CHAPTER 3

NATIONAL INCOME
EQUILIBRIUM
The Circular Flow of Income and
Expenditure

- A model built to simplify the economic

transactions amongst various economic groups
in the economy
- There are 4 economic groups involve in this
flow namely household, firms, government and
foreign sector.
- The simplest model of circular flow of income is
in 2 economy sector, then follow by 3 economy
sector and lastly by 4 economic sector
▪
 2 Sector Economy

 This economy known as closed economy /

simple economy

 It consists of:
1. Household
2. Firm

 Two kinds of flow;

➢ Physical flow
➢ Financial flow
Case 1: two sector economy
(the simple economy)
(land,labor,capital, enterpreneur)

Factor

(rent, wages, profit, interest)

HOUSEHOLD FIRMS

Payment of G&S
Product
Saving Investment (I)
(S) Good &Services

Financial Institution
Physical flow is a flow of goods and services.
✓ Household will supply the factors of production (land, labor,
capital and entrepreneur) to the firms for production of goods
and services
✓ By using combinations of all factors of production, firms will
produce goods and services and sell to the households.

Financial flow is a flow of money. It also can be divided into 2:

✓ When the firm used all the factors of production received from
household, the firm will pay to the household in form of reward
for services (rent, wages, interest and profit)
✓ Household will buy goods and services produced by firms. So,
money will flow back to the firms. Thus, the firms will use back
this money as a cost to produce back goods and services.
*Household will not spend all income received.
*Household will have the saving in financial institutions.
*That money will be loaned out to the firm for their
investments.
Income = Expenditure + Saving
Y= C+S
Saving is a leakage- saving reduce the amount of national
income (NI)
Investment is an injection- investment raised the amount of
NI
 3 Sector Economy

2. Firms
3 sector economy known as closed economy
The economy consist of :
1. Household
2. Firms
3. Government
Case 2: three sector economy
Factor

Government Government
expenditure (G)
expenditure (G)
Household Firm
GOVERNMENT
Taxes (T) Taxes (T)

Product
✓ Government intervene in the market using government
expenditure and taxes:
1. government purchase goods and services from firms
2. cover the payment of benefit and subsidies to firms and
households
2. Firms
3. collect taxes from firms and households

✓ Government expenditure (G) is an injection- G raised the

national income by expenditure on G&S, transfer payment,
welfare program, public investment and others

✓ Taxation (T) represents leakage- Taxes will reduce our disposable

income and thus reduced national income
 4 Sector Economy

▪ 4 economy sector known as open economy

2. Firms
▪ 4 sector economy consists of household, Firms,
Government and Foreign sector
 export import
import Foreign Sector export
Case 2: three sector economy
Factor Market

Government Government
expenditure (G)
expenditure (G)

Household FIRM
GOVERNMENT
Taxes (T) Taxes (T)

Product Market
With foreign sector we have import (M) and export (X)
 Through export, there will be money inflow and it
will raise the national income. So, export is an
2. Firms
injections

 While Import is a leakage since when we import

goods and services from other country, there will be
money outflow.
DETERMINATION OF
NATIONAL INCOME
EQUILIBRIUM
 NATIONAL INCOME
EQUILIBRIUM

Definition:
AS=AD

-A situation when total output (AS) is equal to

total expenditure (AD). Total supply of goods
and services (AS@Y) are equals to total
demand (AD@AE) of goods and services in an
something that you want to buy
economy in a given period.
AS/Y= INCOME @ OUTPUT
 Approaches in Determine
National Income Equilibrium

Two
Approaches

AS=AD Leakage=Injection
Approach Approach

15
 AS = AD
Approach
AGGREGATE SUPPLY/ AGGREGATE DEMAND/
OUTPUT EXPENDITURE
aggregate expenditure

 AS also referred as  AD also referred as AE

Y or output. @ income  Total demand made by
 Total amount of goods households, firms,
and services produced in government and foreign
an economy in any given sectors for final goods and
period of time. services produced in the
economy.

