2. CHAPTER 12
NATIONAL INCOME EQUILIBRIUM

3. 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

4. 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.

5. 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

6. 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

7. 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

8. 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= ( )/( ) =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)/( ) =0.25
APC = 125/100 = 1.25
APS= 25/300 =0.08

9. 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 = Yd
Saving function : S = Yd
Disposable income
MPS
Autonomous saving
Saving

10. CONSUMPTION AND SAVING (cont.)
Each point on the 45 degree
line indicates a point
where disposable income
equals to consumption. C
National Income
C = Yd
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 = (iv) APS = 0 S
S = Yd
National Income
200
-100

11. 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

12. 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.

13. 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.

14. 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

15. 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

16. 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.

17. 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

18. 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 = Yd (In two sector economy, Yd = Y since no tax)
Y = C + I
= Y + 500
Y – 0.7Y = 600
0.3Y = 600
Y = 600/0.3
Y = 2000 EQUILIBRIUM INCOME

19. 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 = Yd
Y=AD
a=100
2000
AD (C,I)
C +I
I=500

20. 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 = Yd , so saving function is S = Yd
I = S
500 = Y
0.3Y = 600
Y = 600/0.3
Y = EQUILIBRIUM INCOME
Algebra Analysis

21. 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 = Yd
a=100
2000
Leakage-Injection
I=500

22. 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

23. 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

24. 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 

25. 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

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

27. 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 = Yd (BEFORE TAX)
AD (C,I,G)
National Income
C = Y
(AFTER TAX)
Y=AD
175
1100
C +I + G
200
325
AD (C,I,G)
National Income
C = Y
(AFTER TAX)
Y=AD
875
C +I + G
200
350
C = Yd (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.

28. 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 = Yd ; I = 100; G = 50; T = 0.2Y
 Solution
 I + G = S + T
= Yd Y
150 = (Y – 0.2Y) + 0.2Y
150 = (0.8Y) + 0.2Y
150 = Y + 0.2Y
0.4Y = 350
Y = 875
Equilibrium using autonomous tax
Given the following information. : C = Yd ; I = 100; G = 50; T = 100
Solution
I + G = S + T
= Yd + 100
150 = (Y – T)
150 = (Y – 100)
150 = Y
0.25Y = 275
Y =

29. 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 = Y
(AFTER TAX)
S = Yd (BEFORE TAX)
Leakages/Injections
National Income
-225
1100
I +G
-200
150
Leakages/Injections
-200
150
S = Yd (BEFORE TAX)
National Income
S +T = Y
(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.

30. 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 = Yd)
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

31. 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

32. 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 = Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50
 Solution
Y = C + I + G + (X – M)
= (Y – T) (100 – 50)
= (Y –100)
= Y – 75
Y – 0.75Y = 325
0.25Y = 325
Y = 325/0.25
Y = 1300 EQUILIBRIUM INCOME
Algebra Analysis

33. 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)

34. 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 = Yd ; I = 100; G = 50; T = 100 ; X = 100; M = 50
 Solution
I + G+ X = S + T + M
= (Y-100)
250 = Y
0.25Y = 325
Y = 1300 EQUILIBRIUM INCOME
Algebra Analysis

35. 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

36. 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

37. 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 - MPC

38. 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-MPC MPS
Given, C = Y 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 =
= 1 /(1-0.75) x = m
Y = 200 million
Example

39. 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-MPC MPS
Given, C = Y; 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-MPC) x G =
= /(1-0.75) x = m
Y = 400 million
Example

40. 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 = Y; 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 =
= -0.75/(0.25) x = m
Y = 150 million
Example

41. 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 = Y; 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 =
= -MPC/MPS x T = 50 million
= /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 =
= /(1-0.75) x 50 = m
Y = 200 million
Example

42. 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.

43. 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