Global Macroeconomy and Financial Crisis

Dr Ritesh Kumar Mishra, Department of Finance and Business Economics, University of Delhi
Lecture – 2: Determination of Economic Activity

Dr Ritesh Kumar Mishra, Department of Finance and Business Economics, University of Delhi
Meaning of equilibrium national output
 Meaning of equilibrium national output

• The aggregate planned expenditure is made up of a number of components:

 Meaning of equilibrium national output

• In order to calculate aggregate planned expenditure on domestically produced good, we

must subtract planned expenditure on imports (M), because the good bought by domestic
households, government as well as exports sold overseas are likely to include a foreign
components (i.e. imported raw materials).
 Components of aggregate planned expenditure

• Consumer expenditure and saving:

 Propensity to spend and save

• Important concept in the determination of economic activity may be derived from the
relationship between consumer spending, savings and disposable income.
 Propensity to spend and save
• The proportion of disposable income that goes towards consumer spending is referred to as
the average propensity to consume (APC).

• Similarity, the proportion of disposable income saved is known as the average propensity to
save (APS). In notation form:
 Propensity to spend and save

• By definition, the numerical values of the APC and APS must sum to 1, because
household disposable income is either spent (consumed) or saved, i.e.:
 Change in income

• When total disposable income rises in an economy, and since consumer spending and
savings are related to income, total consumer spending and savings will also increase.

• Similarly, when total disposable income falls, spending and savings will decline.

• The proportion of any change in disposable income which is spent on consumer goods and
services is known as the marginal propensity to consume (MPC).

• While the part of any change in income which is absorbed by extra savings is referred to as
the marginal propensity to save (MPS).
 Change in income
• More formally:
 Change in income
• Once again, since any change in household disposable income can only be used for
consumption or savings, it follows that the numerical values of the marginal propensities to
consume and save must sum to 1, i.e.:
 Consumption Function
• The relationship between disposable income and consumption expenditure:
 Saving Function
• The relationship between disposable income and savings:
Shifts in Consumption and Saving Functions
Investment Expenditure
The Government Expenditure
The Aggregate Planned Expenditure Schedule
Determination of Equilibrium National income
 Determination of Equilibrium National income
• If values of Y and AE
are graphed together
then the locus of all
possible equilibrium
expenditure positions of
the economy will be
shown along the 45
degree line of figure 4.7
(assuming the same
scales are used on both
axes).

• In other words, any

point along this 45-
degree line represents
an equality between the
level of national income
(which is the same as
real GDP or aggregate
supply) and the level of
aggregate planned
expenditures.
Aggregate Planned Expenditure and Equilibrium National income
Inflationary Gap and Deflationary Gap
 The Multiplier Effects
• Changes in any of the components of aggregate planned expenditure will have an effect on
the equilibrium level of national income Ye.

• For example, a change in any of the injections into or leakages from the circular flow of
income will bring about a change in the level of economic activity.

• Injections refers to either government spending capital (G), investment spending (I) or
expenditure on exports (X), which add to the circular flow of income; while leakages refer to
taxes (T), savings (S) or expenditure on imports (M), which reduce the amount of income
circulating around the economy.

• Let us consider a change in one of the injections. For example, if the government decided to
raise its level of expenditure then by definition, aggregate plant expenditure in the economy
would increase, as shown in figure 4.10 (see next slide).
 The Multiplier Effects
• The multiplier effect is defined as the ratio of the resultant change in national income with
respect to the initial change in injections or leakages.
The Multiplier Effects
 The Multiplier Effects
• To see how the value of the multiplier is derived, let us take a simple case in which the only
leakage from the circular flow of income is saving, that is, all income is either spent
(consumed) or saved.

• Thus, it follows directly for any change in national income:

• In this simple case, therefore, the impact of any change in aggregate planned expenditure
will depend upon the size of the leakages from the circular flow of income in the form of
savings. That is the multiplier will depend upon the MPS and may be measured as follows
 The Multiplier Effects
• This way of expressing multiplier is, clearly, a gross (but useful) simplification of reality. In
addition to savings, the other two leakages from the circular flow (taxation and expenditure
on import) generally affect the size of the multiplier.