16
 Leakage = Injection
Approach
INJECTION
Activities done by various
sectors in the economy that
causes an increase in the
national income.
Examples: Investment,
government expenditures,
exports.
LEAKAGE
Outflow of income that
can decrease in national
income Incomes that flow
out
Examples: Saving, taxation
& import. = creates outflow of money
activity that can lessen the national
income
17
 Equilibrium can be seen in three different ways according to the types
of the economy

AD=AS Leakages= injection

BREAEVEN
Y=C S=O
S=Saving/ Leakages, I=Injection
C=consumption by household
I= Investment buy from 2 SECTOR ECONOMY
Y=C+I S =I
G= government spending by government section

3 SECTOR ECONOMY S=Saving,

4 sector economy T=Tax, I=Investment,
G= Government spending
Y = CY+=IC++GI + (X-M)
G S + ST+M
+T == II ++G
G +X
the leakages

4 SECTOR ECONOMY
Y=C+I+G+(X-M) S +T + M = I + G + X
amaniNZ-UITMCK 18
 M=Impact
CONSUMPTION AND SAVING THEORY:

Y=C+S
y=income, c=consumption

Consumption: Total expenditure on goods & services made by

individuals or households
Saving: The portion of household income that is not used for
consumption, and save in the financial institution
Both consumption and saving are influenced by disposable
income
 Disposable income is the total income received after deducting
the income tax. Y= personal income, T= tax
Yd = Y - T
If income increase, saving and consumption will be increase too
 TYPES OF CONSUMPTIONhow to buy that? using what?
(i) Autonomous consumption (a) from borrowing, your wealth,
your saving
Consumption when household does not have any income
refers to consumption on basic necessities rice, flour
the amount exist does not depend on the income level
the amount determined by other factors, such as wealth and
borrowing.
e.g : when Yd=0, C=50 (autonomous consumption is the value of C when
Yd = 0)
Also known as consumption expenditure when national income is zero

(ii) Planned /Induced consumption Planned consumption

the amount of consumption influenced by income factor

As income increases, the amount of consumption will increase and vice
versa.
It depends on the value of marginal propensity to consume (MPC); where it
is the changes in consumption affect from the changes in disposable income
(Yd) the expenses wont be more than the existed income
 Consumption Function
 Consumption function is an equation that shows the
relationship between consumption level and income level.
 The general equation for linear consumption function is:

C = a + bYd
 where,
C = consumption
a = autonomous consumption (intercept)
b = MPC (slope of C function)
Yd = disposable income

how to get a? it has to be 0

kencenderungan to buy something

21
Relationship between Consumption &
Income

Disposable Income Consumption

(Yd) (C)
0 20
100 110
200 200
300 290
400 380
500 470
600 560

these are not depending on income

 .

22
 Concepts of Consumption

a) Average propensity to consume (APC)

It measures the proportion of income that used
for consumption expenditure by households at
a certain level of income.

APC = = C / Y
Y = RM400million, C = RM380million
APC = 380/400
= 0.95
APC isnt constant

The APC will not be constant. It changes with

income level. As income increases, APC will
fall.

23
b) Marginal propensity to consume (MPC)

It measures the rate of changes in consumption

when income changes.

MPC = ∆ C / ∆Y
Yo = RM100million, Co = RM110million
Y1 = RM200million, C1 = RM200million

MPC = 200-110 Change in C, change in Y

200-100
the new one will minus the old one
= 0.9

MPC is constant at every level of income

because MPC measure the slope of the
consumption function.

24
Disposable Consumption APC MPC
Income (Yd) (C) C/Yd C/Yd

0 20 - -
100 110 1.1 0.9
200 200 1.0 0.9
300 290 0.97 0.9
400 380 0.95 0.9
500 470 0.94 0.9
600 560 0.93 0.9

 APC fall as income increases

 MPC is constant at every level of income
25
 Consumption Schedule

Disposable Consumption (C) APC MPC

income (Yd)
0 50
100 125
200 200
300 275
400 350
500 425

Based on the table:

1.Determine the values of APC and MPC

2.Write the consumption function
 Answer:
Consumption Schedule

Disposable Consumption (C) APC MPC

income (Yd)
0 50 - -
100 125 1.25 0.75
200 200 1 0.75
300 275 0.92 0.75
400 350 0.88 0.75
500 425 0.85 0.75

