All Rights Reserved Ch. 12: 1 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010

All Rights Reserved

Ch. 12: 1

Principles of Economics second edition

© Oxford Fajar Sdn. Bhd. (008974-T) 2010

All Rights Reserved

Ch. 12: 2



NATIONAL INCOME EQUILIBRIUM

CHAPTER 12

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Ch. 12: 3



NATIONAL INCOME EQUILIBRIUM

TWO APPROACHES TO DETERMINE EQUILIBRIUM:

1. AGGREGATE DEMAND – AGGREGATE SUPPLY APPROACH (AD = AS)• Aggregate demand or aggregate expenditure is the total demand

for goods and services in the economy. • There are four components in aggregate demand namely

consumption, investment, government sector and foreign sector (net exports).

• Aggregate supply or aggregate output is the total quantity of goods and services produced in an economy in a given period of time.

• Equilibrium occurs when AD = AS

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TWO APPROACHES TO DETERMINE EQUILIBRIUM:

2. LEAKAGE – INJECTION APPROACH Leakage is a withdrawal from the income – expenditure stream.

Leakages include savings, taxes and imports.

Injection is an addition of spending to the income-expenditure stream.

Injections include investment, government expenditures and exports.

Equilibrium occurs when leakages are equal to injections.

NATIONAL INCOME EQUILIBRIUM (cont.)

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CONCEPT OF CONSUMPTION

CONSUMPTION THEORY Consumption refers to the purchase of goods and services by

individuals or households that are produced by firms. Income (Y) is divided into two parts, consumption (C) and savings (S).

Y = C + S

CONSUMPTION AND SAVING

AVERAGE PROPENSITY TO CONSUME (APC)APC is the ratio of total consumption to total income.

APC = TOTAL CONSUMPTION = C

TOTAL INCOME Y MARGINAL PROPENSITY TO CONSUME (MPC)

MPC is the ratio of change in total consumption to change in total income. MPC = TOTAL CONSUMPTION = C

TOTAL INCOME Y

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C = a + b Y d

CONSUMPTION FUNCTION• Consumption function refers to the relationship

between consumption level and income level. • The general equation for a linear consumption function

can be written as below:

CONSUMPTION AND SAVING (cont.)

Consumption expenditure

Autonomous consumption

MPC

Disposable income

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CONCEPT OF SAVING

SAVING THEORY

• Saving is divided into autonomous saving and induced savings.

• Autonomous saving refers to the part of savings that does not depend on the level of income and occurs when there is autonomous consumption.


AVERAGE PROPENSITY TO SAVE (APS)

APS is the ratio of total saving to total income.

APS = TOTAL SAVING = S

TOTAL INCOME Y

MARGINAL PROPENSITY TO SAVE (MPS)

MPC is the ratio of change in total consumption to

change in total income.

MPS = TOTAL SAVING = S

TOTAL INCOME Y

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CONSUMPTION AND SAVING SCHEDULE Table below shows some relationship between consumption and savings. The sum of APC and APS must be equal to 1.

APC + APS = 1 The sum of MPC and MPS must also equal to one. The equation is as below MPC + MPS = 1

Disposable Income

(Yd)

Consumption (C)

Saving(S)

APC (C/ Yd)

APS (S/ Yd)

MPC (C/ Yd)

MPS (S/ Yd)

0 50 -50 - - - -100 125 -25 1.25 -0.25 0.75 0.25200 200 0 1.00 0 0.75 0.25300 275 25 0.92 0.08 0.75 0.25400 350 50 0.88 0.12 0.75 0.25500 425 75 0.85 0.15 0.75 0.25

APC = 125/100 = 1.25APC = 125/100 = 1.25APS= 25/300 =0.08APS= 25/300 =0.08

MPC= (200 -125)/(200-100) =0.75

MPC= (200 -125)/(200-100) =0.75

MPS= (50 -25)/(400-300) =0.25

MPS= (50 -25)/(400-300) =0.25


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SAVING FUNCTION Saving function refers to the relationship between savings and

income level. The general equation for a linear consumption function can be

written as below.

S = -a + (1- b) Yd

DERIVE SAVING FUNCTION FROM CONSUMPTION FUNCTION

Given the consumption function: C = 100 + 0.65Yd

Saving function : S = -100 + 0.35Yd

SavingAutonomous saving

MPS

Disposable income


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Break-even income is the level at which households consume all their incomes. At the point of break-even,

(i) Y = C (ii) S = 0 (iii) APC = 1 (iv) APS = 0

C

Saving schedule is vertical difference between the Consumption schedule and the 45 degree line.

