National Income:

Real GDP vs. Nominal GDP, GDP deflator & Rate of Inflation

Nominal GDP: Nominal GDP refers to the total monetary value of all final goods & service
produced from all productive sectors at current market prices within a country during a year.

Nominal GDP = P0Q0 + P1Q1 + P2Q2 + ………….PnQn.

Real GDP: Real GDP refers to the total monetary value of all final goods & services produced
from all productive sectors at constant market prices within a country during a year.

Real GDP = P0Q0 + P0Q1 + P0Q2 + ………….P0Qn

GDP deflator: GDP deflator measures relative changes in the current level of prices in
comparison to the level of prices for the base year.

Nominal GDP
GDP deflator = × 100
Real GDP

Rate of Inflation: On the basis of GDP deflator, rate of inflation between any periods of time is
the ratio of change in GDP deflator over previous GDP deflator and multiplied by 100.

Change∈GDP deflator
Rate of Inflation(л) = × 100%
GDP deflator for previous year

Example 1:

From the given data for an economy that produces only two goods X & Y in different years as
follows:

Years Px Qx Py Qy
2010 $100 1000 $200 500
2011 $200 1500 $300 1000
2012 $300 2000 $400 1500
Find out: (i) Nominal GDP (ii) Real GDP (iii) GDP deflator and (iv) Rate of Inflation

Solution,
1
(i) Calculating Nominal GDP:
2010 = ($100 × 1000) + ($200 × 500) = $ 200000
2011 = ($200 × 1500) + ($300 × 1000) = $ 600000
2012 = ($300 × 2000) + ($400 × 1500) = $ 1200000

(ii) Calculating Real GDP:

2010 = ($100 × 1000) + ($200 × 500) = $ 200000
2011 = ($100 × 1500) + ($200 × 1000) = $ 350000
2012 = ($100 × 2000) + ($200 × 1500) = $ 500000

(iii) Calculating GDP deflator:

Nominal GDP
GDP deflator = × 100
Real GDP

200000
GDP deflator (2010) = × 100 = 100
200000

600000
GDP deflator (2011) = × 100 = 171.43
350000

1200000
GDP deflator (2012) = × 100 = 240
500000

(iv) Calculating Rate of Inflation:

Change∈GDP deflator
Rate of Inflation(r) = × 100%
GDP deflator for previous year

2010 (r) = ……………..

171.43−100
2011(r) = × 100% = 71.43%
100

240−171.43
2012(r) = × 100% = 40%
171.43

Example 2:

From the following data, find out:

(a) National Income (b) Personal Income and (iii) Disposable income
Figures in rs. crore
Items Rs. Items Rs.

2
Wages 16,800 Employer’s contribution to Social security 500
Rent 8,000 Corporate tax 400
Interest 1,000 Personal taxes 2,000
Dividend 2,000 Transfer payments 1,500
Mixed Income 2,000 Net income from abroad 3,000
Undistributed Profit 800 Social security contribution 500

Solution,

(a) National Income = Wages + Rent + Interest + Dividend + Mixed Income + Undistributed
Profit + Employer’s contribution to Social security + Corporate Tax + Net
income from abroad
= 16800 + 8000 + 1000 + 2000 + 2000 + 800 + 500 + 400 + 3000
= Rs. 34500.

(b) Personal Income = National Income – Undistributed profit – Social security contribution –
corporate tax + Transfer Payments.
= Rs.34500 – 800 – 500 – 400 + 1500
= Rs. 34300

(c) Disposal Income = Personal Income – Personal Taxes

= Rs. 34300 – 2000
= Rs. 32300

2007 Spring

Following (Hypothetical) figures show expenditures on output (Rs. in million) by different sector
during the year 2006. Compute GDP at market price (MP), GNP at factor cost and NI.

Household expenditure on 100 Government sector purchase 5

Domestic goods & services. of foreign goods.
Household purchase a foreign 20 Foreigners purchase of 80
goods & services. domestic goods & services.
Business sector purchase of 40 Depreciation @10% of
domestic capital goods. GDPmp

Business sectors imports of 10 Indirect Taxes 70

capital goods.
Government sectors purchase 60 Subsidies 0
of domestic goods& services.
Income from abroad 150 Payments abroad 30
3
Solution,

Calculating GDP at market price

GDP at market price = Consumption (C) + Investment (I) + Government expenditure (G) +
Export(X) – Import (M)

GDPmp = C + I + G + (X-M)
= (100+20) + (40+10) + (60+5) + [80-{20+10+5}]
= 120+ 50+ 65+ 45
= Rs.280 million.

