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ECON 141: MACROECONOMICS
HOW TO USE THIS WORKBOOK?
This workbook contains notes on certain topics of the course ECON 141. Thus, notes on all topics
are not included in this workbook. In many places tables are provided but relevant numbers
(information) in those tables are missing. I will explain those concepts in the class and we will together
workout those tables only in the class. Many graphs provided in this workbook. However, for many
graphs, relevant curves are missing. Again, I will explain those graphs in the class and we will
workout those graphs together only in the class.
This workbook also contains exercises and some sample multiple-choice questions that may be
useful for your midterms and final examination.
You must bring this workbook whenever you attend a class.
WARNING: This is NOT a (complete) Study Guide. You should use this workbook with the Text-
book by Parkin and the Study Guide by Mark Rush for Macroeconomics.
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What is macroeconomics?
Objectives of the course
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INTRODUCTION
In macroeconomics we study the total or aggregate performance of an entire economy (or country). Thus
macroeconomic behavior reflects the behaviors of many individuals and firms interacting in markets.
These markets of the economy are added together (or aggregated). Thus in macroeconomics we study the
aggregate market(s). In microeconomics, on the other hand, we study an individual market, say, a coke
market or a fish market. But in macroeconomics we study all markets taken together. Otherwise, the basic
ideas of microeconomics and macroeconomics are the same. For example, we can ask how the price of
coke is determined and how much coke is consumed? Answer to these questions are provided by
microeconomics. We learn from microeconomics that the price of coke and the amount consumed are
determined by the market demand and supply of coke. In macroeconomics we do not study an individual
market such as coke market, but all markets together. An economy produces and consumes many
different goods and services. In macroeconomics we add all these goods and services traded in different
markets and call it aggregate output (GDP).
All these goods have their own prices. From prices of all these goods we make an average price,
called the price level (or index). Thus the price level or index includes many prices of goods and services
the country produces and consumes. The use of aggregation and emphasis on aggregate or total quantities
such as aggregate output is the primary factor that distinguishes macroeconomics from microeconomics.
Otherwise, we ask the similar question, for example, how the aggregate output and the price level of the
economy (country) are determined. In this course, we will find out how macroeconomics answers this
question.
Macroeconomics also studies the policies that government uses to try to affect economic
performances. The two most important policies are fiscal policy and monetary policy. Fiscal policy
concerns government spending and taxation and monetary policy determines the rate of growth of the
country's money supply and is under the control of a government agency known as the central bank. In
this course, we will also study these policy options in details. We start with the basic concepts of
macroeconomics namely gross domestic product (GDP) and the price level.
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Important concepts
GDP
Intermediate and final goods
Capital, gross and net investment
NX > 0 lending to rest of the world
NX 0),
zero (NX = 0) or negative (NX M, this means NX > 0, this means the country is selling
more than the country is buying from abroad. That is, if NX = (X – M) > 0, then the country is lending
an amount equal to X – M to the rest of the world. If exports are less than imports, that is X X, then NX X) or by lending to the rest of the world (if M YP Inflationary Gap (IG) Inflationary GAP = IG = 4400 – 3000 = 1400
= 1400
Figure 4 shows the economy’s present short run equilibrium is at point A with real GDP equal to 1400.
Since the economy’s present short run equilibrium (Y 0 =1400) is below potential GDP (YP = 3000), the
economy has below full-employment. Point A in AD-AS diagram of figure 4 corresponds to point A of
business cycle diagram of figure 7. Figure 5 shows the full-employment equilibrium. Figure 6 shows
the economy’s present short run equilibrium is at point C with real GDP equal to 4400. Since the
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economy’s present short run equilibrium (Y0 =4400) is above potential GDP (YP = 3000), the economy
has above full-employment. Point C in AD-AS diagram of figure 6 corresponds to point C of business
cycle diagram of figure 7. The amount by which potential GDP (YP) exceeds the real GP (Y0) is called
recessionary gap.
Recessionary gap = YP – Y0 = 3000 – 1400 = +1600
The amount by which real GDP exceeds the potential GDP is called inflationary gap.
Inflationary gap = Y0 – YP = 4400 – 3000 = +1400.
Exercise: Consider the following table
Short-run Aggregate Long-run Aggregate
Aggregate Demand Supply Supply
Price level (Millions of Dinar) (Millions of Dinar) (Millions of Dinar)
90 2,000 1,400 1,900
100 1,800 1,600 1,900
110 1,600 1,800 1,900
120 1,400 2,000 1,900
130 1,200 2,200 1,900
1. Draw AD, SAS, and LAS curves.
2. At P = 100, the economy has an excess demand or excess supply?
3. At P = 120, the economy has an excess demand or excess supply?
4. What are the short-run equilibrium real GDP and price level of the economy?
5. Whether the country has an inflationary or a recessionary gap and by how much?
6. If the government of the country would like to achieve full-employment, using economic
policies, which of the following it would do?
(a) By increasing G or decreasing T, it shifts the AD curve to the right to achieve full-
employment
(b) By increasing money or decreasing interest rate, it shifts the AD curve to the right to
achieve full-employment
(c) Both (b) and (c)
7. From the data above, when the economy is at its short-run equilibrium, as the time passes
(a) SAS curve shifts rightward
(b) SAS curve shifts leftward
(c) LAS curve shifts rightward
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Fluctuations in AD and AS
Suppose an economy is initially (or originally) at a long run full-employment equilibrium. Starting
from this full-employment equilibrium, suppose one of the following things happen
i. firms expect a (huge) loss in the future.
ii. money or nominal wage and price of other factors of production (or price of
inputs) increase.
iii. both (i) and (ii) happen at the same time.
What would happen in the short-run in terms of real GDP, employment, and the price level?
i. Firms expect a loss in the future
The economy was initially at point A
in figure 8. When firms expect a loss Price LAS
in the future, AD decreases, and Level SAS0
as a result AD curve AD0 shifts to AD1.
New short-run equilibrium is at point B Figure 8
in figure 8 at the intersection of new AD
curve AD1 and SAS0 curve. P0 A
In the new short-run equilibrium, you
can see that real GDP decreases
to Y1 and with the decrease in real
GDP, employment decreases. The AD0
economy now has less than
full-employment (cyclical
unemployment). Price level decreases
to P1. YP Real GDP
ii. Nominal or money wage and price of other factors of production (or price of inputs) increase.
The economy was initially at point A
in figure 9. When price of factors of Price LAS
production increases, firms cost of Level SAS0
production increases and as a result SAS
decreases and SAS curve shifts up to the
left to SAS1. New short-run equilibrium
is at point C in figure 9 at the intersection
of new SAS curve SAS1 and AD0 curve. P0 A
Real GDP decreases to Y1 and with the
decrease in real GDP, employment Figure 9
decreases or unemployment increases.
