chapter 6 determination of national income

6 - 1Copyright © 2008 Pearson Education Canada

Chapter 6Determination of National Income


Chapter Objectives

1. Explain equilibrium GDP using the circular-flow approach.

2. Explain the paradox of thrift.

3. Use the multiplier formulas to calculate changes in equilibrium GDP.

4. Explain the fiscal-policy changes necessary to reach equilibrium GDP.

5. Define the recessionary and inflationary gaps and briefly describe theories of business cycles.


Gross Domestic Product

GDP is measured by the flow of money in the circular flow diagram.

Money circulates from the business sector to the household sector in the form of wages, salaries, rents, and profits.

This money then returns to the business sector when households purchase goods and services.

What are the reasons for changes in GDP levels?

(Cont.)


Gross Domestic Product (Continued)

When households increase their savings they also reduce spending on goods and services.

Businesses reduce production and forward less money to households in the form wages, interest, and rent.

This reduces the flow of money and the level of GDP.

Household Savings and Investment

(Cont.)


An increase in investment increases the flow of money and the level of GDP.

Household Savings and Investment (Continued)


Whether the overall GDP increases is dependent on relative changes in investment and savings.

If the increase in investment is greater than the increase in savings than the overall level of GDP will increase.

When the levels of savings and investment are equal than the level of GDP will be at equilibrium.

If the increase in investment is less than the increase in savings than the overall level of GDP will decrease.



Taxation removes money from the circular flow, and government spending puts it back in.

When the total amount of money injected into the circular flow (investment, government spending, and exports) exceeds the leakages from circular flow (savings, taxation, and imports), the level of GDP will increase.

The Government and Foreign-Trade Sectors

Exports add money to the circular flow, and imports remove it.

(Cont.)


Injections ($)

The Government and Foreign-Trade Sectors(Continued)

Condition for equilibrium GDP:

Investment (I) + Government spending (G) + Exports (X)

Savings (S) + Taxes (T) + Imports (IM)=

Leakages ($)=


Paradox of Thrift

By saving more we end up saving less.

The paradox of thrift states that an increase in the level of savings in the economy can lead to lower levels of income and ultimately to lower levels of savings.

The paradox applies only if a significant number of people decide to increase their savings.


Components of Aggregate Expenditure

Consumption

Some factors influencing the level of consumption expenditure:

•Disposable income or after-tax income

•Interest rates

•Wealth

•Expectations

(Cont.)


Consumption (Continued)

Other factors influencing the level of consumption expenditure:

•Psychological factors

•New products

•Distribution of income

•Prices

•Demographic factors


Consumption Schedule

Dissaving occurs when spending is greater than disposable income.

(Cont.)


Consumption Schedule (Continued)

Average propensity to consumer (APC) =

Consumption

Disposable Income

Average propensity to save (APS) =

Savings

Disposable Income

APC + APS = 1.0



Marginal propensity to consumer (MPC) =

Change in Consumption

Change in Disposable Income

Marginal propensity to save (MPS) =

Change in Savings

Change in Disposable Income

MPC + MPS = 1.0



At each point on the 45O line, consumption is equal to disposable income.


Investment

Investment is most volatile and most difficult to predict because decisions are based on business expectations about the future.

There are also a number of factors that change investment:

•The interest rate

•Innovation and changes in technology

•Government policy and taxes

•Expectations

(Cont.)


Investment (Continued)

Factors that change investment:

•Replacement

•Cost of capital goods

•Gross domestic product

Other Components of Aggregate Expenditures

Government spending and the difference between exports and imports are the final components of aggregate expenditures.

(Cont.)


Other Components of Aggregate Expenditures(Continued)


The Multiplier

An increase in aggregate expenditures will cause an increase in GDP.

The increase in GDP will be more than the initial increase in aggregate expenditures due to the multiplier process.

For example, if someone decides to spend $10,000 on a new car overall increase in GDP will be larger than $10,000.


If someone decides to spend an extra $1000 on audio equipment then:

The Expenditure Multiplier

1000$GDP1000$)( MPC

1000$))(( MPCMPC

1000$))(( MPCMPC

.....................

(Cont.)


The expenditure multiplier is the amount by which a change in aggregate demand is multiplied in order to determine the change in GDP.

The Expenditure Multiplier (Continued)

MPCADGDP

1

1

5000$8.01

11000$

GDP

Assume MPC = 0.8 and spending increase of $1000.


The tax multiplier is the amount by which any change in the level of taxation must be multiplied in order to determine the impact on GDP.

The Tax Multiplier

]1

[MPC

MPCTaxesGDP

]75.01

75.020$[

GDP 60$

Assume MPC = 0.75 and tax decrease of $20.


The balanced-budget multiplier is the amount by which an equal increase in taxes and in government spending increases GDP. (MPC = 0.8, and G and T increase $10.)

The Balanced-Budget Multiplier

]1

[MPC

MPCTaxesGDP

]

1

1[

MPCG

]8.01

8.010[$

GDP ]

8.01

110[$

50$40$ GDP 10$


An Alternate Approach to Equilibrium GDP

The real gross domestic product (RGDP) is the amount of goods and services produced in the economy adjusted for price increases.

The aggregate demand (AD) is the total demand for all goods and services produced in the economy over a certain period of time.

The aggregate supply (AS) is the total production of goods and services available in the economy over a certain period of time.

(Cont.)


An Alternate Approach to Equilibrium GDP(Continued)

The negative relationship between the price level in the economy and AD is explained by the wealth effect and substitution effect.

When the price level increases (holding all else constant), an individual’s wealth decreases, to restore that wealth individuals will spend less.

When the price level increases (holding all else constant) this will increase interest rates, individuals will substitute away from spending for more saving.



The AS curve is positively related to the price level, as the price level increases more goods and services are produced.

There is a limit to the amount of goods and services produced, determined by an output where all available resources are fully employed, or RDGPfe.

When all resources are fully utilized the economy is operating at its natural level of unemployment.



As the price level increases the RGDP falls along the AD curve and increases along the AS curve.

The AD curve shifts to the right when one of the components of AD increases, such as business investment or government spending.

The AS curve shifts to the right when the quantity and/or quality of resources (land, labour, and capital) increase.



The equilibrium is at the price level where AD = AS, RGDPe.



At a low price of P1 there is a depletion of inventories, firms hire more workers and machinery to increase production.



If overall spending increases the AD curve shifts to the right and the RGDP increase to RGDP2.


Full-Employment GDP

The level of aggregate demand in the economy required to ensure that everyone who wants employment has a job is the full-employment level of GDP.

The amount that aggregate demand must increase in order to bring the equilibrium level of GDP up to full-employment level is the recessionary gap.

(Cont.)

The decrease in the level of aggregate demand required to bring the equilibrium level of GDP down to the full-employment level of GDP is referred to as the inflationary gap.


Full-Employment GDP (Continued)

If RGDPfe is $450 and RGDP is $400, what increase in aggregate demand is necessary in order to achieve full-employment, assuming MPC=0.75?

75.01

150$

AD

AD)4

1(50$ 5.12$


Full-Employment GDP (Continued)

If RGDPfe is $450 and RGDP is $400, what reduction in taxes is necessary in order to achieve full-employment, assuming MPC=0.75?

)75.01

75.0(50$

Taxes

Taxes )3

1(50$ 67.16$


Say’s Law and John Maynard Keynes

Say’s Law states that the supply of products creates its own demand, since all production creates income for households that can be spent on goods and services.

Keynesian economic theory proposes that government take an active role in the economy, increasing government spending in order to support he demand for goods and services and, therefore, preserve employment.

chapter 6 determination of national income

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