• To understand this, consider what happens as a result of an increase in investment

expenditure (I) by firms. This will increase the level of national income (output of real GDP)
which, in turn, will stimulate consumer spending (C).

• But part of the increase in I and C will be spent on imported goods and services not
domestically produced goods and services.

• Thus, the larger the marginal propensity to import, the smaller is the final change in the level
of domestic economic activity resulting from an injection into the circular flow.
 The Multiplier Effects

• Similarly, income taxes also reduce the size of multiplier effect. As before assume there has
been an injection into the economy due to an increase in I, resulting in an initial higher level
of national income.

• If the taxes are raised, disposable income will raise by less than gross income and hence C
will rise by less than it would have done if taxes had not changed. The larger the margin rate
of tax the smaller the change in disposable income and real GDP arising from an injection
into the circular flow.

• In reality therefore, the marginal propensity to save (MPS) combined with the marginal rate
of tax (MPT) and the marginal propensity to import (MPM) determine the size of the
multiplier.
 The Multiplier Effects (as Leakage)
• Thus, in more general place we can define the multiplier as follows:
 Leakages from the Circular Flow and Multiplier

• The amount spent in each successive round of spending is termed ‘induced expenditure’.

• The multiplier indicates how the eventual change in income would be determined by the size
of the MPC and the MPS. The higher the MPC the greater the multiplier effect.

• However, in an open economy with government, any extra $1 is not simply either spent or
saved, some of the extra income may be spent on imported goods and services or go to the
government in taxation – withdrawals from the circular flow.

• Withdrawals (W), or you can say Leakages (L), from the circular flow are classed as
endogenous as they are directly related to changes in income.

• Withdrawals are saving (S), taxation (T) and imports (M).

 Leakages from the Circular Flow and Multiplier

• We must also take into consideration injections into the circular flow of income.

• Governments receive tax revenue (a withdrawal – or leakage – from the circular flow), but
uses it to spend on the goods and services they provide for citizens (an injection into the
circular flow); firms earn revenue from selling goods abroad (exports) which are an injection
into the circular flow; and firms use savings (a withdrawal) as a source of funds to borrow for
investment (an injection).

• Injections into the circular flow are exogenous – they are not related to the level of output or
income – and are investment (I) , government spending (G) and export earnings (X).
 Leakages from the Circular Flow and Multiplier

• The slope of the expenditure line as a whole, therefore, will be dependent on how much of
each extra $1 is withdrawn.

• For each additional $1of income, some will exit the circular flow of income in taxation, some
through savings and some through spending on imports.

• The marginal propensity to taxation (MPT) is the proportion of each additional $1 of income
taken in taxation by the government and the marginal propensity to import (MPM), the
proportion of each additional $1of income spent on goods from abroad.

• When we take into consideration the fact that each extra $1in income is not disposable
income, i.e. not all available for consumption, the multiplier effect when considering the
marginal propensity to withdraw (MPW) will be much lower than if we were simply
considering the MPC alone in any increase in income.
 Leakages from the Circular Flow and Multiplier

• We can restate the formula for the multiplier (k) in an open economy with a government as:

• The size of the MPW will determine the slope of the expenditure line: the steeper the slope
of the expenditure line the greater the size of the multiplier, as shown in Figure 27.2 (see in
next slide).
 Leakages from the Circular Flow and Multiplier
• The slope of the expenditure Line and
Changes in autonomous expenditure

• Panel (a) shows a relatively shallow

expenditure line which would mean that the
marginal propensity to withdraw would be
high and the value of the multiplier would be
relatively low.

• Using the Greek letter delta (D) to mean

‘change’, the impact on national income (DY)
of a change in government spending (DG)
would be more limited in comparison to the
effect as shown in panel (b), where the
expenditure line is much steeper reflecting a
higher value of the multiplier where the MPW
was relatively low.

• In this case it takes a smaller rise in

government spending to achieve the same
increase in national income.
 The Multiplier: An Example
• Consider the impact of a $1 billion public works road building programme announced by the
government.

• For simplicity, assume that we are dealing with a closed economy (i.e. one with no foreign
trade and therefore no leakage effect due to imports) and that there are no taxes. The only
leakage from the circular flow arises from savings the marginal propensity to save, MPS,
which we shall assume is 10%.

• Expenditure of $1 billion by the government will, initially, raise the level of national income, Y,
by one billion.

