MACROECONOMICS

ECN 1215

NATIONAL INCOME

Dale Mudenda @2023

 Measuring the Economy’s output
 National income accounting measures the economy’s overall
performance. The accounting helps economists and policy
makers to:
 Assess the health of the economy by comparing levels of production
at regular intervals
 Track the long-run course of the economy to see whether it has
grown, been constant or declined
 Formulate policies that maintain and improve the economy’s health
 Gross Domestic product
 the market value of all final goods & services produced within a
country in a given period of time, often using the resources within
the country regardless of who owns them
 It doesn’t include what the citizens earn from other countries
(property income from abroad, shares in foreign companies and
interest from loans advanced to foreigners
 Aggregate Output GDP ; Production and Income
3

The definition of GDP has four important pieces

 Market Value: measured in Kwacha (or other currency) – the
individual outputs (such as peanut butter, oranges, etc produced by a
country ) have to be summed up sing a common unit which is the
market value
 Final goods and services (not intermediate goods) – we focus on
the final selling price of the commodity. This helps to avoid double
counting . For example if you buy peanuts at K5, You sell the peanuts
to james at K6 and james makes peanut butter at K10, we ignore the
price of intermediate input –peanuts and go for the price of peanut
butter which is K10. this avoids double counting
 Produced within a country Geographical concept (expatriates are
not included) when looking at GDP
 Period of Time - -output is calculated over any period of time –day,
month, year etc. Mostly, people use GDP to refer to annual figure
 However, output is computed over shorter periods
 National Income Measurement and
Determination

Gross national Income (GNI) -

 is the total domestic and foreign output claimed by
residents of a country, consisting of:
 gross domestic product (GDP), plus factor incomes
earned by foreign residents, minus income earned in
the domestic economy by nonresidents
 It includes income earned by resident from abroad.
 Residents of a given country can earn income from abroad in
three main ways:
a. Can own property abroad
b. Own shares in foreign companies
c. Can earn interest from loans advanced
to foreigners
 National Income Measurement and
Determination
 If we deduct income from abroad from the income owed to
foreigners, we have net income from abroad
 This is significant in distinguishing output:
 GNI = GDP plus net income from abroad (factor payment
from abroad minus factor payment to abroad)
 GDP = GNI minus income from abroad
 If we subtract the depreciation of capital from GNP, we obtain
the net national product
 NNP =GNP - Depreciation
 Zambia uses GDP - because GNI distorts what actually
happens in an economy

Macroeconomics for Policy D Mudenda

 Total output: National product, expenditure and
National Income –Circular flow of income

 In principle, the decisions of the many households, firms and

government departments determine the economy’s total
spending, income and output

 The transactions mainly between households and firms can be

used to model how output is determined in an economy.

 We can use the circular flow of income to show the three ways
in which income can be measured:
 THE CIRCULAR-FLOW DIAGRAM
 The circular flow of income diagram is an example of a
model.
 We all know that the economy consists of millions of
people engaged in many activities—buying, selling,
working, hiring, manufacturing, and so on.
 To understand how the economy works, we simplify our
thinking about all these activities using a model of how
the economy is organized and how participants in the
economy interact with one another.
 We use the circular-flow diagram - a visual model of the
economy that shows how money flow through markets
among households and firms

Dr. Mudenda
 Individuals/Households-  Product Market- receives
provide a service, labor to the products from businesses and
factor market in exchange for provides goods and services
wages. HH also purchase goods
directly to the individual
and services from the product
market using your income consumer in exchange for
 Factor Market- This is where payment.
factors of production are bought
and sold. The Factor Market gives
productive resources to
Businesses in exchange for
payment.
 Firms - buy productive resources
from factor markets to create a
product that they sell to the
Product Market
The Circular-Flow Diagram
Revenue (=GDP) Spending (=GDP)
Markets for
Goods & Goods & Goods and
Services Services services
sold

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
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THE CIRCULAR-FLOW DIAGRAM
Assumptions of the model

1. The economy has two

decision makers which are
households and firms

2.Firms produce goods and

services using inputs or Factors of
production (L, K, H) which are
owned by households

