49

Chapter Overview

Determination of National Income Equilibrium 3

Determination of National Income

Introduction

Aggregate Demand

Consumption and Saving

Investment

Equilibrium Income in a 2 Sector Economy

Equilibrium Income in a 3 Sector

Economy

Equilibrium Income in a 4 Sector Economy

Equilibrium Versus Full Employment

Output

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LEARNING OBJECTIVES: After studying this chapter, you should be able to: 1. Explain the components of aggregate demand

2. Explain the consumption and saving functions from the Keynesian

perspective and from the Islamic perspective.

3. Define and explain how equilibrium national income is determined in a

2 - sector, 3 - sector and 4 - sector economy.

4. Describe how the investment multiplier, government multiplier and tax

multiplier can affect the equilibrium income.

5. Distinguish inflationary and deflationary gaps

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3.1 Introduction

In this chapter we will study the Keynesian Model and understand how

equilibrium national income and output are determined. Classical

economists believe that a market economy will always tend towards full

employment. If unemployment exists, the economy would self-correct itself

to bring it back to full-employment. Government intervention is not needed.

This classical theory of employment is based on Says Law and assumes

downwardly flexible wages. According to Says Law supply creates its own

demand meaning that the creation of products for the market generates an

amount of income equal to the value of the product produced. Example, if a

business firm produces products with a value of RM 1000, then they also

create incomes to the factors of production equal to RM 1000. Hence, the

production process will create the amount of income necessary to purchase

the product.

The development of Keynesian economics was during the Great Depression

(in the 1930s) where unemployment levels remained very high and the

classical models could not explain this phenomena.

Keynes believed that the classical self-correcting mechanism would not

work if the economy is at a high unemployment level. According to Keynes

the level of unemployment is determined by the level of aggregate demand

in the economy. The Keynesian model also implies that government

policies are necessary to bring the economy back to full employment.

Classical economists : believe that the economy will automatically tended

toward the full employment level of output.

Keynesian economist: Government policies are necessary to stabilize the

economy.

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3.2 Aggregate Expenditure.

Aggregate expenditure (AE) is the total demand for goods and services in the

economy. There are 4 components of aggregate demand that is

consumption, investment, government purchases and net exports.

1. Consumer expenditure, or simply consumption (C), is spending by

households on final goods and services. Examples of consumer

expenditure are spending on food, clothing, and entertainment, and on

consumer durable goods like automobiles and furniture.

2. Investment (I) is spending by firms on new capital goods, such as office

buildings, factories, and equipment. Spending on new houses and

apartment buildings and increase in inventories are also investments.

3. Government expenditure (G) is spending by governments on goods

and services. Examples of government expenditure include new schools

and hospitals, and the services of government employees, such as soldiers,

police and government office staffs.

4. Net export or export minus import (X-M). Exports are sales of

domestically produced goods and services to foreigners. Imports are

purchases by domestic residents of goods and services produced abroad.

Net exports represent the net demand for domestic goods by foreigners.

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

3.3 Keynesian Theory of Consumption and Saving

We shall examine the first component of aggregate expenditure that is

consumption expenditure. Consumption is the main component of

aggregate expenditure. The most important determinant of consumer

spending is disposable income Yd (income after tax).

Consumption: Spending on goods and services by consumers

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In a simple world with no government, no taxes and no imports, a household

can do only 2 things with its income - consume or save.

Income (Y) = Consumption (C) + Saving (S) or:

Y= C + S

The part of the income that a household does not consume is called saving.

S= Y - C

Table 3.1 This table exhibits data on income, consumption and savings . It

shows the consumption and saving schedule/function. You will notice that at

every level of disposable income, consumption plus saving is equal to

disposable income.

At lower levels of income , consumption exceeds income and saving are

negative. On the other hand at a higher level of income savings are positive.

And when income is equal to consumption, saving is zero.

.

Table 3.1: Consumption and Saving Schedule

*Income

(Y)

Consumption

(C)

Saving (S) APC APS MPC MPS

0 1100 -1100

1100 1180 -80 1.8 -0.8 0.8 0.2

1200 1260 -60 1.3 -0.3 0.8 0.2

1300 1340 -40 1.13 -0.13 0.8 0.2

1500 1500 0 1.00 0 0.8 0.2

1700 1660 40 0.94 0.06 0.8 0.2

1900 1820 80 0.91 0.09 0.8 0.2

2100 1980 120 0.89 0.11 0.8 0.2

* In an economy with no government (i.e. no income tax) Y = Yd

Consumption and Savings Function

We shall first look at the consumption function and then go on to the saving

function.

Saving : The part of the income that a household does not consume

54

Consumption function is a mathematical relationship between consumption

spending and disposable income. As income increases the consumption

increases.

The general form of the consumption function is

C = a + b Yd

Where: C is consumption expenditure

Yd is disposable income (when there is no tax Y= Yd )

a is that part of consumption when Y is 0, also known as autonomous

consumption. (People will still need to consume basic necessities even

when their income is zero).

b is the proportion of income that is consumed (MPC*.) This consumption is

known as induced consumption.

(MPC* is the marginal propensity to consume).

The saving function can be derived from the consumption function. As

savings is that part of disposable income that is not spent, the saving function

is:

S= Y - C

S = -a + (1 - b) Yd

Where: S is savings

Yd is disposable income

-a represents consumption when income is 0, that part of

consumption spending which is financed out of savings (dissaving)

(1 - b) is the proportion of income that is saved (1 - MPC = MPS*)

(MPS* is the marginal propensity to save).

The consumption and saving functions based on Table 3.1 is:

C = 100 + 0.8 Yd

and

S = -100 + 0.2 Yd

The above functions shows that when income is zero consumption is 100

which is financed by previous saving or borrowing. At this point the saving is -

100.

As income increases by RM1 , 0.8 percent is spent and 0.2 is saved.

Consumption function : the relationship between consumption and income.

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In Diagram 3.1 the 45o line shows the points where consumption equals

disposable income. The vertical distance between the consumption line and

the 45o line represents savings for any level of disposable income on the

horizontal axis.

At disposable income RM 1500, consumption is RM1 500 and

savings are zero. The consumption function intersects the 45o line at this

point. At the disposable income of less than RM 1500, consumption exceeds

disposable income savings is negative (dissaving). Consumption in this case

is financed out of previous savings, borrowing or by the sale of assets. When

disposable income greater than RM 1500, consumption is less than

disposable income, savings are positive. Households save part of their

disposable income

(RM) Diagram 3.1 : Consumption and Saving Function

900 _

Y=C

700 _ C = 100 + 0.8 Yd

500

200 _

100

) 45o

0 200 500 700 900 DISPOSABLE INCOME (RM)

+ 100 _ S = -100 + 0.2 Yd

0

200 500 700 900 DISPOSABLE INCOME(RM) -100

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Marginal Propensity to consume and save

Marginal Propensity to Consume (MPC) is the ratio of a change in

consumption to a change in income.

