Chapter 13-the-theory-of-income-and-employment-determination

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved.

CHAPTER 13

THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION

LECTURE OUTLINE

1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT

2 THE GREAT DEPRESSION

3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT

4 THE KEYNESIAN THEORY IN GREATER DETAIL

4.1 Planned aggregate expenditure (AE)

4.1.1 Consumption expenditure (C)

4.1.2 Planned investment expenditure (I)

4.1.3 Government expenditure on goods and services (G)

4.1.4 Net exports (X M)

4.1.5 Distinction between planned aggregate expenditure and actual aggregate

expenditure

4.2 Circular flow of income and expenditure

4.3 Equilibrium national income

4.4 Multiplier effect and multiplier

4.5 Paradox of thrift

5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT

6 INFLATIONARY GAP AND DEFLATIONARY GAP

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics



1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT

“Classical economists” is a term coined by Karl Marx to refer to economists who include

David Ricardo, James Mill and their predecessors. In other words, “Classical economists”

refers to the founders of the theory which culminated in Ricardian economics. John

Maynard Keynes included in the Classical school the followers of Ricardo, that is to say

those who adopted and perfected the theory of Ricardian economics, including John Stuart

Mill, Alfred Marshall, Francis Ysidro Edgeworth and Arthur Cecil Pigou. The above list of

names may seem confusing. A simpler but looser definition of “Classical economists” is

the economists who wrote before Keynes.

Classical economists believe that prices and wages are totally flexible and hence the

economy is a self-correcting mechanism. In other words, Classical economists believe that

as prices and wages are totally flexible, the economy is always at the full-employment

equilibrium.

Suppose that the economy is at the full-employment equilibrium. Further suppose that

aggregate demand falls. When this happens, national output will fall below the

full-employment level which will lead to unemployment resulting in a downward pressure

on wages. Since wages are totally flexible, in Classical economists‟ view, they will fall

immediately which will induce firms to increase output resulting in national output

returning to the full-employment level. Therefore, the aggregate supply curve is vertical at

the full-employment national output. The implication of a vertical aggregate supply curve

is that only a change in aggregate supply will affect national output.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 does not

have any effect national output. It only leads to a rise in the general price level (P) from P0

to P1.



In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to an

increase national output (Yf) from Yf0 to Yf1. Therefore, Classical economists argue that

the government should focus on the factors that will increase aggregate supply to increase

national output and hence the standard of living. In this sense, Classical economics is

supply-side economics.

Classical economists treat money only as a medium of exchange. Workers are exchanging

labour for goods and services and firms are exchanging goods and services for labour. In

this sense, money simply plays an intermediate role that facilitates transactions. This way

of thinking leads Classical economists to see every sale as a purchase. Since every sale is a

purchase, it is impossible for supply to exceed demand. By producing, firms are spending.

This line of thinking is often stated as “Say's Law”, which states that supply creates its own

demand. Say's Law is attributed to the great French economist Jean-Baptiste Say

(1767-1832). Say's original version was "products are paid for with products". Classical

economists use one or another version of Say's Law when they claim that economic

downturns cannot be caused by a deficiency in aggregate demand.

A version:

Firms employ factor inputs to produce output and hence pay factor income to households.

The income received by households is then partly paid back to firms in the form of

consumption expenditure and partly withdrawn from the inner flow of the circular flow of

income and expenditure in the form of savings, taxes and imports. However, any

withdrawals by households are ultimately paid back to firms in the form of injections such

as investment expenditure, government expenditure and exports. Therefore, the income

generated by the production of firms will be transformed into demand for their goods and

services, either directly in the form of consumption expenditure, or indirectly via

withdrawals and then injections. There will be no deficiency of demand.

http://www.econ.jhu.edu/people/fonseca/het/say.htm



2 THE GREAT DEPRESSION

The Classical view was challenged when the market economies were hit by the Great

Depression in the 1930s during which there was prolonged and mass unemployment. The

Great Depression proved that the economy was not a self-correcting mechanism, not in the

short run at least. For instance, the national output of the United States stayed below the

full-employment level for most part of the 1930s.

3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT

In 1936, John Maynard Keynes published the book "The General Theory of Employment,

Interest and Money to explain the prolonged and massive unemployment in the Great

Depression. The book criticises the classical model. Keynes turns Say‟s Law on its head,

arguing that aggregate demand determines national output and employment in the

economy. In this sense, demand creates its own supply.

