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Income Determination Income Determination
nalytical Iramework nalytical Iramework
In Kevnes`s analvtical íramework . the entire economv is
di·ided into íour sector. ·iz..
1, lousehold sector.
2, lirms or the business sector.
3, Go·ernment sector. and
4, loreign sector.
lor the sake oí simplicitv and svstematic exposition oí the
Kevnesian theorv oí income determination. we will íirst
discuss income determination in a two sector model in·ol·ing
onlv the household and íirm sectors.
1wo Sector Model 1wo Sector Model
e assume a simple or closed economv. Bv deíinition. a
simple or closed economv is one which has no go·ernment or
go·ernment economv and no íoreign trade and transactions.
1he two  sector model makes the íollowing assumptions:
1, 1here are onlv two sectors  household and íirms:
2, louseholds are the owners and íirms are the users oí the
íactors oí production:
3, lousehold incomes are comprised oí íactors pavments 
wages. interest. rent and proíits. louseholds spend their total
income on consumer and capital goods.
4, 1here are no corporate sa·ings or undistributed proíits:
5, 1here are no banks or íinancial institutions. All household
sa·ings are directlv in·ested in íirms: and
6, Supplv oí íactors oí production and the state oí technologv are
gi·en
Households
Business Firms
Determination of
Factor Price
Factor Narket
Product Narket
Determination of
Product Price
a, a, lactor pavments ~  I  R  P lactor pavments ~  I  R  P
b, b,  I  R  P ~ lousehold incomes  I  R  P ~ lousehold incomes
c, c, Value oí output ~ lactor pavments Value oí output ~ lactor pavments
d, d, lousehold income ~ lousehold expenditure lousehold income ~ lousehold expenditure
e, e, lousehold expenditure ~ Value oí output. lousehold expenditure ~ Value oí output.
How is the Equilibrium level of How is the Equilibrium level of
Income Determination Income Determination
The amount oI goods and services that Iirms produces
constitute the Aggregate Supply (AS). Its value equals Iactor
payments (FP). And, household expenditure represents the
Aggregate Demand (AD). According to the Keynesian theory
oI income determination, the equilibrium level oI national
income is determined where aggregate demand (AD) equals
the aggregate demand (AD).
reate demand reate demand depends on households` plans to spend, ,
and aggregate supply depends on Iirms` production plan. and aggregate supply depends on Iirms` production plan.
eynesian 1heory of National Income eynesian 1heory of National Income
Determination Determination
According to the Keynesian theory, the equilibrium level oI
national income is determined where Aggregate Demand (AD)
equals Aggregate Supply (AS).
reate Supply the aggregate supply (AS) reIers to the
value oI goods and services produced and supplied in an
economy per unit oI time. Aggregate supply includes both
consumer goods and producer goods. The goods and services
produced per time unit multiplied by their respective
(Constant) prices give the total value oI the national output.
This is the aggregate supply in terms oI money value.
reate Supply ScheduleIí all that is produced is sold. then
aggregate supplv grows at a constant rate oí increase in output.
1his shown bv 45S line. In the Kevnesian theorv oí income
determination. aggregate income equals consumption (, plus
sa·ings S,. 1hereíore. AS schedule is generallv named as (S
schedule.
Income
Expenditure
O
AS÷C¹S
reate Demand reate Demand ÷÷ 1he aggregate demand is an expost
concept. It implies eííecti·e demand which equals actual
expenditure.
D D ~ (I ~ (I
reate Demand Schedule reate Demand Schedule  In Kevnesian íramework.
in·estment I, is assumed to remain constant in the short  run
analvsis at all le·el the le·els oí the income \,. Let us assume
that the consumption íunction is gi·en as ( ~ a  b\ where a is
a constant denoting ( when \~ 0 and b is the proportion oí
income consumed. i.e.. b~A(´ A\.
1he AD íunction can now be expressed as (I ~ ab\ I.
i, (~50  0.5 \
ii, I ~ Rs. 50 billion
Income
\,
(~500.5\ I (I schedule
0 50  0 ~ 50 50 100
50 50  25 ~ ¯5 50 125
100 50  50 ~100 50 150
150 50  ¯5 ~125 50 1¯5
200 50  100 ~ 150 50 200
250 50  125 ~ 1¯5 50 225
300 50  150 ~ 200 50 250
350 50  1¯5 ~ 225 50 2¯5
400 50  200 ~ 250 50 300
National Income Determination :Graphical National Income Determination :Graphical
Presentation Presentation
Income,
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AS÷C¹S
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(onsumption lunction 1he relationship between
disposable income and consumption spending is called the
consumption function. A consumption íunction shows the
amounts that households plan to spend at diííerent le·els oí
disposable income. 1he amount households plan to spend
increases with income but bv a smaller amount than the increase
in income. In other words. households will spend part oí anv
increase in income and sa·e the rest. hate·er disposable
income is not spent bv households is sa·ed.
arginal and A·erage Propensities to consume
1he íraction oí the total income that is spend on consumer
goods and ser·ices known as a·erage propensitv to consume.
(´\
Suppose consumption íunction is gi·en as (~ 100  0.¯5\.
1hen. íor a gi·en income oí Rs. 200 billion.
AP( ~ (´\ ~ 100  0.¯5 \´200
100  0.¯5 200,
~ 1.25
AP( is important concept. It tells the producers what proportion
oí the total output can be disposed oí or what proportion oí the
total cost oí production can be reco·ered írom the sale oí
consumer goods and ser·ices.
arginal Propensitv to (onsume P(, arginal Propensitv to (onsume P(,  1he concept oí P( is 1he concept oí P( is
related to the marginal consumption related to the marginal consumptionincome relationship. In income relationship. In
other words. P( reíers to the relationship between change in other words. P( reíers to the relationship between change in
consumption consumption AA(, and the change in income (, and the change in income AA\,. According to \,. According to
Kevnesian consumption íunction. P( decreases with the Kevnesian consumption íunction. P( decreases with the
increase in income. increase in income.
1he P( can be deri·ed írom the consumption íunction. Gi·en 1he P( can be deri·ed írom the consumption íunction. Gi·en
the consumption íunction (~ ab\. Ií income increases bv the consumption íunction (~ ab\. Ií income increases bv AA\. \.
consumption increases bv consumption increases bv AA(. 1hus. ií ( ~ab\. then (. 1hus. ií ( ~ab\. then
( ( AA( ~ a  b \ ( ~ a  b \ AA\, ~ ab\b \, ~ ab\b AA\ and \ and
AA( ~ ( ~ (  ab\b (  ab\b AA\. Since ( ~ ab\. bv substituting ab\ \. Since ( ~ ab\. bv substituting ab\
íor (. we get íor (. we get AA( ~ ( ~ ab\, ab\ b ab\, ab\ b AA\. \.
AA( ~ b ( ~ b AA\ \
bv di·iding both sides oí Lq. bv di·iding both sides oí Lq. AA\. we get \. we get AA(´ (´ AA\~b. \~b.
Savin Iunction Savin Iunction : : Sa·ing íunction too is a íunction oí income.
At the aggregate le·el oí income. \~(S. 1hereíore.
S~\  (. Sa·ing íunction is a counterpart oí the consumption
íunction. Sa·ing íunction can. thereíore. be deri·ed írom the
consumption íunction.
S ~ \  (.
(~ a  b\
Bv Substituting a  bv íor (. we get
S ~ \  a  b\,
\ a  b\
~  a  \  b\.
S ~  a  1  b,\
Lq. gi·es the sa·ing íunction. Recall that b ~ A(´A\~P(.
1hereíore.
