National Income Determination-Part2

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CHAPTER 24
National Income Determination- Part 2
The Economic Problem
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In this chapter

• National Income with
• Government (Public sector)
• International trade (exports imports)
• New aggregate expenditure function (extended)
• Equilibrium national income
• Multiplier
• Changes in aggregate expenditure and national
  income

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From the Closed Economy to Open Economy

• The simple model of national income included
• consumption expenditure (a function of disposable
  income)
• investment expenditure (autonomous)
• That was, Y C I
• Now we extend that model by including
• Government expenditure
• Taxes
• Exports
• Imports

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Government Spending and Taxes

• Government influence the economy by fiscal policy
• Fiscal policy is the governments use of its
  taxing and spending powers to affect the level of
  national income
• Fiscal policy affect the equilibrium income in
  two ways
• Government purchases are part of autonomous
  expenditure
• In deriving disposable income, taxes must be
  subtracted from national income
• Government spending is an injection, but taxes
  are withdrawals

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Desired government expenditure (G)

• Government might
• hire a bureucrat
• buy a paper clip
• purchases fuel for official cars
• buy equipment for the army
• They all constitute a demand for goods and
  services in the economy
• but, governments transfer payments such as
  unemployment benefit, social security
  contributions place no direct demand on goods and
  services, while they affect the disposable income
  (and so desired consumption)

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Taxes (T)

• Taxes are revenues for the government
• but negative transfer payments for households,
  decreasing their disposable income
• Effect of government policy depend on net effect
  of these two.
• Net taxes total tax revenues total transfer
  payments
• T will indicate net taxes

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Budget Balance

• Budget balance Difference between total
  government revenue and total government
  expenditure, that is T G
• If T gt G, budget surplus
• If T lt G, budget deficit
• If T G, balanced budget
• Public saving Like private savings, government
  might also save when T gt G (i.e. a budget
  surplus)
• Public saving increases with national income so
  it is an induced expenditure

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The Public Saving (Budget Surplus) Function
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Introducing foreign trade

• Many countries sell their products (export) to
  other countries and buy their goods (import)
• Exports depend on spending decisions made by
  foreigners to purchase Turkish goods and
  services. Thus exports do NOTdepend on Turkeys
  national income
• Exports are autonomous
• Imports depend on our spending decisions and
  increase as our national income rises
• Imports are induced

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Desired net export function (NX)

• Net export function X IM
• Imports (M) are positively related to national
  income,
  
• e.g. IM 0.1Y
• Exports (X) are autonomous
• Net exports (X M) are negatively related to
  national income,
• e.g. NX X 0.1Y

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The Net Export Function
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Shifts in the net export function

• NX function is drawn under the assumption than
  everthing affecting net exports, except the
  domestic national income, remains constant
• However, exports and imports may be changed due
  to many factors
• Any factor affecting exports or imports will
  shift the NX function

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What changes the desired imports?

• Anything affecting the proportion of income that
  Turkish consumers wish to spend on imported goods
  will change the imports, thus changing the slope
  of the NX function (marginal propensity to import)

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What changes the desired exports?

• Foreign income As foreigners income rises, they
  will demand more Turkish goods, thus NX shifts
  upward
• Relative international prices A change in
  relative prices might affect both exports and
  imports thus NX function
• If Turkish prices increase more, X will decrease,
  IM will increase. Net effect NX will shift
  downward and changes its slope
• If foreign prices increase more, X will increase,
  IM will decrease. Net effect NX will shift
  upward and changes its slope

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But what changes the international prices?

• Different inflation rates and changes in exchange
  rate change the relative international prices
• Inflation rates Prices of Turkish goods will
  rise relative to foreign prices if inflation rate
  in Turkey is higher
• Exchange rates If TL depreciates (i.e.if we pay
  more TL for a dolar), our goods will be cheaper.
  IM will decrease, X will increase. If TL
  appreciates (i.e.if we pay less TL for a dolar),
  our goods will e expensive. X will decrease, IM
  will increase

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Shifts in the Net Export Function
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Equilibrium national income

• Remember that desired aggregate expenditure (AE)
  is equal to national income in equilibrium
• Now we have 4 components of AE, not 2 as in the
  simple model
• Consumption (induced )
• Investment (autonomous)
• Government (autonomous)
• Net exports (induced)
• AE C I G NX

