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CHAPTER

12

NATIONAL INCOME
EQUILIBRIUM

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12 1

NATIONAL INCOME
EQUILIBRIUM

12 2

NATIONAL INCOME
EQUILIBRIUM (cont.)

TWO APPROACHES TO DETERMINE EQUILIBRIUM:


2. LEAKAGE INJECTION APPROACH
Leakage is a withdrawal from the income expenditure
stream.
Leakages include savings, taxes and imports.
Injection is an addition of spending to the incomeexpenditure stream.
Injections include investment, government expenditures
and exports.
Equilibrium occurs when leakages are equal to injections.

1. AGGREGATE DEMAND AGGREGATE SUPPLY


APPROACH (AD = AS)
Aggregate demand or aggregate expenditure is the total
demand for goods and services in the economy.
There are four components in aggregate demand namely
consumption, investment, government sector and foreign
sector (net exports).
Aggregate supply or aggregate output is the total quantity
of goods and services produced in an economy in a given
period of time.
Equilibrium occurs when AD = AS
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CONSUMPTION THEORY

CONCEPT
OF
CONSUMPTION

CONSUMPTION FUNCTION
Consumption function refers to the relationship between
consumption level and income level.
The general equation for a linear consumption function can
be written as below:

AVERAGE PROPENSITY TO CONSUME (APC)


APC is the ratio of total consumption to total income.
APC = TOTAL CONSUMPTION = C
TOTAL INCOME

C = a + b Yd

Consumption
expenditure

MARGINAL PROPENSITY TO CONSUME (MPC)


MPC is the ratio of change in total consumption to change in total income.
MPC
= TOTAL CONSUMPTION
= C
TOTAL INCOME
Y
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CONSUMPTION AND SAVINGS


(cont.)

Consumption refers to the purchase of goods and services by


individuals or households that are produced by firms.
Income (Y) is divided into two parts, consumption (C) and
savings (S).
Y=C+S

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CONSUMPTION AND SAVINGS

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Disposable
income
Autonomous
consumption

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MPC

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CONSUMPTION AND SAVINGS


(cont.)

SAVINGS THEORY

CONSUMPTION AND SAVINGS


(cont.)

Savings is divided into autonomous savings and induced


savings.
Autonomous savings refers to the part of savings that does
not depend on the level of income and occurs when there
is autonomous consumption.

AVERAGE PROPENSITY TO SAVE (APS)


APS is the ratio of total saving to total income.
APS = TOTAL SAVING
TOTAL INCOME

= S

CONSUMPTION AND SAVINGS SCHEDULE


Table below shows some relationship between
consumption and savings.
The sum of APC and APS must be equal to 1.
APC + APS = 1
The sum of MPC and MPS must also equal to one. The
equation is as below:
MPC + MPS = 1

MARGINAL PROPENSITY TO SAVE (MPS)


MPC is the ratio of change in total consumption to
change in total income.
MPS = TOTAL SAVING = S
TOTAL INCOME Y

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CONSUMPTION AND SAVINGS


(cont.)

APC
(C/ Yd)
1.25
1.00
0.92
0.88
0.85

APS
(S/
Yd)
-0.25
0
0.08
0.12
0.15

MPC
(C/ Yd)

S = -a + (1- b) Yd
Disposable income
Savings

APS= 25/300 =0.08


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CONSUMPTION AND SAVINGS


(cont.)
Price and wage levels

C = 100 + 0.65Yd

Changes in
consumers
taste and
fashion

Distribution
of wealth

a=100

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Y=C

Each point on the 45 degree


line indicates a point
where disposable income
equals to consumption.

National Income

200

NON-INCOME
DETERMINANTS

Saving schedule is vertical


difference between the
Consumption schedule
and the 45 degree line.

S = -100 + 0.35Yd

Consumer
credit

National Income
-100

MPS

Given the consumption function: C = 100 + 0.65Yd


Saving function : S = -100 + 0.35Yd

CONSUMPTION AND SAVINGS


(cont.)
C

Autonomous
savings

DERIVE SAVINGS FUNCTION FROM CONSUMPTION FUNCTION

MPS= (50 -25)/(400-300) =0.25

APC = 125/100 = 1.25

SAVINGS FUNCTION
Saving function refers to the relationship between savings
and income level.
The general equation for a linear consumption function can
be written as below.

MPS
(S/
Yd)
0.25
0.25
0.25
0.25
0.25

0.75
0.75
0.75
0.75
0.75

12 8

CONSUMPTION AND SAVINGS


(cont.)

