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**DETERMINATION OF NATIONAL INCOME in the Keynesian Model**

At Equilibrium national income: withdrawals equal injections income equals expenditure 5

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**A simplified circular flow of income model**

J = I + G + X Incomes Cd fig W = S + T + M

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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 C’ C**

An increase in wealth, and improvement in expectations, will shift the consumption function upward. C Consumption Spending B′ 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′. A′ B C1 A 45o Y1 Y2 Income

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**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

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**Investment Spending Investment Spending Interest rate I r 50 I 50**

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

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**Graphical Analysis AE = C + I + G + Xn C + I C G Income Aggregate**

Expenditures (Spending) C G I 45o Y* Income

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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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**The Multiplier Principle**

Expenditure stage Additional income (dollars) Additional consumption (dollars) Marginal propensity to consume Round 1 1,000,000 750,000 3/4 Round 2 750,000 562,500 Round 3 562,500 421,875 Round 4 421,875 316,406 Round 5 316,406 237,305 All others 949,219 711,914 Total 4,000,000 3,000,000 For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 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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**Means a Larger Multiplier**

A Higher MPC Means a Larger Multiplier Size of multiplier MPC .9 10.0 .8 5.0 .75 4.0 .66 3.0 .5 2.0 .33 1.5 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 formula: the simple multiplier 1 / (1 – mpc) or 1/mps **

The multiplier: the formula: the simple multiplier 1 / (1 – mpc) or 1/mps the full multiplier: 1 / mpw (mpw=mps+mrt+mpm) 6

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**Withdrawals net saving: the saving function net taxes: tax functions**

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 3

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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 7

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**Showing the multiplier effect on the 45o line and AD/AS diagrams**

Price Level AS AD1 O Output Spending AE1 O fig Y Ye1

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Price Level AS AD1 O Output AE2 Spending AE1 O fig Y Ye1 Ye2

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AD2 Price Level AD3 AS AD1 O Output AE2 Spending AE1 O fig Y Ye1 Ye2

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**Short-run Macroeconomic Equilibrium**

Simple Keynesian Analysis of Unemployment and Inflation

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The recessionary gap Spending AE O fig Ye YF Y

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The recessionary gap Spending AE a recessionary gap b O fig Ye YF Y

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The inflationary gap Spending AE e Inflationary gap f O Ye fig YF Y

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**The recessionary gap AE S I Spending Y a b recessionary gap c d O Ye**

fig Ye YF Y

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Copyright © 2008 Pearson Education Canada 6 - 1 Chapter 6 Determination of National Income.

Copyright © 2008 Pearson Education Canada 6 - 1 Chapter 6 Determination of National Income.

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