Principles of Economics Chapter 10 PDF

CHAPTER 10 National Income Equilibrium and Aggregate Expenditure (2 and 3 Sectors Economy) INTHISLECTURE Consumption and Saving Functions APC, APS, MPC and MPS National Income Equilibrium – Table/numerical and Graphical Approach: Expenditure and...

CHAPTER 10 National Income Equilibrium and Aggregate Expenditure (2 and 3 Sectors Economy) INTHISLECTURE 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 THE CONSUMPTION AND SAVING FUNCTION In A closed economy, there are only households and firms sector. No government intervention and does not involve international trade (exports and imports). In this economy, households will generate income and use it to; a) expenses / consumption (C) b) saving (S) THE CONSUMPTION AND SAVING FUNCTION Then, for the household sector in two sectors’ economy: S=Y-C C=Y-S Y=C+S The relationship between consumption (C) and income (Y) is known as the ‘Consumption Function‘. THE CONSUMPTION AND SAVING FUNCTION The circular flow income in two sector’s economy WAGES AND SALARIES, RENT, INTEREST AND PROFIT Firm’s investment FIRM FINANCIAL HOUSEHOLD Firm’s saving INSTITUTIONS Household’s saving CONSUMPTION EXPENDITURE THE CONSUMPTION AND SAVING FUNCTION Based on circular income flow diagram, the firm will produce goods and services using the of factors of production owned by the households. As a reward, households will receive wages and salaries, rent, interest and profit. Income received by households divided to: 1. Consumption expenditure. 2. Savings in financial institutions. Household savings will be lent to the firm to make investments, as a reward, households will receive interest on their savings. THE CONSUMPTION AND SAVING FUNCTION In addition, the firm will also make savings by keeping some of the profit that are not given to shareholders (undistributed profits). This savings is used to replace capital that has accumulated or purchasing new capital (re-use savings to make investments). Saving represent an outflow (leakage) from the circular flow of income and investment represent inflow (injection) to the circular flow of income. THE CONSUMPTION AND SAVING FUNCTION Consumption function is a curve that shows the relationship between the level of household consumption expenditure (C) with an aggregate output level / national income (Y). Keynesian consumption function relate consumption of households with their current income. The consumption function is a straight line curve, which shows consumption (C) will increase at the same rate for each additional output (Y). Ex: Each time output increased by RM1,000, consumption will increase by RM500. THE CONSUMPTION AND SAVING FUNCTION Consumption function/plan The relationship between consumption and income.  FIGURE 10.1 A Consumption Function for a Household A consumption function for an individual household shows the level of consumption at each level of household income.  THE CONSUMPTION AND SAVING FUNCTION The general equation for a linear consumption function can be written as below: C = a + bY  FIGURE 10.2 An Aggregate Consumption Function The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending. THE CONSUMPTION AND SAVING FUNCTION Consumption function C = a + bY for example, C = 800 + 0.8Y Where: Y = aggregate output / income C = aggregate expenditure / consumption a = autonomous consumption / consumption at level Y = 0 / the point where the consumption function intercepts the axis C. b = The slope of the line, ie ΔC / ΔY or MPC. b> 0, 0, (Planned investment), (Change in inventory) is positive If (Actual investment) < (Planned investment), (Change in inventory) is negative NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Government Expenditure and Taxation Government expenditure (G) refers to the amount of money spend by government in an economy. Net taxes (T) refer to taxes paid by firms and households to the government minus transfer payments made to households by the government. It can be in the form of proportionate (percentage of income) or lump-sum (certain fixed amount independent of income). With taxes, only the income after paying taxes can be spend, which is called disposable, or after-tax income (Yd). Disposable income equal to total income minus taxes: Yd ≡ Y – T NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Government Expenditure and Taxation The aggregate expenditure (AE) equal: C + I + G. Adding taxes to the consumption function [C = a + bY] and saving function [S = – a + (1 – b) Y] will change both functions into a function of disposable income (Yd). For a lump sum tax, the respective consumption and saving function will be as follows: Consumption function with lump sum taxes: C = a + bYd C = a + b(Y – T) NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Government Expenditure and Taxation Saving function with lump sum taxes: S = – a + (1 – b) Yd S = – a + (1 – b) (Y – T) The value of b (which is the MPC) will not be affected when taxes are in the form of lump sum.  NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Government Expenditure and Taxation However, if it is proportionate taxes, the value of b (or MPC) will alter slightly depending on the percentage of proportionate taxes. For instance, assuming the consumption function is C = 100 + 0.75Yd and taxes imposed by the government is 10% of income. The consumption function will then be: C = 100 + 0.75(Y – 0.1Y) C = 100 + 0.75(0.9Y) C = 100 + 0.68Y NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Equilibrium occurs when there is no tendency for change. In the macroeconomic goods/services market, equilibrium occurs when planned aggregate expenditure (AE) is equal to aggregate output (Y) ; Y = AE. Assume that our economy is a closed-economy without taxes (two sectors). NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Two sector economy: Algebra Analysis Given C = 500 + 0.5Y and I = 100, calculate national income equilibrium. Y = AE Y=C+I Y = 500 + 0.5Y + 100 Y-0.5Y= 500 + 100 0.5Y = 600 Y = 600/0.5 Y = 1200 NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Two sector economy: Graphic Analysis NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Two sector economy: Graphic Analysis NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Two Sector Economy In two sector economy, investment spending is an injection into the spending stream. Saving are leakages from the spending stream. National income equilibrium = S=I NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Two sector economy: Algebra Analysis Given S = -500 + 0.5Y and I = 100, calculate national income equilibrium. S=I -500 + 0.5Y = 100 0.5Y= 100 + 500 0.5Y = 600 Y = 600/0.5 Y = 1200 NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Two sector economy: Graphic Analysis NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Algebra Analysis In the closed-economy with government spending (G) and taxes (T), planned aggregate expenditure is equal to the sum of consumption, planned investment and government spending taking taxes into consideration: Y = AE Y=C+I+G Y = a + b(Y-T) + I + G NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH In three-sector economy, we need to focus on two types of taxes. 1. Autonomous Taxes /Lump sum 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 NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH 2. Induced Taxes / Proportionate 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 NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Algebra Analysis (lump- sum tax) Given C = 500 + 0.5 (Yd), I = 100, G = 80 and T= Calculate national income equilibrium. Y=C+I+G Y = 500 + 0.5 (Yd) + 100 + 80 Y = 500 + 0.5 (Y –T) + 100 + 80 Y = 500 + 0.5 (Y – 10) + 100 + 80 Y = 500 + 0.5Y – 5 + 100 + 80 Y – 0.5Y = 500 – 5 + 100 + 80 0.5Y = 675 Y = 675/0.5 Y = 1350 NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Algebra Analysis (proportionate tax) Given C = 500 + 0.5 (Yd), I = 100, G = 80. Assume that the government impose 10% tax from income, besides lump sump tax RM10 million. Find national income equilibrium. Y=C+I+G Y = 500 + 0.5 (Yd) + 100 + 80 Y = 500 + 0.5 (Y –T) + 100 + 80 Y = 500 + 0.5 [Y – (T0+ tY)] + 100 + 80 Y = 500 + 0.5 [Y – (10+ 0.1Y)] + 100 + 80 Y = 500 + 0.5 [Y – 10 – 0.1Y] + 100 + 80 Y = 500 + 0.5Y – 5 – 0.05Y + 100 + 80 Y = 500 + 0.45Y – 5 + 100 + 80 Y = 500 + 0.45Y - 5 + 100 + 80 Y – 0.45Y = 500 – 5 + 100 + 80 0.55Y = 675 Y = 675/0.55 Y =1227.27  NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Graphic Analysis TABLE 24.1 Finding Equilibrium for I = 100, G = 100, and T = 100 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Planned Planned Unplanned Output Net Disposable Consumption Saving Investment Government Aggregate Inventory Adjustment (Income) Taxes Income Spending S Spending Purchases Expenditure Change to Disequi- Y T Yd ≡Y −T C = 100 +.75 Yd Yd – C I G C+I+G Y − (C + I + G) librium 300 100 200 250 − 50 100 100 450 − 150 Output ↑ 500 100 400 400 0 100 100 600 − 100 Output ↑ 700 100 600 550 50 100 100 750 − 50 Output ↑ 900 100 800 700 100 100 100 900 0 Equilibrium 1,100 100 1,000 850 150 100 100 1,050 + 50 Output ↓ 1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output ↓ 1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output ↓ NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Graphic Analysis  FIGURE 24.2 Finding Equilibrium Output/Income Graphically Because G and I are both fixed at 100, the aggregate expenditure function is the new consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900.  NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Graphic Analysis Equilibrium using autonomous tax Equilibrium using induced/proportionate tax Equilibrium using autonomous tax Equilibrium using induced/proportionate tax Y=AE Y=AE AE (C,I,G) C +I + G AE (C,I,G) C +I + G C = 200 + 0.75Yd C = 200 + 0.75Yd (BEFORE TAX) (BEFORE TAX) 325 350 C = 175 + 0.75Y C = 200 + 06Y (AFTER TAX) (AFTER TAX) 200 200 175 National Income National Income 1100 875 The andequilibrium 45 degree line occurs intersects when AEat RM1100. curve The andequilibrium 45 degree line occurs intersects when AEat RM875. curve The equilibrium occurs when AE curve The equilibrium occurs when AE curve and 45 degree line intersects at RM1100. and 45 degree line intersects at RM875. NATIONAL INCOME EQUILIBRIUM: Y=AE APPROACH Three Sector Economy: Graphic Analysis The Derivation of the Total Expenditures (TE) Curve At different levels of Real GDP, we sum consumption (a), investment (b), and government purchases (c) to derive TE curve (d). Total Production Curve ✓ TP curve, which is simply a 45-degree line. (It is called a 45-degree line because it bisects the 90- degree angle at the origin.) ✓ It is important to notice that at any point on the TP curve, total production is equal to Real GDP (TP Real GDP). ✓ This is because TP and Real GDP are different names for the same thing.  Three States of the Economy in the TE-TP Framework I ✓ At QE, TE = TP and the economy is in equilibrium. ✓ At Q1, TE < TP. This results in an unexpected increase in inventories, which signals firms that they have overproduced, which leads firms to cut back production. ✓ The cutback in production reduces Real GDP. The economy tends to move from Q1 to QE.  Three States of the Economy in the TE-TP Framework I ✓ At QE, TE = TP and the economy is in equilibrium. ✓ At Q1, TE < TP. This results in an unexpected increase in inventories, which signals firms that they have overproduced, which leads firms to cut back production. ✓ The cutback in production reduces Real GDP. The economy tends to move from Q1 to QE.  Three States of the Economy in the TE-TP Framework I ✓ At Q2, TE > TP. This results in an unexpected decrease in inventories, which signals firms that they have under produced, which leads firms to raise production. ✓ The increased production raises Real GDP. The economy tends to move from Q2 to QE. Three States of the Economy in the TE-TP Framework I NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Three Sector Economy In three sector economy, 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. National income equilibrium = S+T=I+G NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Three Sector Economy: Algebra Analysis (lump sump tax) Given S = -500 + 0.5Yd, I = 100, G = 80 and T= Calculate national income equilibrium. S+T=I+G -500 + 0.5 (Y – T) + 10 = 100 + 80 -500 + 0.5 (Y - 10) + 10 = 100 + 80 -500 + 0.5Y – 5 + 10 = 100 + 80 -495 + 0.5Y = 100 + 80 0.5Y = 100 + 80 + 495 0.5Y = 675 Y = 675/0.5 Y = 1350 NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Three Sector Economy: Algebra Analysis (proportionate tax) Given S = -500 + 0.5Yd, I = 100, G = 80 and T= 10. Calculate national income equilibrium. S+T=I+G -500 + 0.5 (Y – T) + 10 = 100 + 80 -500 + 0.5 (Y - 10) + 10 = 100 + 80 -500 + 0.5Y – 5 + 10 = 100 + 80 -495 + 0.5Y = 100 + 80 0.5Y = 100 + 80 + 495 0.5Y = 675 Y = 675/0.5 Y = 1350  NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Three Sector Economy: Graphic Analysis C, I, G Y=AE Y= C+I+G 1350 E C = 500 + 0.5Yd 675 I+G a-bT = 495 Y 1350 I, G, S, T S +T 180 E I+G Y 0 1350 -a-bT =-505  NATIONAL INCOME EQUILIBRIUM: INJECTION-LEAKAGES APPROACH Three Sector Economy: Graphic Analysis Equilibrium using autonomous tax Equilibrium using induced/proportionate tax Equilibrium using autonomous tax Equilibrium using induced/proportionate tax Leakages/Injections Leakages/Injections S = -200 + 0.25Yd S = -200 + 0.25Yd (BEFORE TAX) (BEFORE TAX) S +T = -225 + 0.25Y S +T = -200 + 0.2Y (AFTER TAX) (AFTER TAX) 150 150 I +G I +G National Income National Income 1100 -200 -200 875 -225 The equilibrium Intersects with S+T occurs at RM1100. when I+G schedule The equilibrium Intersects with S+T occurs at RM875. when I+G schedule The equilibrium occurs when I+G schedule The equilibrium occurs when I+G schedule Intersects with S+T at RM1100. Intersects with S+T at RM875. THE MULTIPLIER When autonomous expenditure changes, so does equilibrium expenditure and real GDP (Y). But the change in equilibrium expenditure is larger than the change in autonomous expenditure. The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP (Y). THE MULTIPLIER The Basic Idea of the Multiplier An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and real GDP (Y). The increase in real GDP leads to an increase in induced expenditure. The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. So real GDP increases by more than the initial increase in autonomous expenditure. THE MULTIPLIER EFFECT The formula for multiplier (K) is, K = Change in Income (∆Y) Change in Aggregate Expenditure (∆ AE) 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 /1 – MPC or 1/MPS THE MULTIPLIER EFFECT At this point, we are assuming that the government controls G and T. In this section, we will review four multipliers: Planned investment multiplier Government spending multiplier Tax multiplier Balanced-budget multiplier THE MULTIPLIER EFFECT Planned Investment multiplier The multiplier of planned investment (autonomous investment) describes the impact of an initial change (increase or decrease) in planned investment (I) on production, income, and consumption spending and equilibrium income. Based on lump-sum taxes condition is: 1 / (1 – MPC), or 1 / MPS Based on proportionate taxes condition is: 1 / (1 – MPC + MPC.MPT) THE MULTIPLIER EFFECT Planned Investment multiplier Change in the equilibrium income to a change in investment (lump sum tax) = ∆Y= 1 x∆I 1–b Change in the equilibrium income to a change in investment (proportionate tax) = ∆Y= 1 x∆I 1 – b + bt THE MULTIPLIER EFFECT Planned Investment multiplier Given, C = 200 + 0.75Y 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 Y=1/(1-MPC) x I = 1100 + 200 Y=1 /(1-0.75) x 50 = 1300 m Y= 200 million THE MULTIPLIER EFFECT Government spending multiplier The multiplier for government spending is also same as the multiplier for planned investment, which is: Based on lump-sum taxes condition is 1 / (1 – MPC), or 1 / MPS Based on proportionate taxes condition is: 1 / (1 – MPC + MPC.MPT) THE MULTIPLIER EFFECT Government spending multiplier Change in the equilibrium income to a change government spending (lump sum tax) = ∆Y= 1 x∆G 1–b Change in the equilibrium income to a change in government spending (proportionate tax) = ∆Y= 1 x∆G 1 – b + bt THE MULTIPLIER EFFECT Government spending multiplier Given, C = 200 + 0.75Y; 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 Y= 1/(1-MPC) x G = 1100 + 400 Y= 1 /(1-0.75) x 100 = 1500 m Y= 400 million THE MULTIPLIER EFFECT Tax multiplier The multiplier of taxes describes the impact of an initial change (increase or decrease) in taxes (T) on production, income, and consumption spending and equilibrium income. However, the multiplier for a change in taxes is not the same as the multiplier for a change in planned investment, government spending or autonomous consumption. The the multiplier for lump sum taxes is: – MPC / (1 – MPC); or – MPC / MPS The the multiplier for proportionate taxes is: – MPC / (1 – MPC + MPC.MPT) THE MULTIPLIER EFFECT Tax multiplier Change in the equilibrium income to a change in tax (lump sum tax) = ∆Y= -b x∆T 1–b Change in the equilibrium income to a change in tax (proportionate tax) = ∆Y= -b x∆T 1 – b + bt THE MULTIPLIER EFFECT Tax multiplier Given, C = 200 + 0.75Y; 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 Y= 1/(1-MPC) x G = 1100 + 400 Y= 1 /(1-0.75) x 100 = 1500 m Y= 400 million THE MULTIPLIER EFFECT Tax multiplier Given that national income equilibrium for Country N is 800 million, where C = 120 + 0.75Yd, I = 200, G = 150 and T = 200 + 0.2Y. Assume that government reduce tax to 100 million. What is the new national income equilibrium level? ∆Y= -b x∆T Y1 = Y0 + ∆ Y 1 – b + bt Y1 = 800 + 187.5 ∆Y= -0.75 x (100-200) Y1 = 987.5 juta 1 – 0.75 + 0.75(0.2) ∆Y= -0.75 x -100 1 – 0.75 + 0.15 ∆ Y = -0.75 x -100 0.4 ∆ Y = -1.875 x -100 ∆ Y = 187.5