1 A(´ A\~ 1b and 1b is marginal propensitv to sa·e PS,
Assuming a ~ 100 and b ~ 0.¯5. we can the rewrite
consumption and sa·ing íunction as ( ~ 100  0.¯5 \. and
S ~  1000.25
1he 45Sline shows income  consumption relationship on the
assumption that total income is consumed: nothing is sa·ed. In
the analvsis oí national income determination. it shows also the
total expected sale proceeds. i.e.. the ·alue oí the total planned
output.
Expenditure
Disposable
income
Income, Consumption and Saving Relations
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6uilibrium of National Income :1wo Sector 6uilibrium of National Income :1wo Sector
Model Model
Lquilibrium le·el oí national income or national output is
determined at a le·el where aggregate demand íor output (I,
is equal to aggregate supplv oí incomes (S,.
(I ~ (S
Since ( is common to both sides. the equilibrium condition mav
be expressed as I ~ S.
1he consumption (, and sa·ing S, schedule ha·e been drawn
assuming a consumption íunction as (~ 1000.5\ and a sa·ing
íunction. as S~  1000.5\.
Expenditure
Income
National Income Determination
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Undesired
Accumulation oI
inventories
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1he Kevnesian model oí income determination assumes 1he Kevnesian model oí income determination assumes
i, i, 1hat in·estment I, is exogenouslv determined outside the 1hat in·estment I, is exogenouslv determined outside the
model. and model. and
ii, ii, 1hat in the short run. supplv oí in·estment goods is inelastic 1hat in the short run. supplv oí in·estment goods is inelastic
and in·estment is constant at Rs.100 íor all the le·els oí and in·estment is constant at Rs.100 íor all the le·els oí
output. output.
AS and AD schedule intersect each other at point L. at this AS and AD schedule intersect each other at point L. at this
point. (I~(S~Rs. 400 point. (I~(S~Rs. 400
300  100~300  100~400 300  100~300  100~400
1hus AD is equal to AS at Rs.400. 1his equilibrium will 1hus AD is equal to AS at Rs.400. 1his equilibrium will
remain stable in the short run since at point L the expected remain stable in the short run since at point L the expected
sale proceeds are equal to the realized ·alue. sale proceeds are equal to the realized ·alue.
Income Determination 1hrouh I and S Income Determination 1hrouh I and S
Schedule Schedule
In·estment is assumed to be constant. I schedule is a straight
horizontal line. lor sa·ing schedule we ha·e 
( ~ 100  0.5 \
S ~ \  (
S ~ \  100  0.5 \,
~  100  0.5 \
Sa·ing schedule can also be drawn in another wav. e know
that: S ~ \  (. thereíore. when
\ ~ 0. S ~ (. and when \ ~ (. S ~ 0.
hane in reate Demand and 1he hane in reate Demand and 1he
Multiplier Multiplier
Aggregate demand mav change due to change in either ( or I or
both. But. since ( ~ í \,. ( cannot change unless \ changes. In
the short  run. thereíore. AD changes due to the changes in I
onlv. So. let us assume that aggregate demand increases due to
the increase in I. 1he increase in in·estment. AI. mav be the
result oí autonomous in·estment expenditure bv the business
enterprise or bv the go·ernment.
Now let the aggregate demand increases írom ( ~ I to (  I  AI.
e know írom the theorv oí income determination that when
aggregate demand increase due to AI. the le·el oí national
income will also increase. lere a question arises : national
income increases bv how much·
1he theorv oí multiplier tells that national income increases bv 1he theorv oí multiplier tells that national income increases bv
some multiple oí some multiple oí AI. 1he numerical ·alue oí the multiplier.
1hus. multiplier is a number which gi·es a multiple increase in
national income due a gi·en increase in in·estment. i.e.. AI. 1hat
is. ií 2 is the multiplier then A \ ~ AI m. and m ~ A\´ AI.
The Theory oI Multiplier
1he Static Multiplier 1he Static Multiplier
Static multiplier is based on the assumption that AI results
instantlv in A\. 1here is no time lag between AI and A\. It
implies that when AI takes place. the equilibrium oí national
income shiíts írom one point to another point. at a higher le·el
oí income.
