Faculty of
Economic and
Management Sciences
CHAPTER TWO
The basic model 1:
CONSUMERS, PRODUCERS AND
GOVERNMENT
The Total Economy
• We want to know how to think and reason about macroeconomic
events and policy
• To do this we will attempt to model the total economy
 Chapter 2: Goods sector (real sector) – economic activities e.g.
production, consumption, investment, savings, exports, and
imports.
 Chapter 3: Financial/money market (monetary sector) – the
financial institutions, interest rates and money.
 Chapter 4: Foreign sector - balance of payments and exchange
rates.
WE WILL COMBINE ALL SECTORS INTO ONE MODEL TO
ANALYSE THE ECONOMY AS A WHOLE
Models used: IS/LM/BP model (chapter 3 & 4) and AS/AD model (chapter 6)
THE TOTAL ECONOMY
CHAPTER 4
CHAPTER 3
Introduction
 The first step to modeling the total economy:
 Use the Simple Keynesian Theory on the determination of
income
 Focus on the goods sector (activities like production,
consumption, saving, investment, exports and imports)
 Explains determination of and changes in total production
(GDP) and real income (Y)
 Changes in (GDP) are reflected in the business cycle.
 Therefore this analysis helps explain recessions and
unemployment
2.1 The Basic Framework
Original Keynesian Approach of income determination:
 Expenditure (Demand) determines production (Supply).
 Each level of production implies a corresponding level of
income.
 Income–Expenditure circular flow illustrates the Keynesian
approach
 The circular flow is a simplified representation of all
transactions in the economy
 We study the aggregated level of microeconomic activities –
look at the complete circular flow in the economy
The basic model I: consumers, producers and government
The basic model I: consumers, producers and
government
• Aggregate all transactions between households and firms…
E
Y=E
Y
2.1 The Basic Framework
 This represents the chain reaction below:
 Level of Expenditure determines the Production level:
Increase in Expenditure
less than demanded
increases)
Stocks depleted
Production is
Producers produce more (real GDP
Employment increases
Income increases
(increased sales flows to income for managers, workers, land
owners, etc) and real INCOME (Y) increases.
Increases continue until:
TOTAL PRODUCTION = TOTAL EXPENDITURE
2.1 The Basic Framework
◦ Remember – Production and real income will change until
equal to new expenditure level is reached.
◦ When production adjusted fully to changes in total
expenditure an equilibrium is achieved.
◦ Macroeconomic equilibrium:
TOTAL INCOME (Y) = TOTAL PRODUCTION (real GDP) =
TOTAL EXPENDITURE (E)
2.1 The Basic Framework
Graphical illustration of income
determination
 45 ̊-line:
Each point represents equilibrium
where total expenditure (E) = total
production / income (Y)
 Expenditure line:
o Expenditure increase as income
increases (+ slope)
o A – level of minimum existence,
expenditure if Y = 0
A
 Equilibrium will be reached where
the total expenditure line intersects
the 45 ̊-line.
 The equilibrium income (Y0) will be
reached at this intersection.
 At (Y0) total production be equal to
total expenditure.
2.2
The Real (or Goods) Sector
• Total expenditure can be divided into the following:
• Consumption expenditure (C)
• Capital formulation or investment (I)
• Government expenditure (G)
• Net exports (NX): Exports (X) – Imports (M)
TOTAL EXPENDITURE = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴)
REAL CONSUMPTION (C)
2.2.1 Real Consumption (C)
• Definition: The expenditure by households on consumable
items and services. Examples…
• Expenditure on imported items is included.
• What does consumption depend on?
• Consumption depends on:
◦ Real disposable income (Yd) (+),
◦ Tax (-)
◦ Wealth (+),
◦ Average price level (-),
◦ Expectations, Habits, Demographic factors, etc.
2.2.1 Real Consumption (C)
Real disposable income (Yd) is most important factor:
Yd = Y - T
1. Yd increase will lead to
increase in total
Consumption (C).
3. Marginal Propensity to
consume (MPC): the
percentage of additional
income that will be
consumed
2. Tax increase will decrease
disposable or after-tax income,
which will cause total
consumption to decrease.
4. Marginal propensity to
save (MPS): the percentage
of additional income that
will be saved
5. MPC + MPS = 1
NB
Definitions
2.2.1 Real Consumption (C)
Consumption function (Relationship
between real consumption and real income):
•
C = a + bYd
 Yd = Y – T
•
C = a + b (Y – T)
•
T = tY
•
C = a + b (Y – tY)
•
C = a + b(1- t)Y
 a: Autonomous spending
 b: MPC
 Positive slope:
 if Y increases C increases
 Shifts…
REAL INVESTMENT (I) /
CAPITAL FORMATION
2.2.2. Real Investment (I)/ (Capital Formation)
• Definition…
• NB! Distinguish between financial investment and real
investment (capital formation)…
• Financial investment:
• A form of saving
• Invest in a savings account or buy shares or bonds
• Generate interest income
• Real investment (capital formation):
• Purchase of capital goods
• E.g. factories or machinery
• Real asset on which a return is expected from the sales
of production
• I = real investment (capital formation) or business fixed
investment
2.2.2. Real Investment (I)/ (Capital Formation)
Factors that influences Real Investment
 Real interest rates (-)…(explanation NB)
 r = i (nominal interest rate) – π (inflation)
 r represents the return that could have been earned by buying
shares / bonds / saving instead of real assets.
 r is the OPPORTUNITY COST for buying a factory or machine to
increase production INSTEAD of saving the money and earning
interest.
