BUSINESS ECONOMICS II

DETERMINATION OF EQUILIBRIUM NATIONAL INCOME

Concepts of Equilibrium Equilibrium occurs when there is no

tendency for change

Refers to the situation in which neither

consumers nor firms have any incentive to

change their behavior

Refers to the state when:

AGGREGATE OUTPUT (AS) = AGGREGATE EXPENDITURE (AD)

INJECTION (I) = WITHDRAWALS (S)

Injections and Leakages

Any excess of leakages over injections will cause a shortage of total spending forcing producers to cut back production

Any excess of injection over leakages will cause an excess of total spending inducing producers to increase output

So equilibrium is reached when

Total injections = Total leakages

Underlying Assumptions

a) There are unemployed resources

b) The techniques of production remain unchanged

c) The hours worked by each worker remain unchanged

d) Prices remain constant and so output, income, and employment will be determined by aggregate demand

Simple Two Sector Model This is a simplified model in which every

income is assumed to be consumed or saved on the one hand, and consumed or invested on the other hand.

As such,

Y = C + S or Y = C + I

S = I

i.e. At equilibrium,

Planned saving = Planned investmentDraw diagrams

Changes in Equilibrium

At equilibrium, Y = C + I

If planned investment at all level changed, the investment schedule will rise, and eventually, the equilibrium national income level will change.

Usually, the change in income > change in investment and this relationship between change in income and change in investment is explained by one of the most important concepts in economics – The MULTIPLIER

The Multiplier This describes the fact that changes in spending

have an impact on income greater than the original change in spending.

An increase in spending generates several rounds of further spending until the amounts have become infinitely small.

The eventual increase is the sum of the successive rounds of spending generated by the increase in investment. The formula for such a summation is:

Sum of series = First term

1 – the common ratio

The multiplier = 1

1 – the common ratio

The Multiplier Cont’d

The Multiplier = Eventual change in Income

Change in Investment

The common ratio is usually the MPC of the community.

The Multiplier = 1 = 1

1 – MPC MPS

This is because (MPC + MPS) = 1

MPS = 1 - MPC

The Multiplier Cont’d Assume that Investment in housing construction

increase from ¢25million to ¢30 million, calculate the multiplier if MPC = 80% and the effect of the increase in investment on the level of NI.

Solution:

ΔI = 5 million (this is the first term because it is the amount injected into the system)

Multiplier = 1 = 5

1 – 0.8

Total Effect = 5 million x 5 = 25 million

Savings and Investment

Any change in either a leakage or an injection will cause income to change until leakages are once again equal to injections.

In a two sector economy, a change in investment will cause income to change until planned savings are once again equal to planned investment.

Worked Example Assume that an economy is in equilibrium and there is no

foreign trade. National Income = 1200, Consumption = 720,mpc=0.6. What will be the effect on income if planned investment increased by 100.

Solution:

Initially, Y = C + S

1200 = 720 + S

S = 480 (implies that I = 480)

MPC = 0.6 and therefore MPS = 0.4 and the Multiplier = 1 = 2.5

0.4

Investment now increases to 580.

ΔY = ΔI x

= 100 x 2.5 (The new level of NI = ¢1,450 and the new level

= 250 of saving will be 0.4 x 1450 = ¢580)

The Paradox of Thrift

This explain how, under certain circumstances, an attempt to increase saving may lead to a fall in total savings.

Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency of demand.

Leakages will exceed injections and income will fall to a new equilibrium level.

Output and Employment

Since the Keynesian “revolution” full employment has ranked highly amongst the goals of government policy.

The question is “what is the desired level” of output that will provide full employment.

It implies that it does not follow that an equilibrium situation in the markets for goods and services will produce the desired equilibrium in the market labour.

This is one of the most important points to emerge from the Keynesian analysis of Income determination.

A deficiency of Aggregate DD Deficiency of aggregate demand could produce an

equilibrium level of output but the level of NI required to produce full employment may be greater.

The result is a “deflationary gap”.

The deflationary gap is the difference between the equilibrium national income and the level of income required to achieve full employment.

It occurs when the equilibrium NI level is lower than

the NI level required to achieve full employment.

Excess Demand

It is possible that planned consumption and planned investment might produce a level of aggregate demand is greater than that required to produce the full employment output at constant prices.

The result is an “inflationary gap”

This measures the extent of the excess demand over the maximum output at constant prices

This means spending plans is real terms cannot be realized and inflationary pressures will be present in the economy.

Introducing the Government Sector

The government can expand total demand through its purchases of goods and services or by stimulating private spending by means of tax reductions.

Similarly, government can reduce total demand by decreasing its own spending or by increasing taxation.

Government spending (G) can be treated as investment because it is an injection into the circular flow of income.

In the same vein, taxation (T) can be regarded a aleakage from that circular flow.

NI with Gov’t Activity

The deliberate manipulation of G and T is fiscal policy.

Government expenditure (G) is treated as being autonomously determined since it is subject to political decision.

Taxation (T), both direct and indirect, represents a leakage from the system.

Taxes, unlike government spending, cannot be treated as autonomous since revenue from taxation bears a direct relationship to income and tax revenue is a function of income.

NI with Gov’t Activity It is necessary to take account of subsidies,

since they cause the market price to be less than factor cost, can be regarded as negative taxes.

With gov’t activity, the model now has two leakages, S and T

Equilibrium requires;

C + I + G – Ti = C + S + Td

I + G = S + Td + Ti

I + G = S + T

(Planned injections) (Planned leakages)

NI with Gov’t Activity

Disposable Income (Yd) = National Income (Y) – Direct taxes (Td) + Transfer payments –Undistributed profits

Therefore C = f(Yd)

We can then find how much planned consumption will be generated by any particular level of planned output.

For example, if C = 3/5 of disposable income and disposable income is 2/3 of national income, then C = 3/5 x 2/3 Y = 2/5 Y (APC = 2/5)

Find the level of saving (APS)

Gov’t Activity and the Multiplier Assumptions

– The rates of taxation (both direct and indirect) are unchanged. i.e. Marginal rate of taxation is constant.

– Changes in G are assumed to have no influence on Investment (I)

– MPC (c) and MPS (s) are constant

– There are no transfer payments

This means that if G is increased by an amount ΔG , it will give rise to a multiple expansion of Income equal to ΔY. The series of increments in income generated by the increase in G will be:

ΔG + ΔG(k) + ΔG(K)2 + ΔG(k)3 + + + +

K is the proportion of each increment in income spent

Cont’d The sum of the series (= ΔY) is

ΔG = ΔG ( 1 )

1 – k 1 – K

So that the Multiplier = ( 1/1-k)

But k = 1 – marginal rate of leakage

= 1 – (s +t)

The Multiplier is therefore = 1

1 – (1 – (s +t))

= 1

s + t (Marginal rate of leakage)

Example

In an economy, rates of taxation are constant at ¼ of gross income, marginal propensity to consume are at 2/3 of disposable income and the economy is in equilibrium at output of 100 million. What will be the effect of an increase in government spending of 20 million on national income