1he consumption íunction is shown bv the schedule (~ab\
and initial in·estment schedule bv I
1.
1hese two schedules add up
to aggregate demand. AD~ab\
1
I
1
and the equilibrium point
is determined at L
1
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1hese increase in national income A\, can be obtained bv 1hese increase in national income A\, can be obtained bv
subtracting \ subtracting \
11
írom \ írom \
22
. bv subtracting we get. . bv subtracting we get.
\ \
22
 \ \
11
~ a ~ ab\ b\
22
I I
22
, ,  ab\ ab\
1
I I
11
,,
~b\ ~b\
2 2
 \ \
11
,  I I
22
 I I
1 1
,,
\ \
22
 \ \
11
 b \ b \
2 2
 \ \
11
, ~ I , ~ I
22
 I I
1 1 ``
\ \
22
 \ \
11
1 1  b , ~ I b , ~ I
22
 I I
1 1
\ \
22
 \ \
1 1
~ I I
22
 I I
1 1
´ 1  b.
Since \ \
22
 \ \
1 1
~ A\ and I A\ and I
22
 I I
1 ~ 1 ~
AI. the Lq. can be written as AI. the Lq. can be written as
A\ ~ AI ´ 1 A\ ~ AI ´ 1  b or b or
A\ ´ AI ~ 1´1 A\ ´ AI ~ 1´1  b. b.
OR OR
e kn e know that the ·alue oí national output equals aggregate
spending. 1hus we ha·e
\ ~ (  I \ ~ (  I
Suppose that in·estment increases bv Suppose that in·estment increases bv AA I. 1his will result in an I. 1his will result in an
increase in aggregate consumption expenditure and real income. increase in aggregate consumption expenditure and real income.
lence. anv change in income lence. anv change in income AA\ is alwavs equal to \ is alwavs equal to AA(  (  AAI. I.
1hus 1hus 
AA\ ~ \ ~ AA(  (  AAI I
Di·iding both sides bv Di·iding both sides bv AA\. we get \. we get
1 ~ 1 ~ AA(´ (´ AA\  \  AAI´ I´ AA\ \
OR OR
AAI ´ I ´AA\ ~ 1 \ ~ 1  AA(´ (´ AA\ \
Since Since AA(´ (´ AA\ is the marginal propensitv to consume and \ is the marginal propensitv to consume and AAI´ I´ AA\ \
is the reser·e oí multiplier. we ha·e is the reser·e oí multiplier. we ha·e
1´ 1´ ~ 1 ~ 1  P( P(
hich vields the íollowing results hich vields the íollowing results 
 ~ 1´1 ~ 1´1  P(. P(.
1he Dynamics of Investment Multiplier 1he Dynamics of Investment Multiplier
Dvnamic multiplier requires that time must be introduced
explicitlv in the model. Dvnamics oí multiplier tells how a AI
multiplies itselí into A\. In·estment means expenditure on
íactor oí production  capital and labour. hich results
generation oí new income A\, equal to AI in the íirst period.
Since ( ~ 1\,. the increase in income A\, leads to increase in
consumption A(, depending on the marginal propensitv to
consume mpc,. Ií mpc ~ b. then A( ~ b A\ in the second
period. 1hev too consume b times b A\  their additional
consumption equals b
2
A\. 1his generates an equi·alent income.
Since b · 1. b
n
A\÷0. in this process. a series oí new incomes
are generated leading to increase in the national income.
A\ ~ AI  b AI  b
2
AI ... b
n1
AI
~ AI  1´1  b 
Once A\ is calculated. the in·estment multiplier m, can be
obtained as m ~ A\´ AI.
Suppose AI ~ 100. and mpc ~ 0.8. Now A\ can be worked out as
íollow :
A\ ~ 100  0.8, 100  0.8,
2
100 0.8,
3
100..0.8,
n1
100
~ 100  80  64  51.20 ....~500
A\ ~ 100 1´ 1  0.8  ~ 500.00
A\ ~ 500. and AI ~ 100
m ~ A\ ´ AI ~ 500´100 ~ 5
1he number` 5 is the multiplier. So long as mpc ~ 0.8. m ~ 5.
&ses of Multiplier &ses of Multiplier
1he concept oí multiplier is an useíul tool oí analvzing growth.
planning and projecting the in·estment requirement oí an
economv. gi·en the growth objecti·e. Ií mpc is known. the
planners can easilv work out the in·estment requirement to
achie·e a targeted growth rate. lor example :
Suppose that in a simple economv the current le·el oí income is
gi·en at Rs. 10000 million. 1he planners oí the economv íix a
target growth oí 20 percent o·er a certain period oí time. 1he
planners ha·e estimated the mpc íor the economv as a whole at
an a·erage oí 0.8. gi·en this iníormation. the total in·estment
requirement can be easilv obtained. as : 
ultiplier íor the economv. ultiplier íor the economv.
m ~ 1 ´ 1 m ~ 1 ´ 1  mpc ~ 1´ 1 mpc ~ 1´ 1  0.8 ~ 5 0.8 ~ 5
And the total growth target A\, can be worked out as And the total growth target A\, can be worked out as
1arget A\ ~ Rs. 10000 20´100 ~ 2000 million 1arget A\ ~ Rs. 10000 20´100 ~ 2000 million
Since A\ ~ Rs.2000 million and m ~ 5. the total in·estment Since A\ ~ Rs.2000 million and m ~ 5. the total in·estment
requirement AI, íor achie·ing the growth target can be requirement AI, íor achie·ing the growth target can be
computed as : AI ~ A\´m computed as : AI ~ A\´m
AI ~ 2000´5 ~ Rs.400 million. AI ~ 2000´5 ~ Rs.400 million.
1hus. the economv will ha·e to make an additional in·estment oí 1hus. the economv will ha·e to make an additional in·estment oí
Rs.400 million to achie·e a growth oí 20 percent or an absolute Rs.400 million to achie·e a growth oí 20 percent or an absolute
growth oí Rs. 2000 million o·er time. other things remaining the growth oí Rs. 2000 million o·er time. other things remaining the
same. same.
imitation Of Multiplier imitation Of Multiplier
lirst. the multiplier íormula. m ~ 1´1 lirst. the multiplier íormula. m ~ 1´1mpc,. implies that the mpc,. implies that the
higher mpc. the higher the multiplier. It means that the less higher mpc. the higher the multiplier. It means that the less
de·eloped countries which ha·e. in general. a higher mpc must de·eloped countries which ha·e. in general. a higher mpc must
grow at a much higher rate than the de·eloped countries with a grow at a much higher rate than the de·eloped countries with a
lower mpc. lower mpc.
Second. the working oí multiplier assumes that those who earn Second. the working oí multiplier assumes that those who earn
income as a result oí certain autonomous in·estment. would income as a result oí certain autonomous in·estment. would
continue to spend a certain percentage oí their newlv earned continue to spend a certain percentage oí their newlv earned
income on consumption. 1his assumption mav not hold in income on consumption. 1his assumption mav not hold in
realitv since people mav like to spend a part or whole oí their realitv since people mav like to spend a part or whole oí their
additional income on i, pavment oí past debts. ii, purchase oí additional income on i, pavment oí past debts. ii, purchase oí
existing durable goods and other assets. like old houses. second existing durable goods and other assets. like old houses. second
hand cars. etc. iii, shares and bonds írom the shareholders and hand cars. etc. iii, shares and bonds írom the shareholders and
bondholders. and i·, purchase oí imported goods. 1hese are bondholders. and i·, purchase oí imported goods. 1hese are
called as leakage in the consumption ílows. which reduce the rate called as leakage in the consumption ílows. which reduce the rate
oí multiplier. oí multiplier.
