# National Income

**Topics:**Macroeconomics, Keynesian economics, Consumption function

**Pages:**20 (2690 words)

**Published:**March 19, 2013

Introduction

• A key objective of Macroeconomics is to explain GDP growth and its fluctuations • Therefore, need to understand the forces that determine GDP (“National Income”)

• John Maynard Keynes in his “General Theory of Employment, Interest and Money” (1936) developed a model of income determination • Known as Keynesian Theory of Income Determination • Aggregate spending / demand determines the level of aggregate output

Concepts and Functions

Actual vs. Planned Expenditure

• Actual expenditures are expenditures actually incurred by the economic entities in the economy • Planned expenditures are expenditures intended to undertake by the economic entities • Macroeconomic equilibrium (as proposed by Keynes) occurs when the actual Aggregate Demand (expenditure) equals the planned Aggregate Demand (expenditure) • i.e., the planned (intended) AD should equal the actual level of output, which is the equilibrium level of output

Components of Aggregate Demand Two-sector Model

AD = C + I

Consumption Function (C)

• A functional statement of the relationship between disposable income (Y) and consumption expenditure (C)

C = f(Yd)

• Consumption is a positive linear function of income

C = a + bYd

Note: In a two-sector model Y = Yd. (Why?)

a is a positive constant, (a>0) showing the level of consumption at zero level of income, also known as autonomous consumption b represents the slope of the consumption function 0 excess demand (ED) If AD < Output => excess supply (ES)

Equilibrium Output

Desired AD > output spending

E

AD < output

AD = C + I

45o

Output, Income

Planned Investment = Planned Savings

Saving, Investment S = -a + (1-b)Y

-a

E

I

Income (Y)

Planned investment < planned saving i.e. households planned consumption is less than firms’ investment plans; firms build up stocks and/or reduce output

Planned investment > planned saving i.e. households planned consumption is greater than firms’ investment plans; firms deplete stocks and/or raise output

Equilibrium Output, Income

Desired spending

AD > output

AD = C + I

E

C = a + bY

AD < output

(a I )

a

0

S = -a + (1-b)Y E

45o

I

Output, Income

Planned investment < planned saving

-a

Planned investment > planned saving

Y*

Equilibrium level of Income, Output

Value of output should equal aggregate spending Planned savings should equal planned investment

Y CI

SI

Substituting in for S

substituting in for C

Y a bY I

and solving for Y

(a (1 b)Y ) I

and solving for Y

Y bY a I

a I Y

1 b

(1 b)Y a I (a I ) Y (1 b)

a I Y (1 b) (1 b)

Exercise 1

Suppose the household sector’s planned consumption is C = 50 + 0.80Y, and intended investment is Rs.50. (a) Derive an equation for the saving function? (b) What is the equilibrium level of income and aggregate consumption?

Aggregate Spending – The Multiplier

Effect of Changes in Autonomous

Changes in autonomous aggregate spending (a I ) causes parallel shifts of the consumption function

Thus, a change in investment demand leads to a shift in the aggregate demand schedule

Aggregate Spending – The Multiplier

A change in investment demand

Effect of Changes in Autonomous

Suppose there is an increase in the autonomous investment (I ) because firms become optimistic about future demand conditions for their products –

What happens to our analysis?

A change in Investment demand

Aggregate Demand E’ AD’ AD

I

E

45o

Y

Output, Income

A change in Investment demand

We know that

a I Y (1 b) (1 b)

If investment (I) changes, the effect on output is given by: Y 1 b = marginal propensity to consume (MPC) I (1 b) E.g. if investment were to change by one unit, and if the MPC=0.75, then Y 1 4 1 (1 0.75) Thus, a one unit change in...

References: 1. Chapters 6, 7, and 8, ‘Macroeconomics Theory and Policy’, by D.N. Dwivedi.

2. Chapter 9,‘Principles of Macroeconomics’, by William Boyes and Michael Melvin. 3. Chapter 3, ‘Macroeconomic Policy Environment’ by Shymal Roy.

Thank You

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