Calculating GNP at factor cost

GNPFC = GNP at market price – Indirect Taxes + Subsidies

GNPFC = GNPmp - Indirect Taxes + subsidies GNPmp = GDP mp + NFIFA
= Rs.400 - 70 + 0 = 280 + {150- 30}
= Rs.330 million = Rs. 400 million.

Calculating National Income:

National Income (NI) = GNP at factor cost – Depreciation

= GNPFC - Depreciation
= Rs.330 – 10% of GDPmp
= Rs. 330 – 10% of 280
= Rs. 330 – 28
= Rs. 302 million.
2009 spring
Suppose, in a two sector model, that individuals receive the following payments from the
business sector: wage $520, interest $30, rent $10 and profit $80. Consumption spending is $550
and investment is $90.

(a) Find the market value of output household saving

(b) What is the relationship of saving and investment?
Solution,

(a) Calculating National Income

National Income = wages + interest + rent + profit + mixed income + depreciation

= $520 + $ 30 + $10 + $80 + 0 + 0
4
 = $ 640

Personal Income = National Income – Undistributed profit – Social security contribution –

corporate tax + Transfer Payments.
= $640 – 0 – 0 – 0 + 0
= $ 640

Disposal Income (Yd) = Personal Income – Personal Taxes

= $ 640 – 0
= $ 640
Household saving = Disposable income – Consumption
= Yd – C
= $ 640 - $550
= $90

(b) Relationship between saving and investment

At equilibrium: S = I
Here, saving = $90, I = $90
It is proved that S = I at equilibrium. It is the relationship between saving and investment.

2010 fall
Calculate GDP at market price from the following data:

Particulars Rs. Crores

Interest paid by firms 2
Dividends paid 4
Net factor income received from abroad 6
Retained earnings of the firms 6
Wages and salaries 100
Provision for pension 10
Social security Contribution by employees 5
Bonus 20
Corporate profit tax 8
Rent on land paid by firms 5
Mixed income of self employed 150
Indirect taxes 30
Subsidies 10
Consumption of fixed capital 25

5
Solution,

We have,

GDP at market price = GDPFC + Indirect Taxes – Subsidies

GDPFC = Compensation of employees (Wages & salaries) + Rent + Interest + Profits + Mixed
Income + Depreciation

GDPFC = 100 + 5 + 2 + {8 + 6 + 4} +150 +25

= 107 +18 +175
= Rs. 300 Crores.

GDPmp = GDPFC + Indirect Taxes – Subsidies

= Rs. 300 + 30 – 10
= Rs. 320 Crores.

2011 spring
q. n 2c

Find out the value of GNP deflator if nominal and real GNP is given as 17.43 million and 11.37
million respectively.

Solution,

Given,
Nominal GNP = 17.43 million
Real GNP = 11.37 million
Value of GNP deflator =?

We have,
Nominal GNP
GNP Deflator = × 100
Real GNP

17.43
= × 100
11.37

= 153.30

6
 Goods Market Equilibrium:
2005 Fall Q.N 4
Suppose a structural model of the three sector economy is given as follows:
C = 200 + 0.8 (Y – T)
I = 100, G = 150, T = 50 + 0.2Y;
Find out:
(a) National income equilibrium
(b) Tax multiplier
(c) What happens to the National Income if Government Expenditure
decreases to 100 and Investment increase to 150?

Solution,

(a) From the given information, National Income Equilibrium is:

Y=C+I+G
Or, Y = 200 + 0.8 (Y – T) + 100 + 150
Or, Y = 200 + 0.8[Y – {50 + 0.2Y}] +250
Or, Y = 200 + 0.8Y – 40 - 0.16Y + 250
Or, Y = 410 + 0.64Y
Or, Y- 0.64Y = 410
Or, 0.36Y = 410
410
Or, Y =
0.36
= 1138.89

Therefore, the equilibrium level of Income ( Y) = 1138.89.