1hird. the working oí multiplier is based on the assumption that 1hird. the working oí multiplier is based on the assumption that
the goods and ser·ices are a·ailable in adequate supplv. But. ií the goods and ser·ices are a·ailable in adequate supplv. But. ií
goods and ser·ices are in scarcitv. as in the case scarcitv goods and ser·ices are in scarcitv. as in the case scarcitv  ridden ridden
countries. the actual consumption expenditure will be reduced countries. the actual consumption expenditure will be reduced
whate·er the rate oí mpc. (onsequentlv. the multiplier will be whate·er the rate oí mpc. (onsequentlv. the multiplier will be
reduced. Ií expenditure continue to increase in íace oí scarcitv. it reduced. Ií expenditure continue to increase in íace oí scarcitv. it
generate inílation. not real income. generate inílation. not real income.
1hree Sector Model of Income Determination 1hree Sector Model of Income Determination
Let us assume a closed economv with three sectors. ·iz..
households. íirms. and the go·ernment. 1he inclusion oí
go·ernment into the model aííects aggregate demand through
go·ernment expenditure and taxation. Go·ernment expenditures
are injections to the economv  thev add to aggregate demand 
and taxation is a withdrawal írom the economv  it reduces the
aggregate demand. 1he go·ernment expenditure and taxation
aííects the national income to the extent oí their net multiplier
eííect.
In three sector model go·ernment íollows a balanced budget
policv. i.e.. the go·ernment expenditure G, equals the amount
oí taxes 1,. Both G and 1 are exogenouslv determined.
Aggregate Aggregate demand AD, in the three sector is deíined as
AD ~ (  I  G. and aggregate supplv as AD ~ (  I  G. and aggregate supplv as
AS ~ ( S  1. AS ~ ( S  1.
1he equilibrium oí national income in three sector model takes 1he equilibrium oí national income in three sector model takes
place where : place where :
(  S  1 ~ (  I  G ...i, (  S  1 ~ (  I  G ...i,
at equilibrium. thereíore. \ ~ (  I  G at equilibrium. thereíore. \ ~ (  I  G
where ( ~ a  b\ where ( ~ a  b\
dd
: \ : \
dd
~ \  1. 1 ~ lump sum tax.
Bv substituting Lq. i, mav be written as :
\ ~ a  b \  1,  I  G
Sol·ing íor \. we get equilibrium le·el oí national income as
\ ~ 1´1  b a  b1  I  G, ...ii,
lor example : let us suppose that in an economv . lor example : let us suppose that in an economv .
( ~ 100  0.¯5 \ ( ~ 100  0.¯5 \
dd
. I ~ 100 and G ~ 1 ~ 50
bv substituting these ·alues in Lq. we get the equilibrium le·el oí
\ as
\ ~ 1´1  0.¯5 100  0.¯5 50  100 50 ,
~ 850.
1he Government Budet nd 1he Multiplier 1he Government Budet nd 1he Multiplier
1he íiscal policies oí go·ernment aííects the equilibrium le·el 1he íiscal policies oí go·ernment aííects the equilibrium le·el
oí national income. liscal policv reíers to the deliberate oí national income. liscal policv reíers to the deliberate
changes made bv the go·ernment in its expenditure G, and changes made bv the go·ernment in its expenditure G, and
the tax re·enue 1,. 1he impact oí change in íiscal policv is the tax re·enue 1,. 1he impact oí change in íiscal policv is
analvzed in three stages : analvzed in three stages :
1he ffect of Government penditure : G 1he ffect of Government penditure : G   Multiplier Multiplier
Let us suppose that the go·ernment makes expenditure onlv Let us suppose that the go·ernment makes expenditure onlv
on the purchase oí goods and ser·ices and there is no transíer on the purchase oí goods and ser·ices and there is no transíer
pavment. Let us also assume that all other ·ariables remain pavment. Let us also assume that all other ·ariables remain
constant. Now suppose that go·ernment expenditure increases constant. Now suppose that go·ernment expenditure increases
bv AG. this will increase the income le·el bv A\ through the bv AG. this will increase the income le·el bv A\ through the
process oí multiplier. process oí multiplier.