 If r increases, opportunity cost increases, I decreases
As such factors that determine Capital formation/ Real Investment
are Expectations, Business confidence (+), Regulations
2.2.2. Real Investment (I)/ (Capital Formation)
The investment function:
• I = Ia – hr
Ia: autonomous investment –
level of I and r = 0
h: sensitivity of I to changes in
r
r=i–π
• Negative slope:
r increase, I decrease
• Curve shift…
Increase in business
confidence – shifts right
Tax incentives – shifts
right
2.2.2. Real Investment (I)/ (Capital Formation)
• r not on axes of incomeexpenditure diagram
• I horizontal line.
• Upward parallel shift in
investment curve:
• r decreases
• Increase in business
confidence
• Tax incentives
2.2.3 Macroeconomic Equilibrium
Y=C+I
(two sector model)
r decrease =>> I increase =>> total expenditure increase =>>
Production increase =>> Income (Y) increase
2.2.3 Macroeconomic Equilibrium
• At equilibrium
Total expenditure = Total Production
C + I = Total expenditure
Y = Total Production
C+ I = Y
Y = a + bY + Ia – hr
GOVERNMENT
EXPENDITURE (G)
2.2.5 Government expenditure (G) and taxation (T)
 Main elements of the fiscal policy.
 Responsibilities of the National Treasury.
 Government expenditure (G) concerns purchase of goods
and services by the general government. Examples…
 Total government expenditure = General government
consumption (Gc)+ General government investment (IG).
 G – direct influence of total real expenditure.
 T – indirect influence of total real expenditure (influence
disposable income and therefore C).
2.2.5 Government expenditure (G) and taxation (T)
2.2.5 Government expenditure (G) and taxation (T)
• Fiscal policy
• If government wants to increase the equilibrium income
level, they can:
1.Increase G (direct effect – E increases)
2.Reduce t =>> increase C (indirect effect)
• If government wants to reduce the equilibrium income level,
they can:
1.Reduce G (direct effect – E decreases)
2.Increase t =>> decrease C (indirect effect)
NET EXPORTS (X-M)
2.2.6 real exports (X) and imports (M)
 South Africa has an open economy.
 Large portion of total production is exported and a large
portion of total expenditure is spent on the purchase of
imported items.
 Chapter 4 will discuss more detail.
 For now, focus on NX (exports minus imports)
 Total expenditure (E) = C + I + G + (X – M)
2.2.6 real exports (X) and imports (M)
• X is exogenous
• M depends:
 Income
 Relative prices, exchange
rate…(chapter 4)
• Import function:
• M = ma + mY
 + : imports increase if Y
increases
 m: marginal propensity
to import. Percentage of
additional income that
will be spent on imports.
NB Definition
2.2.6 real exports (X) and imports(M)
(X – M) increase =>> total expenditure increases =>> total
production increases =>> Y increases
2.2.6 real exports (X) and imports(M)
Macroeconomic Equilibrium:
 Total expenditure = total production
 C + I + G + (X – M) = total production
 Total production equivalent to total income
 C + I + G + (X – M) = Y
MULTIPLIER
2.2.4 Multipliers
• Def:
• Any change in expenditure will result in a BIGGER
change in income
• The expenditure multiplier mean that one extra
Rand spend in the economy can often translate to
a much more than R1 increase in GDP
• Why is it so?
• Example: Imagine a Firm that wants to build to
Build a Power Station, …..
2.2.4 Multipliers
2.2.4 Multipliers
• How are we going to to figure out how the Original
R10m is going to impact GDP
• We can Add= R 10m + R8m + 6.4m…. Until the
amount is closer to zero, but this would take a long
a long time
• If we know the value of the MPC, we can use the
Multiplier formula to calculate the expenditure
multiplier
Multiplier formula(KE)
1
KE =
1−𝑏
• b = MPC
2.2.4 Multipliers
KE =
1
1−𝑏 1−𝑡 + 𝑚
• Each amount spent is received by (the income of) someone
else =>> proportion re-spent is again the income of someone
else =>> proportion re-spent is again the income of someone
else…
• KE = ΔY / ΔE
1. Marginal propensity to import = m
2. Marginal income tax rate = t
• How big is the multiplier?
• Depends on the % re-spent
• A % of the income is re-spent and the other % is a leakage
from the circular flow
• Leakages = imports, savings, taxes
2.2.4 Multipliers
Multiplier (KE) depends directly on the percentages of income respent and indirectly on the percentages of income “leaked”

KE = 1 / (1 – b(1- t) + m)
 Leakages from the economy =
1. Savings
2. Imports
3. Tax
 Marginal leakage rate =
1. Marginal propensity to save (MPS) = 1 – b
◦ b = MPC
◦ MPC + MPS = 1
◦ MPS = 1 – b
NEXT CLASS – CHAPTER
THREE: Basic Model Two:
Financial Institutions, Money
and Interest rates