Theory of Income Determination

Class
} Introduction
◦ Business Cycles, Great Depression, Introduction to Keynes
} National Income Determination Model OR Simple
Keynesian Model
◦ Assumptions of SKM
◦ Model of SKM without Government Sector
– Stability analysis
– Equilibrium
– Multiplier Derivations
◦ Paradox of Thrift
◦ Model of SKM with the Government Sector
– Stability Analysis
– Equilibrium
– Multiplier

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} 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;
◦ What is GDP/ NI?
◦ Rising long term trend in GDP ensures continuous growth in economy;
◦ 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;

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} Keynesian economics was developed by the British Economist John Maynard
Keynes during the 1930s to understand the Great Depression;
} The Great Depression was the greatest and longest economic recession in modern
world history. It began with the U.S. stock market crash of 1929 and did not end
until 1946 after World War II. Economists and historians often cite the Great
Depression as the most catastrophic economic event of the 20th century;
} It was during this period that the theory of the Classical economists which centered
around the Say’s Law failed;
} According to Say’s Law, “Supply creates its own Demand”;
} However, despite having large resources there was lack of demand in the market
creating huge unemployment, lowering production and hence depression;
} It was then that Keynes came up with the reasoning behind the cause of “The Great
Depression” to be lack of “Effective Demand”;

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} Effective Demand
◦ The level of demand that represents a real intention to purchase by people with
the means to pay. That is, given the ability to pay and the willingness to purchase
the final demand for a product;
} Principle of Effective Demand
◦ According to this principle, in short-run period, an economy’s aggregate income
and employment are determined by the level of aggregate demand which is
satisfied by the aggregate supply. Total employment of an economy depends on
total demand of that economy;

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 XAV_B.COM._MACRO_UNIT II_DR.JAYITA BIT

} 1. There are only households and firms (2-sector);

} No government and foreign trade;
} Hence the total income of the economy is given by: Y = C+I;
} Where C is the consumption expenditure made by the HHs and I is the investment
expenditure made by the firms;
} 2. There is production of single homogeneous commodity in the
economy;
} This is because our objective is to understand the behaviour of the level of
economic activity and not its composition;
} 3. Investment is independent of income and interest rates
} Investment is autonomous and so we can write: I = I* and
can be represented graphically as:

6
} 4. Short-run time-periods
} Prices are rigid
} No difference between Real and Nominal Values
} 5. Consumption is an increasing function of income
◦ C=C(Y), C’(Y) = △C / △Y and C’(Y)>0;
◦ Rise in C is always less than rise in Y;
◦ Because C cannot change as fast as income changes;
◦ So a portion of income remains excess if income rises;
◦ This portion is used for saving or investment – Y = C+I = C+S;
◦ We can also relate that rich people save more than poor people;
◦ Hence C’(Y) <1;
◦ To conclude, 0< C’(Y)<1;
◦ Again, C’(Y) is called Marginal Propensity to Consume (MPC);

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◦ Again, Y = C+S;
◦ Differentiating both sides with respect to Y, we get,
◦ dY/dY = dC/dY + dS/dY;
◦ => 1 = MPC + MPS;
◦ Hence, MPC cannot exceed 1 as MPS>0;
◦ Also, C is a linear function of Y;
◦ That is, C can be represented as a straight-line equation,
◦ C = a +b.Y;
◦ This implies: (i) when Y = 0, C = a
◦ => Even when the income level is zero, there will be some level of consumption;
◦ This can happen by using past savings or by borrowing;
◦ This part of consumption is known as autonomous consumption and is independent of Y;
◦ (ii) MPC = dC/dY = b and hence 0<b<1;
◦ Again, b is the slope of this straight line;
◦ Hence the consumption function can be graphically represented as:

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◦ Again as, C = a +b.Y;
◦ If we divide both sides by Y, we get,
◦ C/Y = a/Y + b. Y/Y;
◦ => APC = a/Y + b; APC is Average Propensity to Consume
◦ => APC = a/Y + MPC; as MPC = b;
◦ Thus, APC is greater than MPC as a>0 and Y>0;

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} 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 spend
◦ All expenditure flows are aggregate flows
– We are not concerned with the behaviour of individual households
or firms;

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XAV_B.COM._MACRO_UNIT II_DR.JAYITA BIT 11
} Aggregate expenditure or aggregate demand is comprised of consumption,
C, and Investment, I,
i.e. AD = C + I
} Using functional forms,

} C = a + bY and I = I*
} Þ AD = I* + a+ bY
AD
AD
} => AD = (I* + a) + b.Y;

