ch09 - national income determination

8/3/2019 Ch09 - National Income Determination

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Chapter 9:THE DETERMINATION

OF NATIONAL

INCOME

Economics 11-UPLBPrepared by TBParis 09/12/07



Main Objective of the Chapter

To explain fluctuations in national income.

helps government, researchers, and

businessmen formulate targets, policies, andbusiness decisions.

gives them an in-sight into the effects of their decisions.

need to explain how it is determined. identifythe factors that cause national income tochange.



Chapter Organization Section 9.1 - framework for analyzing changes

in national income.

Section 9.2 - how changes in income affectconsumption spending.

Section 9.3, introduces the role of the multiplier effects following a change in aggregateexpenditure.

Section 9.4 presents an algebraic treatment of the concepts developed



Aggregate Expenditure and

Equilibrium Income

Definition of aggregate expenditure and

equilibrium income

How the economy adjusts to its equilibrium

position.

How changes in aggregate expenditure

affect equilibrium income.



Aggregate Expenditure and

Equilibrium National Output Aggregate expenditure (AE)

total amount that all economic agents want or

plan to spend on domestic goods andservices.

the planned spending of households,

firms, government, and

foreigners.



Aggregate Expenditure

AE = C + I + G + (X-M)

consumption (C),

investment (I),

government spending (G), and

exports less imports (X-M).

Note that AE is not the same as GDP.

AE represents planned spending

GDP represents actual spending or output.



Aggregate Expenditure ( AE) and

National Output (Y) AE and Y are not necessarily equal:

Firms formulate their production plans with an

estimate of the quantities that people want tobuy.

A mistake on their part will cause productionto exceed or fall below the amounts thatpeople want to buy.



What if

AE and Y are not equal?

If AE < Y people want to buy less than what has been

produced so firms will accumulate inventories. firms will reduce production

If AE >Y

What people want to buy is greater than actualproduction so inventories will decline.

firms will increase production



Equilibrium National Income AE = Y

Can be depicted by the intersection

between the AE schedule and the 45

degree line



The 450

line The 45-degree line is a tool that assists us

in identifying the economy's equilibrium

position.

Property: every point along this line

depicts a situation wherein the value of the

variable on the horizontal axis (in this caseactual output, (Y) is equal to its

counterpart on the vertical axis (AE).



0100

100

450 line

450

200

200



45º

E0

AE20

AE

0 20

Output, income (in pesos)

A g g r e g a t e e x p e n

d i t u r e ( i n p e s o s )

Y

Y*



Equilibrium Income (Y*) When AE is equal to Y

there is no reason for firms to adjust production.

this suggests that the economy is in equilibrium. Equilibrium requires the equality between

income and aggregate expenditure. That is,

Y = AE.



Changes in A

E and Income Suppose that the economy's aggregate

expenditure schedule shifts upward AE 0 to AE 1,

E quilibrium point will move from E 0

to E 1.

As a result, the economy experiences anincrease in equilibrium income from Y O* to Y1*



45°

AE0

E0

E1

AE1

20

30

AE

0 20 30

Y

Output, income (in pesos)

A g g r e g a t e e x p e n

d i t u r e ( i n p e s o s )

Y0 Y1



Consumption and Income Keynes (1936) suggested that

consumption spending (C) tends to

increase with income.

In other words, households with higher

incomes tend to spend more.

There is a positive relationship betweenconsumption spending and income



TABLE 9.1. Consumption and income (in pesos).

(1) (2) (3) (4) (5)

Income Consumption Change In

income

Change in

consumption

mpc

(Y) (C) (¨Y) (¨C) (¨C/¨Y)

0 200 ² ² _

200 350 200 150 0.75

400 500 200 150 0.75

600 650 200 150 0.75

800 800 200 150 0.75

1,000 950 200 150 0.75

1,200 1,100 200 150 0.75

1,400 1,250 200 150 0.75

1,600 1,400 200 150 0.75



Consumption and income

Higher levels of income correspond to higher levels of

consumption spending

When income is equal to zero, consumption spending isequal to 200.

Consumption spending and income are equal at each

other when income = 800.

When income is less than 800, consumption is higher than

income.

When income is greater than 800, consumption less than income



0

450200

C o n s u m

p t i o n S p e n d i n g ( i n p e

s o s )

Output, Income (in pesos)

400

600

800

1000

800 1200 1600

400

1200

1400

1600

C

Y

THE CONSUMPTION SCHEDULE

Y



Consumption and Income

Observations from values above:

(a) autonomous c onsumption spending -

component of consumption spending that doesnot depend on income

- equal to 200 in example

(b) marginal propensity to consume (mpc)-

shows the increase in consumption spending for

a one peso increase in income;



Marginal Propensity to Consume

MPC or the marginal propensity to consume represents thechange in consumption spending that arises from a one pesochange in income.

V alue of MPC is between 0 and 1.

MPC=0.75 means that a one peso increase in income leads to a

75-centavo increase in consumption spending.

C mpcY

(!(



Marginal propensity to consume

In example above,

¨C = 150 for ¨Y = 200. Hence,

1500.75

200

C MPC

Y

(! ! !

(



Consumption Function Consumption Function:

C = c + mpc.Y

C = 200 + 0.75Y



Savings and Income Sum of consumption spending and

savings (S) must equal income. In

symbols,Y = C + S.