MPC = Change in Consumption = C

Change in Income Y

Based on the Table 3.1 MPC can be calculated when disposable income

increases from RM1900 to Rm1700 using the above method:

MPC = 1820-1660 /1900-1700

= 160/200 = 0.8

The top half of Diagram 3.1 shows the consumption function. The slope of

the consumption function is the MPC.

Marginal Propensity to Save (MPS) is the ratio of a change in savings to a

change in income.

MPS = Change in Saving = S

Change in Income Y

Based on the Table 3.1 the MPS, when disposable income increase from

RM1700 to Rm1900 is

MPS = 80-40/1900-1700

= 20/200 = 0.2

Marginal Propensity to consume : The ratio of a change in consumption to a

change in income.

Marginal Propensity to Save : the ratio of a change in savings to a change in

income.

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The bottom half of the Diagram 3.1 shows the saving function. The slope of

the saving function is the MPS.

The sum of the MPC and the MPS for any given change in income must

always be 1.

MPC+MPS = 1

0.8+0.2 =1

Average Propensity to consume and save

Average Propensity to Consume (APC) refers to that fraction of total income

which is consumed.

APC = Consumption = C

Income Y

The Table 3.1 shows that when income increase from RM1700 to RM1900

to RM2100 the consumption increase from Rm1660 to RM1820 to 1980 , but

the APC decreases from 0.94 to 0.91 to 0.89

Average Propensity to Save (APS) refers to that fraction of total income that

is saved.

APS = Savings = S

Income Y

The Table 3.1 shows that when income increase from RM1700 to RM1900

to RM2100 the saving increase from RM 40 to RM80 then to 120 ,the APS

increases from 0.06 to 0.09 then to 0.11

As income increases APC will fall and APS will rise. This is because as

income rises, consumption will increase by a smaller amount and saving

increases by a larger amount.

Average Propensity to consume : That fraction of total income which is

consumed

Average Propensity to save : that fraction of total income that is saved.

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When the average propensity to consume and average propensity to save is

added we get 1

APC + APS = 1

At income level RM1660

0.94 + 0.06 = 1

3.3.1 Non Income Determinants of Consumption and Savings

The consumption and saving are also influenced by other factors besides

income. They are:

1. Wealth. Wealth includes real assets (e.g. Houses, automobiles and

other durables) and financial assets (savings account, stocks, bonds,

insurance policies). The greater the amount of wealth households

accumulates, the larger the amount spent on consumption.

2. Interest rates. Interest rates influence the cost of borrowing. The lower

the interest rates the lower the cost of borrowing, and the greater the amount

spent on consumption..

3. Households expectation of future changes in the economy.

Households expectations concerning future prices, money incomes and the

availability of goods have significant impact on current spending and saving.

Expectation of rising prices and product shortages will increase present

consumption. The expectation of rising money income in the future will also

tends to make consumers increase their current spending

A change in any one or more of the non-income determinants will cause the

consumption and saving schedule to shift. If households consume higher at

each level of disposable income, consumers are saving less. Graphically,

there is an upward shift in the consumption schedule from Co to C1 and a

downward shift in the saving schedule from So to S1 as shown in Diagram 2.2.

Conversely if households consume less at each level of disposable income,

consumers are saving more. Graphically there is a downward shift in the

consumption schedule from Co to C2 and an upward shift of the saving

schedule from So to S2.

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Diagram 3.2 : Shift in the Consumption and Saving Schedules

C1

Co

Consumption

C2

Disposable income

S2

S0

Savings S1

Disposable income

3.3.2 Islamic Consumption Function

Islam believes in the Day of Judgment and the life hereafter (Kiamiat). This

extends the Muslims horizon of the time beyond death. Life before death

and the after death are closely inter related in sequential manner.

A) Objective of Consumption

1. Every individual should consume enough economic goods to lead an

efficient life.

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2. Certain (prohibited) goods should not be consumed.

3. Consumption of economic goods must not be extravagant, excessive

indulgence in luxurious living is discouraged.

4. Consumption of economic goods, and the subsequent satisfaction,

must not be the ultimate objective of the individuals. It should serve

as a means to the achievement of the higher ends of life in this world

and next world.

B) Time-Scale of Consumption in Islam

Since the Islamic belief on the Day of Judgment and life hereafter, this

extends Muslims consumption should not only fulfill the present

objectives but also the objectives of time beyond death.

Therefore consumption must be based on the following time scale :

1) Consumption today has its immediate effects and the in life-to-

come.

2) An increase in income may lead to an increase in consumption

and benefits now and in the hereafter if the alternative uses of

the consumption is used which is encouraged in Islam such as

interest - free loan (al-quar-Hassan), giving to poor and needy

(sedeqah) caring for animals, spending for the welfare of the

future generation, propagating the message of Islam and

promoting good deeds and thoughts.

3) A Muslim has to spend time in the remembrance of God and

contribute some of his energies to the propagation of Islamic

teachings.

C) Ethics of Consumption

According to Islam, Allahs bounties belong to all mankind, the mere

circumstance that some of these bounties may be under the authority

of particular people does not mean that they can utilize them for

themselves alone; others who do not happen to have at their disposal

that much of what god has given to mankind still deserve their share

even though they did not earn it.

Furthermore, the act of use or consumption of good things is in itself

considered as a virtue in Islam, since the enjoyment of what Allah (swt)

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creates for mankind to Him who said to the parents of mankind, Adam

and Hawa as narrated in Quran.

........ and eat of the bountiful (gifts) of God which He has

produced for His servants and the things, clean and pure, (which He

has provided, for sustenance ..... Al - Araf (7:32).

Overconsumption, in which is condemned in Islam, and is termed as

israf (extravagance) or tabthir (profligacy). Profligacy means

spending in the wrong way, e.g. on prohibiting activities such as

bribery, on illegal things in a reckless manner. Each of these

categories includes several types of spending and consumption

behavior which have become almost phenomenal in the consumer

oriented society. Extravagance means overspending on lawful matters

such as food, clothes, shelter or even charity.

The Islamic teachings recommend a moderate and balanced pattern of

consumption and spending, a pattern which lies in between miserliness

and extravagance.

D Macro Consumption Function In Islamic Framework

i) Rationality

In the Islamic economic system, a Muslim consumer has to be rational

in their spending. Unlike secular economics where a consumer is

assumed to be rational, the axiom of rationality required for Islamic

economic theories of consumer behaviour is derived from the ethical

norms of Islam. It is something that a Muslim has to learn and acquire.

Rationality requires that the spending behavior of the Muslim consumer

conforms to the teachings of Islam, which gives rise to the following

condition

1) A consumer is rational only if he spends in moderation.