Based on the table:

1.Determine the values of APC and MPC
2. Write the consumption function
 Consumption Schedule

Disposable Consumption APC MPC

Income (Yd) (C) C/Yd C/Yd

0 20 - -
100 110 1.1 0.9
200 200 1.0 0.9
300 290 0.97 0.9
400 380 0.95 0.9
500 470 0.94 0.9
600 560 0.93 0.9

Based on table, C function is: C = 20 + 0.9Yd

28
 TYPES OF SAVING
(i) Autonomous Saving /Dissaving (-a)
Part of saving does not relate to income
Occurs when there is autonomuos consumption
e.g : a=50 , S=-50
(ii) Planned /Induced saving
the amount of saving influenced by income factor
As income increases, the amount of saving will increase
Y=C+S ; S = Y -C
 Saving Function
 An equation that shows the relationship between the
amounts of saving and income level.
 S function can be written as:

S = -a + (1 – b)Yd
MPC
 where,
S = saving
-a = autonomous saving (intercept)
b = MPC
(1 – b) = 1 – MPC = MPS
Yd = disposable income

30
 Relationship between C, S & Income

Disposable Consumption Saving

Income (Yd) (C) (S)
0 20 -20
100 110 -10
200 200 0
300 290 10
400 380 20
500 470 30
600 560 40

a) The amount of saving will increase when income increase

b) At zero level of income, saving is negative since total consumption
by households exceeds the income levels. This is called
‘autonomous saving’
c) Autonomous saving occurs when there is autonomous consumption.
d) In saving function, it indicates as ‘-a’
1. Average propensity to save APS

- It measures the proportion of income that households

save. It is not constant.
- formula :
APS = Total Saving = S
Total Income Yd

2. Marginal propensity to save (MPS)

- It measures the rate of changes in saving when income
changes.
- formula :
MPS = change in total saving
change in Total Income
 Study Question
YD-C= S

Yd C S APC APS MPC MPS

0 60
100 120
200 180
300 240
400 300
500 360

1. Complete the above table

2. Determine the value of autonomous consumption
3. Derive consumption and saving function

At every level of income; MPC+MPS =1

APC +APS =1
33
Determinants of Consumption and Saving

1. Household income
Consumption and savings has positive relationship with
income.
When household income increases, consumption and
savings will increase because people purchasing power and
standard of living increase
When household income decreases, consumption and
savings decrease

2. Price of goods
Any changes in the price will affect an individual propensity
to consume and saving.
If the price of goods increases, propensity to consume will
decrease and saving will increase. However, if the price of
goods decreases, propensity to consume will increase and
saving will decrease.
3. Rate of interest
When interest rates are low; household consumption will
increase and saving decrease. This is because people turn to
borrow money from bank and spend on goods and services.
When interest rates are high; household consumption will
decrease and saving increase to take advantage of higher
interest rates.

4. Taxes
If tax rates are low, household consumption will increase. This
is because low tax rate will increase disposable income and
people spending power
If tax rates are high, household consumption become
decrease because decrease in disposable income and
spending power.
 TPYES OF INVESTMENT

1. Autonomous investment (I)

• Fixed and independent of income

Investment

Autonomous investment

Income
2. Induced investment
Investment that related with national income. As
national income increase, induce investment also
increase.
Eg: Investment to purchase new machinery,
buildings, trucks and other equipments in order to
increase production and profit.

Income Induced investment

Investment
Factors Influencing Investments
1. Rate of return
If the rate of return greater than cost of investment, investors will increase their
investment because investment may generate profit.
If the rate of return lower than cost of investment, investors will not invest because
investment will lead to losses.

2. Rate of interest
When interest rates are low, cost of loan become cheaper. Therefore, investors will
increase their investment.
When interest rates are high, cost of loan become expensive. Therefore, investors
will decrease their investment.

