National Income Determination

• Looks at how the level of real GDP is

determined and how it fluctuates around
the level of potential GDP
• We consider two models of income
determination:
1. The Aggregate Expenditure Model
(Keynesian Model)
2. The Aggregate Demand-Aggregate Supply
(AD-AS) Model
5/13/23 01:38 PM 1
 Aggregate Expenditure Model
• Put forward by John Menard Keynes who
developed the idea that “total production /output
(Y) is determined by total spending (AE) in the
economy)
• 3 possible relationships between Y and AE
1. AE=Y; equilibrium level of output and income
2. AE>Y; output increases to match spending
3. AE<Y; output falls to match spending
• This brings us to the concept of desired aggregate
expenditure
5/13/23 01:38 PM 2
 Desired Aggregate Expenditure (AE)
• Refers to the sum of desired or planned spending on
domestic output by the four economic agents
AE = C + I + G + (X – M)
• NB: National Income Accounts measure actual
expenditures in the above four categories whilst National
Income Theory deals with desired expenditures.
• AE is divided into two components:
– autonomous (does not change systematically with or
depend on national income); and
– induced (systematically related/respond to changes in
national income)
5/13/23 01:38 PM 3
 Two Sector Model
(Simple Keynesian Model)

• We begin with a very simplified model with only two of

the four components; consumption and investment i.e.
AE = C + I
• These two determine the level of equilibrium output,
• We assume a closed economy, no government, constant
price level
• Wage rate and interest rate are given (exogenous)
• Saving becomes the only withdrawal and investment the
only injection into the circular flow of income

5/13/23 01:38 PM 4
 Consumption, Saving & Investment
• Consumption spending (C) is HH
expenditure on durable & non-durable
goods and services while saving (S) is that
part of disposable income not consumed
• Saved income is borrowed for investment
spending (I)
• Consumption, Saving and Investment play
central roles in an economy
5/13/23 01:38 PM 5
 Consumption, Saving & Investment
• Economies that save and invest more
tend to experience higher growth than
those that consume more.
• Where C & I are high, AD increases raising
output and employment in the short run
• A drop in consumption leads to a drop in
aggregate expenditure leading to a
recession as investment falls
5/13/23 01:38 PM 6
 Income (Y), Consumption (C) and Saving (S)
• Personal income (Y) less taxes (T) gives
disposable income (Yd) that is (Y - T = YD)
• In Two Sector Model, (Y = YD)
• Disposable income less consumption equals
personal saving (YD - C = S)
• Studies show that income is the primary
determinant of C and S
• C and S rise with disposable income hence
there is a positive relationship
5/13/23 01:38 PM 7
 Consumption Function
• Relates total desired consumption
expenditures to factors that determine it, i.e.,
disposable income, wealth, interest rates, and
expectations about the future
• In the simple case, consumption function
relates desired consumption expenditure to
disposable income
• Concept is based on the hypothesis that there
is a stable empirical relationship between
consumption and income (Keynes)
5/13/23 01:38 PM 8
Consumption Function Characteristics
1.C increases as Y increases
2.C is positive even if Y is zero
3.When Y increases, C increases
but by a lesser percentage
Y  C
• Thus, C-function is upward
sloping
5/13/23 01:38 PM 9
 C-function Cont’d
• Consumption can be broken down into:
1. Autonomous: minimal amount consumed by an
individual at zero Y (borrowing or dissaving)
2. Induced: varies with disposable income
• The consumption function can be
represented by the following equation:
C = a + bYD
• a represents autonomous and bYD
represents induced consumption expenditure
5/13/23 01:38 PM 10
 C-function
Consumption C C 2  C1 C
Slope    b
Y 2  Y1 Y
Desired

C = a + bYD

C2 Induced
ΔC Consumption
C1

a
Autonomous
ΔY Consumption

Y1 Y2 Disposable
5/13/23 01:38 PM Income YD 11
 C-Function & The 45⁰ Line
• 45⁰ line helps us to see whether C is
equal to, greater or less than YD
• It is constructed by connecting all points
where desired consumption is equal to
disposable income
• NB: Both axis have the same scale
• At the break-even point:
C = YD
5/13/23 01:38 PM 12
 C-function & the 450 Line

Desired Consumption C C = YD

C = a + bYD
Dissaving ( Yd < C)

Saving ( Yd > C)

