Determinants of Equilibrium Income

Aggregate Output and Aggregate Income (Y)

The fundamental assumption of Keynesian economics is that economic
activity, that is, output and employment, are determined primarily by the
amount of aggregate demand (or total spending) in the economy.

Aggregate Expenditure = C + I + G + (X – M)

In The General Theory, Keynes argued that household consumption is

directly related to its income
 Household Consumption and Saving
Keynes observed that consumption expenditure depends primarily on
personal disposable income, i.e. one’s take home pay.
People can do two things with their income: they can consume it or they
can save it. (For the moment, let’s ignore the need to pay taxes with
some of it).
Each person who receives a raise in income faces this choice.
 Household Consumption and Saving
Keynes psychological law of consumption:
Keynes in 'The General Theory of Employment, Interest and Money' (1936) proposed
the psychological law of consumption to capture the essential spending behavior of
the household sector. It forms the basis of the Keynesian consumption function.

The essence of the law is that consumption varies directly with income but the change
in consumption is of a smaller magnitude than that of change in income. In his words,
"The psychology of the community is such that when aggregate income increased,
aggregate consumption is also increased but not so much as income"
The Consumption function

 The consumption function describes the relationship between consumer

spending and income
C = a + by
 Consumption spending, C, has two parts:
a = autonomous consumption. This is the part of total consumption which does
not vary with the level of income.
by = income-induced consumption. The product of a fraction, b, called the
marginal propensity to consume (MPC) and the level of income, y.
Consumption function
The consumption function is a line that intersects the vertical axis at a. It has a slope equal to b.

C = a  bY
• The slope of the consumption
function (b) is called the
marginal propensity to
consume (MPC), or the fraction
of a change in income that is
consumed, or spent.

0  b< 1
 Household Consumption and Saving
Marginal Propensity to Consume (MPC):
MPC measures the change in
consumption/change in disposable
income. The marginal propensity
to consume can also be shown
by the slope of the consumption
Function. Source: https://ebooks.ibsindia.org/mebe/front-matter/chapter-4-aggregate-demand-and-multiplier-session-7-8/

Average Propensity to Consume (APC):

 Household Consumption and Saving
Factors that determine the marginal propensity to

consume
Income levels
Temporary/permanent increase in income
Interest rates
Consumer confidence
An Aggregate Consumption Function derived from an Equation

C  1 0 0  .7 5 Y
 At a national income of zero,
consumption is $100 billion
(a).
 For every $100 billion
increase in income (DY),
consumption rises by $75
billion (DC).
Can you answer?
For the slope (steepness of the line) of the consumption
function to change, ________ would have to increase or
decrease.
a.Consumer expectations
b.Consumer wealth
c.MPC
Consumption Function (alternative formulation)

C  c  c (Y  T )
c -Autonomous consumption

c -Marginal Propensity to Consume (MPC)

(Y  T ) -Disposable Income (DI) (Income - Net Taxes)

 Saving Function
Saving is that part of income which is not spent on current consumption.
The relationship between saving and income is called saving function.
Simply put, saving function (or propensity to save) relates the level of saving
to the level of income. It is the desire or tendency of the households to save
at a given level of income. Thus, saving (S) is a function (f) of income (Y)
(S= -a + sY)
Consumption and Saving Function
Example

C  1 0 0  .7 5 Y
S  Y  C
Y - C = S
AGGREGATE AGGREGATE AGGREGATE SAVING
INCOME CONSUMPTION (Billions of Dollars)
(Billions of Dollars) (Billions of Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
 Case study on MPC

Indian Express, august 2020: How can India boost the overall demand in the economy?
India is facing a structural demand problem, one that predates the COVID-19 shock. This challenge has been
exacerbated over the past few months as jobs have been lost and incomes have collapsed.
Boosting demand, in particular domestic demand, is critical for an economic revival as external demand is
likely to remain muted.
Rathin Roy of the National Institute of Public Finance and Policy has argued that India’s growth story has
been driven by demand generated by those who are at the top of India’s socio-economic pyramid, but that
has now plateaued.
The question that arises is: Where is demand going to come from now?
Radhicka Kapoor (senior fellow at ICRIER) and Nomaan Majid (a Senior Employment Specialist ILO DWT
for South Asia) tackle this question in their opinion piece in The Indian Express.
“One option is to turn to those at the bottom of the pyramid who have a high marginal propensity to
consume,” they write. However, realising the untapped demand potential of this group requires enhancing
their incomes and earnings.

Q) How do we increase earnings of those at the bottom of the pyramid?

 Investment Function

Investment means the new expenditure incurred on addition of

capital goods such as machines, buildings, equipment, tools, etc.

The addition to the stock of physical capital i.e., net investment

raises the level of aggregate demand which brings about addition to
the level of income and employ­ment in the economy.
Investment Function

Three types of Investments:

(1) Business Fixed Investment (i.e. investment in fixed capital, such
as machines, tools),
(2) Residential Investment i.e., investment in building of houses) and
(3) Inventory Investment (i.e. investment in building stocks of goods
and raw materials)

change in inventory = production – sales

Actual versus Planned Investment
Desired or planned investment refers to the additions to
capital stock and inventory that are planned by firms.

