DETERMINATION OF NATIONAL INCOME in the
Keynesian Model
At Equilibrium national income:
– withdrawals equal injections
– income equals expenditure
fig
Cd
W = S + T + M
J = I + G + X
Incomes
A simplified circular flow of income modelA simplified circular flow of income model
Consumption
• Determinants of consumption– Disposable income
– wealth, interest rates, taxation policy, consumer indebtedness, future expectations
Consumption Function
45o
ConsumptionSpending
Income
B
Y1 Y2
A
A′
B′
C1
C2
An increase in income from Y1 to Y2, leads to an increase in consumption from C1 to C2. Hence the economy moves from point B on the consumption function to point B′.
C
C’An increase in wealth, and improvement in expectations, will shift the consumption function upward.
Investment• Investment
– Interest rate
– net rate of profit – capital stocks– business taxes– technological innovations– future expectations
– Assumptions:interest rates are fixed,hence investment is given at some level
Investment Spending
Investment Spending
(billions $)
Income
I
Interest rate
Investment Demand (billions $)
I
r
50
50
Graphical Analysis
45o
IncomeY*
CAggregateExpenditures(Spending)
I
AE = C + I + G + Xn
G
C + I
The Multiplier
• The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income.
• The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income.
• The size of the multiplier increases with the marginal propensity to consume (MPC).
Expenditure stage
Additional income(dollars)
Marginal propensity to consume
Additional consumption(dollars)
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
1,000,000 750,000
562,500
421,875
316,406
949,219
750,000 562,500
421,875
316,406
237,305
711,914
Round 1
Round 2
Round 3
Round 4
Round 5
Total 4,000,000 3,000,000
All others
3/4 3/4
3/4
3/4
3/4
3/4
3/4
The Multiplier Principle
• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).
MPCSize of
multiplier
.9
.8 .75.66 .5.33
10.0 5.0 4.0 3.0 2.0 1.5
A Higher MPCMeans a Larger Multiplier
• As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.).
• The multiplier:
• the formula: the simple multiplier 1 / (1 – mpc) or 1/mps
• the full multiplier: 1 / mpw (mpw=mps+mrt+mpm)
• Withdrawals– net saving: the saving function
• the mps: marginal propensity to save
• determinants of saving
– net taxes: tax functions• the mrt: marginal rate of taxation
– imports: import functions• the mpm: marginal propensity to import
• effect of imports on Cd
– the withdrawals function• MPS+MRT+MPM = MPW: marginal propensity to
withdraw
The Multiplier• In evaluating the importance of the multiplier,
one should remember:
– taxes and spending on imports will dampen the size of the multiplier;
– it takes time for the multiplier to work; and,
– the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.
DETERMINATION OF NATIONAL INCOME
• Relationship between the 45° line diagram and the AD and AS diagram
fig
AS
AD1
Showing the multiplier effect on the 45o line and AD/AS diagramsShowing the multiplier effect on the 45o line and AD/AS diagrams
Price Level
Output
Y
Spending
Ye1
O
O
AE1
fig
Price Level
Output
Y
Spending
Ye1
O
O
AD1
AE1
AE2
Ye2
AS
fig
AD2
AD3
Price Level
Output
Y
Spending
AS
Ye1
O
O
AD1
AE1
AE2
Ye2
Short-run Macroeconomic Equilibrium
Simple Keynesian Analysis of Unemployment and Inflation
figOY
Spending
YeYF
AE
The recessionary gap
figOYYe
YF
AEa
b
recessionary gap
SpendingThe recessionary gap
figOYYF
AE
Inflationary gap
Spending
e
f
Ye
The inflationary gap
figOY
S
I
YeYF
c
d
AEa
b
recessionary gap
SpendingThe recessionary gap