MBA Program

Professor Mirza Azizul Islam

Income determination and role of monetary and fiscal policies

Product approach or aggregate demand or aggregate expenditure:

Using symbol AD for aggregate demand or aggregate expenditure.

AD = C + I + G + X – M………………………………………………………..………. (1)

Where,

C = Consumption
I = Investment
G = Government expenditure
X = Exports
M = Import

C= C + cYd and Yd = Y + TR – tY

C= C + c(Y + TR – tY)

= C + cY + c TR – ctY

= C + c TR + c (1– t) Y ………………………………………………………..………. (2)

Where C = Autonomous component of consumption

c = Marginal propensity to consume

TR = Transfers received from the Government, assumed constant

t = Tax rate
Y = Income

Combining equation (1) and (2) we find

AD = [ C + c TR + c (1-t) Y] + I + G + NX
…………………………………………… (3)

Where a bar on the top means the element is assumed constant

NX = Net export = X – M

At equilibrium,

Y= A + c (1 – t) Y ……………………………………………………………………… (4)

Where A represents sum of all components assumed constant

Or, Y [1 - c (1 – t)] = A ……………………………………………………………….…. (5)

❑
Or Y = 1−c (1 – t)

∆
Or ∆Y = = 1−c (1 – t) = α∆

1
Where α =
1−c (1 – t)

α is known as the multiplier, depends on c and t.

The higher ‘c’ is, the greater the multiplier and the higher‘t’ is, the lower will be the multiplier.

However I = I - bi ; i = interest rate

b = a measure of sensitivity of interest rate to investment

X = X (Yf, R) ; Yf = foreign income

R = Exchange rate

M = M (Y, R) ; Y = Home country income

Therefore equation (3) can be rewritten as

AD = [ C + c TR + c (1-t) Y] + ( I - bi) + G + X (Yf, R) - M (Y, R)

Role of fiscal policy

 Change in G , TR , t and i

Role of monetary policy

 Change in money supply and hence ‘i’.

Role of exchange rate and trade policies

 These policies affect X and M