BUSINESS ECONOMICSII

DETERMINATION OFEQUILIBRIUM NATIONAL INCOME

Concepts of Equilibrium

Equilibrium occurs when there is no tendencyfor changeRefers to the situation in which neitherconsumers nor firms have any incentive tochange their behaviorRefers to the state when:

AGGREGATE OUTPUT (AS) = AGGREGATE EXPENDITURE (AD) INJECTION (I) = WITHDRAWALS (S)

Injections and Leakages

Any excess of leakages over injectionswill cause a shortage of total spendingforcing producers to cut back productionAny excess of injection over leakages willcause an excess of total spendinginducing producers to increase outputSo equilibrium is reached when

Total injections = Total leakages

Underlying Assumptions

a)

b)

c)

d)

There are unemployed resourcesThe techniques of production remainunchangedThe hours worked by each worker remainunchangedPrices remain constant and so output,income, and employment will bedetermined by aggregate demand

Simple Two Sector Model

This is a simplified model in which everyincome is assumed to be consumed orsaved on the one hand, and consumed orinvested on the other hand.As such,

Y = C + S or Y = C + I S = Ii.e. At equilibrium, Planned saving = Planned investmentDraw diagrams

Changes in Equilibrium

At equilibrium, Y = C + IIf planned investment at all level changed,the investment schedule will rise, andeventually, the equilibrium national incomelevel will change.Usually, the change in income > change ininvestment and this relationship betweenchange in income and change in investmentis explained by one of the most importantconcepts in economics – The MULTIPLIER

The Multiplier

This describes the fact that changes in spendinghave an impact on income greater than the original

change in spending.An increase in spending generates several rounds offurther spending until the amounts have becomeinfinitely small.The eventual increase is the sum of the successiverounds of spending generated by the increase ininvestment. 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 thecommunity.

The Multiplier = 1 = 1 1 – MPC MPS

This is because (MPC + MPS) = 1MPS = 1 - MPC

The Multiplier Cont’d

Assume that Investment in housing constructionincrease from ¢25million to ¢30 million, calculatethe multiplier if MPC = 80% and the effect of theincrease in investment on the level of NI.Solution:

ΔI = 5 million (this is the first term because it isthe 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 aninjection will cause income to change untilleakages are once again equal toinjections.In a two sector economy, a change ininvestment will cause income to changeuntil planned savings are once again equalto planned investment.

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

foreign trade. National Income = 1200, Consumption = 720.What will be the effect on income if planned investmentincreased 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 certaincircumstances, an attempt to increase

saving may lead to a fall in total savings. Any attempt to save more which is notmatched by an equal willingness to investmore will create a deficiency of demand.Leakages will exceed injections and incomewill fall to a new equilibrium level.

Output and Employment

Since the Keynesian “revolution” full employmenthas ranked highly amongst the goals of governmentpolicy.The question is “what is the desired level” of outputthat will provide full employment.It implies that it does not follow that an equilibriumsituation in the markets for goods and services willproduce the desired equilibrium in the marketlabour.This is one of the most important points to emergefrom the Keynesian analysis of Incomedetermination.

A deficiency of Aggregate DD

Deficiency of aggregate demand could produce anequilibrium level of output but the level of NIrequired to produce full employment may be greater.The result is a “deflationary gap”.The deflationary gap is the difference between theequilibrium national income and the level of incomerequired to achieve full employment.It occurs when the equilibrium NI level is lower thanthe NI level required to achieve full employment.

Excess Demand

It is possible that planned consumption andplanned investment might produce a level ofaggregate demand is greater than that required toproduce the full employment output at constantprices.The result is an “inflationary gap”This measures the extent of the excess demandover the maximum output at constant pricesThis means spending plans is real terms cannot berealized and inflationary pressures will be present inthe economy.

Introducing the Government Sector

The government can expand total demand throughits purchases of goods and services or bystimulating private spending by means of taxreductions.Similarly, government can reduce total demand bydecreasing its own spending or by increasingtaxation.Government spending (G) can be treated asinvestment because it is an injection into thecircular 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 isfiscal policy.

Government expenditure (G) is treated asbeing autonomously determined since it issubject to political decision.Taxation (T), both direct and indirect,represents a leakage from the system.Taxes, unlike government spending, cannotbe treated as autonomous since revenuefrom taxation bears a direct relationship toincome and tax revenue is a function of

NI with Gov’t Activity

It is necessary to take account of subsidies,since they cause the market price to be lessthan factor cost, can be regarded asnegative taxes.With gov’t activity, the model now has twoleakages, S and TEquilibrium 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 profitsTherefore C = f(Yd)

We can then find how much plannedconsumption will be generated by anyparticular level of planned output.For example, if C = 3/5 of disposable incomeand disposable income is 2/3 of nationalincome, 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

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Assumptions The rates of taxation (both direct and indirect) areunchanged. i.e. Marginal rate of taxation is constant.Changes in G are assumed to have no influence onInvestment (I)MPC (c) and MPS (s) are constantThere are no transfer payments

This means that if G is increased by an amount ΔG , it will giverise to a multiple expansion of Income equal to ΔY. The seriesof 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 – KSo 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 areconstant at ¼ of gross income, marginalpropensity to consume are at 2/3 ofdisposable income and the economy is inequilibrium at output of 100 million. Whatwill be the effect of an increase ingovernment spending of 20 million onnational income