National Income Equilibrium in Closed Economy

Principle of Economics Study Notes

• There will be 20 questions covering Chapter 10.
• The topics include Chapter 10: National Income Equilibrium and Aggregate Expenditure (2 and 3 Sectors Economy)
• Consumption and Saving Functions
• APC, APS, MPC and MPS
• National Income Equilibrium – Table/numerical and Graphical Approach
• Expenditure and Income Approach, Injection and Leakage Approach
• Changes in National Income Equilibrium
• Investment Multiplier, Government Expenditure Multiplier and Tax Multiplier.
• In a closed economy, only households and firms exist, no government intervention or international trade.
• Households use generated income for expenses/consumption (C) and savings (S).
• Y = C + S (output equals consumption plus savings)
• S = Y - C
• C = Y - S
• The relationship between consumption (C) and income (Y) is known as the Consumption Function.
• Circular flow of income in a two-sector economy involves wages, salaries, rent, interest and profit, firm investment, firm savings, household savings, and consumption expenditure.
• Firms produce goods and services using factors of production owned by households, receiving wages, salaries, rent, interest, and profit.
• Households divide their income to consumption expenditure and savings in financial institutions.
• Households receive interest on their savings, which firms utilize for investment.
• Firms also save through undistributed profits.
• Saving is an outflow (leakage), investment is an inflow (injection).
• Consumption function shows the relationship between consumption expenditure and aggregate output/national income.
• Keynesian consumption function links consumption to current income.
• Consumption function is a straight line, where C increases at the same rate as Y.

Consumption and Saving Functions

• The aggregate consumption function illustrates aggregate consumption at the different levels of aggregate income.
• Higher levels of income lead to higher levels of consumption spending.
• A linear consumption function is expressed as C = a + bY.
• 'a' represents autonomous consumption (consumption at Y=0).
• 'b' represents the slope of the line ie. Change in Aggregate Consumption / Change in Aggregate Income (MPC).
• MPC is between 0 and 1.
• MPC measures the change in consumption due to a change in income.
• If MPC is small, the consumption function curve is steep.
• Factors affecting consumption and changes in disposable income cause movement along curve.
• Aggregate consumption increases with an increase in ‘a’, ‘Y’, or MPC.
• S = – a + (1 – b) Y shows a saving function, where ‘a’ is autonomous saving and (1 – b) represents the slope (MPS).
• MPS represents the marginal propensity to save (change in saving / change in income).
• MPS is between 0 and 1.
• Given a, MPC and Y, calculate aggregate consumption (C).
• Aggregate Consumption increases with increases in autonomous consumption or income, or with increases in MPC.

MPC, MPS, APC and APS (study)

• APC = total consumption/total income
• MPC = change in total consumption / change in total income
• APS = total saving/total income
• MPS = change in saving/change in income
• APC + APS = 1
• MPC + MPS = 1
• Tables show relationships between consumption, saving, APC, APS, MPC, and MPS.

National Income Equilibrium (Y=AE Approach)

• For a closed economy, AE = C + I + G.
• In equilibrium, aggregate expenditure equals aggregate output (Y = AE).
• Aggregate output is the total quantity of goods and services produced.
• Aggregate income is the total income received by all factors of production.

Components of Aggregate Expenditure Model

• Consumption is determined by factors like disposable income, and wealth.
• Consumption tends to rise with wealth, expected future income, and future price.
• Interest rate has a negative relationship with consumption.
• Planned investment is purchases of new buildings, equipment, and inventories.
• Two types of investment: autonomous (fixed and independent of income); induced (depends on national income).
• Factors influencing planned investment include interest rate, expected risk, and inventory change.
• Inventory change = production – sales.
• Government expenditure is the government's spending.
• Net taxes are taxes paid minus transfer payments.
• Taxes can be proportionate (percentage of income) or lump-sum (fixed amount).
• Disposable income (Yd) = total income (Y) – taxes (T).
• AE = C + I + G
• In equilibrium, AE = Y.

Two-Sector Economy (Algebra Analysis)

• Given S and I, calculate national income equilibrium.
• S=I
• Given S = -500 + 0.5Y and I = 100, solve for equilibrium Y.
• Y = 1200 (using S = I approach)

Two-Sector Economy (Graphic Analysis)

• The 45° line represents where Y = AE.
• Equilibrium is where AE crosses the 45° line.

Three-Sector Economy (Algebra Analysis)

• In a closed economy with government spending and taxes (T), AE = C + I + G.
• In equilibrium, Y = C + I + G.

Three-Sector Economy (Graphic Analysis)

• AE curve shifts upward when G increases.
• Equilibrium occurs at the intersection of AE and TP.

The Multiplier

• When autonomous expenditure changes, equilibrium expenditure and GDP also change.
• Change in equilibrium expenditure is proportionally larger than the change in autonomous expenditure.
• The multiplier is how much autonomous expenditure magnified the impact on the equilibrium expenditure.
• The formula for the multiplier (K) is K= 1 / (1-MPC) or K= 1/MPS.
• Proportionate taxes will reduce the multiplier.
• Based on lump-sum taxes, the multiplier is larger.

The multiplier for government spending

• Similar to the planned investment multiplier.
• Using the formula 1/(1 - MPC) or 1/MPS.
• Government spending multiplier formula: ΔY= 1/(1 - b)XG, (proportionate tax) : ΔY = 1/(1 – b + bT) ΔG

The multiplier for taxes

• Tax multiplier is used to compute the changes in equilibrium income due to changes in taxation.
• Using the formula -MPC/(1 – MPC) lump sum taxes formula.
• Proportionate Taxes formula: ΔY=-b/(1 – b + bT)ΔT

Balanced-budget multiplier

• The balanced budget multiplier is 1 because the change in Y is the same size as the initial change in G or T.

Equilibrium (using autonomous tax)

• The equilibrium is achieved when the AE curve intersects with the S+T line.
• Equilibrium occurs where the AE line crosses the TP line.

Equilibrium (using induced/proportionate taxes)

• Equilibrium occurs where the AE curve intersects with the S + T line.