2) A consumer is rational only if he spends not only for this

present world but in the way of Allah S.W.T.

3) A consumer is rational only if (ceterius paribus) his

consumption basket is smaller than that of a secular

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consumer as it includes only permissible things and

exclude prohibited things.

4) A consumer is rational only if he does not hoard his

savings but channel them towards investment. Savings

which are not invested should be delivered in the form of

scat.

ii) Consumption

The total spending of a rational Muslim consumer can be classified

as follows :

1) Spending to achieve satisfaction in this world (E1)

This includes :

a) Present consumption (C1)

b) Saving / investment for consumption in future (S1)

Therefore

E1 = C1 + S1

2) Spending with a view to earn rewards in the next world

(hereafter) (E2 )

This includes :-

a) What is immediately consumed by the recipients (C2)

b) What is saved for social benefit for personal saving / investment

to improve life. (S2)

Therefore

E2 = C3 + S2

So, the Muslim consumption function is

E = E1 + E2

The utility maximization (U) of a Muslim consumer is based on the

consumption of E1 & E2 or U = F (E1 , E2) and subject to the

constraint of his income i.e. Y = E1 + E2

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CHECKLIST At this point you should be able to:

Identify the components of aggregate demand

Explain and draw the consumption and saving functions

Calculate the APC,APS, MPC and MPS

Explain Islamic consumption function

Discuss the various factors influencing consumption and the shift of

the consumption function

Self Assessed Questions

1. Suppose that the linear equation for consumption in a

private 2 sector economy is C = 100 + 0.6Y i) Find the value of the (a) Marginal propensity to consume (b) Marginal propensity to save ii) If Y = 800, determine the (a) Level of consumption (b) Level of saving (c) Average propensity to consume (d) Average propensity to save 2. Given the following income - consumption schedule

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(a) Calculate the APC and APS at each level of income. (b) Write the consumption function equation.

(b) Write the saving function equation. 3. Saving Savings 500 Income 0 2000 4000 - 500 _ With reference to the diagram above answer the following questions. (a) What is the value of MPC and MPS ? (b) Write the consumption and saving function equation. Answers 1. (i) (a) MPC = 0.6 (b) MPS = 0.4 (ii) (a) C = 100 + 0.6 Y Y = 800

Y(INCOME) (RM) C(CONSUMPTION)(RM)

0 60

100 120

200 180

300 240

400 300

500 360

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C = 100 + 0.6 (800) = 580 (b) S = Y - C = 800 - 580 = 220 (c) APC = C Y = 580 800 = 0.725 (d) APS = S Y = 220 800 = 0.275 2.

Y(RM) C(RM) S(RM) APC APS

0 60 -60 - -

100 120 -20 1.2 -0.2

200 180 20 0.9 0.1

300 240 60 0.8 0.2

400 300 100 0.75 0.25

500 360 140 0.72 0.28

(a) APC = C Y APS = S , S = Y - C Y or APS = 1 - APC

(b) MPC = C = 60 = 0.6

Y 100 Consumption function equation : C = a + bY a : autonomous consumption, that is, consumption when Y = 0 b : MPC C = 60 + 0.6Y (c) S = -60 + 0.4Y 3. (a) From the graphs when Y =RM2000, S = 0, C = RM2000

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when Y = RM4000, S = RM 500, C = RM 3500

MPC = C

Y = 1500 2000 = 0.75

MPS = S or MPS = 1 - MPC

Y = 1 - 0.75 = 500 = 0.25 2000 = 0.25

(b) C = 500 + 0.75Y

S = -500 + 0.25Y

3.4 Investment

The second component of aggregate expenditure is investment. In everyday

language, we use investment to refer to what we do with our savings. In the

language of economics, investment refers to the creation of capital stock. To

an economist, an investment is an expenditure that is used to create value in

the future.

Investment, the elements of aggregate expenditure is represented in the

equilibrium equation as Y = C + I + G + X - M. In the context of this

equation, investment is similar to other components of expenditure as it

represents the demand for a part of the nations current output.

Investment is divided into three major categories:

1. Business fixed investment is the value of the stocks of inventories that

business have on hand. For example, when a firm build a new plant or adds

new machinery to its current stock it is investing. When a restaurant owner

buys tables, chairs, cooking equipment and silverware he or she is investing.

2. Residential investment is the construction of houses and apartment

building. Residential investment is also known as investment in real estate.

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3. Inventory investment are stocks of finished goods waiting to be sold.

That is goods that are produced and not sold. Firms keep stocks of inventory

for a number of reasons. One obvious reason is to meet unforeseen demand.

Firms are never sure how much they will sell from period to period. Sales go

up and down. Inventory investment is the most unstable component of private

investment

3.4.1 Investment Functions

Investment function shows the relationship between demand for capital in the

economy and the market interest rate.

There are two forms of investment functions

(i) Autonomous Investment .

This type of investment is addition to capital stock and inventory that are

planned by firms. It is known as an autonomous investment if it is

independent of the level of income. Diagram 3.3 shows an autonomous

investment of RM30 million which is a horizontal straight line.

Diagram 3.3 Autonomous Investment.

RM (millions)

50

40

30 I = 30

20

10

Aggregate income

(ii) Induce Investment

Induced investment is the investment expenditure that depends on income or

production. When income level increases induced investment expenditure will

also increase. Figure 3.4 shows induce investment. The slope of the line

represent induces investment and is the marginal propensity to invest.

Investment : purchases by firms of new buildings and equipment, and

addition to inventories

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Figure 3.4 Induce Investment

Investment (I)

I

Income (Y) Factors that influence Investment

The most important dimension of capital is time. Capital provides useful

services over a period of time. For example, in building a tower, a developer

makes an investment for the future. The tower won't begin to yield returns

until it is completed and utilized. Once it begins to yield a return it will be for a

long period of time. Due to these, investors must make careful decisions on

investment expenditure. The factors that influence investment decisions are:

1) Market Rate of Interest

Interest rate determines the amount of investment expenditure. When interest

rate falls, investment expenditure will increase. The interest rate is said to be

the cost of borrowing. The cost of borrowing influences the returns from

investment. When the cost of borrowing decreases investors will borrow more

as their returns will increase.

2) Expected Economic Conditions

Another factor that determines the investment expenditure is expected

economic conditions of a country. The investment decisions are complex and

investors deal with very few known variables and many unknown

variables. The future demand for goods and services can be affected by

changes in the level of economic activity such as the recession and changes

in world trading conditions. When investors expect the economy is heading

towards recession they will decrease the investment expenditure.

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3) Technology development

When new technology is develop and introduced, the old technology becomes

obsolete. Firms using old technology will not be able to compete with firms

using new technology. To remain competitive firms must increase their

investment expenditure and use new technology.

