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NATIONAL INCOME EQUILIBRIUM
CHAPTER 12
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NATIONAL INCOME EQUILIBRIUM
TWO APPROACHES TO DETERMINE EQUILIBRIUM:
1. AGGREGATE DEMAND – AGGREGATE SUPPLY APPROACH (AD = AS)• Aggregate demand or aggregate expenditure is the total demand
for goods and services in the economy. • There are four components in aggregate demand namely
consumption, investment, government sector and foreign sector (net exports).
• Aggregate supply or aggregate output is the total quantity of goods and services produced in an economy in a given period of time.
• Equilibrium occurs when AD = AS
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TWO APPROACHES TO DETERMINE EQUILIBRIUM:
2. LEAKAGE – INJECTION APPROACH Leakage is a withdrawal from the income – expenditure stream.
Leakages include savings, taxes and imports.
Injection is an addition of spending to the income-expenditure stream.
Injections include investment, government expenditures and exports.
Equilibrium occurs when leakages are equal to injections.
NATIONAL INCOME EQUILIBRIUM (cont.)
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CONCEPT OF CONSUMPTION
CONSUMPTION THEORY Consumption refers to the purchase of goods and services by
individuals or households that are produced by firms. Income (Y) is divided into two parts, consumption (C) and savings (S).
Y = C + S
CONSUMPTION AND SAVING
AVERAGE PROPENSITY TO CONSUME (APC)APC is the ratio of total consumption to total income.
APC = TOTAL CONSUMPTION = C
TOTAL INCOME Y MARGINAL PROPENSITY TO CONSUME (MPC)
MPC is the ratio of change in total consumption to change in total income. MPC = TOTAL CONSUMPTION = C
TOTAL INCOME Y
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C = a + b Y d
CONSUMPTION FUNCTION• Consumption function refers to the relationship
between consumption level and income level. • The general equation for a linear consumption function
can be written as below:
CONSUMPTION AND SAVING (cont.)
Consumption expenditure
Autonomous consumption
MPC
Disposable income
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CONCEPT OF SAVING
SAVING THEORY
• Saving is divided into autonomous saving and induced savings.
• Autonomous saving refers to the part of savings that does not depend on the level of income and occurs when there is autonomous consumption.
CONSUMPTION AND SAVING (cont.)
AVERAGE PROPENSITY TO SAVE (APS)
APS is the ratio of total saving to total income.
APS = TOTAL SAVING = S
TOTAL INCOME Y
MARGINAL PROPENSITY TO SAVE (MPS)
MPC is the ratio of change in total consumption to
change in total income.
MPS = TOTAL SAVING = S
TOTAL INCOME Y
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CONSUMPTION AND SAVING SCHEDULE Table below shows some relationship between consumption and savings. The sum of APC and APS must be equal to 1.
APC + APS = 1 The sum of MPC and MPS must also equal to one. The equation is as below MPC + MPS = 1
Disposable Income
(Yd)
Consumption (C)
Saving(S)
APC (C/ Yd)
APS (S/ Yd)
MPC (C/ Yd)
MPS (S/ Yd)
0 50 -50 - - - -100 125 -25 1.25 -0.25 0.75 0.25200 200 0 1.00 0 0.75 0.25300 275 25 0.92 0.08 0.75 0.25400 350 50 0.88 0.12 0.75 0.25500 425 75 0.85 0.15 0.75 0.25
APC = 125/100 = 1.25APC = 125/100 = 1.25APS= 25/300 =0.08APS= 25/300 =0.08
MPC= (200 -125)/(200-100) =0.75
MPC= (200 -125)/(200-100) =0.75
MPS= (50 -25)/(400-300) =0.25
MPS= (50 -25)/(400-300) =0.25
CONSUMPTION AND SAVING (cont.)
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SAVING FUNCTION Saving function refers to the relationship between savings and
income level. The general equation for a linear consumption function can be
written as below.
S = -a + (1- b) Yd
DERIVE SAVING FUNCTION FROM CONSUMPTION FUNCTION
Given the consumption function: C = 100 + 0.65Yd
Saving function : S = -100 + 0.35Yd
SavingAutonomous saving
MPS
Disposable income
CONSUMPTION AND SAVING (cont.)
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Break-even income is the level at which households consume all their incomes. At the point of break-even,
(i) Y = C (ii) S = 0 (iii) APC = 1 (iv) APS = 0
C
Saving schedule is vertical difference between the Consumption schedule and the 45 degree line.
National Income
C = 100 + 0.65Yd
Y=C
a=100
200O
S = -100 + 0.35Yd
S
National Income
-100 200
Each point on the 45 degree line indicates a point
where disposable income equals to consumption.
CONSUMPTION AND SAVING (cont.)
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Consumer credit
Rate of interest
Distribution of wealth
Price and wage levels
Changes in consumers’
taste and fashion
Change in expectations
CONSUMPTION AND SAVING (cont.)
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INVESTMENT
Investment refers to the spending on purchases and accumulation of capital goods such as buildings, equipments and addition to inventories.
There are two types of investment:
1. Autonomous InvestmentAutonomous investment is fixed and independent of
income. The amount of investment can be influenced by other
factors such as interest rate, repayment rate, business expectation and technology developments.
Example of autonomous investment is the capital depreciation.
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2. Induced InvestmentInduced investment depends on the national income. As national income increases, the induced investment will
also increase since higher national income attracts more investors to invest.
INVESTMENT (cont.)
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Expectation of the future Technological
Changes
Rate of interest Rate of return
Government Policies
INVESTMENT (cont.)
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GOVERNMENT SECTOR
Government sector is another sector that has a major impact on the economy because of its expenditure.
Government spending can be classified into two categories, purchases of goods and services and transfer payment.
National income can be increased through government spending (as we discussed on the expenditure approach).
Government spending is an injection into the spending stream.
Government also can reduce the national income through imposing taxes.
There are various tax imposed by the government such as direct taxes and indirect taxes.
Taxes are leakages from the spending stream.
15PRINCIPLE OF ECONOMICS
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FOREIGN SECTOR
Exports are goods and services that are sold to foreign countries.
For example, Malaysian made DVD player is sold to Thailand. Exports increase the national income and therefore export is
an injection into the spending stream.Imports are goods and services that are purchased from
foreign countries. For example, Malaysia buys cars from Germany. Imports reduce the national income and an import is a leakage
from the spending stream.Net export is the difference between exports and imports. If net export is positive, exports are greater than imports and if
net export is negative, exports are less than imports.
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EQUILIBRIUM IN TWO SECTOR ECONOMY
Equilibrium in a two-sector economy is a simple economy, which consists of 2 agents only, namely households and firms.
Equilibrium occurs when the AD = AS or Leakage = Injection.
17
FIRMHOUSEHOLD
Y = rent, wages, profit, interest
(1)Saving (S)
(2)Investment (I)
Consumption (C)
Factor Market
Financial Market
Product Market
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Equilibrium is achieved when aggregate demand is equal to aggregate supply.
AS = AD
Y = C + I
Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500
Solution
Consumption function, C = 100 + 0.7Yd (In two sector economy, Yd = Y since no tax)
Y = C + I
= 100 + 0.7Y + 500
Y – 0.7Y = 600
0.3Y = 600
Y = 600/0.3
Y = 2000 EQUILIBRIUM INCOME
AD –AS APPROACH
Algebra Analysis
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
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Equilibrium is achieved when aggregate demand is equal to aggregate supply.
AS = AD
Y = C + I
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
AD–AS APPROACH
Graphic Analysis
National Income
C = 100 + 0.7Yd
Y=AD
a=100
2000
AD (C,I) C +I
I=500
The equilibrium occurs when the consumption and 45 degree line intersects at RM2000
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Equilibrium is achieved when leakage is equal to injection.
Injection = Leakage
I = S
Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500
Solution:
Consumption function, C = 100 + 0.7Yd , so saving function is S = -100 + 0.3Yd
I = S
500 = -100 + 0.3Y
0.3Y = 600
Y = 600/0.3
Y = 2000 EQUILIBRIUM INCOME
LEAKAGE - INJECTION APPROACH
Algebra Analysis
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
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Equilibrium is achieved when leakage is equal to injection.
Injection = Leakage
I = SGraphic Analysis
National Income
S = -100 + 0.3Yd
a=100
2000
Leakage-Injection
I=500
The equilibrium occurs when the saving function and investment function intersect at RM2000.
LEAKAGE - INJECTION APPROACH
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
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• The equilibrium is achieved when AD = AS or I = S • When both the AS and AD is same at one level, this is called as
equilibrium income.
AS = AD and I =SAS = AD and I =S
Tabular Analysis
Aggregate Supply
(Y)
Consumption (C)
Saving(S)
Investment(I)
Aggregate Demand (C + I)
Tendency of employment, output and
income0 100 -100 500 600 Increase
1000 800 200 500 1400 Increase1500 1150 350 500 1650 Increase2000 1500 500 500 2000 EQUILIBRIUM2500 1850 650 500 2350 Decrease 3000 2200 800 500 2700 Decrease
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
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EQUILIBRIUM IN THREE SECTOR ECONOMY
Equilibrium in a three-sector economy consists households, firms and government.