Unlike the Classical economists, Keynes believes that prices and wages are rigid,

especially in the downward direction and hence the economy is not a self-correcting

mechanism. In other words, Keynes believes that as prices and wages are rigid, the

economy can stay at a below-full-employment equilibrium.

Suppose that the economy is at the full-employment equilibrium. Further suppose that

aggregate demand falls. When this happens, national output will fall below the

full-employment level which will lead to unemployment resulting in a downward pressure

on wages. Since wages are rigid, in Keynes‟s view, they will not fall. Therefore, firms will

not increase output and hence national output will stay at a below-full-employment level.

Keynes attributes the prolonged and high unemployment in the Great Depression to a

prolonged and huge deficiency in aggregate demand and downward rigidity of wages.

When national output is below the full-employment level, with unemployment in the

economy, firms can increase output without bidding up wages. Therefore, although an

increase in national output will lead to an increase in the total cost of production in the

economy, it will not affect the average cost of production in the economy. Since the

average cost of production in the economy will remain the same, firms will not increase

prices. Therefore, the aggregate supply curve is horizontal at the current general price level

up to the full-employment national output. Once full employment is reached, the economy

cannot expand output any further and hence the aggregate supply curve is vertical at the

full-employment national output. Therefore, the aggregate supply curve is inverse

L-shaped. Keynes believes that unemployment is the normal state of the economy.

Therefore, the implication of an inverse L-shaped aggregate supply curve is that only a

change in aggregate demand will affect national output.



In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 does not have

any effect national output.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an

increase national output (Y) from Y0 to Y1. Therefore, Keynes argues that the government

should focus on the factors that will increase aggregate demand to increase national output

and hence the standard of living. In this sense, Keynesian economics is demand-side

economics.

Note: Keynesian economics is short-run economics. Therefore, the Keynesian aggregate

supply curve is a short-run aggregate supply curve. There is no long-run aggregate

supply curve in Keynesian economics. Classical economists make no distinction

between the short run and the long run as they believe that prices and wages are

totally flexible. Therefore, the Classical aggregate supply curve is simply an

aggregate supply curve.



4 THE KEYNESIAN THEORY IN GREATER DETAIL

4.1 Planned aggregate expenditure (AE)

Planned aggregate expenditure (AE) is the planned total expenditure on the goods and

services produced in the economy over a period of time and is comprised of consumption

expenditure (C), planned investment expenditure (I), government expenditure on goods

and services (G) and net exports (X-M).

AE C I G (X M)

4.1.1 Consumption expenditure (C)

Consumption expenditure is the expenditure made by households on goods and services.

Savings is the excess of disposable income over consumption expenditure. The

consumption function shows the consumption expenditure of households at each

disposable income. Mathematically, the Keynesian consumption function can be expressed

as

C a bYd, where a 0 and 0 b 1.

From the above equation, it can be seen that consumption is comprised of two components:

autonomous consumption (a) and induced consumption (bYd). Autonomous consumption

is the part of consumption that does not depend on disposable income and is determined by

consumer confidence, the wealth of households, interest rates, expectations of price

changes, the availability of credit and the distribution of income. Induced consumption is

the part of consumption that depends on disposable income (Yd). Keynes believes that

consumption will increase with an increase in disposable income (b 0) but the increase in

consumption will be less than the increase in disposable income (b 1).

Note: Students can think of autonomous consumption as the consumption of necessities.

However, it is important to note that different people may view different goods

differently. A necessity to a person may be a luxury to another.



Consumption function

In the above diagram, (b) is the slope of the consumption function. In Keynesian

economics, it is known as the marginal propensity to consume out of disposable income

(MPCYd). The MPCYd is the fraction an increase in disposable income that is spent on

consumption (C/Yd).

Savings is the excess of disposable income over consumption expenditure. The savings

function shows the savings of households at each disposable income. Mathematically, the

Keynesian savings function can be expressed as

S a (1 b)Yd, where a 0 and 0 (1 – b) 1.

From the above equation, it can be seen that savings is comprised of two components:

autonomous savings (a) and induced savings [(1 b)Yd]. Autonomous savings (or

dissavings, which some may like to call it) is the part of savings that does not depend on

disposable income and is determined by consumer confidence, interest rates, expectations

of price changes the distribution of income. Induced savings is the part of savings that

depends on disposable income (Yd). Keynes believes that savings will increase with an

increase in disposable income [(1 b) > 0] but the increase in savings will be less than the

increase in disposable income [(1 b) < 1].



