Equilibrium Income and Output:

Two- Sector Economy

Y = C+I
• Equilibrium is that position in which the
opposing forces of change are in balance.
• It does not denotes a motionless
• state.
If a variable changes through time, the initial
equilibrium will be disturb and new
equilibrium will result
• The determination of equilibrium income and
output may be explained through AD and AS
approach or saving investment approach.
Aggregate demand and aggregate supply

• The level of equilibrium income is determined

by the level of the aggregate demand.
• In two sector economy, the AD is composed of
the aggregate consumption and aggregate
investment outlay.
• I.e. Y = C+ I
the following fig. shows the determination of
income and output in two sector economy
• Let c= 50+0.75Y and I = 75
• Investment outlay is autonomous and it is not
related to level ofY income.
= C+I
Y
C+I
C +I

O 400 500 600 X

Y
S=I=75 I=75

O
500 Income and X
-50
employment
• The equilibrium aggregate income and output
is determined at that point at which the AD
function equals to AS.
• In fig. the equilibrium aggregate output is
attained at 500 unit. Thus the disposable
income will be 500 units. Corresponding to
this disposable income, consumption is 425
units and investment is 75 units both adding
up to the total expenditure of 500 units which
is equals to the total income produced.
• Disequilibrium:
• Equilibrium output say at 400 units?
• Equilibrium output say at 600 units?
• Assumption
I. : There are only two sector economy household and business
sector.
II. No govt. and foreign trade.
III. No tax rate.
IV. Price remains constant.
V. Technology and capital is given.
VI. Only autonomous investment.
VII. MPC remains constant.
VIII.All income are spent.
IX. Factor of production are taken from household sector to business
sector
 Income and output determination in a
three sector economy
• Three sector economy consists of household
sector, business sector and government sector.
• Government purchases of goods and services
when added to the level of private consumption
and business investment demand causes
increase in the equilibrium income in the
economy. The government influences the level of
economic activities through fiscal policy, taxation
policy, credit policy, labour policy, and so on.
 Aggregate demand and aggregate supply

• Aggregate demand under three sector

economy consist of consumption expenditure,
investment expenditure and government
expenditure.
i.e. Y = C+ I +G …………………..(1)
• Aggregate supply function consist of
consumption expenditure, saving and
• tax.
I.e. AS = Y = C +I+G ……………….(2)
• In three sector economy, taxes absorb a
portion of the income generated by
expenditure on net national product.
Therefore disposable personal income is less
than net national product by the amount of
taxes. Let Y denotes net national product and
Yd disposable personal income. We now have
Y d= Y-

Or Y = Y T d + T ……………….(3)
where T = tax (lump sum tax)
•The economy is in equilibrium condition where the aggregate demand is

equals to aggregate supply.

•i.e. Y = C+I+G …………..(4)

where, C = a + bY d

I= I I is the autonomous investment

a, a

G=G a , Gais the autonomous govt. spending.

equation (4) states that equilibrium condition under three sector

economy.
Now Y= C+I+G

or Y = a+ bY d +I a+Ga
or Y = a + I a + Ga ……………………….(5)
1- b
consequent upon a given increase of ΔG amount
in the government purchases of good and services
the higher equilibrium income will be
Y + ΔY =
a+I a+ Ga+ ΔGa

1- b
a+I a+Ga 1 ………….(6)ΔG
+
Y + ΔY =
1 - b 1- b
subtracting equation (5) from equation (6)
gives change in equilibrium level of income ΔY.
i.e. ΔY = (1/1-b) ΔG
or, ΔY/ ΔG = 1/1-b …………(7)
Equation (6) states that total change in
equilibrium aggregate income equals to
• The multiplier times of the given change of ΔG
amount in government purchases of goods
and services.
Y

O X
Y Y1
 The Fiscal
• Governments activities affect the equilibrium
Multiplier
level of national income through multiplier.
• Government expenditure with no taxation rise
the national
• income.
The volume of increase in NI depends upon
the volume of government expenditure.
• On the other hand government expenditure
with taxation reduce the volume of national
income.
• However, both fiscal operations, government

spending and taxation go side by side. If the

government adopts a balance budget policy, then
overall effect of government’s fiscal operation on
the NI depends on the combined effect of
expenditure and tax
multiplier.
• Let us discuss the expenditure multiplier, tax

multiplier and balance budget multiplier.

 Government expenditure
multiplier
• The government expenditure multiplier shows the
overall effect on national income due to change in
government expenditure. It shows the ratio of
change in NI to change government expenditure.
• i.e. K = ΔY/ ΔG
• Where, K= government purchase
• multiplier.
ΔY = change in National
• income
ΔG = Change in govt. Expenditure.
• We have, Y= AD=C+I+G ………(1)
• Similarly, Y= AS= C+S+T ……… (2)
• C= a+bY d……………..(3)

• Y d= Y-

• Where, T
• T= lump sum Tax
• Y = NI
• S= saving
• Equilibrium level of income in three sector
economy is given by AD= AS
• i.e. Y= C+I+G
• Or Y = a+b(Y-
• T)+I+G
or Y= a+……….(5)
bY- bT • •ÄY

• +I+G
Or, Y-bY = a-
• bT+I+G
Or Y = a-bT+I+G/1-b ……….(6)
• Differentiate equation (6) with respect to
G,
• ΔY/ ΔG = 1/1-b
• Here, ΔY/ ΔG is government expenditure
multiplier which is based on MPC. Change in
NI is multiplier 1/1-b times change in level of
government expenditure.
• Y

E1

O
Y Y1
 Tax
• Change in national
multiplier
income due to change in
lump sum tax in an economy is tax
i.e.multiplier.
tax multiplier K= ΔY/
ΔT
In case of three sector economy,
Y= 1/1-b (a-bT+I+G) ………(1)
Differentiate equation (1) with respect to
Ti.e.dy/dt = 1/1-b (-b)
or, ΔY/ ΔT = -b/1-b
Here, ΔY/ ΔT is tax multiplier which is
negative.
• This multiplier equation state that, rise in
lump sum tax leads to fall in national income.
It means , the rise in tax by ΔT leads to fall in
income by 1/ 1-b
times.
Y

ΔT E

X
O Y
Y1
 Balanced budget
• Themultiplier
question is: what happens to equilibrium
income if the government budget is balanced,
i.e. if the given increase in government
expenditure is financed through an equal
increase in taxes?
• According to classical view, a balanced budget
was neutral in its effect on the national
income and employment since the increase in
government spending was offered by a tax
increase of the same amount.
• According to modern view, a balanced budget is
not neutral effects on income. It shows the net
expansionary effect on the national income
because the decrease in aggregate spending
resulting from additional taxes will be less than
the increase in aggregate spending resulting
from additional government expenditure.
• As result of the additional tax levy, the
aggregate consumption will not be reduced by
full amount of the tax because a part of the tax
is paid out of saving.
• Substituting the value of MPC in to the
government purchase and government tax
multipliers it can be seen that the difference
between these two multipliers is
• one.
The balanced budget multiplier can be derived
in the following way:
• Y = C+I+G ……………..(1)
• Or, Y =a+bY d+I+G ………. (2)
• Where, Y d = Y-
• Y= a-b(Y-T+R)
T+R
• +I+G
Y= a-bT +bR+I+G/1-b …………(3)
•
• The increase in government expenditure by
ΔG amount and equal tax expenditure ΔT than
new equilibrium level income will be
• Y+ ΔY= a –bT-b ΔT+bR+ I+G+ ΔG/1-
• Subtracting
b …..(4) equation (3) from equation (4), we
get, ΔY = ΔG -b ΔT/1-b
• or, ΔY= ΔG -b ΔG /1-b (since ΔT = ΔG )
• or, ΔY = ΔG (1-b)/1-b
• or ΔY = ΔG
• i.e. ΔY / ΔG = ΔG/ ΔG = 1 …………(5)
• This equation states that when the government

budget is balanced such that any given increase in

government expenditure incurred in the purchases
of goods and services is financed through
additional tax levies of an equal amount , the
equilibrium income in the economy will increase
by full amount of the additional government
expenditure.
fig.
Y

