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ECONOMICS 11TOPIC 10

DETERMINATION OF NATIONAL INCOME

U-PRIMO E. RODRIGUEZDept. of Econ., UPLB

OBJECTIVEExplain fluctuations in national income

Helps understand changes in national income

Helps in formulating policy and business decisions

The road aheadBasic framework

Consumption and income

Two sector economy

Three sector economy

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BASIC FRAMEWORK

Tasks

Define aggregate expenditure and equilibrium income

Describe how the economy adjusts to equilibrium

Explain how changes in aggregate expenditure affect equilibrium income

Aggregate expenditure (AE)total amount that all economic agents want/plan to spend on domestic goods/servicesAgents: households, firms, govt, foreigners

Common formulationAE = C + I + G + X – MC = consumption, I = investment, G = govt

spending, X = exports, M = importsNote: AE is not the same as GDP.

AE = planned spending GDP = actual spending/output

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AE and National output (Y)There is no reason to expect that Y and AE are equal. Firms formulate production plans armed only with an

estimate of how much economic agents want to buy. If AE is not equal Y, then firms adjust production

AE > Y, increase production AE < Y, decrease production

Discrepancies between AE and Y reflected in unintended inventories AE > Y, firm inventories fall AE < Y, firms accumulate inventories

Equilibrium: Y = AEWhy? No longer an incentive to adjust production

IllustrationAssume AE does not respond to changes in income Horizontal line in (Y,AE) space (AE schedule) Highly unrealistic but sufficient for now

450 line: illustrates all potential equilibrium positions (Y = AE)Equilibrium: intersection of the 450 line and AE schedule

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45º

E0 AE20

AE

020 YY*

Equilibrium

45º

E0 AE20

AE

020 YY*

AE > Y…raise production

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45º

E0 AE20

AE

020 YY*

AE < Y…Reduce production

45º

E1

AE1

30

AE

030 YY1

Higher AE raises equilibrium income (Y*)

20

20Y0

AE0

E0

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Keynes (1936) suggested that consumption spending tends to increase with income

Higher income leads to higher consumption spending

Income Consumption

(Y) (C)0 200

200 350400 500600 650800 800

1,000 9501,200 1,1001,400 1,2501,600 1,400

CONSUMPTION AND INCOME

Low levels of YC > Y

Y C0 200

200 350400 500600 650800 800

1,000 9501,200 1,1001,400 1,2501,600 1,400

Break-even level: C = Y

High levels of YY > C

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Autonomousconsumption

Y C0 200

200 350400 500600 650800 800

1,000 9501,200 1,1001,400 1,2501,600 1,400

Marginal propensityto consume (mpc) =

change in consumption spending for a one peso increase in income

mpc = ∆C / ∆Y

Example Y C0 200

200 350400 500600 650800 800

1,000 9501,200 1,1001,400 1,2501,600 1,400

∆C = 500 – 350 = 150∆Y = 400 - 200 = 200

mpc = ∆C / ∆Y= 150/200 = 0.75

… a 1 peso increase in Y leads to 75 centavo increase in C

Note: 0 < mpc < 1

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Completing the table

Y C ∆Y ∆C ∆C/∆Y0 200 — — _

200 350 200 150 0.75400 500 200 150 0.75600 650 200 150 0.75800 800 200 150 0.75

1,000 950 200 150 0.751,200 1,100 200 150 0.751,400 1,250 200 150 0.751,600 1,400 200 150 0.75

Consumption schedule (based on values in the previous table)

0

200

400

600

800

1000

800 1200 1600

400

1200

1400

1600C

Y

C

Autonomous consumption

Slope is the mpc

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Drawing a 450 line helps identify some important regions

0

200

400

600

800

1000

800 1200 1600

400

1200

1400

1600C

Y

C 450

Break-even

Y > C

Y < C

Mathematical representation: Consumption function

Autonomous consumption

Example consistent with the numbers in the table:C = 200 + 0.75 Y

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TWO-SECTOR MODELTwo sectors: Households and firms

No govt and no foreign trade

ImplicationAE = C + I

Assumption: I is autonomous and equal to 100Next slide: Integrate to previous table on consumption and income

Y C I AE

400 500 100 600

600 650 100 750

800 800 100 900

1,000 950 100 1,050

1,200 1,100 100 1,200

1,400 1,250 100 1,350

investment

AE = C + I

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Y C I AE

400 500 100 600

600 650 100 750

800 800 100 900

1,000 950 100 1,050

1,200 1,100 100 1,200

1,400 1,250 100 1,350

Equilibrium: Y = AEExample, equilibrium income (Y*) = 1,200

Graphical treatment: Revised AE

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Graphical treatment: Equilibrium

Experiment: What if I investment rises from 100 to 200? I.e. ∆I = 100Equilibrium income rises from 1,200 (our original value) to 1,600

Y C I AE

400 500 200 700

600 650 200 850

800 800 200 1000

1,000 950 200 1150

1,200 1,100 200 1300

1,400 1,250 200 1450

1600 1400 200 1600

1800 1550 200 1750

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Graphical treatment

Summary: The 100 peso increase in

investment led to a 400 peso

increase in equilibrium income.

Question: Why is the increase in Y

bigger than the increase in I?

The answer lies in the notion of the

multiplier.

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Multiplier ()Measures the change in income for a unit change in an autonomous component of aggregate expenditure…investment in the previous experiment

Mathematical representation for the change in investment

How is the multiplier calculated?

Applied to our example:

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Using the multiplier to infer the effects of a change in investment:

This explains why a 100 peso increase in investment led to a 400 peso (=4*100) increase in Y*

Why is the multiplier greater than 1?

Round ∆C ∆ I ∆ Y1 0 100 1002 mpc•[100] 0 mpc•100

3 mpc• [mpc•100] 0 mpc2•100

… … … …

n mpc•[ mpcn-2•100] 0 mpcn-1•100

Initial increase in investment

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Mathematical derivation

Algebraic treatment of income determination

Key equations

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Substituting the consumption and investment equations into the equilibrium condition:

Solving for Y:

Applied to our exampleKey equations

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Substituting the consumption and investment equations into the equilibrium condition:

Solving for Y:

Question: Where in all this is saving?

Saving represents that component of income which is not spent on consumption (i.e. S = Y-C)The story on how savings fits into the current topic will be discussed in another course (Econ 101).

WAKAS