Savings function

In the above diagram, (1 b) is the slope of the savings function. In Keynesian economics,

it is known as the marginal propensity to save out of disposable income (MPSYd). The

MPSYd is the fraction of an increase in disposable income that is saved (S/Yd).

Since any additional disposable income will either be spent or saved, the sum of the

marginal propensity to consume out of disposable income and the marginal propensity to

save out of disposable income is equal to one (MPCYd MPSYd 1).

The average propensity to consume out of disposable income (APCYd) is the fraction of

disposable income that is spent on consumption (C/Yd). The average propensity to save out

of disposable income (APSYd) is the fraction of disposable income that is saved (S / Yd).

Since any amount of disposable income will either be spent or saved, the sum of the

average propensity to consume out of disposable income and the average propensity to

save out of disposable income is equal to one (APCYd APSYd 1).

Example

Yd C S MPCYd MPSYd APCYd APSYd

0 20 20 ------- ------- ------- -------

40 50 10 0.75 0.25 1.25 0.25

80 80 0 0.75 0.25 1 0

120 110 10 0.75 0.25 0.92 0.08

160 140 20 0.75 0.25 0.875 0.125

200 170 30 0.75 0.25 0.85 0.15

240 200 40 0.75 0.25 0.83 0.17

The marginal propensity to consume and the marginal propensity to save can be defined

“out of national income”. The marginal propensity to consume out of national income

(MPC) is the fraction of an increase in national income that is spent on consumption



(C/Y). The marginal propensity to save out of national income (MPS) is the fraction of

an increase in national income that is saved (S/Y). The marginal propensity to tax (MPT)

is the fraction of an increase in national income that is taxed (T/Y). Since any amount of

national income will either be spent, saved or taxed, the sum of the marginal propensity to

consume out of national income, the marginal propensity to save out of national income

and the marginal propensity to tax is equal to one (MPC MPS MPT 1). Similarly, the

average propensity to consume and the average propensity to save can be defined “out of

national income”. The average propensity to consume out of national income (APC) is the

fraction of national income that is spent on consumption (C/Y). The average propensity to

save out of national income is the fraction of national income that is saved (S/Y). Since any

amount of national income will either be spent, saved or taxed, the sum of the average

propensity to consume out of national income, the average propensity to save out of

national income and the average propensity to tax is equal to one (APC APS APT 1).

Relationship between the consumption function and the savings function



In the above diagram, when disposable income is equal to zero, consumption expenditure

must be financed by dissavings. At Yd0, where consumption expenditure is equal to

disposable income, savings is zero. Below Yd0, where consumption expenditure exceeds

disposable income, savings is negative. Above Yd0, where disposable income exceeds

consumption expenditure, savings is positive.

Induced consumption is positively related to disposable income. In other words, an

increase in disposable income will lead to an increase in induced consumption and vice

versa. An increase in induced consumption can be shown by an upward movement along

the consumption function.

In the above diagram, an increase in disposable income (Yd) from Yd0 to Yd1 leads to an

upward movement along the consumption function (C) resulting in an increase in

consumption expenditure (C) from C0 to C1. The effect of an increase in disposable income

on consumption will depend on the MPCYd. Given any increase in disposable income, the

larger the MPCYd, the larger the increase in consumption.

Determinants of disposable income

National income

Disposable income will increase when national income increases.

Direct taxes and transfer payments

A decrease in direct taxes such as personal income tax and corporate income tax, or an

increase in transfer payments such as unemployment benefits, social security benefits and

interest payments on national debt will lead to an increase in disposable income.

Autonomous consumption is determined by consumer confidence, the wealth of

households, interest rates, expectations of price changes, the availability of credit and the

distribution of income. An increase in autonomous consumption can be shown by a vertical

upward shift in the consumption function.



In the above diagram, a vertical upward shift in the consumption function (C) from C0 to C1

leads to an increase in consumption expenditure (C) from C0 to C1 at the same disposable

income (Yd0).

Determinants of autonomous consumption

Consumer confidence (Consumer sentiment)

When households are more optimistic about the economic outlook, they will expect their

income to rise and hence increase consumption.

Wealth of households

When the wealth of households increases, consumption will increase.

