Lecture 1: Simple Keynesian Model National Income Determination Two-Sector National Income Model

Outline Introduction Preliminaries definitions and concepts National Income Determination Model OR Simple Keynesian Model Consumption Function Investment Function National Income Identities Expenditure Function Equilibrium condition

Macroeconomics Recall that the study of macroeconomics focuses on a set of issues and goals: National income, general price level and inflation rate, unemployment rate, interest rate and the exchange rate

Macroeconomics What is GDP? Rising long term trend in GDP ensures continuous growth However, short term characterized by oscillations. Why does GDP behave as it does? Rising in some periods and falling in others? What can governments do to influence it? To answer, we need a theory of national income i.e. a theory that explains the size of and changes in national income

Key Concepts Expenditure flows Expenditure flows are real (not nominal) flows i.e. measured in constant prices because we are concerned with real changes All expenditure flows are planned (or desired) flows i.e. what people intend to spend, and not what they actually spend All expenditure flows are aggregate flows We are not concerned with the behaviour of individual households or firms

Basic Assumptions Potential national income is constant An economy’s productive capacity changes slowly from year to year There are unemployed supplies of all factors of production i.e. output can be increased by increasing use of unemployed land, labour or capital, without bidding up prices The interest rate and general price level are constant Assumption relaxed in later studies There are only households and firms (2-sector). No government and foreign trade

Recap: Circular Flow Model Underlying assumptions? Only two economic units and only two markets Households own all factors of production Households spend all their resources in the market for goods and services

The Circular Flow of Income This refers to the flow of expenditures on output and factor services passing between domestic firms and households Any other flow that is not a part of this model is either an injection or a withdrawal/ leakage Injection Income received, either by households or firms, that does not arise from the spending of the other group Withdrawal Income received, either by households or firms, that is not passed on to the other group by buying goods or services from it

The Circular Flow of Income Only domestic households and firms Economy produces only 2 kinds of commodities Consumer goods- produced by firms and sold to households Investment goods- produced by firms and sold to other firms that use them

The Basic Model: The Effects of Savings and Investments Households receive income from firms and pass back through consumption expenditure Savings is income received by households that they do not pass back Savings an injection or withdrawal? Exerts a contractionary force on the flow of income Investments expenditure creates incomes for the firms that produce capital goods and for the factors they employ This income does not arise from household expenditures Investment expenditures injection into the economy or a withdrawal? Exerts an expansionary force on the flow of income

Definitions Given assumptions, total output wholly dependent on total demand Not supply since we assume unemployed factors Total demand comprises Desired consumption expenditure, C Desired investment expenditure, I Aggregate desired expenditure refers to total amount of purchases that all spending units (firms and households) within the economy wish to make i.e. E= C + I

Behavioural Assumptions about C and I Autonomous vs Induced expenditures Autonomous/ exogenous- expenditure flows that are not influenced by any variable the theory is designed to explain Theory explains variations in national income so any expenditure that does not vary with national income is exogenous Also called constants. Can change, but not for reasons explained by the national income theory

Behavioural Assumptions about C and I Autonomous vs Induced expenditures Induced/ endogenous expenditures- any expenditure that is related to national income Variations in these expenditure flows are induced by changes in national income

Behavioural Assumptions about C and I The Investment, I, component For now, we assume investment fixed Firms plan to spend a constant amount on plants and equipment each year Firms plan to hold their inventories constant Planned housing construction is constant from year to year Investment is therefore an autonomous/ exogenous expenditure flow i.e. I= I* Graphical Illustration

Investment Function: Graphical Illustration Investment expenditure I = I* Real National Income

Behavioural Assumptions about C and I The Consumption, C, component Consumption is a function of national income We assume that consumption is always a constant fraction of national income i.e. C= cY, 0<c<1 Where c is the fraction of income spent on consumption Households also decide how much of their income to consume and save i.e. S= sY, 0<s<1 and s= 1-c Where s is the fraction of income saved Graphical Illustration of consumption function

Consumption Function: Graphical Illustration Consumption expenditure Consumption expenditure C = C’ C = cY Real National Income Real National Income

Consumption Functions We know that C= cY What happens if c  ? What happens if Y  ? But what exactly is c?

Propensities to Consume and Save Consumption propensities summarize the relationship between consumption and income

Consumption Function Marginal Propensity to Consume MPC = c It is defined as the change in consumption per unit change in income It is the proportion of each new increment of income that is spent on consumption C= cY MPC = C / Y Average Propensity to Consume APC= c It is defined as the ratio of total consumption C to total income Y It is the average amount of all income spent on consumption APC = C / Y

Consumption Function Relationship between APC and MPC C = cY Divide by Y to obtain APC C/Y = c Differentiate by Y to obtain MPC C / Y = c Therefore, when C= cY, APC = MPC = c

National Income Identities An identity is true for all values of the variables In a 2-sector economy, expenditure consists of spending either on consumption goods C OR investment goods I. Aggregate expenditure (AE OR E) is ,by definition, equal to C plus I E  C + I

National Income Identities National income Y received by households, by definition, is either saved S OR consumed C. Y  C + S

National Income Identities In equilibrium, aggregate expenditure E is, by definition, equal to national income Y Y  E (output- expenditure approach) C + S  C + I  S  I (withdrawals- injections approach)

Equilibrium Income Equilibrium is a state in which there is no internal tendency to change. It happens when firms and households are just willing to purchase everything produced Y = E (v.s. Micro: Qs = Qd) This is the Income-Expenditure Approach planned saving is equal to planned investment S = I This is the Injection-Withdrawal Approach

Equilibrium Income Y > E  Excess supply planned output > planned expenditure  unexpected accumulation of stocks OR unintended inventory investment OR involuntary increase in inventories Firms will reduce output

Equilibrium Income Y < E  Excess Demand Firms will increase output planned output < planned expenditure  unexpected fall in stocks OR unintended inventory dis-investment OR involuntary decrease in inventories Firms will increase output

Equilibrium Income Y= E  Equilibrium There is no unintended inventory investment OR dis-investment Y=E

Equilibrium Income: Summary When there is excess supply, i.e., planned output > planned expenditure, firms will reduce output to restore equilibrium When there is excess demand, i.e., planned expenditure > planned output, firms will increase output to restore equilibrium

Aggregate Expenditure Function Aggregate expenditure is comprised of consumption, C, and Investment, I i.e. E = C + I Using functional forms, C = cY and I = I*  E = I* + cY Graphical representation

Aggregate Expenditure Function: Graphical Illustration Slope of tangent = c C, I, E I C Slope of tangent=0 Y I = I* C = cY E = I* + cY

Readings Lipsey and Chrystal Pp: 467- 480

Next Class Output-Expenditure Approach to Income Determination Expenditure Multiplier Saving Function Injection-Withdrawal Approach to Income Determination Paradox of Thrift