3. National income
As national income increase, investment will increase
As national income decrease, investment will decrease (positive relationship)

4. Production cost
When production costs are low, return from investment or profit will increase.
Therefore, firm will increase investment in order to increase production
When production costs are high, return from investment will decrease. Therefore,
firms will decrease their investment
DETERMINATION OF
EQUILIBRIUM INCOME
IN 2, 3
AND 4 SECTOR
ECONOMY.
 Approaches in Determine
National Income Equilibrium

Two
Approaches

AS=AD Leakage=Injection
Approach Approach

40
1. EQUILIBRIUM IN 2-SECTOR ECONOMY

✓ Equilibrium in a 2 sector economy is a simple

economy, which consist of two agents only, namely
households and firms
✓ Equilibrium occurs when the AD=AS or leakage
=injection

41
Case 1: two sector economy
(the simple economy)
(land,labor,capital, enterpreneur)

Factor

(rent, wages, profit, interest)

HOUSEHOLD FIRMS

Payment of G&S
Product
Saving Investment (I)
(S) Good &Services

Financial Institution
 (AS = AD) APPROACH (Leakage=Injection) APPROACH
▪ Formula is: ▪Formula is:
Y =C+I S=I

Given the following information: Given the following information:

➢Autonomous consumption =130
➢ MPC=0.7
➢ Autonomous investment (I) = 500
Solution:
Consumption function; C=130+0.7Yd (in two
sector economy, Yd=Y since no tax)
➢Autonomous consumption =130
➢ MPC=0.7
➢ Autonomous investment (I) = 500
Solution:
Consumption function; C=130+0.7Yd , so
saving function is S=-130+0.3Yd (Yd=Y)

Y=C+I S=I
Y = 130 + 0.7Y + 500 ;Yd=Y -130 + 0.3Y = 500
Y = 630 + 0.7 Y 0.3Y = 500 + 130
Y-0.7Y = 630 0.3Y= 630
0.3Y = 630 Y= 630/0.3
Y= 630/0.3 Y = 2100 (Income
Y = 2100 (Equilibrium Income) Equilibrium)
 TWO APPROACHES TO DETERMINE NATIONAL INCOME
EQUILIBRIUM
AD=AS APPROACH LEAKAGE = INJECTION APPROACH
Y=C+I S=I

AD Injections, leakages
Y=AD

Leakages
S=-130+0.3Y
(C+I)=630 +0.7Yd
Injections
500

630
Y
2100

45 º
-130
Y
2100
 STUDY QUESTION:

1. Given C=500+0.5Yd I=1000

a) Calculate National income equilibrium in two
sector economy and sketch diagram to show
equilibrium point
b) Determine the value of MPS
c) Derive saving function
d)Calculate the value of consumption at
equilibrium

Answer:

a) RM3000
1. EQUILIBRIUM IN 3-SECTOR ECONOMY

✓ Equilibrium in a 3 sector economy consist of

households, firms and government
✓ Equilibrium occurs when the AD=AS or leakage=
injection

46
Case 2: three sector economy
Factor

Government Government
expenditure (G)
expenditure (G)
Household Firm
GOVERNMENT
Taxes (T) Taxes (T)

Product
 (AS=AD) APPROACH (LEAKAGE=INJECTION) APPROACH
The formula is: Y =C+I+G The formula is: I +G = S + T

Given the following information. Given the following information.

C = 200 + 0.75Yd C = 200 + 0.75Yd
I = 100, G = 50, T = 100 I = 100, G = 50, T = 100
Solution: Solution:

Y = C+I+G ; (Yd = Y – T) S + T =I + G ; (Y = Y – T)

Y = 200+0.75Yd + 100 +50 -200 + 0.25Yd+100 = 100 + 50

Y= 200 +0.75 (Y- 100) +100 +50 -200 + 0.25 (Y – 100) +100 =150
Y= 350+ + 0.75Y -75 -100 +0.25Y – 25= 150
Y = 275+0.75Y -125 + 0.25Y = 150
Y -0.75Y = 275 0.25Y= 150 +125
Y = 275/0.25 0.25Y =275
Y = 1100 Y= 275/0.25
Y=1100
 TWO APPROACHES TO DETERMINE NATIONAL INCOME
EQUILIBRIUM
AD=AS APPROACH LEAKAGE = INJECTION APPROACH
Y=C+I+G S+T=I+G