Interest rates

A fall in interest rates will reduce the incentive to save which will induce households to

increase consumption.

Expectations of price changes

When households expect prices to rise, they will bring forward the purchases of some

durable goods which will lead to an increase in consumption. Note that this is not the same

as consumer confidence which is about expectations of income changes.

Availability of credit

Many consumer durables are purchased with bank loans and hence an increase in the

availability of credit will allow households to increase consumption.

Distribution of income

Lower income groups have higher marginal propensities to consume than higher income

groups and hence a redistribution of income from higher income groups to lower income

groups will lead to an increase in consumption.



4.1.2 Planned investment expenditure (I)

Investment expenditure is the expenditure made by firms on goods produced not for their

present use but for their use in the future. In economics, investment is comprised of

business fixed investment (new factories and machinery), residential investment (new

houses, apartments and condominiums) and inventory investment (the change in the value

of unsold goods). There are two types of investment: autonomous investment and induced

investment.

Autonomous investment

Autonomous investment is the part of investment that does not depend on national income

and is determined by interest rates, business sentiment, business costs, capital costs,

corporate income tax, technological advancements and the availability of credit. According

to the marginal efficiency of capital theory, or some may prefer to call it the marginal

efficiency of investment theory, the marginal efficiency of capital function is the

investment function. The investment function shows the investment expenditure of firms at

each interest rate.

Note: Students do not need to explain the MEC/MEI theory in the examination. All that

they are required to do is to state that the MEC/MEI function is the investment

function.

The marginal efficiency of a type of capital is the discount rate which equates the cost of

the type of capital to the present value of its stream of expected returns. The marginal

efficiency of capital is the summation of the marginal efficiencies of all the types of capital

in the economy.

Consider a type of capital which will generate returns for three years.

Returns (Year1) Returns (Year 2) Returns (Year 3)

Cost ------------------------ ------------------------ ------------------------

(1 r*) (1 r*)2 (1 r*)

3

r* is the marginal efficiency. It should be obvious that the marginal efficiency of a type of

capital is its internal rate of returns (IRR).

The fund can be loaned out if it is not invested in the type of capital. Therefore, interest

rates are the external rate of returns (ERR).

The marginal efficiency of a type of capital function is downward-sloping due to

diminishing marginal returns. As more and more of a type of capital is employed, each

additional unit of it will have less of other types of capital to work with. Therefore, the

additional expected returns resulting from investing in one more unit of a type of capital

falls. Since the marginal efficiency of capital is the summation of the marginal efficiencies

of all the types of capital in the economy, the marginal efficiency of capital function is also

downward-sloping.



Marginal efficiency of capital function

In the above diagram, the marginal efficiency of capital (MEC) is higher than the interest

rate (r) r0 to the left of investment (I) I0. Therefore, the optimal level of investment is I0.

Since investment depends on the marginal efficiency of capital, the marginal efficiency of

capital function is the investment function.

A fall in interest rates will lead to more profitable planned investments resulting in an

increase in investment expenditure and vice versa. An increase in investment expenditure

due to a fall in interest rates can be shown by a downward movement along the marginal

efficiency of capital function.

In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward

movement along the marginal efficiency of investment function (MEC) resulting in an

increase in investment expenditure (I) from I0 to I1.



In addition to a fall in interest rates, the number of profitable planned investments and

hence investment expenditure will also increase when expected returns on planned

investments increase due to stronger business sentiment, lower business costs such as

decreases in oil prices and wages or lower capital costs such as decreases in the costs of

factories and machinery. Further, a decrease in corporate income tax that will increase

expected after-tax returns on planned investments, technological advancements and an

increase in the availability of credit will also lead to an increase in investment expenditure.

An increase in investment expenditure due to a non-interest rate factor can be shown by

rightward shift in the marginal efficiency of capital function.

In the above diagram, a rightward shift in the marginal efficiency of capital (MEC)

function from MEC0 to MEC1 leads to an increase in investment expenditure (I) from I0 to

I1 at the same interest rate (r0).

Induced investment

Induced investment is the part of investment that depends on national income. According

to the accelerator theory of investment, net investment is determined by the rate of change

of national income. When national income rises at an increasing rate, net investment will

increase. However, when national income rises at a decreasing rate, net investment will

decrease.

Since It Kt – Kt1 and Kt vYt, It It vYt – vYt1 or It v(Yt – Yt1), where I net

investment, K capital, Y national income or national output and v capital-output

ratio.

It v(Yt – Yt1) is the accelerator equation.



Example

Time Period (t) Yt Yt1 It

0 $100 --- ---

1 $110 $100 $25

2 $140 $110 $75

3 $180 $140 $100

4 $200 $180 $50

* Assume that v = 2.5

From t = 0 to t =3, because national income rises at an increasing rate, net investment

increases. From t = 3 to t = 5, because national income rises at a decreasing rate, net

investment decreases.

The size of the accelerator effect depends on the capital-output ratio (v), also known as the

accelerator coefficient. The higher the capital-output ratio, the larger the accelerator effect.

For instance, due to the high capital-output ratio in the United States, the accelerator effect

is large.

Note: In the Keynesian model, planned investment expenditure is assumed to be

autonomous as it cannot be expressed as a linear function of national income. In

reality, planned investment expenditure is affected by national income.

4.1.3 Government expenditure on goods and services (G)

Government expenditure on goods and services is the expenditure on goods and services

made by the government. It includes expenditure on both consumer goods and capital

goods. It does not include government expenditure on transfer payments. Transfer

payments are payments made by the government to the recipients not in exchange for any

goods or services and they include social security benefits, unemployment benefits and

interest payments on national debt. About two-thirds of the US federal government

expenditure is made on transfer payments.

The government can also influence aggregate expenditure by controlling consumption

expenditure through changing direct taxes or transfer payments. In addition to the effect on

consumption expenditure, a change in corporate income tax will also affect investment

expenditure and hence aggregate expenditure.

Disposable income National income Transfer payments Corporate income tax –

Other direct taxes Undistributed corporate profit Personal income tax

Taxes T tY, Yd Y – T – tY, where T autonomous taxes, tY induced taxes and t

marginal propensity to tax (MPT).

Assuming no transfer payments and undistributed corporate profit.



Since C a bYd, C a b(Y T tY) or C a – bT b(1 t)Y, where a autonomous

consumption, bYd induced consumption, b the marginal propensity to consume out of

disposable income (MPCYd) and b(1 t) the marginal propensity to consume out of

national income (MPC).

An increase in “t” will decrease the MPC and hence make the consumption function

(plotted against national income) flatter. Therefore, the AE function will become flatter.

However, an increase in “T” will shift the consumption function (plotted against national

income) vertically downwards. Therefore, the AE function will shift vertically downwards.

Note: In the Keynesian model, government expenditure on goods and services is assumed

to be autonomous as it cannot be expressed as a linear function of national income. In

reality, government expenditure is affected by national income. In a recession, the

government may increase expenditure on goods and services to increase economic

growth and hence reduce unemployment. When the economy is overheating, the

government may decrease expenditure on goods and services to reduce inflation.

4.1.4 Net exports (X M)

Exports (X) are the expenditure made by foreigners on domestic goods and services. The

following are the determinants of exports.

Foreign income

An increase in foreign income will lead to a rise in exports. The converse is also true.

Domestic general price level relative to foreign general price level

When the domestic general price level falls relative to the foreign general price level,

domestic goods and services will become relatively cheaper than foreign goods and

services. When this happens, exports will rise. The converse is also true.

Exchange rate

When domestic currency depreciates, domestic goods and services will become relatively

cheaper than foreign goods and services. When this happens, exports will rise. The

converse is also true.

Other factors

Factors such as comparative advantage, trade policy, quality and tastes will also affect

exports.

Imports (M) are the expenditure made by domestic residents on foreign goods and services.

The following are the determinants of imports.

National income

An increase in national income will lead to a rise in imports. The converse is also true.



Domestic general price level relative to foreign general price level

When the domestic general price level rises relative to the foreign general price level,

domestic goods and services will become relatively more expensive than foreign goods

and services. When this happens, imports will rise. The converse is also true.

Exchange rate

When domestic currency appreciates, domestic goods and services will become relatively

more expensive than foreign goods and services. When this happens, imports will rise. The

converse is also true.

Other factors

Factors such as comparative advantage, trade policy, quality and tastes will also affect

imports.

Mathematically, the import function can be expressed as M m0 m1Y, where m0

autonomous imports, m1Y induced imports, m1 the marginal propensity to import

(MPM).

Net export function

In the above diagram, as exports are independent of national income and imports rise with

national income, the net export function is downward-sloping.

