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Principles of Economics
Session 11
Topics To Be Covered
Identities of Saving and Investment
Consumption Function
Marginal Propensity to Consume
Marginal Propensity to Save
Investment Function
Equilibrium of the Goods Market
Case Study: Output Accounting and Output
Determination
Topics To Be Covered
Business Cycle
Fiscal Policy
Multiplier Effect
Crowding-Out Effect
Paradox of Thrift
National Saving

National saving is the amount of income
that households have left after paying
their taxes and consumption and the
revenue that the government has left
after paying for its purchases.
National Saving = Private Saving + Public Saving
Private Saving

Private saving is the amount of income
that households have left after paying
their taxes and paying for their
consumption.
Private Saving = Y – T - C
Public Saving
 Public
saving is the amount of tax
revenue that the government has left
after paying for its spending.
Public Saving = T - G
Surplus and Deficit
Budget Surplus
If T>G, the government runs a budget
surplus because it receives more money
than it spends.
 Budget Deficit
If G>T, the government runs a budget
deficit because it spends more money
than it receives in tax revenue.

Identities of
Saving and Investment
Assume a economy consisting of households
and firms only. The expenditures are
consumption and investment and the incomes
are either spent on consumption or saved.
C+I=C+S
Therefore, saving is equal to investment.
I=S
Identities of
Saving and Investment
In a closed economy with households, firms,
and government, there exists the following
equation, the left side being expenditures and
the right side being income allocations:
C+I+G=C+S+T
Therefore, the national saving is equal to
investment.
I = S + (T – G)
Identities of
Saving and Investment
 In
an open economy, import and export
should be considered. Since the aggregate
income (Y) is equal to the aggregate
expenditure, there exist the following
equations:
Y= C + I + G + NX
I + NX = Y – C - G
Identities of
Saving and Investment
 For an
economy as a whole, net export
(NX) and net foreign investment (NFI)
must balance each other so that:
NX = NFI
 Therefore,
in an open economy national
saving is equal to the sum of domestic
investment and net foreign investment.
I + NFI = (Y – C -T ) – (T – G)
Consumption and Saving
In a society without tax, a household can
do two things with its income—
consumption and saving.
Y=C+S
Determinants of Consumption
Household income
 Household wealth
 Interest rates
 Households’ expectations

Consumption Function
Keynes points out that the household
consumption is closely related to the income.
With the income increase, people will consume
more. However, the increase of consumption is
not as great as that of income.
Empirical studies also reveal the close
relationship between consumption and income
but the increase of consumption is on the
whole proportional to income.
Consumption Function
Keynes’ View
Consumption
C=Y
C = f ( Y)
45º
Income
Consumption Function
Empirical Finding
Consumption
C=Y
C = a + bY
45º
Income
Marginal Propensity to Consume
The marginal propensity to consume
(MPC) is the extra amount that people
consume when they receive an extra
dollar of income.
Marginal Propensity to Consume
Consumption
MPC = f ‘( Y)
C = f ( Y)
MPC=Slope
Income
Marginal Propensity to Consume
Consumption
C = a + bY
MPC=Slope=b
Income
Consumption Function
Keeping other variables (interest rate,
expectation, etc.) constant, consumption can
be thought of as a function of income.
C = f (Y)
If the function is linear, it can be expressed as:
C = a + bY
Consumption Function
Aggregate Income (Y)
(Billion Dollars)
0
80
100
200
400
600
800
1,000
Aggregate Consumption (C)
(Billion Dollars)
100
160
175
250
400
550
700
850
Consumption Function
Consumption
C = 100 + 0.75Y
100
Income
Marginal Propensity to Save
 The marginal propensity to save (MPS)
is the fraction of an additional dollar of
income that is saved.