(b) Calculating tax multiplier

7
 −b
We have the tax multiplier (Tm) =
1−b

−0.64
= 1−0.64 =¿- 1.78

Therefore, the tax multiplier(Tm) = - 1.78

2007 fall Q.N 3

Consider a three sectors Keynesian economy with following behavioral equations:

C = 20 + 0.5Yd; T = 20; I = 500; G = 250
Where symbols have their usual meaning:

Find out:

1. The equilibrium level of income

2. Government expenditure multiplier
3. What would be the equilibrium level of income if marginal propensity to
consume (MPC) changes from 0.5 to 0.8? Does it also change the value
Government expenditure multiplier?
Solution,

From the given information, National Income Equilibrium is:

Y=C+I+G
Or, Y = 20 + 0.5Yd + 500 + 250
Or, Y = 20 + 0.5[Y –T] +750
Or, Y = 20 + 0.5[Y –20] + 750
Or, Y = 770 + 0.5Y –10
Or, Y = 770 + 0.5Y
Or, Y -0.5Y = 770
760
Or, Y =
0.50
= 1520

Therefore, the equilibrium level of Income (Y) = 1520.

8
Calculating Government Expenditure multiplier
1
We have the Government Expenditure multiplier (Gm) =
1−b
Here, mpc (b) = 0.5
0.50
= 1−0.50 =¿2

Therefore, the Government Expenditure multiplier (Gm) = 2

When MPC increases from 0.5 to 0.8, new consumption function (C) = 20 + 0.8Y
At new equilibrium,

Or, Y = 20 + 0.8 (Y – 20) + 500 + 250

Or, Y = 20 + 0.8Y – 16 + 750
Or, Y – 0.8Y = 754
Or, 0.2Y =754
754
Y=
0.20
= 3770
Therefore, new equilibrium Income (Y) = Rs.3770

At MPC or, b = 0.8

1
Gm =
1−0.8
=5

Due to increase in the value of MPC, equilibrium income increases from 1520 to 3770. It also
changes the value of Government expenditure multiplier from 2 to 5. It implies that at MPC =
0.5, equilibrium income increases by 2 times due to increase in Government Expenditure and
MPC = 0.8, the equilibrium income will increase by 5 times due to increase in Government
expenditure.

2008 fall q.n

Consider a three sectors Keynesian economy with following behavioral equations:
C=50+0.6Yd; T=30; I=1000; G=500 Where symbols have their usual meaning; find,

(a) Equilibrium level of income.

(b) Drive expressions for Government expenditure multiplier for same model given above.
9
(c) If tax function is taken instead T=30+0.2Y, will it alter the equilibrium level of income? Show
necessary calculations.

Solution,
(a) Finding equilibrium level of income

Y = C + I + G Where, C = a + b (Y-T)
Then,
Y = 50 + 0.6Yd + 1000 + 500
Y = 50 + 0.6(Y-T) + 1000 + 500
Y = 50 + 0.6(Y-30) + 1500
Y = 1550 + 0.6Y - 18
Y =1532+0.6Y
Y – 0.6Y = 1532
0.4Y = 1532
1532
Y=
0.40
= 3830

Therefore the equilibrium Income (Y) Rs.3830

(b) At an initial equilibrium,

Y=C+I+G
Y = C + b (Y – T) + I + G
Y = C + bY –bT + I + G
Y – bY = C – bT + I + G
Y (1-b) = C – bT + I + G
1
Y= [C – bT + I + G] …………………………………….(i)
1−b

When Government expenditure increases by ∆G, as a result, income will increases by ∆Y. Then,
At new equilibrium,

1
Y + ∆Y = [C – bT + I + G +∆G] …………………………………….(ii)
1−b

Subtracting eqn (i) from eqn (ii), we get

1
∆Y = [∆G]
1−b

∆Y 1
=
∆G 1−b

∆Y 1
Therefore, the government expenditure multiplier [Gm= ¿=
∆G 1−b

10
At MPC or b= 0.60

1
Gm =
1−0.60
= 2.5

Calculating equilibrium level of income, if Tax function: T = 30+0.2Y, then

At new equilibrium,
Y = 50 + 0.6[Y-(30+0.2Y)] + 1000 + 500
Y = 50 + 0.6[Y - 30 – 0.2Y] + 1500
Y = 1550 + 0.6Y – 18 – 0.12Y
Y =1532+0.48Y
Y – 0.48Y = 1532
0.52Y = 1532
1532
Y=
0.52
= 3830

Therefore, the equilibrium Income (Y) Rs.2946.15

Due to change in tax function, Equilibrium income decreased by (3830 – 2946.15) = Rs. 883.15

2008 spring q.n 4a

In the Keynesian cross (closed economy), assume that the consumption function is given by
C=100+0.8(Y-T). If investment expenditure is 100, Government Expenditure is 150 and Tax is
100, what is the equilibrium level of income?

