A Simple Model of Income Determination

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Presentation transcript:

A Simple Model of Income Determination

The most influential economist of all times

A Simple Model of Income Determination This module gives a first introduction to macroeconomic models The model is way too simple to be of much practical use, but still some of the most important topics are introduced In constructing models, which variables do we include and what is the relationship between them exogenous variables endogenous variables

Important assumptions There is excess capacity (unemployment) in the economy The price level is fixed Technology is given Investments only affect demand, not supply Aggregate demand determine the equilibrium level of income Firms will supply whatever is demanded without raising prices This is a short term model

Closed economy, no public sector We only have two sectors in the economy, households and firms. The only demand is therefore consumption and investment Y = C + I How do these affect each other, or what determine: Private consumption, C ? Private investment, I?

Keynes postulated that consumption demand depends on income Private consumption Keynes postulated that consumption demand depends on income Keynes consumption function C = a + bYd a = income independent consumption b = marginal propensity to consume = MPC C/ Yd C/Yd = average propensity to consume = APC (APC > MPC) Yd = disposable income

C = 10 + 0.8Yd

Keynes consumption function C = 100 + 0,8Yd Slope = C/ Yd = MPC = 0,8 100 Income (Yd)

Long-run and short-run consumption functions Y C10 years’ time C5 years’ time Cnow Consumption (£bn) Y (£bn)

UK consumption and saving Disposable income Consumer expenditure

Investments are exogenous 60 Income (Yd)

How do we find equilibrium values for the endogenous variables? Which values on Yd and C will ensure that Y = C + I ? Graphical solution Algebraic solution

The structural version of the model Algebraic solution The structural version of the model I = I C = a + bYd Y = C + I The model on reduced form:

Macroeconomic equilibrium

Equilibrium graphically Y=AD C + I C + I C 160 100 450 800 Income (Yd)

The multiplier Our model was: C = 100 + 0,8Yd Y = 800 What happens to Y if I increases by 10, i.e.  I = 10?

The multiplier C + I +I Y=AD C + I C + I C 170 I 160 100 Income (Yd) 450 Income (Yd) 800 850

The Model