1. A Simple Model of Income Determination

2. The most influential economist of all times

3. 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

4. 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

5. 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?

6. 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

7. C = Yd

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

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

10. UK consumption and saving
Disposable income
Consumer expenditure

11. Investments are exogenous60
Income (Yd)

12. 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

13. 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:

14. Macroeconomic equilibrium

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

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

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

18. The Model