MPC + MPS = 1
MPS = 1 - MPC
Marginal Propensity to Save
Aggregate Income
0
80
100
200
400
600
800
1,000
Aggregate Consumption Aggregate Saving
(All in Billion Dollars)
100
160
175
250
400
550
700
850
-100
-80
-75
-50
0
50
100
150
Marginal Propensity to Save
consumption
C=Y
C = 100 + 0.75Y
0
Save
45°
Income
MPS = 0.25
S = -100 + 0.25Y
0
Income
Investment
Investment refers to purchases by firms
of new buildings and equipment and
additions to inventories, all of which add
to firms’ capital stocks.
Generally, investment is considered a
function of interest rate (r). When the
interest rate is high (low), the financial
cost for the firm is high (low), the firm
invests less (more).
Investment
Interest rate
I = f (r)
Investment
Planned Investment
Desired or planned investment refers to
the additions to capital stock and
inventory that are planned by firms.
Actual investment is the actual amount
of investment that takes place; it
includes items such as unplanned
changes in inventories.
Planned Investment
For simplicity, it is assumed that planned
investment is fixed, for the major
determinant of investment is the interest
rate and the investment is an exogenous
variable in the Keynesian cross model.
It does not change when income changes,
so investment is an autonomous variable.
Planned Investment
Investment
I = 25
Income
Planned Aggregate Expenditure
To determine planned aggregate
expenditure (AE), we add
consumption spending (C) to
planned investment spending (I) at
every level of income.
Planned Aggregate Expenditure
C+I
AE = C+ I = 125 + 0.75Y
C = 100 + 0.75Y
125
100
25
I = 25
Y
Equilibrium in Goods Market
 In macroeconomics, equilibrium in the
goods market is the point at which
planned aggregate expenditure is equal
to aggregate output.
Y=C+I
Equilibrium in Goods Market
Y＞C+I
Inventory investment is greater than planned.
Actual investment is greater than planned, so
there is unplanned inventory
Y＜C+I
Inventory investment is smaller than planned.
There is negative unplanned inventory.
Equilibrium in Goods Market
Saving is a leakage out of the spending
stream. If planned investment is exactly
equal to saving, then planned aggregate
expenditure is exactly equal to aggregate
output, and there is equilibrium.
Aggregate output will be equal to planned
aggregate expenditure only when saving
equals planned investment (S = I).
Case Study: Output Accounting
and Output Determination
Assume an economy consists of
the firm and the family only
and the firm produces a single
product—bread.
Case Study: Output Accounting
and Output Determination
The firm thinks that the household
will consume $800 of bread.
Considering that the firm needs the
inventory $200 of bread to entertain
international guests, the firm
produces $1000 worth of bread.
Case Study: Output Accounting
As expected, the firm sells
exactly $800 of bread and keeps
an inventory of $200 of bread.
What’s the GDP of this
economy for this period?
Case Study: Output Accounting
Aggregate Output=$1000
Aggregate Income=$1000
Output:$1000
Aggregate Expenditure=C+I=$1000
GDP=$1000
Consumption: $800
Income: $1000
Inventory: $200
Case Study:
Output Determination
As expected, the firm sells
exactly $800 of bread and keeps
an inventory of $200 of bread.
Is the goods market in
equilibrium? Why?
Output = AS: $1000
Case Study:
Output Determination
Planned Expenditure = AD: $1000
Planned
Saving:
$200
Unplanned
Inventory: $0
Income: $1000
Case Study:Output Determination
AD= Planned Expenditure
=C+I
AS=AD Output=AD, so the
C+I
1000
0
Investment here doesn’t
include unplanned inventory,
so investment does not
necessarily equal saving.
45°
1000
Saving and
Investment
goods market is in
equilibrium.
GDP= AS =Output
= Income=C+S
Planned Saving
Planned Investment
200
0
1000
GDP=Income
Case Study: Output Accounting
Unexpectedly, the firm sells only
$600 of bread, so it has to keep an
inventory of $400 of bread.
What’s the GDP of this
economy for this period?