4.1.5 Distinction between planned aggregate expenditure and actual aggregate

expenditure

Actual aggregate expenditure, or national expenditure, is always equal to national income

or national output. However, planned aggregate expenditure is not necessarily equal to

actual aggregate expenditure and therefore is not necessarily equal to national income or

national output.



Firms will experience an unplanned increase in inventory investment if they sell less of

their output than expected, in which case, actual aggregate expenditure, national output or

national income will exceed planned aggregate expenditure. Conversely, if firms sell more

of their output than expected, they will experience an unplanned decrease in their inventory

investment, in which case, planned aggregate expenditure will exceed actual aggregate

expenditure, national output or national income.

4.2 Circular flow of income and expenditure

The circular flow of income and expenditure shows the flow of income and expenditure

between the different sectors in the economy.

In the above diagram, households provide factor inputs which include labour, land, capital

and entrepreneurship to firms and in return, they receive factor income (Y) in the form of

wages, rent, interest and profits. Firms provide goods and services to households and in

return, they receive payments known as consumption expenditure on domestic goods and

services (CD). However, not all the factor income received by households return to

domestic firms as revenue. Rather, they go to the government in the form of taxes (T),

some go to the financial sector in the form of savings (S) and some go to the external sector

in the form of imports (M). Taxes, savings and imports are known as withdrawals, which

are basically the factor income received by households that does not return to domestic

firms as revenue. Further, some of the payments received by domestic firms do not come

from households. Rather, they come from the government in the form of government

expenditure on goods and services (G), the financial sector in the form of loans to finance

investment expenditure (I) and the external sector in the form of exports (X). Government

expenditure, investment expenditure and exports are known as injections, which are

basically are the payments received by domestic firms that do not come from households.



4.3 Equilibrium national income

The equilibrium national income is the national income that has no tendency to change and

it can be determined in three ways: the expenditure-income approach, the

injections-withdrawals approach and the AD-AS approach.

Expenditure-income approach (AE Y)

According to the expenditure-income approach, which is also known as the

expenditure-output approach, the equilibrium national income is the national income

where planned aggregate expenditure is equal to national income or national output.

In the above diagram, the equilibrium national income is Y0 where planned aggregate

expenditure (AE) is equal to national income (Y). At a national income lower than planned

aggregate expenditure, such as Y2, firms whose output is insufficient to meet the planned

expenditure of the economy will experience an unplanned decrease in their inventories,

and to bring their inventories up to the planned levels, they will increase output which will

lead to an increase in national income. At a national income higher than planned aggregate

expenditure, such as Y1, firms whose output is more than sufficient to meet the planned

expenditure of the economy will experience an unplanned increase in their inventories, and

to bring their inventories down to the planned levels, they will decrease output which will

lead to a decrease in national income. At Y0, firms will not experience any unplanned

changes in their inventories and hence there will be no incentive for them to change output.

Note: Since AE C I G (X M) and Y = C S T, when AE Y, C I G (X –

M) C S T. Therefore, when AE Y, I G X = S T M.

Injections-withdrawals approach (J W)

According to the injections-withdrawals approach, the equilibrium national income is the

national income where planned injections are equal to withdrawals. Injections are the

payments received by domestic firms that do not come from households and they comprise



government expenditure on goods and services, investment expenditure and exports.

Withdrawals are the factor income received by households that does not return to domestic

firms as revenue and they comprise taxes, savings and imports.

In the above diagram, the equilibrium national income is Y0 where planned injections (J)

are equal to withdrawals (W), because at this national income, planned aggregate

expenditure is equal to national income. At a national income where planned injections are

higher than withdrawals, planned aggregate expenditure is higher than national income,

and vice versa.

Aggregate demand-aggregate supply approach (AD AS)

According to the aggregate demand-aggregate supply approach, the equilibrium national

income is the national income where aggregate demand is equal to aggregate supply.



In the above diagram, the equilibrium national income is Y0 where aggregate demand (AD)

is equal to aggregate supply (AS). At Y0 where there is neither a shortage nor surplus, firms

will not experience any unplanned changes in their inventories and hence there will be no

incentive for them to change output.

4.4 Multiplier effect and multiplier

An increase in autonomous expenditure will lead to an increase in national income.

Furthermore, due to the multiplier effect, the increase in national income will be larger than

the initial increase in autonomous expenditure.