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Disposable income

• Taxes influence the level of national income via
  their effect on consumption which is a function
  of disposable income (YD)
• If T tY where t is the tax rate
• YD Y T Y tY
• YD (1-t)Y e.g. If t 10 ? YD 0.9Y
• e.g. If C 50 0.8YD 50 0.8(0.9Y)
• C 50 0.72Y

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Y C C500.72Y I G NX NX120-0.1Y AE
0 50 125 85 120 380
250 230 125 85 95 535
500 410 125 85 70 690
1000 770 125 85 20 1000
1500 1130 125 85 -30 1310
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The Aggregate Expenditure Function
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Equilibrium National Income
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Disequilibrium

• If Y lt AE ? some of the households, firms,
  foreign demanders and governments will either be
  frustrated or take the form of purchases of
  inventories of goods that were produced in the
  past ? as firms see their inventories being
  depleted, they will increase production ? the
  level of national income will increase
• If AE lt Y ? firms will notice that they are
  unable to sell all of their output ? their
  inventories will be rising ? they will eventually
  reduce the level of national output until it
  equals the level of sales

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Marginal propensity to spend (z)

• z is not equal to MPC any more with the addition
  of net taxes and net exports
• MPC is found out of disposable income, thus
  should be corrected to include t (tax rate)
• Imports is an induced function, thus marginal
  propensity to import should be taken into account
  in multiplier
• Now we have to sources of leakages in the
  economy saving (MPS) and imports (MPI)
• Multiplier (k) 1 / (MPSMPI)

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Change in autonomous expenditures

• How will the equilibrium national income change
  when there is a change in an autonomous
  expenditure such as G or X?
• Calculate the equilibrium again from AE Y?
• No need. Multiply that change with the multiplier
  to find the change in equilibrium national income
• e.g. If the government increases its spending by
  200 billion TL, what will happen to the eq.
  national income (assume that k3)?
• National income will rise by 3x200 600 billion
  TL

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The Multiplier
The multiplier is the amount by which a change in
autonomous expenditure is multiplied to determine
the change in equilibrium real GDP. D Yn k(D
C) if consumption changes or k(D I)
if investment changes or k(D G) if
Government changes or k(D Xn) if net export
changes
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Saving Investment Approach

• Remember that in the simple model of closed
  economy, another way of finding equilibrium
  national income was equating S to I
• However, when there are government and
  international trade, national saving will be
  equal to national asset formation in equlibrium

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National saving

• National saving is the sum of private (S) and
  public saving (T-G)
• The slope of the national saving function depends
  on t and MPS, that is t MPS(1-t)
• e.g. Assume that t0.1, MPS0.2
• If income rises by 10 TL, 1TL goes to public
  saving as tax (G autonomous) and 9TL goes to
  disposable income.
• From the disposable income, 9x0.21.8TL goes to
  private saving. Total national saving is
  11.82.8 The slope the national saving function
  is 0.1 0.2(1-0.1) 0.28

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The National Saving Function
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National asset formation

• In the simple model, the counterpart of saving
  was investment which was the only way of asset
  formation for future uses
• Positive net exports (X gtIM) can be accepted as a
  way of asset formation. How?
• excess of the production is sold to abroad
• get revenue in response
• nation will accumulate assets either in the form
  of foreign exchange, balances in foreign banks,
  stocks and bonds or even in lands and factories
• however, if IM gt X, the nation will incur foreign
  liabilities, running down the foreign assets
• In sum, like investment, net exports generate
  income for future uses for the exporting country

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Injections Withdrawals

• When national income is in equilibrium, national
  saving will be equal to national asset formation
  in the economy, that is
• S (T G) I (X IM)
• Rearranging this will give
• S T IM G I X
• Does that remind you of something?

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injections leakages

• S T IM G I X
• ? ?
• withdrawals injections
• Compare the equilibrium level of income in the
  following table with the previous table if you
  dont believe me !

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National saving national asset formation
Y S T - G I X - IM Balance
0 -135 245 -380
500 5 195 -190
1000 145 145 0
1500 285 95 190
2000 425 45 380
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National Saving and National Asset Formation
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Changes in aggregate expenditure

• Taxes and imports are leakages from the income
  flow, thus reduce the multiplier (the change in
  national income in response to a change in
  autonomous expenditure)
• The higher the marginal propensity to import, the
  lower the simple multiplier
• The higher the income tax rate, the lower the
  simple multiplier

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Change in net exports

• If net export function shifts upward, equilibrium
  national income will rise
• Net exports have two components
• Autonomous net exports If autonomous net exports
  rise by 1million , the net export function and
  AE function will shift up (without changing the
  slope) by 1million and the equilibrium income
  will increase by 1million times the multiplier
• Induced net exports Any change in the induce
  part (i.e.marginal propensity to import) will
  change the slope of the net export function and
  AE function

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Change in fiscal policy

• Fiscal policy involves the use of government
  spending and tax policies to influence total
  desired expenditure so as to change the eq. level
  of national income
• Changes in government purchases An increase in G
  will shift the AE curve upward. The change in the
  eq. income will be ?G times the multiplier
• Changes in tax rates ? t ? ?YD ? ?C ? ?AE ? ?Ye.
  A fall in tax rates will shift the AE curve up
  by changing its slope, increasing the eq. level
  (see the graph)
• Balanced budget changes If government alters its
  spending and taxes equally, that will have a mild
  expansionary or contractionary effect on national
  income

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The Effect of Changing the Tax Rate
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Recessionary and Inflationary Gap

• Recessionary gap occurs when the actual Y is less
  than the full employment level of Y (Yf).
• Government might use fiscal policy to close the
  recessionary gap by either increasing its
  spending or by reducing taxes
• Inflationary gap occurs when the actual Y is
  greater than the Yf
• Government might use fiscal policy to close the
  inflationary gap by either decreasing its
  spending or by rising taxes

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Recessionary Gap
Recessionary gap - When aggregate
expenditures are inadequate to bring about full
employment
(C Ig Xn G)0
Private and government spending (billions of
dollars)
Full Employment
o
400 800 1200
Real GDP (billions of dollars)
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Recessionary Gap
Recessionary gap - When aggregate
expenditures are inadequate to bring about full
employment
(C Ig Xn G)0
(C Ig Xn G)1
Private and government spending (billions of
dollars)
Recessionary Gap 100 billion
Full Employment
o
400 800 1200
Real GDP (billions of dollars)
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Recessionary Gap Problem
The economy is in equilibrium at 5,800,
full-employment 5,900, the mpc .75 What DG
would bring YF equilibrium?
We use D Yn k (D G) k 1/(1-mpc)

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Recessionary Gap Problem
D Yn k (D G) k 1/(1 - .75) 1/.25 4
D Yn k (D G) 100 4 (D G)
100/4 (D G) 25 (D G)
The government could achieve YF equilibrium with
an increase in G of 25 billion
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Inflationary Gap
Inflationary gap - When aggregate
expenditures are greater than the full employment
level causing demand-pull inflation
(C Ig Xn G)0
Private and government spending (billions of
dollars)
Full Employment
o
400 800 1200
Real GDP (billions of dollars)
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Inflationary Gap
Inflationary gap - When aggregate
expenditures are greater than the full employment
level causing demand-pull inflation
(C Ig Xn G)1
(C Ig Xn G)0
Private and government spending (billions of
dollars)
Inflationary Gap 100 billion
Full Employment
o
400 800 1200
Real GDP (billions of dollars)
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Inflationary Gap Problem
The economy is in equilibrium at 7,200,
full-employment 6,900, the mpc .8 What DG
would bring YF equilibrium?
We use D Yn k (D G) k 1/(1-mpc)

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Inflationary Gap Problem
D Yn k (D G) k 1/(1 - .8) 1/.2 5
D Yn k (D G) - 300 5
(D G) - 60 (D G)
The government could achieve YF equilibrium with
a decrease in G of 60 billion
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Inflationary Gap Problem
AE0
45o line
AE1
mpc .8
Aggregate expenditure ( billions of 1992 dollars)
G 60 B
Inflationary Gap
6,900 YF
7,200
Real GDP (of billions of 1992 dollars)
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