■ Accounting Values Ex post and Ex ante

■ Ex Post : National Income Accounts: Actual / realized

■ Ex Ante : Planned / intended to Consume or Intended to Invest

■ Equilibrium Income and Output = Planned Output =

Actual/Effective Demand

■ Natural Level of GDP /Full Employment of Resources: Zero

involuntary unemployment

■ Wage Price Flexibility : Classical Economist / Wage Price Rigidity

: Keynesian Theory of Income determination

■ Involuntary Unemployment : Unemployment that exist when there

is deficit demand = Actual/Effective Demand < Planned Output

leads to increase in unused inventories and creates deflationary gap

■ Keynesian Theory of Income and Output Determination :

Establishes relationship between aggregate income and aggregate

demand at underemployment and overemployment

■ Keynesian economics was developed by the British economist

John Maynard Keynes during the 1930s in an attempt to

understand the Great Depression.

■ Keynes advocated increased government expenditures and lower

taxes to stimulate demand and pull the global economy out of the

Depression.

■ Subsequently, the term “Keynesian economics” was used to refer

to the concept that optimal economic performance can be achieved

and economic slumps can be prevented by influencing aggregate

demand through activist stabilization and economic intervention

policies by the government.

■ Keynesian economics is considered to be a “demand-side” theory

that focuses on changes in the economy over the short run.

■ According to classical theory, if aggregate demand in the economy

fell, the resulting weakness in production and jobs would

precipitate a decline in prices and wages.

■ A lower level of inflation and wages would induce employers to

make capital investments and employ more people, stimulating

employment and restoring economic growth.

■ Aggregate supply curve describes, for each given price level, the

quantity of output firms are willing to supply

■ Upward sloping since firms are willing to supply more output

at higher prices

■ Aggregate demand curve shows the combinations of the price level

and the level of output at which the goods and money markets are

simultaneously in equilibrium

■ Downward sloping since higher prices reduce the value of

the money supply, which reduces the demand for output

■ Intersection of AS and AD curves determines the equilibrium level

of output and price level

Spending determines income, but income also determines spending.

Equilibrium is reached when actual income equals intended

spending,

Y = C + I + G + (X-M)

National Income = Consumption +Investment + Government

Expenditure + (Exports-Imports)

This equilibrium condition can also be expressed in another way,

namely,

S + T + M = I + G + X

Savings+ Taxes+ Imports = Investment + Government Expenses

+ Exports

Intended withdrawals/leakages = Intended injections

In the Keynesian model of income determination discussed in this

chapter, the adjustment process from one equilibrium output level

to another is based on unintended inventory changes. These are

defined as the difference between actual output and aggregate

demand

Firms try to maintain an optimal inventory stock;

1. If (actual AD) Effective AD > AS (Planned Output)

2. Unplanned Inventory

3. Actual Production /Output

4. Employment

4. Total production = aggregate demand

# The largest part of aggregate demand comes from consumption

spending

C = a + bYD with 0 < b < 1

YD = Y - TA + TR

Yd = Disposable Income

TA = Tax

TR = Transfer Receipts

If we assume for simplicity that TA = TR = 0, it follows that YD =

Y, and thus the savings function can be derived from YD = C + S,

that is,

C= a +by

Or

S = - a + (1 - b) Y

(1 – b) is the marginal propensity to save.

Aggregate Demand =C+I (Two Sector Model )

Aggregate Supply

Equilibrium in Two Sector Model AD= AS or C+I =C+S

Equilibrium Savings (leakages) = Investment(injection)

Change in Autonomus Investment : Multiplier and National

Income

Increase in Autonomous investment increases consumption

demand and income in the economy

In underdeveloped countries Multiplier Impact is high but value

is low due to lack of productivity efficiency of labour and capital

In other words, any increase in autonomous Investment spending by

I will increase national income by Y = [1/(1 - c)](I) =k

K = Y/I = 1/(1-MPC) = 1/(MPS) Multiplier

The output in the economy is a multiple of the increase or decrease

in investment spending.

The Maximum value of multiplier is infinity; if MPC=1

For example, a Rupees 1 million increase in the total amount of

investment in an economy will set off a chain reaction of increases in

expenditures.

Those who produce the goods and services that are ultimately

purchased as a result of the Rupees 100 million investment will

realize the Rupees100 million as increases in their incomes.