Case Study: Output Accounting
Aggregate Output=$1000
Aggregate Income=$1000
Output:$1000
Aggregate Expenditure=C+I=$1000
GDP=$1000
Consumption: $600
Income: $1000
Inventory: $400
Case Study:
Output Determination
Unexpectedly, the firm sells only
$600 of bread, so it has to keep an
inventory of $400 of bread, $200
of which is unplanned inventory.
Is the goods market in
equilibrium? Why?
Output = AS: $1000
Case Study:
Output Determination
Planned Expenditure = AD: $800
Planned
Saving:
$400
Unplanned
Inventory: $200
Income: $1000
AD= Planned Expenditure
=C+I
Case Study:Output Determination
Output is greater
than AD by $200
800
0
C+I
45°
Saving and
Investment
Equilibrium
output
1000
GDP= AS =Output
= Income=C+S
S
400
I
200
0
1000
Other things held
constant, the firm
should decrease its
output next period.
Planned saving is
greater than planned
investment by $200.
GDP=Income
Case Study: Output Accounting
Unexpectedly, the firm sells all the
bread it has produced—$1000 of
bread, so it has run out of inventory.
What’s the GDP of this
economy for this period?
Case Study: Output Accounting
Aggregate Output=$1000
Aggregate Income=$1000
Output:$1000
Aggregate Expenditure=C+I=$1000
GDP=$1000
Consumption: $1000
Income: $1000
Inventory: $0
Case Study:
Output Determination
Unexpectedly, the firm sells all the
bread it has produced—$1000 of
bread, so it has run out of
inventory, which means a negative
unplanned inventory of $200.
Is the goods market in
equilibrium? Why?
Output = AS: $1000
Case Study:
Output Determination
Planned Expenditure = AD: $1200
Planned
Saving:
$0
Unplanned
Inventory: - $200
Income: $1000
AD= Planned Expenditure
=C+I
Case Study:Output Determination
C+I
1200
Output is smaller
than AD by $200
0
45°
1000
Saving and
Investment
Other things held
constant, the firm
should increase its
output next period.
Equilibrium
output
GDP= AS =Output
= Income=C+S
S
I
200
0
1000
Planned saving is
smaller than planned
investment by $200.
GDP=Income
Case Study:
Output Determination
Planned
Planned Planned
GDP Consumption Saving Investment
1000
600
400
200
1000
800
200
1000
1000
0
GDP
Total
Planned
C and I
Resulting
Tendency
of Output
Contraction
200
1000 ＞ 800
1000 ＝ 1000
Equilibrium
200
1000 ＜ 1200
Expansion
Business Cycle
GDP
Peak
Trend Growth
Trough
Trough
Time
Business Cycle
AE
AE
800
0
45°
150
GDP
Equilibrium
output
1000
Expansion
Trough
Peak
Recession
Business Cycle
 A recession
is a period of declining
real GDP, falling incomes, and rising
unemployment.
 A depression is a severe recession.
Business Cycle
 Economic
fluctuations are irregular and
unpredictable.
 Most
macroeconomic variables fluctuate
together.
 As
output increases, unemployment falls,
but the price level increases.
Fiscal Policy
 The
government can play a very important
role in smoothing the economic fluctuation.
 When the economy is in recession, the
government may adopt expansionary
policy—decrease taxes or increase spending.
 When the economy develops too fast, the
government may adopt contractionary
policy—increase taxes or decrease spending.
Expansionary Fiscal Policy
AS
Price
Level
P2
P1
AD2
AD1
0
Q1
Potential
Output
Quantity of
Output
Contractionary Fiscal Policy
AS
Price
Level
P1
P2
AD1
AD2
0
Potential
Output
Q1
Quantity of
Output
Potential Output
 The potential output is determined by the
stock of labor, capital, land, and technology.
The price level has little effect on the supply
of these factors in the long run. So in the ASAD model, the potential output is vertical.
