National Income Determination For more, see any Macroeconomics text book

Determination of equilibrium Y and P Equilibrium output and prices are determined by aggregate demand (AD) & aggregate supply (AS) AD shows the combination of the price level and level of output at which the goods and money markets are simultaneously in equilibrium AS describes, for each given price level, the quantity of output firms are willing to supply AD-AS can be used to understand the policy options available a) to reduce unemployment, b) to smooth out output fluctuations, and c) to maintain stable prices 2

Classical System Vs. Keynesian System (Classical) Macroeconomic system is based on the writings of all the major economists before Keynes (1936) In this system, the equilibrium level of national income, Y, occurs at full employment level, given the flexibility of the wage rate – AS curve is vertical On the other hand, Keynes assumed unemployment and hence so what matters for equilibrium is AD curve – AS curve is horizontal 3

AD and AS In Keynes equilibrium national income/output is determined by aggregate demand But in classical system aggregate demand has got nothing to do with the determination of national income But we use both AS and AD to understand the equilibrium level of prices and output in the economy When a change shifts either AS or AD, we can determine how price and output shift 4

Aggregate Demand Aggregate demand is the total amount of goods demanded in the economy Following notations used: AD = Aggregate Demand Y = Output C = Consumption I = Investment G = Government purchases of goods and services E = Exports M = Imports NX = Net exports (Export – Import) S = Savings

Aggregate Demand… Output is at its equilibrium level when the quantity of output produced is equal to the quantity demanded That is, Y = AD = C + I + G + NX

Aggregate Demand… When Y ≠ AD, there is unplanned inventory investment (IU) or disinvestments That is, IU = Y – AD If IU > 0, firms cut back production If IU < 0, inventories are drawn down

Consumption Chief component of aggregate demand Refers to household spending For simplicity, set I, G, NX equal to 0

Consumption function It defines the relationship between consumption and income Consumption increases with income, that is, demand for consumption goods is not constant, it increases with income Consumption function is given as

Consumption function … Intercept C represents factors affecting consumption other than income – wealth such as ownership of assets c defines Slope of consumption curve Indicates the extent of rise in consumption with income Also known as marginal propensity to consume (MPC) MPC = ΔC/ΔY = c (0< c < 1) MPC is less than 1, indicating that for an unit increase in come, only a faction of it, c, is spent on consumption

Saving (S) Saving is that part of an individual’s income which is not spent In a simple economy Y = C + S = (1-c) Y = sY Where s = (1- c)

Saving Function Saving function relates the level of savings to the level of income This shows the magnitudes of saving at different levels of Y S = sY, where, 0 < s < 1 ‘s’ is called the marginal propensity to save (mps)

Saving Function Saving function, S = sY, shows that saving is an increasing function of the level of income because the mps (s = 1-c) is positive Saving increases as income rises At equilibrium level of income, saving equals planned investment.

Marginal propensity to save (MPS) MPS is the increase in savings per unit increase in income MPS = ΔS/ΔY = s (0< s < 1) This implies that saving is an increasing function of Y but the increase in s is less than that in Y

Relation between MPC & MPS MPC + MPS = 1 Y = C + S Δ Y = Δ C + Δ S 1 = Δ C / Δ Y + Δ S / Δ Y 1 = MPC + MPS

Average Propensity to Consume (APC) & Average Propensity to Save (APS) APC = C/Y APS = S/Y Y = C+ S 1 = C/Y + S/Y 1= APC + APS

Question Savings function of an economy is S = – Yd. If saving is Rs. 500, the consumption in the economy is Rs. 2700/- Rs. 1500/- Rs. 1720/- Rs. 3000/- Rs. 2500/-

Autonomous Spending Autonomous variables – Determined outside the model / system – In the present context, they are assumed to be independent of income In equation AD = C + I + G + NX I, G, NX were autonomous variables Now introduce G in the mode, and hence there is taxes TA and transfer payment TR

Autonomous Spending … In the new situation, consumption depends on disposable income, YD Recall AD = C + I + G + NX

Autonomous Spending … In the new situation, after substituting for C,

Autonomous Spending … That means, – Part of aggregate demand is independent of the level of income or Autonomous – AD also depends on the level of income Y. It increases with income because of c What follows? – The new equilibrium is where the level of output and income, planned spending matches production – That is where Y = AD The economy will reach equilibrium by adjusting production (Recall IU = Y- AD)

Autonomous Spending … Equilibrium level of output is higher, the larger c and A How is equilibrium achieved? Equilibrium in goods market is given by Y = AD And therefore, new equilibrium condition is

Autonomous Spending … Y is on both sides, collecting terms and solving for equilibrium level of output or income, denoted by Yo Implies Level of output is a function of c, and autonomous spending, A Higher A, given the MPC, higher is Yo

Question How change in some component of A will change output For instance, If mpc = 0.9 and autonomous spending is Rs. 1000, what will be the Y? How did it happen?

Multiplier Mechanism known as multiplier Multiplier is the amount by which equilibrium output changes when autonomous aggregate demand increases by 1 unit

Multiplier …. In the equation, 1/ (1-c) is the multiplier Implies that – Cumulative change in aggregate spending is equal to a multiple of the increase in autonomous spending – That is we are talking about change in equilibrium output when autonomous demand increases by 1 unit

Government Sector Popular expectation is: Govt should do something if anything goes wrong with the economy. Why such expectations are formed? Govt affects level of equilibrium income – Govt purchases of goods and services (G) – Transfers (TR) and taxes (TA) affect the relation between output and income Y, and the disposable income (income available for consumption and savings) YD

Government Sector … YD is the net income available for household spending

Government Sector … Fiscal policy – Policy of the government with regard to the level of government purchases, the level of transfers and the tax structure Assume : – G and TR are constant – Govt imposes a proportional income tax, collecting a fraction, t, of income in the form of taxes, that is, TA = tY

Government Sector … Consumption function now can be rewritten as

Government Sector … In the above equation: – Presence of transfers raises autonomous consumption spending by the mpc – Income tax lowers consumption spending at each level of income – Mpc out of income now is c(1-t) Ex: if mpc is.67; t =.3; what is the mpc out of income

Government Sector … Combining the aggregate demand identity with the above equations:

Government Sector … Determination of income :

Government Sector … We can solve the above equation for Yo, the equilibrium level of income

Government Sector … Implications for fiscal policy: – Fiscal policy can be used to stabilize the economy – When the economy is in a recession, or growing slowly, taxes should be cut increase the government spending – When the economy is booming, increase taxes and reduce government spending

Investment (I) Gross private domestic investment Associated with business sectors adding to the physical stock of capital, including inventories It is gross in the sense that depreciation is not deducted It is domestic in the sense that this is investment spending by domestic residents & not spending on goods produced within the country Investment may be assumed to be autonomous to be independent or dependent on the level of income (Y)

Investment function In particular, (b> 0) the parameter ‘b’ the component depending on income, which is called marginal propensity to investment

Investment Part of investment is independent of income Part is dependent on income, that is, bY

External Sector Exports are independent of income Imports dependent on income, that is, mY