• But only 90% of this increase will be spent subsequently since there will be a leakage of
10% from the circular flow in the form of savings.
 The Multiplier: An Example

• Thus $900 million of extra spending will arise, increasing the level of national income by
further $900 million.

• As national income rises, there will be a further stimulus to spending, again leading to a rise
of AE (and Y) 90% of $900 million (i.e. $810 million).

• This process will continue with each subsequent stimulus to the level of aggregate
expenditure and economic activity being smaller than the previous one.

• In principle, the total rise in national income resulting from the initial $1 bn injection will be
$10 billion if the MPS is 10%.
 The Multiplier: An Example
• Thus: Multiplier = 1 /MPS = 1/0.10 = 10 times the initial injections
 The Multiplier: An Example
• Thus:

Multiplier = 1/MPS = 1/0.10 = 10 times the initial injections

• The concept of a ‘ripple’ effect also gives rise to the notion of ‘regional’ as well as ‘national’
multiplier effects, with the leakage of income into imports now defined as spending outside a
particular geographic region of the economy in question.

• For example, a new government shipbuilding order would probably have its greatest impact
upon the levels of income in the region in which the ship building industry is based,
especially in terms of increased employment and therefore expenditure in local shops and
on local services.
 Multiplier: Regional & National Effects

• However, other regions further afield would also benefit from the new shipyard orders
and the increased spending power of the shipyard workers, for example steel
producing areas.

• The larger the spending on goods and services outside the ship building region, the
smaller the regional multiplier effect of the new shipbuilding order since imports
include all spending outside the region, generally the smaller the regional economy,
the smaller will be the multiplier.

• For this reason, national multiplier effects can be expected to be larger than regional
multiplier effects, except where the term region is used to cover a group of countries
for, example the European Union.
 Importance of National Income Multiplier
• Many industries are affected directly by private and government sector investment expenditure
programmes, both local and national.

• In this context, and appreciation of multiplier effects is of immense value in helping to plan ahead.

• For example, decision by the government to build new roads have a significant impact upon
directly related industrial sectors, such as the various construction industries. But there are also
likely to be important additional effects from large investment programmes for the rest of the
economy.

• For example, the building of rail or road link between India and Bangladesh or Nepal had far
reaching effects on employment levels and output in both countries and especially with regard to
the local economies near the road itself.

• Not only can businesses gain from an understanding of the multiplier process, it also provides a
simple but useful quantitative guide for the government in assessing the impact of policy
measures upon the economy.

• Government economic policy may even be directed at influencing the size of the multiplier itself
and hence aggregate expenditure, through affecting changes in the rate of taxation, the level of
saving and the flow of import.
 Multiplier and Demand Management

• Government usually resort to demand management when economy is in danger of

‘overheating’; that is, when domestic spending exceeds the ability of the economy to
supply goods and services, thereby aggravating inflation and attracting imports.

• Similarly, in the case of downturns in economic activity, the government may decide
to intervene and stimulate aggregate spending to boost output.

• In both cases, in deciding by how much demand should be lowered or raised in order
to reduce or increase national income to the desired level, account must be taken of
the multiplier effects.
 Multiplier and Demand Management
• For example:

• Suppose that if government estimates that demand should decline by $3 billion to close an
inflationary gap and hence to reduce inflationary pressures, and the multiplier effect of the
government spending is estimated accurately to be 2, then by how much the government
spending should actually be reduced to achieve the target?

• Answer:

= $1.5 billion

• Hence, the government spending needs only to be reduced only by $1.5 billion in order to
achieve the $3 billion (= $1.5 billion x 2) final reduction in spending.
 Multiplier and Demand Management

• Indeed, if the government spending was reduced by the full $3 billion and the multiplier
remained at 2, the result would be a severe and unintended collapse in aggregate spending
and national income of $6 billion.

• The result might well be an unintended ‘deflationary gap’ leading to rising unemployment and
recession.

• Hence, a clear understanding of the multiplier process and its estimated numerical values
are very important in managing the level of aggregate demand and aggregate spending in
the economy in order to produce desired impact in controlling recession or inflationary
pressure in the economy using the fiscal policy.
 The Accelerator Principle

• The multiplier process is related with explaining why an increase (or decrease) in an
injection into the circular flow of income will lead to an increase (or decrease) in the level of
national income. The final change in level of economic activity will depend on the size of the
corresponding multiplier effect, after allowing for leakages.

