Equilibrium National Income

Products Market
Goods and
services

Saving Saving
Firms Financial Market Households
Investment

Income flow
Factors of
production
Factors Market Physical flow
 In two sectors economy, income flow between households
and firms.
 Firms and households interact each others through goods
and factors market.
 Households will provide factors of production to firms in
factors market. In return, firms will compensate households
with income. (wage, rent, interest and profit).
 Firms will provide goods and services to households in
goods market. In return, household pay for the goods and
services received.
 However, not all income earn by households and firms will
be spend. Portion of their income will be save in financial
institution.
 As such, financial institution will use these saving to fund
others firms investment.
 Leakage – withdrawal from the flow (reduce the flow of
income)
 When households and firms save part of their incomes it
constitutes leakage.
 More money save to bank, lesser money in the market.

 Injection – Introduction of income into the flow (increase the

flow of income)
 When households and firms borrow the savings, they constitutes
injection.
 More investment, more income to roll.
 Aggregate expenditure is the sum total of all the
expenditures undertaken in the economy by the factors
during a given time period.

 In two sectors economy, there are two type of expenditure:

 Consumption (C)
 Investment (I)

 Hence, the total expenditure on aggregate in the economy:

 Y=C+I
 Refer to the purchase of final goods and services by
individual.

 Consumption function
 Is a mathematical function that express consumer
spending in terms of its determinants.
 Keynesian consumption function expresses the level of
consumer spending depending on three factors:
 Disposable income (Yd)
 Autonomous consumption (a)
 Marginal propensity to consume (b)

 C = a + bYd
 Personal income
 Refers to an individual's total earnings from wages, investment
enterprises, and other ventures.
 It is the sum of all the incomes actually received by all the
individuals or household during a given period.

 Disposable income
 Is the total personal income minus personal current taxes.
Personal income - personal current taxes =
disposable personal income
 Yd = Y – T
 Refers to the consumption when income is zero.

 This is because, even with no income, you still need to make

consumption to survive.

 E.g: You may borrow money to be able to buy food.

 Unlike consumption, autonomous consumption is constant

and exogenous to disposable income.

 E.g: Autonomous consumption = 100.

 Marginal propensity to consume (MPC)
 Refer to the proportion of additional
income that an individual consumes.

 For example, if a household earns one

extra dollar of disposable income, and
the marginal propensity to consume is
0.65, then of that dollar, the household will
spend 65 cents and save 35 cents.
 Is the average amount of total household
income that is devoted consumption
expenditures.
 It is found by dividing consumption by
income.
 APC = Consumption / Income.
 C = a + bYd
 This suggests consumption is primarily determined by the
level of disposable income (Yd). Higher Yd, leads to higher
consumer spending.
 This model suggests that as income rises, consumer
spending will rise. However, spending will increase at a
lower rate than income.
 At low incomes, people will spend a high proportion of their
income. The average propensity to consume could be one or
greater than one. This means people spend everything they
have. When you have low income, you don’t have the luxury
of being able to save. You need to spend everything you have
on essentials.
 However, as incomes rise, people can afford the luxury of
saving a higher proportion of their income. Therefore, as
income rise, spending increases at a lower rate than
disposable income. People with high incomes have a lower
average propensity to spend.
  A consumption schedule is table of numbers showing the
relation between consumption expenditures and income for
the household sector.

 Given that the consumption function is as follow:

C = 100 + 0.6Yd
 Hence, the consumption schedule for each level of
disposable income will be:

Disposable Calculation Consumption APC

income
1000 C = 100 + 0.6 (1000) 700 700/1000 = 0.7
2000 C = 100 + 0.6 (2000) 1300 1300/2000 = 0.65
3000 C = 100 + 0.6 (3000) 1900 1900/3000 = 0.63
4000 C = 100 + 0.6 (4000) 2500 2500/4000 = 0.625
Consumption

C = a + bYd

0 Real disposable income

Consumption
• An increase in the
C = 200 + bYd level of
consumption at
C = 100 + bYd each level of
disposable income
will shift
consumption curve
upward.

