CHAPTER THREE

3.1 Income Determination in the two sector model

Closed economy is an economy where there are no imports, exports and foreign transfer
payments. Generally, it is an economic system where there is no foreign economical interaction.
The basic proposition of Keynesian theory is the equilibrium level of income and output depends
on the economy’s aggregate demand (spending) for output. If aggregate demand is not sufficient
unemployment results and production of goods and services falls below its potential. If, on the
other hand, aggregate demand is sufficient full employment results, and production reaches its
potential. Therefore, according to the simple Keynesian theory the level of output not only
depends on aggregate demand (spending ) on goods and services, but it increases or decreases
with the rise and fall of the level of aggregate demand.

This model assumes that the aggregate supply curve is perfectly elastic up to full employment
level of output. This means that the price of goods and services is given and remain unchanged.
We start discussion of determination of equilibrium level of income or output first by assuming
the two-sector model in which there are only households and businesses in the economy given
this assumption: consumption expenditure and domestic private investment spending determine
aggregate demand.

3.1.1 The consumption function

Real income determines the aggregate amount of goods purchased by consumers in any time. An
increase in the real income of households will lead them to increase the amount of goods they
will purchase. This clearly indicates the close relationship that exists between the aggregate
amount of consumer spending and the real disposable personal income. The consumption
expenditure varies directly with real disposable income.
To know how much is the change on expenditure as the result of the change in real disposable
income; we have to know about the fundamental psychological law of Keynes. According to the
law, as the real income increases, consumers will spend part but not all of the increase. They will
choose to save some part of it. Implying that as the income increases the smaller proportion of
the additional income will be consumed.
Consumption expenditure is defined as aggregate spending on goods and services to satisfy
wants.
The amount of goods purchased by consumers is dependent on real income. An increase in real
income of households will increase the amount of goods they will purchase. The income of
households is the disposable income. As disposable income of consumers increase, they will
spend part but not all of the increase; they save part of it.
When we consider the income side of GDP, it can be disposed of as
- consumption( C )
- saving (S )
- tax payments ( T )

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 - private transfers to foreigners ( Rf)
So, the income side of GNP is
GDP = C + S + T + Rf and the expenditure side is
GDP= C + I+ G+ NX, but the two approaches measure the same GDP
⇒ C+I+G+NX ≡GDP ≡ C + S + T + R f
In closed economy, it becomes
⇒ C+I+G≡ GNP≡C+S+T
In the two sector model, in the absence of government, it becomes,
⇒C+I≡ GDP≡ C+S
So, GDP= C+S
 Let's assume that GDP= Y ( income ) and be disposable income (Yd )
Y = C+S= Yd
Yd = C+S ⇒C= Yd - S
⇒What is not consumed is saved.
To know what proportion of the increased disposable income goes to consumption, let's discuss
about:
i. Average propensity to consume and
ii. Marginal propensity to consume
i/ Average propensity to consume ( APC )
 It is the proportion of disposable income or national income Y that is spent on all
consumption in a given time pried. It is the proportion of income allocated for
consumption expenditure.
( ) C Ca cYd Ca
APC= = =   c
( ) Yd Yd Yd Yd
ii/ Marginal propensity to consume ( MPC )
 It is the change in consumption as result of a one-unit change in disposable income. In
other words it is the fraction of each additional units of disposable income that goes to
consumption.
Changeinconsumption exp enditure C
MPC= 
Changeindisposableincome Yd
 It is the slope of the consumption function(c).
 Now we know how to measure the proportion of income that goes to consumption next
let's see the consumption function.
The consumption function equation
 Consumption is a function of disposable income.
C = Ca + cYd, where, -Ca is autonomous consumption
- c is the MPC (the slope of the consumption function)
- C is consumption

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 - Yd is disposable income
 Autonomous consumption is the amount of consumption expenditure expend at a zero
disposable income. It is the intercept (Y-axis) of the consumption function.

C C
MPC ⇒ c = , but we have defined that MPC =
Yd Yd
C
⇒ c = MPC =
Yd
Properties of APC and MPC
1. 0< MPC < 1 it is positive but less than one; this is because as income increases
consumption would increase (mpc>0), but also saving would increase(mpc<1)
2. The MPC is constant for any change in income when the consumption function is
linear.
3. The APC approaches to infinity as income approaches zero and deciles as income
increases(APC= + c)
4. APC > MPC(APC= + c > ) because of the following basic assumption
i. the assumption of liner consumption function
ii. Consumption remains positive even if income is zero, i.e., autonomous
consumption (Ca>0).

