chapter 3

Lecturer: Pn. Siti Hajar Binti Md.Jani

Power Point by ; Pn.Azizah Isa. UiTM Kelantan 1

Chapter 3Determination of Equilibrium

National Income

Lecturer: Pn. Azizah Isa 2

BUSINESS CYCLE

Aggregate Econ. Activity

Boom/Inflation

Trough/Depression/Slump/Unemployment

Potential Growth Path

Actual Growth Path

years

(% in real GDP)


NATIONAL INCOME EQUILIBRIUM

Keynes argued that “an economy could reach equilibrium but not necessarily at the full employment.”


Equilibrium and Full-employment

Equilibrium will occur when there is no tendency for an economy to change. It refers to a situation when all consumers and firms have no incentive to change their behaviour.

Full employment equilibrium is the situation of

equilibrium in an economy at the best efficient and full utilization of resources.

“An economy can be at the equilibrium but not

always to be at full-employment.”


Two approaches:

To Determine National Income Equilibrium:

1. Total Approach.

2. Injection-Leakage Approach.


i) Total Approach:

Equilibrium may occur when planned aggregate expenditure is equivalent to planned output.

(AD = AS)

(aggregate demand = aggregate supply).


i) Leakage-Injection Approach:

Equilibrium also can be determined when: INJECTION = LEAKAGE

Injections are additional spending from:

investments (I), government purchases (G) and exports (X).

Leakages are withdrawals from: savings (S),

tax payment (T) and imports (M).

So, at equilibrium, (I+G+X = S+T+M) (INJECTION = LEAKAGE)


DETERMINATION OF EQUILIBRIUM NATIONAL

INCOMEKeynesian model is drawn based on the relationship between income and expenditure:

Y = C + I + G + (X – M)

where,

C = f (Yd) ,

C is a function of Real Disposable Income

(income after tax), where, Yd = Y – t .


Components of Aggregate Expenditure:

1. CONSUMPTION, C = f (Yd)

2. INVESTMENT, I = f (i, Y)

3. GOVERNMENT EXPENDITURE, G

4. NET EXPORT (X – M)


1. Consumption and Saving

Disposable Income is used for Consumption spending and Saving.

Yd = C + S

and, C = f (Yd), S = f (Yd)

Both C and S is a function of income,Y and having a positive relationships.

( Y rises, C and S also will rise).


Given that;

Consumption function: C = a + bYd

and Saving function: S = – a + (1 – b) Yd

There is (two)2 components of Consumption spending by households:

C1, Autonomous Consumption = a

C2, Induced Consumption = bYd

Where,

b is the Marginal Propensity to Consume (MPC).


Autonomous Consumption, a and Induced Consumption, bY

C2 = a is a fixed amount irrespective of the income earned,

is the part of consumption which does not vary with the level of income (Y increases but “a” is constant).

C2 = bY is an amount that depends on the disposable income,

is the amount of consumption spending by households that is induced by disposable income (Y increases, C2 increases).


CONSUMPTION, C

Consumption function, C = f (Yd)

C C = a + bYd

a

real output, Y

The slope of consumption function is given by:

b = C/ Y

= Marginal Propensity to Consume (MPC)

and the value 0 < b < 1 (positive but less than).


Autonomous Consumption,C1 = a

is the vertical intercept of the consumption function,

at a (in the diagram). It is the amount of consumption that

would occur even if the household earned nothing, Y=0.

when Y= 0 (no income earned), C = a.

(basic consumption for living).

C C = a + b Yd

a 0 real output, Y


Consumption and Saving schedule

Y C S 0 60 -60

100 120 -20 200 180 20 300 240 60 400 300 100 500 360 140

With no income earned, Y = 0 , autonomous C = a = 60 and dissaving = - a = - 60.While Y = C + S , if Y = 0 , then C = - S.


How is the increase in income will increase consumption?

