Chapter 9:

THE DETERMINATION
OF NATIONAL
INCOME
Economics 11-UPLB
Prepared by TBParis 09/12/07
Main Objective of the Chapter

To explain fluctuations in national income.

helps government, researchers, and

businessmen formulate targets, policies, and
business decisions.

gives them an in-sight into the effects of their

decisions.

need to explain how it is determined. identify

the factors that cause national income to
change.
Chapter Organization

Section 9.1 - framework for analyzing changes

in national income.

Section 9.2 - how changes in income affect

consumption spending.

Section 9.3, introduces the role of the multiplier

effects following a change in aggregate
expenditure.

Section 9.4 presents an algebraic treatment of

the concepts developed
Aggregate Expenditure and
Equilibrium Income

Definition of aggregate expenditure and

equilibrium income

How the economy adjusts to its

equilibrium position.

How changes in aggregate expenditure

affect equilibrium income.
Aggregate Expenditure and
Equilibrium National Output

Aggregate expenditure (AE)

total amount that all economic agents want or

plan to spend on domestic goods and
services.

the planned spending of

households,

firms,

government, and

foreigners.
Aggregate Expenditure

AE = C + I + G + (X-M)

consumption (C),

investment (I),

government spending (G), and

exports less imports (X-M).

Note that AE is not the same as GDP.

AE represents planned spending

GDP represents actual spending or output.

Aggregate Expenditure (AE) and
National Output (Y)

AE and Y are not necessarily equal:

Firms formulate their production plans with an

estimate of the quantities that people want to
buy.

A mistake on their part will cause production

to exceed or fall below the amounts that
people want to buy.
What if AE and Y are not equal?

If AE < Y

people want to buy less than what has been

produced so firms will accumulate inventories.

firms will reduce production

If AE >Y

What people want to buy is greater than actual

production so inventories will decline.

firms will increase production

Equilibrium National Income

AE = Y

Can be depicted by the intersection

between the AE schedule and the 45
degree line
The 45
0
line

The 45-degree line is a tool that assists us in

identifying the economy's equilibrium
position.

Property: every point along this line depicts

a situation wherein the value of the variable
on the horizontal axis (in this case actual
output, (Y) is equal to its counterpart on the
vertical axis (AE).
0
100
100
45
0
line
45
0
200
200
45
E
0
AE 20
AE
0 20
Output, income (in pesos)
A
g
g
r
e
g
a
t
e

e
x
p
e
n
d
i
t
u
r
e

(
i
n

p
e
s
o
s
)
Y
Y*
Equilibrium Income (Y*)

When AE is equal to Y

there is no reason for firms to adjust production.

this suggests that the economy is in equilibrium.

Equilibrium requires the equality between

income and aggregate expenditure. That is,
Y = AE.
Changes in AE and Income

Suppose that the economy's aggregate

expenditure schedule shifts upward AE
0
to AE
1
,

Equilibrium point will move from E

0
to E
1
.

As a result, the economy experiences an

increase in equilibrium income from Y
O
* to Y
1
*
45
AE
0
E
0
E
1
AE
1
20
30
AE
0 20 30
Y
Output, income (in pesos)
A
g
g
r
e
g
a
t
e

e
x
p
e
n
d
i
t
u
r
e

(
i
n

p
e
s
o
s
)
Y
0
Y
1
Consumption and Income

Keynes (1936) suggested that

consumption spending (C) tends to
increase with income.

In other words, households with higher

incomes tend to spend more.

There is a positive relationship between

consumption spending and income
TABLE 9.1. Consumption and income (in pesos).
(1) (2) (3) (4) (5)
Income Consumption Change In
income
Change in
consumption
mpc
(Y) (C) (Y) (C) (C/Y)
0 200 _
200 350 200 150 0.75
400 500 200 150 0.75
600 650 200 150 0.75
800 800 200 150 0.75
1,000 950 200 150 0.75
1,200 1,100 200 150 0.75
1,400 1,250 200 150 0.75
1,600 1,400 200 150 0.75
Consumption and income

Higher levels of income correspond to higher levels of

consumption spending

When income is equal to zero, consumption spending is

equal to 200.

Consumption spending and income are equal at each

other when income = 800.

When income is less than 800, consumption is higher than

income.

When income is greater than 800, consumption less than

income
0
45
0
200
C
o
n
s
u
m
p
t
i
o
n

S
p
e
n
d
i
n
g

(
i
n

p
e
s
o
s
)
Output, Income (in pesos)
400
600
800
1000
800 1200 1600
400
1200
1400
1600
C
Y
THE CONSUMPTION SCHEDULE
Y
Consumption and Income

Observations from values above:

(a) autonomous consumption spending -
component of consumption spending that does
not depend on income
- equal to 200 in example
(b) marginal propensity to consume (mpc) -
shows the increase in consumption spending for
a one peso increase in income;
Marginal Propensity to Consume

MPC or the marginal propensity to consume represents the

change in consumption spending that arises from a one peso
change in income.

Value of MPC is between 0 and 1.

MPC=0.75 means that a one peso increase in income leads to a

75-centavo increase in consumption spending.
C
mpc
Y

Marginal propensity to consume

In example above,
C = 150 for Y = 200. Hence,
150
0.75
200
C
MPC
Y

Consumption Function

Consumption Function:
C = c + mpc.Y
C = 200 + 0.75Y
Savings and Income

Sum of consumption spending and

savings (S) must equal income. In
symbols,
Y = C + S.

Subtracting C from both sides of this

equation leads to
S = Y - C.
(1) (2) (3) (4) (5) (6) MPS
Y C S Y C S S
Y
0 200 -200 - - - -
200 350 -150 200 150 50 0.25
400 500 -100 200 150 50 0.25
600 650 -50 200 150 50 0.25
800 800 0 200 150 50 0.25
1000 950 50 200 150 50 0.25
1200 1000 100 200 150 50 0.25
1400 1200 150 200 150 50 0.25
1600 1400 200 200 150 50 0.25
Relationship bet. Income and Savings
Savings and income

Savings - that component of income

that is not allocated to consumption.
S = Y C

How is savings linked to income?

Y S.
Savings and Income

Marginal propensity to save (MPS) is the

increase in savings for a one peso increase
in income;

In the example above, S = 50 for Y = 200.

Implies that
50
0.25
200
S
MPS
Y

Savings function

Note: MPC+MPS = 1

Savings schedule listing of values of

savings at each levels of income

Savings function in equation form

S = -200 + .25Y
1
Y C S
Y C S
Y C S
Y Y Y
mpc mps
+
+

+

+
Relationship between mpc and mpc
S
-200
-50
150
0
400 800 1,200 1,600
Income (in pesos)
S
a
v
i
n
g
s

(
i
n

p
e
s
o
s
)
Y
S
F9.4
Propensity to Save
The determination of equilibrium income in a
two-sector economy

Two sector economy - households and firms only

Implies that AE is given by:

AE = C + I

Assume that I is autonomous and equal to 100

In equilibrium, Y = AE equilibrium income (Y*) =

1200
Table 9.3 Consumption, Investment and Equilibrium
Income.
Y C S I AE
400 500 -100 100 600
600 650 -50 100 750
800 800 0 100 900
1,000 950 50 100 1,050
1,200 1,100 100 100 1,200
1,400 1,250 150 100 1,350
E
0
S
I
-200
100
0
800 1,200 1,600
Income (in pesos)
Y
Y*
(B)
S, I
(A)
E
0

Fig 9.5
C+I = AE
C
0 400 800 1,200 1,600
Y
45
AE
300
200

Y*

Investment and Multiplier

Suppose that investment I increases from

100M pesos to 200M pesos

What happens to equilibrium income?

Equilibrium income Y* will increase

Not by 100M

But by a multiplied amount!!

WHY???
Table 9.4 Effects of a 100 peso increase
in investment.
Y C S I AE
400 500 -100 200 700
600 650 -50 200 850
800 800 0 200 1000
1,000 950 50 200 1150
1,200 1,100 100 200 1300
1,400 1,250 150 200 1450
1600 1400 200 200 1600
1800 1550 250 200 1750
A
g
g
r
e
g
a
t
e

E
x
p
e
n
d
i
t
u
r
e

(
i
n

p
e
s
o
s
)
AE
0
AE
1
Y
0
Y*
0
Y*
1
A
B
E
1
E0
1200 1600
I=100
The effect of an increase in investment
AE
Y
45
o
300
400
Y=400
Calculation of equilibrium income

In numerical example,
*
1
( ).
1
Y C I
mpc
_
+

,
1
multiplier
1 mpc

C 200, I 100,mpc 0.75

_
+

,
1
Y* (200 100) 1,200
1 0.75

For I = 200, Y* = 1,600

Hence, if I from 100 to 200 Y* from 1200 to

1600.

In other words,


I 100
Y* 400


The concept of the multiplier

Increase in Y is greater than increase in I. Why?

Multiplier ( ) - measures the change in

equilibrium income as a result of a one-peso
change in the sum of the autonomous
components of AE;
*
Y
I

The multiplier concept

Round C + I = Y
1 0 100 100
2 mpc[100] 0 mpc100
3 mpc [mpc100] 0 mpc
2
100

n mpc[ mpc
n-2
100] 0 mpc
n-1
100
Calculation of the multiplier:

1 1
1 mpc mps

Calculation of multiplier

With the mpc = 0.75,

The multiplier is used determine the amount

by which Y* changes in response to a
change in investment.
1
4
1 0.75

Y* I

So the total change in income is given by:

Y = I + mpc I + mpc
2
I +mpc
3
I +

= (1 + mpc + mpc
2
+ mpc
3
) . I

or
_

,
1
Y I I
1 mpc
2 3
2 3
2 3
...
...
(1 ...)
1
1
Y Y Y I mpc I mpc I mpc I
Y I mpc I mpc I mpc I
Y I mpc mpc mpc
Y I
mpc
Y I
+ + + + + +
+ + + +
+ + + +
1

1

]

The Multiplier
The Paradox of Thrift

Many people believe that higher savings lead

to higher income.

In the present model, we get a result that is

contrary to this belief.

In other words, equilibrium income falls

when people want to save more.

Idea: the attempt to achieve higher savings

may reduce equilibrium income
S
0
Income (in pesos)
S
a
v
i
n
g
s

(
i
n

p
e
s
o
s
)
Y
S,I
S
1
I
Y
0
Y
1
Fig 9.7
0
The Paradox of Thrift
End
Chapter 9: