Econ109 Lec 2 Output Determination

Principles Of Macroeconomics ECON109
By
Dr. A. Makochekanwa
Deputy Dean Faculty of Social Studies
&
Senior Lecturer - Department of Economics
University of Zimbabwe
Lecture 2
2016 Created by: Dr. Makochekanwa 1

NATIONAL INCOME
DETERMINATION

National Income Determination
Looks at how the level of real GDP is
determined and how it fluctuates
around the level of potential GDP.
We consider two models of income
determination:
1. The Aggregate expenditure Model
(Keynesian Model).
2. The Aggregate Demand-Aggregate
Supply (AD-AS) Model.
Aggregate Expenditure Model
Put forward by John Maynard Keynes who
developed the idea that total production
/output (Y) is determined by total spending
(AE) in the economy.
3 possible relationships between Y and AE:
1. AE=Y equilibrium level of output and income.
2. AE>Y output increases to match spending.
3. AE<Y output falls to match spending.
This brings us to the concept of desired
aggregate expenditure.
Desired Aggregate Expenditure (AE)
Refers to the sum of desired or planned spending on domestic
output by the four economic agents.
AE is made up of the expenditure components: consumption (C),
investment (I), government expenditure (G), and net exports
(X M).
AE = C + I + G + (X M)
NB: National Income Accounts measure actual expenditures in
the above four categories whilst National Income Theory deals
with desired expenditures.
AE is divided into two components:
autonomous (does not change systematically with or depend
on national income); and
induced (systematically related/respond to changes in
2016 national income). Created by: Dr. Makochekanwa 5
The Two Sector Model
(Simple Keynesian Model)
Our analysis begins with a very simplified model with
only two of the four components mentioned above
consumption and investment i.e.
AE = C + I
These two determine the level of equilibrium output.
We assume a closed economy (no international trade),
no government, and a constant price level.
Wage rate and interest rate are given (exogenous).
Saving becomes the only withdrawal and investment
the only injection into the circular flow of income.
Consumption, Saving & Investment
Consumption spending (C) is household
expenditure on durable and non-durable
goods and services while saving (S) is
that part of disposable income not
consumed.
Saved income is the one that is borrowed
for investment spending (I).
Consumption, Saving and Investment
play central roles in an economy.
Consumption, Saving & Investment
Economies that save and invest more tend to
experience higher growth than those that
consume more.
Where consumption and investment spending
are high, aggregate demand increases raising
output and employment in the short run.
A drop in consumption leads to a drop in
aggregate expenditure leading to a recession
as investment falls.
Income (Y), Consumption (C) and Saving (S)
Personal income (Y) less taxes (T) gives
disposable income (Yd) that is (Y - T = YD).
But in our Two Sector Model, (Y = YD) since we
assume no govt hence no income tax.
Disposable income is either consumed or saved.
(YD = C + S).
Studies show that income is the primary
determinant of C and S.
C and S rise with disposable income hence there
is a positive relationship.
The Consumption Function
Relates total desired consumption
expenditures of all households to factors that
determine it, i.e., disposable income, wealth,
interest rates, and expectations about the
future.
In the simple case (this case) the consumption
function relates desired consumption
expenditure to disposable income.
The concept is based on the hypothesis that
there is a stable empirical relationship
between consumption and income (Keynes).
Consumption Function Characteristics
1. Consumption increases as income increases.

2. Consumption is positive even if income is
zero.
3. When income increases, consumption
increases but by a lesser percentage.
Y f C
Since the two are positively related, the c-
function is upward sloping on a graph.

C-function Contd
Consumption can be broken down into:
1. Autonomous consumption is the minimal amount
consumed by an individual at zero income (through
borrowing or dissaving).
2. Induced consumption is the one that varies with
disposable income (the higher the income, the higher
the amount consumed).
The consumption function can be represented by
the following equation:
C = a + bYD
a represents autonomous and bYD represents
induced consumption expenditure
Consumption-Function
Consumption C C 2 C1 C
Slope = = = b
Y 2 Y1 Y
Desired
C = a + bYD
C2
C Induced
C1 Consumption
a
Autonomous
Y Consumption
45
Y1 Y2 Disposable
Income YD
C-Function & The 45 Line
The 45 line helps us to quickly see whether
consumption expenditure is equal to (break-even
point), greater or less than disposable income.
It is constructed by connecting all points where
desired consumption (vertical axis) is equal to
disposable income (horizontal axis).
NB: Both axis have the same scale.
At the break-even point:
C = YD
C-function & the 45 0 Line
C = YD
Desired Consumption C
C = a + bYD
Dissaving ( Yd < C)
Saving ( Yd > C)
45
Disposable Income YD
The 45 Line Contd
At any point on the 45 line, C = YD
and S = 0
If the C-function lies above 45
line, ( YD < C) household is
dissaving.
If C-function lies below the 45
line, ( YD > C) household is saving.
Average Propensity to Consume (APC)
The average propensity to consume (APC) is