AD Injections, leakages
Y=AD

Leakages
S+T= -125+0.25Y
C+I+G=275+
0.75Y
Injections
150
(I + G)

275
Y
1100

45 º
-125
Y
1100
 STUDY QUESTION:

1. Given C=500+0.5Yd I=1000 G=2250

T=100

a) Calculate National income equilibrium in three

sector economy
b) Calculate the value of consumption and saving
at equilibrium
c) Derive S function after tax.
EQUILIBRIUM IN A 4-SECTOR
ECONOMY

51
 export import
import Foreign Sector export
Case 2: three sector economy
Factor Market

Government Government
expenditure (G)
expenditure (G)

Household FIRM
GOVERNMENT
Taxes (T) Taxes (T)

Product Market
1. EQUILIBRIUM IN 4-SECTOR ECONOMY

✓ Equilibrium in a 4 sector economy consist of

households, firms, government and foreign sector
✓ Equilibrium occurs when the AD=AS or leakage
=injection

53
 (AS = AD) APPROACH (LEAKAGE=INJECTION) APPROACH
The formula is: The formula is:
Y = C + I + G + (X-M) S + T+M = I +G+X

➢ Given the following information: ➢ Using the same information:

C = 200 + 0.75Yd Equilibrium income is:
I = 100 G = 50
T = 100 X = 100 M = 50 S+T+M = I+G+X
-200+0.25(Y-100)+100+50 =100+50+100
❖ So: Equilibrium income is: -50 +0.25Y -25 = 250
Y = C+I+G+ (X-M) -75 + 0.25Y =250
= 200+0.75Yd+100+50+(100-50) 0.25Y =325
= 400+0.75(Y-T) Y = 325/0.25
= 400+0.75(Y-100) Y = 1300 (Equilibrium Income)
= 400+o.75Y-75
Y = 325 + 0.75Y
Y-0.75Y = 325
Y = 325/0.25
Y = 1300 (Equilibrium Income)
 TWO APPROACHES TO DETERMINE NATIONAL INCOME
EQUILIBRIUM
AD=AS APPROACH LEAKAGE = INJECTION APPROACH
Y = C + I + G + (X – M) S+T+M=I+G=X

AD Injections, leakages
Y=AD

Leakages
S+T+M= -75+0.25Y
AD=325+0.75Y
Injections
250
(I+G+X)

325
Y

1300
45 º
-75
Y

1300
 STUDY QUESTION:

1. Given S=-500+0.5Yd I=1000 G=2250

X=1500 M=1000 T=100
a) Derive consumption function after tax
b)Calculate National income equilibrium in four
sector economy
MULTIPLIER
 MULTIPLIER APPROACH

Multiplier is used to measure how many times

the changes in national income (Y) due to changes
in agregate demand (AD)

AD (investment, government spending and

taxes)

Three types of multiplier:

1. Investment multiplier
2. Government mutiplier
3. Tax multiplier
1. Investment Multiplier (Ki)

Formula:
Ki = 1 or; 1
MPS 1 - MPC

Ki is used to measure how many times the changes in

equilibrium income due to a change in investment

Therefore; Δ Y = Ki x Δ I
 STUDY QUESTION

Given: C=200+0.75Y and

National income (Y) = RM1100 million,

1. Calculate investment multiplier

2. Calculate change in national income when there
is a change in investment (increase) by 50 million
3. What is the new equilibrium income level
(Formula: Y1 = Yo + Δ Y)
 ANSWER
1. Investment multiplier:

Ki = 1
MPS
= 1
0.25
= 4
(This means that the national income will increase
by 4 times the increase in investment)
 ANSWER
2. Change in National income:

Δ Y = Ki x Δ I
= 4 x 50
ΔY = 200 million

3. New equilibrium income (Y1) = Yo + ∆Y

= 1100 + 200
= 1300 million
2. Government Multiplier (Kg)