National Income

C = 100 + 0.65Yd

Y=C

a=100

200O

S = -100 + 0.35Yd

S

National Income

-100 200

Each point on the 45 degree line indicates a point

where disposable income equals to consumption.


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Ch. 12: 11



Consumer credit

Rate of interest

Distribution of wealth

Price and wage levels

Changes in consumers’

taste and fashion

Change in expectations


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INVESTMENT

Investment refers to the spending on purchases and accumulation of capital goods such as buildings, equipments and addition to inventories.

There are two types of investment:

1. Autonomous InvestmentAutonomous investment is fixed and independent of

income. The amount of investment can be influenced by other

factors such as interest rate, repayment rate, business expectation and technology developments.

Example of autonomous investment is the capital depreciation.

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2. Induced InvestmentInduced investment depends on the national income. As national income increases, the induced investment will

also increase since higher national income attracts more investors to invest.

INVESTMENT (cont.)

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Ch. 12: 14



Expectation of the future Technological

Changes

Rate of interest Rate of return

Government Policies

INVESTMENT (cont.)

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GOVERNMENT SECTOR

Government sector is another sector that has a major impact on the economy because of its expenditure.

Government spending can be classified into two categories, purchases of goods and services and transfer payment.

National income can be increased through government spending (as we discussed on the expenditure approach).

Government spending is an injection into the spending stream.

Government also can reduce the national income through imposing taxes.

There are various tax imposed by the government such as direct taxes and indirect taxes.

Taxes are leakages from the spending stream.

15PRINCIPLE OF ECONOMICS

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Ch. 12: 16



FOREIGN SECTOR

Exports are goods and services that are sold to foreign countries.

For example, Malaysian made DVD player is sold to Thailand. Exports increase the national income and therefore export is

an injection into the spending stream.Imports are goods and services that are purchased from

foreign countries. For example, Malaysia buys cars from Germany. Imports reduce the national income and an import is a leakage

from the spending stream.Net export is the difference between exports and imports. If net export is positive, exports are greater than imports and if

net export is negative, exports are less than imports.

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EQUILIBRIUM IN TWO SECTOR ECONOMY

Equilibrium in a two-sector economy is a simple economy, which consists of 2 agents only, namely households and firms.

Equilibrium occurs when the AD = AS or Leakage = Injection.

17

FIRMHOUSEHOLD

Y = rent, wages, profit, interest

(1)Saving (S)

(2)Investment (I)

Consumption (C)

Factor Market

Financial Market

Product Market

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Equilibrium is achieved when aggregate demand is equal to aggregate supply.

AS = AD

Y = C + I

Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500

Solution

Consumption function, C = 100 + 0.7Yd (In two sector economy, Yd = Y since no tax)

Y = C + I

= 100 + 0.7Y + 500

Y – 0.7Y = 600

0.3Y = 600

Y = 600/0.3

Y = 2000 EQUILIBRIUM INCOME

AD –AS APPROACH

Algebra Analysis

EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)

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AS = AD

Y = C + I


AD–AS APPROACH

Graphic Analysis

National Income

C = 100 + 0.7Yd

Y=AD

a=100

2000

AD (C,I) C +I

I=500

The equilibrium occurs when the consumption and 45 degree line intersects at RM2000

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Equilibrium is achieved when leakage is equal to injection.

Injection = Leakage

I = S

Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500

Solution:

Consumption function, C = 100 + 0.7Yd , so saving function is S = -100 + 0.3Yd

I = S

500 = -100 + 0.3Y

0.3Y = 600

Y = 600/0.3


LEAKAGE - INJECTION APPROACH

Algebra Analysis


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Injection = Leakage

I = SGraphic Analysis

National Income

S = -100 + 0.3Yd

a=100

2000

Leakage-Injection

I=500

The equilibrium occurs when the saving function and investment function intersect at RM2000.

LEAKAGE - INJECTION APPROACH


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• The equilibrium is achieved when AD = AS or I = S • When both the AS and AD is same at one level, this is called as

equilibrium income.