The economy now has below
full-employment (cyclical AD0
unemployment). Price level increases
to P1. It creates Stagflation.
YP Real GDP
Stagflation is a combination of recession and inflation. In figure 9, we started with full-
employment. Then due to increase factor prices, economy moved to below full-employment means the
economy moved to recession. It also creates inflation because price level increased from P 0 to P1. So
we had a combination of recession and inflation or stagflation.
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iii. both (i) and (ii) happen at the same time.
The economy was initially at point A
in figure 10. When price of factors of Price LAS
production increases and at the same Level SAS0
time firms expect loss, both
AD and SAS curves shift. SAS curve Figure 10
shifts to SAS1 and AD curve shifts
to AD1. One possible, new short-run P0 A
equilibrium is at point E in figure 10.
In the new short-run equilibrium E, real
GDP decreases and employment decreases
or unemployment increases. The price AD0
level increases. Note that when SAS
decreases and at the same time AD
decreases, real GDP and employment
definitely decrease but price level YP Real GDP
is indeterminate meaning that
price level may increase, decrease, or remain the same. In the example of figure 10, price level
increases to P1 and real GDP decreases to Y1.
Effects of Government’s Economic Policies
How the government’s economic policies such as fiscal policy (changes in G or T) or monetary policy
(changes in money or interest rates) affects real GDP, employment, and price level. Remember,
Expansionary fiscal policy = increase in G or decrease in T
Expansionary monetary policy = increase in money or decrease in interest rate
If G increases or tax decreases or money increases or interest rate decreases, AD curve shifts to the
right.
Consider an economy in long run equilibrium (or full employment equilibrium). Remember, in the long
run an economy has full employment. Starting from this full employment position, suppose quantity of
money increases or government increases its expenditure (G). The change in any one of these factors
will shift the AD curve to the right and will affect the economy’s output (real GDP), employment, and
inflation in short run and long run. That is, there will be short run and long run effects.
I. Short Run Effect
The economy is initially in long run full employment equilibrium at point A in figure 7 with Real GDP
equal to YP and price level P0. Now increase in any one of those factors mentioned above will shift the
AD curve from AD0 to AD1. The new short run equilibrium is at point B.
Price LAS
Level
SAS0
P1 B
P0 A
Figure 7
AD0 AD1
YP Y1 Real GDP
At the new short run equilibrium B, real GDP increases from Y P to Y1 and with the increase in real
GDP, employment increases (or unemployment decreases). We also see that in the short run price level
increases from P0 to P1 in figure 7. That is, economy now has inflation.
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II. Long run Effect
In the new short run equilibrium B in figure 8, workers nominal wage remains the same as in point A.
Since the price level has increased from P0 to P1, workers now have a lower real wage (nominal wage
divided by price level) at point B compared to point A. That is, workers purchasing power has
decreased. Firms on the other hand have a higher
Price SAS1
Level LAS
SAS0
P2 C
P1 B
A Figure 8
P0
AD1
AD0
YP Y1 Real GDP
profit at point B compared to point A. (Remember, moving upward along a SAS curve gives a higher
profit.) Then, at the new short run equilibrium B, workers are unhappy (because their purchasing power
decreased) and firms are happy (because their profits are higher). So, workers demand a higher nominal
wage. Firms to keep their workers and higher profits, raise nominal wage. When nominal wage
increases, SAS curve shifts up and to the left. As the nominal wage increases, SAS curve keeps on
shifting till it reaches SAS1. Point C in figure 8 is the new long run equilibrium. In the long run, there is
no increase in real GDP (real GDP comes backs to YP) and employment, only price level increases to
P2.
Exercise: True or false
(a) Along a LAS curve, price level increases but prices of labor (nominal wages) do not change.
(b) Along a LAS curve, firms profit increases or decreases.
(c) A change in nominal wage shifts both LAS and SAS curves.
(d) Along a SAS curve, nominal wages remain the same.
(e) As one moves upward along a SAS curve, firms profit increases.
(f) The term “monetary policy” refers to the government’s spending more money to purchase
more goods and services.
(g) If the price level increases, real wealth decreases and when real wealth decreases, people save
more.
(h) When the price level rises and other things remain the same, interest rates rise.
(i) When price level increases, SAS increases.
(j) When price level increases, AD decreases.
SAMPLE MULTIPLE CHOICE QUESTIONS
1. Suppose that the money wage in the economy increases by 8 percent. As a result
(a) the SAS will decrease
(b) the LAS will decrease
(c) the LAS will increase and the SAS will decrease
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2. If the economy is at the natural rate of unemployment,
(a) real GDP > potential GDP
(b) real GDP = potential GDP
(c) real GDP r0, there is surplus in the
loan market and interest rate decreases to r0,
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Exercise
In the figure below, the initial investment demand curve is ID 0 and the initial saving curve is SS0.
Real Interest
Rate (r)
% SS 0
5%
ID0
1500 Investment(I), Saving(S)
1. Suppose an economic expansion raises people’s disposable income and raises
expected profit rate. In the figure show what happens to ID and SS curves.
2. Suppose there was a recession that lowers expected profit and decreases people
wealth. In the figure show what would happen to ID and SS curve.
3. Suppose there was technological progress. In the figure show what would happen to
ID and SS curve.
4. Suppose people expect a higher future income. What would happen to real interest
rate?
5. In the figure above, suppose real interest rate increased to 7%. This could be caused
by
(a) Recession that lowers expected profit rate
(b) An increase in people’s disposable income
(c) A decrease in people’s wealth
(d) Expansion that raises expected profit rate
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SAMPLE MULTIPLE CHOICE QUESTIONS
1. In economics capital is the
(a) amount of financial assets such as stocks and bonds people hold
(b) quantity of machines, plant, inventories
(c) both (a) and (b) are true
2. A country’s nominal interest rate increases from 5% to 10%. The country’s investment (I)
(a) must be decreased
(b) must be increased
(c) may remain the same
(d) cannot be answered given the information above
3. The capital stock increases if
(a) net investment is positive
(b) net investment is negative
(c) gross investment is greater than net investment
4. A fall in the real interest rate
(a) increases investment demand
(b) increases investment (or increases quantity of investment demanded)
5. Suppose expected profit rate is 10% and real interest is 12%,
(a) the firm will take or undertake the project
(b) the firm will not undertake the project
6. If real interest rate is above equilibrium interest rate, then
(a) lenders will be unable to find borrowers willing to borrow all the available funds and the real
interest rate will fall.
(b) Borrowers will be unable to borrow all the funds they want to borrow and the real interest rate
will rise.
7. Economic recession causes
(a) firms’ expected profit rate to decrease and as a result ID curve shifts to the left
(b) firms’ expected profit rate to increase and as a result ID curve shifts to the left.
