Chapter 3

CHAPTER 3
National Income Equilibrium

Dr. Nurul Nadia Abd Aziz
Copyright © 2020 Dr. Nurul Nadia Abd Aziz 1

Syllabus
• 3.1 Two approaches in determine national income equilibrium
• 3.1.1 AD=AS approach
• 3.1.2 Injection=Leakages approach
• 3.2 Consumption theory: Conventional Autonomous and induced
consumption
• 3.3 Islamic consumption theory: Fahim Khan Islamic
consumption
• 3.4 Investment theory conventional perspective Autonomous
and induced investment
• 3.5 Calculation Income equilibrium in a 2, 3, and 4-sector
economy
• 3.6 Expenditure multiplier and tax multiplier
• 3.7 Inflationary gap and deflationary gap

Definition
Equilibrium refers to the state when total

output (also aggregate supply) is equal to
or in balance with total demand (also
aggregate expenditure).

Disequilibrium refers to the state when

total output over total demand or total
demand over total output.

Approaches to Determine
National Income Equilibrium
There are 2 approaches to determine

national income equilibrium:
Aggregate Demand = Aggregate Supply

Approach (AD = AS).
Injection = Leakages approach

AS = AD Approach
• Aggregate demand is the total demand for goods
and services in the economy.
• There are 4 components in AD, namely
• Consumption (C),
• Investment (I),
• Government sector (G) and
• Foreign sector / net export (X-M)
• Aggregate supply is the total quantity of goods and
services produced in an economy in any given
period of time.
• Equilibrium occurs when aggregate demand is
equal to aggregate supply.
Leakage = Injection Approach
• Leakage is a withdrawal from the income-

expenditure stream.
• Leakage include savings, taxes and imports.
• Injection is additional spending to the
income-expenditure stream.
• Injections include investment, government
expenditure and exports.

Consumption Theory
Consumption theory we can be divided into
two perspectives:
Conventional Islamic
Perspective Perspective

Conventional Perspective
Consumption function is the
relationship between consumption
and income, other thing remain
constant.
Saving function showing the

relationship between saving and
income, other thing remain constant.

Consumption Theory
• Consumption refers to the purchase of
goods and services by individuals or
households which are produced by firms.
• Fundamental Psychological Law – a person would
increase his consumption as his income increases,
but the expenditure will be less than the increase in
income.
• Consumers will spent only a part if the increase in
their income and save the rest.
Income = Consumption + Saving

Y =C+S
Average Propensity to Consume
(APC)
• APC is the ration of total consumption to total
income.
• In other words APC is defined as a fraction of the
total income spent on consumption as a whole.
APC = Total Consumption

Total Income
APC = C
Y
Marginal Propensity to Consume
(MPC)
• MPC is the ration of the change in consumption to
the change in total income.
MPC = Change in Total Consumption

Change in Total Income
MPC = ∆C
∆Y

Example
• Change in income from RM0-RM100 leads to a rise in
consumption RM100-RM175
Y0 = 0;
MPC = C1 – C0
C0 = 100;
Y1 – Y0
Y1 = 100;
= 175 – 100
C1 = 175
100 - 0
MPC = 75
100
= 0.75
• Means that for any change in income the consumer will spend
75% of it.
Consumption Function
C = a + bYd
Autonomous Disposable
Induced income
consumption consumption
Refers to consumption on basic Is the amount of consumption related
necessities, where the amount exists to income. Change in disposable
regardless of whether income is income leads to change in
available or not consumption.
When Yd=O, consumption of basic The amount of consumption depends
necessities come from borrowing, on the value of MPC.
dissaving or steal. MPC =
MPC measure the
change in consumption
that result from change
in income

Saving Theory
• Autonomous savings refers to that part of savings
that does not depend on the income level and
occurs when there is autonomous consumption.
• Induced savings is a part of the income and it

depends on the quantum of the savings, the higher
the income, the higher the amount of savings.

Average Propensity to Save (APS)
• APS is the ration of total saving to total income.

