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CHAPTER
12
NATIONAL INCOME
EQUILIBRIUM
12 1
NATIONAL INCOME
EQUILIBRIUM
12 2
NATIONAL INCOME
EQUILIBRIUM (cont.)
12 3
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:
C = a + b Yd
Consumption
expenditure
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Disposable
income
Autonomous
consumption
MPC
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2/9/2015
SAVINGS THEORY
= S
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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
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C = 100 + 0.65Yd
Changes in
consumers
taste and
fashion
Distribution
of wealth
a=100
Y=C
National Income
200
NON-INCOME
DETERMINANTS
S = -100 + 0.35Yd
Consumer
credit
National Income
-100
MPS
Autonomous
savings
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
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200
Change in
expectations
Rate of interest
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2/9/2015
INVESTMENT
INVESTMENT (cont.)
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.
All Rights Reserved
12 13
INVESTMENT (cont.)
FACTORS
INFLUENCING
INVESTMENT
Government
Policies
Expectation of
the future
Technological
Changes
12 15
12 16
FOREIGN SECTOR
GOVERNMENT SECTOR
(cont.)
12 14
GOVERNMENT SECTOR
Rate of
return
Rate of
interest
12 17
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2/9/2015
EQUILIBRIUM IN
TWO-SECTOR ECONOMY
FIRM
HOUSEHOLD
Consumption (C)
(1)
Saving (S)
(2)
Investment (I)
Product Market
Financial Market
12 19
EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
12 20
EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
AD AS APPROACH
ADAS APPROACH
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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
All Rights Reserved
EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
LEAKAGE
AS = AD
Y = C+I
Graphic Analysis
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EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
- INJECTION APPROACH
LEAKAGE
- INJECTION APPROACH
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
PRINCIPLES OF ECONOMICS Third Edition
Oxford Fajar Sdn. Bhd. (008974-T), 2013
12 23
RM2000.
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2/9/2015
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
EQUILIBRIUM IN
TWO-SECTOR ECONOMY (cont.)
Tabular Analysis
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
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
All Rights Reserved
12 25
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
12 26
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
AD AS APPROACH
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
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EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
AD AS APPROACH
Algebra Analysis
Graphic Analysis
Solution
Solution
C+I+G
C+I+G
350 + 0.75(Y T)
350 + 0.75(Y T)
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
12 28
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
AD AS APPROACH
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
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National Income
875
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2/9/2015
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
LEAKAGEINJECTION APPROACH
LEAKAGEINJECTION APPROACH
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
I+G
= S+T
100 + 50
150
= -100 + 0.25(Y T)
150
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
All Rights Reserved
12 31
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
12 32
Factor Market
Import (M)
Transfer Payment
(G)
GOVERNMENT
HOUSEHOLD
Taxes (T)
FIRM
Taxes (T)
Consumption (C)
(1)
Savings (S)
(2)
Investment (I)
Product Market
Financial Market
12 33
EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)
12 34
EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)
ADAS APPROACH
ADAS APPROACH
=
=
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
PRINCIPLES OF ECONOMICS Third Edition
Oxford Fajar Sdn. Bhd. (008974-T), 2013
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
S = -200 + 0.25Yd
(BEFORE TAX)
S +T = -225 + 0.25Y
(AFTER TAX)
EQUILIBRIUM IN
THREE-SECTOR ECONOMY
(cont.)
Aggregate
Supply
(Y)
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
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2/9/2015
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.
=
=
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
12 38
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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12 40
INVESTMENT MULTIPLIER
National Income
EQUILIBRIUM IN
FOUR-SECTOR ECONOMY
(cont.)
I+G+X
-75
(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
(Y)
=
=
Leakage-Injection
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)
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
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
PRINCIPLES OF ECONOMICS Third Edition
Oxford Fajar Sdn. Bhd. (008974-T), 2013
12 42
2/9/2015
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)
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
All Rights Reserved
12 43
INFLATIONARY GAP
12 44
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
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.
C +I+G + (X-M)
C+I+G +(X-M)fe
12 45
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.
12 46