(c) firms’ expected profit rate to increase and as a result ID curve shifts to the right
8. If expected profit rate increases
(a) there will be a movement along a ID curve
(b) the ID curve shifts to the right
(c) the ID curve shifts to the left
9. A rise in the real interest rate
(a) increases saving supply
(b) increases saving (or increases quantity of saving supplied)
10. A decrease in disposable income causes
(a) movement along a SS curve
(b) shifts of the SS curve to the left
(c) shifts of the saving supply curve to the right
11. A simultaneous (or at the same time) economic expansion and increase in disposable income
causes
(a) real interest to increase
(b) real interest to decrease
(c) real interest to be unchanged
(d) any one of the above may happen
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Important Concepts
Medium of Exchange
Unit of Account
Store of Value
M1
M2
Balance Sheet of Commercial Banks
Investment securities
Reserves: Actual and Required
How Banks Create Money?
Multiple Deposit Creation
The Central Bank
Required reserve ratio
Discount rate
Open market operation
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MONEY AND BANKING
What is money?
Money is anything that is accepted for payments and settling debt.
FUNCTIONS MONEY
Three Functions of Money: Medium of exchange
Unit of account
Store of Value
Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange of goods and services.
Money acts such a medium. Without money, it would be necessary to exchange goods and services
directly for other goods and services – an exchange called barter that requires double coincidence of
wants. For example, a vegetable seller needs milk must find a milkman who wants vegetable. Money
guarantees that there is double coincidence of wants because the money received by the vegetable
seller can always use it to buy milk or anything else.
Unit of Account
A unit of account is a measure for stating prices. It serves two purposes: (1) it is simply a pricing
mechanism and (2) it simplifies the counting of prices. Money provides the term in which prices are
quoted and debts are recorded. The usual unit of account in Bahrain is Bahraini Dinar. People quote
prices in dinars and write totals on price tags in dinars. A car dealer tells you that a car costs BD6000,
not 500 shirts (even though it may amount to the same thing).
Store of Value
A store of value is any good or asset that people can store while it maintains some or all its value. If
you work today and earn BD100, you can hold the money and spend it tomorrow, next week, next
month, or next year. If you decide to spend next year, it maintains (or stores) most of value if prices do
not rise much. With rising prices (inflation), money may lose some of its value but still maintain most
of its value.
Exercise
Indicate which of the three primary functions of money is illustrated by each statement
(a) Ahmed buys a TV by writing a check
(b) John drops the coins from his pocket into a box in his study desk.
(c) The prices of goods in a jail were stated in terms of cigarettes
(d) A BD500 price tag on a computer
(e) Beth calculates that the opportunity cost of her time was $10 per hour.
(f) Jack purchases a gift of $50 for his parents
(g) The role of money that would not be provided if bananas were to serve as money
MEASURES MONEY
Money consists of Currency and Deposits at banks and other financial institutions.
Currency: The paper notes and coins that you use in Bahrain (or any other country) today are known
as currency. They are money because the government declares them so.
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Deposits. Deposits at banks and other financial institutions are also money. Deposits are money
because they can be converted into currency and they are used to settle debts.
Official measures of money:
M1 = Currency held outside banks + private demand or checking deposits + traveler’s check
M2 = M1 + private time and saving deposits + money market mutual funds
Important note: Currency held by banks is not part of money and is not included in M1 or M2.
BANKS (or COMMERCIAL BANKS)
Commercial banks or simply banks are financial intermediaries. A financial intermediary is an
institution that stands between lenders and borrowers. It borrows itself and then relends those funds
(money) to the borrowers. A commercial bank borrows currency (notes and coins) from the people
(public), issuing a deposit in exchange. Then it uses the money it has borrowed to make loans to firms
or individuals who it believes will repay them. Banks earn profits by lending the money that people
deposit and charging higher interest rates to borrowers than the interest rates that they pay to
depositors. For example, you may earn 3% interest on the money in your bank account, but the bank
lends most of the money you deposited, perhaps charging 10% interest. The difference covers the
bank’s costs and provides a profit for the bank’s owners.
In summary: Banks are depository institutions that accept deposits and making loans.
A simplified balance sheet of commercial banks
Table 1 is a simplified (consolidated) balance sheet of banks.
Table 1
Consolidated balance sheet of Banks [in million (m) dinar]
Assets Liabilities
Reserves 200 Deposits 800
Notes and coins (vault cash) 160
Reserve with the central bank 40
Investment Securities 100 Borrowing 50
Loans 700 Other liabilities 150
Total 1000 Total 1000
Table 1 shows the assets and liabilities of all (or consolidated) commercial banks of a hypothetical
country. For any bank has this kind of structure for any country. The banking system’s liabilities are
the deposits, which are the bank’s debts or obligations to the public. That is, these are the money that
public deposited with the banks. In this case total deposits are 800 m. Banks also sometimes borrow
money. Borrowing from the central bank is known as the discount loan. In table 1, borrowing is 50 m.
By definition, its total assets are also 1000 m. In asset side we see two major items: Banks’ reserves or
simply reserve and loans. Out of total deposits banks’ keep a small part as reserves and rest they use to
make loans. Banks are profit maximizing institutions. If a bank kept all its deposits as reserves, it
would not make any profit. More loans they can make, more profit they earn. In table 1, loan is 700 m.
Investment securities are long-term government bonds and other bonds. These bonds earn interest
income for banks.
Reserves: Actual and Required
Reserves are the money that banks hold to backup their deposits. Banks hold reserves for two reasons:
1. They need money to give to people who make withdrawals from the accounts. This is
shown in table 1 as Notes and Coins broadly known as Vault Cash. Note banks keep
only a fraction of its total deposit. Notes and coins are currency held by banks
inside banks and as mentioned above it is not included in M1 or M2.
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2. Banks also hold reserves because the government (the central bank) requires them to
hold a certain fraction of deposits as reserves.
We will use the following symbols:
R = total (or actual) reserves
D = deposits.
r = required reserve ratio
RR = required reserves
Required reserves are the reserves that banks are required to hold by Banking Regulation and the
required reserve ratio (r) is calculated as
Re quired reserves RR
r RR = (r)(D)
Deposits D
Excess Reserves (ER) are actual reserves (R) minus required reserves (RR):
ER= R – RR.
Whenever banks have excess reserves, they are able to make loans that create money. The following
example will help you to understand these concepts. Table 2 is a hypothetical balance sheet of a
commercial bank named Falcon Bank. In the liability side, it has only deposits (D) and on the asset side
it has only reserves (R) and loans (L).
Table 2
Balance sheet of Falcon Bank
(million dinar)
Assets Liabilities
Reserves 50 Deposits 200
Loans 150
Total 200 Total 200
Here reserve (R) is 50. Suppose the required reserve ratio is 20% by the regulation. This means, Falcon
bank’s required reserves must be equal to 40 million dinar out of 200 million dinar of deposits:
RR = (r)(D) = (.2)(200) = 40
However, the Falcon bank is keeping 50 million dinar as reserves. This means, the bank has an excess
reserves of 10 million dinar:
ER = R – RR = (50 – 40 ) = 10.