The multiplier effect is the effect of an increase in autonomous expenditure leading to a

larger increase in national income.

In the above diagram, an increase in AE leads to a larger increase in national income.

The marginal propensity to withdraw (MPW) is the fraction of an increase in national

income that is withdrawn from the inner flow of income and expenditure. Therefore, MPW

MPS MPT MPM. The marginal propensity to consume domestic goods and services

out of national income (MPCD) is the fraction of an increase in national income that is

spent on domestic goods and services. Therefore, MPCD MPC – MPM.

Suppose that MPCD 0.8, MPW 0.2 and AE $1000. When aggregate expenditure

increases by $1000, firms will employ more factor inputs to produce more output and

hence pay more factor income to households. Household income and hence consumption

expenditure will increase by $1000 and $800 (0.8 × $1000) respectively. Due to the

increase in consumption expenditure of $800, firms will employ even more factor inputs to

produce even more output and hence pay even more factor income to households.

Household income and hence consumption expenditure will increase further by $800 and



$640 (0.8 × $800) respectively. However, each time household income rises, savings, taxes

and imports will rise, and when these withdrawals have increased by $1000 to the level that

matches injections, equilibrium will be restored and national income will stop increasing.

Round Y CD W

1 $1000 $800 $200

2 $800 $640 $160

3 $640 „ „

„ „ „ „

„ „ „ „

„ „ „ „

Sum $5000 $4000 $1000

In the above table, Y $1000 $800 $640 ……….

Therefore, Y $1000 (0.8)($1000) (0.8)2($1000) ……….

Applying geometric progression, Y $1000/(1 0.8) $5000 AE $1000.

The multiplier is the number of times by which national income increases due to an

increase in autonomous expenditure.

Since Y = AE/(1 MPCD), Y/AE 1/(1 MPCD).

Multiplier Y/AE 1/(1 MPCD)

Since MPS MPT MPM MPCD 1, Y/AE 1/MPW.

Multiplier Y/AE 1/MPW

Since the multiplier is the inverse of the MPW, it will be larger the lower the savings, the

lower the income taxes and the lower the imports. The multiplier in Singapore is small due

to the high savings and high imports.

Note: In reality, when aggregate expenditure rises, real national income will not rise by the

full multiplier effect due to a rise in the general price level (which will be explained

later).

4.5 Paradox of thrift

Classical economists argue that saving is desirable for the economy. An increase in savings

will lead to lower interest rates which will result in higher consumption and investment and

hence higher economic growth. However, Keynes argues that an increase in savings is

undesirable for the economy.



The fallacy of composition is the wrong belief that if something is good for an individual, it

is also good for the nation. However, just because something is good for an individual, it

does not follow that it is good for the nation.

If an individual increases savings, he will increase his future consumption. However, if the

nation increases savings, it will decrease its future income and future consumption. Given

any amount of disposable income, an increase in savings will lead to a decrease in

consumption expenditure. Further, the decrease in consumption expenditure will weaken

business sentiment which will lead to a decrease in investment expenditure. The combined

decreases in consumption expenditure and investment expenditure will lead to a decrease

in aggregate demand and hence national income. The phenomenon of higher savings

leading to lower national income is known as the paradox of thrift. Keynes‟ idea is that

when the economy is in a recession, people should not tighten their belts. Rather, they

should spend their way out of the recession.

5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT

Classical economics and Keynesian economics are traditional schools of thought in

macroeconomics. Today, no economist subscribes to these precise collections of views.

Instead, what is taught to students today is neo-classical economics which is the

mainstream economics.

Neo-classical economists believe that although prices and wages are totally flexible in the

long run, they are rigid in the short sun. Therefore, although the economy will be at the

full-employment equilibrium in the long run, it can stay at an above-full-employment

equilibrium or a below-full-employment equilibrium in the short run.

Aggregate demand is the total demand for the goods and services produced in the economy

over a period of time and is comprised of consumption expenditure, investment

expenditure, government expenditure on goods and services and net exports. The

aggregate demand curve shows the total demand for the goods and services produced in the

economy at each general price level over a period of time.

Aggregate Demand Curve



In the above diagram, the aggregate demand (AD) curve is downward-sloping. The AD

curve will shift rightwards if there is an increase in C, I, G or (X – M).

Aggregate supply is the total supply of goods and services in the economy over a period of

time and is determined by the amount and the productivity of factor inputs, given factor

prices. The aggregate supply curve shows the total supply of goods and services in the

economy at each general price level over a period of time.