AS = AD and I =SAS = AD and I =S

Tabular Analysis

Aggregate Supply

(Y)

Consumption (C)

Saving(S)

Investment(I)

Aggregate Demand (C + I)

Tendency of employment, output and

income0 100 -100 500 600 Increase

1000 800 200 500 1400 Increase1500 1150 350 500 1650 Increase2000 1500 500 500 2000 EQUILIBRIUM2500 1850 650 500 2350 Decrease 3000 2200 800 500 2700 Decrease


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EQUILIBRIUM IN THREE SECTOR ECONOMY

Equilibrium in a three-sector economy consists households, firms and government.


FIRMHOUSEHOLD


(1)Savings (S)

(2)Investment (I)

Consumption (C)

GOVERNMENT

Taxes (T) Taxes (T)

Transfer Payment (G)

Government Expenditure (G)

Product Market

Financial Market

Factor Market

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AS = AD Y = C + I + G

In three-sector economy, we need to focus on two types of taxes.

1. Autonomous Taxes Autonomous taxes refer to the amount of tax that is independent

of income. If the income increases or decreases, autonomous taxes remain

constant. For example, Tax = RM100

AD –AS APPROACH

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)

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2. Induced Taxes Induced taxes refer to the amount of tax that depends on

income. If income increases, induced tax will increase and vice

versa. For example, Tax = 0.6Y


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Equilibrium using autonomous tax

Given the following information: C = 200 + 0.75Yd ; I = 100; G = 50; T = 100

Solution

Y = C + I + G

= 200 + 0.75Yd + 100 + 50

= 350 + 0.75(Y –T)

= 350 + 0.75(Y – 100)

Y – 0.75Y = 275

0.25Y = 275

Y = 275/0.25

Y = 1100

AD –AS APPROACH

Algebra Analysis

Equilibrium using induced tax

Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y

Solution

Y = C + I + G

= 200 + 0.75Yd + 100 + 50

= 350 + 0.75(Y –T)

= 350 + 0.75(Y – 0.2Y)

= 350 + 0.75(0.8Y)

= 350 + 0.6Y

Y – 0.6Y = 350

0.4Y = 350

Y = 350/0.4

Y = 875


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AD –AS APPROACH

Graphic Analysis

The equilibrium occurs when AD curve and 45 degree line intersects at RM1100.

C = 200 + 0.75Yd

(BEFORE TAX)

AD (C,I,G)

National Income

C = 175 + 0.75Y(AFTER TAX)

Y=AD

175

1100

C +I + G

200

325

AD (C,I,G)

National Income

C = 200 + 06Y(AFTER TAX)

Y=AD

875

C +I + G

200

350

C = 200 + 0.75Yd

(BEFORE TAX)

The equilibrium occurs when AD curve and 45 degree line intersects at RM875.

Equilibrium using autonomous tax Equilibrium using induced tax


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Equilibrium using autonomous tax

Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 100

Solution

I + G = S + T

100 + 50 = -200 + 0.25Yd + 100

150 = -100 + 0.25(Y – T)

150 = -100 + 0.25(Y – 100)

150 = -125 + 0.25Y

0.25Y = 275

Y = 1100

LEAKAGE – INJECTION APPROACH

Algebra Analysis

Equilibrium using induced tax

Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y

Solution I + G = S + T100 + 50 = - 200+ 0.25Yd + 0.2Y150 = - 200 + 0.25(Y – 0.2Y) + 0.2Y150 = -200 + 0.25(0.8Y) + 0.2Y150 = -200 + 0.2Y + 0.2Y0.4Y = 350 Y = 875


Equilibrium is achieved when leakages are equal to injectionsInjection = LeakageI + G = S + T

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LEAKAGE – INJECTION APPROACH

Graphic Analysis

The equilibrium occurs when I+G schedule Intersects with S+T at RM1100.

The equilibrium occurs when I+G schedule Intersects with S+T at RM875.