Remember, loan is the main source of a bank’s income and profit. More loans may earn more profit.
Table 3 shows how the Falcon Bank by keeping excess reserves equal to zero or by keeping actual
reserves exactly equal to required reserves will increase loan and profit.
Table 3
Balance sheet of Falcon Bank
Assets Liabilities
Reserves 40 Deposits 200
Loans 160
Total 200 Total 200
In table 3, the Falcon Bank actual reserves are 40 million dinar which are exactly equal to required
reserves and excess reserves are equal to zero. By keeping reserves exactly equal to required reserves,
the bank has increased loan by 10 million dinar (equal to excess reserves) and as a results its profit will
may increase.
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Exercise: Questions 1 and 2 refer to the following balance sheet of a bank.
Assets Liabilities
Reserve 10000 Deposits 60000
Loan 50000
Total 60000 Total 60000
Required reserve ratio (r) is 15%.
1. The bank’s excess reserve is __________
2. The bank can provide an additional (or more) loan equal to ___________.
Exercise
A bank with $1 billion in deposits hold $70 million in cash, $80 million on deposits with the Fed
(central bank), and owns $100 million in government securities. If the reduction in the required
reserves generates excess reserves of $30 million and prior to change the bank had no excess reserves.
This means the initial required reserve ratio was ______________ and the new required reserve ratio is
_______________.
HOW BANKS CREATE MONEY?
In all our following discussions, we make three important assumptions:
1. Banks are able to make as much loan as they are allowed to.
2. Banks always keep reserves equal to required reserves.
3. People take loans and deposit back to their banks.
Consider the initial balance sheet of banks (that is, for the whole banking system) as in table 4 in which
liability side has only checking deposits of 1000 and asset side has only reserves and loans.
Table 4
Initial situation
Assets Liabilities
Reserves 100 Deposits 1000
Loans 900
Total 1000 Total 1000
This banking system has 10% required reserve ratio. Now suppose people go to their banks and deposit
100 of currency in their checking accounts.
Multiple Deposit Creation
We will now see that when the banking system is supplied with 100 extra deposits (or checking
deposits are increased by 100), at the end (in the final balance sheet) deposits increase by a multiple of
the extra deposits. This process is called multiple deposit creation. You need to know how it works and
how we obtain final balance. Start with the initial balance sheet as in table 4:
Consolidated balance sheet of commercial banks
Initial situation
Assets Liabilities
Reserves 100 Deposits 1000
Loans 900
Total 1000 Total 1000
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Required reserve ratio (r) is 10%, so initially the banking system has reserves equal to required reserves
and it always keeps reserves equal to required reserves. Now 100 additional (extra) money is deposited.
Step 1
Assets Liabilities
Reserves 100 + Deposits 1000 + 100
Loans 900 +
Total 1100 Total 1100
In step 1, excess reserves equal to 90 will be available for new loan. That is, loan is immediately
increased by 90. Thus a direct result of 100 addition deposit is that a new money of 90 is created.
This is equal to increased loan of 90. This increased loan is deposited back and the process continues:
Step 2
Assets Liabilities
Reserves Deposits 1100 +
Loans
Total Total
Step 3
Assets Liabilities
Reserves Deposits
Loans
Total Total
.
.
.
Final Balance sheet
Assets Liabilities
Reserves Deposits
Loans
Total Total
First, here R = RR because ER = 0. This means, r = RR/D = R/D or we can write D = R/r. In the final
balance sheet new or final total reserve is 200 (that is, 100 original plus increase in reserve by 100).
Thus new deposit, D = 200/.1 = 2000, which means in the final balance sheet deposits increased by
1000. New or final loan is equal 2000 – 200 = 1800, that is, loan increased by 900. Money supply will
increase by 900.
∆Money = ∆M = ∆loan = ∆L = 900.
The basic idea of why money supply increases when deposit increases is that the bank can increase
their loans as deposits increase. This increase in loans gets multiplied many times to get a final
increase in money supply. In every step loan increases and as a result money supply increases.
Thus change in loan is equal to change in money supply (M = 900). Similarly, when deposits
decrease, loan decreases and money supply decreases.
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Exercise
Consider an initial (original) balance sheet of a commercial bank
Initial Balance Sheet (all numbers in $)
Assets Liabilities
Reserves 200 Deposits 1000
Loans 800
Total 1000 Total 1000
Suppose the required reserve ratio = 20% and assume that the banking system keeps zero excess
reserves. Now suppose people deposit $500 in currency in their checking accounts.
1. As a direct result of people’s deposit, the banks will create new money equal to _____________.
(a) 500
(b) 400
2. As a direct result of people’s deposit, the banks will create new loan equal to _____________.
(c) 500
(d) 400
3. How much is the change in reserve?
(a) 700
(b) 500
4. In the final balance sheet, deposit is _________ and loan is ________.
(a) 25,000; 3,000
(b) 35,000; 2800
THE CENTRAL BANK
A central bank is the government authority in charge of controlling and regulating the country’s money
supply and financial markets. There is one central bank for each country. The central of the US is
known as the Federal Reserve System or Fed. The central bank of Bahrain is known as Bahrain
Central Bank (formerly known as Bahrain Monetary Agency - BMA). The central bank uses policy
tools or instruments to control money supply and thereby carrying out monetary policy. Monetary
policy is something of changing money supply and interest rates.
A central bank has many tools or instruments to control money supply. Three most discussed tools are
(1) Required reserve ratio
(2) Discount rate
(3) Open market operations
(1) Required reserve ratio: A central bank sets required reserve ratios, which are the minimum
percentages deposits that banks must hold as reserve. If 4% is the required reserve ratio, then
banks must keep at least 4% of their deposits with the central bank.
An increase in the required reserve ratio increases the banks reserves (R) and as a result loan
decreases, and when loan decreases money supply decreases. Similarly, money supply increases if
required reserve ratio decreases.
(2) Discount rate: The discount rate is the interest rate the central bank charges (commercial) banks
when banks borrow (reserve) money from the central bank. An increase in the discount rate raises
cost of borrowing reserves from the central bank, thereby decreases banks reserves which
decreases banks loan and as a result money supply decreases.
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(3) Open market operations: Open market operations (OMO) are the purchase and sell of
government bonds (securities) by the central bank. When the central bank through OMO,
purchases government bonds, money supply increases. When the central bank through OMO, sales
government bonds, money supply decreases.
Let us see how it works. Table 5 is a balance sheet of a commercial bank – Bank A.
