National Income DeterminationPart1

1
CHAPTER 23
National Income Determination- Part 1
The Economic Problem
2
Desired Versus Actual Expenditure

• Desired or planned expenditure refers to what
  people would like to spend out of the resources
  that are at their command.
• National income accounts measure actual
  expenditure in each of the four expenditure
  categories (C, I, G, (X-M)).
• National income theory deals with desired
  expenditures in each of the four categories.

3
Desired Consumption Expenditure

• There are only two possible uses of disposable
  income of a typical household consumption and
  saving.

4
Consumption Function (C)

• Is the function that relates total desired
  consumption of all household to the national
  income. Therefore,
• It is a function that describes the relationship
  between consumption expenditure and national
  income .
• Therefore C f(Y)

5
Consumption Function - continued

• Since consumption of households depends on their
  disposable income (YD), so we will start with the
  relationship between consumption and disposable
  income
• C f (YD)

6
Consumption Function-continued

• Since consumption consist of two parts
• Autonomous Consumption
• Induced Consumption
• Therefore, the consumption function in the short
  run can be written as follows
• C a bYD
• where a autonomous consumption
• b marginal propensity to
  consume (MPC) or it is the slope of the
  consumption function (it relates the change in
  desired consumption to the change in disposable
  income).

7
Example

• YD a bYD Desired
  Consumption
• 0 100 0 100
• 400 100 320 420
• 500 100 400 500
• 1000 100 800 900
• 2000 100 1600 1700
• Where b0.8

8
Average and Marginal Propensity to Consume

• APC Total Consumption C
• Total disposable income YD
• It measures the proportion of disposable
  income that a household desires to spend on
  consumption .

9
Marginal Propensity to Consume

• MPC Change in Total Consumption
• Change in disposable income
• It measures the portion of any incremental
  income (additional income ) that a household
  desires to spend on consumption .

10
Example

• Assume you are given the following data
• a 100 b 0.8. Write the consumption
  function and calculate APC based on the values of
  YD shown in the table.
• Solution
• The desired consumption function is C 100
  0.8YD
• YD a bYD C APC
  MPC
• 0 100 0 100 -
  .8
• 100 100 80 180 1.8
  .8
• 500 100 400 500 1.0
  .8
• 1000 100 800 900 0.9
  .8

11
The Properties of Consumption Function

• 1. There is a break even level of income at which
  APC 1 when C Yd
• Below the break-even level of income
• APC gt 1 because C gt Yd
• Above the break-even level of income
• APC lt 1 because C lt Yd
• 2. 0 lt MPC lt 1 for all level of income

12
The Saving Function (S)

• It is the function that describe the relationship
  between saving and disposable income therefore
  
• S f(YD)

13
Saving Function Continued

• Also, saving is defined as the part of disposable
  income that is not consumed . So
• S YD - C
• and since C a b YD
• Thus S YD ( a b YD)
• so S YD a b YD
• Therefore S -a (1-b) YD

14
Average Propensity to Save (APS)

• APS Total Saving S
• disposable income YD
• It represent the proportion of disposable
  income that a household desires to save .

15
Marginal Propensity to Save (MPS)

• MPS Change in Saving
• Change in disposable income
• It represent the proportion of incremental
  income that a household desires to save .

16
APC and APS

• Since YD C S (
  1 )
• dividing both sides of equation (1) by Yd, we
  get the following
• Yd C S
  ( 2 )
• Yd Yd Yd
• 1 APC APS

17
MPC and MPS

• Since YD C S
  (1)
• Change in YD change in C change in S (2)
• Dividing both sides of equation (2) by change in
  Yd ,we get
• change in YD change in consumption change
  in saving
• change in YD change in YD
  change in YD
• 1 MPC
  MPS

18
Example

• Given that C 100 0.8 Yd
• S Yd C
• Prove that APC APS 1 ?
• Solution
• Yd C S APC APS APC APS
• 0 100 -100 - -
  -
• 100 180 - 80 1.8 - 0.8
  1
• 500 500 0 1.0 0
  1
• 1000 900 100 0.9 0.1
  1

19
Figure 23-1The Consumption and Saving Functions
The level of autonomous consumption is 500
The level of autonomous saving is -500
20
Wealth and the Consumption Function

• The keynesian consumption function relates
  consumption expenditure to current disposable
  income only.
• Life-cycle and permanent income theories state
  that there are other factors that explain
  consumers behavior such as their desire to
  accumulate wealth that they can use during their
  retirement.
• An unexpected increase in wealth increases the
  current consumption and reduces current saving.
  