Solution,
From the given information, National Income Equilibrium is:
Y = C + I + G Then,
Y = 100 + 0.8 (Y – T) + 100 + 150
Y = 100 + 0.8 (Y – 100) + 100 + 150
Y = 350 + 0.8Y – 80
Y = 270 +0.8Y
Y – 0.8Y = 270
0.20Y =270
11
 270
Y= = 1350
0.20

Therefore, the equilibrium Income (Y) Rs.1350

2009 spring q.n 2

Suppose a structural model of the three sector economy is given as follows:

C = 200 + 0.8 (Y – T)
I = 100, G = 150, T = 50 + 0.2Y; Find:
(a) National income equilibrium
(b) Tax multiplier.
(c) What happens to the National Income if Government Expenditure decreases to 100 and
Investment increase to 150?

Solution,
(a) From the given information, National Income Equilibrium is:
Y = C + I + G Then,
Y = 200 + 0.8 (Y – T) + 100 + 150
Y = 200 + 0.8 [Y –(50 + 0.2Y)] + 100 + 150
Y = 450 + 0.8Y – 40 – 0.16Y
Y = 410 +0.64Y
Y – 0.64Y = 410
0.36Y =410
410
Y= = 1138.89
0.36

Therefore, the equilibrium Income (Y) Rs.1138.89

(b) Calculating tax multiplier in three sector economy,

We have,
−b
The tax multiplier (Tm) =
1−b
At consumption function,
C = 200 + 0.8 (Y – T)
C = 200 + 0.8[Y – (50 + 0.2Y)]
C = 200 + 0.8Y – 40 – 0.16Y
C = 160 + 0.64Y

Here MPC (b) = 0.64, then

12
 −0.64
The tax multiplier (Tm) = =¿- 1.78
1−0.64

Therefore, the tax multiplier(Tm) = - 1.78

(c) If Government Expenditure decreases to 100 and Investment increase to 150, the new
National Income is:
Y = 200 + 0.8 (Y – T) + 150 + 100
Y = 200 + 0.8 [Y – (50 + 0.2Y)] + 150 + 100
Y = 450 + 0.8Y – 40 – 0.16Y
Y = 410 +0.64Y
Y – 0.64Y = 410
0.36Y =410
410
Y= = 1138.89
0.36

Therefore, the equilibrium Income (Y) Rs.1138.89

Due to increase in investment by 50 and decrease in Government Expenditure by 50, then there is no
change in equilibrium National Income.

2011 fall q.n 4a

Compute Y (National Income), C (Consumption), S (Saving) and Yd (Disposable Income) with the
help of following information.
C=100+0.8Yd; I=500; G=100 and
T= 80
Find change in equilibrium Income if G increases to 200 and I decreases to 400 in Question no
Solution,

Since, at equilibrium,
Y = C + I + G Where, C = a + b (Y-T)
Then,
Y = 100 + 0.8Yd + 500 + 100
Y = 100 + 0.8(Y-80) + 600
Y = 700 + 0.8Y - 64
Y = 636 + 0.8Y
Y – 0.8Y = 636
13
0.2Y = 636
636
Y=
0.20
= 3180

Therefore the equilibrium Income (Y) Rs.3180

Here,
Yd = Y – T = 3180 – 80 = 3100

At, Disposable Income (Yd) = 3100,

Consumption (C) = 100+0.8Yd
C = 100 + 0.8 × 3100 = 2480

Saving (S) = Yd - C
(S) = 3100 – 2480 = 620

(b) Calculating equilibrium Income if G increases to 200 and I decreases to 400

Y = 100 + 0.8Yd + 400 + 200

Y = 100 + 0.8(Y-80) + 600
Y = 700 + 0.8Y - 64
Y = 636 + 0.8Y
Y – 0.8Y = 636
0.2Y = 636
636
Y=
0.20
= 3180

Therefore the equilibrium Income (Y) Rs.3180

When government expenditure increases to 200 and investment decreases to 400, there is no
change in equilibrium income.

2011 spring q.n.4

Consider the three sector economy with following behavioral equations (where symbols have
their usual meaning).
C = 1000 + 0.75 Yd T = 3000
I = 2000 G = 10,000
(a) Find equilibrium level of income
(b) Calculate government expenditure multiplier.
(c) If tax function is T= 3000+ 0.2Y. When equilibrium level of income will alter?