3.4.2 Investment From Islamic Perspectives

Islam encourage investment and does not allow Muslims to freeze their

wealth (pembekuan harta). The objective of investment is not only to attain

profit but Islam also emphasis on the welfare of the society. Besides that, an

individual Muslim must be sure that he is not involved in any wrong doings or

being unjust to others-such as misused of power, suppress others or

manipulation.

Investment in Islam must be based on the following elements :-

a. religion

b. life

c. intelligence

d. descendent

e. wealth

Constrains (conditions) of Investment in Islam

1. Halal wal Haram

Islam forbidden any economic activity that is against the Islamic Law

or Shariah. Any goods that are forbidden or haram, the price is also

considered as haram.

2. The benefit of investment

Investment must be benefited not only through the profit margin of the

producer but is must also be benefited by the society. Investment must

be according to the categories of goods in Islam i.e Dharuriyat,

followed by Hajiyat, Kamaliyat and Tahsiniyat.

3. Not element of interest or riba

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The word riba - means excess, additional or growth. It denotes

excession to wealth and an addition to the principle. Some Muslim

scholars refers riba to increment on capital.

There are various types of riba :

a. Riba al-nasiah

- an addition to the capital loaned out.

b. Riba al-fadhal

- An addition to the exchange of goods or other objects which is of

the same nature eg. adi, wheat, money.

Alternatives of Investment

a. Mudharabah

Mudharabah is based on joint-venture which gives the right to the

contracting parties that is the entrepreneur and capital provider to

share profits while losses are borne by the capital providers.

b. Musyarakah

Musyarakah is based on joint venture where interest is not charged by

the capita provider , but instead and agreement is made by the capital

provider and the business entity give a share of the profit made from

the venture.

CHECKLIST

At this point you should be able to:

Distinguish between autonomous and induce investment

Explain the factors influencing investment

3.5 Equilibrium Income in a 2 Sector Economy

Equilibrium refers to a state where aggregate expenditure is equal to

aggregate output. It is a state where there is neither consumers nor firms

have any incentive to change their behaviour.

Equilibrium : Occurs when there is no tendency for income to change

change

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There are two approaches to analyze this equilibrium. The first is aggregate

expenditure - output approach and the second is total planned leakage = total

planned injection

Based on the aggregate expenditure-output approach When output increases,

additional income is generated as more workers are hired and paid, and

owners of factors of production earn more profits. When output is cut, income

falls as workers are laid off or are paid less and profits fall.

A complementary approach is leakage - injection approach to determine

equilibrium national income. Injections are addition of spending to the

income-expenditure stream and that includes investment, government

purchases and exports. Leakages are withdrawals of potential spending from

the income-expenditure stream and include saving, tax payment and imports.

Any excess of planned withdrawals over injection will cause a shortage of

total spending, forcing producers to cut back production. Any excess of

planned injection over leakages will cause an excess of total spending

inducing producers to increase output. Equilibrium is reached when total

planned injection equals total planned leakages.

In the following analysis of macroeconomic equilibrium, we shall use the

variable Y to refer to both aggregate output and aggregate income. We shall

also think of output and income in real terms, that is in terms of the quantity of

goods and services produced.

In the macroeconomic goods market, equilibrium occurs when planned

aggregate expenditure is equal to aggregate output. When this happens,

planned leakages will also equal planned injections.

Injections : Addition of spending to the income-expenditure stream and

includes investment, government purchases and exports.

Leakages L Leakages Withdrawals of potential spending from the income-expenditure

stream and include savings, tax payment and import

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We shall illustrate this with a simple economy. A simple economy has only 2

sectors they are firms and households. Aggregate expenditure in this

economy is the sum of consumer purchases (C) and planned investment

purchases by firms (I), that is :

Planned aggregate expenditure (AE) = Consumption (C) + Planned

Investment (I)

AE = C + I

The Keynesian model takes planned investment purchases as autonomous,

which is fixed and do not change with income. Investments are referred to as

injections.

Income is equal to consumption plus saving.

Y = C + S

Savings are referred to as leakages as this amount does not flow back into

the economy.

The equilibrium level of output (Y) occurs when income is equal to planned

aggregate expenditure

Y = AE (Expenditure- Output approach)

Rewritten as:

C + S = C + I

Therefore, in equilibrium:

S = I (Leakage Injection approach)

Simple economy: In simple economy has only 2 sectors that is firms and

households.

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These two approaches to determining equilibrium can be explained with the

help of the Table 3.2 below.

Table 3.2 : Determination of the equilibrium levels of employment,

output and income : 2-sector economy

AGGREGATE

OUTPUT (INCOME) (Y)

AGGREGATE

CONSUMPTION (C = 100+0.8Y)

AGGREGATE

SAVING (S)

PLANNED

INVESTMENT (I)

PLANNED

AGGREGATE EXPENDITURE

(AE = C + I)

UNPLANNED

INVENTORY CHANGE

Y - (C + I)

TENDENCY OF

OUTPUT, INCOME AND

EMPLOYMENT

100 180 -80 20 200 -100 Increase

200 260 -60 20 280 -80 Increase

500 500 0 20 520 -20 Increase

600 580 20 20 600 0 Equilibrium

700 660 40 20 680 20 Decrease

900 820 80 20 840 60 Decrease

1100 980 120 20 1000 100 Decrease

All figures are in billions of RM

Aggregate expenditure - output approach

When aggregate expenditure exceeds aggregate output at income level less

than RM 600 billion, an unanticipated reduction in business inventories takes

place. As inventories fall, producers increase output. Aggregate output and

income thus tend to increase.

When aggregate output is greater than planned aggregate expenditure that is

at income level more than RM 600 billion sellers are unable to sell everything

they produced at current prices. The unsold goods pile up as an unintended

inventory investment. Firms will cut back production and output and income

earned in the nation will tend to fall.

Equilibrium occurs when the quantity of goods supplied just equals the

quantity that consumers and businesses are willing to purchase. When

equilibrium is reached there will be no unintended inventory increase or

decrease and no tendency for output, income and employment in the

economy to increase or decrease. From the table, equilibrium is

reached at RM 600 billion

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Leakage-injection approach

At income level less than RM600 billion, planned investment is greater than

the savings. This excess of investment will drive up aggregate expenditure

thus causing a fall in inventories and producers increase output. At an

income level more than RM600 billion, savings are greater than planned

investment. This excess of savings over investment will cause total spending

to fall, thus resulting in unsold goods and producers cutting back production.

Aggregate output will be equal to planned aggregate expenditure only when

savings equal planned investment at income level 600 billion.