• But in the case of an increase in the net investment expenditure (i.e. gross investment
minus and allowance for depreciation or replacement investment), another important
principle must be considered, referred to as the accelerator principle.

• The accelerator principle relates to the relationship between the amount of net investment
and the rate of change of national income, whereby a rapid rise in income (and thus
consumer spending) will stimulate firms to increase existing production capacity and
encourage them to invest not only to replace existing capital equipment, as it wears out, but
also to invest in new plant and machinery to meet and expected future increase in aggregate
demand.
 The Accelerator Principle

• Hence, the accelerator principle helps to explain why a small increase in the output
of consumer goods and services tends to leads to lead to a larger increase in the
production of capital equipment needed to produce those goods. This change in
output in the capital goods industry then has an impact upon the economy by
accelerating the pace of income growth – hence the name.

• The accelerator can also work in reverse.

• A small decline in demand for consumer goods and services tend to lead to serving
of investment expenditure plants, which in turn provokes a fall in orders for capital
equipment and ultimately a downturn in economic activity.
 The Accelerator Principle
• A brief example might help to clarify the accelerator principle.

• Suppose that a firm manufactures goods using 10 machines each of which produces 1,000
units per annum. So, suppose that the total demand for the firm’s output is currently 10,000
units per annum. To simplify the discussion we will assume no depreciation (allowance for
capital goods wearing out or obsolescent), therefore all investment expands capacity.

• If demand remains at 10,000 units per annum, no investment would take place; but if
demand rose to, say, 12,000 units then two new machines would be ordered to produce the
extra output. If subsequently demand rose again, this time to 15,000 units further three
machines would be purchased and so forth.

• Note that the 3000 rice in demand represents a 25% increase in the output of goods that is
from 12,000 to 15,000 units that year while the purchase of an extra three machine amounts
to a 50% rise in the production of the machine manufacturing industry (i.e. from two to three
machines that year).
 The Accelerator Principle
• Hence, the rise in consumer demand has caused an accelerated increase in the production
of new machines.

• Equally, of course, if at some stage consumer demand ceased to grow, then the firm would
cease investing and a small fall in consumer demand would trigger a much larger
proportionate fall in the demand for machines.

• For example, if demand subsequently stagnated or if it shrank from 15, 000 units in the
above example, new investment that year would fall to zero.

• This process by which investment jumps as consumer demand rises and then collapses
when the growth in demand ends can be observed in all economies and makes the state of
new orders for the engineering industry a good barometer of changes in the overall level of
economic activity.
 The Accelerator Principle

• Specifically, the accelerator principle highlights the following:

• Net investment by a firm will be maintained only if the demand for the firm’s
output continues to rise at a steady rate.

• Demand for consumer goods and services must increase at an increasing rate if
net investment is to rise.

• When demand ceases to grow then net investment becomes zero.

 The Accelerator Principle
• In practise, the accelerator principle does not work quite so mechanically as set out above.

• In particular, investment decisions are also affected by business expectations: for example,
businesses may continue to invest during a downturn in consumer demand if they feel it is
temporary and that investment is necessary if they are to compete successfully in the future.

• Similarly, if a firm is working with excess capacity, and increase in consumer demand might
be met out of this excess capacity rather than through new investments.

• Nevertheless, the accelerator effect operates in all economies to varying degrees and is
important in understanding the causes of economic fluctuations.

• More particularly, the accelerator principle emphasises the relationship between output,
consumer demand, investment and business cycle.
 The Accelerator Principle
• Since a change in consumer demand is largely dependent upon a change in national income
(Y) from one time period to the next, and net investment (I) is affected by changes in
consumer demand.

• The accelerator principle in its simplest form can be expressed as follows:

 The Multiplier – Accelerator Model
• In other words, the level of investment is related to changes in income overtime by the
accelerator process.

• The combined effects of multiplier and accelerator forces working through an investment
cycle was put forward by Keynes as an explanation for changes in the level of economic
activity over time associated with business cycle.