• In other words APS is defined as a fraction of the
total income that is saved.
APS = Total Saving

Total Income
APS = S
Y

Marginal Propensity to Save
(MPS)
• MPS is the ration of change in total savings to a

change in total income.
MPS = Change in Total Saving

Change in Total Income
MPS = ∆S
∆Y

Saving Function
S = -a + (1-b)Yd
Autonomous Disposable
Induced income
saving saving
When Yd=0, and a = 100, Is the amount of saving related to income.
so, the consumption 100 is Change in disposable income leads to
come from saving. change in saving. The amount of saving
Therefore –a = -100. depends on the value of MPS.
MPS =
MPS measure the
change in saving
that result from
change in income

The Relationship between
Consumption and Saving
C = a + bYd
S = -a + (1-b)Yd
1 = APC + APS
1 = MPC + MPS

Example
Fill in the blank with the correct answers.
Y C S=Y–C MPC MPS APC APS

0 100
100 175
200 250
300 325
400 400
500 475
600 550
Breakeven Income
C
Y=C
BE C = 100 + 0.75Yd
AS = AD 100
Approach
400 Y
Leakage =
Injection S = -100 + 0.25Yd
BE
Approach 0 400 Y
-100

Change in Autonomous Change in Induce
Consumption Consumption
• The effect of a change in • The effect of a change in
autonomous consumption induced consumption is that
is that the curve will shift the slope of the curve rotate
upward or downward. upward or downward.
• Factor: Non-factor of • Factor: Disposable income
income
C Y=C C Y=C
C = 110 + 0.75Yd C = 100 + 0.80Yd

C = 100 + 0.75Yd C = 100 + 0.75Yd
C = 90 + 0.75Yd C = 100 + 0.70Yd
110
100 100
90
Y Y

Determinants of Aggregate
Consumption
Tax
Expected Future
Income
Household Income
Wealth
Interest Rate

Induced Consumption
Household Income
• Since induced consumption directly
related with income, this component
only influences the induced
consumption (b).
• As income increase, our induced
consumption also increases
• So consumption and saving depend
directly on disposable income.

Determinants of Autonomous
Consumption
Tax - If tax rate Interest Rate - If Wealth - The greater Expected future
reduces, consumption interest rate the amount of Income - If we expect
will increase. This is decrease, wealth, the larger will future income
because since tax rate consumption will be the amount of increase,
reduce, the disposable increase. Inversely consumption. consumption will
income and purchasing related to interest Directly related to increase too. Directly
power increase. It is rate. wealth. related to expected
inversely related with future income.
consumption
Islamic Perspective
• According to M. Fahim Khan. Muslim consumption is
obviously different from conventional consumption
pattern. There are two types of consumption:
• 1. Consumption expenditure for own and family, E1
• 2. Consumption expenditure for others, E2
Total expenditure = E1 + E2
• E1 includes present Consumption (C1) & Future
consumption (S1)
• E2 includes present consumption (C2) & future
consumption (S2)

E1
E2
• The basket of goods for
• The Al-Quran does not
Muslim is limited to
specify exactly how much to
permissible goods and the
spend on E2 but the
way of Allah.
minimum amount should be
• Means that a Muslim must
the amount of zakat
not only spend now but (compulsory to pay yearly).
must save for future • However the more Muslim
consumption or
sincerely spend for others,
investment, as to improve
the better it is for him in this
their economic condition in
world and hereafter.
the future.

• Islam has own distinct ethical, sociological, and
cultural framework.
• Islam associates belief in the day of judgement and
the life hereafter.
• A Muslim are free to decide how much of his
income will spend on these expenditure.
• However Islam give two guidelines on the spending
pattern.
– Rational spending - wealth, price
level, expectation etc.
– Degree of God fear ness or
God consciousness (Taqwa)
Objective of Consumption is Islamic
Perspective
• Every individual should consume enough