Consumption is induced by

the value of b (that is = MPC),

since,

C = a + bY


FOR EXAMPLE: Given that C = a + bY, therefore, if b = 0.6 , how large is the increase in consumption if there is an increase in income?Since C = a + 0.6Y, thus C will increase by 0.6Y , (given a = fixed or autonomous consumption) , so, C will increase by 60% out of total income, Y. Meaning that, for any increase in income, 40% can be saved and 60% will be spend on consumption.


For example:

a change in income from RM1000 to RM1500 with the MPC = 0.6,

C = b Y

= 0.6 (500) = 300.

Therefore, consumption will increase by RM300.


Consumption and Saving schedule

Y C S 0 60 -60

100 120 -20 200 180 20 300 240 60 400 300 100 500 360 140

In a 2-sector economy, C = a + bY .Since C = a + 0.6Y, and a = 60 thus C = 60 + 0.6Y.

At income 200, C = 60 + 0.6(200) = 60 + 120 = 180 and Y = C + S so , S = Y – C = 200 -180 = 20.


Changes in consumption when income change.

consumption

Y = CC = a + b Y

C Y

45°

income

Note: b = C = 400

1000 1500

Y

500

400


Changes in consumption when income change.

consumption Y = C

C = a + b Y

C Y

45°

income

Note: b = C

= 400

1000 1500

Y

500

e

a

400


SAVINGSSome part of income earned is saved.

two components of savings: autonomous dissaving, S1 = – a

induced saving, S2 = (1 – b)Y

where,

(1 – b) = Marginal Propensity to Save. = S/Y

= slope of saving function.


Dissaving and induced saving.

Autonomous dissaving, (- a), is the amount that households draw out from their wealth to consume when no income earned.

Induced saving, (1 –b)Y, is the amount of saving that is induced by earnings of disposable income.


Saving Function, S

Saving

Yd (real output)

S = – a + (1– b)Yd

–a

0

(1 – b) is the slope of saving function = ΔS/ΔY


Consumption & Saving Function,

C,S

Yd (real output)

S = – a + (1– b)Yd

– a

0

C = a + bYd

a

45º

e

Y = C + S,When S = 0,Y = C at the breakeven,

point, e.

Y = C

Y = AD


Note that:

MPC + MPS =1, thus MPS = (1 – MPC).

If MPC = b and MPS = (1 – b),

Then,

b + (1 – b) = 1


APC, APSThe fraction of income that is used for

consumption is the: Average Propensity to Consume (APC): APC = C YAnd, the fraction of income that is used for

saving is the: Average Propensity to Save (APS): APS = S Y and, at any level of income, APC + APS = 1


MPC, MPS, APC, APS

INCOME,Y

CONSUMPTION, C C = a + bYd

0 1600

1200

a

1000

800


MPC

INCOME,Y


∆C

∆Y

0 1600

1200

a

MPC = ∆C = 400

∆Y 600

is the slope of the consumption function.

1000

800


MPC, APC

INCOME,Y


∆C

∆Y

0 1600

1200

a

MPC = ∆C = 400

∆Y 600 APC = TC = 1200 TY 1600

1000

800

TC

TY


MPC, APC

INCOME,Y


0 1600

1200

a

MPC = ∆C = 400

∆Y 600 APC = TC = 1200 TY 1600

1000

800

TC

TY

TC


Saving

Yd (real output)

S = – a + (1– b)Yd

–a

0

MPS = (1 – b) = ΔS/ΔY

is the slope of saving function.

ΔS

ΔY

MPS, APS


Saving

Yd (real output)

S = – a + (1– b)Yd

–a

0

while, APS = TS/TY

ΔS

ΔYTS

TY

MPS, APS

TS


Saving

Yd (real output)

S = – a + (1– b)Yd

–a

0

while, APS = TS/TY

TS

TY

MPS, APS

TS


APC, APS changes with income; MPC, MPS are constant.

APC falls and APS will rise as income increases.

- because as income increases, households consumption will rise but with a smaller percentage compared to the increase in income, while saving will rise with a larger percentage instead.

While MPC and MPS is assume constant as long as the slopes of the consumption and saving curves are constant or assume to be straight lines.