The analysis above can be shown in Diagram 3.5

Diagram 3.5 : Determination of equilibrium output

RM

Y

I = 20

0

500 600 Aggregate output (Y)

500

-100

600

120

4 100

20

C + I

(AE)

C = 100 + 0.8 Y E

20

0

S

I

Income (Y) 600

75

The top half of Diagram 3.5 above illustrates the aggregate expenditure -

output approach to determine the equilibrium income. Planned investment is

added to consumption at every level of income to get the C + I line or

aggregate expenditure (AE). The 45o line represents all points on the graph

where the variables in the horizontal and vertical axis are equal, in this case,

it is where Y = C + I . The equilibrium level of output is achieved when

the aggregate expenditure schedule, C + I intersects the 45o line, that is at

point E at Y = RM600 billion.

The bottom half of Diagram 3.5 shows the leakage - injection approach to

determine the equilibrium income. Equilibrium is achieved at Y = RM600

billion when the savings and investment schedules intersect.

Finally, let us calculate the equilibrium level of output (income) algebraically.

Given C = 100 + 0.8 Y

I = 20

Using the aggregate expenditure - output approach, equilibrium is achieved

when

Y = C + I

= 100 + 0.8 Y + 20

Rearranging terms :

Y - 0.8 Y = 100 + 20

0.2Y = 120

Y = 120 = 600

0.2

Using the injection-leakage approach, equilibrium is achieved when :

S = I

If C = 100 + 0.8 Y, then

S = - 100 + 0.2 Y

Therefore -100 + 0.2Y = 20

0.2 Y = 20 + 100

0.2 Y = 120

Y = 120 = 600

0.2

76

The equilibrium level of output is thus RM 600 billion, as we have already

seen in Table 3.2 and Diagram 3.5.

3.5.1 The Investment Multiplier

If there is an autonomous change in planned investment, what is the effect on

output? As we will see, this change will generate changes in consumption

spending and cause the ultimate change in aggregate output to be greater

than the initial change in planned investment. This is known as the multiplier

effect.

The multiplier effect works in the following manner. Assume that the

consumption function is C = 100 + 0.8 Y. If investment spending rises by

RM 20 billion, this will represent income to makers of capital goods.

According to the consumption function, consumption will rise by 0.8 (20) =

RM16 billion. This increase in consumption spending further increase income

by RM 16 billion, since the money spent on consumption goods become the

income of shopkeepers and production workers who produce and sell the

goods we buy. This further increase in income causes consumption to rise

even more. The second round effect on consumption is an increase of 0.8

(16) = RM12.8 billion. This increase in consumption spending further

increases income, which then generates a third round effect on consumption

spending and so on. Table 3.3 illustrates the process.

Investment multiplier : The ratio of the change in the equilibrium level of

output to a change in investment.

77

Table 3.3: Multiplier Process

Round Change in income Change in Consumption

(MPC = 0.8)

1

2

3

4

5

6

7

RM 20 billion

16

12.8

10.24

-

-

-

RM 16 billion

12.8

10.24

8.19

-

-

-

Total RM 100 billion RM 80 billion

The ultimate effect on aggregate output of the initial RM 20 billion increase in

investment spending is given by the formula:

The change in output = Increase in investment x 1

1 - MPC

or Y = I x 1

1 - MPC

where 1 is the multiplier

1 - MPC

or multiplier = 1

MPS

In the example above, the ultimate change in output would be :

Y = 20 x 1

0.2

= 20 x 5

= Rm 100 billion

That is aggregate output will increase by $ 100 billion, if investment spending

increases by $ 20 billion.

The multiplier, 1 = 5,

MPS

This multiplier shows that the aggregate output will increase 5 times more

than the increase in investment spending.

78

CHECKLIST At this point you should be able to:

Determine income equilibrium in two- sector economy using both

aggregate approach and leakage-injection approach

Calculate equilibrium income

Explain and calculate investment multiplier

3.6 Equilibrium Income in a 3 Sector Economy

In the previous section, we explained the equilibrium level of output for a

simple economy with no government and no imports and exports now, we will

add the government sector to the analysis of equilibrium output. The 2 major

government activities are the collection of taxes (T) and government spending

on goods and services (G). For simplicity, we shall assume that both taxes

and government spending are autonomous and independent of the level of

income, that is S and T are fixed.

We know from the previous chapter that equilibrium income occurs

when an aggregate output equals planned aggregate expenditure. Planned

aggregate expenditure in an economy with a government is

AE = C + I + G.

We can thus write the equilibrium conditions as

Y = C + I + G.

Consumption now depends on income after tax (Y-T, that is disposable

income, Yd and now the consumption function is

C = a + b Yd

Rewritten as

C = a + b (Y - T)

Since government takes a portion of household income in the form of taxes,

the income of households is now divided into 3 uses that is

Y = C + S + T

79

AE = C + I + G

The equilibrium using the aggregate expenditure- output approach is reached

when:

Y = AE

C + S + T = C + I + G

Or when using the leakage-injection approach

S + T = I + G

Table 3.4 explains how the equilibrium income is achieved using these 2

approaches.

Aggregate expenditure - output approach

The equilibrium analysis presented in the previous chapter still holds. In Table 3.4 at

income levels greater than 900, the output (Y) exceeds planned aggregate

expenditure (C + I + G) there will be an unplanned increase in inventories. Firms

will cut back on output as inventory will start to accumulate and income will fall until

equilibrium is achieved. Conversely, at income levels less than RM 900 billion, the

output (Y) is less than planned aggregate expenditure(C + I + G) there will be an

unplanned decrease in inventories, and firms will increase output. Income will also

increase until equilibrium is achieved.

Diagram 3.4 illustrates the aggregate expenditure-output approach in determining

equilibrium. Planned investment and government expenditure is added to

consumption at every level of income to get the C + I + G line or the aggregate

expenditure(AE1). The 45o line shows all points where Y = C + I + G. or Y =

AE. The equilibrium level of income is where the aggregate expenditure schedule,

C + I + G intersects the 45o line. The equilibrium income is at Y = RM 900

billion. At Y less than RM 900 billion the aggregate expenditure is greater than the

output. Inventory is decreasing, whereas production, employment and income will

be increase. At Y less than RM 900 billion the aggregate expenditure is less than

the output, inventory increases and production, employment and income will

80

decrease. When an aggregate expenditure is equal to output there is the economy is

in equilibrium. There is no incentive for firms to increase or decrease output

Leakage-injection approach

Aggregate savings are calculated by subtracting consumption from disposable

income at every level of Y ( S = Yd - C). As you can see in Table 3.4 injection I +

G are fixed, I + G equals 160 at every level of income. Leakages S + T is less

than I + G at Y less than RM 900 billion and greater than I + G at Y greater than RM

900 billion. I+ G = S + T which is equal to RM 160 billion at Y = RM 900 billion.

Thus the equilibrium level of income is RM 900 billion.

The lower half of the Diagram 3.4 shows the equilibrium using the leakage-injection

approach.. Equilibrium is determined when the injection I + G is equal to

leakages S + T. The equilibrium occurs at income (Y) = RM 900 billion.

