Economics for Management

GSB728

Topic 8:

National Income Determination

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Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

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Learning Objectives

1. The components of aggregate demand – What determines the demand for all goods and services?

2. The equilibrium level of gross domestic product – What determines the level of a country’s output in the short run?

3. The multiplier – What will be the effect on output of a rise in spending?

4. Types of unemployment – How can we easily classify unemployment?

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Learning Objectives (contd.)

5. Determinants of the level of unemployment – What causes unemployment?

6. Explanations of the business cycle – Why do countries suffer from periodic booms and recessions?

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Equilibrium Level of Gross Domestic Product

• What determines the demand for all goods and services?

AD = C + I + G + X - M

• Output in the short run can be represented in the circular flow of income.

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CdIncomes

The Circular Flow of Income

6Source: Sloman et al. (2014).

Cd

W = S + T + M

J = I + G + X

Incomes

The Circular Flow of Income (contd.)

7Source: Sloman et al. (2014).

Components of aggregate demand in Australia, 2007-08 (in percentage)

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Source: Sloman et al. (2014).

– Effects on output of a change in injections and/or withdrawals.

– The Multiplier Effect: An increase in aggregate demand (as a result of an increase in injections) of $x million leads to a rise in GDP greater than $x million.

– If J > W : GDP rises and W rises until J = W

– If W > J : GDP falls and W falls until J = W

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Equilibrium Level of Gross Domestic Product (contd.)

• The withdrawals and injections approach:

– The withdrawals curve (W).

– The injections curve (J).

– Equilibrium.

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Equilibrium in a Keynesian Model

0GDP

W

W, J

J

Equilibrium GDP: Withdrawals (W) and Injections (J)

Source: Sloman et al. (2014).11

0GDP

W

W, J

J

b

a d

c

x

GDPeSource: Sloman et al. (2014).

Equilibrium GDP: Withdrawals (W) and Injections (J) (contd.)

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• The income and expenditure approach:

– The 45° line income curve.

– The expenditure curve.

– Equilibrium

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Equilibrium in a Keynesian Model (contd.)

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0GDP

GDP = Cd + WCd, W, J

Deriving Equilibrium ofGross Domestic Product (“GDP”)

Source: Sloman et al. (2014).

150

GDP = Cd + W

J

Deriving of Equilibrium GDP (contd.)

Cd, W, J

GDP

x

Injection J adds to AD.

Cd

GDP0

Aggregate demand, AD = Aggregate expenditure

Source: Sloman et al. (2014).

0

Cd

GDP = Cd + W

J

Cd, W, J

GDP

z

x

Increase in aggregate demand (expenditure)

causes rise in equilibrium GDP from x to z

AD = E = Cd + J

GDP0 GDP1 Source: Sloman et al. (2014).

Deriving of Equilibrium GDP (contd.)

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The Multiplier

• The Multiplier (k):

– Number of times by which a rise in GDP exceeds the rise in injections that caused it.

k = ΔGDP/ΔJ

• Analysis using the withdrawals and injections approach:

– Shift in the J line.

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0 GDP

W

W, J

J1

The Multiplier: A Shift in Injections

E0

GDP0

J2

E1

GDP1

D JJ2

J1D W

D GDP

The Multiplier = DGDP / DJ

Marginal Propensity to Withdraw = DW / DGDP

18Source: Sloman et al. (2014).

The Multiplier (“k”)

– The Multiplier: k = 1/mpw where mpw represents the marginal propensity to withdraw

– The formula can also be expressed as: k = 1/(1–mpcd)

where mpcd represents the

marginal propensity to consume domestically produced goods and services.

mpw + mpcd = 119

The Multiplier (contd.)

• Analysis using the income and expenditure approach

– Shift in the E line.

– In the following diagram injections (J) increases by

20, inducing an increase in GDP of 60.

– The multiplier can be expressed in the form:

DGDP / D J

and is therefore 60/20, or 3.

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The Multiplier: A Shift in The Expenditure Curve

0GDP ($bn)

Cd, E, W, J

GDP = Cd + W

E1

100

Cd

100

E2

160

160

$bn

120

∆GDP = 60

∆GDP = 60

∆J = 20

∆Cd = 40

60

Source: Sloman et al. (2014).21

The Multiplier Process: A Shift in Injections

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Source: Sloman et al. (2014).

Types of Unemployment• Frictional (search) unemployment.

• Structural unemployment:• Changing patterns of demand.

• Improved production methods.

• Regional unemployment.

• Cyclical unemployment.

• What is full employment?

• When there is no cyclical unemployment.

• Full employment level of GDP: Level of GDP at which there is full employment of labour. 23

Determinants of the Level of Unemployment

• Unemployment at full employment:• Frictional unemployment.

• Structural unemployment.

• Unemployment above the full employment rate:• Deflationary gap.

• Unemployment below the full employment level:• Inflationary gap.

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0GDP

W

Cd,W, J

J

GDPe

The Deflationary Gap

GDPf

Deflationary gaps

Equilibrium GDP

Full employment GDP GDP

EE < GDP

J < W

Source: Sloman et al. (2014).25

0GDP

W

Cd,W, J

J

GDPe

The Inflationary Gap

GDPf

Equilibrium GDPFull employment GDP GDP

E

E > GDP

J > W

Inflationary gaps

26Source: Sloman et al. (2014).

Why are there booms and recessions?

• Instability of investment: The accelerator theory.

– The level of investment depends on the rate of

change of GDP, not on its level.

• Fluctuations in stocks: The stocks of finished goods that companies hold tend to fluctuate with the business cycle, which contributes to fluctuations in output.

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Keynesian Analysis of the Business Cycle

• Determinants of the business cycle:

– Why do booms and recessions persist?• Time lags.

• ‘Bandwagon' effects.

– Why do booms and recessions come to an end? What determines the turning points?

• Ceilings and floors.• Echo effects.• The accelerator.• Random shocks.• Changes in government policy.

Keynesian Analysis of the Business Cycle (contd.)

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References

Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

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