2.

Income determination in Short run: Basic model

Dr. U.B. Raju

*Compiled from different published sources *Strictly for academic purpose and for restricted private circulation

Aggregate Expenditure and Equilibrium Income

Definition of aggregate expenditure and equilibrium income How the economy adjusts to its equilibrium position. How changes in aggregate expenditure affect equilibrium income.

Aggregate Expenditure and Equilibrium National Output

Aggregate expenditure (AE)
total amount that all economic agents want or plan to spend on domestic goods and services. the planned spending of
households, firms, government, and foreigners.

Aggregate Expenditure
AE = C + I + G + (X-M)
consumption (C), investment (I), government spending (G), and exports less imports (X-M).

Note that AE is not the same as GDP.

AE represents planned spending GDP represents actual spending or output.

Aggregate Expenditure (AE) and National Output (Y)

AE and Y are not necessarily equal:
Firms formulate their production plans with an estimate of the quantities that people want to buy. A mistake on their part will cause production to exceed or fall below the amounts that people want to buy.

What if AE and Y are not equal?

If AE < Y
people want to buy less than what has been produced so firms will accumulate inventories. firms will reduce production

If AE >Y
What people want to buy is greater than actual production so inventories will decline. firms will increase production

Equilibrium National Income

AE = Y Can be depicted by the intersection between the AE schedule and the 45 degree line

The

0 45

line

The 45-degree line is a tool that assists us in identifying the economy's equilibrium position. Property: every point along this line depicts a situation wherein the value of the variable on the horizontal axis (in this case actual output, (Y) is equal to its counterpart on the vertical axis (AE).

450 line 200

100

450

100

200

AE

Aggregate expenditure (in Rs)

E0 20 AE

45 Y 0 20 Y* Output, income (in Rs)

Equilibrium Income (Y*)

When AE is equal to Y
there is no reason for firms to adjust production. this suggests that the economy is in equilibrium.

Equilibrium requires the equality between income and aggregate expenditure. That is, Y = AE.

Changes in AE and Income

Suppose that the economy's aggregate expenditure schedule shifts upward AE0 to AE1, Equilibrium point will move from E0 to E1. As a result, the economy experiences an increase in equilibrium income from YO* to Y1*

AE

Aggregate expenditure (in pesos)

E1 30 E0 20 AE0 AE1

45 Y 0 20 Y0 30 Y1

Output, income (in pesos)

Consumption and Income

Keynes (1936) suggested that consumption spending (C) tends to increase with income.
In other words, households with higher incomes tend to spend more. There is a positive relationship between consumption spending and income

TABLE 9.1. Consumption and income (1) Income (Y) 0 200 400 600 800 1,000 1,200 1,400 1,600 (2) Consumption (C) 200 350 500 650 800 950 1,100 1,250 1,400 (3) Change In income (Y) 200 200 200 200 200 200 200 200 (4) Change in consumption (C) 150 150 150 150 150 150 150 150 (5) mpc (C/Y) _ 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75

Consumption and income

Higher levels of income correspond to higher levels of consumption spending When income is equal to zero, consumption spending is equal to 200. Consumption spending and income are equal at each other when income = 800.
When income is less than 800, consumption is higher than income. When income is greater than 800, consumption less than income

Y
1600 1400 1200 1000 800 Consumption Spending 600 400 200

450

Y
400 800 Output, Income 1200 1600

THE CONSUMPTION SCHEDULE

Consumption and Income Observations from values above: (a) autonomous consumption spending component of consumption spending that does not depend on income - equal to 200 in example (b) marginal propensity to consume (mpc) shows the increase in consumption spending for a one rupee increase in income;

Marginal Propensity to Consume

MPC or the marginal propensity to consume represents the change in consumption spending that arises from a one rupee change in income.

(C mpc ! (Y

Value of MPC is between 0 and 1. MPC=0.75 means that a one rupee increase in income leads to a 75 paise increase in consumption spending.

