investment in Meralco to repair the facilities bring an
additional income of 100 million in the economy? Since Y
= C + I, hence an increase by 100 million of I will result in
100 million of I will result in Y also increase by 100
million.

Planned Investments
And Its Multiplier Effect
After deducting the reduction in income brought about by
the damaged facilities, will a 100 million increase in
investment in Meralco to repair the facilities bring an
additional income of 100 million in the economy? Since Y
= C + I, hence an increase by 100 million of I will result in
100 million of I will result in Y also increase by 100
million.

The answer is flat NO. Why? Because an increase in

planned investment has a multiplier effect in the economy.
Income, Y, will actually increase by a multiple of I. This is
because an increase in I will also include an increase in C.

Planned Investments
And Its Multiplier Effect
Let us explain this phenomenon. Initially, income will increase by
the same amount as the increase in I. But the money from the
investment will be paid o additional workers who will work to repair
the damaged facilities and/or to those existing employees who will
render overtime; some will be paid to suppliers of equipment,
wires, transformer, bus-station spare parts, etc.

The recipient of this investment money will naturally spend all or a

part of this additional disposable income on consumption.
Therefore, C will also be effectively increased. For the rest next
round, further recipients of this investment money paid to workers
and suppliers will spend part of it for their own familys
consumption needs. Then, there will be another round of spending,
and another and another, until there will be no more residual
money left for further spending.

Planned Investments
And Its Multiplier Effect
The graph in Figure 4.4
shows the effect of I to
Y. By ocular inspection,
we can easily see that the
distance from Y0 to Y1 is
longer than the distance
from I0 to I1. Hence, Y >
I because of the
multiplier effect of I in
the economys income.

The Value of the Multiplier

The value of the investment
multiplier can be derived by
putting together the various
equilibrium relationships that we
have established in this chapter.

It was also established that:

C= a + bY

By rearranging this equation, we

find:

First we have to establish that:

Y=C+S

But since at equilibrium,

S=I

Hence, Y = C + I at equilibrium

Therefore, Y = a + bY + I

Y - by = a + I, and
Y (1 - b) = a + I, and
1
a+I
Y=
or Y= a + I

1 - b
1- b

The Value of the Multiplier

Since a is the
intercept (starting
value) of C, its value is
assumed to be
constant.

Hence, if I is increased
by I,
1
DY=DI
b
and because b=MPC
1
DY=DI

1-MPC
Hence, the value of the multiplier is

1
1-MPC

The Value of the Multiplier

Example:

Using the computed MPC of 0.75 in Figure 4.4, estimate the effect on
income at equilibrium of the change in planned investment using the
following data:
Given:
I0 = 850
I1 = 900
a = 350
b = 0.75
Calculate:
I change in investment= ?
Y change in income= ?
Y (resulting income)= ?
Y0income before I appears= ?

The Value of the Multiplier

Solution:
1. DI=I1-I0
= 900 - 850
= 50
1
2.DY =DI

1-MPC
1
= 50

0.25
= 200

3. Y = C + I + DI
= a + bY + I +D I
=350 + 0.75Y + 50
Y - 0.75Y = 350 + 50
0.25Y = 400
400
0.25
Y=1,600
Y=

4. Y0 = Y - DY
= 1600 - 200
= 1400