EXAMPLE 1

Y C S APC APS MPC MPS 0 60 -60 - - - -

100 120 -20 1.2 -0.2 0.6 0.4 200 180 20 0.9 0.1 0.6 0.4 300 240 60 0.8 0.2 0.6 0.4 400 300 100 0.75 0.25 0.6 0.4 500 360 140 0.72 0.28 0.6 0.4

As income increases, APC falls but APS rises.Meanwhile, MPC and MPS are constant.


Other determinants of Consumption:

Wealth The richer the higher is the consumption.

Interest ratesLarge items were bought on loans that pay interest.Expectation of future pricesPrice is expected to increase in future, more consumption now (may involve in hoarding).


Consumption in Islam (according to M. Fahim Khan, 1922)

A Muslim has to be rational in their spending.

The rationality of consumption in Islam is:

to spend wisely and moderately: to consume only enough goods for healthy

living. Excessive indulgence in luxurious living is

discouraged: Israf (extravagant or overspending on goods excessively are wasteful and prodigal.


to follow the hierarchy of needs: Dharuriyat, Hajiyat, Kamaliat and not to consume the Tarafiat goods.

to consume only permissible goods (halal) but not prohibited goods (haram).

part of his expenditure is also spend for fi-sabilillah (spending for the betterment of Islamic livings)

part of his income is also saved for future expenditure.

Conclusion: spending by Muslim consumers is to achieve the satisfaction in this world and also to earn reward in the hereafter.


BREAK-EVEN INCOME is a situation when all the income is just

nice for consumption purposes while no saving at all.

thus, Y = C and S = 0.

S = - a + (1 – b)Y

C = a + bYe

C,S

Y45º

AS=AD

S < 0

S > 0

S = 0

QUESTION TO PONDER: look out in the manual

INCOME(Y) CONSMPTN (C) SAVING(S)

0 140

200 260

400 20

600 500

800

1000

1. Use the given data to answer the following questions. (All figures are in RM million)

a) Fill up the blank with appropriate values.

QUESTION TO PONDER: ANSWER


0 140 140

200 260 60

400 120 + 260 = 380 20

600 500 100

800 120 + 500 = 620 180

1000 120 + 620 = 740 260

1. Use the given data to answer the following questions. (All figures are in RM million)

a) Fill up the blank with appropriate values.

Y = 200 and C = 120 , S = 80


b) What are the values of MPC and MPS?

c) Write down the consumption function and saving function.

d) What is the amount of break-even income?


b) What are the values of MPC and MPS?

MPC = C = 260 - 140 = 0.6 Y 200 – 0

MPS = 1 – MPC = 1 – 0.6 = 0.4


c) Write down the consumption function and saving function.

C = 140 + 0.6Y

S = - 140 + 0.4Y


d) What is the amount of break-even income?

is a point at e, when S = 0, so Y = C.

S = - 140 + 0.4Y

Since S = 0, 0 = -140 + 0.4Y

140 = 0.4Y

Y = 140/0.4 = 350

S = -140 + 0.4Y

C= 140 + 0.6Ye

C,S

Y45º

S = 0

Additional Question:


0 140 140

200 260 60

400 380 20

600 500 100

800 620 180

1000 740 260

Use the given data to answer the following questions. (All figures are in RM million)

Calculate the APC and APS at each level of income.

INCOME

(Y)

CONSMPTN (C)

SAVING

(S)

0 140 140

200 260 60

400 380 20

600 500 100

800 620 180

1000 740 260

ANSWER:

The values for APC and APS at each level of income.

APC APS

- -

1.3 - 0.3

0.95 0.05

0.83 0.17

0.78 0.23

0.74 0.26


2. INVESTMENT

Definition:

Investment is defined as the spending or purchase of plants, machineries, buildings and inventories by firms for the purpose of producing goods and services.


2 types of INVESTMENT - Keynes

two(2) types of investment spending: i) Autonomous Investment what firms may had intended to plan or

desired or has been fixed and does not depend on income.

ii) Induced Investment actual investment expenditures used to

produce newly produced goods, and depends on the level of:

I = f ( i, e, Y, t…)


Investment depends on the level of:

I = f ( i, e, Y, t ….) interest rate, future expected profitability, income, technology, capacity and business taxes.


