The Expanded Model of Income Determination

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• The Expanded Model of Income Determination

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Expanded model of income determination

• In chapter 14, a very basic Keynesian model of
  income determination was introduced
• This model serves as an introduction to income
  determination and capacity utilisation in the
  economy
• If is far to simple to be of any use in the real
  world, but it establishes some important points
  nevertheless

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Keynes, John Maynard, 1st Baron Keynes of Tilton
(1883-1946)
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Expanded model of income determination

• Recall when Keynes was writing mid thirties
  with massive unemployment
• Established theory until then had assumed that
  this would be a temporary phenomenon
• In a world with flexible prices, in the long run
  equilibrium will exist in all markets
• Keynes In the long run, we are all dead

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Expanded model of income determination

• Keynes gave politicians theoretically sound
  arguments for intervening in the economy
• Keynes in particular focused on how the
  authorities could affect aggregate demand through
  fiscal policy, i.e. government purchases of goods
  and services and taxes
• In chapter 15, this is incorporated into the
  basic model of income determination.

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Expanded Model of Income Determination

• We introduce a public sector, with government
  purchases of goods and services G and taxes T.
  This model could be labelled a Keynes model for a
  closed economy with a public sector
• Later in the chapter, another sector is
  introduced the foreign sector. Only goods
  transactions takes place, exports (X) and imports
  (Z)
• This chapter also provides a more satisfactory
  explanation of investment demand

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Investment demand

• Demand for investment goods (I) very much depends
  on the outlook for the economy
• Profitability depends on
• Investment outlay
• Increased income due to the investment
• Costs of financing the investment
• Increased income cost of investment
  MEI(marginal efficiency of investment)
• Cost of financing R

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Time value of money

• The investment outlay is paid for today
• Income will accrue in the future, and value may
  be reduced due to
• impatience and postponement of demand
• risk
• inflation
• Income must be discounted by an interest rate R

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Net Present Value

• Example
• Investment outlay 10 000
• Income year 1 6 000
• Income year 2 2 6 000
• Interest rate (R) 5 (0,05)
• What is the PV of the income?

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Marginal Efficiency of Investment (MEI)
Rate of return (R)
Marginal efficiency of investment
R2
R1
I0
I2
I1
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Expectations change
Rate of return (R)
Marginal efficiency of investment
R0
I2
I0
I1
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Keynesian business cycle

• The accelerator
• changes in national income and induced investment
• the accelerator coefficient
• the instability of investment
• The multiplier / accelerator interaction

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Fluctuations in UK real GDP and investment
1978-2002
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Fluctuations in UK real GDP and investment
1978-2002
GDP
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Fluctuations in UK real GDP and investment
1978-2002
Investment
GDP
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Accelerator 1970-1999 in Norway
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Accelerator theorycapital output ratio 2
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Accelerator theory

• Investments are dependent on expected changes in
  GDP or I ? ?Y
• Accelerator a small change in income gives a
  large change in induced investment
• This depends on the marginal ratio between
  capital and production
• In addition, we will have multiplier effects
  between I and Y

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Introducing the public sector

• Taxes T represent a withdrawal from the economic
  circulation (like savings S)
• The Governments demand for goods and services G
  represent an injection (like investments I)
• Equilibrium when realised withdrawals realised
  injections
• S T I G

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Keynes expanded model - 1

• The public sectors demand for goods and services
  G is always exogenousTaxes (T)
• Version 1 Lump sum taxes T T
• Version 2 Income taxes T tY, where t is the
  (average) tax rate

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The model version 1
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Equilibrium
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An example

• Assume we have the following
• C 0,8Yd
• I 60
• G 50
• T 50

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The multipliers
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The model
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Haavelmos theorem

• What happens if an increase in public spending is
  financed by an equivalent tax increase, i.e. ?G
  ?T?

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The Model Version 2
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Equilibrium
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The multipliers
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The model
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Built in stabilisers
Government expenditure and Taxes
T
G
G
T
Yb
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Introducing the foreign sector

• Imports Z and Exports X
• Equilibrium when leakages injectionsS T Z
  I G X
• It is assumed that imports are endogenous and
  dependent on income
• Exports are exogenous

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Economic circulation
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The model
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The multipliers
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The open economy model