Marginal propensity to consume

In example above, C = 150 for Y = 200. Hence,
(C 150 MPC ! ! ! 0.75 (Y 200

Consumption Function
Consumption Function: C = c + mpc.Y C = 200 + 0.75Y

Savings and Income

Sum of consumption spending and savings (S) must equal income. In symbols, Y = C + S. Subtracting C from both sides of this equation leads to S = Y - C.

Relationship bet. Income and Savings

(1) (2) (3) (4) (5) (6) MPS

Y
0 200 400 600 800 1000 1200 1400 1600

C
200 350 500 650 800 950 1000 1200 1400

S
-200 -150 -100 -50 0 50 100 150 200

Y
200 200 200 200 200 200 200 200

C
150 150 150 150 150 150 150 150

S
50 50 50 50 50 50 50 50

S Y
0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25

Savings and income

Savings - that component of income that is not allocated to consumption. S=YC How is savings linked to income? oY p oS.

Savings and Income

Marginal propensity to save (MPS) is the increase in savings for a one rupee increase in income; In the example above, S = 50 for Y = 200. Implies that

(S 50 ! ! 0.25 MPS ! (Y 200

Savings function
Note: MPC+MPS = 1 Savings schedule listing of values of savings at each levels of income Savings function in equation form S = -200 + .25Y

Relationship between mpc and mpc

Y !CS (Y ! (C  (S ( Y (C (S !  ( Y (Y (Y 1 ! mpc  mps

Propensity to Save
S S

150 Savings (in rupees)

0 -50 400 800 1,200 1,600

-200

Income (in rupees)

The determination of equilibrium income in a two-sector economy

Two sector economy - households and firms only Implies that AE is given by: AE = C + I Assume that I is autonomous and equal to 100 In equilibrium, Y = AE p equilibrium income (Y*) = 1200

Table 9.3 Consumption, Investment and Equilibrium Income.

Y 400 600 800 1,000 1,200 1,400 C 500 650 800 950 1,100 1,250 S -100 -50 0 50 100 150 I 100 100 100 100 100 100 AE 600 750 900 1,050 1,200 1,350

AE E0 y

C+I = AE C

y (A) 300 200 45 0 S, I S 100 0 -200 Y* Income E0 y y 800 1,200 1,600 I Y (B) 400 800 1,200 Y* 1,600

Investment and Multiplier

Suppose that investment I increases from 100M rupees to 200M rupees What happens to equilibrium income? Equilibrium income Y* will increase
Not by 100M But by a multiplied amount!!

WHY???

Table 9.4 Effects of a 100 rupee increase in investment.

Y 400 600 800 1,000 1,200 1,400 1600 1800 C 500 650 800 950 1,100 1,250 1400 1550 S -100 -50 0 50 100 150 200 250 I 200 200 200 200 200 200 200 200 AE 700 850 1000 1150 1300 1450 1600 1750

AE

Y
AE1
E1 B E0 A

Aggregate Expenditure (in pesos)

AE0

400 300

I=100

45o

Y=400 1200 1600

Y*0

Y*1

The effect of an increase in investment

Calculation of equilibrium income

In numerical example,
1 Y ! (C  I ). 1  mpc 1 !E n multiplier 1 mpc
*

C ! 200, I ! 100,mpc ! 0.75 1 Y* ! (200  100) ! 1,200 1  0.75

 For I = 200, Y* = 1,600 Hence, if Io from 100 to 200 p Y*o from 1200 to 1600. In other words,

( I ! 100 (Y* ! 400

The concept of the multiplier

Increase in Y is greater than increase in I. Why? Multiplier (E) - measures the change in equilibrium income as a result of a one-rupee change in the sum of the autonomous components of AE;

(Y E! (I

Calculation of the multiplier:

1 1 E! ! 1  mpc mps

Calculation of multiplier
With the mpc = 0.75,

1 E! !4 1  0.75
The multiplier is used determine the amount by which Y* changes in response to a change in investment.

(Y* ! E ( I

1 (Y ! (I ! E (I 1  mpc

The Paradox of Thrift

Many people believe that higher savings lead to higher income. In the present model, we get a result that is contrary to this belief. In other words, equilibrium income falls when people want to save more. Idea: the attempt to achieve higher savings may reduce equilibrium income