If they, in turn, collectively spend about 0.5 of that additional

income, then a total of Rupees 50 million further 25 million

followed by 12.5 million and so on .

K = Y/I = 1/(1-MPC) = 1/(MPS)

K=1/1-0.5 = k= 1/0.5 = 2

Income will increase from 100ˣ 2= Rupees 200 million

Increase in National Income will be Rupees 200 million with 100

million investments

Note:

Increase in income due to increase in initial investment, does not go

on endlessly. The process of income propagation slows down and

ultimately comes to halt. The decline in income is due to leakages.

Due to leakages

If MPS is higher multiplier impact will be less. Similarly there are

other leakages that results in lowering down the consumption

expenditure for example:

1. Progressive taxes results in reducing the impact of increase in

income

2. High Liquidity Preference and low MPC

3. Excess of Inventory investment and high reliance on Imports

4. Investment in existing financial products, shares, bonds,

Government securities

5. High debt obligations

6. High Retained earnings of Corporate

7. Scarcity of Supply despite high consumption demand

8. Economy is at full employment hence increase in demand would

lead to inflation in the economy

# Illustration 1

In an economy, every time income rises, 75 percent of rise in income

is spent on consumption. If the investment in the economy increases

by Rs 750 million

a. Find change in Income

b. Change in saving

Question: If savings function= -10 +0.2Y, I= 50 crore

Find Equilibrium level of Income, consumption and if investment

increases by INR 5 crore. Find new level of income and consumption

-10 +0.2Y =50

0.2Y=60

Y = 60/0.2

Y= 300 crore

Y= C+S

300= C+50

C=250

Given ∆I= 5 crore

MPS = 0.2

MPC = 1- MPS

MPC= 0.8

K= 1/ (1-MPC) = ∆Y/ ∆I

K= 5 = ∆Y/ 5

25 crore = ∆Y

New Income = 300+ 25 = 325 Crore

Increase in consumption = ∆Y ×MPC

= 25 × 0.8

=20.0 crore

Equilibrium of Income and Output in Three Sector Model

Y = C+I+G (AS= AD)

S+T= I+G (Leakages = Injections) Government expenses

increases national income from y to y1 . This is government

expenditure multiplier

Numerical

At Equilibrium Y= C+I+G

Government Transfer Payments and its impact on Income

The formula and size of the expenditure multiplier is always

determined by the particular model of the expenditure sector that is

being used.

If Government expenditure increases by 5 percent

Tax rate increases by 5 percent

Disposable income will remain unchanged.

There is no induced increase in consumption, as the effect of higher

taxes exactly offsets the effect of the income expansion, leaving

disposable income unchanged.

Four Sector Model

Y= C+I+G+(X-M)

Product Market = Production of goods and services and purchase of

goods and services

Factor Market = Factor services rendered and factor payments

made

Four Sector Model and Impact of Imports on National Income

Import Function = Imports =M (constant) + mY

m( is marginal propensity to import) = ∆Y/ ∆ m

Foreign Trade Multplier

Y= C+I+G+X-M Aggregate Supply = Aggregate Demand

S+T+M= I+G+X Leakages = Injections

Higher the value of ‘m’ (propensity to import) lower will be the

impact of Investment and government expenditure on the

national income of the country. Direct effect on Income and

induced effect on consumption of domestic goods results in lower

domestic production. Increase in imports per unit of the income

leads to leakages in the economy.

Question:

Due to recession in an economy, government expenditure increases

by INR 6 billion, if MPC =0.8 compute the increase in GDP (2

Marks)

Government Expenditure Multiplier = ∆Y/∆G = 1/ (1-MPC)

Question : If Consumption = 200+ 0.60 Yd

Government Spending = 150 crore

# Comment on the following statement:

“When aggregate demand falls below the current output level, an

unintended inventory accumulation occurs and the economy is no

longer in equilibrium.”

Deflationary Gap and Inflationary Gap is with respect to full

employment

If Aggregate Demand < Aggregate Supply at full employment:

Economy is performing at less than the real GDP or Potential

GDP or at full employment. Desired investment < actual

investment as well as unintended inventories are more.

Involuntary unemployment will increase.

If Aggregate Demand > Aggregate Supply at full employment:

Economy is performing at more than the real GDP or Potential

GDP or at full employment. No increase in real output and real

income but due to increase in price level nominal output and

nominal income will increase.