• The may be causes

by an increase in
real wealth or
consumer
confident.

0 Real disposable income

 • An increase in the
marginal
Consumption propensity to
C = 100 + 0.6Yd consume, people
will spend a higher
C = 100 + 0.4Yd % of their
additional income.
Eventually, it will
change the slope of
consumption curve.

• The may be causes

by an increase in
consumer
confident, easier
access to finance
and lower saving.

0 Real disposable income

 Refer to the portion of income that save is save by individual.
 Saving function
 Is a mathematical function that express saving in terms of
its determinants.
 Keynesian saving function expresses the level of saving
depending on three factors:
 Disposable income (Yd)
 Autonomous consumption (a)
 Marginal propensity to save (s)

 S = -a + sYd
 Marginal propensity to save
 Refer to the proportion of additional income that
an individual save.

 For example, if a household earns one extra

dollar of disposable income, and the marginal
propensity to save is 0.35, then of that dollar, the
household will save 35 cents and spend 65 cents.

 Note that MPC + MPS = 1

 Is the average amount of total household
income that is devoted saving.

 It is found by dividing saving by income.

 APS = Saving / Income.

 A saving schedule is table of numbers showing the relation
between saving and income for the household sector.

 Given that the saving function is as follow:

S = -100 + 0.4Yd
 Hence, the consumption schedule for each level of
disposable income will be:

Disposable Calculation Saving APS

income
1000 S = -100 + 0.4 (1000) 300 300/1000 = 0.3
2000 S = -100 + 0.4 (2000) 700 700/2000 = 0.35
3000 S = -100 + 0.4 (3000) 1100 1100/3000 = 0.37
4000 S = -100 + 0.4 (4000) 1500 1500/4000 = 0.375
Saving

S = -a + sYd

0 Real disposable income

 There are several others factors that
determine the level of consumption and
saving in the economy.

 Wealth
 An increase in wealth will increase your
consumption even at the same income level
illustrated by an upward shift in both
consumption and saving function.
 Example: If you inherited a sum of wealth
from your deceased parent or hit a jackpot,
your spending behavior will change.
 Expectation
 There are times when consumers adjust their
spending, based not on their actual income but
rather on their expectations of future changes in
their income.
 Changes in expectations will cause a shift in the
curve, because consumption has changed
without an actual chance in income.
 For example, if you think your income is going to
go up in the future, you may consume more
today.
 Consumer indebtedness
 Consumers adjust their consumption to levels of
indebtedness as well.
 We observe in the aggregate economy that when
indebtedness goes up, consumption falls and
savings rise.
 There is a level of debt beyond which consumers
feel uncomfortable with additional spending.
Even if income has stayed the same, if too much
debt accumulates, consumers will start to spend
less and pay off debt.
 This is illustrated by a downward shift in the
Consumption Function and an upward shift in the
Savings Function
 Refer to an asset or item that is purchased with the
hope that it will generate income or appreciate in the
future.

 In an economic sense, an investment is the purchase

of goods that are not consumed today but are used in
the future to create wealth.

 The decision to invest are depending on the following

several factors:
 Interest rate
 Future prospect on the economy
 Government policy
 Currency stability
 Political stability
 Here, we assume that the investment is
autonomous and is not depend on national
output/income.
Investment (RM Billion)

0 Y/Output (RM Billion)

 Equilibrium in the economy is achieved
when national output/GDP/income is in
steady state.

 Two method to determine equilibrium

 AE-AS approach
 Leakage-Injection approach
 Keynesian suggest that aggregate
expenditure in the economy will determine
the aggregate supply in the economy.

 In two sector economy aggregate

expenditure will be the summation of
consumption and investment in the
economy.