economic goods to lead an efficient life.
• Certain prohibited goods should not be consumed
• Consumption of economic goods must not be
extravagant, just as excessive indulgence in luxurious
living is discourage
• Consumption of economic goods and consequent
satisfaction, must not be ultimate objective of
individuals
28
Time-scale of Consumption in Islamic
Perspective
• Consumption today has its immediate effects in life-
to-come.
• An increase in income may lead to an increase in
consumption and benefits now and in the hereafter.
• If the alternative uses of the consumption is used
which is encouraged in Islam such as free loan,
sedeqah, spending for welfare etc.
• Muslim has to expand some of the
time in the remembrance of God.
29
Ethic of Consumption in Islamic
Perspectives
• According to Islam, Allah’s bounties
belong to all mankind.
• Some of these bounties may be under the
authority of particular people.
• Doesn’t mean they can utilize them for themselves
alone.
• The act of uses or consumption of goods things is in
itself considered as a virtue in Islam.
• The Islamic teaching recommend a moderate and
balance pattern of consumption and spending.
• The pattern which lies in between miserliness and
extravagance. 30
Muslim Consumer Behaviour
The belief in the hereafter life
Al-Falah principle
Principle of Wealth
Principle of consumption
of goods and services

The belief in the hereafter life
• The consumption of goods and services by Muslims
should comply with the Syariah and obey the rules
predetermined by Allah S.W.T.
• Consumption should not only focus on the
satisfaction of this world, but also the rewards in
the hereafter.
Al-Falah principle
• Based on Islam, it is vital to received blessings from
Allah S.W.T during spending to achieve Al-Falah
(success).
• Al-Falah is the Arabic word which means complete
happiness in this world and in the hereafter.
Principle of Wealth
• A Muslim need to believe the principle that all that exists in the
universe belongs to Allah S.W.T. As much, men are more custodians
over their properties and are not real masters.
• Therefore, Muslim should manage their wealth according to the
guideline of Allah S.W.T for the benefit of mankind.
Principle of consumption of goods and services

• Consumption of goods and services from Islamic perspective must
be clean and pure.
• Consumer goods in Islam must be tied up with ethical values such as
goodness, purity and nourishment.
• Goods which are bad, harmful, and worthless are not
considered as goods in Islam.
• For example, alcoholic drinks which are harmful to the
mind and health of man are not considered as goods.

Macroeconomics
Effective Practice
(Page 45 - 86)

Investment Theory

Definition
Investment defined as the process

of producing and purchasing
capital/investment goods.

Investment includes
All purchases of real or capital goods.
Ex: tools, machinery, factory, office, building, storage
facility, transportation etc.
New
constructions
Include construction of All change in
factories, warehouse, stock/inventories
office, shops, houses
etc. Ex: physical increase in the
amount of goods produced
but unsold.

Types of Investment
Autonomous Induced
Investment Investment
• This kind of investment does not • This kind of investment is
effected by level of income but depending on level of income.
effected by non-other factors such • It has positive relationship with
as interest rate, level of technology. national income. As national
• There is no relationship between income increase, investment will
national income and autonomous increase too.
investment. • Ex: investment on capital goods.
• Whether income increase or
decrease, the investment will
remain constant.

Total Investment =
Autonomous Investment
+ Induced Investment
This amount effected

Investment
Total by income, as national
Investment Induced income increase,
Investment
investment will
increase too.
Autonomous Amount is fixed and

Investment
not effected by
National income (effected by
Income non-income factors)

Determinants of Investment
3
1 4
2
Government Technology
Rate of
Policies Changes
Interest Rate of
return

Determinants of Investment
INTEREST RATE GOVERNMENT POLICIES
• The higher the real interest rate, the • Depends on the policies that the
smaller is the quantity of government undertaking.
investment demanded and vice • Ex: to promote local investment
versa. the government can give tax
• Firm invest only when they expect exemption or reduction or other
to earn a rate of profit that exceeds incentives could also be given to
the real interest rate. Thus the investor.
higher interest rate, the fewer
projects that are profitable, so the
smaller is the amount of investment
demanded. PROFIT EXPECTATION
• The higher the expected profitability
of new capital equipment, the greater
NATIONAL INCOME the amount of investment.
• As national income increase, • Profits earned on past sales are
investment will increase too. retained by the firm are reinvested in
• The value of investment is directly new capital investment. Higher
related to national income. current profit, a larger flow of fund
• Ex: capital consumption. available for re-investment.

Rate of Interest
• The financial cost needs to finance real capital.
• If the interest rate is high, cost of borrowing
will increase and the investment will decrease.
• Firm invest only when they expect to earn a
rate of profit that exceeds the real interest
rate.
• Thus the higher interest rate, the fewer
projects that are profitable, so the
smaller is the amount of investment
demanded.
Rate of Return
• All firms will expect higher return for their
investment.
• To increase the return, cost is need to be
reduced.
• If the cost is high, the return is low and
discourage firms from invest.

Government Policies
• Government is responsible to
attract investors from domestic
and foreign countries.
• To promote local investment the government
can give tax exemption or reduction or other
incentives could also be given to investor.
• This will encourage investors to invest.

Technology Changes
• Improvement in technology will reduce cost
of production and increase rate of return.
• This will increase investment.

Investment in Islam
• Dr. Aqed A. Ansari pointed out that capital formation from
the conventional is rather limited since only focus on human
behavior.
• In Islam it includes wide integration of various dimensions of
social, moral, political as well as spiritual.
• There are 4 institution that encourage the process of capital
formation/investment:
• Family
• Ummah
• Mosque
• Government
• The need to invest not only lies on government but every
individual in the economy.
Only permissible activities
are allowed. 01
Investment is based on the
needs of human (Dharuriyah,
Hajiyah and Kamaliyah) 02
Investment should
emphasize on welfare
besides profitability
03
Its implementation should
not against Syariah 04
Does not involve any form
of riba and gharar. 05
The Boundaries of Investment in Islam
Multiplier

Definition
Multiplier indicates how many times

the change in national income due to
change in variable aggregate
expenditure /spending (investment,
government, taxes, import).

M ul tip lie r 01 Investment multiplier indicates how
many the change in national income
nt due to change in investment
e st me
I nv
ulti
plie
r 02 Government multiplier indicates how
many the change in national income due
M to change in government spending
m ent
ver n
G o
ulti
p lie r 03 Tax multiplier indicates how many
times the change in national
M income due to change in taxes.
Tax
Types of Multiplier
Formula
AD Autonomous/constant/lump
multiplier sum tax or without tax
Investment
multiplier
Government
multiplier
Tax
multiplier


Inflationary Gap

Inflationary Gap
• Situation where national income exceeds the full employment
level Yfe.
• The increase is only in the increase of nominal income but no
real increase in goods and services.
• Y : C + I + G + (X-M) exceeds full employment
• To eliminate inflation, the inflationary gap must closed by
either raising withdrawals/ lowering injections/ combinations
until Ye=Y.
• Example:
• Deflationary fiscal policy:
• Lowering government expenditure/raising taxes
• Deflationary monetary policy:
• reducing the amount of money and raising interest rate
Inflationary Gap Using
AS=AD Approach
AD
AS = AD
ADE
Inflationary ADFE
gap
AS
YFE YE

Deflationary Gap

Deflationary gap
• Situation where the equilibrium level of income is not a
full employment level of national income.
• Resources are not fully utilized and any increase in
national income shows an increase in goods and
services
• To close this gap, government must implement
• Expansionary monetary policy:
• Increase the supply of money
• Expansionary fiscal policy;
• Reduces tax, increase government expenditure.
This will increase AD since spending increases.
The deflationary gap will be reduced.

Deflationary Gap Using
AS=AD Approach
AD
AS = AD
ADFE
Deflationary gap
ADE
AS
YE YFE

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Chapter 3 - National Income Equilibrium

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National Income Equilibrium

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 1

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 2

Equilibrium refers to the state when total

Disequilibrium refers to the state when

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 3

There are 2 approaches to determine

Aggregate Demand = Aggregate Supply

Injection = Leakages approach

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 4

• Leakage is a withdrawal from the income-

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 6

Copyright © 2020 Dr. Nurul Nadia Abd Aziz 7

Saving function showing the

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Income = Consumption + Saving

APC = Total Consumption

MPC = Change in Total Consumption

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• Induced savings is a part of the income and it

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• APS is the ration of total saving to total income.

APS = Total Saving

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• MPS is the ration of change in total savings to a

MPS = Change in Total Saving

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Y C S=Y–C MPC MPS APC APS

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C = 110 + 0.75Yd C = 100 + 0.80Yd

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• Every individual should consume enough

The belief in the hereafter life

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Principle of consumption of goods and services

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Investment defined as the process

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This amount effected

Autonomous Amount is fixed and

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Multiplier indicates how many times

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