14
Solution,
(a) From the given information, National Income Equilibrium is:
Y = C + I + G Then,
Y = 1000 + 0.75Yd + 2000 + 10000
Y = 1000 + 0.75 (Y – T) + 12000
Y = 1000 + 0.75 [Y –3000] + 12000
Y = 13000 + 0.75Y – 2250
Y = 10750 +0.75Y
Y – 0.75Y = 10750
0.25Y =10750
10750
Y= = 43000
0.25

Therefore, the equilibrium Income (Y) Rs.43000

(b) Calculating government expenditure multiplier

We have,
1
The Government Expenditure multiplier (Gm) =
1−b
Here, mpc (b) = 0.75
0.75
= 1−0.75 =¿4

Therefore, the Government Expenditure multiplier (Gm) = 4

(c) Calculating equilibrium level of income, if Tax function: T = 3000+0.2Y, then

At new equilibrium,
Y = 1000 + 0.75Yd + 2000 + 10000
Y = 1000 + 0.75 [Y – (3000+0.2Y)] + 12000
Y = 1000 + 0.75Y –2250 - 0.15Y] + 12000
Y = 13000 + 0.60Y – 2250
Y = 10750 +0.60Y
Y – 0.60Y = 10750
0.4Y =10750
10750
Y= = 26875
0.40

Therefore, the equilibrium Income (Y) Rs. 26875

When govern imposes 20% tax, the equilibrium level of income decreases from Rs. 43000 to
26875.

2013 q.n 4a
15
Suppose that the economy is in equilibrium at
Y = C + I + G + (X-M), where, C = 100 + 0.7(Y-T)
I = 100, G = 70, X = 20, T = 30 and M= 10 + 0.2Y

(i) Find out the equilibrium level of National Income(Y)

(ii) Determine foreign trade multiplier.

Solution,
(i) We have equilibrium level of national income

Y = C + I + G + (X – M)
Y = 100 + 0.7(Y-T) + 100 +70 + 20 – (10 + 0.2Y)
Y = 290 + 0.7(Y – 30) – 10 – 0.2Y
Y = 290 + 0.7Y – 21 – 10 – 0.2Y
Y = 259 + 0.5Y
0.5Y = 259
259
Y= = 518
0.50

Therefore, the equilibrium level of income (Y) = 518

1
(ii) Foreign trade multiplier (Fm) =
1−b+ m
1
=
1−0.7+ 0.2

1
= =2
0.5

Therefore, the foreign trade multiplier (Fm) = 2

IS and LM function: General Equilibrium of Product and

Money Market Equilibrium

2009 spring

Suppose structural model for the product market is given as:

16
 C = 100 + 0.75(Y- T)
I = 200 – 200i
G = 100 and
T = 0.20Y
Similarly, the money market equilibrium as:
Mt = 0.5Y
Msp =100 – 2500i and
Ms = 200
Where the symbols have their usual meaning
Find the equilibrium value of income and rate of interest.

Solution,
In three sector economy,
The product market equilibrium as:
Y=C+I+G

Then,
Y = 100 + 0.75(Y – T) + 200 -200i + 100
Y = 100 + 0.75(Y – 0.2Y) + 200 -200i + 100
Y = 100 + 0.75(0.8Y) + 300 -200i
Y = 400 +0.60Y – 200i
Y – 0.60Y = 400 – 200i
0.4Y = 400 – 200i
400 200i
Y= –
0.40 0.40
Y = 1000 – 500i
Therefore, the IS equation Y = 1000 – 500i………………………(i)

At money market equilibrium

Md = Ms
Here,
Md = Mt + Msp [Mt = money demand for transaction and precautionary motive]
[ Msp = Speculative demand for money]
Md = 0.5Y + 100 – 2500i
Ms = 200

Then,
17
200 = 0.5Y + 100 – 2500i
200 -100 +2500i = 0.5Y
0.5Y = 100 + 2500i
100 2500i
Y= +
0.50 0.50
Y = 200 + 5000i
Therefore, the LM equation: Y = 200 + 5000i……………………………..(ii)

At equilibrium in the economy, we have IS = LM, then

1000 – 500i = 200 + 5000i

-500i - 5000i = 200 – 1000
- 5500i = -800
−800
i= = 0.1455 = 14.55%
−5500
Therefore, The rate of interest (i) = 14.55%.