3.1.2. The saving function

As we discussed above we have seen that in the closed economy, in the absence of government.
Y= C+ S = Yd
S= Yd – C⇒ the income that is not consumed is saved. So, saving is the difference
between disposable income and consumption.
Like the consumption function the saving function is linear
S = Sa + sYd
From the equation
Sa, is autonomous saving- the amount of saving at a zero level of income.
S is the marginal propensity to save (MPS)
MPS is changes in the amount of saving due to a one unite change in income.
S
MPS =
Yd

Average propensity to save (APS) is the portion of total income (Yd) that goes to saving.
S
⇒APS =
Yd
Derivation of MPS from the saving equation
S= Sa + sYd ……………………………………………. (1)

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if income is changed to  Yd, S will also change to  S
⇒ S+  S = Sa + s ( Yd +  Yd ) …………………... (2)
if we subtract ( 1 ) from ( 2 ) we get
(S +  S) – S = Sa + s (Yd +  Yd) - (Sa + Yd)
⇒  S = s  Yd
S
⇒s =  MPS
Yd
On the other hand
Yd = S + C
⇒S = Yd – C, but C = Ca + cYd
⇒ S = Yd – (Ca + cYd)
= Yd – Ca – cYd
S = - Ca + Yd (1-c), now Sa = - Ca and 1 – c = s
⇒ S = - Ca + (1 – c) Yd
⇒ MPC = 1 – c, but c = MPC
⇒ MPS = 1- MPC
Example: given the following saving function, derive consumption function.
S= - 20 + 0.4Yd

Note that!
i. APC+APS=1
S Yd  C C
APS =  =1 
Yd Yd Yd
C
⇒ APS = 1 – APC,as APC=
Yd
⇒ APS + APC = 1
ii. MPS + MPC = 1
S
MPS = , but S = Yd – C
Yd
⇒  S = Yd  C
Yd  C C
⇒ MPS =  1
Yd Yd
⇒ MPS = 1 – MPC
⇒ MPS + MPC = 1

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 iii. if APC decreases as income increases , its counter pert ( APS ) must increases for an
increases in income this implies APC and APS move in opposite direction as income
increases or decreases.
iv. As MPC is constant for any change in income, MPS will remain constant.
v. If APC is always greater than MPC, then it follows that APS must always less than
MPS.
⇒ If APC > MPC ⇒ APS < MPS
Determination of equilibrium levels of income and out put
Conditions for Equilibrium output /the simple Keynesian model
At the earlier, we have said: aggregate expenditure determines income and output of an
economy. Prices are given because the aggregate supply curve is perfectly elastic up to the full
employment level. Therefore, there is any amount of output at the prevailing levels of prices that
will be supplied. Now, what will determine the level of output actually produced? The demand is
the answer. The production then will determine the demand. A central notion in the Keynesian
model is that for a level of output to be an equilibrium level requires that output be equal to
aggregate demand (E).
 Y = E -------------------- (1)
Where Y is equal to total output (GDP) and E equals aggregate demand or desired expenditure
on output. Aggregate demand consists of two components; household consumption (C) and
desired investment demand (I). Thus, in equilibrium we have.
 Y = E = C+I ------------- (2)
The simple form of (2) and the identities discussed later neglects depreciation; so we do not need
to distinguish between GDP and net national product. We also assumed that GDP and national
income are equivalent. This means indirect business taxes are not included. The final assumption
is that the aggregate price level is fixed. And all variables are real variables.

With national product Y also measuring national income we can write,

Y  C+S------------------------------------------------------------ (3)
Equation (3) is an identity stating that national income, all of which is assumed to be paid to
households in return for factor services, is either consumed (C) or saved (S)

Planned and actual demand

Planned expenditure is the amount of spending on goods and services planned by households and
firms; Actual expenditure is the payment for goods and services on goods and services that
households and firms actually pays.
The difference between the two comes because of unplanned inventory investment.
I Unintended = actual demand – planned demand
In addition, from the fact that Y is national product we can write;
Y  C+I -------------------------------------------------------- (4)
Equation (4) defines national product as equal to consumptions plus realized investment

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Using the definition given in (3) and (4) we can rewrite the condition for an equilibrium level of
income given in (2) in two alternative ways. By (2), in equilibrium Y must equal (C+I) and from
(3), Y is defined as (C+S), in equilibrium therefore;
C + S  Y = C+I
S = I ---------------------------------------------------------- (5)
Now the equilibrium level of income will be:
Planned investment is fixed atI and:
Y=C+I
At equilibrium level; actual expenditure= planned expenditure

C = Ca + cY, we have assumed that there is no government and no tax and government purchase
and hence Y= Yd for this analysis and incorporate later.

At equilibrium; we have the following output levels

Y = Ca + cY + I
Y – cY= Ca +I
(1 – c)Y = Ca + I
Ca  I
Ye = , this level of income equilibrates actual expenditure and planned expenditure
(1  c)
in an economy where there is no government and foreign sector (in closed economy)
There are then two equivalent ways to state the condition for equilibrium.
1. Y = C + I
2. S = I
Now we can examine the two equivalent expressions for equilibrium.
Production of a level of output Y generates an equivalent amount of income to households. A
portion of this income, equal to consumption demand (C), returns directly to the firms as a
demand for output. The level of output is an equilibrium level if this directly generated demand (
C ), when added to desired investment expenditure of firms ( I ) produces a total demand equal to
Y, i.e., if
Y = C+I

From the second version output will be in equilibrium if the leakages (S) from the economy are
balanced by injections (I) to the economy. This ensures that the amount of income households do
not spend on output (S), and therefore the amount of output that is produced but not sold to
households (Y-C  S) is just equal to the other sector wish to buy (I). This is equivalent to saying
that total output equals aggregate demand and is thus equivalent to the first way of stating the
condition for equilibrium.

At the level of income below planned expenditure is greater than actual expenditure or at what
are sold are greater than what are produced, aggregate demand exceds output C+I>Y resulting
unintended inventory short fall ( some of previously produced and stored are slod). Firms hire

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more of labor, produce more output, income will increase . At level of income beyond Ye,
Actual expenditure is greater than planned expenditure (actual output is greater than what are
actually sold) and hence inventory will increase. For instance at income level of Y1, planned
expenditure is E1 where as output is Y1. The difference is inventory. Firms hireoff labor,
production decrease, income decreases. In this way equilibrium income always holds.

Once equilibrium in income is realized a change in either authonomous consumption ( Ca) or

change in investment could cause change in income.

An increase in investment of ΔI raises planned expenditure by that amount for any given level of
income. The equilibrium moves from point A to point B, and income rises from Y1 to Y2. Note
that the increase in income ΔY exceeds the increase in ΔI thus, it has a multiplied effect. So does
change in autonomous consumption.

3.2 Income Determination in the three sector model

Government spending and Taxation
In the previous discussion we have seen how income is determined in the two sector model. Now
we will see how income is determined incorporating the government sector.
Government can increase aggregate expenditure by increasing its expenditure by purchasing
goods and services or by reducing the amount it takes from the stream of private spending
through its tax collection. It also contracts aggregate expenditure in two ways i.e.
 By reducing its spending that it adds to private spending or
 By increasing the amount that it diverts from private spending through its tax
collection.
Thus, the effect of government spending depends on how much it injects in to the spending and
on how much it withdraws from the stream of spending through its tax collection. We will see
how income is determined when tax is autonomous / lump sum tax / and when tax is a function
of income.

1. When Tax is autonomous / Lump sum tax /

From the accounting identities;
C+ I + G + N X  C + S + T + R f
In the three-sector model it will be;
C+I+G  C+S+T
From this the saving investment identity is;
I  S + (T - G)
There are two types of saving;
 privet saving (S ) and
 government saving ( T- G )
So, I = Sp + Sg, where Sg = T- G

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 I = S, where S = Sp + Sg
Disposable personal income now will be equal to net national income minus amount of taxes.
Let Y = NNI, then
Yd = Y – T  Y= Yd + T
The consumption function will be
C = Ca + c Yd
= Ca + c (Y – T)
The saving function will be
S = Yd – C
= Yd – Ca – c (Y – T)
= (Y-T) – Ca – c (Y – T)
S = - Ca + (1 – c) (Y – T)
= S a + s (Y – T)
Assuming that both investment and government expenditure are exogenously determined and be
fixed at I and G respectively the equilibrium level of income is given as;
Y=C+I+G
Y = Ca + c (Y – T) + I+ G
= Ca + cY – c T+ I+G
Y-cY = Ca – cT +I+G

1
Y= ( Ca  cT  I  G )
1 c
1
 Any change in Ca, I and G will result a change in equilibrium income times
1 c
Y 1 1
i.e. =  Y= (  G)
G 1  c 1 c

Y 1 1
=  Y= (  I)
I 1 c 1 c

Y c c
But =  Y= (  T)
T 1 c 1 c
c
Where is the tax multiplier, it is always negative. This means that when tax is increased by
1 c
c
a unit equilibrium income will decrease by amount.
1 c
There is a relation between the absolute values of tax and government expenditure multipliers,
which can be seen in the following examples.
1 1 c 0. 5
c=0.5; = = 2; =- = -1
1 c 1  0. 5 1 c 1  0. 5