3. Households and firms interact in

two types of markets.
a) In the markets for goods and
services, households are buyers and
firms are sellers of goods and
services

Or money

Dr. Mudenda
 THE CIRCULAR-FLOW DIAGRAM
Assumptions of the model
b. Factor markets -households are
sellers and firms are buyers.
In this market, HH provide firms the
inputs like labor, land and capital
that the firms use to produce
commodities
The inner loop represents the
flows of commodities between
households and firms.
o HH own the factors of production.
They sell their L Land and K to the
firms in the markets for the factors
of production. In return they get
wages, rent, salaries and profits
o The firms then use these factors to
produce goods and services, which
in turn are sold to households in the
Consumption can be regarded as total commodities markets.
expenditure by HH on commodities which o The HH spending on goods and
yield utility in the current period services is called consumption

Dr. Mudenda
 Government and
THEforeign sector
CIRCULAR-FLOW DIAGRAM

Exports
Factor
Market
GDP=

Part of the HH income that is nor

spent on consumption is either:
 saved, spent on imports or
Government transferred to government as
taxes
o Saving- is the part of income
not spent buying goods and
Government
borrowing
services or paid as taxes to
government which is not spent in
the current period
GDP= Income o HH may put their savings in the
Financial banks or financial institutions.
Institutions
o The firms tend to borrow the
savings from the financial
markets and use it as investment
for the production
o Investment – is the production
or expenditure by firms on goods
and services which are not for
o Taxes, savings and imports are called leakages current consumption or the
to circular flow of income purchase of need capital goods
o Government spending, exports and investment like factories & machines by the
o Are injections in the circular flow firms
Government and foreign sector
Exports Factor
Market

GDP=
Some of the goods that are not
bought by local people can be sold to
other countries. These are called
exports (X)
Government Also, local people, firms &
government can buy goods from
abroad. These are called imports (M)
The difference between imports and
Government
borrowing
exports is called the net export NX=
X-M
When HH save, the money move out
of the circular flow of income. This is
GDP=
Financial Income called a leakage
Institutions
Leakage from the circular flow is the
money not recycled from HH to
firms
However, when firms invest, we have
an injection into the circular flow.
Injection is the money that flows to
firms without being recycled through
the households.
If we are a closed economy, the
savings are equal to investment
S=I
Government and foreign sector
Exports Factor
Market

GDP=  Let Y denote total output in the

economy or GDP, C denote
household spending , S denotes
savings. By definition, savings is
unspent income:
Government  Y ≈ C+S ; Since savings are equal to
investment we can also say
 Y ≈ C +I ;

Government
borrowing
o Government raises revenue
through direct taxes on (wages,
profits etc.) and through indirect
taxes (VAT, excise duty etc.)
Financial
GDP= o Taxes finance tow kinds of
Income
Institutions expenditure. First government
spending on goods (physical goods)
and services (wages etc) G
o Government also spends money on
transfer payments or benefits (B)
such as social cash transfers,
pensions etc.
o A transfer payment by government
is one for which no corresponding
service is provided by the recipient
(These don’t affect GDP)
 National Income
 Expenditure approach – this
 Let Y denote total output in
highlights the importance of
the economy or GDP, C
consumer spending versus
denote household spending , S
denotes savings. By definition, government spending
savings is unspent income:  measures the total amount
 Y ≈ C+S ; Since savings are spent by purchasers of output
equal to investment on all final goods and services
 Y ≈ C +I ; during a given period
 Buy national income is also  Income approach – Computes
affected by government the total amount of earned by all
spending G factors of production in form of
 Y = C+I+ G +(X-M) wages, rent, profit, and interest in
producing final goods and
 The circular flow of income
shows as three approached to services
measuring income (GDP) in a  Emphasizes importance of factors
closed economy of production
 National Income Measurement

 Example: computing output

Trade Mwisho
Wages to employees K15, 000
Taxes paid to government 5,000
Revenue from sale of oranges 35,000

o Oranges sold to the public 10, 000

o Oranges sold to TJ investment 25, 000

T. J Investments
Wages paid to employees K 10, 000
Taxes to government 2,000
Oranges purchased from Mwisho 25, 000
Revenue from sales of Juice 40, 000