21
Figure 23-2Wealth and the Consumption Function
22
Desired Investment Expenditure

• Investment expenditure is the most volatile
  component of GDP, and changes in investment
  expenditure are strongly associated with economic
  fluctuations.
• Three important determinations of aggregate
  investment expenditure explain such fluctuations
  in investment the real interest rate, changes in
  sales, and business confidence.
• Investment expenditure will be treated in this
  chapter as autonomous expenditure.

23
The Aggregate Expenditure Function (AE)

• It relates the level of desired real expenditure
  to the level of real income.
• In a simplified economy where there is no
  government and no international trade, the
  desired aggregate expenditure function will take
  the form
• AE C I

24

• Given the following consumption function
• C 500 0.8Y, and that investment expenditure
  1250, then the AE function will be
• AE 1750 0.8Y
• Note that C is a function of YD which is in turn
  is a function of national income Y, so C is a
  function of Y and 0.8 is the MPC out of the
  national income.
• Example if C 500 0.8YD and YD 0.9Y, then
• C 500 0.72Y

25
Figure 23-4The Aggregate Expenditure Function
26
The Propensity to Spend Out of National Income

• The economys marginal propensity to spend on
  national income (Z) is the fraction of any
  increment to national income that people desire
  to spend on purchasing domestic output
• Z ?AE/?Y, (the slope of the AE
  function)
• This means that (1-Z) is the marginal propensity
  not to spend or to withdraw.

27
Equilibrium National Income

• Desired expenditure and actual output
• National Income would be at equilibrium when
• AE Y
• At any level of national income at which
  aggregate desired expenditure exceeds actual
  output, there will be pressure for national
  income to rise.
• At any level of national income at which
  aggregate desired expenditure is less than actual
  output, there will be pressure for national
  income to fall.

28
Example

• Y C I
  AE
• 100 180 250
  430
• 400 420 250
  670
• 500 500 250
  750
• 1000 900 250
  1150
• 1750 1500 250
  1750
• 2000 1700 250
  1950
• 2500 2000 250
  2250
• Equilibrium income 1750

Pressure on income to rise
Pressure on Income to fall
29

• If AE gt Y (such as when AE is 1150 and Y is
  1000), then 2 things might happen
• Either households, firms, and the government will
  be unable to spend the extra 150 and lines and
  waiting lists of unsatisfied customers will
  appear (which is a signal to firms to increase
  their production).
• Or, all spenders will spend everything they
  wanted to spend because firms will satisfy the
  extra 150 of expenditure by purchasing
  inventories of goods. Again, firms will increase
  their output as they see their inventories being
  depleted. In both cases Y will increase.
• Note that the reduction in inventories is called
  unplanned negative investment.

30

• If AE lt Y, inventories must rise and firms will
  start to reduce their output and thus, national
  income will fall.

31
Figure 23-5Equilibrium National Income
32
Desired Saving and Desired Investment

• Suppose that the difference between desired
  saving and desired investment is equal to some
  number, W. Thus
• S I W
• Recall S Y C, and AE C I, thus
• Y C I W ? Y (C I) W ? Y AE W
• This means that, in a simple model with no
  government and international trade, the
  differences between desired saving and desired
  investment is exactly the same as the difference
  between national income and desired aggregate
  expenditure.

33
Example

• Y AE C 100.8 Y
  S Y C I
• 0 350 100
  - 100 250
• 100 430 180
  - 80 250
• 400 670 420
  - 20 250
• 500 750 500
  0 250
• 1000 1150 900
  100 250
• 1750 1750 1500
  250 250
• 2000 1950 1700
  300 250

34
Equilibrium Illustrated

• Shift VS. Movement Along AE Function
• Movement Along AE Function A change in National
  Income causes a movement along the AE Function .
• Shift in AE Function
• Parallel Shift in AE Function An increase in
  the autonomous expenditure will lead to an upward
  parallel shift in AE function which reflect an
  increase in the desired expenditure by the same
  amount at all levels of national income.
• Nonparallel Shift in AE Function Any change in
  the marginal propensity to spend out of national
  income ( Z ) will lead to nonparallel shift in AE
  function .

35
Figure 23-6Movements Along and Shifts of the AE
Function
36
Figure 23-7Shifts in the Aggregate Expenditure
Function
37
The Multiplier

• The Multiplier (K) measures the magnitude or the
  size of the change in income . It is defined as
  the ratio of change in income to the change in
  autonomous expenditure . Therefore
• K change in Y 1 .
• change in A 1- Z

38

• The size of the multiplier depends on the slope
  of the AE function or ( Z ) . Therefore
• The larger the Z , the larger the multiplier
• Example If Z 0 , then K 1
• If Z 0.5, then K
  2
• If Z 0.8, then K
  5

39
Figure 23-9The Simple Multiplier
40
Figure 23-10The Size of the Simple Multiplier