Lecture 3: Simple Keynesian Model National Income Determination Three-Sector National Income Model

Outline The Consumption Function Three-Sector Model Fiscal Policy Output-Expenditure Approach: Equilibrium National Income Ye Injection-Withdrawal Approach: Equilibrium National Income Ye Fiscal Policy

Introduction Why focus on the consumption function? Largest component of nations’ GDP Important to understand relationship between consumption and national income in order to explain large changes in national income from shifts in autonomous expenditure In two-sector model, consumption is the only endogenous variable. Therefore, changes in exogenous expenditure that affect national income depend on how consumption related to national income

Keynesian consumption function Basic x’tic is that current consumption is related to current (disposable) income Here, MPC= APC= c Consumption function may also have a constant term C= a + cY Graphical illustration Calculate the APC and MPCs. Are these equal?

Constant consumption and autonomous expenditure Recall: E= C + I Define C= a + cY; I= I* Aggregate Expenditure (E)= a + cY + I* (grouping autonomous expenditures together: A= a + I* Aggregate Expenditure (E)= A + cY Compare with usual expenditure function (E= I* + cY)

Constant consumption and autonomous expenditure All autonomous expenditure flows and constants on expenditure functions can be grouped together into a single autonomous expenditure term, A A shift (upwards or downwards) in any component of A also leads to shift in A

Assigned reading Read on determinants of consumption Lipsey pp, 491

Three-sector models Introducing a Government sector

Three-Sector Model With the introduction of the government sector (i.e. together with households C, firms I), aggregate expenditure E consists of one more component, government expenditure G. E = C + I + G Still, the equilibrium condition is Planned Y = Planned E

Definitions and terminology Government expenditure is made up of two parts Government expenditure on current production, G Transfer payments, Q Government also collects tax revenues, T Government budget balance may be defined as revenues minus expenditures T- (G + Q) When positive, there is a government surplus i.e. more revenues When negative, there is a government deficit i.e. more expenditures When zero, there is a balanced budget

Brief digression: implications of deficit in government budget A deficit requires an increase in borrowing Borrowing from private sector (local and foreign) Borrowing from central bank Private sector Selling of bills and bonds (longer term) Bills and bonds are promises to pay a stated amount sometime in the future Central Bank Creation of new money No limit (presumably) to how much government can borrow

Behavioural assumptions of g Assumptions about the Government component of AE Government expenditure on current production is assumed constant, G= G* Transfer payments are also an autonomous expenditure flow, Q= Q* These assumptions may be relaxed later Deal with simple case of how national income responds to constant G and Q Graphical Illustration Additional assumptions All transfer payments are made to households Firms may also receive these payments in the form of subsidies All taxes are direct taxes on personal and company incomes No indirect taxes like VAT in present economy Taxes are a constant proportion of national income i.e. T= tY where 0<t<1 No progressive or regressive tax structures

Introducing new propensities Average propensity to tax, T/Y Total tax revenue as proportion of total income Marginal propensity to tax, ∆T/ ∆Y Change in tax from one unit change in income Given functional form of taxes i.e. T= tY APT= MPT= t

Behavioral assumptions about the household sector In the 2-sector model, all national income was paid out to households Households decided to consume or save amounts National income, Y= disposable income, Yd Introduction of taxes and transfer payments drives a wedge between national income and disposable income Yd= Y- T + Q Taxes reduce disposable income Transfer payments increase disposable income In the absence of each, Yd= Y

Behavioral assumptions about the household sector We continue to assume C= cYd Households spend a fraction of disposable income and save the rest Given that Yd= Y-T+Q, C= c(Y-T+Q) =cY – cT + cQ, but T= tY =cY – ctY + cQ = c(1 – t) Y + cQ // But what does this mean?

Behavioral assumptions about the household sector First term :c(1-t)Y If t is the proportion of income taxed, 1-t is proportion not taxed i.e. disposable income c(1-t) is proportion of income that is consumed or spent or marginal propensity to consume out of national income Second term: cQ Proportion of transfer payments that is consumed or spent So total consumption, C, is made up of proportions of consumption from disposable income and transfer payments. Question: Is there an autonomous component of this consumption function? Graphical illustration

Next class Equilibrium in the 3 sector model The Multiplier Output Expenditure Approach Withdrawals Injections Approach The Multiplier Limitations of the Keynes Theory of National Income