Macroeconomics for Policy D Mudenda

 National Income Measurement
 Check …….
 Trade Mwisho : Example: computing output
 Pays wages 15, 000 Trade Mwisho

 Sells oranges at 35, 000 Wages to employees (picking K15, 000

oranges)
 Before tax Profit is: 35000-15000
Taxes paid to government 5,000
• =K20, 000
Revenue from sale of oranges 35,000
 K5000 paid as taxes hence subtract
from 20, 000 gives K15000 after o Oranges sold to the public 10, 000
tax income o Oranges sold to TJ investment 25, 000
 T J Investments:
T. J Investments
 Pays wages 10, 000 Wages paid to employees K 10, 000
 Buys oranges 25, 000 processing oranges
 Sells orange juice 40, 000 Taxes to government 2,000

 Tax to government 2000 Oranges purchased from Mwisho 25, 000

 Profit before tax is 5000 Prove Revenue from sales of Juice 40, 000
 Profit after tax is 3000 this
Macroeconomics for Policy D Mudenda
 National Income Measurement
Example: computing output
 Question: what is the total value of
Trade Mwisho
the economic activity in this
Wages to employees K15, 000
country?
Taxes paid to government 5,000
 The three methods: product , income
Revenue from sale of oranges 35,000
and expenditure approach give us
the same results: o Oranges sold to the public 10, 000
1. Product Value added Approach:
o Oranges sold to TJ investment 25, 000
o Measures economic activity by adding
the market value of goods and services T. J Investments
produced. It makes use of the value-
Wages paid to employees K 10, 000
added concept
Taxes to government 2,000
o Value added of any producer is the value
of the inputs it purchases from other Oranges purchased from Mwisho 25, 000
producers Revenue from sales of Juice 40, 000
o The approach sums up all the value
added by all producers

Macroeconomics for Policy D Mudenda

 National Income Measurement
Example: computing output
1. Product Value added Approach:
Trade Mwisho
o Mwisho produces output of 35, 000
Wages to employees K15, 000
o T J investment produces output of
Taxes paid to government 5,000
K40, 00
Revenue from sale of oranges 35,000
o If we measure economic activity by
adding 35000 and 20, 000 , we would o Oranges sold to the public 10, 000
double count the K25, 000 TJ spent
on oranges o Oranges sold to TJ investment 25, 000
o Hence – we subtract this from the
final sale 40, 000 – 25, 000 – 15000 T. J Investments
Wages paid to employees K 10, 000
o Mwisho doesn’t use any input bought
elsewhere: Taxes to government 2,000

o Hence its value added equal its Oranges purchased from Mwisho 25, 000
revenue of K35,000 Revenue from sales of Juice 40, 000

o Total Economic activity is:

o K35,000 + k15,000 = K50, 000
Macroeconomics for Policy D Mudenda
 National Income Measurement
2. Income Approach: Example: computing output
o Measures economic activity by Trade Mwisho
adding all income received by Wages to employees K15, 000
producers of output , including wages Taxes paid to government 5,000
received by workers and profits by
Revenue from sale of oranges 35,000
owners of firms:
o Mwisho before tax profit is K20, 000 o Oranges sold to the public 10, 000
(35000-15000)
o T. J investments profit is revenue o Oranges sold to TJ investment 25, 000
K40,000 minus 25000 used to buy T. J Investments
oranges and K10, 000 paid as wages to
Wages paid to employees K 10, 000
its employes gives us K5000
Taxes to government 2,000
o Economic activity is:
Oranges purchased from Mwisho 25, 000
o Profit for Mwisho is – 2o, 000
Revenue from sales of Juice 40, 000
o Profit for TJ investments is K5000
o Wages in the two companies K25,00
o Total economic activity K50, 000
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 National Income Measurement
2. Expenditure Approach Example: computing output
o Measures economic activity by Trade Mwisho
adding the amount spent by all Wages to employees K15, 000
ultimate users of output
Taxes paid to government 5,000
o In this example, HHs are ultimate Revenue from sale of oranges 35,000
users:
o Mwisho sells oranges worth K10, 000 o Oranges sold to the public 10, 000
to ultimate users
o Oranges sold to TJ investment 25, 000
o T.J. Investment sells Juice worth
K40,00 to ultimate users T. J Investments
o Total expenditure is: 50,000 Wages paid to employees K 10, 000
o The three methods give us the same output
Taxes to government 2,000
level;
Oranges purchased from Mwisho 25, 000
o Reason: the value of goods and services
produced in a period is by definition equal to Revenue from sales of Juice 40, 000
the amount that buyers must spend to
purchase them. This means the product and
expenditure approach are equal
Macroeconomics for Policy D Mudenda
 National Income Measurement
Example: computing output
 Next observation: what the sellers
Trade Mwisho
receive must equal what the buyers
spend Wages to employees K15, 000