Equilibrium using autonomous tax Equilibrium using induced tax

S +T = -225 + 0.25Y(AFTER TAX)

S = -200 + 0.25Yd

(BEFORE TAX)

Leakages/Injections

National Income

-225

1100

I +G

-200

150

Leakages/Injections

-200

150

S = -200 + 0.25Yd

(BEFORE TAX)

National Income

S +T = -200 + 0.2Y(AFTER TAX)

875

I +G

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Aggregate Supply

(Y)

Taxes (T)

Disposable Income (Yd)(Yd = Y-T)

Consumption (C)

(C = 200+0.75Yd)

Saving(S)

Investment(I)

Government Expenditure

(G)

Aggregate Demand (C+ I+G)

Tendency of employment, output and

income

100 100 0 200 -200 100 50 350 Increase

300 100 200 350 -150 100 50 500 Increase

600 100 500 575 -75 100 50 725 Increase

900 100 800 800 0 100 50 950 Increase

1100 100 1000 950 50 100 50 1100 EQUILIBRIUM

1300 100 1200 1100 100 100 50 1250 Decrease

1500 100 1400 1250 250 100 50 1400 Decrease

The equilibrium is achieved when AD = AS or I + G = S + T When both the AS and AD is same at one level, this is called as equilibrium income.


AS = AD and I+G =S+T

AS = AD and I+G =S+T

Tabular Analysis

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EQUILIBRIUM IN FOUR SECTOR ECONOMY

Equilibrium in a three-sector economy consists households, firms, government and foreign sector.


HOUSEHOLD


(1)Savings (S)

(2)Investment (I)

Consumption (C)

GOVERNMENT

Taxes (T) Taxes (T)

Transfer Payment (G)

Govt Expenditure (G)

Foreign Sector

Import (M)

Export (X)

Product Market

Financial Market

Factor Market

FIRM

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AS = AD

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

Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50

Solution

Y = C + I + G + (X – M)

= 200 + 0.75(Y – T) + 100 + 50 + (100 – 50)

= 400 + 0.75 (Y –100)

= 400 + 0.75Y – 75

Y – 0.75Y = 325

0.25Y = 325

Y = 325/0.25


AD–AS APPROACH

Algebra Analysis

EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)

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AS = AD

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


AD–AS APPROACH

Graphic Analysis

National Income

Y=AD

325

1300

AD (C,I)

C +I+G + (X-M)

The equilibrium occurs when the aggregate demand (C+I+G+(X-M)) and 45 degreeline intersects at RM1300.

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Injection = Leakage

I + G+ X = S + T+ M

Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50

Solution

I + G+ X = S + T + M

100 + 50 + 100 = -200 + 0.25(Y-100) + 100 + 50

250 = -75 + 0.25Y

0.25Y = 325


LEAKAGE-INJECTION APPROACH

Algebra Analysis


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Ch. 12: 35




Injection = Leakage

I+G+X = S +T+M


Graphic Analysis

The equilibrium occurs when the I+G+X scheduleand S+T+M schedule intersect at RM1300.

LEAKAGE-INJECTION APPROACH

I+G+X

Leakage-Injection

National Income

S +T+M

-75

1300

250

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Ch. 12: 36



Aggregate

Supply

(Y)

Taxes

(T)

Disposable

Income

(Yd)

Consumption

(C)

Saving

(S)

Investment

(I)

Government

Expenditure

(G)

Exports

(X)

Imports

(M)

Aggregate

Demand

(C+ I+G+

[X – M])

Tendency of

employment,

output and

income

100 100 0 200 -200 100 50 100 50 400 Increase

300 100 200 350 -150 100 50 100 50 550 Increase

600 100 500 575 -75 100 50 100 50 775 Increase

900 100 800 800 0 100 50 100 50 1000 Increase

1100 100 1000 950 50 100 50 100 50 1150 Increase

1300 100 1200 1100 100 100 50 100 50 1300 EQUILIBRIUM

1500 100 1400 1250 250 100 50 100 50 1450 Decrease

The equilibrium is achieved when AD = AS or I + G + X = S + T + M When both the AS and AD is same at one level, this is called as equilibrium

income.


AS = AD and I+G+X =S+T+M

AS = AD and I+G+X =S+T+M

Tabular Analysis

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The multiplier is the ratio of the change in income to the change in AD.

Multiplier shows how many times the effect of an initial change in AD is multiplied by causing changes in consumption and finally in the aggregate income.

The formula for multiplier (K) is,

K = Change in Income (Y)

Change in Aggregate Demand (AD)The size of multiplier depends upon the size of the marginal

propensity to consume (MPC). Higher the MPC, higher is the size of the multiplier and lower the

MPC, lower shall be the size of multiplier.