} (a+I*) being y-intercept and b being slope

Slope=b
◦ Graphical representation:

a+I*

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} Aggregate supply of an economy is the actual output produced in the
economy;
} According to the effective demand principle, aggregate demand determines
the actual output;
} Hence, actual output Y = AD;
} That is, AD = Y AD
AD=Y
} => AD = 1. Y
} => AD = tan 450 .Y
} Hence slope being 1 and there is no y-intercept;
Slope=1
◦ Graphical representation:

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} 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
} That is, actual output, Y = AD (v.s. Micro: Qs = Qd)
} Y > AD =>Excess supply
} => planned output > planned expenditure
} => unexpected accumulation of stocks AD AD=Y inv>0
Slope=b
} => unintended inventory investment AD
} => involuntary increase in inventories E
} => Firms will reduce output
inv<0
} Y < AD=> Excess Demand
} => planned output < planned expenditure Slope=1
a+I*
} => unexpected fall in stocks
} => unintended inventory dis-investment
} => involuntary decrease in inventories Y
} => Firms will increase output
What happens if b>1?
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} Y= AD Þ Equilibrium
} There is no unintended inventory investment OR dis-investment
} Y=AD
} Y = (a+I*) + b.Y;
} (1-b)Y = (a+I*)
} Y= (a+I*)/(1-b) =YE ;
} Where YE is the equilibrium level of Income or output in the economy;
} 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;

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} If C=10+0.9Y and I*=60, what is the level of unplanned
inventory at Y=850?
} AD = C+I
} AD = 10 + 0.9Y + 60 = 70 + 0.9Y
} AD = 70 + 0.9 x 850 = 70 + 765 = 835;
} AS: Y = 850;
} So, there is difference between actual output and aggregate demand;
} Hence, there will be unplanned inventory accumulation given by,
} AS – AD = 850 – 835 = 15

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 I,S
S
} Y= C+ S;
} S = Y - C;
} S = Y – (a+b.Y); Slope=1-b
} S = (1-b)Y – a; I=I*
E
} S = -a + (1-b).Y
} Hence slope being (1-b); Y
} => 0<b<1, say 0.25, 0.5, 0.75,etc.; -a
} 1-b = 0.75, 0.5, 0.25 respectively;
} => positive slope;
} And there is negative y-intercept;
◦ Graphical representation:
◦ Since we can draw I and S on the same plane, we have incorporated the
investment function;
◦ I intersects S at E;
– We can consider E to be equilibrium as I = S at the level of equilibrium;

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} If C=12+4/5Y and I*=20, what are the values of autonomous
saving and MPS?
} What is the level of equilibrium?
} S= -a + (1-b).Y
} S= -12 + (1-4/5).Y
} S=-12 + 1/5.Y;
} Therefore, the value of autonomous saving is -12 and MPS is 1/5.
} Level of equilibrium income, YE = (a+I*)/ (1-b)
} = (12+20)/(1/5)
} = 32 x 5 = 160.

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 S’
I,S
} What happens if people become thrifty? S
} They save more or want to save more;

} That is, either the autonomous saving increases,

} Or the marginal propensity to save increases; Slope=1-b

} We know, S = -a + (1-b).Y; I=I*
} 1)If autonomous saving increases, the value of
E’ E
-a rises and comes near origin;
} There is no change in slope;
Y2 Y1 Y
-a
} Therefore, savings function will parallelly shift to left;

} Given, I=I*, the new equilibrium will be obtained at E’;

} Hence, there will be loss in income (Y1 falls to Y2);

} While the total saving in the economy remains to be same given I =I*;

} Thus, we find that if individuals save more, individually their saving increases, but the total
saving of the economy remains unchanged and total income falls making the situation non-
beneficial for the society;
} Thus, the situation is paradoxical (self-contradictory) in nature;

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} 2)If mps increases, the value of (1-b) rises;
} Slope of saving function increases but no change in autonomous saving (-a);

} Therefore, savings function will rotate to left;

} Given, I=I*, the new equilibrium will be obtained at E’;

} Hence, there will be loss in income (Y1 falls to Y2);

} While the total saving in the economy remains to be same given I =I*; S’
} Thus, we find that if individuals save more,
I,S
} individually their saving increases,
S
} but the total saving of the economy remains unchanged

} and total income falls making the situation

} non-beneficial for the society;

Slope=1-b
} Thus, the situation is paradoxical in nature; I=I*
} Hence paradox of thrift states that E’ E
individuals try to save more during an economic recession,
which essentially leads to a fall in aggregate demand Y2 Y1 Y
-a
and hence in economic growth.