 The seller’s income must Taxes paid to government 5,000

ultimately equal the total income Revenue from sale of oranges 35,000
generated by the economic activity
including incomes paid by workers o Oranges sold to the public 10, 000
and suppliers, taxes to government
o Oranges sold to TJ investment 25, 000
and profits
 Thus, total expenditure must equal T. J Investments
total income generated. Wages paid to employees K 10, 000
 Thus income and expenditure Taxes to government 2,000
approaches must give the same Oranges purchased from Mwisho 25, 000
answer!
Revenue from sales of Juice 40, 000
 Finally, both product value and
income equal expenditure.
Fundamental identify of national income accounting
Total production =Income =Expenditure
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 GDP: Production and Income(1)
 What is the GDP in this simple two firm economy?
23

STEEL COMPANY (FIRM 1) CAR COMPANY (FIRM 2)

REVENUES REVENUES FROM

100 200
FROM SALES SALES

EXPENSES 80 EXPENSES 170

WAGES 80 WAGES 70

STEEL
100
PURCHASES

PROFIT 20 PROFIT 30

• There are three possible methods:

• 2 production side methods
• 1 income side method
 GDP: Production and Income(2)
 Method 1: GDP is the value of the final goods and services
produced in the economy during a given period
 24intermediate goods)
Count only the value of final goods(not

STEEL COMPANY (FIRM 1) CAR COMPANY (FIRM 2)

REVENUES REVENUES FROM

100 200
FROM SALES SALES

EXPENSES 80 EXPENSES 170

WAGES 80 WAGES 70

STEEL
100
PURCHASES

PROFIT 20 PROFIT 30

STEEL AND CAR COMPANY

REVENUES FROM SALES 200

EXPENSES (WAGES) 80 + 70 = 150

PROFIT 20 + 30 = 50
 GDP: Production and Income(3)
 Method 2: GDP is the sum of value added in
the economy during a25given period
 Value added = value of production minus value of
intermediate goods used in production

STEEL COMPANY (FIRM 1) CAR COMPANY (FIRM 2)

REVENUES REVENUES FROM Value added = Value of

100 200
FROM SALES SALES
production (200) – value
EXPENSES 80 EXPENSES 170
of intermediate goods
WAGES 80 WAGES 70 (100)
STEEL
100
PURCHASES

PROFIT 20 PROFIT 30

• Value of final goods and services → sum of value added by all

firms in the economy
Expenditure Approach
 GDP: Production and Income(4)

 Method 3: GDP is the sum of income in the economy

during a given period 27
 Look at revenues left to the firm after it has paid for its
intermediate inputs.
STEEL COMPANY (FIRM 1) CAR COMPANY (FIRM 2)
Labour Income
REVENUES REVENUES FROM
100 200
FROM SALES SALES

EXPENSES 80 EXPENSES 170

Capital Income
WAGES 80 WAGES 70

STEEL
100
PURCHASES

PROFIT 20 PROFIT 30

• Value added is equal to sum of labour income and

capital income
The Circular-Flow Diagram
Revenue (=GDP) Spending (=GDP)
Markets for
Goods & Goods & Goods and
Services Services services
sold

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
Macroeconomics for Policy D Mudenda
 National Income Measurement