\ A\ ~ 1´1  b a  b1  I  G AG, ...iii,
1he eííect oí AG on the le·el oí national income can be obtained
bv subtracting Lq. iii, írom Lq. ii,. Bv subtracting. we get :
A\ ~ 1´ 1  b AG, ....i·,
Bv di·iding both sides oí Lq. i·, bv AG. we get go·ernment
expenditure multiplier G
m
, as
G
m
~ A\ ´ AG ~ 1´1  b.
Go·ernment multiplier is the same as in·estment multiplier.
2, 2, 1he Impact of hane in ump Sum 1a : 1he 1a 1he Impact of hane in ump Sum 1a : 1he 1a ÷÷
Multiplier Multiplier ::
1he method oí analvzing the impact oí a change in lump sum tax
i.e.. the eííect oí A1, on the le·el oí national income is the same
as one used to analvze the change in in·estment or go·ernment
expenditures. 1he impact oí change in tax A1, howe·er. on the
national income is. negati·e and smaller than the impact oí AG
or AI,. ií A1 ~ AG or A1 ~ AI.
\  A\ ~ 1´1  b a  b 1  A1 ,  I  G ,
~ 1´1  b a  b1  b A1  I  G, ...·,
Now. the eííect oí A1 on the le·el oí national income can be
obtained bv subtracting Lq. i, írom Lq. ·,. Bv subtracting. we
get :
A\ ~ 1´1  b  b A 1,
~ ~  b b A1´ 1  b ~  b ´ 1  b A1 ...·i,
1he tax multiplier 1
m
, can be obtained bv di·iding both sides oí
Lq. ·i, bv A1. 1hus.
1
m
~ A\´ A1 ~  b ´ 1  b.
e mav compare here the 1
m
and G
m
. Since b ~ mpc and mpc · 1.
1
m
~ b
1b

 ·  Gm ÷ 1
1  b

By way oI comparison, two points are important to note:
(i) Tmultiplier is smaller than Gmultiplier, and
(ii) the eIIect oI taxation on the level oI income is negative
whereas that oI the government expenditure is positive. It
means that iI AG÷ AY, national income will increase.
3, 3, 1he Balanced 1he Balanced   Budet Multiplier : Budet Multiplier :
hen AG~ A1. the go·ernment budget is said to be balanced. 1he
balanced budget theorem states that the balanced budget
multiplier is alwavs equal to one. 1hat is whv it is also called as
unit multiplier theorem.
Basic equilibrium Lq. 
\~1´1  b a  b1 I  G 
Bv incorporating AG and A1 while AG ~ A1 , and resulting
combined change in income. A\,. the equilibrium le·el oí
income oí income can be expressed as
\ A\~ 1´1  b a  b 1 A1 ,  I  G  AG 
Bv subtracting 
A\ ~ 1´1  b  b A1  AG ,
Since Since AA1~ 1~AAG. bv substitution. we can rewrite Lq. as : G. bv substitution. we can rewrite Lq. as :
AA\~1´1 \~1´1  b b  b b AAG GAAG, G,
Bv multiplving both sides bv 1 Bv multiplving both sides bv 1  b. we get b. we get
A\ 1  b,~  bAG  AG
A\ 1  b ,~ AG 1  b,
A\ ~ AG
e can obtained balanced budget multiplier B
m
, bv di·iding both
sides oí Lq. bv AG. 1hat is.
B
m
~ A\ ´AG ~AG´AG
A\ ´AG ~ 1
1he balanced budget multiplier can be obtained bv adding up 1he balanced budget multiplier can be obtained bv adding up
together the G together the G  multiplier and 1 multiplier and 1  multiplier. multiplier.
e know that  G
m
~ 1´ 1  b. and
1
m
~  b´ 1  b
bv adding them together we get.