K = 1

1 - MPC

MULTIPLIER CONCEPT

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Ch. 12: 38



Investment multiplier refers to the ratio of the change in the equilibrium income to a change in investment. The formula for investment multiplier (Ki) is,

Ki = Change in Income (Y)

Change in Investment (I) Investment multiplier can also derived as follows: Investment Multiplier (Ki) = 1 = 1

1-MPC MPS

Given, C = 200 + 0.75Y and I = 100. What is the equilibrium income level when there is an increase in investment by 50 million?

Solutions:

Y = Ki x I New equilibrium income level = Y + Y

= 1/(1-MPC) x I = 1100 + 200

= 1 /(1-0.75) x 50 = 1300 m

Y = 200 million

MULTIPLIER CONCEPT

INVESTMENT MULTIPLIER

Example

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Ch. 12: 39



The government expenditure multiplier refers to the ratio of the change in the equilibrium income to a change in government expenditure assuming there is no change in taxes.

Kg = Change in Income (Y)

Change in Government Expenditure (G) Government expenditure multiplier can also derived as follows:

Government Expenditure Multiplier (Kg) = 1 = 1

1-MPC MPS

Given, C = 200 + 0.75Y; I = 100 and G = 50. What is the equilibrium income level when there is an increase in government spending by 50 million?

Solutions:

Y = Kg x G New equilibrium income level = Y + Y

= 1/(1-MPC) x G = 1100 + 400

= 1 /(1-0.75) x 100 = 1500 m

Y = 400 million

MULTIPLIER CONCEPT (cont.)

GOVERNMENT EXPENDITURE MULTIPLIER

Example

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Ch. 12: 40



Tax multiplier refers to the ratio of the change in the equilibrium income to a change in taxes assuming there is no change in government expenditure.

Kt = Change in Income (Y)

Change in Taxes (T) Tax multiplier can also derived as follows:

Tax Multiplier (Kt) = - MPC

MPS

Given, C = 200 + 0.75Y; I = 100; G = 50 and T = 100. What is the equilibrium income level when there is a tax cut of 50 million?

Solutions:

Y = Kt x T New equilibrium income level = Y + Y

= -MPC/(MPS) x T = 1100 + 150

= -0.75/(0.25) x 50 = 1250 m

Y = 150 million

TAX MULTIPLIER

Example


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Ch. 12: 41



Balanced budget multiplier refers to the change in the equilibrium income by the same amount as the changes in taxes and government expenditure.

Kb = 1

Given, C = 200 + 0.75Y; I = 100; G = 50 and T =100. What is the equilibrium income level when there is an increase in government spending and taxes by 50 million?

Solutions:

Tax multiplier

Y = Kt x T Net increase in income, Y = -150+200

= -MPC/MPS x T = 50 million

= -0.75 /0.25 x 50

Y = -150 million

Government Expenditure multiplier

Y = Kg x G New equilibrium income level = Y + Y

= 1/(1-MPC) x G = 1100 + 50

= 1/(1-0.75) x 50 = 1150 m

Y = 200 million

BALANCE BUDGET MULTIPLIER

Example


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Ch. 12: 42



Inflationary gap occurs when national income exceeds the full employment level. Inflationary gap can be caused by the increase in aggregate expenditure. The inflationary gap is measured as the excess of the aggregate expenditure over the full

employment aggregate supply, Yfe.

INFLATIONARY GAP

Inflationary GapY fe < Y

Inflationary GapY fe < Y

C+I+G +(X-M)

National Income

Y=AD

A

Yfe

Aggregate Demand

C+I+G +(X-M)fe

Y0

BThe inflationary gap of AB will increase

the general price level.

To reduce the inflationary gap of AB, contractionary policy can be implemented. Government can practice contractionary fiscal policy through reducing government expenditure and raise taxes.

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Ch. 12: 43



Deinflationary gap occurs when national income below the full employment level. The deflationary gap is measured as the difference between the aggregate expenditure

over the full employment aggregate supply, Yfe.

DEFLATIONARY GAP

Deflationary GapYfe > Y

Deflationary GapYfe > Y

C +I+G + (X-M)

National Income

Y=AD

C

Yfe

Aggregate DemandC+I+G+(X-M)fe

Y0

D

To reduce the deflationary gap of CD, expansionary policy can be implemented. Government can practice expansionary fiscal policy through

increase in government expenditure and tax cut.

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All Rights Reserved Ch. 12: 1 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010