CHAPTER 12 NATIONAL INCOME EQUILIBRIUM

NATIONAL INCOME EQUILIBRIUM TWO APPROACHES TO DETERMINE EQUILIBRIUM: 1. AGGREGATE DEMAND – AGGREGATE SUPPLY APPROACH (AD = AS) Aggregate demand or aggregate expenditure is the total demand for goods and services in the economy. There are four components in aggregate demand namely consumption, investment, government sector and foreign sector (net exports). Aggregate supply or aggregate output is the total quantity of goods and services produced in an economy in a given period of time. Equilibrium occurs when AD = AS

TWO APPROACHES TO DETERMINE EQUILIBRIUM: NATIONAL INCOME EQUILIBRIUM (cont.) TWO APPROACHES TO DETERMINE EQUILIBRIUM: 2. LEAKAGE – INJECTION APPROACH Leakage is a withdrawal from the income – expenditure stream. Leakages include savings, taxes and imports. Injection is an addition of spending to the income-expenditure stream. Injections include investment, government expenditures and exports. Equilibrium occurs when leakages are equal to injections.

CONSUMPTION AND SAVING CONSUMPTION THEORY Consumption refers to the purchase of goods and services by individuals or households that are produced by firms. Income (Y) is divided into two parts, consumption (C) and savings (S). Y = C + S CONCEPT OF CONSUMPTION AVERAGE PROPENSITY TO CONSUME (APC) APC is the ratio of total consumption to total income. APC = TOTAL CONSUMPTION = C TOTAL INCOME Y   MARGINAL PROPENSITY TO CONSUME (MPC) MPC is the ratio of change in total consumption to change in total income. MPC =  TOTAL CONSUMPTION =  C  TOTAL INCOME  Y

CONSUMPTION AND SAVING (cont.) CONSUMPTION FUNCTION Consumption function refers to the relationship between consumption level and income level. The general equation for a linear consumption function can be written as below: C = a + b Y d Disposable income Consumption expenditure Autonomous consumption MPC

CONSUMPTION AND SAVING (cont.) SAVING THEORY Saving is divided into autonomous saving and induced savings. Autonomous saving refers to the part of savings that does not depend on the level of income and occurs when there is autonomous consumption. CONCEPT OF SAVING MARGINAL PROPENSITY TO SAVE (MPS) MPC is the ratio of change in total consumption to change in total income. MPS =  TOTAL SAVING =  S  TOTAL INCOME  Y   AVERAGE PROPENSITY TO SAVE (APS) APS is the ratio of total saving to total income. APS = TOTAL SAVING = S TOTAL INCOME Y  

CONSUMPTION AND SAVING (cont.) CONSUMPTION AND SAVING SCHEDULE Table below shows some relationship between consumption and savings. The sum of APC and APS must be equal to 1.   APC + APS = 1 The sum of MPC and MPS must also equal to one. The equation is as below   MPC + MPS = 1 MPC= (200 -125)/(200-100) =0.75 Disposable Income (Yd) Consumption (C) Saving (S) APC (C/ Yd) APS (S/ Yd) MPC (C/ Yd) MPS (S/ Yd) 50 -50 - 100 125 -25 1.25 -0.25 0.75 0.25 200 1.00 300 275 25 0.92 0.08 400 350 0.88 0.12 500 425 75 0.85 0.15 MPS= (50 -25)/(400-300) =0.25 APC = 125/100 = 1.25 APS= 25/300 =0.08

CONSUMPTION AND SAVING (cont.) SAVING FUNCTION Saving function refers to the relationship between savings and income level. The general equation for a linear consumption function can be written as below.   S = -a + (1- b) Yd DERIVE SAVING FUNCTION FROM CONSUMPTION FUNCTION Given the consumption function: C = 100 + 0.65Yd Saving function : S = -100 + 0.35Yd Disposable income MPS Autonomous saving Saving

CONSUMPTION AND SAVING (cont.) Each point on the 45 degree line indicates a point where disposable income equals to consumption. C National Income C = 100 + 0.65Yd Y=C a=100 200 Saving schedule is vertical difference between the Consumption schedule and the 45 degree line. O Break-even income is the level at which households consume all their incomes. At the point of break-even, (i) Y = C (ii) S = 0 (iii) APC = 1 (iv) APS = 0 S S = -100 + 0.35Yd National Income 200 -100

