ECON112 (Spring 2011)
2 & 4.3.2011 (Tutorial 1)
Chapter 2: Key Macroeconomics Variables
National income accounting
Gross domestic product (GDP): The market value of all final goods and services produced
within a country (residence) during a specific time period.
Gross national product (GNP): The market value of all final goods and services produced by
the citizens of a country (nationality) during a specific time
period.
Three approaches to calculate GDP
1. Product approach
 The value of final goods and services in the economy during a given period
 The sum of value added in the economy during a given period
2. Income approach
 The sum of incomes in the economy during a given period
 Compensation of employees, proprietors’ income, rental income, corporate profits, net
interest, tax…
3. Expenditure approach
 We could find out GDP by looking at the Expenditure of different sectors
 National income accounts identity: GDP = Y = C + I + G + (EX – IM)
The level of price and inflation

Real GDP: the values of goods and services measured using a constant set of prices

Nominal GDP: the value of goods and services measured at current prices

Inflation rate: (Pt – Pt-1) / Pt-1 (where Pt could be GDP deflator or CPI)
GDP deflator

GDP deflator: The ratio of nominal GDP and real GDP
 GDP Deflator = Nominal GDP / Real GDP = $Y/Y = (P  Q)/ (Pbase  Q) = P/ Pbase
 We sometimes multiply the GDP deflator by 100 to make the index base as 100)
 P/ Pbase shows the change in the price level


Nominal GDP = Real GDP  GDP deflator
GDP deflator allows us to separate nominal GDP into 2 parts: one part measures
quantities (real GDP) and the other measures prices (GDP deflator)
Consumer price index (CPI)
 A measure of the overall price level of prices that shows the cost of a fixed basket of
consumer goods relative to the cost of the same basket in a base year
 CPI in current year = Nominal Expenditure / Real Expenditure
= $Y/Y = (P  Q)/ (Pbase  Q) = P/ Pbase
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Chapter 3: The Goods Market
Composition of GDP
 GDP = Y = C + I + G + X – IM
 Consumption (C): purchases of goods and services by consumers
 Investment (I): purchases of new capital goods (residential and nonresidential investment)
 Government spending (G): purchases of goods and services by the government.
Government transfers are not included.
 Export (X): purchases of domestic good and services by foreigners
 Import (IM): purchase of foreign goods and services
Consumption function

The consumption function shows the relationship between consumption and disposable
income
 C (YD) = c0 + c1YD = c0 + c1 (Y – T)



Disposable income: income after tax, i.e. YD = Y – T
c0: Autonomous consumption: the amount of consumption which is independent of Y
c1: Marginal propensity to consume (MPC): the ratio of change in consumption to
C
change in YD  MPC 
YD
Saving function

The saving function shows the relationship between the amount of saving and disposable
income
 S=Y–C
 S(YD) = –c0 + (1 –c1) YD

(1 –c1): Marginal propensity to save (MPS): the ratio between change in saving to
S
change in YD  MPS 
Y
Determining goods market equilibrium
 The equilibrium GDP is achieved when Demand = Supply i.e. Z = Y
 As we assume that price is fixed in SR, supply will respond to demand passively, i.e. any
quantity demanded would be supplied.




Aggregate demand : Z = C + I + G  (c0  I  G  c1T )  c1Y
Y-intercept of the demand curve is  (c0  I  G  c1T ) and slope is c1
The GDP is in equilibrium when Y = Z (Point E)
Y  c0  c1 (Y  T )  I  G
 Y  c0  c1Y  c1T  I  G
 (1  c1 )Y  c0  I  G  c1T
1
[c0  I  G  c1T ]
 Y
1  c1
are autonomous spending
where
1
is the multiplier and are (c0 + I + G – c1T)
1  c1
2
Z/ Y
45 (Production)
Y2

Suppose Y = Y1  Excess demand (Z1 > Y1)
Excess Supply  The price is fixed and the producer would
Z=C+I+G
response to the demand and increases production
Z2
 Y increases and then Z increases
 This process continues until point E is reached.
E
Z1
Excess Demand 
Suppose Y = Y2 Excess supply (Y2 > AD2)
 Producers would reduce production
 Y falls and AD falls
 This process continues until point E is reached.
Y1
Y
Y1






Y*
Y2
In the goods market equilibrium, Aggregate Saving = Investment
I = private saving + public saving
I = SP + public saving
I = (Y – C – T ) + ( T – G )
I=Y–C–G
Y=C+I+G=Z
The Multiplier
(1) Change in autonomous spending
 An increase in autonomous demand (autonomous G, I or C) would rise Y by more than
the original increase in demand.
Y
 Multiplier: the ratio of the change in Y to a change in the G, i.e.
G
 Effect of an Expansionary Fiscal Policy
Period 1
Period 2
Period 3
Period 4