Table 5: Bank A (in million $)
Assets Liabilities
Reserves 10 Deposits 100
Loans 90
Total 100 Total 100
The Bank A’ preferred RR is 10%. Now suppose the central bank buys 1 million worth of government
bonds from Mr. David. Mr. David after receiving 1 m from the central bank deposits to Bank A and as
a result both the banks deposit and reserves will increase immediately by 1 million. That is, change in
reserve will be R = 1 m and this will increase loans which will increase deposits. The final balance
will be as shown in table 6.
Table 6
Assets Liabilities
Reserves 11 Deposits 110
Loans 99
Total 110 Total 110
So every step loan increases that will ultimately increase money supply. Thus, we have seen when the
central bank buys government bonds through OMO, money supply increases. The opposite is also true,
whenever the central bank sells government bonds through OMO, money supply decreases.
Change in money supply
The central banks all over the world use mainly the open market operations to increase or decrease
money supply. One way to calculate change in money supply from open market operation is as
follows:
∆M = m∆R
where m is called money multiplier. When central bank purchases government securities ( bonds),
usually ∆R > 0 which means money supply increases and when it sells securities, usually ∆R YD.
69
Marginal propensity to save (MPS)
The MPS indicates the change in saving due to a change in disposable income or income. Thus, MPS is
defined as
S
MPS = = slope of the saving function.
YD
In the table suppose YD increases from 50 to 100, so that ∆YD = 100 – 50 = 50 and as a result S
increases from –45 to –30, so that ∆S = –30 – (–45) = 15, so that
S 15
MPS = 0.3
YD 50
How we understand MPS?
The MPC and MPS always add to 1.
MPC + MPS = 1.
Import function and marginal propensity to import
70
Autonomous Expenditures (A)
Autonomous expenditures are independent of income or real GDP. Investment (I) and government
purchases are assumed to autonomous expenditure. Exports of a country are also autonomous
expenditure. Thus, there are four autonomous expenditures in this model and they are
3. Autonomous consumption (Ca)
4. Investment (I)
5. Government purchases (G)
6. Exports.
Sum of these autonomous expenditures (A) is
A = Ca + I + G + exports.
Sum of expenditures is
AE = C + I + G + exports – imports = C + I + G + NX
Table 2 summarizes discussions above.
Table 2
Planned Expenditure Aggregate
Real Gov. planned
GDP Consumption Investment purchases Exports Imports Expenditure
(Y) I (I) (G) (AE)
0 70 10 40 30 0 150
100 130 10
200 190 20
300 250 30
400 310 40
500 370 50
600 430 60
700 490 70
Few things you need to understand in this table. First of all, autonomous consumption is C a = 70,
autonomous investment is 10, autonomous government purchase is 40 and autonomous export is 30.
Thus the autonomous expenditures are equal to 150:
A = Ca + I + G + exports = 70 + 10 + 40 + 30 = 150
Another way to find out autonomous expenditure is the aggregate expenditure when income or real
GDP is equal to zero.
Induced expenditures are expenditures that change with real GDP. In the table, consumption (above
70) and imports are induced expenditures because they change (increase) as real GDP changes
(increases).
We have taken 1st column and the last column of table 2 and put in the table 3.
Table 3
Aggregate
Real planned
GDP Expenditure
(Y) (AE)
0 150
100 200
200 250
300 300
400 350
500 400
600 450
700 500
71
The positive relationship between aggregate planned expenditure and real GDP is described as the
aggregate expenditure (AE) curve and it is shown as AE curve (line) in figure 2 below.
Aggregate planned
Expenditure (AE)
AE
300
Figure 2
150
0 300 Real GDP (Y)
(aggregate planned exp enditure) AE
Slope of the AE curve =
(real GDP ) Y
Equilibrium expenditure
Equilibrium expenditure is same as the equilibrium real GDP. Equilibrium expenditure in table 2 is 300
when Y = AE = 300. Using a figure, we can find the equilibrium expenditure or equilibrium GDP at the
intersection of AE curve and 450 line at the point A in figure 3 below.
450
AE
AE
300 A
Figure 3
150
300 Real GDP (Y)
Equilibrium expenditure = Equilibrium GDP = 300
72
Determination of equilibrium expenditure or equilibrium Real GDP
Table 4
Real GDP Planned Aggregate Unplanned Real GDP and
(Y) Expenditure (AE) Inventory Change Employment
0 150 -150 Increasing
100 200 -100 Increasing
200 250 -50 Increasing
300 300 0 Constant
400 350 50 Decreasing
500 400 100 Decreasing
Equilibrium expenditure is the level of aggregate expenditure that occurs when planned aggregate
expenditure equals real GDP. Thus, in table 4, equilibrium expenditure and real GDP is 300. We can
write the equilibrium condition as
Real GDP = AE
Y = C + I + G + NX.
In figure 4, equilibrium is at point A with real GDP and AE equal to 300 at which 45 0 line intersects
AE line.
AE
450
AE
A
150 Figure 4
100 200 300 400 Real GDP (Y)
The question is how the economy gets to the equilibrium level of real GDP at point A? To understand
this, what happens if the economy’s real GDP is 100 which is less than equilibrium GDP 300. When
the economy’s real GDP is 100, economy’s planned aggregate expenditure is 200. AE = 200 is greater
than production Y =100. If firms have inventories or stocks of goods available, they sell more than they
produce, thus unplanned inventories decrease or go down. If firms do not have inventories of goods,
they have to turn away customers who wants to buy goods but now cannot. Firms in response to
declining inventories or unsatisfied customers raise output, so output or real GDP increases. Thus,
whenever, real GDP (Y) is below the equilibrium level (Y AE) means firms are producing more than they can sell, firms
unplanned inventories increase and in response firms decrease production and real GDP decreases.
Equilibrium real GDP is at which AE exactly equal to real GDP (or production).
Note: A decrease (fall) in inventory is synonymous (or same) as the negative inventory investment.
Similarly, an increase (rise) in inventory is synonymous as the positive inventory investment.
73
Changes in equilibrium GDP
Suppose there no tax and assume that both export and net export s are autonomous.
When autonomous expenditures increase (or decrease), aggregate expenditure (AE) increases (or
decreases) by the amount of increase (or decrease) in autonomous expenditures, AE curve shifts up (or
down), and equilibrium real GDP increases (or decreases). Consider table 5 below:
Table 5
Real Aggregate Planned
GDP Planned Expenditure Expenditure
(Y) C I0 I1 G NX AE0 AE1
0 70 10 40 30 150
100 120 10 40 30 200
200 170 10 40 30 250
300 220 10 40 30 300
400 270 10 40 30 350
500 320 10 40 30 400
600 370 10 40 30 450
700 420 10 40 30 500
Original equilibrium real GDP is 300. In figure 5, the original equilibrium is at point A and original AE
curve is AE0.
450
AE
AE0
A
Figure 5
150
300 Real GDP
Now suppose an autonomous expenditure such as autonomous investment (I) increases by 50. Original
I0 = 10 and new I1 = 60, so ∆I = 60 – 10 = +50. As a result, AE increases by 50 and AE curve shifts up
by 50 to AE1 at each level of real GDP. New equilibrium is at point B in figure 5. You can determine
from table 5 and figure 5 that the new equilibrium real GDP is 400.