45º

Disposable Income YD
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Average Propensity to Consume (APC)
• APC is the total consumption spending
divided by the total disposable income
APC = C/YD
• APC falls as disposable income increases
• At break-even APC = 1 (unity)
• Below break-even APC > 1 (dissaving)
• Above break-even APC < 1 (saving)
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Marginal Propensity to Consume (MPC)
• MPC - amount of extra consumption
generated by an extra dollar of disposable
income:
MPC = ∆C/∆YD = b
• MPC is slope of C-function & 1>MPC>0
for all levels of income.
• For every $1 of income, less than $1 is
spent on consumption and the rest is
saved.
5/13/23 01:38 PM 16
 Saving Function
• Saving is all the disposable income
that is not spent on consumption:
S = YD – C
= YD – (a + bYD)
= YD – a – bYD
= – a + (1 – b)YD
5/13/23 01:38 PM 17
 S-function
S
Slope   (1  b )
Desired Saving S
Y

S = -a + (1-b)YD

ΔYD
0
Disposable Income YD
ΔS
-a

5/13/23 01:38 PM 18
 Average Propensity to Save (APS)
• The proportion of disposable income
that households want to save is called
the average propensity to save (APS).
• It is derived by dividing the total
desired saving by total disposable
income:
APS = S/YD

5/13/23 01:38 PM 19
Marginal Propensity to Save (MPS)
• the extra saving generated by an extra dollar of
disposable income is called the marginal propensity
to save (MPS).
• The MPS is also the slope of the S-function given by
the formula:
MPS = ∆S/∆YD = (1 – b)
• The saving line cuts the horizontal axis at the break-
even level of income, thus:
S = 0 when C = YD
5/13/23 01:38 PM 20
 Relationship between C and S
• Because income is either spent or saved, it
follows that fractions of income spent or
saved must account for all income:
APC + APS = 1
• It also follows that fractions of any increments
to income consumed or saved must account
for all that income:
MPC + MPS = 1
5/13/23 01:38 PM 21
 (i) Consumption function

45 ? Line

C = a + bYD

450 Line
Ye
0
Disposable Income (YD)

S = -a + (1-b)YD

0
Ye Disposable Income (YD)

-a

(ii) Saving function

5/13/23 01:38 PM 22
 Investment Spending
• Three components of investment spending
are:
a) Inventory accumulation (finished goods, work in
progress and raw materials)
b) Residential housing and construction
c) Business fixed capital formation
• All these components are negatively related
to interest rates

5/13/23 01:38 PM 24
 Investment Function
• Shows the relationship between investment
and the interest rate
• As the interest rate declines, the cost of
borrowing goes down leading to an increase in
investment
• The inverse relationship between investment
and the interest rate leads to a down-ward
sloping investment function shown below.

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 Investment Function
Interest Rate r

Investment- function

0
Investment Spending I

5/13/23 01:38 PM 26
 Determinants of Investment
• Costs – high interest rates (cost of borrowing) and
high taxes on capital income discourage I
• Expectations – forecasts of the future state of the
economy (profit expectations and business
confidence can boost investment)
• Investment decisions are independent of income
levels hence it is considered
autonomous/exogenous
• It can affect income but it is not determined by it.
• Thus investment is fixed at I = I0
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 Investment and Income Diagram
Investment (I)

I0 I = I0

0 Real GDP (Y)

5/13/23 01:38 PM 28
 Back to Two-Sector Model

• Initially we said desired aggregate

spending is:
AE = C + I
= (a + bYD) + I0
• Thus the AE function is a summation of the
consumption function and autonomous
investment spending as shown below:

5/13/23 01:38 PM 29
 AE Function
Desired Spending (AE)
AE = C + I

C = a + bYD

a + I0
I = I0
a

Real GDP (Y)

The AE function is parallel to the consumption function, the vertical distance

between them being equal to the autonomous investment I0

5/13/23 01:38 PM 30
 AE Function Cont’d
• Given that consumption has an autonomous
and induced component, the constant
investment (I0) adds to the autonomous
component of consumption (a) hence the
intercept becomes (a + I0)
• Superimposition of a 45o line (a locus of all
points where AE=Y) which shows all possible
equilibrium points will help us determine the
equilibrium level of output
5/13/23 01:38 PM 31
 AE Function & 45o Line
AE = Y
Desired Spending (AE)

AE < Y AE = C + I

AEe

AE > Y

45º
Ye Real GDP (Y)

5/13/23 01:38 PM 32
 AE Function & 45o Line Cont’d

1. AE > Y – Excess Demand – unexpected

decrease in inventories – planned output rises

2. AE < Y – Excess Supply – unexpected increase

in inventories – planned output decreases

3. Equilibrium level of GDP is determined where

AE = Y i.e. where AE curve intersects the 45o
line
5/13/23 01:38 PM 33
 Algebraic Derivation
AE = C + I
Equilibrium is where AE = Y, and Y=YD hence
Y=C+I
Y = (a + bY) + I0
Y – bY = a + I0
Y (1– b) = a + I0
1
Y  (a  I0 )
1 b

Let a + I0 be represented A (all autonomous spending),

hence Y 
1
(A)
5/13/23 01:38 PM 1 b 34
 Saving & Investment Approach
• Equilibrium output can be determined where
planned saving (S) is equal to planned investment
spending
S=I
• Saving is a leakage (withdrawal) and Investment is
an injection (addition). Income and spending can
only be in equilibrium if leakages equal injections
• The intersection of the saving and investment
functions at point E in diagram (b) gives equilibrium
income Ye
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 I & S Approach
Desired (I & S)

S = -a + (1-b)YD

I0

0
Ye Real GDP (Y)

-a

5/13/23 01:38 PM 36
 Reconciliation of the two Approaches

5/13/23 01:38 PM 37
• At GDP level Ye, S = I, hence Y = AE thus
equilibrium
• At GDP levels above Ye, S > I (b) (households
saving more than firms want to invest hence
demand will be low), hence AE < Y in (a) thus
firms cut down output and GDP declines towards
Ye
• At GDP levels below Ye, S < I (b) households
saving less than firms want to invest hence
demand will be high, hence AE > Y in (a) thus
firms increase output and GDP rises towards Ye
5/13/23 01:38 PM 38
 The Multiplier
• It provides a measure of the magnitude of changes
in GDP induced by a given change in autonomous
expenditure
• The simple multiplier is the impact of a $1 change
in exogenous expenditure on Equilibrium GDP at a
given/constant price level
• In the two sector model, the exogenous
component is investment, hence :
Multiplier = ∆Y/∆I

5/13/23 01:38 PM 39
 The Multiplier Cont’d
AE = Y
Desired Spending (AE)

AE1

AE1 E1
AE0

I
AE0
E0

45º Y
Y0 Y1 Real GDP (Y)

5/13/23 01:38 PM 40
 Multiplier Cont’d
• An increase in autonomous expenditure (in this case ∆I)
sets into motion successive rounds of aggregate
expenditures that will result in an increase in income (∆Y)
which is more than the initial increase in autonomous
expenditure.
• In the diagram, an increase in investment (∆I) shifts the
AE from AE0 to AE1 resulting in a much larger increase in
GDP (∆Y) i.e [∆Y > ∆I] and new equilibrium E1
• As a result of this, the multiplier is always greater than 1.
• The magnitude of the multiplier dependes on the fraction
of the additional income generated in each round that is
spent in the next round, i.e. on the MPC.
• 5/13/23
The01:38greater
PM the MPC, the larger is the multiplier. 41
 Deriving the Multiplier
For the two sector model, the change in real GDP (Y)
equals the change in consumption expenditure (C) plus
the change in investment (I) i.e
 Y = C +  I
But the change in consumption expenditure is determined
by the change in real GDP and the marginal propensity to
consume.
It is:
C = MPC  Y
Thus Y = MPC  Y + I
5/13/23 01:38 PM 42
Now solve for Y as:
(1 – MPC)Y = I
Rearrange to get
I
Y =
(1 – MPC)
Now, divide both sides I to give:
 Y 1 1
Multiplier = I = (1 – MPC) = (1 – b)
But the MPS = 1 – MPC therefore:

 Y 1
Multiplier = I = MPS
5/13/23 01:38 PM 43
Representing the multiplier by α :
 Y 1
α = I = (1 – b)
Therefore for the two sector model:
Y = α I
But for the general change in autonomous expenditure A:
 Y = α A

5/13/23 01:38 PM 44
But earlier we saw that income is
determined where:
1
Y = (1 – b) (A)
Which there fore can be reduced to:
Y = αA
Thus, given the amount of autonomous
expenditure and the value of the multiplier two
sector model, you can derive the equilibrium
level of output
5/13/23 01:38 PM 45
 Limitations
• Oversimplified
• Omits the impact of financial markets
and monetary policy
• Omits interaction between domestic
economy and the rest of the world
• Omits supply side of the economy as
represented by interaction of spending
with aggregate supply and prices
5/13/23 01:38 PM 46
 Three Sector Model
• We add Government Expenditure (G) and
Taxes (T) into the model.
• Thus
AE = C + I + G
• G is independent of Y hence is exogenous.
Thus G = G0
• G is an injection into the circular flow i.e. it
directly adds to demand for goods &
services.
5/13/23 01:38 PM 47
 Gvt Exp & Income Diagram
Govt Exp (G)

G0 G = G0

0 Real GDP (Y)

5/13/23 01:38 PM 48
 Taxes
• Taxes (T) indirectly reduce the income
available for consumption; leakage.
• Taxes are directly linked to income i.e.
they are a certain proportion of t of Y
where t is the tax rate:
T = tY
• Remember YD = Y - T
• Thus, YD = Y – tY = (1 – t)Y
5/13/23 01:38 PM 49
 Taxes Cont’d
• But C = a + bYD
C = a + b(1 - t)Y