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 1 1  0.8
c= 0.8; = 5; -c/1-c = = -4
1  c 1  0. 8 1  0.8

1 1 1  0 .9
c = 0.9; = 10; = =-9
1  c 1  0 .9 1 c 1  0 .9

The tax multiplier is one less in absolute value than the government expenditure multiplier. This
fact has an interesting implication for the effect of an increase in government spending
accompanied by an equal increase in taxes, a balanced budget increase. To find the effect of
such a combination of policy changes, we add the two multipliers to get the following
expression.
Y Y 1 c 1 c
+ = + = =1
I T 1 c 1 c 1 c
A one dollar increase in government spending financed by a one dollar increase in tax increase
equilibrium income by just one dollar. This result, termed the balanced budget multiplier, which
reflect the fact that tax changes have smaller per dollar impact on equilibrium income than
government spending changes. The value of 1 for the multiplier results because the tax
multiplier is one less in absolute value than the spending multiplier. The latter result does not
carry through in many more complex models, but the result that tax changes affect aggregate
demand by lass per dollar than changes in government spending is quit general.

Example: / 1. Determine the equilibrium income given that

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C = 20 + (Y- T)
4
G = 0, and T = 0
I = 20
1
Y= (Ca – c T + I + G )
1 c
From the consumption function
Ca = 20 and c = 3/4
1
So Y = (20 – 3/4 (0) + 20+ 0
3
1
4
= 4 (40)
Y = 160
2. If G = 25 and T = 25, then
1
Y= (20 – 3/4 (25) + 20+25
1 3/ 4

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 75
= 4 (64 - )
4
Y = 185
We have earlier said that; if  G =  T, then  Y =  G
 G = 25 and  T = 25
 Y = 185 – 160 = 25
  Y = 25 =  G
1. Given the above consumption function what is the change in income if government
expenditure is changed by 10?
 G = 10
1
 Y= G
1 c
1
= 10 = 40
1 3/ 4
2. Given the above consumption function what is the change in income if the tax is
decreased to 20?
 T = 20 – 25 = -5
c
 Y= T 
1 c
 3/ 4
=( ) -5
1 3/ 4
= 15
 When T decreased by 5 incomes is increased by 15

2. When Gross Tax Receipt is a Function of Income

In this case, instead of having exogenously determined tax receipts, we assume that it varies
with changes in income. Thus, we take the following tax function;
Tg = Ta + tY where; Tg = Gross tax receipts
Ta = autonomous tax receipts
T = marginal propensity to tax (MPT)
The consumption function is
C = Ca+ cYd , but Yd = Y – ( Ta + t Y )
 C = Ca + c ( Y – Ta – tY ) and
S = Sa + s ( Y – Ta – tY )
Equilibrium income is determined as;
Y= C + I + G,
 Y = Ca + c(Y – Ta – t Y ) + I + G
 Y – cY + ctY = Ca – cTa +I + G

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 Y ( 1 – c + ct ) = Ca – cTa + I + G

1
Y= (Ca – cTa + I + G)
1  c1  t 

 To calculate the change in Y due to change in G, T , Ta, Ca and the tax rates;

The change in Y due to the changes in G, I, Ca, Ta & tax rate (t) making the others
constant will be;
1
dY  dG
1  c(1  t ) 1
1. ; Is the expenditure multiplier
1 1  c (1  t )
dY  dI
1  c(1  t )
c c
2. dY = d Ta , is the autonomous tax multiplier
1  c (1  t ) 1  c (1  t )
c  cY
3. dY = dt, is the tax rate multiplier
1  c (1  t ) 1  c (1  t )
Where Y is initial income level and t is the new tax rate
Example ; consider an economy described by the following equations;
C = 500 + 0.6Yd
I = 300
G = 500
t = 0.2
Find the equilibrium level of income?
1
Y= (Ca + I + G - cTa)
1  c (1  t )
1
= (500 + 300 + 500)
1  0.6(1  0.2)
1
= 1300 
0.52
= 2500
AGGREGATE SUPPLY
INTRODUCTION
Aggregate supply (AS): is the relationship between the quantity of goods and services supplied and the
price level. Because the firms that supply goods and services have flexible prices in the long run but
sticky prices in the short run, the aggregate supply relationship depends on the time horizon. We need to
discuss two different aggregate supply curves: the long-run aggregate supply curve LRAS and the short-
run aggregate supply curve SRAS though we don’t need to discuss how the economy makes the transition
from the short run to the long run. Most macroeconomists believe that the key difference between the
short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond o
changes in supply or demand. In the short run, many prices are “sticky’’ at some predetermined level.