81

Table 3.4 Determination of the equilibrium levels of employment, output and income : 3-sector economy

AGGREGATE

OUTPUT (INCOM

E) (Y)

TAXES

(T)

DISPOSABLE INCOME

Yd= Y-T

AGGREGATE

CONSUMPTION (C =

100+0.8Y)

AGGREGATE

SAVING (S)

PLANNED INVESTM

ENT (I)

GOVERNMENT

PURCHASES (G)

PLANNED AGGREGA

TE EXPENDITURE (AE = C + I+G)

UNPLANNED

INVENTORY

CHANGE Y - (C +

I+G)

TENDENCY OF OUTPUT,

INCOME AND

EMPLOYMENT

300 100 200 260 -60 60 100 420 -120 Increase

500 100 400 420 -20 60 100 580 -80 Increase

700 100 600 580 20 60 100 740 -40 Increase

900 100 800 740 60 60 100 900 0 Equilibriu

m

1100 100 1000 900 100 60 100 1060 40 Decrease

1300 100 1200 1060 140 60 100 1220 80 Decrease

1500 100 1400 1220 180 60 100 1380 120 Decrease

* All figures are in billions of dollars.

82

Diagram 3.6: Determination of equilibrium output in a 3-sector economy. RM

600 900 Disposable income(RM) S + T 160 I + G I 20 0 600 900 Disposable income (Y) - 100

Now, let us find the equilibrium level of output (income) in a 3 sector

economy, algebraically.

Given C = 100 + 0.8Yd

= 100 + 0.8 (Y - T)

T = 100

I = 60

G = 100

Using the aggregate expenditure - output approach,

equilibrium is achieved when

900

260

100

0

C+ I

(AE)

C + I + G

(AE1)

) 45o

83

Y = C + I + G

= 100 + 0.8 (Y - 100) + 60 + 100

= 100 + 0.8Y - 80 + 160

Y - 0.8Y = 180

0.2Y = 180

Y = 180 = RM 900 billion

0.2

Using the injection - withdrawal approach,

equilibrium is achieved when :

S + T = I + G

- 100 + 0.2 (Y - 100) + 100 = 60 + 100

- 100 + 0.2Y - 20 + 100 = 160

0.2Y - 20 = 160

0.2Y = 180

Y = 180 = RM 900 billion

0.2

The equilibrium level of output is thus 900, as we have already seen in Table

3.4 and Diagram 3.4 .

3.6.1 The Multiplier Effects

If government were to change the level of government expenditure or taxes

the equilibrium income will change. We shall first examine the effects of

government expenditure and taxes separately on equilibrium output and then

the effects of government expenditure and taxes when combined.

Government Spending Multiplier

The government spending multiplier is the ratio of the change in the

equilibrium level of output to a change in government spending, assuming

that there is no change in taxes.

Government spending multiplier : The ratio of the change in the equilibrium

level of output to a change in government spending.

84

An increase in government spending has exactly the same impact on the

equilibrium level of output and income as an increase in planned

investment. Thus the equation for the government spending multiplier is the

same as the equation for the multiplier for a change in planned investment.

Government spending multiplier = 1

MPS

Let us work through a numerical example to see the effect on equilibrium

output when government spending (G) increases by 200. (Take previous

example).

Change in output = Increase in government

spending x 1

MPS

Y = G x 1___ MPS = 200 x 1

0.2

= 200 x 5

= RM 1000 billion

Old equilibrium output, Y = 900

* New equilibrium output = Y + Y

= 900 + 1000

= RM 1900 billion

Tax Multiplier

Tax multiplier is the ratio of the change in equilibrium level of output to a

change in taxes, when there is no change in government spending. Taxes

affect the household's disposable income and household's disposable.

income in return influences household consumption. The MPC tells us how

much consumption spending changes when disposable income changes.

Tax multiplier : The ratio of the change in the equilibrium level of output to a

change in taxes

85

Therefore when taxes are cut, the initial increase in planned aggregate

expenditure is not the full amount of the tax cut but is only the MPC times the

change in taxes (example, if taxes fall by RM 10, disposable income will

increase by RM 10. Consumers do not spend all RM 10 but only RM 8 if MPC

is 0.8).

Because the initial increase in planned aggregate expenditure (AE) is smaller

for a tax cut than it is for a government spending increase, the final effect on

the equilibrium level of output will be smaller.

Y = initial change in AE x 1

MPS

Initial change in aggregate expenditure caused by a tax

change of T is (- T x MPC)

therefore :

Y = (- T x MPC) 1

MPS

= - T x MPC

MPS

Tax multiplier = - MPC

MPS

Because a tax cut will cause an increase in consumption expenditure and a

tax increase will cause a reduction in consumption expenditure, the tax

multiplier is a negative multiplier.

Let us work through a numerical example to see the effect of a tax cut of 100

(T = - 100) on equilibrium output. Let us use the previous example where

MPC = 0.8.

Therefore :-

Y = - T x MPC

MPS

= - (- 100) x 0.8

0.2

= + 400

Equilibrium output will increase by 400 if there is a tax out of 100.

86

Balanced-budget multiplier

A balanced budget is occurs government spending and tax increase by the

same amount. The government pays for its extra spending by increasing

taxes by the same amount. The balanced budget multiplier is 1, that is if

government spending and taxes are each increased by a particular amount,

the equilibrium level of output will rise by that same amount.

Take for example that the government increases spending by 40. Using the previous example where MPC = 0.8, the government spending multiplier is:

Y = G x 1

MPS

= 40 x 1 = 200

0.2

The government also increases tax by 40. Using the tax multiplier:

Y = - T x MPC

MPS

= - 40 x 0.8

0.2

= - 160

Net increase of Y is therefore 200 - 160 = 40.

Balanced - budget : When government spending and taxes increase by the same

amount

Balanced budget multiplier : The balanced budget multiplier is 1, that is if

government spending and taxes are each increased by a particular amount, the

equilibrium level of output will rise by that same amount.

87

In other words, the net increase in the equilibrium level of Y resulting from the

increase in G and an equal increase in T is exactly the size of the increase in

G or T itself.

CHECKLIST At this point you should be able to:

Determine income equilibrium in three- sector economy using both

aggregate approach and leakage-injection approach

Calculate equilibrium income in three sector economy

Explain and calculate government and multiplier

Explain and show the effects of balanced budget multiplier

3.7 Equilibrium Income in a 4 Sector Economy

Thus far, our aggregate expenditure model has ignored international sector by

assuming a closed economy. Opening the economy to foreign trade adds

another component to planned aggregate expenditure, which are exports (X)

and imports (M) of goods and services. Like consumption and investment,

exports give rise to domestic production, income and employment.

Conversely in measuring aggregate expenditure for domestic goods and

services, we need to subtract expenditure on imports since imports are not

produced by the country.