AE = C + I
 Hence, equilibrium achieved when
aggregate expenditure is equal to
aggregate supply:
AE = AS
Or
Y=C+I
 The economy will be disequilibrium if Y > C + I
and Y < C + I.
Aggregate expenditure (RM
Billion) AS

C+I

50

40

30

0 20 40 60 Y/Output (RM Billion)

 On the above diagram, when aggregate
expenditure are more than aggregate
supply (30 > 20), excess expenditure will
motivate firms to produce more.
 As result, firms will continue to produce
until AE = AS.
 In contrast, when aggregate supply are
more than aggregate expenditure (60 > 50),
excess supply will motivate firms to
produce less.
 As result, firms will continue to produce
until AE = AS.
 In two sector economy, investment (I) is
injection while saving (S) is leakage.

 Hence, equilibrium achieved when saving

is equal to investment in an economy.
I=S

 The economy will be in disequilibrium

when I > S or I < S.
Saving/Investment (RM
Billion)

20

10 I

0 Y/Output (RM Billion)

20 40 60
 On the above diagram, when saving are
more than investment (20 > 10), leakage are
more than injection.
 Hence, saving will reduce the national
income until saving equal to investment.
 In contrast, when investment are more than
saving (10 > 0), injection are more than
leakage.
 Hence, investment will increase the national
income until saving equal to investment.
 Increased saving does not always correspond to increased
investment.
 If savings are stashed in or under a mattress, or otherwise not
deposited into a financial intermediary such as a bank, there
is no chance for those savings to be recycled as investment
by business.
 This means that saving may increase without increasing
investment, possibly causing a short-fall of demand (a pile-
up of inventories, a cut-back of production, employment, and
income, and thus a recession) rather than to economic
growth.
 In the short term, if saving falls below investment, it can lead
to a growth of aggregate demand and an economic boom.
 In the long term if saving falls below investment it eventually
reduces investment and detracts from future growth. Future
growth is made possible by foregoing present consumption
to increase investment. However savings kept in a mattress
amount to an (interest-free) loan to the government or central
bank, who can recycle this loan.
 In three sectors economy, income flow between
households ,firms and government.
 Government will collect tax from firms and
household.
 In return, government will use the collected tax
(tax revenue) and spend it by purchasing good
and services from firms or transfer income to
households.
 Like investment and saving, government spending
(G) is injection while tax (T) is leakage.
 Hence, in 3 sector model:
 Injection: Investment and government spending
 Leakage: Saving and tax
 Products Market
Goods and
services

Tax Tax

Firms Government Expenditure Households

Government Government
Spending Spending

Saving
Saving
Financial Market Income flow
Investment
Factors of
production
Factors Market Physical flow
 The multiplier is the change in income/output due
to a change in investment, government
expenditure or export.
 In other word, it refers to the increase/decrease in
final income arising from any new
injection/leakage of spending.
 Given that S is spending multiplier:
S = 1/MPS or 1/(1-MPC)
 Hence, the size of the multiplier depends upon
household’s MPC or MPS.
 Example:
 Given that the MPC is 0.6, S will be
1/(1-0.6) = 1/0.4 = 2.5
 S = 2.5 mean an increase in injection of $1 will
multiply income in circulation by $2.5.
 Example:
 Given that the consumption function is C = 30 +
0.6Y and autonomous investment = $ 10 and
autonomous government spending = $ 10.
 Hence, the national income/output at equilibrium
using AE-AS approach will be:
Y=C+I+G
Y = 30 + 0.6Y + 10 + 10
Y = 50 + 0.6Y
 If there is no tax in the economy, Y will be equal to
Yd, hence,
Y = Yd
Y = 50 + 0.6Y
Y – 0.6 Y = 50
0.4Y = 50
Y = 50/0.4
Y = 125
 Let say now investment increase $10, the new
equilibrium will be:
Y = 30 + 0.6Y + 20 + 10
Y = 60 + 0.6Y
Y – 0.6 Y = 60
0.4Y = 60
Y = 60/0.4
Y = 150
 Note that the total income in the economy is not
increase by $10 but increase by $25.
 This is because of multiplier effect.
 Which I x S = 10 x 2.5 = 25.
Aggregate expenditure (RM
Billion) AS
C + I1 + G or 60 + 0.6Y
C + I + G or 50 + 0.6Y
150

125

0 125 150 Y/Output (RM Billion)