the proportion of YD that is committed to
consumption.
APC = C/YD
APC falls as disposable income increases.
At break-even APC = 1 (unity).
Below break-even APC > 1 (dissaving).
Above break-even APC < 1 (saving).
Marginal Propensity to Consume (MPC)
The marginal propensity to consume (MPC) is
the amount of extra consumption generated by
an extra dollar of disposable income and is given
by the formula:
MPC = C/YD = b
The MPC gives the slope of the C-function and
1 > MPC > 0 for all levels of income.
For every $1 of income, less than $1 is spent on
consumption and the rest is saved.
The Saving Function
Saving is all the disposable income that is
not spent on consumption, that is:
S = YD C
= YD (a + bYD)
= YD a + bYD
= a + (1 b)YD
The relationship between desired saving
and income is represented by the saving
function shown in the figure below.
Graphical Presentation of the S-function
S
Slope = = (1 b )
Desired Saving S
Y
S = -a + (1-b)YD
YD
0
Disposable Income YD
S
-a

Average Propensity to Save (APS)
The proportion of disposable income
that households want to save is called
the average propensity to save (APS).
It is derived by dividing the total
desired saving by total disposable
income:
APS = S/YD

Marginal Propensity to Save (MPS)
the extra saving generated by an extra
dollar of disposable income is called the
marginal propensity to save (MPS).
The MPS is also the slope of the S-function
given by the formula:
MPS = S/YD = (1 b)
The saving line cuts the horizontal axis at
the break-even level of income, thus:
2016 S = 0 when C = YD
Created by: Dr. Makochekanwa 22
Relationship between C & S
Because income is either spent or saved, it
follows that fractions of income spent or saved
must account for all income:
APC + APS = 1
It also follows that fractions of any increments to
income consumed or saved must account for all
that income:
MPC + MPS = 1

Consumption & Saving Relation
(i) Consumption function
45 ? Line
C = a + bYD
450 Line
0
Ye Disposable Income (YD)
S = -a + (1-b)YD
0
Ye Disposable Income (YD)
-a
(ii) Saving function
The saving function is basically the vertical distance between the consumption function
and the 450 line since disposable income must either be consumed or saved. When C
exceeds
2016 income, S<0, when C is belowCreatedincome, S>0.
by: Dr. Makochekanwa 24
Investment Spending
Three components of investment spending
are:
a) Inventory accumulation (finished goods,
work in progress and raw materials).
b) Residential housing and construction.
c) Business fixed capital formation .
All these components are negatively
related to interest rates.
Investment Function
Shows the relationship between investment
and the interest rate.
As the interest rate declines, the cost of
borrowing goes down leading to an increase
in investment.
The inverse relationship between
investment and the interest rate leads to a
down-ward sloping investment function
shown below.
Investment Function
Interest Rate r
Investment- function
0
Investment Spending I

Determinants of Investment
Costs high interest rates (cost of borrowing)
and high taxes on capital income discourage I.
Expectations forecasts of the future state of the
economy (profit expectations and business
confidence can boost investment).
Investment decisions are independent of income
levels hence it is considered
autonomous/exogenous .
It can affect income but it is not determined by
it.
Thus investment is fixed at I = I0.
Investment and Income Diagram
Investment (I)
I0 I = I0
0 Real GDP (Y)

Back to Two-Sector Model
Initially we said desired aggregate
spending is:
AE = C + I
= (a + bYD) + I0
Thus the AE function is a summation of
the consumption function and
autonomous investment spending as
shown below:
AE Function
Desired Spending (AE)
AE = C + I
C = a + bYD
a + I0
I = I0
a
Real GDP (Y)
The AE function is parallel to the consumption function, the

vertical distance between them being equal to the
autonomous
2016
investment.
Created by: Dr. Makochekanwa 31
AE Function Contd
Given that consumption has an autonomous
and induced component, the constant
investment (I0) adds to the autonomous
component of consumption (a) hence the
intercept becomes (a + I0)
Superimposition of a 45o line (a locus of all
points where AE=Y) which shows all possible
equilibrium points will help us determine the
equilibrium level of output

AE Function & 45o Line
AE = Y
AE < Y AE = C + I
AEe
AE > Y
45
Ye Real GDP (Y)

AE Function & 45o Line Contd
1. AE > Y Excess Demand unexpected
decrease in inventories planned output rises
2. AE < Y Excess Supply unexpected increase

in inventories planned output decreases
3. Equilibrium level of GDP is determined where