MPC= (200 -125)/(200-100) =0.75

Disposabl Consumption Savin


e Income
(C)
g
(Yd)
(S)
0
50
-50
100
125
-25
200
200
0
300
275
25
400
350
50
500
425
75

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200

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Change in
expectations
Rate of interest

Break-even income is the level at which households


consume all their incomes. At the point of break-even,
(i) Y = C (ii) S = 0 (iii) APC = 1 (iv) APS = 0
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INVESTMENT

INVESTMENT (cont.)

Investment refers to the spending on purchases


and accumulation of capital goods such as
buildings, equipments and addition to inventories.
There are two types of investment:

Example of autonomous investment is the capital


depreciation.

2. Induced Investment
Induced investment depends on the national income.
As national income increases, the induced investment will
also increase since higher national income attracts more
investors to invest.

1. Autonomous Investment
Autonomous investment is fixed and independent of
income.
The amount of investment can be influenced by other
factors such as interest rate, repayment rate, business
expectation and technology developments.
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INVESTMENT (cont.)

FACTORS
INFLUENCING
INVESTMENT

Government
Policies
Expectation of
the future

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Technological
Changes

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FOREIGN SECTOR

Government spending is an injection into the


spending stream.
Government also can reduce the national income
through imposing taxes.
There are various tax imposed by the government
such as direct taxes and indirect taxes.
Taxes are leakages from the spending stream.

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Government sector is another sector that has a


major impact on the economy because of its
expenditure.
Government spending can be classified into two
categories, purchases of goods and services and
transfer payment.
National income can be increased through
government spending (as we discussed on the
expenditure approach).

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GOVERNMENT SECTOR
(cont.)

12 14

GOVERNMENT SECTOR

Rate of
return

Rate of
interest

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Exports are goods and services that are sold to


foreign countries.
For example, Malaysian made DVD player is sold
to Thailand.
Exports increase the national income and therefore
export is an injection into the spending stream.
Imports are goods and services that are purchased
from foreign countries.
For example, Malaysia buys cars from Germany.

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EQUILIBRIUM IN
TWO-SECTOR ECONOMY

FOREIGN SECTOR (cont.)

Imports reduce the national income and an import


is a leakage from the spending stream.
Net export is the difference between exports and
imports.
If net export is positive, exports are greater than
imports and if net export is negative, exports are
less than imports.

Equilibrium in a two-sector economy is a simple economy, which


consists of 2 agents only, namely households and firms.
Equilibrium occurs when the AD = AS or Leakage = Injection.
Factor Market
Y = rent, wages, profit, interest

FIRM

HOUSEHOLD

Consumption (C)
(1)
Saving (S)

(2)
Investment (I)

Product Market
Financial Market

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EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)

12 20

EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)

AD AS APPROACH

ADAS APPROACH

Equilibrium is achieved when aggregate demand is equal to aggregate supply.


AS = AD
Y = C+I
Algebra Analysis
Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous
Investment = 500
Solution
Consumption function, C = 100 + 0.7Yd (In two sector economy, Yd = Y since no tax)
Y
= C+I
= 100 + 0.7Y + 500
Y 0.7Y = 600
0.3Y
= 600
Y
= 600/0.3
Y
= 2000
EQUILIBRIUM INCOME

Equilibrium is achieved when aggregate demand is equal to aggregate supply.

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Y=AD
AD (C,I)

C +I

C = 100 + 0.7Yd
I=500

a=100
National Income

2,000

The equilibrium occurs when the consumption and 45 degree line intersects at RM2000
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EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
LEAKAGE

AS = AD
Y = C+I

Graphic Analysis

12 22

EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)

- INJECTION APPROACH

LEAKAGE

- INJECTION APPROACH

Equilibrium is achieved when leakage is equal to injection.


Injection = Leakage
I = S
Graphic Analysis

Equilibrium is achieved when leakage is equal to injection.


Injection = Leakage
I = S
Algebra Analysis
Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous
Investment = 500
Solution:
Consumption function, C = 100 + 0.7Yd , so saving function is S = -100 + 0.3Yd
I
= S
500 = -100 + 0.3Y
0.3Y = 600
Y
= 600/0.3
Y
= 2000
EQUILIBRIUM INCOME

Leakage-Injection

S = -100 + 0.3Yd
I=500

2,000

National Income

a=100

The equilibrium occurs when the saving function and investment function intersect at
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RM2000.

