1

National Income Determination

Two approaches:
To Determine National Income Equilibrium:

1.Total Approach.
2.Injection-Leakage Approach.


Total Approach:

Equilibrium may occur when planned aggregate
expenditure is equivalent to planned output.
(AE=Y) or (AD = AS)
(aggregate demand = aggregate supply).

Leakage-Injection Approach:

Equilibrium also can be determined when:
INJECTION = LEAKAGE
Injections are additional spending from:
investments (I),
government purchases (G) and
exports (X).

Leakages are withdrawals from:
savings (S),
tax payment (T) and
imports (M).
So, at equilibrium,
(I+G+X = S+T+M)
(INJECTION = LEAKAGE)
DETERMINATION OF EQUILIBRIUM
NATIONAL INCOME
Aggregate demand is the total amount of
expenditure on domestic goods and services.
AD= C + I + G + (X M)

Y = C + I + G + (X M)

The higher the level of aggregate demand or
aggregate expenditure, the higher the level of
output and employment.

Components of Aggregate Expenditure:
1. CONSUMPTION, C = f (Y
d
)
2. INVESTMENT, I = f (i, Y)
3. GOVERNMENT EXPENDITURE, G
4. NET EXPORT (X M)


1. Consumption and Saving
Disposable Income is used for Consumption spending and Saving.
Y
d
= C + S
and, C = f (Y
d
), S = f (Y
d
)
Both C and S is a function of income,Y and having a positive
relationships.
( Y rises, C and S also will rise).

Given that;
Consumption function: C = a + bY
d
and Saving function: S = a + (1 b) Y
d

There is (two)2 components of Consumption spending by households:
C
1
, Autonomous Consumption = a
C
2
, Induced Consumption = bY
d

Where,
b is the Marginal Propensity to Consume
(MPC).
Autonomous Consumption,
C
1
= a
is the vertical intercept of the consumption
function,

It is the amount of consumption that would
occur even if the household earned nothing, Y=0.
when Y= 0 (no income earned), C = a.
(basic consumption for living).
C
C = a + b Yd

a

0 Y
Autonomous Consumption (a)

and
Induced Consumption (bY)

C1 = a is a fixed amount irrespective of the income
earned,
is the part of consumption which does not vary
with the level of income (Y increases but a is
constant).

C
2
= bY is an amount that depends on the
disposable income,
is the amount of consumption spending by
households that is induced by disposable income
(Y increases, C
2
increases).

CONSUMPTION, C
Consumption function,
C
C = a + bY
d
a
Yd

The slope of consumption function is given by:
b = C/ Y
= Marginal Propensity to Consume (MPC)

Consumption and Saving schedule
Y C S
0 60 -60
100 120 -20
200 180 20
300 240 60
400 300 100
500 360 140

With no income earned, Y = 0 ,
autonomous C = a = 60 and dissaving = - a = - 60.
While Y = C + S , if Y = 0 , then C = - S.
How is the increase in income will increase
consumption?

Consumption is induced by the value of b (that is =
MPC),

since,

C = a + bY


FOR EXAMPLE:

Given that C = a + bY, therefore, if b = 0.6 , how
large is the increase in consumption if there is an
increase in income?
Since C = a + 0.6Y, thus C will increase by 0.6Y ,
(given a = autonomous consumption) ,
so, C will increase by 60% out of total income, Y.

Meaning that, for any increase in income,
40% can be saved and
60% will be spend on consumption.
Consumption and Saving schedule
Y C S
0 60 -60
100 120 -20
200 180 20
300 240 60
400 300 100
500 360 140

In a 2-sector economy, C = a + bY .
Since C = a + 0.6Y, and a = 60 thus C = 60 + 0.6Y.
At income 200, C = 60 + 0.6(200) = 60 + 120 = 180
and Y = C + S
so , S = Y C = 200 -180 = 20.


Changes in consumption when income
change.
consumption
Y = C
C = a + b Y
C
Y

45
income
Note: b = C

= 400

1000 1500
Y
500
400
Changes in consumption when income
change.
consumption
Y = C
C = a + b Y
C
Y

45
income
Note: b = C

= 400

1000 1500
Y
500
e
a
400
SAVINGS
Some part of income earned is saved.
two components of savings:
autonomous dissaving, S
1
= a
induced saving, S
2
= (1 b)Y
where,
(1 b) = Marginal Propensity to Save.
= S/Y
= slope of saving function.



Dissaving and saving.
Autonomous dissaving, (- a), is the amount
that households draw out from their wealth
to consume when no income earned.

Induced saving, (1 b)Y, is the amount of
saving that is induced by earnings of
disposable income.

Saving Function, S
Saving
Y
d
(output)
S = a + (1 b)Y
d

a
0
(1 b) is the slope of saving function = S/Y

Consumption & Saving Function,
C,S
Y
d
(output)
S = a + (1 b)Y
d


a
0
C = a + bYd
a
45
e
Y = C + S,
When S = 0,
Y = C at the
breakeven,
point, e.
Y = C
Y = AD
Note that:
MPC + MPS =1, thus MPS = (1 MPC).
If MPC = b and MPS = (1 b),
Then,
b + (1 b) = 1

APC, APS
The fraction of income that is used for
consumption is the:
Average Propensity to Consume (APC):
APC = C
Y
And, the fraction of income that is used for saving
is the:
Average Propensity to Save (APS):
APS = S
Y
and, at any level of income,
APC + APS = 1

MPC
INCOME,Y
CONSUMPTION, C
C = a + bYd
C
Y
0
1600
1200
a
MPC = C = 400
Y 600
is the slope of the
consumption
function.
1000

800
MPC, APC
INCOME,Y
CONSUMPTION, C
C = a + bYd
C
Y
0
1600
1200
a
MPC = C = 400
Y 600
APC = TC = 1200
TY 1600
1000
800
TC
TY
MPC, APC
INCOME,Y
CONSUMPTION, C
C = a + bYd
0
1600
1200
a
MPC = C = 400
Y 600
APC = TC = 1200
TY 1600
1000
800
TC
TY
TC
Saving
Y
d
( output)
S = a + (1 b)Y
d


a
0
MPS = (1 b) = S/Y
is the slope of saving function.
S
Y
Saving
Y
d
(real output)
S = a + (1 b)Y
d


a
0
while, APS = TS/TY
S
Y
TS
TY

TS
Saving
Y
d
(real output)
S = a + (1 b)Y
d


a
0
while, APS = TS/TY
TS
TY

TS
BREAK-EVEN INCOME
is a situation when all the income is just nice
for consumption purposes while no saving at
all.
thus,
Y = C and S = 0.

S = - a + (1 b)Y
C = a + bY
e
C,S
Y
45
AS=AD
S < 0
S > 0
S = 0
Activity
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140
200 260
400 20
600 500
800
1000
1. Use the given data to answer the following
questions.
a) Fill up the blank with appropriate values.
b) What are the values of MPC and MPS?
c) Write down the consumption function and saving function.
d) What is the amount of break-even income?

ANSWER
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140
140
200 260
60
400 120 + 260 = 380 20
600 500 100
800 120 + 500 = 620 180
1000 120 + 620 = 740 260
1. Use the given data to answer the following
questions.
a) Fill up the blank with appropriate values.



b) What are the values of MPC and MPS?
MPC = C = 260 - 140 = 0.6 Y
200 0

MPS = 1 MPC = 1 0.6 = 0.4
c) Write down the consumption function and saving function.
C = 140 + 0.6Y
S = - 140 + 0.4Y


d) What is the amount of break-even income?
is a point at e, when S = 0, so Y = C.
S = - 140 + 0.4Y
Since S = 0, 0 = -140 + 0.4Y
140 = 0.4Y
Y = 140/0.4 = 350

S = -140 + 0.4Y
C= 140 + 0.6Y
e
C,S
Y
45
S = 0
Activity 2
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140
140
200 260
60
400 380 20
600 500 100
800 620 180
1000 740 260
Calculate the APC and APS at each level of income.

INCOME
(Y)
CONSMPTN
(C)
SAVING
(S)
0 140
140
200 260
60
400 380 20
600 500 100
800 620 180
1000 740 260
APC APS
- -
1.3 - 0.3
0.95 0.05
0.83 0.17
0.78 0.23
0.74 0.26
ANSWER:
The values for APC and APS at each level of income.

2. INVESTMENT

Investment is defined as the spending or purchase of plants,
machineries, buildings and inventories by firms for the purpose
of producing goods and services.
two(2) types of investment spending:
i) Autonomous Investment
what firms may had intended to plan or desired or
has been fixed and does not depend on income.
ii) Induced Investment
actual investment expenditures used to produce
newly produced goods, and depends on the level of:



Investment depends on the level of:
I = f ( i,)
interest rate,
future expected profitability,
income,
technology,
capacity and
business taxes.

1. Autonomous Investment
As assume by Keynes;
- is a fixed investment that does not change with the change in
income,
but ;
there will be a shift in the autonomous horizontal function, up or
down when therere other factors that affect it.

1. Autonomous Investment Function
Investment

I
1


Autonomous
Investment I
0


Diagram: Autonomous Investment
A shift in autonomous investment upward to I
1
may cause
by an increase in expected profit or a fall in interest rate
but does not depend on income.


Income
refers as a fixed
investment that
does not
change with the
change in
income.
2. Induced Investment Function
real interest rate (i)




I = f(i,
e
)

I = f(i)


I I Investment
Diagram: Induced Investment
Induced investment has a negative relationship with real rate of interest.
If future profit is expected to increase, at any given level of real interest rate the investment function will
increase and shift the curve to the right.
i
1
i
2

refers to an
investment that
changes with the
interest rate,
income or
expected
profitability etc.
2. Induced Investment Function
investment


I = f(Y)




Income

Diagram: Induced Investment
Induced investment has a positive relationship with aggregate income.
Example is capital investment by the purchase of new plants and equipments.

is the actual
investment that is
induced by changes
in income.
Investment and Saving
Investment is an injection: could increase aggregate
expenditure (AD) and boost up economic growth
(income).
Investment spending will multiply through the
multiplier effect to increase income.
Saving is a leakage: could lower aggregate
expenditure (AD) and income.
Saving becomes an outflow of money (leakage) from
an economy. It becomes a stock of money that is not
spent.
At equilibrium,
Saving will be equal to Investment,
( S = I )
Equilibrium in 2 sector economy
C,I
Y
d
(output)

0
45
C + I
Y2
Y=AD
e2
equilibrium; Y = C + I
(in 2 sector economy)
Equilibrium in 2 sector economy
C,S,I
Y
d
(real output)
S = a + (1 b)Y
d

0
I
Y2
e2
S = I
In 2 sector econ;
equilibrium; S = I
1) If investment is 150 millions, calculate the equilibrium income
and sketch a diagram to show this.

I = 150
C = 140 + 0.6Y
Answer:
At equilibrium (in 2 sector economy);
(Using Total Approach):
Y = C + I
Y = 140 + 0.6Y + 150
Y 0.6Y = 290
0.4Y = 290
Y = 290/0.4
Y = 725

Y = AD
C + I
Y
C,I
e
Ye = 725
45
ANSWER:
3. GOVERNMENT EXPENDITURE
Government
Expenditure




Income

Diagram: Autonomous Government Expenditure
G
1
G
0
G will be
autonomously
fixed according
to Government
Budget Policy
for each year.
4. NET EXPORT (X M)
Export is an injection and could increase the
national income through the foreign trade
multiplier, but import is a leakage.

Thus, net export (X-M), means the real foreign
sector minus the total import of goods and
services into the economy.


FULL
EMPLOYMENT
Equilibrium
full employment equilibrium is an ideal
objective because at this level of income,
there is no available and useful resource of
the economy that is wasted.

full employment means the full utilization of
all available labor and capital resources so
that the economy is able to produce at the
limits of its potential gross national product.
NATIONAL INCOME EQUILIBRIUM with
inflation
Real Output
(National Income)
Expenditure
Y
1
=C+I+G+(X-M)
Y=E
45
Y
fe
=C+I+G+(X-M)
Y
fe

Ye
1

Inflationary Gap
e
1
e
f
NATIONAL INCOME EQUILIBRIUM with
unemployment
Real Output
(National Income)
Expenditure
Y
0
= C+I+G+(X-M)
Y=E
45
Y
fe
=C+I+G+(X-M)
Ye
0
Y
fe


Deflationary Gap
e
0
e
f
MULTIPLIERS
Any Injection will multiply positively,
while
any Leakage will multiply negatively.