Distribution of wealth NON-INCOME DETERMINANTS Change in expectations CONSUMPTION AND SAVING (cont.) Price and wage levels Distribution of wealth NON-INCOME DETERMINANTS Changes in consumers’ taste and fashion Consumer credit Change in expectations Rate of interest

INVESTMENT Investment refers to the spending on purchases and accumulation of capital goods such as buildings, equipments and addition to inventories. There are two types of investment: 1. Autonomous Investment Autonomous investment is fixed and independent of income. The amount of investment can be influenced by other factors such as interest rate, repayment rate, business expectation and technology developments. Example of autonomous investment is the capital depreciation.

INVESTMENT (cont.) 2. Induced Investment Induced investment depends on the national income. As national income increases, the induced investment will also increase since higher national income attracts more investors to invest.

FACTORS INFLUENCING INVESTMENT Expectation of the future INVESTMENT (cont.) FACTORS INFLUENCING INVESTMENT Rate of interest Rate of return Government Policies Expectation of the future Technological Changes

GOVERNMENT SECTOR Government sector is another sector that has a major impact on the economy because of its expenditure. Government spending can be classified into two categories, purchases of goods and services and transfer payment. National income can be increased through government spending (as we discussed on the expenditure approach). Government spending is an injection into the spending stream. Government also can reduce the national income through imposing taxes. There are various tax imposed by the government such as direct taxes and indirect taxes. Taxes are leakages from the spending stream. PRINCIPLE OF ECONOMICS

FOREIGN SECTOR Exports are goods and services that are sold to foreign countries. For example, Malaysian made DVD player is sold to Thailand. Exports increase the national income and therefore export is an injection into the spending stream. Imports are goods and services that are purchased from foreign countries. For example, Malaysia buys cars from Germany. Imports reduce the national income and an import is a leakage from the spending stream. Net export is the difference between exports and imports. If net export is positive, exports are greater than imports and if net export is negative, exports are less than imports.

EQUILIBRIUM IN TWO SECTOR ECONOMY Equilibrium in a two-sector economy is a simple economy, which consists of 2 agents only, namely households and firms. Equilibrium occurs when the AD = AS or Leakage = Injection. Factor Market Y = rent, wages, profit, interest FIRM HOUSEHOLD Consumption (C) (1) Saving (S) (2) Investment (I) Product Market Financial Market

EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) AD –AS APPROACH EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) Algebra Analysis Equilibrium is achieved when aggregate demand is equal to aggregate supply. AS = AD Y = C + I Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500 Solution Consumption function, C = 100 + 0.7Yd (In two sector economy, Yd = Y since no tax) Y = C + I = 100 + 0.7Y + 500 Y – 0.7Y = 600 0.3Y = 600 Y = 600/0.3 Y = 2000 EQUILIBRIUM INCOME

EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) AD–AS APPROACH EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) Graphic Analysis  Equilibrium is achieved when aggregate demand is equal to aggregate supply.   AS = AD Y = C + I The equilibrium occurs when the consumption and 45 degree line intersects at RM2000 National Income C = 100 + 0.7Yd Y=AD a=100 2000 AD (C,I) C +I I=500

LEAKAGE - INJECTION APPROACH EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)  Equilibrium is achieved when leakage is equal to injection.   Injection = Leakage I = S Given the following information. Autonomous consumption = 100; MPC = 0.7; Autonomous Investment = 500 Solution: Consumption function, C = 100 + 0.7Yd , so saving function is S = -100 + 0.3Yd I = S 500 = -100 + 0.3Y 0.3Y = 600 Y = 600/0.3 Y = 2000 EQUILIBRIUM INCOME Algebra Analysis

LEAKAGE - INJECTION APPROACH EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) The equilibrium occurs when the saving function and investment function intersect at RM2000. Graphic Analysis Equilibrium is achieved when leakage is equal to injection.   Injection = Leakage I = S National Income S = -100 + 0.3Yd a=100 2000 Leakage-Injection I=500

EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) Tabular Analysis EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) The equilibrium is achieved when AD = AS or I = S When both the AS and AD is same at one level, this is called as equilibrium income. Aggregate Supply (Y) Consumption (C) Saving (S) Investment (I) Aggregate Demand (C + I) Tendency of employment, output and income 100 -100 500 600 Increase 1000 800 200 1400 1500 1150 350 1650 2000 EQUILIBRIUM 2500 1850 650 2350 Decrease 3000 2200 2700 AS = AD and I =S

EQUILIBRIUM IN THREE SECTOR ECONOMY Equilibrium in a three-sector economy consists households, firms and government. Equilibrium occurs when the AD = AS or Leakage = Injection. Factor Market Y = rent, wages, profit, interest Government Expenditure (G) Transfer Payment (G) GOVERNMENT FIRM HOUSEHOLD Taxes (T) Taxes (T) Consumption (C) (1) Savings (S) (2) Investment (I) Product Market Financial Market

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) AD –AS APPROACH EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) Equilibrium is achieved when aggregate demand is equal to aggregate supply. AS = AD Y = C + I + G In three-sector economy, we need to focus on two types of taxes. 1. Autonomous Taxes Autonomous taxes refer to the amount of tax that is independent of income. If the income increases or decreases, autonomous taxes remain constant. For example, Tax = RM100 

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) 2. Induced Taxes Induced taxes refer to the amount of tax that depends on income. If income increases, induced tax will increase and vice versa. For example, Tax = 0.6Y

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) AD –AS APPROACH Algebra Analysis Equilibrium using autonomous tax Given the following information: C = 200 + 0.75Yd ; I = 100; G = 50; T = 100 Solution Y = C + I + G = 200 + 0.75Yd + 100 + 50 = 350 + 0.75(Y –T) = 350 + 0.75(Y – 100) Y – 0.75Y = 275 0.25Y = 275 Y = 275/0.25 Y = 1100 Equilibrium using induced tax Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y Solution Y = C + I + G = 200 + 0.75Yd + 100 + 50 = 350 + 0.75(Y –T) = 350 + 0.75(Y – 0.2Y) = 350 + 0.75(0.8Y) = 350 + 0.6Y Y – 0.6Y = 350 0.4Y = 350 Y = 350/0.4 Y = 875

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) AD –AS APPROACH EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.)   Graphic Analysis Equilibrium using autonomous tax Equilibrium using induced tax C = 200 + 0.75Yd (BEFORE TAX) AD (C,I,G) National Income C = 175 + 0.75Y (AFTER TAX) Y=AD 175 1100 C +I + G 200 325 AD (C,I,G) National Income C = 200 + 06Y (AFTER TAX) Y=AD 875 C +I + G 200 350 C = 200 + 0.75Yd (BEFORE TAX) The equilibrium occurs when AD curve and 45 degree line intersects at RM875. The equilibrium occurs when AD curve and 45 degree line intersects at RM1100.

LEAKAGE – INJECTION APPROACH EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) Algebra Analysis Equilibrium is achieved when leakages are equal to injections Injection = Leakage I + G = S + T Equilibrium using induced tax Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 0.2Y  Solution  I + G = S + T 100 + 50 = - 200+ 0.25Yd + 0.2Y 150 = - 200 + 0.25(Y – 0.2Y) + 0.2Y 150 = -200 + 0.25(0.8Y) + 0.2Y 150 = -200 + 0.2Y + 0.2Y 0.4Y = 350 Y = 875 Equilibrium using autonomous tax Given the following information. : C = 200 + 0.75Yd ; I = 100; G = 50; T = 100 Solution I + G = S + T 100 + 50 = -200 + 0.25Yd + 100 150 = -100 + 0.25(Y – T) 150 = -100 + 0.25(Y – 100) 150 = -125 + 0.25Y 0.25Y = 275 Y = 1100

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) LEAKAGE – INJECTION APPROACH EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) Equilibrium using autonomous tax Graphic Analysis Equilibrium using induced tax S +T = -225 + 0.25Y (AFTER TAX) S = -200 + 0.25Yd (BEFORE TAX) Leakages/Injections National Income -225 1100 I +G -200 150 Leakages/Injections -200 150 S = -200 + 0.25Yd (BEFORE TAX) National Income S +T = -200 + 0.2Y (AFTER TAX) 875 I +G The equilibrium occurs when I+G schedule Intersects with S+T at RM875. The equilibrium occurs when I+G schedule Intersects with S+T at RM1100.

EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) Tabular Analysis EQUILIBRIUM IN THREE SECTOR ECONOMY (cont.) The equilibrium is achieved when AD = AS or I + G = S + T When both the AS and AD is same at one level, this is called as equilibrium income. Aggregate Supply (Y) Taxes (T) Disposable Income (Yd) (Yd = Y-T) Consumption (C) (C = 200+0.75Yd) Saving (S) Investment (I) Government Expenditure (G) Aggregate Demand (C+ I+G) Tendency of employment, output and income 100 200 -200 50 350 Increase 300 -150 500 600 575 -75 725 900 800 950 1100 1000 EQUILIBRIUM 1300 1200 1250 Decrease 1500 1400 250 AS = AD and I+G =S+T

EQUILIBRIUM IN FOUR SECTOR ECONOMY Equilibrium in a three-sector economy consists households, firms, government and foreign sector. Equilibrium occurs when the AD = AS or Leakage = Injection. Foreign Sector Export (X) Factor Market Import (M) Y = rent, wages, profit, interest Govt Expenditure (G) Transfer Payment (G) HOUSEHOLD GOVERNMENT FIRM Taxes (T) Taxes (T) Consumption (C) (1) Savings (S) (2) Investment (I) Product Market Financial Market

EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.) AD–AS APPROACH EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.) Equilibrium is achieved when aggregate demand is equal to aggregate supply. AS = AD Y = C + I + G + (X-M) Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50  Solution Y = C + I + G + (X – M) = 200 + 0.75(Y – T) + 100 + 50 + (100 – 50) = 400 + 0.75 (Y –100) = 400 + 0.75Y – 75 Y – 0.75Y = 325 0.25Y = 325 Y = 325/0.25 Y = 1300 EQUILIBRIUM INCOME Algebra Analysis

EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.) AD–AS APPROACH EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)  Equilibrium is achieved when aggregate demand is equal to aggregate supply. AS = AD Y = C + I + G + (X- M) Graphic Analysis The equilibrium occurs when the aggregate demand (C+I+G+(X-M)) and 45 degree line intersects at RM1300. National Income Y=AD 325 1300 AD (C,I) C +I+G + (X-M)

LEAKAGE-INJECTION APPROACH EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.)  Equilibrium is achieved when leakage is equal to injection. Injection = Leakage I + G+ X = S + T+ M Given the following information. C = 200 + 0.75 Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50    Solution I + G+ X = S + T + M 100 + 50 + 100 = -200 + 0.25(Y-100) + 100 + 50 250 = -75 + 0.25Y 0.25Y = 325 Y = 1300 EQUILIBRIUM INCOME Algebra Analysis

EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.) LEAKAGE-INJECTION APPROACH EQUILIBRIUM IN TWO SECTOR ECONOMY (cont.)   Equilibrium is achieved when leakage is equal to injection.   Injection = Leakage I+G+X = S +T+M Graphic Analysis The equilibrium occurs when the I+G+X schedule and S+T+M schedule intersect at RM1300. I+G+X Leakage-Injection National Income S +T+M -75 1300 250

EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.) Tabular Analysis EQUILIBRIUM IN FOUR SECTOR ECONOMY (cont.) The equilibrium is achieved when AD = AS or I + G + X = S + T + M When both the AS and AD is same at one level, this is called as equilibrium income. Aggregate Supply (Y) Taxes (T) Disposable Income (Yd) Consumption (C) Saving (S) Investment (I) Government Expenditure (G) Exports (X) Imports (M) Aggregate Demand (C+ I+G+ [X – M]) Tendency of employment, output and income 100 200 -200 50 400 Increase 300 350 -150 550 600 500 575 -75 775 900 800 1000 1100 950 1150 1300 1200 EQUILIBRIUM 1500 1400 1250 250 1450 Decrease AS = AD and I+G+X =S+T+M

MULTIPLIER CONCEPT The multiplier is the ratio of the change in income to the change in AD. Multiplier shows how many times the effect of an initial change in AD is multiplied by causing changes in consumption and finally in the aggregate income. The formula for multiplier (K) is, K = Change in Income (Y) Change in Aggregate Demand (AD) The size of multiplier depends upon the size of the marginal propensity to consume (MPC). Higher the MPC, higher is the size of the multiplier and lower the MPC, lower shall be the size of multiplier. K = 1 1 - MPC

