DETERMINATION OF NATIONAL INCOME in the

Keynesian Model

At Equilibrium national income:

– withdrawals equal injections

– income equals expenditure

fig

Cd

W = S + T + M

J = I + G + X

Incomes

A simplified circular flow of income modelA simplified circular flow of income model

Consumption

• Determinants of consumption– Disposable income

– wealth, interest rates, taxation policy, consumer indebtedness, future expectations

Consumption Function

45o

ConsumptionSpending

Income

B

Y1 Y2

A

A′

B′

C1

C2

An increase in income from Y1 to Y2, leads to an increase in consumption from C1 to C2. Hence the economy moves from point B on the consumption function to point B′.

C

C’An increase in wealth, and improvement in expectations, will shift the consumption function upward.

Investment• Investment

– Interest rate

– net rate of profit – capital stocks– business taxes– technological innovations– future expectations

– Assumptions:interest rates are fixed,hence investment is given at some level

Investment Spending

Investment Spending

(billions $)

Income

I

Interest rate

Investment Demand (billions $)

I

r

50

50

Graphical Analysis

45o

IncomeY*

CAggregateExpenditures(Spending)

I

AE = C + I + G + Xn

G

C + I

The Multiplier

• The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income.

• The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income.

• The size of the multiplier increases with the marginal propensity to consume (MPC).

Expenditure stage

Additional income(dollars)

Marginal propensity to consume

Additional consumption(dollars)

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

1,000,000 750,000

562,500

421,875

316,406

949,219

750,000 562,500

421,875

316,406

237,305

711,914

Round 1

Round 2

Round 3

Round 4

Round 5

Total 4,000,000 3,000,000

All others

3/4 3/4

3/4

3/4

3/4

3/4

3/4

The Multiplier Principle

• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).

MPCSize of

multiplier

.9

.8 .75.66 .5.33

10.0 5.0 4.0 3.0 2.0 1.5

A Higher MPCMeans a Larger Multiplier

• As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.).

• The multiplier:

• the formula: the simple multiplier 1 / (1 – mpc) or 1/mps

• the full multiplier: 1 / mpw (mpw=mps+mrt+mpm)

• Withdrawals– net saving: the saving function

• the mps: marginal propensity to save

• determinants of saving

– net taxes: tax functions• the mrt: marginal rate of taxation

– imports: import functions• the mpm: marginal propensity to import

• effect of imports on Cd

– the withdrawals function• MPS+MRT+MPM = MPW: marginal propensity to

withdraw

The Multiplier• In evaluating the importance of the multiplier,

one should remember:

– taxes and spending on imports will dampen the size of the multiplier;

– it takes time for the multiplier to work; and,

– the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

DETERMINATION OF NATIONAL INCOME

• Relationship between the 45° line diagram and the AD and AS diagram

fig

AS

AD1

Showing the multiplier effect on the 45o line and AD/AS diagramsShowing the multiplier effect on the 45o line and AD/AS diagrams

Price Level

Output

Y

Spending

Ye1

O

O

AE1

fig

Price Level

Output

Y

Spending

Ye1

O

O

AD1

AE1

AE2

Ye2

AS

fig

AD2

AD3

Price Level

Output

Y

Spending

AS

Ye1

O

O

AD1

AE1

AE2

Ye2

Short-run Macroeconomic Equilibrium

Simple Keynesian Analysis of Unemployment and Inflation

figOY

Spending

YeYF

AE

The recessionary gap

figOYYe

YF

AEa

b

recessionary gap

SpendingThe recessionary gap

figOYYF

AE

Inflationary gap

Spending

e

f

Ye

The inflationary gap

figOY

S

I

YeYF

c

d

AEa

b

recessionary gap

SpendingThe recessionary gap