# Chapter 9

:

THE DETERMINATION OF NATIONAL INCOME

Economics 11-UPLB

Prepared by TBParis 09/12/07

Main Objective of the Chapter

**To explain fluctuations in national income.
**

helps government, researchers, and businessmen formulate targets, policies, and business decisions. gives them an in-sight into the effects of their decisions. need to explain how it is determined. identify the factors that cause national income to change.

Chapter Organization

Section 9.1 - framework for analyzing changes in national income. Section 9.2 - how changes in income affect consumption spending. Section 9.3, introduces the role of the multiplier effects following a change in aggregate expenditure. Section 9.4 presents an algebraic treatment of the concepts developed

**Aggregate Expenditure and Equilibrium Income
**

Definition of aggregate expenditure and equilibrium income How the economy adjusts to its equilibrium position. How changes in aggregate expenditure affect equilibrium income.

Aggregate Expenditure and Equilibrium National Output

Aggregate expenditure (AE)

total amount that all economic agents want or plan to spend on domestic goods and services. the planned spending of

households, firms, government, and foreigners.

Aggregate Expenditure

AE = C + I + G + (X-M)

consumption (C), investment (I), government spending (G), and exports less imports (X-M).

**Note that AE is not the same as GDP.
**

AE represents planned spending GDP represents actual spending or output.

Aggregate Expenditure (AE) and National Output (Y)

**AE and Y are not necessarily equal:
**

Firms formulate their production plans with an estimate of the quantities that people want to buy. A mistake on their part will cause production to exceed or fall below the amounts that people want to buy.

What if AE and Y are not equal?

If AE < Y

people want to buy less than what has been produced so firms will accumulate inventories. firms will reduce production

If AE >Y

What people want to buy is greater than actual production so inventories will decline. firms will increase production

**Equilibrium National Income
**

AE = Y Can be depicted by the intersection between the AE schedule and the 45 degree line

**The 450 line
**

The 45-degree line is a tool that assists us in identifying the economy's equilibrium position. Property: every point along this line depicts a situation wherein the value of the variable on the horizontal axis (in this case actual output, (Y) is equal to its counterpart on the vertical axis (AE).

450 line 200

100

450

0

100

200

AE Aggregate expenditure (in pesos)

E0 20 AE

45º Y 0 20 Y* Output, income (in pesos)

Equilibrium Income (Y*)

When AE is equal to Y

there is no reason for firms to adjust production. this suggests that the economy is in equilibrium.

Equilibrium requires the equality between income and aggregate expenditure. That is, Y = AE.

**Changes in AE and Income
**

Suppose that the economy's aggregate expenditure schedule shifts upward AE0 to AE1, Equilibrium point will move from E0 to E1. As a result, the economy experiences an increase in equilibrium income from YO* to Y1*

AE

Aggregate expenditure (in pesos)

E1 30 E0 20 AE0 AE1

45° 0 20 Y0 30 Y1

Y

Output, income (in pesos)

Consumption and Income

**Keynes (1936) suggested that consumption spending (C) tends to increase with income.
**

In other words, households with higher incomes tend to spend more. There is a positive relationship between consumption spending and income

TABLE 9.1. Consumption and income (in pesos). (1) Income (Y) 0 200 400 600 800 1,000 1,200 1,400 1,600 (2) Consumption (C) 200 350 500 650 800 950 1,100 1,250 1,400 (3) Change In income (¨Y) ² 200 200 200 200 200 200 200 200 (4) Change in consumption (¨C) ² 150 150 150 150 150 150 150 150 (5) mpc (¨C/¨Y) _ 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75

**Consumption and income
**

Higher levels of income correspond to higher levels of consumption spending When income is equal to zero, consumption spending is equal to 200. Consumption spending and income are equal at each other when income = 800.

When income is less than 800, consumption is higher than income. When income is greater than 800, consumption less than income

Y

1600 1400 1200 Consumption Spending (in pesos) 1000 800 600 400 200

C

450

0

Y

400 800 Output, Income (in pesos) 1200 1600

THE CONSUMPTION SCHEDULE

**Consumption and Income
**

Observations from values above: (a) autonomous consumption spending component of consumption spending that does not depend on income - equal to 200 in example (b) marginal propensity to consume (mpc) shows the increase in consumption spending for a one peso increase in income;

Marginal Propensity to Consume

MPC or the marginal propensity to consume represents the change in consumption spending that arises from a one peso change in income.

(C mpc ! (Y

Value of MPC is between 0 and 1. MPC=0.75 means that a one peso increase in income leads to a 75-centavo increase in consumption spending.

Marginal propensity to consume

**In example above, ¨C = 150 for ¨Y = 200. Hence,
**

(C 150 ! ! 0.75 MPC ! (Y 200

Consumption Function

Consumption Function: C = c + mpc.Y C = 200 + 0.75Y

**Savings and Income
**

Sum of consumption spending and savings (S) must equal income. In symbols, Y = C + S. Subtracting C from both sides of this equation leads to S = Y - C.

