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DETERMINATION OF NATIONAL INCOME in the Keynesian Model At Equilibrium national income: – withdrawals equal injections – income equals expenditure A simplified circular flow of income model J=I+G+X Cd Incomes fig W=S+T+M Consumption • Determinants of consumption – Disposable income – wealth, interest rates, taxation policy, consumer indebtedness, future expectations Consumption Function C’ C Consumption Spending C2 An increase in wealth, and improvement in expectations, will shift the consumption function upward. B′ A′ An increase in income from Y1 to Y2, leads to an increase in consumption from C1 to C2. Hence the economy moves from point B on the consumption function to point B′. B C1 A 45o Y1 Y2 Income Investment • Investment – Interest rate – net rate of profit – capital stocks – business taxes – technological innovations – future expectations – Assumptions: interest rates are fixed, hence investment is given at some level Investment Spending Investment Spending Interest rate (billions $) r I 50 I 50 Investment Demand (billions $) Income Graphical Analysis AE = C + I + G + Xn C+I Aggregate Expenditures (Spending) C G I 45o Y* Income The Multiplier • The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. • The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. • The size of the multiplier increases with the marginal propensity to consume (MPC). The Multiplier Principle Expenditure stage Additional income Additional consumption Marginal propensity to consume (dollars) (dollars) Round 1 Round 2 Round 3 Round 4 Round 5 All others 1,000,000 750,000 562,500 421,875 316,406 949,219 750,000 562,500 3/4 3/4 421,875 316,406 237,305 711,914 3/4 3/4 3/4 3/4 Total 4,000,000 3,000,000 3/4 For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. • The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4). A Higher MPC Means a Larger Multiplier MPC .9 .8 .75 .66 .5 .33 Size of multiplier 10.0 5.0 4.0 3.0 2.0 1.5 • As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). • The multiplier: • the formula: the simple multiplier 1 / (1 – mpc) or 1/mps • the full multiplier: 1 / mpw (mpw=mps+mrt+mpm) • Withdrawals – net saving: the saving function • the mps: marginal propensity to save • determinants of saving – net taxes: tax functions • the mrt: marginal rate of taxation – imports: import functions • the mpm: marginal propensity to import • effect of imports on Cd – the withdrawals function • MPS+MRT+MPM = MPW: marginal propensity to withdraw The Multiplier • In evaluating the importance of the multiplier, one should remember: – taxes and spending on imports will dampen the size of the multiplier; – it takes time for the multiplier to work; and, – the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes. DETERMINATION OF NATIONAL INCOME • Relationship between the 45° line diagram and the AD and AS diagram Showing the multiplier effect on the 45o line and AD/AS diagrams Price Level AS AD1 O Output Spending AE1 O fig Ye Y Price Level AS AD1 O Output AE2 Spending AE1 O fig Ye Ye2 Y Price Level AS AD2 AD1 O AD3 Output AE2 Spending AE1 O fig Ye Ye2 Y Short-run Macroeconomic Equilibrium Simple Keynesian Analysis of Unemployment and Inflation ending The recessionary gap AE O Ye figY F Y Spending The recessionary gap AE a b recessionary gap O Ye figY F Y Spending The inflationary gap AE e Inflationary gap O f Yfig F Ye Y Spending The recessionary gap AE a b recessionary gap S c d O Ye figY F I Y