Planned aggregate expenditure (AE) for an open economy is now

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

And the equilibrium condition of the economy is

Y = AE or

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

We can think of exports as an injection into the circular flow and imports

as a leakage from the circular flow.

Therefore, using the injection-leakage approach, equilibrium is reached when

S+ T + M = I + G + X

88

The determination of national income equilibrium in the 4 - sector economy

can be illustrated by using a tabular example. Table 3.5 below is carried over

from Table 3.4 for the 3 - sector economy. A new column of net exports is

added. Net exports is assumed to be autonomous, that is fixed and do not

vary with income.

Net exports : The difference between - countrys total exports and total imports

89

Table 3.4 Determination of the equilibrium levels of employment, output and

income : 4-sector economy

* All figures are in billions of RM.

AGGREGATE

OUTPUT

(INCOM

E) (Y)

TAXES (T)

DISPOSABLE

INCOME

Yd= Y-

T

AGGREGATE

CONSUMPTION

(C =

100+0.8Y)

AGGREGA

TE SAVI

NG

(S)

PLANNED

INVESTMEN

T (I)

GOVERNMENT

PURCHASES (G)

NET EXPOR

TS (X-M)

PLANNED

AGGREGATE

EXPEN

DITUR (AE = C

+

I+G+(X-M))

UNPLANNED

INVENTORY

CHAN

GE Y - (C +

I+G+(X

-M)

TENDENCY OF OUTPUT,

INCOME AND EMPLOYMENT

300 100 200 260 -60 60 100 40 460 -160 Increase

500 100 400 420 -20 60 100 40 620 -120 Increase

700 100 600 580 20 60 100 40 780 -80 Increase

900 100 800 740 60 60 100 40 940 -40 Increase

1100 100 1000 900 100 60 100 40 1100 0 Equilibrium

1300 100 1200 1060 140 60 100 40 1260 40 Decrease

1500 100 1400 1220 180 60 100 40 1420 80 Decrease

90

Aggregate Expenditure - Output Approach

Equilibrium national income is reached when aggregate output equals planned

aggregate expenditure that is when Y = C + I + G + (X - M). Based on Table

3.4 at income level higher than RM1100 billion, output exceeds planned

aggregate expenditure, there will be an unplanned increase in inventories and

firms will cut back production. At income level less than RM1100 billion,

planned aggregate expenditure exceeds output, there will be an unplanned

decrease in inventories, causing firms to increase their output. At income

RM1100 aggregate output is equal to aggregate output RM1100 billion.

Leakage - injection Approach

Net exports like government purchases and investment are injections of

spending. Savings, taxes and imports are leakages. When leakages are

greater than injections at an income level higher than RM1100 billion, total

spending falls creating an unanticipated increase in inventories. Firms will cut

back on production.

At income level less than RM 1100 billion, injections are greater than

leakages, the total spending increases inducing firms to raise output.

Equilibrium national income is reached only when

S + T + M = I + G + X at an income level Y = RM 1100 billion.

The Diagram 3.7 below shows the determination of equilibrium output in a 4

sector economy graphically. To simplify our discussion, we assume that net

exports are autonomous or independent of income. Diagram 3.7 shows the

equilibrium output is achieved when the AE line, that is C + I + G +

(X - M) intersects the 45o line at income RM1100 billion

Or when the S + T + M schedule intersects with the I + G + X

schedule.

91

Diagram 3.7 : Determination of equilibrium output in a 4 - sector

economy

C + I + G + (X - M)

(AE2)

900 1100 Disposable income (RM)

3.7.1 Open Economy Multiplier

The multiplier in a closed economy is the reciprocal of the marginal

propensity to save, the multiplier in an open economy is the reciprocal of

marginal propensity to taxation, and marginal propensity to imports beside

marginal propensity to save. The value of the multiplier is much smaller

compared to closed economy. This is because government taxation and

spending on imports reduces the multiplier effect on the countrys economy.

For an open economy, the multiplier is given by the following :

C+I+G

(AE1)

E

E

S + T

I + G + (X-M)

Disposable income (RM) 1100

)45o

300

260

200

160 I + G

900

92

Multiplier = 1

s + t + m

where: s is the marginal propensity to save

m is the marginal propensity to import That is the

amount of any increase in income that will be spent on

imports

t is the marginal propensity to tax that is the amount of

any increase in income that will be paid in taxes.

For example, if in a country, the marginal propensity to save is 10%, the

marginal propensity to import is 45%, and the marginal propensity to tax is

25%, the size of the multiplier would be

1 = 1 = 1.25

0.1 + 0.45 + 0.25 0.8

Marginal propensity to import : The amount of any increase in income that

will be spent on imports.

Marginal propensity to tax : The amount of any increase in income that will

be paid in taxes

93

CHECKLIST At this point you should be able to:

Determine income equilibrium in four - sector economy using both

aggregate approach and leakage-injection approach

Calculate equilibrium income in four sector economy

Explain and calculate the multiplier for open economy

3.8 Equilibrium Versus Full Employment Output

Full employment output is the level of real output associated fully utilized

factors of production. Equilibrium output may or may not entail full

employment. Keynes believed that full employment is more of an accident

than a norm. The economy might come to rest, that is, reach an aggregate

output equilibrium with either considerable unemployment or substantial

inflation.

3.8.1 Recessionary (Deflationary) Gap

Assume in Diagram 3.8 that the full employment non-inflationary and

the level of domestic output is Yf. Suppose that the AE is [ C + I +

G + (X - M)]e and intersects the 45o line to the left of the full

employment output. At Ye the economys aggregate production falls

short of its capacity production. The economy is therefore unable to

employ some of its available workers.

The amount by which AE falls short of the full employment level of

output is called the deflationary gap. This deficiency of spending has a

contractionary impact on the economy. The deflationary gap is the

amount by which the AE schedule would have to shift up to reach the

full potential output. Graphically, the deflationary gap is the vertical

distance between [ C + I + G + (X - M) ]e and [ C + I + G

+ (X - M) ]f

94

Diagram 3.8 : Deflationary Gap

[C + I + G + (X - M) ]f

Aggregate } Deflationary Gap

expenditure [C + I + G + (X - M) ]e

) 45o

Aggregate output

Ye Yf

3.8.2 Inflationary Gap

If AE are at [C + I + G + (X - M)]e in Diagram 3.9, a demand-pull

inflationary gap will exist. The amount by which AE exceeds the full

employment level of output is called an inflationary gap. The inflationary gap

is the amount by which the AE schedule [C + I + G + (X - M)e would have

to shift down to reach the full employment output. Graphically, it is the

vertical distance between [C + I + G + (X - M)]e and [C + I + G + (X -

M)]f.

The effect of this inflationary gap that is the excess demand will o pull up the

prices of the economys product. Businessmen cannot respond to this excess

demand by expanding their real output, so prices will increase instead.