**Relationship bet. Income and Savings
**

(1) (2) (3) (4) (5) (6) MPS

Y

0 200 400 600 800 1000 1200 1400 1600

C

200 350 500 650 800 950 1000 1200 1400

S

¨Y

¨C

¨S

¨S ¨Y

0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25

-200 -150 -100 -50 0 50 100 150 200

200 200 200 200 200 200 200 200

150 150 150 150 150 150 150 150

50 50 50 50 50 50 50 50

Savings and income

Savings - that component of income that is not allocated to consumption. S=Y±C How is savings linked to income? oY p oS.

Savings and Income

Marginal propensity to save (MPS) is the increase in savings for a one peso increase in income; In the example above, ¨S = 50 for ¨ Y = 200. Implies that

(S 50 MPS ! ! ! 0.25 (Y 200

Savings function

Note: MPC+MPS = 1 Savings schedule ± listing of values of savings at each levels of income Savings function ± in equation form S = -200 + .25Y

Relationship between mpc and mpc

Y !CS (Y ! (C (S (Y (C (S ! ( Y (Y (Y 1 ! mpc mps

Propensity to Save

S S

F9.4

150

Savings (in pesos)

0 -50 400 800 1,200 1,600

Y

-200

Income (in pesos)

**The determination of equilibrium income in a two-sector economy
**

Two sector economy - households and firms only Implies that AE is given by: AE = C + I Assume that ³I´ is autonomous and equal to 100 In equilibrium, Y = AE p equilibrium income (Y*) = 1200

Table 9.3

**Consumption, Investment and Equilibrium Income.
**

C 500 650 800 950 1,100 1,250 S -100 -50 0 50 100 150 I 100 100 100 100 100 100 AE 600 750 900 1,050 1,200 1,350

Y 400 600 800 1,000 1,200 1,400

AE E0 y

C+I = AE C

Fig 9.5

y (A) 300 200 45º 0 S, I S 100 0 -200 Y* Income (in pesos) E0 y y 800 1,200 1,600 I Y (B) 400 800 1,200 Y* 1,600

Y

**Investment and Multiplier
**

Suppose that investment I increases from 100M pesos to 200M pesos What happens to equilibrium income? Equilibrium income Y* will increase

Not by 100M But by a multiplied amount!!

WHY???

**Table 9.4 Effects of a 100 peso increase in investment.
**

Y 400 600 800 1,000 1,200 1,400 1600 1800 C 500 650 800 950 1,100 1,250 1400 1550 S -100 -50 0 50 100 150 200 250 I 200 200 200 200 200 200 200 200 AE 700 850 1000 1150 1300 1450 1600 1750

AE

Y

AE1

E1 B E0 A

Aggregate Expenditure (in pesos)

AE0

400 300

¨I=100

45o

¨Y=400 1200 1600

Y

0

Y*0

Y*1

The effect of an increase in investment

Calculation of equilibrium income

**In numerical example,
**

¨ 1 ¸ Y ! (C I ). © ¹ 1 mpc º ª 1 !E n multiplier 1 mpc

*

C ! 200, I ! 100,mpc ! 0.75 1 ¸ ¨ Y* ! (200 100) © ¹ ! 1,200 ª 1 0.75 º

For I = 200, Y* = 1,600 Hence, if Io from 100 to 200 p Y*o from 1200 to 1600. In other words, p p

( I ! 100 (Y* ! 400

**The concept of the multiplier
**

Increase in Y is greater than increase in I. Why? Multiplier (E) - measures the change in equilibrium income as a result of a one-peso change in the sum of the autonomous components of AE;

(Y E! (I

*

**The multiplier concept
**

Round

1 2 3

¨C +

0 mpc[100] mpc [mpc100]

¨I =

100 0 0

¨Y

100 mpc100 mpc2100

«

n

«

mpc[ mpcn-2100]

«

0

«

mpcn-1100

Calculation of the multiplier:

1 1 E! ! 1 mpc mps

Calculation of multiplier

With the mpc = 0.75,

1 E! !4 1 0.75

The multiplier is used determine the amount by which Y* changes in response to a change in investment.

(Y* ! E ( I

So the total change in income is given by: (Y = (I + mpc (I + mpc2(I +mpc3 (I +« = (1 + mpc + mpc2 + mpc3 «) . (I or

¨ 1 ¸ (Y ! © ¹ (I ! E (I ª 1 mpc º

The Multiplier

Y (Y ! Y (I mpc (I mpc 2 (I mpc 3 (I ... (Y ! (I mpc (I mpc (I mpc (I ...

2 3

(Y ! (I (1 mpc mpc 2 mpc3 ...) « 1 » ( Y ! (I ¬ ¼ 1 mpc ½ ( Y ! E (I

**The Paradox of Thrift
**

Many people believe that higher savings lead to higher income. In the present model, we get a result that is contrary to this belief. In other words, equilibrium income falls when people want to save more. Idea: the attempt to achieve higher savings may reduce equilibrium income

S,I

S1 S0 I

Fig 9.7

Savings (in pesos)

0

Y1

Y0

Y

Income (in pesos)

The Paradox of Thrift

End Chapter 9: