Adigrat University Dep.

t of AcFn Macroeconomics 2019

Planned investment and aggregate demand
We have now specified one component of aggregate demand, consumption
demand. The other component planned investment spending is assumed to be
constant at the level of investment for our present discussion. Since we are
considering two sector models i.e. government spending and net exports each
assumed to be equal to zero, aggregate demand is the sum of consumption and
investment demands. That is
AD= C+I, but C= Ca +cY
Hence, AD = Ca + I +cY,
Let Ca+ I= A
AD= A+cY -------------------------- (1)
The aggregate demand function above is shown in figure 3.3 part of aggregate
demand. A = Ca+I, is independent of the level of income or it is autonomous.
However, aggregate demand depends on the level of income. It increases with
the level of income since consumption demand increases with income.

C AD=Y

IU>0
AD = A+cY
AD E
I C=Ca+cY

A IN<0

Ca

450
Yo income, output

Fig 3.3 the consumption function And Aggregate demand

3.1.4. Equilibrium income and output

Chapter III Page 1 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
The equilibrium level of income is maintained when the aggregate demand
equals output, which in turn equals income. The 45 o line, AD=Y in figure 3.3
shows points at which output and aggregate demand are equal only at point E,
and the corresponding equilibrium levels of income and output (Yo), aggregate
demand exactly equal output. At that level of output and income planned
spending precisely matches production.
The arrows in figure 3.3 indicate how the economy reaches equilibrium. At any
income level below Yo, firms find that demand exceeds output and that their
inventories are declining. They therefore increase production; conversely, for
output levels above Yo, firms find inventories piling up and therefore cut
production as the arrows show. This process leads to the output level Yo, at
which current product exactly matches planned aggregate spending and
unintended inventory changes are therefore equal to zero.
The equilibrium level of income can be algebraically derived as follows.
The consumption function is given as: C = Ca+cY, at equilibrium aggregate
demand is equal to total output produced. That is AD=Y, but in equation (3),
we have AD= A+cY
Hence Y= A+cY, solving for Y, we have
Y= (1/1-c) A ----------------------------------- (1)
As you can see from the above formula the equilibrium level of output is
higher, the larger the marginal propensity to consume(c) and the higher the
level of autonomous spending (A) is.
There is a useful alternative formulation of the equilibrium condition that
aggregate demand is equal to output. In equilibrium, planned investment
equals saving this applies only in a closed two sector economy.
At equilibrium Y= AD,
But Y= C+S and AD= C+I
Hence C+S= C+I
S= I

Chapter III Page 2 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
On figure 3.3 you can see that the distance between the 45 o line and the
consumption function is the saving function. In addition, the distance between
the AD function and the consumption function is the planned investment.
These two distances are equal only at point “E”. With Yo level of income (S=I)
any point above Yo shows saving exceeding investment and any point below Yo
depict investment greater than saving.
3.1.5 The Multiplier
The concept of “multiplier” was first introduced by R.F Kahn, a colleague of
Keynes and this was used as an employment multiplier i.e. finding the effect of
an increase in investment in an employment. Keynes borrowed this concept
and developed another type of multiplier called the income multiplier or the
investment multiplier.
Definition –a multiplier is the ratio expressing the relationship between the
increase in national income and the increase in investment, which induces the
rise in income. Precisely the multiplier can be defined as the ratio of change in
income to the change in investment.
The multiplier concept explains the cumulative effect of change in investment
on income via their effect on consumption expenditures. It describes the fact
that additions to spending have an impact on income greater than the original
increase or decrease in spending itself. In other words, even small increments
in spending can multiply their effects.
Working of the multiplier – we can illustrate how a small investment increase
in the economy goes multiplied to propagate a large volume of income
ultimately.
Suppose an industrialist makes an investment of 10 million dollar to expand
his business. By this, those producing investment goods will get 10 million
dollar and this becomes the additional income for that group which would be
spending the amount. The quantity spent by them would depend on the
marginal propensity to consume. Let the MPC be 0.5, the group producing

Chapter III Page 3 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
investment goods would be spending 5 million dollars on consumption out of
the realized income of 10 million. Due to this, the group producing
consumption goods would get 5 million as their income. This additional income
would be paid out by way of wages, interest, etc. Those who have received the
income of 5 million would spend half of it i.e. 2.5 million since MPC = 0.5.
Consequently, the next group that had helped in catering to the needs of the
preceding group will get 2.5 million dollar and they will spend half of this. Thus
the process will continue till the entire sum gets exhausted. This is
summarized in the following table.
Table 3.2 investment and aggregate income multiplier
Multip Initial invest. Increase in consumption through Total increase in
lies (In million income aggregate income
period dollar) (In million dollar) (In million dollar)
0 10 -- 10
1 10 10+5 15
2 10 10+5+2.5 17.5
3 10 10+5+2.5+1.25 18.75
4 10 10+5+2.5+1.25+0.625 19.375
5 10 10+5+2.5+1.25+0.625+0.312 19.688
6 10 10+5+2.5+1.25+0.625+0.312+0.156 19.844
7 10 10+5+2.5+1.25+0.625+0.312+0.156+0. 19.922
075 etc
We can see from table 3.2 that the initial investment of 10 million reemerges
ultimately as nearly as 20 million. Here, the marginal propensity to consume
has been assumed to be 0.5 and hence, the investment doubles itself after a
series of emergence in different groups over a period. Since an investment of 10
million has become an aggregate income of 20 million the multiplier is 2.
Marginal propensity to consume and multiplier – In the above illustration,
the initial investment had multiplied two times to become the ultimate
aggregate income this is because the MPC has been assumed to be ½. The
value of the multiplier depends upon the consumption function and MPC.