B
m
~ G
m
 1
m
~ 1´ 1  b   b´ 1  b.
1  b´1  b ~ 1.
1hus. the balanced budget multiplier is equal to unitv. It implies
that ií AG ~ A1 national income increases exactlv bv the amount
oí increase in go·ernment expenditure.
Proportional Income 1a and Balanced Budet Multiplier
: 1ax svstem consists oí both the lump sum and proportional
taxes. 1he tax íunction used íor this analvsis is oí the íorm :
1 ~ 1  t\
where 1 ~ autonomous lump sum tax. and t ~ the rate oí
proportional income tax. also called marginal propensitv to tax.`
\ ~ a  b \  1 ,  I  G
bv substituting Lq. íor 1 in we get :
\ ~ a  b \  1  t\, ,  I  G
~ a  b\  b1  bt\  I  G
~ 1
1 b  bt
(a bT ¹ I ¹ G)
Now let the go·ernment expenditure increase bv Now let the go·ernment expenditure increase bv AAG causing an G causing an
increase in national income bv increase in national income bv AA\. New equilibrium le·el oí \. New equilibrium le·el oí
national income will be national income will be 
\  \  AA\ ~ 1 \ ~ 1
1 b ¹ bt
a bT ¹ I ¹ G ¹ AG
By subtracting Eq., we get :
AY ÷
1
1 b ¹ bt
AG
By dividing both sides oI Eq. by AG, we get the balanced budget
Multiplier (Bm) with proportional tax as
Bm ÷
AY
AG
÷
1
1 b  bt
Iour ÷ Sector Model of Income Determination
Model With Iorein Sector
1he inclusion oí íoreign trade makes the income determination
model a íour  sector model. In case oí íoreign trade. exports
X, are injections and imports , are outílows írom the
economv. In the national income analvsis. howe·er onlv the net
oí exports X, o·er the imports , is considered.
port Iunction : Lxports oí the countrv depends on a
number oí íactors 
prices oí domestic goods in relation to those in
other countries. tariíís and trade policies oí importing countries.
export subsidies. income  elasticitv íor imports in importing
countries. le·el oí imports bv the domestic economv etc. lor
simplicitv. thereíore we take exports as exogenous. i.e.. bv the
íactor operating outside the model economv.
Import Iunction : Imports oí the countrv. like its exports depends
on similar íactors. , depends on the le·el oí domestic income
\, and the marginal propensitv to imports mpm,. 1he import
íunction is thus speciíied as 
~  g\
where ~ autonomous imports. g ~ A´A\ ~ mpm. assumed to
be constant.
Lquilibrium equation íor íour sector model is 
\ ~ (  I  G X  ,
where ( ~ a  b\d. I ~ I. G ~ G. X ~ X. ~  g\. \
~ \  1
bv substitution we can write as 
\ ~ a  b \  1, I  G  X   g\,
~ 1´ 1 b g a  b1  I  G  X  , ....i,
Iorein 1rade Multiplier : 1he term 1´ 1  b  g, is the
íoreign trade multiplier. when consumption and imports are
both a linear íunction oí domestic income. Suppose exports X,.
while other ·ariables remain constant. ith AX. the equation íor
the equilibrium le·el oí income can be written as :
\  A\ ~ 1´1  b  g a  b1  I  G  X   AX,...ii,
Subtracting Lq. ii, írom Lq. i,. we get
A\ ~ 1
1 b ¹ g
AX
By dividing both side oI Eq. by AX, we Ioreign trade multiplier
(F
m
) ÷ (AY / AX) as
F
m
÷
AY/ AX ÷ 1 / 1 b ¹ g ....(iii)
Where b is mpc and g is mpm (marginal propensity to import).
Eq. (iii) reveals that iI b ÷ g, than Ioreign trade multiplier is equal
to unity.
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