We find that autonomous investment increased by only 50 but equilibrium GDP increased by 100. That
is, equilibrium GDP increased twice (or 2 times) than the increase in I. That is, equilibrium GDP
increases 2 multiples of investment increase, hence the name multiplier.
74
MULTIPLIER
(Assume NO IMPORTS and NO TAX)
Definition: Multiplier indicates how many times (or multiples) equilibrium GDP would increase when
autonomous expenditure(s) increases by one unit. Multiplier shows as autonomous expenditure
changes , real GDP changes by a larger amount. That is, multiplier is greater than 1.
In other words,
changes in equilibrium real GDP Y
Multiplier =
changes in autonomous exp enditures A
Y
Multiplier = 1 Y A.
A
Remember, there are four autonomous expenditures: (1) autonomous consumption, (2) investment (I),
(3) government purchases, and (4) exports.
Suppose, autonomous expenditure is autonomous investment (I), then ΔA = ΔI we can write multiplier
as
Y
Multiplier =
I
Use small letter m to indicate multiplier so that
Y
Multiplier = m = ∆Y = m(∆I)
I
This implies that we can determine the changes in equilibrium GDP (∆Y) if we know the value of
multiplier (m) and changes in any autonomous expenditure such as I. The value of multiplier can be
obtained as
1 1
m=
1 MPC MPS
where MPC = marginal propensity to consume and marginal propensity to save, MPS = 1 – MPC. Then
you can determine the changes in equilibrium GDP as
1 1
∆Y = mΔI= I I.
1 MPC MPS
In table 5,
C 50
MPC = = .5
I 100
So that for table 5, multiplier is
1 1 1 1
m= = 2.
1 MPC MPS 1 .5 .5
Now go back to table 5. Now you can see why in table 5 equilibrium GDP increases by 100 (from 300
to 400) when I increased by 50. This is because ∆Y = m(∆I) = 2(50) = 100.
Determinants of multiplier (or Factors that multiplier depends on)
Discussion above shows that the value of multiplier depends on MPC or MPS. If MPC increases
multiplier increases, on the other hand, if MPS increases, multiplier decreases. That is, multiplier and
MPC are directly (or positively) related and multiplier and MPS are inversely (or negatively) related.
75
Exercise: Consider the data presented in Table below for a country.
Income or Planned Planned Planned
output, consumpti investment Government Exports Imports
Real GDP on (C) (I) expenditures
(Y) (G)
100 110 50 60 60 15
200 170 50 60 60 30
300 230 50 60 60 45
400 290 50 60 60 60
500 350 50 60 60 75
600 410 50 60 60 90
(a) How much is the MPC?
(b) What is aggregate planned expenditure when real GDP is 200?
(c) If real GDP is 200, what is happening to inventories?
(d) If real GDP is 600, what is happening to inventories?
(e) How much is the equilibrium level of real GDP
(f) How much is the equilibrium level of expenditures
Exercise: Consider the following figure
450 AE2
Aggregate planned
Expenditure (AE)
AE1
280
200
0 400 600 Real GDP (Y)
1. How much is the autonomous expenditure along AE1?
2. How much is the autonomous expenditure along AE2?
3. How much is the change in autonomous expenditure?
4. How much is the multiplier?
5. Starting with original equilibrium GDP equal to 400, now G increased by 30, what
would be the new equilibrium GDP?
6. What is the slope of the AE1 curve? AE2 curve?
76
Price level and AE Curve
Price level is fixed along an AE curve. For example, price level along AE0 in figure 6 is 110. That is,
any point on AE0, the price level is 110.
Aggregate planned
Expenditure (AE)
AE0 (P0 = 110)
300
Figure 6
150
0 300 Real GDP (Y)
When price level increases, autonomous consumption decreases. Increase in price level also increases
interest rate. Increase in interest rate decreases investment. Thus when price level increases
consumption and investment decrease and as a result aggregate expenditure decreases and AE curve
shifts down. In figure 6, AE shifts down to AE 1 when price level increases from P0 = 110 to P1 = 120.
Conclusion: Along an AE curve price level is fixed. When price level increases (or decreases),
AE curve shifts down (or up)
77
Derivation of AD Curve
Suppose an economy’s original equilibrium real GDP is 400 and original price level is P 0 = 110.
Equilibrium is at point A in figure 7 and original AE curve is AE0.
AE 450
AE0(P0 = 110)
AE1(P1 = 120)
A
200
B
Figure 7
100
200 400 Real GDP
Price
Level
P1 = 120 B’
A’ Figure 8
P0 = 110
200 400 Real GDP
Original equilibrium is at point A in figure 7. This means when price level is P 0 = 110, quantity of real
GDP demanded is 400. This is shown in figure 8 as point A’. Now suppose price level increases to P 1 =
120. Increase in price level decreases autonomous consumption and autonomous investment and as a
result AE decreases and AE curve shifts down to AE 1 in figure 7. New equilibrium is at point B in
figure 7 and new equilibrium GDP is 200. Thus, when price level increases to P 1 = 120, quantity of real
GDP demanded decreases to 200. This is shown as point B’ in figure 8. Connecting points such as A’,
B’, etc, we obtain the aggregate demand curve AD0 as shown in figure 8.
Shifts in AD curve
Suppose an autonomous expenditure such as investment or government purchase increases (with no
change in the price level), AE curve shifts up and AD curve shifts to the right.
If some factors other than a change in the price level increases autonomous expenditure, AE curve shits
upward and the AD curve shifts rightward.
Point A is the original equilibrium as shown in all figures (figures 9 and 10 below). Thus P 0 = 110 is
the original price level and Y0 is the original equilibrium real GDP. Now suppose investment or
78
government purchase increases and as a result AE curve shifts up from AE0 to AE1 in figure 9. Note
that price level along both AE0 to AE1 is P0 =110, so that price level did not change.
450
AE
AE1
AE0
B
A Figure 9
Real GDP
Y0 Y2
Price
Level
SAS0
P1 C
Figure 10
P0 A B
AD1
AD0
Real GDP
Y0 Y1 Y2
Increase of AE from AE0 to AE1 in figure 9 increases real GDP from Y0 to Y2. This means, AD curve
in figure 10 must have shifted from AD0 to AD1 (since price level did not change).
An increase in AD in the Short Run
In the short run, an increase in I or G shifts AE up from AE 0 to AE1 and shifts AD curve to the right
from AD0 to AD1 in the short run.
If the price level is fixed in the short run, point B is the new equilibrium, and we see equilibrium real
GDP in the short run increases to Y2 and with it employment increases (unemployment decreases). The
real GDP increases to Y2 as shown in both figures 9 and 10.