Equilibrium occurs when the AD = AS or Leakage = Injection.
FIRMHOUSEHOLD
Y = rent, wages, profit, interest
(1)Savings (S)
(2)Investment (I)
Consumption (C)
GOVERNMENT
Taxes (T) Taxes (T)
Transfer Payment (G)
Government Expenditure (G)
Product Market
Financial Market
Factor Market
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Equilibrium is achieved when aggregate demand is equal to aggregate supply.
AS = AD Y = C + I + G
In three-sector economy, we need to focus on two types of taxes.
1. Autonomous Taxes Autonomous taxes refer to the amount of tax that is independent
of income. If the income increases or decreases, autonomous taxes remain
constant. For example, Tax = RM100
AD –AS APPROACH
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
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2. Induced Taxes Induced taxes refer to the amount of tax that depends on
income. If income increases, induced tax will increase and vice
versa. For example, Tax = 0.6Y
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
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Equilibrium using autonomous tax
Given the following information: C = 200 + 0.75Yd ; I = 100; G = 50; T = 100
Solution
Y = C + I + G
= 200 + 0.75Yd + 100 + 50
= 350 + 0.75(Y –T)
= 350 + 0.75(Y – 100)
Y – 0.75Y = 275
0.25Y = 275
Y = 275/0.25
Y = 1100
AD –AS APPROACH
Algebra Analysis
Equilibrium using induced tax
Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y
Solution
Y = C + I + G
= 200 + 0.75Yd + 100 + 50
= 350 + 0.75(Y –T)
= 350 + 0.75(Y – 0.2Y)
= 350 + 0.75(0.8Y)
= 350 + 0.6Y
Y – 0.6Y = 350
0.4Y = 350
Y = 350/0.4
Y = 875
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
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AD –AS APPROACH
Graphic Analysis
The equilibrium occurs when AD curve and 45 degree line intersects at RM1100.
C = 200 + 0.75Yd
(BEFORE TAX)
AD (C,I,G)
National Income
C = 175 + 0.75Y(AFTER TAX)
Y=AD
175
1100
C +I + G
200
325
AD (C,I,G)
National Income
C = 200 + 06Y(AFTER TAX)
Y=AD
875
C +I + G
200
350
C = 200 + 0.75Yd
(BEFORE TAX)
The equilibrium occurs when AD curve and 45 degree line intersects at RM875.
Equilibrium using autonomous tax Equilibrium using induced tax
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
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Equilibrium using autonomous tax
Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 100
Solution
I + G = S + T
100 + 50 = -200 + 0.25Yd + 100
150 = -100 + 0.25(Y – T)
150 = -100 + 0.25(Y – 100)
150 = -125 + 0.25Y
0.25Y = 275
Y = 1100
LEAKAGE – INJECTION APPROACH
Algebra Analysis
Equilibrium using induced tax
Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y
Solution I + G = S + T100 + 50 = - 200+ 0.25Yd + 0.2Y150 = - 200 + 0.25(Y – 0.2Y) + 0.2Y150 = -200 + 0.25(0.8Y) + 0.2Y150 = -200 + 0.2Y + 0.2Y0.4Y = 350 Y = 875
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
Equilibrium is achieved when leakages are equal to injectionsInjection = LeakageI + G = S + T
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EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
LEAKAGE – INJECTION APPROACH
Graphic Analysis
The equilibrium occurs when I+G schedule Intersects with S+T at RM1100.
The equilibrium occurs when I+G schedule Intersects with S+T at RM875.
Equilibrium using autonomous tax Equilibrium using induced tax
S +T = -225 + 0.25Y(AFTER TAX)
S = -200 + 0.25Yd
(BEFORE TAX)
Leakages/Injections
National Income
-225
1100
I +G
-200
150
Leakages/Injections
-200
150
S = -200 + 0.25Yd
(BEFORE TAX)
National Income
S +T = -200 + 0.2Y(AFTER TAX)
875
I +G
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Aggregate Supply
(Y)
Taxes (T)
Disposable Income (Yd)(Yd = Y-T)
Consumption (C)
(C = 200+0.75Yd)
Saving(S)
Investment(I)
Government Expenditure
(G)
Aggregate Demand (C+ I+G)
Tendency of employment, output and
income
100 100 0 200 -200 100 50 350 Increase
300 100 200 350 -150 100 50 500 Increase
600 100 500 575 -75 100 50 725 Increase
900 100 800 800 0 100 50 950 Increase
1100 100 1000 950 50 100 50 1100 EQUILIBRIUM
1300 100 1200 1100 100 100 50 1250 Decrease
1500 100 1400 1250 250 100 50 1400 Decrease
The equilibrium is achieved when AD = AS or I + G = S + T When both the AS and AD is same at one level, this is called as equilibrium income.
EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)
AS = AD and I+G =S+T
AS = AD and I+G =S+T
Tabular Analysis
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EQUILIBRIUM IN FOUR SECTOR ECONOMY
Equilibrium in a three-sector economy consists households, firms, government and foreign sector.
Equilibrium occurs when the AD = AS or Leakage = Injection.
HOUSEHOLD
Y = rent, wages, profit, interest
(1)Savings (S)
(2)Investment (I)
Consumption (C)
GOVERNMENT
Taxes (T) Taxes (T)
Transfer Payment (G)
Govt Expenditure (G)
Foreign Sector
Import (M)
Export (X)
Product Market
Financial Market
Factor Market
FIRM
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Equilibrium is achieved when aggregate demand is equal to aggregate supply.
AS = AD
Y = C + I + G + (X-M)
Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50
Solution
Y = C + I + G + (X – M)
= 200 + 0.75(Y – T) + 100 + 50 + (100 – 50)
= 400 + 0.75 (Y –100)
= 400 + 0.75Y – 75
Y – 0.75Y = 325
0.25Y = 325
Y = 325/0.25
Y = 1300 EQUILIBRIUM INCOME
AD–AS APPROACH
Algebra Analysis
EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)
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Equilibrium is achieved when aggregate demand is equal to aggregate supply.
AS = AD
Y = C + I + G + (X- M)
EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)
AD–AS APPROACH
Graphic Analysis
National Income
Y=AD
325
1300
AD (C,I)
C +I+G + (X-M)
The equilibrium occurs when the aggregate demand (C+I+G+(X-M)) and 45 degreeline intersects at RM1300.
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Equilibrium is achieved when leakage is equal to injection.
Injection = Leakage
I + G+ X = S + T+ M
Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50
Solution
I + G+ X = S + T + M
100 + 50 + 100 = -200 + 0.25(Y-100) + 100 + 50
250 = -75 + 0.25Y
0.25Y = 325
Y = 1300 EQUILIBRIUM INCOME
LEAKAGE-INJECTION APPROACH
Algebra Analysis
EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)
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Equilibrium is achieved when leakage is equal to injection.
Injection = Leakage
I+G+X = S +T+M
EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)
Graphic Analysis
The equilibrium occurs when the I+G+X scheduleand S+T+M schedule intersect at RM1300.
LEAKAGE-INJECTION APPROACH
I+G+X
Leakage-Injection
National Income
S +T+M
-75
1300
250
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Aggregate
Supply
(Y)
Taxes
(T)
Disposable
Income
(Yd)
Consumption
(C)
Saving
(S)
Investment
(I)
Government
Expenditure
(G)
Exports
(X)
Imports
(M)
Aggregate
Demand
(C+ I+G+
[X – M])
Tendency of
employment,
output and
income
100 100 0 200 -200 100 50 100 50 400 Increase
300 100 200 350 -150 100 50 100 50 550 Increase
600 100 500 575 -75 100 50 100 50 775 Increase
900 100 800 800 0 100 50 100 50 1000 Increase
1100 100 1000 950 50 100 50 100 50 1150 Increase
1300 100 1200 1100 100 100 50 100 50 1300 EQUILIBRIUM
1500 100 1400 1250 250 100 50 100 50 1450 Decrease
The equilibrium is achieved when AD = AS or I + G + X = S + T + M When both the AS and AD is same at one level, this is called as equilibrium
income.
EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)
AS = AD and I+G+X =S+T+M
AS = AD and I+G+X =S+T+M
Tabular Analysis
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The multiplier is the ratio of the change in income to the change in AD.
Multiplier shows how many times the effect of an initial change in AD is multiplied by causing changes in consumption and finally in the aggregate income.
The formula for multiplier (K) is,
K = Change in Income (Y)
Change in Aggregate Demand (AD)The size of multiplier depends upon the size of the marginal
propensity to consume (MPC). Higher the MPC, higher is the size of the multiplier and lower the
MPC, lower shall be the size of multiplier.