Formula:
Kg = 1 or; 1
MPS 1 - MPC

Kg is used to measure the changes in equilibrium income

due to a change in government spending

Therefore; Δ Y = Kg x Δ g
 STUDY QUESTION

Given: C=100+0.75Yd
I = 300
G=500
T= 10

1. Calculate national income equilibrium for this

economy
2. If government expenditure decreases by RM
100 million, find the new equilibrium income
(using multiplier Approach)
 ANSWER

1. Y=100+0.75Yd+300+500
=900+0.75(Y-T)
=900+0.75(Y-10)
=900+0.75Y-7
=893+0.75Y
Y-0.75Y=893
0.25Y=893
Y=893
0.25
Y=3572
 ANSWER
2. New equilibrium income when government
expenditure decreases by 100 million

Y1 =Yo +∆Y ; ∆Y = Kg x ∆g
= 1 x (-100)
0.25
= 4 x (-100)
= - 400

Therefore: Y1 = Yo + ∆Y
= 3572 + (- 400)
= 3172
3. Tax Multiplier (Kt)

Formula:
Kt = -MPC or; -MPC
MPS 1 - MPC

Kt is used to measure the changes in equilibrium income

due to a change in taxes

Therefore; Δ Y = Kt x Δ T
 EXERCISE:

Given: S= -100+0.75Yd
National Income = RM 2200

1. Calculate tax multiplier

2. If government increase tax collection by RM
10, find the new equilibrium income (using
multiplier Approach)
 ANSWER

1.Tax multiplier
Kt = -MPC
MPS
= -0.25
0.75
= - 0.33
2. New equilibrium income when government
increases by RM10
Therefore: Y1=Yo + ∆Y ; ∆Y=Kt x ∆T
= 2200 + (-3.30) = -0.33 x10
= RM2196.70 = -3.30
 BREAKEVEN INCOME
❑ Is the level of income where total income equal to total consumption
-In other word : savings is equal to zero
At Breakeven Point :
• Y=C
• S=0
• APC = 1
• APS = 0

Eg: Given C = 100 + 0.75 Yd,

Calculate Breakeven Income.

Y= C
S= 0
Y= 100 + 0.75Yd
-100+0.25Yd= 0
Y-0.75Yd= 100
0.25Yd= 100
o.25Y= 100
Y= 400
Y= 400
 C
Y=C

100

National income
400
S

National income
400
-100

Figure : Consumption and saving curve.

 Determination of
National Income
Disequilibrium

❑ A situation when aggregate demand (AD) is

not equals to aggregate supply (AS) in an
economy in a given period

72
 Inflationary &
Deflationary Gap

 Inflationary gap (inflation) occurs when:

AD > AS or; Y > Yfe

 Deflationary gap (unemployment) occurs when:

AD < AS or; Y < Yfe

73
 Inflationary Gap
 Occurs when AD exceeds AS in full
employment condition
 Full employment is condition when all
available resources have been utilize with max
efficiency.
 Therefore, when AD increase, AS cannot be
increased as demanded. As a result, the
problem of inflation will exist.
 Also measured as; when national income (Y)
exceeds full employment income (Yfe)

Y > Yfe
Y > Yfe 74
AD
Y=AD
Inflationary gap E AD
A
ADfe

Y > Yfe → Inflationary gap.

B The inflationary gap A to B
will increase general price
level.
Yfe Y NI

75
 Deflationary Gap
 Occurs when AD is less than full employment
AS.
 A situation when the resources are not fully
utilized. Thus, it will cause unemployment.
 Also measured as; when full employment
income (Yfe) exceeds national income (Y)

Yfe > Y
76
AD
Y=AD
ADfe
C Deflationary gap
AD
E D Y < Yfe → Deflationary gap
The deflationary gap C to D
where the equilibrium
income level is below full
Y Yfe NI employment

77
 Example:
C = 7500 + 0.8Yd
I = 8000
G = 4500
T = 4000
(all figures are in RM billion)

a) Calculate the equilibrium level of national income.

b) If the full-employment level of income is RM100,000
billion, is there inflationary gap or deflationary gap?
Why?
c) Using multiplier approach, calculate how much should
the government change its spending to close the gap
above?

78