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} What happens if the autonomous investment rises?
} AD = C(Y) + I*;
} So, AD rises if the value of I* rises;
} If I* rises by △I, AD (AD*) rises by △I;
} Since there is no change in mpc(b), so AD parallely shifts to AD*;
} The new equilibrium is created at E*; AD=Y
} Then equilibrium output rises from YE to YE;* E*
AD AD*
} And the change in output is given by △Y; Slope=b
} From the diagram, we can understand △Y>△I;
AD
} So, when investment rises, Y rises but
E
} Y rises more than the rise in investment; △I
} WHY?
} This is because: Slope=1 △Y
a+I*
} If the investment increases its spending,
incomes and consumption will spiral upward
in multiple rounds of earning and spending; YE YE * Y
} Once the process has played itself out, the economy’s equilibrium income will be
higher by some multiple of the initial investment spending;
  Thus, this is called INVESTMENT MULTIPLIER;
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◦ Say, I increases by 100,
◦ Y increases by C + 100 in the first round;
◦ But as Y increases by 100, C also rises as C depends on Y;
◦ But C rises by b.Y;
◦ Let b be 0.8;
◦ Then, C rises by 0.8x100 = 80;
◦ Now this rise in C will again increase Y;
◦ Then in the second round, Y rises more by 80;
◦ So, at the end of second round, Y in total rises by 100+80=180;
◦ As Y have increased by 80 more in the second round, so C will rise by 0.8x80=64 more in the
third round;
◦ So, at the end of 3rd round, Y will again increase by 64;
◦ Thus:

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 Increase in C/I Increase in Y
100.00 (I) 100.00
Let the MPC be 0.80. 80.00 180.00
64.00 244.00
Suppose that investment spending 51.20 295.20
increases by 100. 40.96 336.16
32.77 368.93
By how much will income increase? 26.21 395.14
20.97 416.11
That is, what DY is implied by a DI 16.78 432.89
of 100. 13.42 446.31
10.74 457.05
8.59 465.64
6.87 472.51
5.50 478.01
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Y = C + I, where C = a + bY
Eq. 1.: Y = a + bY + I
Suppose I changes by DI such that Y changes by DY. The new equation is:
Eq. 2.: Y + DY = a + b(Y + DY) + I + DI
Eq. 2.: Y + DY = a + bY + bDY + I + DI
Now, how do you find the difference between Equation 1 and Equation 2?
Eq. 2.: Y + DY = a + bY + bDY + I + DI
Eq. 1.: Y = a + bY +I

DY = bDY + DI
DY - bDY = DI
(1 – b )DY = DI
DY = [ 1/(1 – b )] DI

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Y = C + I, where C = a + bY
Y = a + bY + I
Differentiating both sides with respect to I,
dY/dI = da/dI+b.(dY/dI) + dI/dI
Or, dY/dI = 0 + b. (dY/dI) + 1
Or, dY/dI = 1+ b.(dY/dI)
Or, (1-b)dY/dI = 1
Or, dY/dI = 1/(1-b)
Or, dY = {1/(1-b)}.dI;
Thus, if I changes by dI, dY changes by {1/(1-b)}.dI;
Since 0<b<1, 0<(1-b)<1, [1/(1-b)]>1;
Hence Y rises more than I;

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} 1. There are three sectors: households, firms and government;
} 2. There is production of single homogeneous commodity in the economy;
} 3. Investment is independent of income and interest rates;
} 4. Government expenditure is autonomous in nature;
} G = G* is a horizontal straight line parallel to the income axis;

} 5. Short-run time-periods;
} 6. Consumption is an increasing function of disposable income;
} C=C(Y-T), C’(Y-T)>0; T for lump-sum tax;
} 0< C’(Y-T)<1;

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26
} C=C(Y-T);
} C = a + b(Y-T)
} = a + b.Y – b.T;
} C = (a – b.T*) + b.Y; lumpsum taxes are autonomous;
} Then slope remaining to be b but y-intercept changes to (a-b.T*);
} Graphical representation:

a – b.T*

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27
} Aggregate expenditure or aggregate demand is comprised of consumption,
C, Investment, I, and Government expenditure, G
i.e. AD = C + I + G
} Using functional forms,

} C = a + b(Y-T*), I = I* and G=G*

} Þ AD = G*+ I* + a+ b(Y-T*)
AD
AD
} => AD = (G* + I* + a – b.T*) + b.Y;

} (a – b.T*+I*+G*) being y-intercept and b being slope

Slope=b
◦ Graphical representation:

a-b.T*+I*+G*

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} Aggregate supply of an economy is the actual output produced in the
economy;
} According to the effective demand principle, aggregate demand determines
the actual output;
} Hence, actual output Y = AD;
} That is, AD = Y AD
AD=Y
} => AD = 1. Y
} => AD = tan 450 .Y
} Hence slope being 1 and there is no y-intercept;
Slope=1
◦ Graphical representation:

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} Y= AD Þ Equilibrium
} There is no unintended inventory investment OR dis-investment
} Y=AD
} Y = (a – b.T*+I*+G*) + b.Y;
} (1-b)Y = (a – bT*+I*+G*)
} Y= (a-bT*+I*+G*)/(1-b) =YE ;
} Where YE is the equilibrium level of Income or output in the economy;
} 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; AD AD=Y inv>0
Slope=b
AD
E

inv<0

Slope=1
a–b.T*+I*+G*

Y
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30
Y = C + I + G, where C = a + b(Y-T)
Y = a + bY - bT + I +G
Differentiating both sides with respect to I,
dY/dI = da/dI + b.(dY/dI) – [Link]/dI+ dI/dI + dG/dI
Or, dY/dI = 0 + b. (dY/dI) – 0 + 1 + 0; since a, T and G are constants;
Or, dY/dI = 1+ b.(dY/dI)
Or, (1-b)dY/dI = 1
Or, dY/dI = 1/(1-b)
Or, dY = {1/(1-b)}.dI;
Thus, investment multiplier remains the same in both the SKM models
with and without government;

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Y = C + I + G, where C = a + b(Y-T)
Y = a + bY - bT + I + G
Differentiating both sides with respect to G,
dY/dG = da/dG + b.(dY/dG) – [Link]/dG+ dI/dG + dG/dG
Or, dY/dG = 0 + b. (dY/dG) – 0 + 0 + 1; since a, T and I are constants;
Or, dY/dG = 1+ b.(dY/dG)
Or, (1-b)dY/dG = 1
Or, dY/dG= 1/(1-b)
Or, dY = {1/(1-b)}.dG;
Thus, government expenditure multiplier is same as the investment
multiplier depending on the values of mpc;

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Y = C + I + G, where C = a + b(Y-T)
Y = a + bY - bT + I + G
Differentiating both sides with respect to T,
dY/dT = da/dT + b.(dY/dT) – [Link]/dT+ dI/dT + dG/dT
Or, dY/dT = 0 + b. (dY/dT) – b + 0 + 0; since a, G and I are constants;
Or, dY/dT = b.(dY/dT) – b;
Or, (1-b)dY/dT = -b;
Or, dY/dT= -b/(1-b);
Or, dY = {-b/(1-b)}.dT;
Thus, Tax multiplier works negatively on the values of Y;
If b=0.1, b/(1-b) =0.1/(1-0.1) = 0.1/0.9=1/9<1;
Thus, when b<0.5,if tax rises, Y decreases less than the increase in the amount of tax;
But if b=0.8, b/(1-b) = 0.8/(1-0.8)=0.8/0.2 = 4>1;
Thus, when b>0.5, if tax rises, Y decreases more than the increase in the amount of tax;
And if b=0.5, 1-b=0.5, b/(1-b)=1, hence dY=-dT;

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By balanced budget we mean, T=G
Or, △T = △G;
Now if both tax and government expenditure increases by the same amount, then
what will be the impact on Y?
G has a positive impact on Y while T has negative impact on Y;
Again, the multiplier values of G and T are different;
So, when both G and T increases by the same amount, the impact of Y must be
calculated:
△Y=△Y⎮△G + △Y⎮△T;
△Y = {1/(1-b)}.△G + {-b/(1-b)}.△T;
△Y = {1/(1-b)}.△G + {-b/(1-b)}.△G;
△Y = [{1/(1-b)}-{b/(1-b)}].△G;
△Y = {(1-b)/(1-b)}. △G;
△Y = 1. △G;
Thus, the value of balanced budget multiplier is unity;
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1. Suppose the level of autonomous investment in an economy is 200 crores of
rupees and consumption function of the economy is: C = 80 +0.75Y.
(a) What will be the equilibrium level of income?
(b) What will be the increase in NI if investment increases by 25 crores of
rupees?
Ans: (a) YE = (a+I) / (1-b)
= (80+200)/ (1-0.75)
= 280/0.25
= 1120 crores of rupees;
(b) Increase in NI, △Y = (1/1-b) . △I
= (1/1-0.75). 25
= (1/0.25).25
= 100 crores of rupees

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2. Suppose C = 10 +0.75Yd; T = 10%, I*=G*=10. Calculate the impact on
equilibrium output if
(a) The tax rate is raised to 20%.
(b) Autonomous C falls to 5 due to an increase in the propensity to save.
Ans: (a) Tax Multiplier = -b/1-b = -0.75/1-0.75 = -0.75/0.25 =-3;
△Y = -3.△T = -3 .(20-10) =-3x10=-30.
Thus, equilibrium level of output decreases by 30%.
(b) Initial YE = (a-bT+I+G) / (1-b)
= (10 -0.75x10 +10+10)/ (1-0.75)
= (10-7.5+20)/0.25
= 90
Final YE = (a-bT+I+G) / (1-b)
= (5 -0.75x10 +10+10)/ (1-0.75)
= 70;
Thus, the change in equilibrium output is -20.
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