Income and Expenditure

Lecture 5
 Overview
• Important questions to address
 How GDP or Income grows over period of
time during expansionary phase?
 How GDP growth slows down during
recession?
• Income grows due to Investment spending
• Income slows down due to lack of
Aggregate Demand
From Expenditure side of GDP measure

1. Consumption (C): Is the spending by households on

goods and services
e.g. buying clothing, food, movie tickets
2. Investment (I): Is the purchases of capital equipment and
structures, e.g. factory, houses, etc.
3. Government Purchases (G):Includes spending
on goods and services by local, provincial and
federal governments (e.g. roads, police, etc.).
Does not include transfer payments, because it
is not made in exchange for currently
produced goods or services.
4. Net Exports (NX): Exports minus imports.
 Consumption
Consumption (C)
(C)

The main determinant of C is disposable income (YD)

The consumption function
C = C(YD)

(+) -- increases in disposable income (YD) leads to

increases in consumption (C)
 Consumption
Consumption Function
Function

C (yd) = C0 + bYd
b = marginal propensity to consume
Change in C from a rupee change
in income
0<b<1
C = C0 when Yd is zero
 C is autonomous consumption independent of
income.
 Average Propensity to consume (APC)=C/Y
 Consumption
Consumption Function
Function

Household
Consumer Spending
C (yd) = C0 + bYd

Slope = MPC

∆C=MPC x ∆ yd
∆ yd
C0

Household Current Disposable Income

 Shifts
Shifts in
in Consumption
Consumption Function
Function

Household
Consumer Spending

C0

Household Current Disposable Income

 Determinants of autonomous
consumption
• Changes in Expected Future Disposable
Income – Based on Permanent Income
Hypothesis of Milton Friedman
• Changes in Aggregate Wealth – Based on
Life Cycle Hypothesis
Features of Investment Spending

• Investment spending is volatile

• Investment spending is a function of interest
rates and therefore monetary policy
implication exists
• Taxes affect investment hence fiscal policy
tools affect investment and hence GDP
• Investment over long period of time
determines stock of capital stock & thus
helps LR Growth
 Theory of investment
• It is a theory of demand for capital
• Investment is a flow concept and capital is a
stock concept
• As compared to large capital stock
investment flow is very very less
• Three types of investment
 Business Fixed investment
 Residential investment
 Inventory investment
 Determinants of Planned Investment
spending
• Depends on the net rate of return
• Net rate of return = Expected output growth –
Opportunity/cost of investment
• Opportunity/Cost of investment = Nominal Interest
Rates
• Investment Inversely Related to Interest
• Expected Output growth depends on Current
Production Capacity and Expected Future Real GDP
• Inventory and unplanned investment
Investment Function
 Government Expenditure
• Policy induced variable and hence
autonomously determined by the state
• It also depends on the role of government
in the economy
• If there is need for expansionary
(contractionary) policy Govt Exp increases
(decreases)
Exports and Imports
Aggregate demand & INCOME IN simple keynsian model

 GDP identity Y = C+I+G+(X-M)

 Assumptions:
• Interest Rate is fixed
• Zero Taxes, Zero Government expenditure
• =>Disposable Income Yd=Y
• Zero exports and imports
 Total expenditure is equal to the sum of
consumption which varies with income and
investment which is constant (E = C + I)
 45 degree line, total expenditure (E) = GDP (Y)
at the point of equilibrium
Demand determined output

YF
Changes in GDP

 The equilibrium level of income will not

change unless there is a change in the
consumption or investment functions.

 This equilibrium would be a desirable

outcome if level of income (output) was at
full employment level.
Government to rescue

 Keynes was concerned that changes in

autonomous spending would cause wide
fluctuations in economic activity.

 Government spending was necessary to offset the

changes in autonomous spending and restore the
economy to full employment.

 Therefore, total spending is the sum of consumer,

investment, and government expenditures.
Effectiveness of fiscal policy

 The effect of additional government spending to

raise the income level of the economy, ideally to the
full employment level.

 Government spending (G) is added to C + I.

 This increases spending in the economy to

C + I + G.

 Total impact of additional government spending is

enhanced through the multiplier.
Adding Government spending raises income
 Determination of National
Income: Keynesian TWO sector
model
 Determination of equilibrium level of National
Income algebraic analysis
• Simple model of Keynes is also known as 2
sector model where government expenditure,
taxation, export and import is not considered.
• Assumptions:
a) Investment is autonomous( will not change
with change of income)
b)Consumption is positive sloped
c) Aggregate supply or income line is 45degree
line starting from origin.
 Problem 1:
Let in an economy, autonomous investment is Rs 600 Crores
and the following consumption function: C= 200+.8Y. Given
the above , find the equilibrium level of income.
Rs in Crores

National Consumption Saving

Investment(I) AD=C+I AS=C+S
Income(Y) 200+.8Y S=Y-C

0 600 200 -200 800 0

1000 600 1000 0 1600 1000
2000 600 1800 200 2400 2000
3000 600 2600 400 3200 3000
4000 600 3400 600 4000 4000
5000 600 4200 800 4800 5000
6000 600 5000 1000 5600 6000
7000 600 5800 1200 6400 7000
S=S(Y)

I=Ia
Keynesian 3 sector model excluding
tax
National Government
Income Investment Consumption Expenditure Saving AD AS

0 600 200 200 -200 1000 0

1000 600 1000 200 0 1800 1000

2000 600 1800 200 200 2600 2000

3000 600 2600 200 400 3400 3000

4000 600 3400 200 600 4200 4000

5000 600 4200 200 800 5000 5000

6000 600 5000 200 1000 5800 6000

7000 600 5800 200 1200 6600 7000

 Keynesian 3 sector model including tax

NATIONAL GOVT.
INCOME INVESTMENT CONSUMPTION TAX EXP SAVING AD AS

0 600 40 200 200 -40 840 0

1000 600 840 200 200 160 1640 1000

2000 600 1640 200 200 360 2440 2000

3000 600 2440 200 200 560 3240 3000

4000 600 3240 200 200 760 4040 4000

5000 600 4040 200 200 960 4840 5000

6000 600 4840 200 200 1160 5640 6000

7000 600 5640 200 200 1360 6440 7000

8000 600 6440 200 200 1560 7240 8000

 Problem 1
Suppose consumption function c=.8y,
planned investment by entrepreneur for a
year is Rs 500 Crores. Find out equilibrium
level of income.
 Problem 2
Suppose the level of autonomous investment
in an economy is Rs 200 Crores. The
following saving function is given:
S=-80 +0.25 Y
Find the level of income.
 Problem 3
Suppose the consumption of an economy is
given by
C=20+0.6 Y
The following investment function is given:
I=10+0.2Y
What will be the equilibrium level of
national income?
 Problem 4
Given saving function of the economy is
given by S=-10+0.2 Y
Investment is 50 Crores
i)Find out the equation level of NI?
ii) Find the level of consumption
iii)If investment increases permanently by 5
Crores, what will be the new income and
consumption level?