Actual investment is the actual amount of investment

that takes place; it includes items such as unplanned
changes in inventories.
 Investment Function
Just as a consumption function shows the relationship between real GDP
(or national income) and consumption levels, the investment
function shows the relationship between real GDP and investment levels

I  I
Investment is autonomous (independent of income)
Investment as a function of National Income
When businesses make decisions about whether to build a new factory or to place an order for
new computer equipment, their decision is forward-looking, based on expected rates of return,
and the interest rate at which they can borrow for the investment decisions do not depend
primarily on the level of GDP in the current year. Thus, the investment function can be drawn as a
horizontal line, at a fixed level of expenditure. The slope of the investment function is zero,
indicating no relationship between GDP and investment.
Determinants of Investment
Below are all the things that can cause a shift in the
investment function

The interest rate

Expectations of future profits
Technology
The S = I Approach to Equilibrium

Aggregate output will be equal to planned aggregate

expenditure only when saving equals planned
investment (S = I).
Aggregate Expenditure: Government Spending and
Taxes as a Function of National Income
 We will assume that government
expenditures (G) and net taxes (T)
are autonomous
$
T  T
◦ This assumption will keep our
models from becoming overly
complex
◦ It will also allow us to easily
G  G
analyze fiscal policy as both G and
T change
G
 It would be possible to consider
taxes that vary with GDP (income T
taxes)

Real income
Aggregate Expenditure: Net Export (X-M) as a Function
of National Income
 Ifboth exports (X) and imports $
(M) are autonomous, then net
exports are autonomous

X’’-M’’

X-M

X  M  X  M X’-M’

Real disposable income

Determinants of X-M
 The following will cause a shift in the net export function.
◦ The Exchange Rate
 If the Rupee appreciates, then exports fall and imports rise, both causing
net exports to fall, or shift down.
◦ Foreign GDP (Income)
 As foreign income rises, they import more goods from around the world
including the India. So our exports will rise as we satisfy their demand
for our goods.
Putting It Together: The Aggregate Expenditure
Function 
Graphing Aggregate Expenditure. The aggregate expenditure is the vertical sum of C + I + G + (X-
M).

Source: https://courses.lumenlearning.com/wm-macroeconomics/chapter/aggregate-expenditure-investment-government-spending-and-net-exports/
Equilibrium in the Income-Expenditure Model
Macro equilibrium in the income-expenditure model is found at the point where the level of

GDP, or national income, equals aggregate expenditure. Graphically, this is easy to see as a

point along the line that evenly divides the two axis on the graph. This line, called the 45

degree line, shows the only point on the aggregate expenditure line where the total quantity of

goods and services being purchased (AD) equals the total quantity of goods and services

being produced (AS). 

Equilibrium occurs when there is no tendency for change. In the macroeconomic goods

market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output.
Deriving Equilibrium Income and Output
The combination of the aggregate expenditure line and the income=expenditure line is the Keynesian Cross,
that is, the graphical representation of the income-expenditure model. The equilibrium occurs where aggregate
expenditure is equal to national income;

$
45o
C+I+G+(X-M)

Equilibrium Real GDP

Real GDP
 Equilibrium Income and Output
Equilibrium in the Keynesian Cross:
If output was above the equilibrium level, at H, then
the real output is greater than the aggregate
expenditure in the economy. If output was below the
equilibrium level at L, then aggregate expenditure
would be greater than output. Only point E can be at
equilibrium, where output, or national income and
aggregate expenditure, are equal. The equilibrium
(E) must lie on the 45-degree line, which is the set
of points where national income and aggregate
expenditure are equal.
Source: https://courses.lumenlearning.com/wm-macroeconomics/chapter/equilibrium-in-the-
income-expenditure-model/
Recessionary and Inflationary Gaps in the Income-Expenditure Model

(a) If the equilibrium occurs at an output below potential GDP, then a recessionary gap exists. The policy
solution to a recessionary gap is to shift the aggregate expenditure schedule up from AE0 to AE1, using
policies like tax cuts or government spending increases. Then the new equilibrium E1 occurs at potential
GDP.
(b) If the equilibrium occurs at an output above potential GDP, then an inflationary gap exists. The policy
solution to an inflationary gap is to shift the aggregate expenditure schedule down from AE0 to AE1, using
policies like tax increases or spending cuts. Then, the new equilibrium E1 occurs at potential GDP.
 The Aggregate Demand Curve
P 45 o
AE’’ (P’’)
AE (P)
AE’ (P’)

Y
P
P’
P
P’’
AD

Y
 Shifts in the Aggregate Demand Curve
P 45o
C+I’+G+(X-M)
C+I+G+(X-M)

Y
P

AD AD’
Y