• Slope is now b(1 - t) which is smaller

than b.
• Thus the C-function for the 2-Sector
Model is steeper than that for the 3-
Sector Model
5/13/23 01:38 PM 50
 C- function 3-Sector Model
Consumption (C)
C = a + bY

C = a + b(1-t)Y

0 Real GDP (Y)

5/13/23 01:38 PM 51
 Equilibrium 3-Sector Model
AE = Y
AE
AE2 = a + bY + I0 + G0
E2
AE3 = a + b(1-t)Y + I0 + G0

E3 AE1 = a + bY + I0

a + I0 + G0
E1
G

a + I0

45o
0 Y1 Y3 Y2 Real GDP (Y)
5/13/23 01:38 PM 52
 Algebraic Derivation
Equilibrium is where Y= AE
AE = C + I + G
Y=C+I+G
But C = a + b(1 - t)Y and G = G0
Y = [a + b(1 - t)Y] + I0 + G0
Y - b(1 - t)Y = a + I0 + G0
Y[1 - b(1 - t)] = a + I0 + G0
1
Y  (a  I 0  G 0 )
1  b (1  t )

Let a + I0 + G0 be represented A 1(all autonomous spending), hence

Y  (A)
5/13/23 01:38 PM 1  b (1  t ) 53
 Conclusion
1
• For the 3-Sector Model: Y 
1  b (1  t )
(A)

1
 
• Where 1  b (1  t ) (the multiplier) and (A) is all
autonomous expenditure .
• Thus once again Y = α A.
• The only difference with the 2-Sector Model is that
autonomous expenditure now has an extra component
(G0) and the multiplier (α) is now smaller with the
introduction of the proportional tax rate (t).
5/13/23 01:38 PM 54
 Four Sector Model
AE = C + I + G + (X – M)
• X is independent of Y, hence
X=X0
• X is an injection into the circular
flow i.e. it directly adds to
demand for goods & services.
5/13/23 01:38 PM 55
 Exports & Income Diagram
Exports (X)

X0 X = X0

0 Real GDP (Y)

5/13/23 01:38 PM 56
 Imports
• Imports (M) increase as domestic incomes
increase
• They are a leakage from the circular flow
• They have an autonomous component M0
and an induced component mY where m is
the marginal propensity to import, hence:
M = M0+ mY

5/13/23 01:38 PM 57
 Imports & Income
Imports (M)

M = M0 + mY

M0

0 Real GDP (Y)

5/13/23 01:38 PM 58
 Net Exports
X&M M = M0 + mY

(X = M)
X = X0

0 YB (Y)

(NX)

(X – M) = 0
0
YB (Y)

NX = X0 – M0 – m Y
5/13/23 01:38 PM 59
 Equilibrium 4-Sector Model
AE = Y

AE
AE1 = a + b(1-t)Y + I0 + G0
E1

E2 AE2 = a + [b(1 - t) – m]Y + I0 + G0 +

X0 – M0

a + I0 + G0 + (X0 – M0)

a + I0 + G 0

45o
0 Y2 Y1 Real GDP (Y)
5/13/23 01:38 PM 60
 Algebraic Derivation
Equilibrium is where Y= AE
AE = C + I + G + (X – M)
Y = C + I + G + (X – M)
But C = a + b(1 - t)Y , M = M0 + mY and X = X0 ,G = G0 , I = I0
Y = [a + b(1 - t)Y] + I0 + G0 + [X0 – (M0 + mY)]
Y = b(1 - t)Y – mY + a + I0 + G0 + X0 – M0
Y – b(1 - t)Y + mY = a + I0 + G0 + X0 – M0
Y(1 – b(1 – t) + m) = a + I0 + G0 + X0 – M0
1
Y  (a  I0  G 0  X 0  M 0 )
1  b (1  t )  m

Let (a + I0 + G0 + X0 – M0 ) be represented A (all autonomous spending),

hence 1
Y  (A)
5/13/23 01:38 PM
1  b (1  t )  m 61
 Conclusion
1
• For the 4-Sector Model: Y  (A)
1  b (1  t )  m
1
 
• Where 1  b (1  t )  m (the multiplier) and (A) is all
autonomous expenditure.
• Thus once again Y = α A.
• The only difference with the 3-Sector Model is that
autonomous expenditure now has an extra component (X0 -

M0) and the multiplier (α) is now smaller with the introduction
of the marginal propensity to import (m).
5/13/23 01:38 PM 62