At I = 14.55% rate of interest, the equilibrium level of income

Y = 1000 – 500i
Y = 1000 – 500(0.1455)
Y = 1000 – 72.75
Y = 927.25
Therefore, the equilibrium level of income (Y) = 927.25 million.

2010 fall

The following data are given for an economy

Consumption (C) = 40 + 0.75Yd
Investment (I) = 140 – 10i
Government Expenditure (G) = 100
Lump sum tax (T) = 80

Money demand (Md) = 0.2Y – 5i

Money supply (Ms) = 85
(i is the % interest rate, other figures in Rs. Crores)

(a) Find the equilibrium income and interest rate

(b) Suppose the government increases its expenditure on education and health services by rs.
65 crores, what would be its effect on equilibrium income and interest rate?

Solution,
18
(a) At product market equilibrium

Y = C + I + G Where, C = a + b (Y – T), I = Ǐ – hi
Then,
Y = 40 + 0.75(Y – T) + 140 -10i + 100
Y = 40 + 0.75[Y – 80] + 240 -10i
Y = 280 + 0.75Y - 60 -10i
Y = 220 +0.75Y – 10i
Y – 0.75Y = 220 – 10i
0.25Y = 220 – 10i
220 10 i
Y= –
0.25 0.25
Y = 880 – 40i
Therefore, the IS equation Y = 880 – 40i………………………(i)

At money market equilibrium

Ms = Md
Here,
Md = Mt + Msp [Mt = money demand for transaction and precautionary motive]
[Msp = Speculative demand for money]
Md = 0.2Y – 5i
Ms = 85
Then,
85 = 0.2Y – 5i
0.2Y = 85 + 5i
85 5i
Y= +
0.20 0.20
Y = 425 + 25i
Therefore, the LM equation: Y = 425 + 25i……………………………..(ii)

At equilibrium in an economy, IS = LM
880 – 40i = 425 + 25i
-40i – 25i = 425 – 880
- 65i = -455
−455
i== =7
−65
At i = 7, then Y = 425 + 25×7 = Rs. 600 crores.

(b) If government increases its expenditure on education and health services by rs. 65 crores,
then the new equilibrium at product market as

Y = C + I + (G +∆G) Where, C = a + b (Y – T), I = Ǐ – hi

At ∆G by Rs. 65 crores, New G = 100 + 65 = 165 crores.

19
Then,
Y = 40 + 0.75(Y – T) + 140 -10i + 165
Y = 40 + 0.75[Y – 80] + 305 -10i
Y = 345 + 0.75Y - 60 -10i
Y = 285 +0.75Y – 10i
Y – 0.75Y = 285 – 10i
0.25Y = 285 – 10i
285 10 i
Y= –
0.25 0.25
Y = 1140 – 40i
Therefore, the new IS equation Y = 1140 – 40i………………………(iii)

At new equilibrium,
New IS = Initial LM equation
1140 – 40i = 425 + 25i
- 40i – 25i = 425 – 1140
- 65i = -715
−715
i= = 11
−65

At i = 11, then Y = 425 + 25×11 = Rs 700 crores.

Due to increase in government expenditure on education and health services by Rs. 65 crores,
equilibrium income increases by Rs 100 crores ( 700 – 600 =100) and rate of interest increases
by 4 percent (11 – 7 = 4 )

2013 fall q.n 6a

Suppose the following functions are given as:

C = 100 + 0.8Yd Mt = 0.5Y
T = 20 Msp = 100 – 50i
I = 100 – 30i Ms = 150
Where, symbols have their usual meanings. With this information’s determine equilibrium level
of income(Y) and interest rate(i) under the framework of IS – LM model.

Solution,
In three sector economy, the product market equilibrium as:
Y=C+I
Then,
Y = 100 + 0.8(Y – T) + 100 -30i
Y = 200 + 0.8(Y – 20) - 30i
Y = 200 + 0.8Y - 16 - 30i
Y = 184 + 0.80Y – 30i
20
 Y – 0.80Y = 184 – 30i
0.2Y = 184 – 30i
184 30 i
Y= –
0.20 0.20
Y = 920 – 150i
Therefore, the IS equation Y = 920 – 150i………………………(i)

At money market equilibrium

Ms = Md
Here,
Md = Mt + Msp [Mt = money demand for transaction and precautionary motive]
[ Msp = Speculative demand for money]
Md = 0.5Y + 100 – 50i
Ms = 150
Then,
150 = 0.5Y + 100 – 50i
0.5Y = 150 – 100 + 50i
0.5Y = 50 - 50i
50 50 i
Y= -
0.50 0.50
Y = 100 - 100i
Therefore, the LM equation: Y = 100 - 100i……………………………..(ii)

At equilibrium in the economy, we have IS = LM, then

920 – 150i = 100 - 100i

-150i + 100i = 100 – 920
- 50i = - 820
−820
i, = = = 16.4
−50
Therefore, The rate of interest (i) = 16.4%

At I = 16.40% rate of interest, the equilibrium level of income

Y = 100 – 100i
Y = 100 – 100(0.164)
Y = 100 – 16.4
Y = 83.6
Therefore, the equilibrium level of income (Y) = 83.6 million.