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3.2 The Classical Approach to Aggregate Supply
According to classicalist, in the short run, an economy’s output of goods and services—its GDP
(supply)—depends on (1) its quantity of inputs, called the factors of production, and (2) its ability to turn
inputs into output, as represented by the production function and does not depend on price.
Factors of production are the inputs used to produce goods and services. The two most important factors
of production are capital and labor. Capital is the set of tools that workers use: the construction worker’s
crane, the accountant’s calculator, and this author’s personal computer and so on. Labor is the time people
spend working. Land is also a factor of production. The available production technology determines how
much output is produced from given amounts of capital and labor. Economists express the available
technology using a production function. We do not discuss each of these in turn.
In the long run, these recourses are fully employed and long run aggregate supply is fixed at certain level
and hence vertical line. It does not depend on price le
Price, P
Long run aggregate supply
(Natural rate of output)
P2

P1 AD2
AD1

Output, income, Y
According to classicalist, once long-run output and price is determined Variables that shifts AD
affects price not output unlike Keynesian.

3.3 Keynesian approach to aggregate supply

The total supply curve implicit in the Keynesian IS-LM model is based on the notion that there
are no supply constraints and that prices are pre-determined in the short-run (one year or less).
Thus, whatever output level is demanded will be produced and the total supply curve is a
horizontal line. There is sufficient excess capacity so that an increase in demand leads to more
production without increasing production costs and prices. For this reason the early Keynesian
economists who were schooled by the experiences of the depression used IS-LM analysis
exclusively because they thought in terms of situations with a great deal of excess productive
capacity.

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In this framework, we can view the price level as being set by existing contractual arrangements
such as union contracts, sales agreements, and price lists. It is assumed that any level of output can be
supplied at this given level of prices.

AD1 AD2

Short run aggregate supply

P1 P2
Give horizontal supply curve, change in aggregate demand affects output not price since price is
constant in the short run.
The classical vertical total supply curve and the Keynesian horizontal total supply curve
represent two theoretical extremes, neither of which is a satisfactory representation of behavior
in the real world. The traditional Keynesian approach leaves us without a theory of price
determination. The classical approach introduces a theory of price determination, but at the cost
of eliminating an explanation of fluctuations in real output. By assuming that competitive
markets at all times generate equilibrium levels of output, the model cavalierly does away with
fluctuations in output. A more appropriate view of the total supply curve will be the middle
road—a positively sloped total supply curve. Let we see these models

Models of aggregate supply

In all the models, some market imperfection causes the output of the economy to deviate from
the classical bench mark (full employment output). As the result the AS cures is upward sloping
rather than vertical, and shifts in AD causes the level of output to deviate temporarily from the
natural rate. Although each of these models takes us down a different theoretical rout, each rout
ends up in the same place that the short run AS equation of the from;

Y =Y   (P  P e ) ,  >0 Where, Y is out put


Y is natural rate of out put

P is price level
e
P is the expected price level.
-  indicted how much output responds to un expected change in price level ; and
1
the slope of the AS curve


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 This equation states that output deviates from its natural rate when the price level deviates
from the expected price level.

AD and As together
Using the two curves let’s see how the economy responds to unexpected increase in AD due to
unexpected monetary expansion.

P LRAS
SRAS2
e
P3 = P 3 SRAS1
C B
P2 A
e e
P1= P 1= P 2 AD2
AD1


Y1=Y3= Y Y2

In the short run the economy moves from A to B. The shift in AD increases the actual P level
from P1 to P2. B/c people didn't expect this increase in the P level, the expected P level remains
at P e 2, and output rises from Y1 to Y2 which is above the natural rate Y. Thus the unexpected
expansion in AD causes the economy to boom in the short run.

Yet the boom does not last forever. In the long run the expected ‘p’ level rises, causing the short
run AS curve to shift up wards. P e rises from P e 2 to P e 3 and the economy moves from B to C
and output falls from Y2 to Y3. In other words the economy return to the natural rate level of
output in the long run, but at a much higher ‘p’ level.

This analysis shows an important principle; long run monetary neutrality and short run
monetary non-neutrality
 Monetary policy in the short run moves the economy from AtoB increasing output from
Y1 to Y2 and (money is non-neutral)
 Monetary policy in the long run moves the economy from A to C and output remains at
its natural rate.(money is neutral)

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