INVESTMENT MULTIPLIER MULTIPLIER CONCEPT Investment multiplier refers to the ratio of the change in the equilibrium income to a change in investment. The formula for investment multiplier (Ki) is, Ki = Change in Income (Y) Change in Investment (I) Investment multiplier can also derived as follows:   Investment Multiplier (Ki) = 1 = 1 1-MPC MPS Given, C = 200 + 0.75Y and I = 100. What is the equilibrium income level when there is an increase in investment by 50 million?   Solutions: Y = Ki x I New equilibrium income level = Y + Y = 1/(1-MPC) x I = 1100 + 200 = 1 /(1-0.75) x 50 = 1300 m Y = 200 million Example

MULTIPLIER CONCEPT (cont.) GOVERNMENT EXPENDITURE MULTIPLIER MULTIPLIER CONCEPT (cont.) The government expenditure multiplier refers to the ratio of the change in the equilibrium income to a change in government expenditure assuming there is no change in taxes. Kg = Change in Income (Y) Change in Government Expenditure (G) Government expenditure multiplier can also derived as follows:   Government Expenditure Multiplier (Kg) = 1 = 1 1-MPC MPS Given, C = 200 + 0.75Y; I = 100 and G = 50. What is the equilibrium income level when there is an increase in government spending by 50 million? Solutions: Y = Kg x G New equilibrium income level = Y + Y = 1/(1-MPC) x G = 1100 + 400 = 1 /(1-0.75) x 100 = 1500 m Y = 400 million Example

MULTIPLIER CONCEPT (cont.) TAX MULTIPLIER MULTIPLIER CONCEPT (cont.) Tax multiplier refers to the ratio of the change in the equilibrium income to a change in taxes assuming there is no change in government expenditure.   Kt = Change in Income (Y) Change in Taxes (T) Tax multiplier can also derived as follows:   Tax Multiplier (Kt) = - MPC MPS Given, C = 200 + 0.75Y; I = 100; G = 50 and T = 100. What is the equilibrium income level when there is a tax cut of 50 million?   Solutions: Y = Kt x T New equilibrium income level = Y + Y = -MPC/(MPS) x T = 1100 + 150 = -0.75/(0.25) x 50 = 1250 m Y = 150 million Example

BALANCE BUDGET MULTIPLIER MULTIPLIER CONCEPT (cont.) Balanced budget multiplier refers to the change in the equilibrium income by the same amount as the changes in taxes and government expenditure.   Kb = 1 Given, C = 200 + 0.75Y; I = 100; G = 50 and T =100. What is the equilibrium income level when there is an increase in government spending and taxes by 50 million? Solutions: Tax multiplier Y = Kt x T Net increase in income, Y = -150+200 = -MPC/MPS x T = 50 million = -0.75 /0.25 x 50 Y = -150 million Government Expenditure multiplier Y = Kg x G New equilibrium income level = Y + Y = 1/(1-MPC) x G = 1100 + 50 = 1/(1-0.75) x 50 = 1150 m Y = 200 million Example

INFLATIONARY GAP Inflationary gap occurs when national income exceeds the full employment level. Inflationary gap can be caused by the increase in aggregate expenditure. The inflationary gap is measured as the excess of the aggregate expenditure over the full employment aggregate supply, Yfe. C+I+G +(X-M) National Income Y=AD A Yfe Aggregate Demand C+I+G +(X-M)fe Y B Inflationary Gap Yfe < Y The inflationary gap of AB will increase the general price level. To reduce the inflationary gap of AB, contractionary policy can be implemented. Government can practice contractionary fiscal policy through reducing government expenditure and raise taxes.

DEFLATIONARY GAP Deinflationary gap occurs when national income below the full employment level. The deflationary gap is measured as the difference between the aggregate expenditure over the full employment aggregate supply, Yfe. C +I+G + (X-M) National Income Y=AD C Yfe Aggregate Demand C+I+G+(X-M)fe Y D To reduce the deflationary gap of CD, expansionary policy can be implemented. Government can practice expansionary fiscal policy through increase in government expenditure and tax cut. Deflationary Gap Yfe > Y