Numerical Illustration:

21
(1) Suppose the structural model for the product market is given as:
C = 100 + 0.75Yd
I = 200 – 20i
G = 100
T = 0.2y
Similarly, the money market model is given as:
Mt = 0.5Y
Msp = 100 – 25i
Ms = 200, where the symbols have their usual meanings.

Find the equilibrium value of income and interest.

Solution,
The goods market in a three sectors economy is in equilibrium when
Y=C+I+G
Substituting the values for the relevant variables, we have
Y = 100 + 0.75Yd + 200 – 20i + 100
Y = 400 + 0.75(Y – T) – 20i
Y = 400 + 0.75(Y – 0.2Y) – 20i
Y = 400 + 0.75Y – 0.15Y – 20i
Y – 0.6Y = 400 – 20i
0.4Y = 400 – 20i
400 20i
Y= –
0.40 0.40
Y = 1000 – 50i………………………….(i)

The money market equilibrium when

Ms = Md
Here,
Md = Mt + Msp [Mt = money demand for transaction and precautionary motive]
[ Msp = Speculative demand for money]
Md = 0.5Y + 100 – 25i
Ms = 200
Then,
200 = 0.5Y + 100 – 25i
0.5Y = 100 + 25i
100 25i
Y= +
0.50 0.50
Y = 200 + 50i
Therefore, the LM equation: Y = 200 + 50i……………………………..(ii)
At equilibrium in an economy, IS = LM
1000 – 50i = 200 + 50i
-50i – 50i = 200 – 1000
- 100i = -800

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 −800
i== =8
−100
At i = 8, then Y = 200 + 50 × 8 = Rs. 600 crores.

Therefore, the equilibrium interest rate (i) = 8% and equilibrium income(Y) = 600 crores.

Example 1
Given C = 102 + 0.7Y, I = 150 – 100i, Ms = Rs 300 million, Mt = 0.25Y, Msp = 124 – 200i.
Find
(a) The equilibrium level of income and interest rate
(b) The level of C, I and L or Md when the economy is in equilibrium.
(c) If the money supply increases by Rs. 17 million what happens to the equilibrium level of
income and interest.

Example 2
Suppose the structural model for the product market is given as follows:
C = 100 + 0.8Y(Y-T); S = -100 + 0.20Y(Y- T); I = 200 – 1080I; T= 50 + 0.20Y.
Compute the Equilibrium income and the rate of interest.

Example 3
Let, product market model is given as follows:
C= a + b(Y-T), S = -a + (1-b) Yd
I =Ǐ– hi, G = Ǵ, T = Ť – tY (where, 0t1)
Derive the product market equilibrium and IS curve.

Example 4
Consider the following features of Nepalese economy:
C= 80 + 0.8Yd, T = 60 + 0.2Y, I = 200 – 10i, G = Rs. 160 billions, Mt = 0.4Y, net transfers = + 40,
Msp = 300 – 20i, Ms = Rs. 476 billion.

(a) Calculate the equilibrium income and rate of interest

(b) Is the Government budget is surplus or deficit
(c) What will be the effect on equilibrium income and the rate of interest when NRB increases
money supply by Rs. 24 billion?
(d) What will be the effect on equilibrium income and the rate of interest when Nepal
government increases its autonomous spending by Rs. 20 billion and increases income tax by
5%?
(e) What will be the simultaneous effect on equilibrium income and interest rate when NRB
increases money supply by Rs. 24 billion, autonomous spending Rs. 20 billion and tax rate by
5%? Does it reflect the inflation and the pressure in the economy?