Chapter III Page 4 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
Greater the volumes of consumption expenditure, larger the volume of
aggregate income as the value of the multiplier will be greater.
The formula for the multiplier is,
K= 1 or 1 …………………………………… (1)
1-MPC 1-c

Where, K stands for the multiplier and MPC (c) for marginal propensity to
consume.
Since the marginal propensity to save is 1-MPC the multiplier formula can also
be written as: K=1/MPS.
In our illustration stated above we have MPC= 0.5 hence the multiplier can be
calculated using the formula as follows.
K= 1/1-MPC = 1/1-0.5 = 2
Or MPS= 1-0.5 = 0.5 and K= 1/MPS = 1/0.5 =2

3.2. Government spending and taxation (Three Sector Model)

It is when the model of income determination is expanded to include government, aggregate

consumption, domestic investment and government expenditure for final product. The aggregate
flow of income is now allocated not only to consumption and private saving but in part of tax as
well.
In general, government can expand aggregate spending in any time period by increasing the
amount it adds to the stream of private spending through its purchase of goods and service or by
decreasing the amount it diverts from the stream of private spending through its net tax
collection. Government policy with respect to spending and taxing is known as fiscal policy.

To explain the mechanics of fiscal policy we will construct a series of three models, each of
which is built on the models developed for the two sector economy.

In the first, only tax receipts (T) and government purchases (G) are added to the two sector
model, government transfer payments are in effect assumed to be zero. In the second model,
government transfer payments are added. Both of these models assume that tax receipts are
independent of the level of income. In the third model, the breakdown of government

Chapter III Page 5 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
expenditures into purchases of goods and services and transfer payments is retained, but tax
receipts are recognized as being in part, dependent on the level of income.

Fiscal Policy– including taxes and government purchases

Recall the accounting identities in chapter two, the GNP identity for a three sector economy was
given as C+S+T= GNP= C+I+G.

Let; C+S+T= C+I+G

Form this we can find the saving-investment identity which is;

S+T-G = I

Where; T-G equals public saving

In the two sector economy, disposable personal income (Yd) was found to be equal to net
national product (Y), in the three sector economy, however, taxes absorb a portion of the income
generated by expenditures on net national product. Therefore, disposable personal income is less
than net national product by the amount of taxes. Algebraically, it can be putted as:-

Yd= Y-T

Or Y= Yd +T, where Yd is disposable income, Y is net national product and T is net tax.

And also the consumption function for the three sector model becomes:-
C= Ca+cYd
Or C = Ca+c(Y-T)

Investment is independent of income the equilibrium level of income is given by:-

Y= Ca+c(Y-T) + I+G……………… (1)

Chapter III Page 6 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
Expressed in terms of saving and investment, equilibrium will be found at that level of income
and output at which planned saving plus taxes equals planned investment plus government
purchases.

S+T= I+G………………………... (2)

If planned savings are equal to planned investment, then equilibrium is established by

government’s balanced budget i.e. taxation revenue being equal to government expenditure. But
government may use a budget deficit or surplus to influence the level of aggregate demand.
Since government expenditure is a component of AD, an increase in it, if not offset by a rise in
taxation, has a multiplier effect on incomes. The government instead of balanced budget will
start framing deficit budgets. Similarly, the lowering of rates of taxation without corresponding
fall in government expenditures provided higher disposable incomes to the people who will raise
their consumption expenditure, will cause a multiplier expansion of the level of income.

To show the multiplier effect, let us rewrite the aggregate spending equation (1)

Y= Ca+c (Y-T) + I+ G

This can be rearranged as;

Y = 1/1-c (Ca- cT+I+G)……… ……………… (3)

For instance, if we assume a change in investment, the other values remaining unchanged, the
new equilibrium level of Y is equal to the original level of Y plus the change in Y.

Y+ ∆Y = 1/1-c (Ca-cT+I+G) + 1/1-c ∆I

Subtracting Y from both sides of the equation, we have

∆Y = 1/1-c ∆I ………………………………. (4)

In the same way, we will find that

∆Y = 1/1-c ∆G ………………………………. (5)

Chapter III Page 7 of 8

 Adigrat University Dep.t of AcFn Macroeconomics 2019
∆Y = 1/1-c ∆Ca ……………………..………. (6)
∆Y = -c/1-c ∆T …………………………...….. (7)

Note – change in government expenditure and change in the amount of tax have different impact
on the level of income. To analyze this, we can compare the multipliers equation in (5) and (7).
∆Y = 1 ∆G or ∆Y = 1
1-c ∆G 1-c ……………. (8)

And ∆Y = -c ∆T or ∆Y = -c
1-c ∆T 1-c...……….….. (9)

From equations (8) and (9) we can see that the tax multiplier is less than the government
spending multiplier and they have different effect on income, the former has a negative impact
shown by the negative sign and the later a positive impact.

Regardless of the level of consumption (C), the government purchase multiplier is alwaysgreater
than the tax multiplier. This may be shown by combining the separate multiplier expressions for
∆G and ∆T.

∆Y + ∆Y = 1 + -c = 1-c = 1 ……………… (10)

∆G ∆T 1-c 1-c 1-c

The sum of the two multipliers is always unity. This is known as the balanced budget theorem or
the unit multiplier theorem.

Chapter III Page 8 of 8