K = 1
1 - MPC
MULTIPLIER CONCEPT
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Investment multiplier refers to the ratio of the change in the equilibrium income to a change in investment. The formula for investment multiplier (Ki) is,
Ki = Change in Income (Y)
Change in Investment (I) Investment multiplier can also derived as follows: Investment Multiplier (Ki) = 1 = 1
1-MPC MPS
Given, C = 200 + 0.75Y and I = 100. What is the equilibrium income level when there is an increase in investment by 50 million?
Solutions:
Y = Ki x I New equilibrium income level = Y + Y
= 1/(1-MPC) x I = 1100 + 200
= 1 /(1-0.75) x 50 = 1300 m
Y = 200 million
MULTIPLIER CONCEPT
INVESTMENT MULTIPLIER
Example
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The government expenditure multiplier refers to the ratio of the change in the equilibrium income to a change in government expenditure assuming there is no change in taxes.
Kg = Change in Income (Y)
Change in Government Expenditure (G) Government expenditure multiplier can also derived as follows:
Government Expenditure Multiplier (Kg) = 1 = 1
1-MPC MPS
Given, C = 200 + 0.75Y; I = 100 and G = 50. What is the equilibrium income level when there is an increase in government spending by 50 million?
Solutions:
Y = Kg x G New equilibrium income level = Y + Y
= 1/(1-MPC) x G = 1100 + 400
= 1 /(1-0.75) x 100 = 1500 m
Y = 400 million
MULTIPLIER CONCEPT (cont.)
GOVERNMENT EXPENDITURE MULTIPLIER
Example
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Tax multiplier refers to the ratio of the change in the equilibrium income to a change in taxes assuming there is no change in government expenditure.
Kt = Change in Income (Y)
Change in Taxes (T) Tax multiplier can also derived as follows:
Tax Multiplier (Kt) = - MPC
MPS
Given, C = 200 + 0.75Y; I = 100; G = 50 and T = 100. What is the equilibrium income level when there is a tax cut of 50 million?
Solutions:
Y = Kt x T New equilibrium income level = Y + Y
= -MPC/(MPS) x T = 1100 + 150
= -0.75/(0.25) x 50 = 1250 m
Y = 150 million
TAX MULTIPLIER
Example
MULTIPLIER CONCEPT (cont.)
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Balanced budget multiplier refers to the change in the equilibrium income by the same amount as the changes in taxes and government expenditure.
Kb = 1
Given, C = 200 + 0.75Y; I = 100; G = 50 and T =100. What is the equilibrium income level when there is an increase in government spending and taxes by 50 million?
Solutions:
Tax multiplier
Y = Kt x T Net increase in income, Y = -150+200
= -MPC/MPS x T = 50 million
= -0.75 /0.25 x 50
Y = -150 million
Government Expenditure multiplier
Y = Kg x G New equilibrium income level = Y + Y
= 1/(1-MPC) x G = 1100 + 50
= 1/(1-0.75) x 50 = 1150 m
Y = 200 million
BALANCE BUDGET MULTIPLIER
Example
MULTIPLIER CONCEPT (cont.)
All Rights Reserved
Ch. 12: 42
Principles of Economics second edition
© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Inflationary gap occurs when national income exceeds the full employment level. Inflationary gap can be caused by the increase in aggregate expenditure. The inflationary gap is measured as the excess of the aggregate expenditure over the full
employment aggregate supply, Yfe.
INFLATIONARY GAP
Inflationary GapY fe < Y
Inflationary GapY fe < Y
C+I+G +(X-M)
National Income
Y=AD
A
Yfe
Aggregate Demand
C+I+G +(X-M)fe
Y0
BThe inflationary gap of AB will increase
the general price level.
To reduce the inflationary gap of AB, contractionary policy can be implemented. Government can practice contractionary fiscal policy through reducing government expenditure and raise taxes.
All Rights Reserved
Ch. 12: 43
Principles of Economics second edition
© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Deinflationary gap occurs when national income below the full employment level. The deflationary gap is measured as the difference between the aggregate expenditure
over the full employment aggregate supply, Yfe.
DEFLATIONARY GAP
Deflationary GapYfe > Y
Deflationary GapYfe > Y
C +I+G + (X-M)
National Income
Y=AD
C
Yfe
Aggregate DemandC+I+G+(X-M)fe
Y0
D
To reduce the deflationary gap of CD, expansionary policy can be implemented. Government can practice expansionary fiscal policy through
increase in government expenditure and tax cut.