Macroeconomics: National Income, IS-LM and Stabilization Policy

National income. GDP = value of all final goods and services produced within domestic territory in a year; GNP = GDP + net factor income from abroad; NNP = GNP − depreciation, and NNP at factor cost is national income proper; NDP = GDP − depreciation; personal income = national income − undistributed profits, corporate taxes and social-security contributions + transfers; disposable income = personal income − direct taxes. Measured three equivalent ways: value-added (output added per production stage), income (wages + rent + interest + profit), or expenditure (Y = C + I + G + (X − M)).

Classical vs Keynesian output determination. Classical theory (Say's Law, the classical dichotomy) fixes output at full employment by real factors alone; unemployment beyond it is voluntary. Keynesian theory denies this: with sticky prices, output settles wherever aggregate demand meets supply — the principle of effective demand — which can leave genuine involuntary unemployment in place.

Consumption function. Keynes' psychological law: C = a + bY, with autonomous consumption a > 0 and 0 < MPC = ΔC/ΔY < 1, so consumption rises with income but less than proportionately; APC = C/Y therefore falls as income rises even though MPC stays roughly constant.

Investment function. A firm invests until the marginal efficiency of capital — capital's expected return — equals the interest rate, so investment moves inversely with r. Autonomous investment is independent of income; induced investment responds to output changes.

Multiplier and accelerator. k = ΔY/ΔI = 1/(1 − MPC) = 1/MPS converts a change in autonomous spending into a larger income change, as spending becomes others' income in turn. The accelerator runs the other way: induced I = v·ΔY, where v is the accelerator coefficient — a rise in output induces a proportionally larger rise in capital investment, and together the two can turn one shock into a multi-period cycle.

Demand for and supply of money. Liquidity preference: transactions and precautionary demand rise with income; speculative demand falls as the interest rate rises, since low rates raise expectations of a reversal, so wealth-holders prefer cash. Money supply is the stock of money in circulation, controlled through the monetary base and the money multiplier.

The IS-LM model. IS plots every (Y, r) pair clearing the goods market, Y = C(Y) + I(r) + G: a higher r lowers investment, which — via the multiplier — lowers equilibrium income, so IS slopes downward. LM plots every (Y, r) pair clearing the money market, real money demand L(Y, r) equal to a fixed real money supply M/P: a higher Y raises transactions demand for money, so with supply fixed, r must rise to squeeze speculative demand back down, so LM slopes upward. Their intersection fixes income and the interest rate together.

Inflation and the Phillips curve. Inflation is a sustained rise in the price level, from excess demand (demand-pull) or rising costs (cost-push). The original short-run Phillips curve showed inflation and unemployment inversely related — an exploitable trade-off. The expectations-augmented, long-run Phillips curve is vertical at the natural rate of unemployment: once expected inflation catches up with actual inflation, only unanticipated inflation can move unemployment off that rate, so exploiting the trade-off systematically only raises inflation, permanently.

Business cycles. Aggregate activity fluctuates around its trend through recurring, non-identical phases — expansion, peak, contraction, trough — with output and employment moving together, though amplitude and duration vary cycle to cycle.

Monetary and fiscal policy. Monetary policy (open-market operations, reserve requirements, the policy rate) shifts LM; fiscal policy (government spending and taxation) shifts IS. An expansionary fiscal stance raises both income and the interest rate, partly crowding out private investment; an expansionary monetary stance lowers the rate and raises income.

Rational expectations hypothesis and its critique. Agents use all available information efficiently to form expectations — not just past errors, as adaptive expectations assumed — so expectations are correct on average and only unanticipated policy can move real output; anticipated policy is discounted in advance. Its critique: agents cannot costlessly process all information, given bounded rationality and unequal access, and forecast errors are often systematic, not random. Separately, the Lucas critique holds that relationships estimated from past data embed the old policy regime's expectations, so they are unreliable for evaluating a new policy, since rational agents change behaviour once the regime changes.