Macroeconomics

LEC 5
• Theory of Income Determination:
• This part will study the determination of income (output &
employment), that mean explaining what factors contributed to
increase or decrease in income and the economic activity of a
nations.
• Our analysis depends basically on Simple Keynesian Model of income
determination.
• Keynes assumed that, there are two approaches to determine the
equilibrium level of income:
1- Aggregate supply = Aggregate Demand.
(income – expenditures method)
2- Saving = Investment
(injection – leakage method)
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1- Income – expenditure methods:-
• In order to determine equilibrium income level aggregate
supply (Y) must equal aggregate demand on goods & services
(C + I).
• Graphically: The aggregate demand shows the level of
desired expenditure by consumers and business. It the sum
of consumption function and investment function
(independent in restrict) .
• At E we get equilibrium level of income, when aggregate
supply (Y) line intersects aggregate demand (C+I) line.

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 Y
C,I
AD= C+I=a+bY+I0

C=a+bY
a+I0

Y
Ye

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 Mathematical Analysis:-
• The eequilibrium condition is set at:
Y=C+I
• So if we have consumption function
C = a + bYd = 40+ 0.80Yd
• Investment function I = I0 = $20 millions
• Based on equilibrium condition: Y = C + I
Y = 40 + 0.80Yd + 20
Y – 0.80Yd = 60
0.20Yd = 60
Y= 60 ÷ 20
100
Y = 60 x5
• Y= $ 300 millions the equilibrium level
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2015income 5
2- Investment = Saving Method:
or injection – leakage approach:
• Investment(I) is regarded as injections to the flow of income
spend on consumption while saving(S) regarded as leakage
for income not use in consumption.
• Mathematically: Equilibrium level of income determined
When
• I=S

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S,I S= -a+(1-b)Y

I0 I=I0

0 Y
Ye

-a

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 Example (1)
• Assume C = 40 + 0.80Yd Consumption Function
• I = $ 20 million Investment Function.
• Find the equilibrium level of income(use 2 nd approach)
• Solution :
Equilibrium Condition I = S
• S = - a + (1- b) Yd
• S = - 40 + (1- 0.80) Yd
• S = -40 + 0.20Yd
• I=S
• -40 + 0.20Yd = 20
• 0.20Yd = 60 Y = 300
• It is same level of income obtained when we use the first approach (Y =
C+ I) Dr YASSIR ABBAS 2015 8
Example(2):
• Assume C = 100 +0.75Yd…. Consumption Function
• I = 50 millions…….. Investment Function
1- find the equilibrium level of income.
2- At the above income level find the value of consumption and
saving
Solution:
• The first approach: Y = C + I
• Y = 100 + 0.75Yd + 50
• Y- 0.75Y= 150
• 0.25Y= 150
• Y = 600 millions. Equilibrium level of income
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 The second approach: S = I
• S = -100 + 0.25Yd
• - 100 +0.25Yd = 50
• 0.25Yd = 150 Y = 600. equilibrium level of income
• It is same level of income obtained when we use the first
approach (Y= C+ I)
For consumption value substitute Y=600 in consumption
function
• C = 100 + 0.75(600) , C= 550 Consumption value
• Also for saving substitute Y=600 in saving function
• S= -100 + 0.25 (600) , S= 50 Saving value
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• Investment Multiplier:
• This concept used to examine how a change in exogenous
investment spending affect income level or GDP.
• It is logical that an increase investment will raise the level of
output and employment. But by how much?
• The multiplier model shows that an increase in income by an
amplified or multiplied amount ( by an amount greater than
itself).

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• When we assume investment is regarded as induced investment
or independent investment which is determined by factors
rather than income the mathematical derivation of investment
multiplier will depend on the following functions:
• Ct = a + bYt consumption function in period t.
• It = I0 investment function in period t.
• And depend on the equilibrium level of income Y=C+I
• Using a long derivation the relationship between ΔY and Δ I will
be:

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• ΔY = 1 x Δ I
1-b
1/(1-b) called investment multiplier KI

That mean changes in income(ΔY) as a result of changing

investment(ΔI) is equal to changing in investment multiplied
by one over (1-b) which equal the value of investment
multiplier KI.

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• Example: assume MPC = 0.75 and investment increases by $
20 millions.
• Determine the change in equilibrium income.
• Solution: KI = 1_ = 1_ = 1_ = 4
1-b 1-0.75 0.25
 
• ΔY = KI ΔI KI = 4 ΔI = 20
• ΔY = 4 x 20
• Change in income = $80

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 Exercise
• Assume investment change by $ 100 millions and MPC equal
the following values
1/ 0.9 2/ 0.65 3/ 0.50
• Find the change in equilibrium income in these three values
of MPC,
• Explain the relationship between the change in MPC and the
multiplier values?

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THANK YOU

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