 Given that t is tax multiplier:
t = MPC/MPS or MPC/(1-MPC)
 Hence, the size of the multiplier depends upon
household’s MPC or MPS.
 However, government will impose income tax in
the economy.
 Assume that income tax impose by the
government is proportional tax (fixed
amount)which is equal to $10.
 Hence, at equilibrium
Y=C+I+G
Y = a + bYd + I + G
Y = a + I + G + b(Y – T)
 Numerical example:
C = 100 + 0.6Yd
I = 100
G = 100
T = 50

Hence, at equilibrium:
Y=C+I+G
Y = 100 + 0.6Yd + 100 + 100
Y = 300 + 0.6 (Y – 50)
Y = 300 + 0.6Y – 30
Y = 270 + 0.6Y
Y = 270/0.4
Y = 675
 Injection-Leakage approach
 In 2 sector economy, equilibrium in
economy achieved when Saving
equal to investment or S=I.
 However, in 3 sectors economy,
equilibrium in economy will
achieved when:
Leakage = Injection
S+T=I+G
Saving/Investment (RM
Billion)

S+T

20 I+G

0 Y/Output (RM Billion)

40
 Full employment
 Is the level of employment rates where there is no
unemployment literally.

 Inflationary gap
 Is a situation where actual gross domestic
product/output exceeds potential full-employment
GDP.
 When this happen, it will cause inflation.

 Deflationary/recessionary gap
 Is a situation where actual gross domestic
product/output is less than potential full-
employment GDP.
 When this happen, it will cause deflation.
Aggregate expenditure (RM
Billion) AS

C+I+G

0 Yf Y1 Inflationary gap Y/Output (RM Billion)

Aggregate expenditure (RM
Billion) AS

C+I+G

Deflationary gap

0 Y1 Yf Y/Output (RM Billion)

Saving/Investment (RM
Billion)

S+T

I+G

0 Yf Y1 Y/Output (RM Billion)

Inflationary gap
Saving/Investment (RM
Billion)

S+T

I+G

Deflationary gap

0 Y1 Yf Y/Output (RM Billion)

 Refers to change in government expenditures and/or taxes
to achieve particular economics goals

 Goals such as low unemployment, stable prices and

economic growth

 Government expenditure/spending
 Includes all government consumption, investment, and transfer
payments

 Tax
 Includes all taxes in the economy such as income tax, import tax
and etc
 The income from tax are known as government tax revenue
 Government implement fiscal policy
through announcing its budget:
 Budget deficit
 Where government spending is greater
than tax revenue
 Budget surplus
 Where tax revenue is greater than
government spending
 Balanced budget
 Where government spending is equal to
tax revenue
 Automatic fiscal policy
 Changes in government expenditures and/or
taxes that occur automatically without
government congressional action

 Example:
 Recession in the economy causes
unemployment. Hence, more people will
receive unemployment benefits. These added
unemployment benefits automatically boost
government spending
 Discretionary fiscal policy
 Deliberate changes of government expenditures
and/or taxes to achieve particular economic
goals
 Example:
 Government deliberate spend RM 10 million to
decrease unemployment rate in the economy
 Two types of discretionary fiscal policy
 Expansionary fiscal policy
 Contractionary fiscal policy
 Expansionary fiscal policy
 Increase in government spending and/or
decrease in taxes to achieve particular economic
goals
 Aims to counter deflation in the economy
(recession)
 When economy is in recession (deflation),
government can increase its spending and
reduce tax rate to increase aggregate demand
 As result, unemployment reduced in the
economy
 Contractionary fiscal policy
 Decrease in government spending and/or
increase in taxes to achieve particular economic
goals
 Aims to counter inflation in the economy
 When inflation happened in the economy,
government can decrease its spending and
increase tax rate to decrease aggregate demand
 As result, inflation reduced in the economy
Aggregate expenditure (RM
Billion) AS

C+I+G

C + I + G1

0 Yf Y1 Y/Output (RM Billion)

Aggregate expenditure (RM
Billion) AS
C + I + G1
C+I+G

0 Y1 Yf Y/Output (RM Billion)