AE = Y i.e. where AE curve intersects the 45o
line

Algebraic Derivation
AE = C + I
Equilibrium is where AE = Y, and Y=YD hence
Y=C+I
Y = (a + bY) + I0
Y bY = a + I0
Y (1 b) = a + I0
1
Y = (a + I0 )
1 b
Let a + I0 be represented A (all autonomous spending),
hence 1
Y = (A)
2016 Created by:1Dr.Makochekanwa
b 35
Saving & Investment Approach
Equilibrium output can be determined where
planned saving (S) is equal to planned investment
spending
S=I
Saving is a leakage (withdrawal) and Investment is
an injection (addition). Income and spending can
only be in equilibrium if leakages equal injections
The intersection of the saving and investment
functions at point E in diagram (b) gives
equilibrium income Ye
I & S Approach
Desired (I & S)
S = -a + (1-b)YD
I0
0
Ye Real GDP (Y)
-a

Reconciliation of the two Approaches

At GDP level Ye, S = I (b), hence Y = AE in (a)
thus the economy is at equilibrium
At GDP levels above Ye, S > I (b) (households
saving more than firms want to invest hence
demand will be low), hence AE < Y in (a) thus
firms cut down output and GDP declines
towards Ye
At GDP levels below Ye, S < I (b) households
saving less than firms want to invest hence
demand will be high, hence AE > Y in (a) thus
firms increase output and GDP rises towards Ye

The Multiplier
It provides a measure of the magnitude of
changes in GDP induced by a given change in
autonomous expenditure
The simple multiplier is the impact of a $1
change in exogenous expenditure on
Equilibrium GDP at a given/constant price
level
In the two sector model, the exogenous
component is investment, hence :
Multiplier = Y/I
The Multiplier Contd
AE = Y
AE1
AE1 E1
AE0
I
AE0
E0
45 Y
Y0 Y1 Real GDP (Y)

Multiplier Contd
An increase in autonomous expenditure (in this case I)
sets into motion successive rounds of aggregate
expenditures that will result in an increase in income (Y)
which is more than the initial increase in autonomous
expenditure.
In the diagram, an increase in investment (I) shifts the
AE from AE0 to AE1 resulting in a much larger increase in
GDP (Y) i.e [Y > I] and new equilibrium E1
As a result of this, the multiplier is always greater than 1.
The magnitude of the multiplier dependes on the
fraction of the additional income generated in each
round that is spent in the next round, i.e. on the MPC.
The greater the MPC,Created
2016 theby:larger is the multiplier.
Dr. Makochekanwa 42
Deriving the Multiplier
For the two sector model, the change in real GDP (Y)
equals the change in consumption expenditure (C)
plus the change in investment (I) i.e
Y = C + I
But the change in consumption expenditure is
determined by the change in real GDP and the marginal
propensity to consume.
It is:
C = MPC Y
Thus Y = MPC Y + I
Now solve for Y as:
(1 MPC)Y = I
Rearrange to get
I
Y =
(1 MPC)
Now, divide both sides I to give:
Y 1 1
Multiplier = I = (1 MPC) = (1 b)
But the MPS = 1 MPC therefore:
Y 1
Multiplier = I = MPS
Representing the multiplier by :
Y 1
= I = (1 b)
Therefore for the two sector model:
Y = I
But for the general change in autonomous expenditure A:
Y = A

But earlier we saw that income is determined
where:
Y 1 (A)
= (1 b)
Which there fore can be reduced to:
Y = A
Thus, given the amount of autonomous expenditure
and the value of the multiplier two sector model, you
can derive the equilibrium level of output

Limitations
Oversimplified
Omits the impact of financial markets and
monetary policy
Omits interaction between domestic economy
and the rest of the world
Omits supply side of the economy as
represented by the interaction of spending
with aggregate supply and prices

TANGA PANO 14 March 2016

Three Sector Model
We add Government Expenditure (G) and
Taxes (T) into the model.
Thus
AE = C + I + G
G is independent of Y hence is exogenous.
Thus G = G0
G is an injection into the circular flow i.e. it
directly adds to demand for goods &
services.
Gvt Exp & Income Diagram
Govt Exp (G)
G0 G = G0
0 Real GDP (Y)

Taxes
Taxes (T) indirectly reduce the income
available for consumption; leakage.
Taxes are directly linked to income i.e.
they are a certain proportion of t of Y
where t is the tax rate:
T = tY
Remember YD = Y - T
Thus, YD = Y tY = (1 t)Y
Taxes Contd
But C = a + bYD
C = a + b(1 - t)Y
Slope is now b(1 - t) which is smaller

than b.
Thus the C-function for the 2-Sector
Model is flatter than that for the 3-
Sector Model
C- function 3-Sector Model
Consumption (C)
C = a + bY
C = a + b(1-t)Y
0 Real GDP (Y)