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EQUILIBRIUM IN
THREE-SECTOR ECONOMY

EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
Tabular Analysis

The equilibrium is achieved when AD = AS or I = S


When both the AS and AD is same at one level, this is called as

equilibrium income.
Aggregate Consumption Saving Investment Aggregat
(C)
(S)
(I)
Supply
e
(Y)
Demand
(C + I)
0
100
-100
500
600
1000
800
200
500
1400
1500
1150
350
500
1650
2000
1500
500
500
2000
2500
1850
650
500
2350
3000
2200
800
500
2700

Tendency of
employment,
output and
income
Increase
Increase
Increase
EQUILIBRIUM
Decrease
Decrease

Equilibrium in a three-sector economy consists households, firms


and government.
Equilibrium occurs when the AD = AS or Leakage = Injection.
Factor Market
Y = rent, wages, profit, interest
Government
Expenditure (G)

Transfer Payment
(G)

GOVERNMENT

HOUSEHOLD
Taxes (T)
(1)
Savings (S)

FIRM

Taxes (T)

Consumption (C)

(2)
Investment (I)

Product Market

AS = AD and I =S

Financial Market
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EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

12 26

EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

AD AS APPROACH

Equilibrium is achieved when aggregate demand is equal to


aggregate supply.
AS = AD
Y = C+I+G

In three-sector economy, we need to focus on two types of taxes.


1. Autonomous Taxes

2. Induced Taxes
Induced taxes refer to the amount of tax that depends on
income.
If income increases, induced tax will increase and vice
versa.
For example, Tax = 0.6Y

Autonomous taxes refer to the amount of tax that is independent


of income.
If the income increases or decreases, autonomous taxes remain
constant.
For example, Tax = RM100
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EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

AD AS APPROACH

Algebra Analysis

Graphic Analysis

Equilibrium using autonomous tax

Equilibrium using induced tax

Given the following information:


C = 200 + 0.75Yd ; I = 100; G = 50; T = 100

Given the following information. :


C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y

Solution

Solution

Equilibrium using autonomous tax

C+I+G

C+I+G

200 + 0.75Yd + 100 + 50

200 + 0.75Yd + 100 + 50

350 + 0.75(Y T)

350 + 0.75(Y T)

350 + 0.75(Y 100)

350 + 0.75(Y 0.2Y)

Y 0.75Y

275

350 + 0.75(0.8Y)

0.25Y

275

350 + 0.6Y

275/0.25

Y 0.6Y

350

1100

0.4Y

350

350/0.4

875

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EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

AD AS APPROACH

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Equilibrium using induced tax

Y=AD
AD (C,I,G)

Y=AD

C +I + G

AD (C,I,G)

C +I + G

C = 200 + 0.75Yd
(BEFORE TAX)

C = 200 + 0.75Yd
(BEFORE TAX)
325

350
C = 175 + 0.75Y
(AFTER TAX)

200

C = 200 + 06Y
(AFTER TAX)
200

175
National Income
1100

The equilibrium occurs when AD curve


and 45 degree line intersects at RM1100.
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National Income
875

The equilibrium occurs when AD curve


and 45 degree line intersects at RM875.
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EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)

LEAKAGEINJECTION APPROACH

LEAKAGEINJECTION APPROACH

Equilibrium is achieved when leakages are equal to injections


Injection = Leakage
I+G
= S+T

Graphic Analysis
Equilibrium using autonomous tax

Algebra Analysis
Equilibrium using autonomous tax
Given the following information. :
C = 200 + 0.75Yd ; I = 100; G = 50; T = 100
Solution

Equilibrium using induced tax


Given the following information. :
C = 200 + 0.75Yd ; I = 100; G = 50; T =
0.2Y

I+G

= S+T

100 + 50

= -200 + 0.25Yd + 100

150

= -100 + 0.25(Y T)

150

= -100 + 0.25(Y 100)

150

= -125 + 0.25Y

Solution
I+G
100 + 50
150
150
150
0.4Y
Y

0.25Y

= 275
Y = 1100

=
=
=
=
=
=
=

S+T
- 200+ 0.25Yd + 0.2Y
- 200 + 0.25(Y 0.2Y) + 0.2Y
-200 + 0.25(0.8Y) + 0.2Y
-200 + 0.2Y + 0.2Y
350
875
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Leakages/Injections

150

Tabular Analysis

Investment
(I)

Government
Expenditure
(G)

Aggregate
Demand
(C+ I+G)

Tendency of
employment,
output and
income

100

100

200

-200

100

50

350

Increase

300

100

200

350

-150

100

50

500

Increase

600

100

500

575

-75

100

50

725

Increase

900

100

800

800

100

50

950

Increase

1100

100

1000

950

50

100

50

1100

EQUILIBRIUM

1300

100

1200

1100

100

100

50

1250

Decrease

1500

100

1400

1250

250

100

50

1400

Decrease

National Income
-200

875

-225

The equilibrium occurs when I+G schedule


Intersects with S+T at RM1100.