S,I

S1 S0 I

Savings

Y1

Y0

Income

The Paradox of Thrift

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Unemployment and Inflation the Phillips Curve

NAIRU(non-accelerating inflation rate of unemployment) arose to explain how Stagflation could occur. The latter theory, also known as the natural rate of unemployment", distinguished between the "short-term" Phillips curve and the "long-term" one. The short-term Phillips Curve looked like a normal Phillips Curve, but shifted in the long run as expectations changed. In the long run, only a single rate of unemployment (the NAIRU or "natural" rate) was consistent with a stable inflation rate. The long-run Phillips Curve was thus vertical, so there was no trade-off between inflation and unemployment. Edmund Phelps won the Nobel Prize in Economics in 2006 for this.

GDP and Unemployment The negative relationship between unemployment and output is called Okuns law: Typically, as per US statistics, for every percentage point the unemployment rate rises, real GDP growth typically falls by 2 percent

Inflation (respectively, deflation) is a sustained increase (respectively, decrease) in the general price level over a period of time. Disinflation is a slowing of the rate of inflation. Demand pull inflation is inflation caused by sustained or continual increases in aggregate demand. Cost push inflation is inflation caused by sustained or continual decreases in SR aggregate supply.

Concept of business/trade cycle According to J.M.Keynes A trade cycle is composed of periods of good trade characterised by rising prices & low unemployment percentages with periods of bad trade characterised by falling prices & high unemployment rate. Business cycles are recurrent but irregular fluctuations in economic activity & occurs one after another The time span of the period & phases may vary

The Business Cycle

Business cycle is the rise and fall of economic activity relative to the long-term growth trend of the economy

The Business cycle is the rise and fall of economic activity

Phases of Business Cycles Expansion (Boom, Upswing or Prosperity) Peak (Upper Turning Point, when economic activity begins to slow down) Contraction (Downswing, Recession or Depression) Trough (Lower Turning Point, when economic activity begins to rise) Features of Business Cycles Business cycles are irregular in nature Fluctuations occur in a number of other variables simultaneously apart from production Investment & Consumption of durable goods are more affected Investment & Consumption of non durable goods are much less affected Immediate effect on the level of inventory stock Profits fluctuate more than any other incomes

Causes of Business Cycles

There are many theories suggesting explanations for business cycles. Climatic changes Under consumption Over Investment Keynes theory of effective demand, particularly investment Booms/recessions can be generated by rise/fall in government expenditure, fiscal policy. Similarly, a wave of optimism/pessimism can cause consumers to spend more/less than usual. Similarly, firms may invest more (build up new capacities)/disinvest. Another possible cause of recessions and booms is monetary policy. A firm faced with high interest rates may decide to postpone building a new factory. Households may be lured by cheap housing loans, and construction activities may boom.

Movements of Certain Macro economic Variables during Business Cycles

Procyclical- Variables have positive correlation... Countercyclical- Variables have negative correlation. Unemployment is countercyclical. Acyclical- Variables have zero correlation,.

Variables can be classified as leading, coincident or lagging variable. Leading Indicator: which occurs ahead of the occurrence of business cycle variable. Coincident Indicator: which move up and down along with the business cycle variable. Lagging Indicator: which follow the business cycle variable after some time lag.

Leading Indicators Housing starts New orders for plant and equipment stock prices demand for consumer durables consumer expectations New employment Deliveries by Companies Index of consumer confidence Money growth rate (M2) Coincident Indicators Nonagricultural employment Index of industrial production Personal income Manufacturing and trade sales Lagging Indicators Wage rates Rate of inflation Consumer credits Lending rates Outstanding loans

Cross Classification of Indicators Items Industrial output Capacity utilization Employment Unemployment Inflation rate Corporate profits Short-term interest Share price Capital stock Direction of change procyclical procyclical procyclical countercyclical procyclical procyclical procyclical procyclical acyclical Time of occurrence coincident coincident coincident coincident lagging coincident lagging Leading lagging