Equilibrium 3-Sector Model
AE = Y
AE
AE2 = a + bY + I0 + G0
E2
AE3 = a + b(1-t)Y + I0 + G0
E3 AE1 = a + bY + I0
a + I0 + G0
E1
G
a + I0
45o
0 Y1 Y3 Y2 Real GDP (Y)
Equilibrium is where Y= AE
AE = C + I + G
Y=C+I+G
But C = a + b(1 - t)Y and G = G0
Y = [a + b(1 - t)Y] + I0 + G0
Y - b(1 - t)Y = a + I0 + G0
Y[1 - b(1 - t)] = a + I0 + G0
1
Y = (a + I0 + G 0 )
1 b (1 t )
Let a + I0 + G0 be represented A (all autonomous spending),

hence Y =
1
(A)
2016 1 by: bDr.(Makochekanwa
Created 1 t) 55
Conclusion
1
For the 3-Sector Model: Y = (A)
1 b (1 t )
1
Where 1 b (1 t )
= (the multiplier) and (A) is all
autonomous expenditure .
Thus once again Y = A.
The only difference with the 2-Sector Model is that
autonomous expenditure now has an extra component
(G0) and the multiplier () is now smaller with the
introduction of the proportional tax rate (t).
Four Sector Model
Here we Exports (X) and Imports (M)
hence the economy is now open.
Thus
AE = C + I + G + (X M)
X is independent of Y hence is
exogenous. Hence X = X0
X is an injection into the circular flow i.e.
it directly adds to demand for goods &
services.
Exports & Income Diagram
Exports (X)
X0 X = X0
0 Real GDP (Y)

Imports
Imports (M) increase as domestic incomes
increase
However, since they are spending on foreign
output, they are a leakage from the circular
flow
They can have an autonomous component M0
and an induced component mY where m is
the marginal propensity to import, hence:
M = M0+ mY
Imports & Income
Imports (M)
M = M0 + mY
M0
0 Real GDP (Y)

Net Exports
X&M M = M0 + mY
(X = M)
X = X0
0 YB (Y)
(NX)
(X M) = 0
0
YB (Y)
NX = X0 M0 m Y
Equilibrium 4-Sector Model
AE = Y
AE
AE1 = a + b(1-t)Y + C0 + I0 + G0
E1
E2 AE2 = a + [b(1 - t) m]Y + C0 + I0

+ G0 + X0 M0
a + I0 + G0 + (X0 M0)
a + I0 + G0
45o
0 Y2 Y1 Real GDP (Y)
Equilibrium is where Y= AE
AE = C + I + G + (X M)
Y = C + I + G + (X M)
But C = a + b(1 - t)Y , M = M0 + mY and X = X0 ,G = G0 , I = I0
Y = [a + b(1 - t)Y] + I0 + G0 + [X0 (M0 + mY)]
Y = b(1 - t)Y mY + a + I0 + G0 + X0 M0
Y b(1 - t)Y + mY = a + I0 + G0 + X0 M0
Y(1 b(1 t) + m) = a + I0 + G0 + X0 M0
1
Y = (a + I0 + G 0 + X 0 M 0 )
1 b (1 t ) + m
Let (a + I0 + G0 + X0 M0 ) be represented A (all autonomous

spending), hence 1
2016
Y =Created by: Dr. Makochekanwa (A) 63
1 b (1 t ) + m
Conclusion
1
For the 4-Sector Model: Y = (A)
1 b (1 t ) + m
1
Where 1 b (1 t ) + m
= (the multiplier) and (A) is
all autonomous expenditure.
Thus once again Y = A.
The only difference with the 3-Sector Model is that
autonomous expenditure now has an extra component
(X0 - M0) and the multiplier () is now smaller with the
introduction of the marginal propensity to import (m).
Matendwa

Econ109 Lec 2 Output Determination

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Econ109 Lec 2 Output Determination

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Principles Of Macroeconomics ECON109

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1. Consumption increases as income increases.

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The average propensity to consume (APC) is

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(ii) Saving function

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0 Real GDP (Y)

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Real GDP (Y)

The AE function is parallel to the consumption function, the

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2. AE < Y Excess Supply unexpected increase

3. Equilibrium level of GDP is determined where

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Which there fore can be reduced to:

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0 Real GDP (Y)

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Slope is now b(1 - t) which is smaller

0 Real GDP (Y)

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Let a + I0 + G0 be represented A (all autonomous spending),

0 Real GDP (Y)

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0 Real GDP (Y)

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E2 AE2 = a + [b(1 - t) m]Y + C0 + I0

Let (a + I0 + G0 + X0 M0 ) be represented A (all autonomous

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