INCOME EXPENDITURE

MODEL: GOODS

MARKET EQUILIBRIUMDongpeng Liu

Department of Economics

Nanjing University

ROADMAP

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INCOME

EXPENDITURE

LIQUIDITY

PREFERENCE

IS

CURVE

LM

CURVE

AGGREGATE

DEMAND

SHORT-RUN

LABOR

MARKET

AGGREGATE

SUPPLY

AS-AD

MODEL

IS-LM

MODEL

PHILLIPS

CURVE

INTERMEDIATE-RUN

SOLOW

MODEL

LONG-RUN w/

CAPITAL

ACCUMULATION

LONG-RUN

AS-AD

MODEL

LONG-RUN w/o

CAPITAL

ACCUMULATION

TOTAL EXPENDITURE

Total expenditure: 𝑍 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 Expenditures are made by consumers, firms, governments and foreigners

For the majority of the course, we focus on closed economy

macroeconomics

𝑁𝑋 = 0

𝑍 = 𝐶 + 𝐼 + 𝐺

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CONSUMPTION

Disposable income is the income after all taxes and transfer

payments

𝑌𝐷 = 𝑌 − 𝑇

Y is total income, T is the difference between taxes and transfer payment.

For simplicity, throughout this course, T will be called “taxes”

The tax discussed here is a lump-sum tax: a tax that is a fixed amount, no

matter the change in circumstance of the taxed entity

Note: Y, Z, C, I, G, NX, and T are real values, rather than nominal values

Consumption function: 𝐶 = 𝑐0 + 𝑐1𝑌𝐷 𝑐0: Autonomous consumption expenditure

𝑐1: Marginal propensity to consume

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CONSUMPTION

𝑐0: Amount of consumptions when disposable income is 0 When 𝑌𝐷 = 0, 𝐶 = 𝑐0

Normally, 𝑐0 > 0 (Why?)

Marginal propensity to consume: The additional consumption

expenditure when disposable income increases by 1 unit

0 < 𝒄1 < 1

Consumption increases as disposable income increases

Only a part of the increase of disposable income is consumed

Whose marginal propensity to consume is higher, the rich or the poor?

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CONSUMPTION

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INVESTMENT

For simplicity, in this lecture, we assume that investment is

exogenously given

𝐼 = 𝐼

Variables whose values are determined or explained by the model are

endogenous variables

Variables whose values are not determined nor explained by the model are

exogenous variables

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FISCAL POLICY

Fiscal policies are governments’ choices of government purchase

(G) and Taxes (T)

Throughout this course, G and T are treated as exogenous

variables

One major task of macroeconomists is to propose fiscal policies. Hence, we

want economic models to tell us what would be the consequences of a policy

of interest. That is why G and T shall be treated as exogenous variables,

rather than explained with the model.

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GOODS MARKET EQUILIBRIUM

Goods market equilibrium means total output (Y) equals to total

expenditures (Z)

𝑌 = 𝑍

𝑌 = 𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐼 + 𝐺 = 𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺 + 𝑐1𝑌

𝑌 =1

1−𝑐1(𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺)

𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺 is the part of total expenditure not depending on

total output, which is called autonomous spending

Autonomous spending can only be negative when there is huge (government)

budget surplus. For the purpose of this course, we ignore this possibility.

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GOODS MARKET EQUILIBRIUM

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The intersect of the total

expenditure line and the 45

degree line shows the

equilibrium level of total

output (or total

income/expenditures)

WHAT IF GOVERNMENT PURCHASE INCREASES BY $1

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G

increase

s by $1

Output and

income

increases

by $1

Consumption

and total

expenditure

increases by

𝑐1

Output

and

income

increase

s by 𝑐1

Consumption

and total

expenditure

increases

by 𝑐12

Output

and

income

increases

by 𝑐12

THE MULTIPLIER EFFECT

This is an infinite decreasing geometric series

The change of GDP caused by an $1 increase in G is

∆𝑌 = 1 + 𝑐1 + 𝑐12 + 𝑐1

3 +⋯ =1

1 − 𝑐1> 1

1/(1 − 𝑐1) is the multiplier. for each $1 increase of 𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺(autonomous spending), GDP will increase by 1/(1 − 𝑐1)

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AN EXAMPLE OF CALCULATING GDP

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EFFECTIVENESS OF EXPANSIONARY FISCAL POLICIES

In the short-run, expansionary fiscal policies can raise total

output

In response to a recession, the government can hire some workers to dig a

big hole, and then fill the it with dirt

However, expansionary fiscal policy is not a panacea

Income expenditure model relies on very restrictive assumptions

Expansionary fiscal policies will raise interest rate and crowd out a part

of investment (IS-LM model)

Expansionary fiscal policies will cause inflation and change the expected

price level of firms, making the expansion unsustainable (AS-AD model)

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SAVINGS AND INVESTMENT

Private savings (S) are the savings of

𝑆 = 𝑌𝐷 − 𝐶 = 𝑌 − 𝑇 − 𝐶

Public savings: 𝑇 − 𝐺

IS relation

𝑆 = 𝐶 + 𝐼 + 𝐺 − 𝑇 − 𝐶 = 𝐼 − 𝑇 − 𝐺𝐼 = 𝑆 + 𝑇 − 𝐺

Investment = Private savings + Public savings

Savings are the source of investment. IS relation and the

income expenditure model are the two sides of the same coin.

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SUMMARY

Income expenditure model

Consumption function

Goods market equilibrium

Fiscal policies

The multiplier effect

IS relation

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