Period N
G  by 200
Y  by 200
Y  by (200 MPC)
Y  by (200 MPC2)

Y  by (200 MPCn-2)
AD  by 200
C  by (200  MPC)
C  by (200 MPC2)
C  by (200 MPC3)

 C  by (200 MPCn-1)




Y  by 200
AD and Y  by (200 MPC)
AD and Y  by (200 MPC2)
AD and Y  by (200 MPC3)

 AD and Y  by (200 MPC n-1)




 Y  G  (G  MPC )  (G  MPC 2 )    (G  MPC n1 )
1
 Y  G 
1  MPC
Y
1

 Multiplier 
G 1  MPC

The size of the multiplier (i.e. Y/G) depends on the size of MPC: the higher (lower)
the value of MPC, the larger (smaller) the multiplier effect.
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(2) Change in Tax (assuming lump-sum tax)
 Y  (T  MPC )  (T  MPC 2 )    (T  MPC n1 )
MPC
 Y  T 
1  MPC
Y
MPC
 Multiplier 

T 1  MPC
(3) Balanced budget multiplier
 Suppose G and T increases by the same amount, the total effect on Y would be G
Y
Y
1
MPC
 Multiplier 
 (
)

 1  Y  G 1
G
T
1  MPC 1  MPC
1
[c0  I  G  c1T ]
1  c1
 Suppose both G and T increases by the same amount, that is G  T
1
 Y '
[c0  I  G  G  c1T  c1T ]
1  c1
1
 Y  Y 'Y 
[G  c1G]  G
1  c1
(What is the intuition behind? How would the total demand change?)
Recall in the goods market equilibrium, Y 

(4) Automatic stabilizers

Automatic stabilizers are features of the tax and transfer systems that tend to offset
fluctuations in economic activity without direct intervention by government
The Paradox of Saving
S, I

S’
S
S=I

I
Y
’
-c0

As people attempt to save more, the result is both
a decline in output and unchanged saving
Suppose at a given level of disposable income,
consumers decide to save more (reduction in c0,
assuming c1 remains unchanged). What will
happen to output and saving?
Given
-c0
C = c0 + c1YD
S = –c0 + (1 –c1) YD
I I
1
[c0  I  G  c1T ]
1  c1

Output (Y): drops, since in equilibrium, Y 





Private saving (S): S does not change. Why?
–c0 is higher, YD is lower, that is (1 –c1) YD is lower.
In the goods market equilibrium, I = S + (T – G) and I  I
Increase –c0 = drop (1 –c1) YD
Paradox of saving

Suppose consumers decide to save more and increase their MPS (decrease in c1 and c0
remains unchanged). What will happen to output and saving?
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Review Questions
Question 1
During a given year, the following activities occur:
(i) A silver mining company pays its workers $400000 to mine 150 pounds of silver. This
silver is then sold to a jewelry manufacturer for $500000
(ii) The jewelry manufacturer pays its workers $450000 to make silver necklaces, which the
manufacturer sells directly to consumers for $1500000
(a) Using the “production of final goods” approach, what is GDP in this economy?
$1,500,000 which is the value of the silver necklaces.
(b) What is the value added at each stage of production? Using the “value added” approach,
what is GDP?
1st Stage: $500,000
2nd Stage: $1,500,000 – $500,000 = $1,000,000.
GDP: $500,000 + $1,000,000 = $1,500,000.
(c) What are the total wages and profits earned? Using the income approach, what is GDP?
Wages: $400,000 + $450,000 = $850,000.
Profits: ($500,000 – $400,000) + ($1,500,000 – $450,000 – 500,000)
= $100,000 + $550,000 = $650,000
GDP: $850,000 + $650,000 = $1,500,000
Question 2
Consider an economy that produces only 3 types of fruits: apples, oranges, and bananas.
In the base year and current year, the production and price date were as follows:
Base Year
Apples
Bananas
Oranges
Quantity
3000
6000
8000
Price
2
3
4
Current Year
Quantity
Price
4000
3
14000
2
32000
5
a) Find nominal GDP in the current year and in the base year.
GDP in current year: (4000*3) + (14000*2) + (32000* 5) = 200000
b) Find real GDP in current year and in the base year.
Real GDP in base year: 56000
Real GDP in current year: (4000*2) + (14000*3) + (32000* 4) = 178000
c) Find the GDP deflator for the current year and the base year. By what percentage does the
price level change from the base year to the current year?
GDP deflator = (Nominal GDP / Real GDP) *100
GDP deflator of base year: 100
GDP deflator of current year: (200000/178000)*100 = 112
Percentage change in price level from base year to current year = 12%
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Question 3
Giving the consumption function, C = 200 + 0.8Y
(a) Derive the saving function.
Y=C+S
S = Y – C  S = Y – 200 – 0.8Y