1. Autonomous Investment

As assume by Keynes;

- is a fixed investment that does not change with the change in income,

but ;

there will be a shift in the autonomous horizontal function, up or down when there’re other factors that affect it.


1. Autonomous Investment Function

Investment

I1

Autonomous

Investment I0

Diagram: Autonomous InvestmentA shift in autonomous investment upward to I1 may

cause by an increase in expected profit or a fall in interest rate but does not depend on real income.

Example; the government planned spending to provide public goods.

Real Income

refers as a fixed investment that does not change with the change in income.


2. Induced Investment Functionreal interest rate (i)

I = f(i, e

)

I = f(i)

I’ I’’ Investment

Diagram: Induced Investment

Induced investment has a negative relationship with real rate of interest.

If future profit is expected to increase, at any given level of real interest rate

the investment function will increase and shift the curve to the right.

i1

i2

refers to an investment that changes with the interest rate, income or expected profitability etc.


2. Induced Investment Function investment

I = f(Y)

Income

Diagram: Induced Investment

Induced investment has a positive relationship with aggregate income.

Example is capital investment by the purchase of new plants and equipments.

is the actual investment that is induced by changes in income.


Investment From Islamic Perspective

Investment is permissible in Islam but extravagant and maximizing profit in doing any business activities is not allowed.

Muslims are not allowed to freeze their wealth.

Islam encourages Muslim to produce goods and to attain profit but also to give the emphasis on the welfare benefits to the society.

This means, Muslim entrepreneurs were not allowed to maintain maximum profit but only satisfactory profit or responsibility profit, which includes their responsibility to Allah and the responsibility for the benefits of the society.



According to Siddiqui (1979), a relevant profit returns

for a Muslim in production is a “satisfactory profit”

earning, whereby it lies between the maximum profit

that could be allowed by the Islamic principles and the

minimum limit that could cover the cost.

Meaning that, it is the profit that gives satisfaction to

the investor in terms of the well beings and money

returns that could afford to maintain his business and

future business expansion, for the long term benefit of

the consumers, society and government.



Underlying constraints in business activities in Islam involves:

i. Avoid the monopoly profit making. Any control of output and prices are strictly not allowed.

ii. Producing only the permissible (halal) goods but not the forbidden (haram) goods.

iii. Avoid transactions which involve the gharar and gambling activities.

iv. Does not involve in any misused of powers, injustice, suppress others and manipulation – must emphasis on the welfare of the society.



v. Production of goods must follow the hierarchy of needs: Dharuriyat

Hajiyat and

Kamaliat goods

but not the Tarafiat (Tassiniyat)(haram) goods.

vi. Does not involves interest payment or any riba activities, both the riba al-nasiah (the addition to the capital) and the riba al-fadhal (an addition to the exchange of goods or other objects which is of the same nature – e.g. padi, wheat and money). Instead to avoid riba, Muslims are encouraged to have alternatives profit sharing in terms of mudharabah (sharing profit) or musyarakah (joint-venture).


Factors that influence Investment in Islam are:

I. Income

II. Expected returns

III. Viability of the projects.

IV. Facilities available or provided by the government.

V. The respond of market demand.

VI. Availability of fund.


Investment and SavingInvestment is an injection: could increase aggregate expenditure (AD) and boost up economic growth (income).

Investment spending will multiply through the multiplier effect to increase income. Saving is a leakage: could lower aggregate expenditure (AD) and income.

Saving becomes an outflow of money (leakage) from an economy. It becomes a stock of money that is not spent.At equilibrium,

Saving will be equal to Investment, ( S = I )


Equilibrium in 2 sector economy

C,S,I

Yd (real output)

S = – a + (1– b)Yd

– a

0

C = a + bYd

a

45º

C + I

I

Y2Y1

Y=AD

e1

e2

S = I

In 2 sector econ; equilibrium; Y = C + I

Y= C+I



C,I

Yd (real output)

045º

C + I

Y2

Y=AD

e2

equilibrium; Y = C + I (in 2 sector economy)



C,S,I

Yd (real output)

S = – a + (1– b)Yd

0

I

Y2

e2S = I

In 2 sector econ; equilibrium; S = I


QUESTION TO PONDER

1e) If investment is RM150 millions, calculate the equilibrium income

and sketch a diagram to show this.

I = 150

C = 140 + 0.6Y


At equilibrium (in 2 sector economy);

(Using Total Approach):

Y = C + I

Y = 140 + 0.6Y + 150

Y – 0.6Y = 290

0.4Y = 290

Y = 290/0.4

Y = 725

ANSWER:

Y = AD

C + I

Y

C,I

e

Ye = 725

45º

ANSWER:

Example: Question to Ponder 2. Refer to this diagram to answer the following questions.

S,I S = -300 + 0.25Yd I2 400 I1

0 Y0 Y1 3500 Income (RM million) -300

o Find the break-even income at Y0 o Find the equilibrium income when investment (I1) is at RM400 million. o How much is the new investment (I2) to achieve equilibrium income of

RM3500 million? o If equilibrium income is RM3500 million, how much is the amount of

saving and consumption? o At income level of RM3500 million, calculate the APS and APC.

Look out: in the manual

3. GOVERNMENT EXPENDITURE

Government Expenditure

Real Income Diagram: Autonomous Government Expenditure

G1

G0

G will be autonomously fixed according to Government Budget Policy for each year.


AD

Yd

S+T

0

C

45º

C + I

I

Y2Y1

Y=AD

e1

e2

C + I +G

I + G

Y3

e3

S+T = I+G


AD

Yd

S+T

045º

Y2Y1

Y=AD

C + I +G

I + G

Y3

e3

S+T = I+G


4. NET EXPORT (X – M)

Export is an injection and could increase the national income through the foreign trade multiplier, but import is a leakage.

Thus, net export (X-M), means the real foreign sector minus the total import of goods and services into the economy.

NATIONAL INCOME EQUILIBRIUM in 4 sector

Real Output (National Income)

Expenditure(RM)

Y0 = C+I+G+(X-M)

Y1=C+I+G+(X-M)Y=E

45°

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

Ye0 Yfe Ye1

e0

e1

ef


KEYNESIAN EQUILIBRIUM NATIONAL INCOME

Keynesian assume that equilibrium output can be reached not necessarily at the full-employment.

- the equilibrium can be less or more than the full-employment equilibrium, causing the economy with the inflationary or deflationary-gap.

Inflationary & Deflationary Gaps


Expenditure(RM)

Y0 = C+I+G+(X-M)

Y1=C+I+G+(X-M)Y=E

45°

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

Ye0 Yfe Ye1

Inflationary Gap

Deflationary Gape0

e1

ef

-GDP GapInflationary gap:

Yfe < Ye.

Deflationary gap: Yfe > Ye

+GDP Gap

NATIONAL INCOME EQUILIBRIUM with inflation


Expenditure(RM)

Y1=C+I+G+(X-M)Y=E

45°

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

Yfe Ye1

Inflationary Gape1

ef

Inflationary gap: Yfe < Ye1

NATIONAL INCOME EQUILIBRIUM with

unemployment


Expenditure(RM)

Y0 = C+I+G+(X-M)

Y=E

45°

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

Ye0 Yfe

Deflationary Gape0

ef

Deflationary gap: Yfe > Ye0

NATIONAL INCOME EQUILIBRIUM


Expenditure(RM)

Y0 = C+I+G0+(X-M)

Y1=C+I+G2+(X-M)

Y=E

45°

Yfe=C+I+G1+(X-M)

Y0 Yfe Y1

e0

e1

ef

G

Y

Spending multiplier ,

m =Y Yfe– Y0

Thus , Y = m G

G

+GDP Gap

G1 – G0

=


MULTIPLIERS

Any Injection will multiply positively,

while

any Leakage will multiply negatively.