 Expenditure approach comprises

 Personal consumption expenditures (C): household spending
on consumer goods
 Gross private domestic investment (I): spending by firms and
households on new capital, that is, plant, equipment,
inventory, and new residential structures
 Government consumption and gross investment (G)
 Net exports (EX –IM=NX): net spending by the rest of the
world, or exports (EX) minus imports (IM)

Y = C + I + G + NX
 In a closed economy, this translates to Y = C +I+ G

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 National Income Measurement
 The level of consumption depends on the level of available
income. The households receive income from their labour and
ownership of capital, pay taxes to government:
 Once deductions are made, the HH remains with disposable
income Yd:

 Yd = Y – T (i.e., gross minus taxes equal disposable income)

 Yd: is the amount of money available for spending. It can be
consumed or saved or both
 Yd = C + S : S = savings
 There are three possibilities in this case:
 Case 1: C = Yd no savings and all income is consumed
 Case 2: C = cYd HH consumes only a small share of Yd & save part
of it
Macroeconomics for Policy D Mudenda
 National Income Measurement
▪ Case 2: C = cYd HH consumes only a small share of Yd &
save part of it. The portion c is called the marginal
propensity to consume
C Ratio of the change in consumption to the change in
mpc = =c
Yd disposable income

S
mps = =s
yd in general mps+mpc =1 : c =1-s
3. Regardless of one’s level of income, there is a proportion
that is consumed and it is called the autonomous
consumption
C = a + cYd
where – a - is the autonomous spending i.e., independent of
income
Macroeconomics for Policy D Mudenda
 National Income Measurement

C =Yd

C = a + cYd consumption function

Consumption (c)

C =cYd

Disposable income Yd

Macroeconomics for Policy D Mudenda

 National Income Measurement

 Savings Function:
 Yd = C+ S
 S = Yd – C but C = a + cYd
 Substituting the consumption function into saving function we
have:
 S = Yd – (a + cYd)
 S = -a +(1-c) Yd but 1 - c =s
 S = -a + sYd ( saving function)
▪ The saved money finds its way to business firms and it is
used for investment. It occurs in two ways:
a. The HH buy stocks and bonds issued by firms which
invest the money. E.g., shares in CEC
Macroeconomics for Policy D Mudenda
 National Income Measurement

a. The HH buy stocks and bonds issued by firms which

invest the money. E.g., shares in CEC
b. The money that is saved is left in financial institutions
which lend the money to business firms and firms use it
for investment. Whether the funds are invested directly or
indirectly, savings are equal to investment:
 S  I ……….1
 Yd = C+ S
 From equation 1 : Yd = C+ I
 I + C = E ( i.e., expenditure )
 Y  E (i.e., income equal expenditure)
 In this case, there will be pressure to change iff:
Macroeconomics for Policy D Mudenda
 National Income Measurement

 In this case, there will be pressure to change iff:

 Case 1
 Y > E - the current level of production exceed expenditure
 Y  ( Ep= C + Ip )+ Iu
 Where
 Ep = planned expenditure
 Ip - planned investment
 Iu –unintended inventory accumulation
 When current output is greater than expenditure, then
firms accumulate unplanned inventory. It is not the
intention of the firms to accumulate unplanned inventories
 They respond to this by cutting production
Macroeconomics for Policy D Mudenda
 National Income Measurement
 Case 2: Y < E: current output is less than expenditure
 Y  ( Ep= C + Ip ) - Iu
 We have unintended inventory decumulation. Firms do not
desire this situation. They respond by increasing production
 Case Y = Ep and Iu =0: No pressure to change and there is
neither inventory accumulation or decumulation

 Economic Scenarios:
Case 1: Closed economy and no government sector and nor
foreign trade:
a. Y = Yd gross = net income
b. Ep = C + Ip
Macroeconomics for Policy D Mudenda
 National Income Measurement

c. C = a + cY - take this into b above

d. Ep = a + cY + Ip in equilibrium,
e. Y = Ep
• Sub d into e we obtain
• Y = Ep = a + cY + Ip

• Y – cY = a + Ip
• (1-c)Y =a + Ip but s = 1-c
f. Y = (a + Ip )/S and a + Ip is autonomous spending (AP)
so that Y = 1/s (AP)
s is knows as a multiplier

