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DETERMINATION OF NATIONAL INCOME in the Keynesian Model At Equilibrium national income: –withdrawals equal injections –income equals expenditure

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fig CdCd W = S + T + M J = I + G + X Incomes A simplified circular flow of income model

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Consumption Determinants of consumption –Disposable income –wealth, interest rates, taxation policy, consumer indebtedness, future expectations

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Consumption Function 45 o Consumption Spending Income B Y1Y1 Y2Y2 A A B C1C1 C2C2 An increase in income from Y 1 to Y2, leads to an increase in consumption from C 1 to C 2. 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.

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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

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Investment Spending (billions $) Income I Interest rate Investment Demand (billions $) I r 50

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Graphical Analysis 45 o Income Y* C Aggregate Expenditures (Spending) I AE = C + I + G + Xn G C + I

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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).

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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, , , , , , , , , , , ,914 Round 1 Round 2 Round 3 Round 4 Round 5 Total 4,000,0003,000,000 All others 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).

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MPC Size of multiplier A Higher MPC Means 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.).

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The multiplier: the formula:the simple multiplier 1 / (1 – mpc) or 1/mps the full multiplier: 1 / mpw (mpw=mps+mrt+mpm)

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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

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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.

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DETERMINATION OF NATIONAL INCOME Relationship between the 45° line diagram and the AD and AS diagram

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fig AS AD 1 Showing the multiplier effect on the 45 o line and AD/AS diagrams Price Level Output Y Spending Ye1Ye1 O O AE 1

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fig Price Level Output Y Spending Ye1Ye1 O O AD 1 AE 1 AE 2 Ye2Ye2 AS

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fig AD 2 AD 3 Price Level Output Y Spending AS Ye1Ye1 O O AD 1 AE 1 AE 2 Ye2Ye2

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Short-run Macroeconomic Equilibrium Simple Keynesian Analysis of Unemployment and Inflation

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fig O Y Spending YeYe YFYF AE The recessionary gap

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fig O Y YeYe YFYF AE a b recessionary gap Spending The recessionary gap

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fig O Y YFYF AE Inflationary gap Spending e f YeYe The inflationary gap

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fig O Y S I YeYe YFYF c d AE a b recessionary gap Spending The recessionary gap

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