S = – 200 + 0.2Y
(b) Graph the saving function (Try to derive it from the consumption function!). How much
is saving/ dissaving when Y = 400 and Y = 2000
C
45
2000
1800
Saving = 200
C = 200 + 0.8Y
520
400
200
Dissaving = 120
Y
400
1000
2000
S
S
200
Y
–120
1000
2000
–200
At Y = 0, C = 200, which means S = –200
At Y = 400, C = 520, which means S = –120
At Y = 1000, C = 1000, which means S = 0
At Y = 2000, C = 1800, which means S = 200
The saving function is a linear function.
The saving function is upward sloping, meaning that Y and S are positively related.
The slope of the saving function is MPS and it is constant at different level of Y.
When MPS changes, the slope of the saving function will change
(c) Identify the autonomous saving and the marginal propensity to save (MPS). What is the
relationship between MPS and MPC?
Autonomous saving = –200 (borrowing) and MPS = 0.2 (MPS = S/Y).
MPC + MPS = 1
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Question 4
Suppose the economy is characterized by the following equations:
C = 160 + 0.6 YD
I = 150
G = 150
T = 100
Solve for the following questions and put your answers in a graph.
AD
45
(a) Equilibrium output (Y)
AD’’
AD
E
Y = 160 + 0.6 (Y – 100) + 150 +150
Y* = 1000
AD’
E
(b) Disposable income (YD)
YD = Y – T = 1000 – 100 = 900
(c) Consumption spending
440
400
360
E
C = 160 + 0.6 (900) = 700
Y**=900
(d) Suppose now G falls to 110. Solve for the new equilibrium.
’
’Y
’
Y**=1100
Y*=1000
1
1

 2.5
1  MPC 1  0.6
G = 40, Y = -40  Multiplier = -40  2.5 = -100
Y** = Y* + Y = 900
Multiplier 
(e) For the new equilibrium in part (d), compute the total saving. Is it equal to investment?
Total saving = private saving + public saving
Private saving = Y – C – T = 900 – 160 – 0.6 (900 – 100) – 100 = 160
Public saving = T – G = 100 – 110 = -10
Total saving = 150 = Investment
(f) Suppose the government increases taxes and government expenditure by 100 at the same
time. Solve for the new equilibrium.
Y = 160 + 0.6 (Y – 100-100) + 150 +250
Y*** = 1100
Alternatively,
Y = 100  [1/(1 – MPC) – C1 /(1– MPC)] = 100
Y*** = Y* + Y = 1100
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Question 5: The balanced budget multiplier
For both political and macroeconomic reasons, governments are often reluctant to run budget
deficits. Here, we examine whether policy changes in G and T that maintain a balanced
budget are macroeconomically neutral. Put another way, we examine whether it is possible to
affect output through changes in G and T so that the government budget remains balanced.
Start from Equation (3.7),
(a) By how much does Y increase when G increases by one unit?
In the goods market equilibrium, Y = c0 + c1(Y – T) + I + G = Z (equation 3.7), and
Y = [1/ (1 – c1)] [c0 + I + G + c1T]
1/ (1 – c1) is the multiplier, so Y increases by 1/ (1 – c1) when G increases by one unit.
(b) By how much does Y decrease when T increases by one unit?
c1/ (1 – c1) is the tax multiplier, so Y decreases by c1/ (1 – c1) when T increases by one
unit.
(c) Why are your answers to parts (a) and (b) different?
The answers differ because government spending affects demand directly, but taxes affect
demand through consumption, and the propensity to consume is less than one.
Suppose that the economy starts with a balanced budget: T = G. If the increase in G is equal
to the increase in T, then the budget remains in balance. Let us now compute the balanced
budget multiplier.
(d) Suppose that both G and T increase by one unit. Using your answers to (a) and (b), what
is the change in equilibrium GDP? Are balanced budget changes in G and T
macroeconomically neutral?
The change in Y equals 1/ (1 – c1) – c1/ (1 – c1) = 1. Balanced budget changes in G and T
are not macroeconomically neutral.
(e) How does the specific value of the propensity to consume affect your answer to part (d)?
Why?
The propensity to consume has no effect because the balanced budget tax increase aborts
the multiplier process. Y and T both increase by on unit, so disposable income, and hence
consumption, do not change.
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