1. Lecture 1: Simple Keynesian Model
National Income Determination
Two-Sector National Income Model

2. Outline
Introduction
Preliminaries definitions and concepts
National Income Determination Model OR Simple Keynesian Model
Consumption Function
Investment Function
National Income Identities
Expenditure Function
Equilibrium condition

3. Macroeconomics
Recall that the study of macroeconomics focuses on a set of issues and goals:
National income, general price level and inflation rate, unemployment rate, interest rate and the exchange rate

4. Macroeconomics What is GDP?
Rising long term trend in GDP ensures continuous growth
However, short term characterized by oscillations.
Why does GDP behave as it does?
Rising in some periods and falling in others?
What can governments do to influence it?
To answer, we need a theory of national income
i.e. a theory that explains the size of and changes in national income

5. Key Concepts Expenditure flows
Expenditure flows are real (not nominal) flows
i.e. measured in constant prices because we are concerned with real changes
All expenditure flows are planned (or desired) flows
i.e. what people intend to spend, and not what they actually spend
All expenditure flows are aggregate flows
We are not concerned with the behaviour of individual households or firms

6. Basic Assumptions Potential national income is constant
An economy’s productive capacity changes slowly from year to year
There are unemployed supplies of all factors of production
i.e. output can be increased by increasing use of unemployed land, labour or capital, without bidding up prices
The interest rate and general price level are constant
Assumption relaxed in later studies
There are only households and firms (2-sector).
No government and foreign trade

7. Recap: Circular Flow Model
Underlying assumptions?
Only two economic units and only two markets
Households own all factors of production
Households spend all their resources in the market for goods and services

8. The Circular Flow of Income
This refers to the flow of expenditures on output and factor services passing between domestic firms and households
Any other flow that is not a part of this model is either an injection or a withdrawal/ leakage
Injection
Income received, either by households or firms, that does not arise from the spending of the other group
Withdrawal
Income received, either by households or firms, that is not passed on to the other group by buying goods or services from it

9. The Circular Flow of Income
Only domestic households and firms
Economy produces only 2 kinds of commodities
Consumer goods- produced by firms and sold to households
Investment goods- produced by firms and sold to other firms that use them

10. The Basic Model: The Effects of Savings and Investments
Households receive income from firms and pass back through consumption expenditure
Savings is income received by households that they do not pass back
Savings an injection or withdrawal?
Exerts a contractionary force on the flow of income
Investments expenditure creates incomes for the firms that produce capital goods and for the factors they employ
This income does not arise from household expenditures
Investment expenditures injection into the economy or a withdrawal?
Exerts an expansionary force on the flow of income

11. Definitions
Given assumptions, total output wholly dependent on total demand
Not supply since we assume unemployed factors
Total demand comprises
Desired consumption expenditure, C
Desired investment expenditure, I
Aggregate desired expenditure refers to total amount of purchases that all spending units (firms and households) within the economy wish to make
i.e. E= C + I

12. Behavioural Assumptions about C and I
Autonomous vs Induced expenditures
Autonomous/ exogenous- expenditure flows that are not influenced by any variable the theory is designed to explain
Theory explains variations in national income so any expenditure that does not vary with national income is exogenous
Also called constants. Can change, but not for reasons explained by the national income theory

13. Behavioural Assumptions about C and I
Autonomous vs Induced expenditures
Induced/ endogenous expenditures- any expenditure that is related to national income
Variations in these expenditure flows are induced by changes in national income

14. Behavioural Assumptions about C and I
The Investment, I, component
For now, we assume investment fixed
Firms plan to spend a constant amount on plants and equipment each year
Firms plan to hold their inventories constant
Planned housing construction is constant from year to year
Investment is therefore an autonomous/ exogenous expenditure flow
i.e. I= I*
Graphical Illustration

15. Investment Function: Graphical Illustration
Investment expenditure
I = I*
Real National Income

16. Behavioural Assumptions about C and I
The Consumption, C, component
Consumption is a function of national income
We assume that consumption is always a constant fraction of national income
i.e. C= cY, 0<c<1
Where c is the fraction of income spent on consumption
Households also decide how much of their income to consume and save
i.e. S= sY, 0<s<1 and s= 1-c
Where s is the fraction of income saved
Graphical Illustration of consumption function

17. Consumption Function: Graphical Illustration
Consumption expenditure
Consumption expenditure
C = C’
C = cY
Real National Income
Real National Income

18. Consumption Functions
We know that C= cY
What happens if c  ?
What happens if Y  ?
But what exactly is c?

19. Propensities to Consume and Save
Consumption propensities summarize the relationship between consumption and income

20. Consumption Function Marginal Propensity to Consume MPC = c
It is defined as the change in consumption per unit change in income
It is the proportion of each new increment of income that is spent on consumption
C= cY
MPC = C / Y
Average Propensity to Consume APC= c
It is defined as the ratio of total consumption C to total income Y
It is the average amount of all income spent on consumption
APC = C / Y

21. Consumption Function Relationship between APC and MPC C = cY
Divide by Y to obtain APC
C/Y = c
Differentiate by Y to obtain MPC
C / Y = c
Therefore, when C= cY, APC = MPC = c

22. National Income Identities
An identity is true for all values of the variables
In a 2-sector economy, expenditure consists of spending either on consumption goods C OR investment goods I.
Aggregate expenditure (AE OR E) is ,by definition, equal to C plus I
E  C + I

23. National Income Identities
National income Y received by households, by definition, is either saved S OR consumed C.
Y  C + S

24. National Income Identities
In equilibrium, aggregate expenditure E is, by definition, equal to national income Y
Y  E (output- expenditure approach)
C + S  C + I
 S  I (withdrawals- injections approach)

25. Equilibrium Income
Equilibrium is a state in which there is no internal tendency to change.
It happens when
firms and households are just willing to purchase everything produced Y = E (v.s. Micro: Qs = Qd)
This is the Income-Expenditure Approach
planned saving is equal to planned investment S = I
This is the Injection-Withdrawal Approach

26. Equilibrium Income Y > E  Excess supply
planned output > planned expenditure 
unexpected accumulation of stocks OR
unintended inventory investment OR
involuntary increase in inventories
Firms will reduce output

27. Equilibrium Income Y < E  Excess Demand Firms will increase output
planned output < planned expenditure 
unexpected fall in stocks OR
unintended inventory dis-investment OR
involuntary decrease in inventories
Firms will increase output

28. Equilibrium Income Y= E  Equilibrium
There is no unintended inventory investment OR dis-investment
Y=E

29. Equilibrium Income: Summary
When there is excess supply, i.e., planned output > planned expenditure, firms will reduce output to restore equilibrium
When there is excess demand, i.e., planned expenditure > planned output, firms will increase output to restore equilibrium

30. Aggregate Expenditure Function
Aggregate expenditure is comprised of consumption, C, and Investment, I
i.e. E = C + I
Using functional forms,
C = cY and I = I*
 E = I* + cY
Graphical representation

31. Aggregate Expenditure Function: Graphical Illustration
Slope of tangent = c
C, I, E I C
Slope of tangent=0 Y
I = I*
C = cY
E = I* + cY

32. Readings
Lipsey and Chrystal
Pp:

33. Next Class Output-Expenditure Approach to Income Determination
Expenditure Multiplier
Saving Function
Injection-Withdrawal Approach to Income Determination
Paradox of Thrift