Aggregate Supply Curve

In the above diagram, the aggregate supply (AS) curve is upward sloping. The AS curve

will shift rightwards if there is a decrease in factor prices or an increase in the amount or the

productivity of factor inputs.



Long-run aggregate supply is the total supply of goods and services in the economy when

all factor prices have fully adjusted in the long run and is determined by the amount and the

productivity of factor inputs. The long-run aggregate supply curve shows the total supply

of goods and services in the economy when all factor prices have fully adjusted in the long

run.

Long-run Aggregate Supply Curve

In the above diagram, the long-run aggregate supply (LRAS) curve is vertical at the

full-employment national income. The LRAS curve will shift rightwards if there is an

increase in the amount or the productivity of factor inputs.

Note: The full-employment national income is the national income where there is no

demand-deficient unemployment (which will be discussed in greater detail later).

If the economy is at an above-full-employment equilibrium, national income will fall.

Above-full-employment equilibrium



In the above diagram, the equilibrium national income (Y0) is above the full-employment

national income (Yf), creating a positive output gap (Y0 Yf). When national income is

above the full employment level, unemployment will be below the natural rate. In such a

state of the economy, firms will find it difficult to employ workers but workers will find it

easy to get jobs which will lead to an upward pressure on factor prices. When factor prices

and hence the cost of production in the economy rise in the long run, aggregate supply (AS)

will fall from AS0 to AS1 and hence national income will fall from Y0 to Y1.

If the economy is at a below-full-employment equilibrium, national income will rise.

Below-full-employment equilibrium



In the above diagram, the equilibrium national income (Y0) is below the full-employment

national income (Yf), creating a negative output gap (Y0 Yf). When national income is

below the full employment level, unemployment will be above the natural rate. In such a

state of the economy, firms will find it easy to employ workers but workers will find it

difficult to get jobs which will lead to a downward pressure on factor prices. When factor

prices and hence the cost of production in the economy fall in the long run, aggregate

supply (AS) will rise from AS0 to AS1 and hence national income will rise from Y0 to Y1.

If the economy is at the full-employment equilibrium, national income will remain

unchanged, other things being equal.

Full-employment equilibrium

In the above diagram, the equilibrium national income (Y0) is equal to the full-employment

national income (Yf). When national income is at the full-employment level,

unemployment will be at the natural rate. Therefore, there will be neither upward nor

downward pressure on factor prices and hence the short-run equilibrium will be the

long-run equilibrium, other things being equal.

6 INFLATIONARY GAP AND DEFLATIONARY GAP

In the short run, the equilibrium national income may not be equal to the full-employment

national income.

If the equilibrium national income is higher than the full-employment national income, the

economy is at an above-full-employment equilibrium. The output gap, which is the excess

of the equilibrium national income over the full-employment national income, is positive.

A positive output gap is also known as an inflationary gap.



Above-full-employment equilibrium

In the above diagram, the equilibrium national income (Ye) is higher than the

full-employment national income (Yf). The output gap (Ye Yf) is positive.

If the equilibrium national income is lower than the full-employment national income, the

economy is at a below-full-unemployment equilibrium. The output gap, which is the

excess of the equilibrium national income over the full-employment national income, is

negative. A negative output gap is also known as a deflationary gap.

Below-full-employment equilibrium

In the above diagram, the equilibrium national income (Ye) is lower than the

full-employment national income (Yf). The output gap (Ye Yf) is negative.



If the equilibrium national income is the same as the full-employment national income, the

economy is at the full-employment equilibrium.

Full-employment equilibrium

When the economy is at the full-employment equilibrium, there is neither inflationary gap

nor deflationary gap.

Note: In Keynesian economics, inflationary gap and deflationary gap do not refer to

positive output gap and negative output gap. An inflationary gap is the excess of

planned aggregate expenditure over national income at the full-employment national

income. In other words, it is the amount of decrease in planned aggregate

expenditure which is needed to close a positive output gap. A deflationary gap is the

shortfall of planned aggregate expenditure below national income at the

full-employment national income. In other words, it is the amount of increase in

planned aggregate expenditure which is needed to close a negative output gap.

Chapter 13-the-theory-of-income-and-employment-determination

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Transcript of Chapter 13-the-theory-of-income-and-employment-determination