i) Investment Multiplier = mI

= 1/MPS = 1/(1 – MPC)

Therefore, Y = 1/MPS x I

= mI x I

Y = mI

MULTIPLIERS

I

Spending Multipliers, m:


Example: Investment Multiplier Given, I = RM10 million and MPC = 0.75Therefore,

Y = 1/MPS x I = 1/0.25 X 10 mil. = 4 X 10 mil. = 40 mil.Thus, New Y = Y + 40 mil. If the initial income, Y= 2000, then New Y = 2000 + 40 = 2040 mil.

in the manual


MULTIPLIERSii) GOVERNMENT SPENDING MULTIPLIER Y 1 MPS

(assume an economy without tax, Yd =Y)Therefore, Y = 1/MPS X GThus, national income increases by the

amount of Y as Government increases spending.

That is, new Y2 = Y1 + Y

G=


iii) Government Multiplier with tax

= 1

MPSt

= 1

= 1

1 – b(1 – t)

(1 – b) + btLook at example 7 and exercise 3 and 4 in the manual.


iv) Simple Tax Multiplier, if tax, T = a

Tax Multiplier, mT = 1 – Spending Multiplier

= 1 – 1/MPS

= – MPC/MPS

– b

(1 – b)

And, Y = mT T T = Y mT

=


Example:Assume that, to achieve full-employment equilibrium,

the GDP has to be increased by RM 5 billion and MPS is 0.5. Calculate the tax cut

required to achieve this full-employment. tax multiplier, mT = 1 – (1/MPS)

= – MPC/MPS

= 1 – (1/0.5)

= 1 – 2

= – 1

tax cut, T = Y (-1) = - 5/(-1) = - 5By reducing the tax RM5 billion, GDP then will increase

by RM 5 billion.


v) If tax, T = a + tY

Tax Multiplier = - b

= - b

1 – b(1 – t)

(1 – b) + bt

Look at example 7 and 8 in the manual.

Now, C = a + b(1-t)Y


The effect of a change in Income Tax

A tax reduction may caused to an increase in consumption and thus effect towards a higher income.Assume, T = a + tYAnd the slope of AD is now b(1 – t).

AD0 = C = a + bYd

AD1 = Ct = a + b(1 – t)YdAD

Y

Y = – b . T

1 – b(1 – t)

a tax cut may increase income

Y0 Y1


vi) OPEN ECONOMY MULTIPLIER

1

(MPS + MPT + MPM)=


Accelerator Principle

state that:

“a change in Consumption would lead to a greater change in Investment.”

i.e. a small change in DD (consumption on output) would lead to a great change in Investment.

∆ C great ∆I


Relationship between multiplier and accelerator:

The effect with multiplier is that:

The effect with accelerator is that:

I greater Yby the multiplier, k

C greater Iby the accelerator, a

∆ Y = k ∆ I

∆ I = a ∆ C


This means that;

with the multiplier, m and the accelerator, a working together;

I Y C IAD


ACCELARATOR – J.M. CLARK

it was then incorporated into Keynesian theory.

- ‘cos it was closely related to multiplier

effect.

(an increase in C would lead to the increase in Investment and Aggregate Demand and thus towards an increase in Income.)

C I Y


THANK YOU FOR LEND ME

YOUR EARS.

That’s all for today.


3. Balanced Budget Policy

When government expenditure is just equivalent to the tax revenue collection. A balanced budget is also used to increase real output and economic growth. Any increase in government expenditure (which is equal to the amount of tax collection) will increase the real output by the same amount. Its multiplier is equivalent to one (1).

Y = 1 . GThus, the resulting increase in the equilibrium Y is exactly equal to the increase in G or T itself.

∆Y = ∆G = −∆TIt can be conclude that, although the government does not spend more than what it collects in tax revenue, she still can stimulate the economy, since the spending multiplier effect is larger than the tax multiplier effect.

chapter 3

Documents

azizah isalecturer

function of income

employment equilibrium

situation of equilibrium

savingdisposable income

induced consumption

disposable income y

autonomous consumption