If price level is changing (adjusted) in the short run, equilibrium is at point C as shown in figure 10.
Thus, if price level changes, the increase in real GDP in the short run would be Y 1 (figure 10) and the
price level in short run increases to P1.
79
Important:
In the short-run when prices are flexible, the multiplier effect is smaller
than when the price level is fixed.
An increase in AD in the long run
Price level
LAS
SAS1
SAS0
P2
P0 A
Figure 11
AD1
AD0
Y0 Y1 Real GDP
Suppose the economy was initially in full-employment equilibrium A with potential real GDP Y0. With
increase in I or G shifts AE curve up and AD curve shifts to AD 1 in figure 11 and real GDP increases to
Y1. In the long run, all prices including nominal wage change. Thus, nominal wage rates increase and
as a result SAS0 curve shifts to SAS1 as shown in figure 11. The price level rises from P 0 to P2 and real
GDP returns from Y1 to Y0. In the long run there is no increase in output. This means, in the long run,
multiplier is zero.
Exercise: Consider table below for a country for which no tax, no export and no import.
Income or Planned Planned Planned
output, consumpti investment Government
Real GDP on (C) (I) expenditures
(Y) (G)
100 110 50 60
200 170 50 60
300 230 50 60
400 290 50 60
500 350 50 60
600 410 50 60
(a) How much is the autonomous consumption?
(b) How is the autonomous expenditure?
(c) How much is the MPC?
(d) How much is the aggregate planned expenditure when real GDP is 200?
(e) If real GDP is 600, what is happening to inventories?
(f) What is the multiplier?
(g) If investment increases by100 to 150, how much is the new equilibrium GDP?
80
Summary
Important things to remember
1. The Keynesian model of aggregate expenditures assumes that both individual prices and the
price level are fixed in the short run.
2. MPC is the slope of the consumption function. MPC = ∆C/∆YD where YD is disposable
income; or MPC = ∆C/∆Y where Y is income or real GDP.
3. MPC + MPS = 1 → MPS = 1 – MPC.
4. Autonomous expenditures are expenditures that are independent of real GDP. That is,
autonomous expenditures do not change when GDP changes. Autonomous expenditures are
sum of 4 autonomous expenditures: (1) autonomous consumption (C a), (2) investment (I) (3)
government purchases(G) and (4) exports (E). Autonomous expenditure = A = C a + I + G + E.
5. Slope of an aggregate expenditure (AE) line is: slope = ∆AE/∆Y.
6. Definition of multiplier (m): m = ∆(Equilibrium GDP)/∆(Autonomous EXP) = ΔY/ΔA. For
example, Ca increases by 40, I increases by 50, G decreases by 60 and exports increases by 20.
And as a result real GDP increases by 100. So that change in equilibrium GDP is 100 and
change in autonomous expenditure is A = (40 + 50 – 60 + 20) = 50 and change in eq. GDP is
Y = 100. So that
multiplier m = Y /A = 100/50 = 2.
1 1
7. Formula for multiplier: m = . In calculating multiplier, this chapter
1 MPC MPS
assumes that there is NO tax and NO Imports. In general multiplier also depends on marginal
propensity to import which is zero if no import. Value of a multiplier is greater than 1. The
multiplier effect occurs because an autonomous change in expenditure causes an induced
change in consumption expenditure.
8. Along an AE line price level is fixed. When price level increase real wealth decreases and real
interest rate increases and as a result AE decreases and AE curve shifts down. Thus, when
price level increases (or decreases) AE curve shifts down (or up). In general, an increases (or
decrease) in autonomous expenditure that is NOT caused by a change in price level results in
AE curve shifts up (or down) and AD curve shifts to the right (or left).
9. Multiplier effect is smaller when price level changes than when price level is fixed.
10. Long run multiplier is zero.
81
SAMPLE MULTIPLE CHOICE QUESTIONS
1. When disposable income is $500 million, planned consumption is $250 million. When
disposable income is $300 million, planned consumption is $100 million. Then planned saving
is _______ when disposable income is $500 and MPS is ______.
(a) $250; 0.75
(b) $250; 0.25
2. If the real interest rate falls, the consumption function and AE function ______ and
________________ AD curve.
(a) shifts upward; movement downward along*
(b) shifts downward; movement upward along
3. If the wealth increases, the consumption function and AE function _________ and
________________ the AD curve
(a) shifts upward; movement downward along*
(b) shifts downward; movement downward along
4. The slope of the aggregate expenditure curve equals the change in
(a) planned expenditure divided by the change in real GDP
(b) real GDP divided by the change in planned expenditure
5. Suppose investment increases by $40 billion and equilibrium GDP increases by $100 billion.
All other autonomous expenditures remain the same. What is the multiplier?
(a) 2
(b) 2.5
6. Suppose investment (I) increases by $40 billion, autonomous consumption increases by $10
billion and export decreases by $30 billion and equilibrium GDP increases by $40 billion. All
other autonomous expenditures remain the same. What is the multiplier?
(a) 2
(b) 2.5
7. Suppose there is no tax and no import. Planned saving increases by $25 billion when
disposable income increases by $100 billion. What is the multiplier?
(a) 3
(b) 4
8. Multiplier shows as _____________ changes, real GDP changes by a __________ amount..
(a) autonomous expenditure; larger (or greater)
(b) aggregate expenditure; smaller
(c) autonomous expenditure; smaller
(d) aggregate expenditure; larger
9. The larger the value of MPC _________ is the multiplier and larger the value of
MPS____________ is the multiplier
(a) larger; larger
(b) larger; smaller
10. In the short run, with fixed price level and no import or tax, a decrease in investment
(a) decreases real GDP by a smaller amount
(b) decreases real GDP by a greater amount
11. If the price level increases, AE curve shifts
(a) upward and we move along the AD curve
(b) downward and we move along the AD curve
82
12. In the short run, which of the following is fixed and does not change when real GDP changes?
(a) planned consumption
(b) planned import
(c) planned export
(d) all of the above answers are correct
13. If disposable increases by 200, consumption increases by
(a) more than 200
(b) less than 200
(c) exactly 200
14. When disposable income equals $800 billion, planned consumption equals $600 billion, and
when disposable income equals $1,000 billion, planned consumption equals $640 billion.
What is the MPS?
(a) 0.8
(b) 0.4
(c) 0.2
(d) cannot be determined from the information given
15. Which of the following is true
(a) The multiplier effect occurs because an autonomous change in expenditure causes an
induced change in consumption expenditure
(b) The multiplier is greater than 1 because one person’s spending becomes another
person’s income
(c) Because of multiplier, a one-time change in autonomous expenditure will cause more
additional income than initial change in autonomous expenditure
(d) All of the above are true.
16. MPC or MPS is
(a) greater than 1
(b) less than 1
(c) greater than 1 but less than 2
17. Autonomous consumption
(a) increases with income
(b) is independent of income
(c) is independent of income and must be equal to zero
(d) decrease with income.