Subtracting C from both sides of thisequation leads to

S = Y - C.



(1) (2) (3) (4) (5) (6) MPS

Y C S ¨Y ¨C ¨S ¨S

¨Y

0 200 -200 - - - -

200 350 -150 200 150 50 0.25

400 500 -100 200 150 50 0.25

600 650 -50 200 150 50 0.25

800 800 0 200 150 50 0.25

1000 950 50 200 150 50 0.25

1200 1000 100 200 150 50 0.25

1400 1200 150 200 150 50 0.25

1600 1400 200 200 150 50 0.25

Relationship bet. Income and Savings



Savings and income Savings - that component of income

that is not allocated to consumption.

S = Y ± C

How is savings linked to income?

o Y p oS.



Savings and Income Marginal propensity to save (MPS) is the

increase in savings for a one peso increase

in income; In the example above, ¨S = 50 for ¨ Y = 200.

Implies that

50 0.25200

S MP S

Y (! ! !(



Savings function

Note: MPC+MPS = 1

Savings schedule ± listing of values of

savings at each levels of income

Savings function ± in equation form

S = -200 + .25Y



1

Y C S

Y C S

Y C S

Y Y Y

mpc mps

!

( ! ( (( ( (

! ( ( (

!

Relationship between mpc and mpc



S

-200

-50

150

0

400 800 1,200 1,600

Income (in pesos)

S a v i n g s ( i n p e s o s )

Y

S F9.4

Propensity to Save



The determination of equilibrium income in a

two-sector economy

Two sector economy - households and firms only

Implies that AE is given by:

AE = C + I Assume that ³I´ is autonomous and equal to 100

In equilibrium, Y = AE p equilibrium income (Y*) =

1200



Table 9.3 Consumption, Investment and Equilibrium

Income.

Y C S I AE

400 500 -100 100 600

600 650 -50 100 750

800 800 0 100 900

1,000 950 50 100 1,050

1,200 1,100 100 100 1,200

1,400 1,250 150 100 1,350



E0

S

I

-200

100

0800 1,200 1,600

Income (in pesos)

Y

Y*

(B)

S, I

(A)

E0

yy

Fig 9.5

C+I = AE

C

0 400 800 1,200 1,600

Y45º

AE

300

200

y

Y*

y



Investment and Multiplier

Suppose that investment I increases from

100M pesos to 200M pesos

What happens to equilibrium income?

Equilibrium income Y* will increase

Not by 100M

But by a multiplied amount!!

WHY???



Table 9.4 Effects of a 100 peso increase

in investment.

Y C S I AE

400 500 -100 200 700

600 650 -50 200 850800 800 0 200 1000

1,000 950 50 200 1150

1,200 1,100 100 200 1300

1,400 1,250 150 200 1450

1600 1400 200 200 1600

1800 1550 250 200 1750



A g

g r e g a t e E x p e n d i t u r e ( i n p e s o s )

AE0

AE1

Y0

Y*0 Y*1

A

B

E1

E0

1200 1600

¨I=100

The effect of an increase in investment

AE Y

45o

300

400

¨Y=400



Calculation of equilibrium income

In numerical example,

* 1( ).

1Y C I

mpc

¨ ¸!

© ¹ª º1 multiplier

1 mpcE! n

C 200, I 100,mpc 0.75! ! !

¨ ¸! !© ¹ª º

1Y* (200 100) 1,200

1 0.75



For I = 200, Y* = 1,600

Hence, if Io from 100 to 200 p Y*o from 1200

to 1600. In other words, p

( !

( !I 100

Y* 400

p



The concept of the multiplier

Increase in Y is greater than increase in I. Why?

Multiplier (E) - measures the change in

equilibrium income as a result of a one-pesochange in the sum of the autonomous

components of AE;

*

YI

(E !(



The multiplier concept

Round ¨C + ¨ I = ¨ Y

1 0 100 100

2 mpc[100] 0 mpc100

3 mpc [mpc100] 0 mpc2100

«« « «

n mpc[ mpcn-2100] 0 mpcn-1100



Calculation of the multiplier:

1 1

1 mpc mpsE ! !



Calculation of multiplier

With the mpc = 0.75,

The multiplier is used determine the amount

by which Y* changes in response to a

change in investment.

141 0.75

E ! !

Y* IE( ! (



So the total change in income is given by:

(Y = (I + mpc (I + mpc 2 (I +mpc 3 (I +«

= (1 + mpc + mpc 2 + mpc 3 «) . (I

or

¨ ¸( ! ( ! E (© ¹ª º

1Y I I1 mpc



2 3

2 3

2 3

...

...(1 ...)

1

1

Y Y Y I mpc I mpc I mpc I

Y I mpc I mpc I mpc I Y I mpc mpc mpc

Y I

mpc

Y I E

( ! ( ( ( (

( ! ( ( ( ( ( ! (

« »( ! ( ¬ ¼

- ½( ! (

The Multiplier



The Paradox of Thrift

Many people believe that higher savings lead

to higher income.

In the present model, we get a result that iscontrary to this belief.

In other words, equilibrium income falls

when people want to save more.

Idea: the attempt to achieve higher savings

may reduce equilibrium income



S0

Income (in pesos) S a v i n g s ( i n p e s o s )

Y

S,I S1

I

Y0 Y1

Fig 9.7

0

The Paradox of Thrift



End

Chapter 9:

ch09 - national income determination

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