Macroeconomics for Policy D Mudenda

 National Income Measurement

Case 2: Closed economy with government sector:

In this case:
a. Yd = Y-T
b. Ep = C +G + Ip in equilibrium
c. C = a + cY sub into EP and simplify to get
d. Y = a + cY –cT + G + Ip
Make Y subject to get:
Y = ( a + –cT + G + Ip )/s
Case 3: Open economy with government sector
 Ep = C +G + Ip + X-M
 Using the same process above we obtain:

Macroeconomics for Policy D Mudenda

 Measurement

Case 3: Open economy with government sector

 Ep = C +G + Ip + X-M
 Using the same process above we obtain:
• Y = (a + –cT + G +Ip + (X-M))/s
Note that 1/s is the Keynesian multiplier

Macroeconomics for Policy D Mudenda

 National Income

C + IP +G + (X-M)

C + IP +G ( Ep =C+ IP +G)

C + IP ( Ep =C+ IP )
expenditures

EP =C; C = a cYd

Disposable Income
The slope of PE line equals the MPC: with I and G exogenous, the only
component of (C+I+G) that changes when income changes is consumption.
A one-unit increase in income causes consumption---and therefore PE---
to increase by the MPC.
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 The Determination of Equilibrium Output
How it41works

 In the Short Run Demand determines the Output level

 Only when Demand = Total Production will there be
equilibrium
 E <Y
 Output will decrease until equilibrium is reached
 E >Y
 Output will increase until equilibrium is reached
 The Determination of Equilibrium Output
Finding where Z=Y
42
(Equilibrium)
Total Demand Z, Production Y

E=Y

500 All points along 45 line

are Equilibrium points

100

45˚
100 500 Income, Y
 The Determination of Equilibrium Output
Finding where Z=Y
43
(Equilibrium)
Total Demand Z, Production Y

E=Y

500 B E<Y

E >Y
100 A
All points off 45 line
are Disequilibrium
points

45˚
50 600 Income, Y
 The Determination of Equilibrium Output
Finding where Z=Y
44
(Equilibrium)
Total Demand Z, Production Y

Disequilibrium
E=Y

E= (C0 + I + G - c1T) + c1Y

E >Y Inventories Run Down

100 Firms increase
Equilibrium Production
0
900 A

45˚
500 100 Income, Y
0
 The Determination of Equilibrium Output
Finding where Z=Y
45
(Equilibrium)
Total Demand Z, Production Y

Disequilibrium
E=Y
E = (C0 + I + G - c1T) + c1Y

B
1100 Inventories Build up
100 Firms Decrease
0 Production
E<Y

Equilibrium
45˚
100 150 Income, Y
0 0
 How long does it take for output to adjust?
47
 According to the model instantaneously
 Y=E → Production responds to DD instantaneously
 C responds to YD instantaneously
 Instantaneously from A to A’
 Realistic?
 Firm: may not respond immediately to an increase in DD
 Consumer: may not respond immediately to an increase in Y
 Describing formally the adjustment of output over time is
what economists call the dynamics of adjustment.
 This requires a lot more mathematics
 Specifically, Economists use Dynamic Optimisation
 Not needed for Macro II
Investment Equals Saving (1): An Alternative Way of Thinking
about Goods-Market Equilibrium
48
 Saving is the sum of:
 Private Saving and
 Public saving

Private saving Public saving (= T – G)

S  YD − C ▪ If T > G: budget surplus
S Y−T−C ▪ If T < G: budget deficit

Y = C+ I + G
Y− T− C= I + G− T
S = I + G− T
I = S + (T − G )
 Investment Equals Saving(2):
An Alternative Way of Thinking about Goods-Market
Equilibrium
49

I = S + ( T − G)

 IS relation
 What firms want to invest must be equal to what people
and the government want to save
 Investment Equals Saving(3):
An Alternative Way of Thinking about Goods-Market
Equilibrium
50

 Consumption and saving decisions

are one and the same.
S= Y−T−C
S = Y − T − c0 − c1 (Y − T ) The term (1−c) is called the
S = − c0 + (1 − c1 )(Y − T ) propensity to save.