83
Important Concepts
Meaning of Fiscal Policy
Budget deficit, budget surplus and balanced budget
Expansionary fiscal policy
Contractionary fiscal policy
Discretionary fiscal policy
Automatic fiscal policy
Government Purchase (G) Multiplier
Tax (T) Multiplier
Balanced budget multiplier
Discretionary Fiscal Stabilization
Recessionary gap
Inflationary gap
84
FISCAL POLICY
(Chapter 31)
Fiscal policy refers to changes in government purchases (G) or changes in taxes (T).
We will consider only lump-sum tax (T). Lump-sum tax does not depend on income (real GDP). That
is, T is independent of income.
Expansionary fiscal policy = increase in G (G > 0) or decrease or cut in T (T 0).
Government budget
If G > T, government has budget deficit
If G < T, government has budget surplus and
If G = T, government has balanced budget.
Discretionary fiscal policy – fiscal policy initiated by parliament (congress)
Automatic fiscal policy – fiscal action required by the state or condition of the economy.
GOVERNMENT PURCHASE (G) MULTIPLIER
Remember G is an autonomous expenditure. Suppose only G changes. Then change in autonomous
expenditure (ΔA) is equal to change in G (ΔG). That is, ΔA = ΔG.
G multiplier = m = (EQ. GDP)/A = Y/G. But remember multiplier formula is m = 1/1 – MPC.
1
This means, Y = (m)G = G. Thus we find change in equilibrium GDP if we know
1 MPC
MPC and change in G.
Example
Suppose MPC = 0.75 and original equilibrium is $3000 million. G increases by 100, that is, ΔG = 100.
Then equilibrium GDP increases by
1 1
Y = (m)G = G 100 4 100 400 .
1 MPC 1 0.75
That is, equilibrium GDP increases by 400 and the new equilibrium GDP is $3000 + $400 = $3400
million.
This example shows the effect of changes in G is multiplied 4 throughout the economy. G increases by
100 but GDP increases by 400 (4 times). This is because G purchases generate changes in
consumption expenditure through MPC.
TAX (T) MULTIPLIER
T is an autonomous tax. So, T multiplier = m = (EQ. GDP)/T = Y/T. But,
MPC
T multiplier formula is m =
1 MPC
85
This means,
MPC
Y = (m)T = T .
1 MPC
Thus we find change in equilibrium GDP if we know MPC and change in T.
Example
Suppose MPC = 0.75 and original equilibrium is $3000 million. Now T increases by 100, that is, ΔT =
100. Then change in equilibrium is given as
MPC 0.75
Y = (m)T = T 100 3 100 300 .
1 MPC 1 0.75
That is, equilibrium GDP decreases by 300 and the new equilibrium GDP is $3000 – $300 = $2700
million.
This example shows the effect of changes in T is multiplied 3 throughout the economy. T increases by
100 but GDP decreases by 300 (3 times). This is because changes in T generate changes in
consumption expenditure through MPC.
BALANCED BUDGET MULTIPLIER
Suppose G = $1000 million and T = $1000 million. This means government has balanced budget.
Suppose MPC = .75, original equilibrium GDP = $3000 million. Now suppose G increases by 100 (G
= +100) and also T increases by 100 (T = +100), so that budget remains balanced. The balanced
budget multiplier is the multiplied effect on AD of a simultaneous (at the same time) change in G and
T that leave the balanced budget unchanged. In our case G = +100 and T = +100 leave the balanced
budget unchanged. But the balanced budget multiplier is positive. You can see why, we have shown
when G increased by 100, equilibrium GDP increased by 400 and when T increased by 100,
equilibrium GDP decreased by 300, so overall GDP still increased by 100 = (400 – 300).
Discretionary Fiscal Stabilization
When government takes an expansionary fiscal policy (G increases or T decreases) with no change in
the price level, AE curve shifts up AD curve shifts to the right. Similarly, with a contractionary policy
(G decreases or T increases), AD curve shifts to the left.
How discretionary fiscal policies can help to eliminate recessionary gap and inflationary gap?
Price Price
Level Level
LAS LAS
SAS0 SAS0
P0 B
A AD 0
P0
AD0
Y0 YP Real GDP YP Y0 Real GDP
Figure 1 Figure 2
In figure 1, the country has less-than In figure 2, the country has more-than
full-employment. Since Y0 < YP, it full-employment and inflationary gap
has a recessionary gap equal to equal to (Y 0 – YP ). Here contractionary
(YP – Y0 ). Here expansionary fiscal policy can eliminate the inflationary
fiscal policy can eliminate the gap.
recessionary gap.
86
Eliminating recessionary gap using expansionary fiscal policy. First consider figure 1. At present
economy is at point A with real GDP equal to Y0. Since the country’s present GDP Y0 is less than
potential GDP YP, the country at present has a recessionary gap equal to (Y P – Y0). Government can
use a discretionary expansionary fiscal policy to eliminate the recessionary gap. When government uses
expansionary fiscal policy of increasing G or decreasing T, the aggregate expenditure (AE) increases
and the multiplier increases induced expenditure and as a result AD curve shifts to the right. AD curve
shifts to AD1 in figure 1, so that at the new equilibrium at point C in figure 1, the economy has full-
employment and the recessionary gap is eliminated.
Eliminating inflationary gap using contractionary fiscal policy. Next consider figure 2. At present
economy is at point B with real GDP equal to Y0. Since the country’s present GDP Y0 is more than
potential GDP YP, the country at present has a inflationary gap equal to (Y 0 – YP). Government can use
a discretionary contractionary fiscal policy to eliminate the inflationary gap. When government uses
contractionary fiscal policy of decreasing G or increasing T, the aggregate expenditure (AE) decreases
and the multiplier increases induced expenditure and as a result AD curve shifts to the left. AD curve
shifts to AD1 in figure 2, so that at the new equilibrium at point E in figure 2, the inflationary gap is
eliminated.
SAMPLE MULTIPLE CHOICE QUESTIONS
1. If the government wants to use fiscal policy to increase real GDP, it could
a. cut T or increase G
b. increase T or decrease G
2. Suppose potential GDP is $300 million and present real GDP is $350. Economy has _________
gap and to eliminate ______________ policy should be used.
a. recessionary; expansionary
b. inflationary; contractionary
3. Suppose government revenue comes from income tax and suppose tax rate is 20%. Suppose
income is $100 million and government purchase (G) is $17 million. Then the government has a
budget
a. deficit by $3 million.
b. surplus of $3 million
c. surplus of $83 million
4. An increase in G approved by the parliament (congress) helped to increase GDP is an example of
a. automatic fiscal policy
b. discretionary fiscal policy
5. If government spends more than it receives in tax revenue, then government has
a. budget surplus
b. budget deficit
c. balanced budget