• If firms face and increase in actual demand (or even expected demand) that cannot be made
from existing capacity, they will invest in more capital equipment. Investment expenditure (I)
is an injection into the circular flow of income, the level of national income (Y) will rise and by
more than the initial increase in investment because of the multiplier effect.

• The rise in national income itself may stimulate a further rise in planned consumer
expenditure, which leads to more planned investment expenditure through the accelerator
process and so on.
 The Multiplier – Accelerator Model
• The inter-relationship between the accelerator and multiplier effects in business cycle can be
summarised as follows:
 The Multiplier – Accelerator Model and Business Cycle
• These interactions between multiplier and accelerator effects are the basis of the peak
(booms) and troughs (bursts) in economic activity, i.e. the primary explanation of the
business cycle as shown in figure 4.12.
 The Multiplier – Accelerator Model and Business Cycle

• An initial rise in investment expenditure leads to higher income through the multiplier effect.

• The rise in income in turn leads to more consumer demand and, through the accelerator
effect, a further increase in the pace of investment expenditure, and so on. This process
occurs in the recovery and boom phases of the business cycle.

• Similarly, during the recession and bust stages, a reduction in investment leads to a poll in
incomes, less consumer demand, more cancelled investment programmes and so forth, with
the multiplier and accelerator effect working in reverse.

• The multiplier and accelerator effects exaggerate the consequences for economic activity
(real GDP) for any initial small changes in consumer demand.
 Multiplier – Accelerator Model: Turning Points
• Less obvious, perhaps, is why a boom, once it is underway, comes to an end or why, once
an economy goes into a slump, the end result is not total economic collapse.

• The explanation relates to turning points in the business cycle.

• In a period of economic expanse and economic bottlenecks eventually emerge, notably

shortages of labour and uncertain labour skills, raw material and perhaps energy. In addition,
high investment may increase the cost of credit (interest rates). The overall effect is to drive
up the costs of firms’ inputs. The rise in cost in turn pushes up output prices (referred to as
cost-push inflation) leading eventually to a fall in the rate of growth of demand for goods and
services.

• Higher, prices may also lead to government action to deflate demand through physical and
monetary measures to prevent accelerating inflation. These deflationary pressures
eventually affect demand in the economy, leading to a slowdown in planned investment
expenditures.
 Multiplier – Accelerator Model: Turning Points
• A turning point also occurs when economies are in recession.

• Although businesses will initially cancel investment when trading activity slackens, it
is very unlikely that investment will contract to zero.

• Some investment expenditure must occur if production is to continue at all over the
longer term, if only to replace the existing stock of capital as it wears out
(depreciates).

• Therefore, there will be a floor to the level of investment. In addition, after a period of
economic contraction cost pressures, including the cost of capital (i.e. interest rates)
and perhaps wage rates, tend to ease, leading to new business opportunities.

• Eventually the economic decline is reversed.

Some definitions
 Application of Multiplier
• Question: suppose that a recession overseas reduces the demand for India’s net exports
by $1billion. If the MPC is ¾ (or 0.75), then what will be final contraction in output?

• Answer: The actual final decline in output will be the multiplier times initial decline in
exports.

• In this case, the multiplier is equal to 4 [=(1/(1-0.75)], and hence, the total final decline in
output will be:

(Multiplier) X (Decline in exports) = 4 x $1 billion

= $4 billion

• So the $1billion fall in net exports means a $4 billion contraction in output.

 Application of Multiplier
• Question: Suppose that a stock market boom increases households’ wealth and stimulates
their spending on goods and services by $2 billion. If the MPC is ¾ (or 0.75), then what will be
the final increase in aggregate demand?

• Answer: The actual final rise in aggregate demand will be the multiplier times initial increase
in spending due to the wealth effect.

• In this case, the multiplier is equal to 4 [=(1/(1-0.75)], and hence, the total final increase in
aggregate demand will be:

(Multiplier) X (Increase in spending) = 4 x $2 billion

= $8 billion

• So the initial impulse of $2 billion in consumer spending translates into an $8 billion

increase in AD.
 Further Readings

• Mankiw and Taylor, Economics (2020). ch. 27

• Nellies and Parker, Principles of Macroeconomics (2004). Ch. 4.

Dr Ritesh Kumar Mishra, Department of Finance and Business Economics, University of Delhi