In equilibrium:
I = − c0 + (1 − c1 )(Y − T ) + (T − G )
Rearranging terms, we get the same result as
before: 1
Y= [c0 + I + G − c1T ]
1 − c1
 Spending Interest and Money

We assume that there is only one interest rate r

 Investment – Savings (IS) Curve
 Invented by Hicks in 1937. It shows the relationship
between interest rates and Income in which the goods
market is in equilibrium. It is a function of autonomous
spending

Macroeconomics for Policy D Mudenda

 What are we saying so far??

 Equilibrium in good market:

• We assumed that the relation between consumption and

disposable income was linear. Here we do not make that
assumption and use a more general form for the
consumption function:

• Equilibrium condition:

• Assumption → r did not affect the demand for goods

• We now abandon this simplification (introduce r into
goods market model). (r↔I)
 INVESTMENT, SALES, AND THE INTEREST RATE

 We assumed Investment was exogenous (given)

 Now, expand model – investment is endogenous
 Investment depends upon two factors:
1. The level of sales
+ve
2. The interest rate
 Investment relation:

+ve

• Investment depends upon production (inventory investment =

0, thus sales=production) and the interest rate (r)
 DETERMINING OUTPUT (1)
 Taking into account the new investment relation, the
condition for equilibrium in the goods market is given by:

Y = C (Y − T ) + I + G

• Objective: What happens to output when the interest

rate changes?
• Graphically
 DETERMINING OUTPUT (2)

For a given value of i, Ep is

an increasing function of Y.
Demand,

Demand, Ep Two reasons:

Z

1. Consumption:↑Y → ↑YD
→ ↑C
A
2. Investment:↑Y → ↑I

45°

Y Output, Y
 Ep
Demand, (for i)
DERIVING THE
A
Ep’ IS CURVE
(for r’>r)

A’
 What happens to output as
the interest rate changes?
45°  Initial Ep relation for r
Y Y Output, Y  Initial equilibrium at A
’
• Increase r
Interest rate, r

• ↑r → ↓I → ↓Y
• Ep → Ep’
i’
A’ • New equilibrium at A’

• Derive IS curve
A
i
IS
Curve
Y Y Output, Y
 SHIFTS OF THE IS CURVE(2)

 The IS curve gives the equilibrium

Interest, i

level of output as a function of the

interest rate

• ↑T at a given r
• ↓Yd → ↓C → Ep → ↓Y
i

IS (T)

IS’ (T’>T)
• IS shifts left
• At give r, equil Y is
Y Y lower
’
Output, Y

∆G, ∆T, ∆consumer confidence → Shift IS curve

 The IS Curve
 IS Curve
 Shows combinations of Output and Interest Rate
 That ensures that goods market is in equilibrium
 Production = Demand

 Any pt on IS curve is a good market equilibrium pt

 Movement of IS Curve (shift)

 Change in C, G, T or non-interest determined I

 Movement along IS Curve

 Change in interest rate, i
 Investment and savings:
PE PE =Y PE =C +I (r )+G
2

PE =C +I (r1 )+G

I Equilibrium: C+I+G=C+S+T
The IS curve
shows us, for any
A fall in interest rate motivate
Y1 Y2 Y firms to increase investment
given interest r
rate, the level spending, which drives up to
of income that r1 planned spending (PE ).
brings the goods
market into r2 This leads to increased outpu
Equilibrium! IS restore equilibrium in the goo
Y1 Y2 Y Market – hence negative slop
of IS curve
 How did we arrive there?

✓ An increase in r reduces
planned I
➢ The fall in PE reduces output
from Y1 to Y2
✓ The IS summarises the
relationship between r and Y
 HOW DOES FISCAL POLICY AFFECT THE EQUIL. R &Y

An increase in G raises PE PE =Y PE =C +I (r )+G

1 2
planned expend.
At any value of r, the PE =C +I (r1 )+G1
increase
in G leads to an increase in Y
The IS –shifts to the
right
Y2 Y
The horizontal r
distance of the IS
r1
shift equals
Y
IS1 IS2
Y1 Y2 Y