95

Diagram 3.9 : Inflationary Gap

[C + I + G + (X - M) ]e

Aggregate } Inflationary Gap

expenditure [C + I + G + (X - M) ]f

) 45o

Aggregate output

Yf Ye

CHECKLIST At this point you should be able to:

Explain Inflationary and deflationary gap

3.9 CONCLUSION

The Keynesian model shows that the economy can achieve an equilibrium

national income and output with a high level of unemployed resources. The

equilibrium level of national income occurs where aggregate output equals

aggregate expenditure. The main components of aggregate demand or

aggregate expenditure are consumption, investment, government expenditure

and net exports. When aggregate expenditure exceeds aggregate output,

there is an unplanned fall in inventories. Firms will therefore increase output.

This increased output leads to increased income. On the other hand, if

aggregate expenditure is less than aggregate output, there is an unplanned

increase in inventories. Firms will cut back production and output and income

earned in the economy will fall. Equilibrium output may or may not entail full

employment. Keynes believed that full employment is more of an accident

than a norm. The economy might reach an equilibrium level of output with

either considerable unemployment or substantial inflation.

96

3.10 Key Terms

aggregate output aggregate income

consumption function saving

disposable income Dissaving

marginal propensity to consume marginal propensity to save

planned investment actual investment

investment changes in inventory

planned aggregate expenditure equilibrium income

government spending multiplier tax multiplier

balanced budget multiplier open economy multiplier

full employment output deflationary gap

inflationary gap

3.11 SUMMARY

Aggregate demand is total planned spending on final goods and services.

There are four components of aggregate demand consumption (C),

saving (S), government expenditure (G) and net export (X-M).

Consumption is related to disposable, or after tax income, by a relation

called the consumption function.

The amount by which desired consumption increases when disposable

income rises by RM1.00 is called the marginal propensity to consume

(MPC). The MPC is always greater than 0 but less than 1. MPC is

inversely related to marginal propensity to save (MPS). The value of

MPC +MPS must always equals to 1.

An increase in national income raises the aggregate demand, since

higher income encourages households to consume more.

Consumption can be broken down into two components, autonomous

consumption and induced consumption.

Equilibrium national income is the level of output or income that equals

aggregate demand.

Changes in aggregate demand will lead to changes in equilibrium

national income level. If the economy is initially at full employment, a

decrease in aggregate demand will create recessionary gap and an

increase in aggregate demand will create inflationary gap.

97

Practice Questions Multiple Choice Questions 1. If the autonomous consumption increases, the size of the multiplier

would A. increase. B. decrease. C. remain constant. D. either increase or decrease depending on the size of the change in

autonomous consumption. 2. The multiplier effect means that A. consumption is typically several times as large as saving. B. a small change in consumption demand can lead to a much larger

increase in investment. C. a small increase in investment can cause national income to change by

a larger amount. D. a small decline in the MPC can cause equilibrium national income to

rise by several times that amount. 3. National income equilibrium occurs when A. demand equals supply in product market. B. total injections equals total investment. C. aggregate expenditure equals aggregate supply in the economy. D. aggregate expenditure more than aggregate supply in the economy. 4 If the Malaysian government decides to lower spending by RM20

million, with marginal propensity to consume (MPC) = 0.6, the national income will

A. fall by RM50.0 million. B. fall by RM33.3 million. C. rise by RM25.0 million. D. rise by RM12.0 million. 5. If the autonomous consumption decreases, the size of multiplier would A. decrease. B. increase. C. remain constant. D. either increase or decrease.

98

6. The average propensity to save is A. the ratio of saving to income. B. the ratio of income to saving. C. the change in income that is saved. D. the ratio of a change in saving to a change in income. 7. The diagram below is for a 2-sector economy: Based on the diagram above, the marginal propensity to consume is A. 0.1. B. 0.9. C. 1.0. D. cannot be determined.

TABLE 1

Disposable Income

( Y )

Change in Disposa

ble income

Consumption ( C )

0 500

1000 1000 1400

2000 1000 2200

3000 1000 2900

4000 1000 2500

5000 1000 4000

8. Referring to table 1, when disposable income is increased from RM1,

000 to RM2, 000, the marginal propensity to consume is: A. 0.2 B. 0.6 C. 0.8 D. 1.0

AS = AD

C

400

0 4000 Income, Y

99

9. Referring to table 1, when disposable income is increase from RM2, 000 to RM3, 000 to RM4, 000

A. total consumption increases by RM 1, 000 B. MPC remains constant C. MPC increases from0.6 to 0.7 D. MPC decreases from 0.7 to 0.6 10. If MPC is equal to 0.8 then: A. MPS equals 1.20 B. Multiplier equals to 0.20 C. Multiplier equals to 1 divided by 0.80 D. The multiplier equals to 5

Structured Questions

1. a) The table below shows national income, consumption and

saving of a country.

National Income

(RM million)

Consumption

(RM million)

Saving

(RM million)

0 40

1 000 790 210

2 000 1 540

3 000 2 290 710

4 000 960

5 000 3 790 1 210

6 000 1 460

i) Complete the above table.

ii) Determine the value of autonomous consumption and marginal

propensity to consume (MPC).

iii) Derive the saving function.

iv) Calculate the amount of the breakeven income.

100

b) Given the following data (RM billion):

Consumption, C = 40 + 0.75Yd

Investment, I = 120

Government expenditure, G = 40

Taxation, T = 10

i) Calculate the equilibrium level of national income.

ii) Given the full employment income at RM800 billion, is the economy

facing an inflationary gap or a deflationary gap?

iii) Calculate the government expenditure multiplier in this economy.

iv) Determine the change in government expenditure required to achieve

the full employment level of income. (Use multiplier principle)

2. Based on the information given, answer the following questions. (All

values in RM million)

C = 150 + 0.8Yd

G = 80

I = 40

T = 10

where C = consumption

G = government spending

I = investment

T = tax

Yd = disposable income

a) Based on the consumption function above, derive the saving (S)

function.

b) Calculate the national income equilibrium for this economy.

101

c) Calculate the tax multiplier.

d) Calculate the government spending multiplier.

e) If the government increases the spending to RM120 million, what is

the new equilibrium?

f) Based on question (e), if the full-employment income is RM1 800

million, how much should investment change in order to achieve full-

employment income?

(Use multiplier principle)

3. The following Diagrams are for a 3-sector economy: (all Diagrams in

RM million)

Consumption C = RM 800 + 0.75Yd

Investment I = RM 525

Government Spending G = RM 300

Tax T = RM 200 + 0.12Y

a) Write the new saving function with the effect of tax.

b) Using the leakage-injection approach, calculate the equilibrium level of

income for the economy.

c) Suppose this economy practices international trade and its export and

imports are RM200 and RM220 respectively. Calculate the new level of

equilibrium income with others remain unchanged.

d) What is government multiplier principle?

102