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Inflation:
From the following data compute:
(i) Real GNP
(ii) GNP deflator and rate of Inflation.
Year Nominal GNP(In billions) Wholesale PIN(2000-2001)=100
2005-2006 54195 228.1
2006-2007 61583 251.0

Solution,

Nominal GNP
(i) Real GNP = × 100
Wholesale PIN (¿ ,GNP deflator)

54195
Real GNP (2005 – 2006) = × 100
228.1

= Rs.23759.32 billions.

61583
Real GNP (2006 – 2007) = × 100
251

= Rs.24535.06 billions

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(ii) Since, GNP Deflator = Wholesale (PIN)

Then,

GNP Deflator (2005 – 2006) = 228.10

GNP Deflator (2006 – 2007) = 251.00

Change∈GNP Deflator
Rate of Inflation (2006 – 2007) = × 100
Previous GNP Deflator

251−228.10
= × 100
228.10

= 10.04%

Multiplier
Formulas of multiplier:

1
Super multiplier (Ks) =
1−b−v

Where,
Ks = super multiplier
b = marginal propensity to consume
s = marginal propensity to save
v = marginal propensity to invest

−b
Tax multiplier (Tm) =
1−b
Where,
b = marginal propensity to consume

Note:
(i) A rise in tax (∆T) has negative effect on the equilibrium level of national income.
(ii) A fall in tax (-∆T) has a positive effect on the equilibrium level of national income.

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 1
Government Expenditure Multiplier (Gm) =
1−b

Where,
b = marginal propensity to consume

1 −b 1−b
Balanced budget multiplier (BBm) = Gm + Tm = + = =1
1−b 1−b 1−b

Where,
b = marginal propensity to consume

1
Export multiplier (Xm) =
1−b

Where,
b = marginal propensity to consume

1
Import Trade multiplier (Im) =
1−b

Where,
b = marginal propensity to consume

1
Foreign Trade Multiplier (FTm) =
1−b+ m

Where,
b = marginal propensity to consume
m = marginal propensity to import
(i) The value of foreign trade multiplier depends upon the value of marginal propensity to
consume (b) and marginal propensity to import (m)
(ii) If b = m, foreign trade multiplier is equal to unity.
(iii) If b ˃ m, foreign trade multiplier is greater than unity.

Q.n 1.

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Consider the four sector economy with
C = 100 + 0.8(Y – T); I = 1000; G = 100
T = 100; X = 500 and M = 0.25Y

Where, C = household consumption, Y = National income, I = autonomous business investment,

G = Autonomous government expenditure on goods and services, T = Lump-sum tax, X =
Autonomous exports. Calculate the size of the multiplier and the equilibrium level of income.

Solution,

We have the equilibrium in four sector economy as:

Y = C + I + G + (X – M)…………………………….(i)
Substituting the given above value in equation (i) then,
Y = 100 + 0.8(Y – T) + 1000 + 100 + 500 – 0.25Y
Y = 1700 + 0.8(Y – 100) – 0.25Y
Y = 1700 + 0.8Y – 80 – 0.25Y
Y = 1620 + 0.55Y
0.45Y = 1620
1620
Y= = 3600 million.
0.45

1
And the size of multiplier (m) = Here, b = 0.55
1−b

1 1
= = = 2.22
1−0.55 0.45

Q.n 2

Supose a structural model of the three sector economy is given as follows:

C = 200 + 0.8Yd; I = 100, G = 150, T = 50 + 0.2Y.
Find,
(i) Equilibrium National Income and Tax multiplier.
(ii) What happens to the national income if government expenditure decreased to 100 and
investment increases to 150?

Q.n 3

Consider a three sector Keynesian economy with the following equations:

C = 20 + 0.5Yd; T = 20, I = 50, G = 250

Where, the symbols have their usual meanings. Find the equilibrium level of income and
government expenditure multiplier. What would be the equilibrium level of income if marginal
propensity to consume (mpc) changes from 0.5 to 0.8?

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Consumption Function and Saving Function:

Example 1
Consider following schedule and derive linear consumption function and saving function (Rs. In
millions)
Disposable Income(Yd) 0 400 800 1200 1600
Consumption(C) 160 480 800 1120 1440
Saving (S) - 160 - 80 0 80 160

Solution,
Derivation of linear consumption function:
Since, C = a + bYd
Here, C = 160 at Yd = 0; therefore, a = 160
At any two consecutive points, ∆Yd = 400; ∆C = 320

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 ΔC 320
Therefore, Slope (b) = = = 0.8
ΔYd 400
Therefore, C = Rs. 160 million + 0.8Yd
Derivation of linear saving function:
Then, S = Yd -

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