The equilibrium occurs when I+G schedule


Intersects with S+T at RM875.
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Equilibrium in a three-sector economy consists households, firms,


government and foreign sector.
Equilibrium occurs when the AD = AS or Leakage = Injection.
Foreign Sector
Export (X)

Factor Market

Import (M)

Y = rent, wages, profit, interest


Govt Expenditure
(G)

Transfer Payment
(G)

GOVERNMENT

HOUSEHOLD
Taxes (T)

FIRM

Taxes (T)

Consumption (C)

(1)
Savings (S)

(2)
Investment (I)

Product Market
Financial Market

AS = AD and I+G = S+T


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EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)

12 34

EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)

ADAS APPROACH

ADAS APPROACH

Equilibrium is achieved when aggregate demand is equal to aggregate supply.


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

Equilibrium is achieved when aggregate demand is equal to aggregate supply.


AS
Y

=
=

Graphic Analysis

Algebra Analysis
Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ;
X = 100; M = 50
Solution
Y
= C + I + G + (X M)
= 200 + 0.75(Y T) + 100 + 50 + (100 50)
= 400 + 0.75 (Y 100)
= 400 + 0.75Y 75
Y 0.75Y = 325
0.25Y = 325
Y
= 325/0.25
Y
= 1300
EQUILIBRIUM INCOME
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I +G

National Income
1100

-200

Disposable
Consumption
Saving
Income (Yd)
(C)
(S)
(Yd = Y-T) (C = 200+0.75Yd)

S +T = -200 + 0.2Y
(AFTER TAX)
150

I +G

EQUILIBRIUM IN
FOUR-SECTOR ECONOMY

The equilibrium is achieved when AD = AS or I + G = S + T


When both the AS and AD is same at one level, this is called as equilibrium income.
Taxes
(T)

S = -200 + 0.25Yd
(BEFORE TAX)

S +T = -225 + 0.25Y
(AFTER TAX)

EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
Aggregate
Supply
(Y)

Equilibrium using induced tax


Leakages/Injections

S = -200 + 0.25Yd
(BEFORE TAX)

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

AD (C,I)
C +I+G + (X-M)

325

1300

National Income

The equilibrium occurs when the aggregate demand (C+I+G+(X-M))


and 45 degree line intersects at RM1300.
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EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)

EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)

LEAKAGE-INJECTION APPROACH

LEAKAGE-INJECTION APPROACH
Equilibrium is achieved when leakage is equal to injection.

Equilibrium is achieved when leakage is equal to injection.


Injection
I + G+ X

=
=

Leakage
S + T+ M

Graphic Analysis

Algebra Analysis

=
=
=
=
=

1300

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Aggregate

Taxes

Disposable

Consumption

Saving

Investment

Government

Exports

Imports

Supply

(T)

Income

(C)

(S)

(I)

Expenditure

(X)

(M)

(G)

Aggregate

Tendency of

Demand

employment,

(C+ I+G+

output and

[X M])

income

100

100

200

-200

100

50

100

50

400

Increase

300

100

200

350

-150

100

50

100

50

550

Increase

600

100

500

575

-75

100

50

100

50

775

Increase

900

100

800

800

100

50

100

50

1000

Increase

1100

100

1000

950

50

100

50

100

50

1150

Increase

1300

100

1200

1100

100

100

50

100

50

1300

EQUILIBRIUM

1500

100

1400

1250

250

100

50

100

50

1450

Decrease

AS = AD and I+G+X = S+T+M


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MULTIPLIER CONCEPT

Tabular Analysis
The equilibrium is achieved when AD = AS or I + G + X = S + T + M
When both the AS and AD is same at one level, this is called as equilibrium income.

The multiplier is the ratio of the change in income to the change in AD.
Multiplier shows how many times the effect of an initial change in AD
is multiplied by causing changes in consumption and finally in the
aggregate income.
The formula for multiplier (K) is,
K =
Change in Income (Y)
Change in Aggregate Demand (AD)
The size of multiplier depends upon the size of the marginal
propensity to consume (MPC).
Higher the MPC, higher is the size of the multiplier and lower the
MPC, lower shall be the size of multiplier.
K
=
1
1 - MPC

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MULTIPLIER CONCEPT (cont.)

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MULTIPLIER CONCEPT (cont.)


GOVERNMENT EXPENDITURE MULTIPLIER

INVESTMENT MULTIPLIER

National Income

The equilibrium occurs when the I+G+X schedule


and S+T+M schedule intersect at RM1300.

EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)

I+G+X

-75

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(Yd)

Leakage
S +T+M
S +T+M

250

S+T+M
-200 + 0.25(Y-100) + 100 + 50
-75 + 0.25Y
325
1300 EQUILIBRIUM INCOME

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(Y)

=
=

Leakage-Injection

Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50;


T = 100 ; X = 100; M = 50
Solution
I + G+ X
100 + 50 + 100
250
0.25Y
Y

Injection
I+G+X

Investment multiplier refers to the ratio of the change in the equilibrium income to a
change in investment. The formula for investment multiplier (Ki) is,
Ki =
Change in Income (Y)
Change in Investment (I)
Investment multiplier can also derived as follows:

The government expenditure multiplier refers to the ratio of the change in the
equilibrium income to a change in government expenditure assuming there is
no change in taxes.
Kg =
Change in Income (Y)
Change in Government Expenditure (G)

Investment Multiplier (Ki)

Government expenditure multiplier can also derived as follows:


Government Expenditure Multiplier (Kg) =
1
=
1
1-MPC
MPS

1
1-MPC

1
MPS

Example

Example

Given, C = 200 + 0.75Y and I = 100. What is the equilibrium income level when there is an
increase in investment by 50 million?
Solutions:
Y =
=
=
Y =

Ki x I
1/(1-MPC) x I
1 /(1-0.75) x 50
200 million

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New equilibrium income level = Y + Y


= 1100 + 200
= 1300 m

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12 41

Given, C = 200 + 0.75Y; I = 100 and G = 50. What is the equilibrium income level when there is
an increase in government spending by 50 million?
Solutions:
Y
= Kg x G
New equilibrium income level
= Y + Y
=
1/(1-MPC) x G
= 1100 + 400
=
1 /(1-0.75) x 100
= 1500 m
Y
= 400 million
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2/9/2015

MULTIPLIER CONCEPT (cont.)

MULTIPLIER CONCEPT (cont.)


TAX MULTIPLIER

Tax multiplier refers to the ratio of the change in the equilibrium income to a
change in taxes assuming there is no change in government expenditure.
Kt = Change in Income (Y)
Change in Taxes (T)

Tax multiplier can also derived as follows:


Tax Multiplier (Kt) = - MPC
MPS

Given, C = 200 + 0.75Y; I = 100; G = 50 and T =100. What is the equilibrium income level when
there is an increase in government spending and taxes by 50 million?
Solutions:
Tax multiplier
Y
=
Kt x T
Net increase in income, Y = -150+200
=
-MPC/MPS x T
= 50 million
=
-0.75 /0.25 x 50
Y
=
-150 million
Government Expenditure multiplier
Y
=
Kg x G
New equilibrium income level = Y + Y
=
1/(1-MPC) x G
= 1100 + 50
=
1/(1-0.75) x 50
= 1150 m
Y
=
200 million

Example
Given, C = 200 + 0.75Y; I = 100; G = 50 and T = 100. What is the equilibrium income level
when there is a tax cut of 50 million?
Solutions:
Y
=
Kt x T
New equilibrium income level = Y + Y
=
-MPC/(MPS) x T
= 1100 + 150
=
-0.75/(0.25) x 50
= 1250 m
Y

150 million
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12 43

BALANCE BUDGET MULTIPLIER


Balanced budget multiplier refers to the change in the equilibrium income by
the same amount as the changes in taxes and government expenditure.
Kb = 1
Example

INFLATIONARY GAP

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DEFLATIONARY GAP

Inflationary gap occurs when national income exceeds the full employment level.
Inflationary gap can be caused by the increase in aggregate expenditure.
The inflationary gap is measured as the excess of the aggregate expenditure over
the full employment aggregate supply, Yfe.
Y=AD

Deinflationary gap occurs when national income below the full employment level.
The deflationary gap is measured as the difference between the aggregate
expenditure over the full employment aggregate supply, Yfe.
Y=AD
Aggregate Demand

Aggregate Demand

C+I+G+(X-M)fe

C+I+G +(X-M)

Inflationary Gap
Yfe < Y

Deflationary Gap
Yfe > Y

The inflationary gap of AB will


increase the general price level.

National Income

National Income
0

Yfe

To reduce the inflationary gap of AB, contractionary policy can be implemented. Government can
practice contractionary fiscal policy through reducing government expenditure and raise taxes.

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C +I+G + (X-M)

C+I+G +(X-M)fe

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Yfe

To reduce the deflationary gap of CD, expansionary policy can be implemented. Government can
practice expansionary fiscal policy through increase in government expenditure and tax cut.

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