 This level of production is also referred to as
natural rate of output or full-employment
output.
Fiscal Policy and
Aggregate Expenditure
In a closed economy with three sectors—
firms, households, and government.
Government spending (G) is a very important
component in aggregate expenditure.
AE = C + I + G
In the Keynesian model, government
spending does not change with output, so G is
an autonomous variable.
Fiscal Policy and
Aggregate Expenditure
AE
150
125
100
50
25
C+I+G = 150 + 0.75Y
C+ I = 125 + 0.75Y
C = 100 + 0.75Y
G = 25
I = 25
Y
The Multiplier
The 1 dollar increase of autonomous
variable (investment, government purchase,
etc.) is likely to result in more than 1 dollar
increase in total output.
For example, if the government spending
increases by $1, the individual who earns
that dollar saves $0.25 and pays $0.75 for a
book.
△GDP = $1 + $0.75 = $1.75
The Multiplier
If the book seller saves 25% of $0.75 received
and spends 75%, the increase of GDP is:
△GDP = $1 + $0.75 + $0.5625= $2.3125
If the MPC of every person is 0.75, then the
GDP increase is:
$1
GDP  $1  $1  0.75  $0.75  0.75  
 $4
1  0.75
GDP increases four times as large as the increase
of government spending, so the multiplier is 4.
The Multiplier
The multiplier is the ratio of the change in
the equilibrium level of output to a
change in some autonomous variable.
The Multiplier
MPS may be expressed as:
S
MPS 
Y
Because △S must be equal to △I for
equilibrium to be restored, △I can be
substituted for △S.
I
1
MPS 
Y  I 
Y
MPS
1
1
Multiplier 

MPS 1  MPC
The Multiplier
AE2 = C+ I + G2
=150 + 0.75Y
AE
AE1 = C+ I + G1
=125 + 0.75Y
1
Multiplier 
1  MPC
1

4
1  0.75
150
125
45º
500
600
Y
The Tax Multiplier
A tax cut increases disposable income, which
is likely to lead to added consumption
spending. Income will increase by a multiple
of the decrease in taxes.
However, a tax cut has no direct impact on
spending. The tax multiplier for a change in
taxes is smaller than the multiplier for a
change in government spending.
The Tax Multiplier
1
MPC
Y  (  T  MPC) 
  T 
MPS
MPS
MPC
Tax Multiplier 
MPS
Tax Multiplier  MPC  Expenditure Multiplier
However, a tax cut has no direct impact on
spending. The tax multiplier for a change in
taxes is smaller than the multiplier for a change
in government spending.
The Crowding-Out Effect
There are two macroeconomic
effects from the change in
government purchases:
 The
multiplier effect
 The crowding-out effect
The Crowding-Out Effect
Fiscal policy may not affect the
economy as strongly as predicted by the
multiplier.
An increase in government purchases
causes the interest rate to rise.
A higher interest rate reduces
investment spending.
The Crowding-Out Effect
This reduction in demand that results
when a fiscal expansion raises the interest
rate is called the crowding-out effect.
The crowding-out effect tends to dampen
the effects of fiscal policy on aggregate
demand.
The Crowding-Out Effect
AS
Price
Level
Crowding-out effect=
Q2 – Q3
P2
P3
P1
AD2
AD1
0
Q1
Q3 Q2
AD3
Quantity of
Output
The Paradox of Thrift
When households are concerned about the
future and plan to save more, the
corresponding decrease in consumption
leads to a drop in spending and income.
In their attempt to save more, households
have caused a contraction in output, and
thus in income. They end up consuming
less, but they have not saved any more.
The Paradox of Thrift
S, I
175
125
S2
75
S1
I
25
－25
－75
300
600
Y
Assignment
Review Chapter 22, 23, and 24
Answer questions on P430, 444 and 463.
Search for information on China’s fiscal
policies in the recent years.
Preview Chapter 25 and 26
Thanks