AS

X
O
Y1 Y2 Y3
• The balance budget multiplier with the
autonomous tax function , the net increase in
equilibrium aggregate income is only Y 1Y2=
ΔG not Y 1Y3.
• If the increase of given amount of ΔG in govt.
spending in the budget was not balanced by
additional tax levies of ΔT (= ΔG ), the increase
in income would be Y1Y3. since additional
spending is financed through additional taxes
of an equal amount: the negative tax
multiplier operates simultaneously partly
offsetting the increase in income
• The net increase in income will be equal to the
difference between the total increase in
income due to increase of ΔG amount of govt.
spending and the total decrease in income
due to the levying of additional taxes of the
same amount.
• The negative change in AD income due to
additional tax levies of ΔT (= ΔG ) amount is
Y2Y3. consequently, the net increase in AD
income is Y1Y2which is equal to the increase in
govt. spending of ΔG amount.
 Foreign trade
multiplier
• A four sector economy consists four sectors such
as households, business sector, government
sector and foreign sectors .
• Foreign sector consist two components export
and import.
• Export refers to foreign demand for goods and
services which generates NI
• Imports refers to demand for foreign goods by
nation which reduce AD
expenditure.
• Thus NI depends on amount of Export.
• Mathematically
• ,Y=C+I+G+(X-
• M)………..(1)
Y= a+b(Y-T+R) +I+G +(X-
• M)
Y= a-bT+bR+I+G+(X-M)/1-
• b……..(II)
Equation 1 state that the equilibrium level of
income is the sum of all autonomous
expenditures time the value of
• multiplier.
Fig.
 A complete four sector model.
• Y=C+I+G+(X-
• M)
Where, C=a+b(Y-
• T+R)
T= T+tY (tax
• function)
R = transfer of payment
• M= M+mY (import
• function)
Then Y=a+b(Y-(T+tY)+R+I+G+X-
• (M+mY)
Y=a-bT+bR+I+G+X/1-b(1-t)+m
• Ie foreign tax
• ΔY/ ΔX= 1/1-b(1-t)+m
multiplier
 Export
• multiplier
export consist a part of AD in the economy.
• It is originated from outside of the economy.
• Thus export is the function of internal and external
factors.
• The main external factors are:
1) Domestic prices of export in relation to those
importing
2) countries
Income of the importing
3) countries
Imports income elasticity for
4) inputs
Their tariffs and trade
5) policy
And their exchange rate policy
• The main internal determinants are:
1) Export policy of the exporting
countries
2) export duties and
subsides
3) availability of exportable surplus
4) trade and tariffs Agreements with other
countries
5) international competitiveness of domestic
goods.
• The AD with export can be express as
• Y=C+I+G+X
• C= a+b(Y-
• Y= a-bT+R+I+G+X/1-b …….(1)
T+R)
• New equilibrium in four sector economy after
change in export
• Y+ ΔY = a-bT+R+I+G+X+ ΔX/1-b ……(2)
• Subtracting equation 1 from 2 we
• ΔY/ ΔX = 1/1-b
get
• It conclude that change in NI depends on the
value of export
multipliplier.
• Import function and import
• multiplier:
Imports refers to the expenditure made by
residents of a country on foreign goods and
services.
• All payments for imports are considered as
leakages.
• Level of imports depends on the domestic
income flow out of the economy.
• The main determinants of imports are as
follows:-
• Prices of the foreign goods in relation to
domestic
• price.
NI of the domestic
• economy.
Income elasticity of
• imports
Tariff rates and imports policy of the
• Gov.
Exchange rate policy and foreign exchange
restrictions
• .Taste and preference for foreign goods.
• In short run it is depends on income and
autonomous import.
• Here import function M=
• M+mY
M= marginal propensity to import.
• The AD= C+I+G+(X-
• M)
Derivation of import trade
• multiplier
Y= a+b(Y-T+R)+I+G+(X-
• M)
Y= a-bT+bR+I+G+(X-M)/1-
• ΔY/ ΔX = 1/1-b
b
• It is the import
multiplier.
 Derivation of foreign trade multiplier.
• Let Y= C+I+G+(X-M) in four sector
• economy.
Where, C= a+b(Y-T+R) and
• M=M+mY
Y= a-bT+bR+I+G+(X-M)/ 1-
• b+m
Other….(1)
thing being equal, net export increase
by ΔX, the new equilibrium in four sector
economy will be
• ΔY/ ΔX = 1/ 1-b+m
• The foreign trade multiplier depend upon the
• Value of MPC and marginal propensity to
import
• If b=m the foreign trade is equal to unity.
• If b>m foreign trade multiplier is greater than
unity.