2. Income Determination in Short Run

8/3/2019 2. Income Determination in Short Run

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Dr. U.B. Raju

*Compiled from different published sources

*Strictly for academic purpose and for restricted private circulation

2. Income determination in Short run: Basic model


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Aggregate Expenditure and

Equilibrium Income

Definition of aggregate expenditure and

equilibrium income

How the economy adjusts to its equilibrium

position.

How changes in aggregate expenditure

affect equilibrium income.


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Aggregate Expenditure and

Equilibrium National Output

Aggregate expenditure (AE)

total amount that all economic agents want or

plan to spend on domestic goods and services.

the planned spending of

households,

firms, government, and

foreigners.


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Aggregate Expenditure AE = C + I + G + (X-M)

consumption (C),

investment (I),

government spending(G), and

exports less imports (X-M).

Note thatAE is not the same as GDP.

AErepresentsplannedspending

GDP represents actualspending or output.


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Aggregate Expenditure (AE) and

National Output (Y) AE and Y are not necessarily equal:

Firms formulate their production plans with an

estimate of the quantities that people want tobuy.

A mistake on their part will cause productionto exceed or fall below the amounts that peoplewant to buy.


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What ifAE and Y are not equal?

If AE < Y

people want to buy less than what has been

produced so firms will accumulate inventories. firms will reduce production

If AE >Y

What people want to buy is greater than actual

production so inventories will decline.

firms will increase production


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Equilibrium National Income AE = Y

Can be depicted by the intersection

between the AE schedule and the 45

degree line


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The 45

0

line The 45-degree line is a tool that assists us in

identifying the economy's equilibrium

position.

Property: every point along this line depicts

a situation wherein the value of the variable

on the horizontal axis (in this case actualoutput, (Y) is equal to its counterpart on the

vertical axis (AE).


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0100

100

450 line

450

200

200


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45

E0AE20

AE

0 20

Output, income (in Rs)

Aggregateexpen

diture(inRs)

Y

Y*


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Equilibrium Income (Y*) WhenAEis equal to Y

there is no reason for firms to adjust production.

this suggests that the economy is in equilibrium. Equilibrium requires the equality between

income and aggregate expenditure. That is,

Y = AE.


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Changes in AE and Income

Suppose that the economy's aggregate expenditureschedule shifts upwardAE0 toAE1,

Equilibrium point will move fromE0

toE1.

As a result, the economy experiences an increase inequilibrium income from YO* to Y1*


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45

AE0

E0

E1

AE1

20

30

AE

0 20 30

Y

Output, income (in pesos)

Aggregateexpen

diture(inpesos)

Y0 Y1


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Consumption and Income

Keynes (1936) suggested that consumption

spending(C) tends to increase with income.

In other words, households with higher incomes

tend to spend more.

There is a positive relationship between

consumption spending and income


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TABLE 9.1. Consumption and income

(1) (2) (3) (4) (5)

Income Consumption Change In

income

Change in

consumption

mpc

(Y) (C) (Y) (C) (C/Y)

0 200 _

200 350 200 150 0.75

400 500 200 150 0.75

600 650 200 150 0.75

800 800 200 150 0.75

1,000 950 200 150 0.75

1,200 1,100 200 150 0.75

1,400 1,250 200 150 0.75

1,600 1,400 200 150 0.75


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Consumption and income

Higher levels of income correspond to higherlevels of consumption spending

When income is equal to zero, consumptionspending is equal to 200.

Consumption spending and income are equal ateach other when income = 800.

When income is less than 800, consumption is higherthan income.

When income is greater than 800, consumption lessthan income


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0

450200

Consum

ptionSpending

Output, Income

400

600

800

1000

800 1200 1600

400

1200

1400

1600

C

Y

THE CONSUMPTION SCHEDULE

Y


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Consumption and Income

Observations from values above:

(a)autonomous consumptionspending-

component of consumption spending thatdoes not depend on income

- equal to 200 in example

(b) marginal propensity to consume (mpc) -shows the increase in consumption spendingfor a one rupee increase in income;


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Marginal Propensity to

Consume

MPC or the marginal propensity to consume represents the changein consumption spending that arises from a one rupee change inincome.

Value of MPCis between 0 and 1.

MPC=0.75 means that a one rupee increase in income leads to a 75

paise increase in consumption spending.

CmpcY

(!(


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M

arginal propensity to consume In example above,

C = 150 for Y = 200. Hence,

1500.75

200

CMPC

Y

(! ! !

(


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Consumption Function

Consumption Function:

C = c + mpc.Y

C = 200 + 0.75Y


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Savings and Income Sum of consumption spending andsavings

(S) must equal income. In symbols,

Y = C + S. SubtractingC from both sides of this

equation leads to

S = Y -C

.


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(1) (2) (3) (4) (5) (6) MPS

Y C S Y C S S

Y

0 200 -200 - - - -

200 350 -150 200 150 50 0.25

400 500 -100 200 150 50 0.25

600 650 -50 200 150 50 0.25

800 800 0 200 150 50 0.25

1000 950 50 200 150 50 0.25

1200 1000 100 200 150 50 0.25

1400 1200 150 200 150 50 0.25

1600 1400 200 200 150 50 0.25

Relationship bet. Income and Savings


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Savings and income Savings - that component of income that

is not allocated to consumption.

S = Y C

How is savings linked to income?

oY p oS.


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Savings and Income Marginal propensity to save (MPS) is the

increase in savings for a one rupee increase in

income; In the example above, S = 50 for Y = 200.

Implies that

500.25

200

SMPS

Y

(! ! !

(


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Savings function

Note: MPC+MPS = 1

Savings schedule listing of values of

savings at each levels of income

Savings function in equation form

S = -200 + .25Y


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1

Y C S

Y C SY C S

Y Y Y

mpc mps

!

( ! ( (( ( (!

( ( (!

Relationship between mpc and mpc


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S

-200

-50

150

0

400 800 1,200 1,600

Income (in rupees)

Savings(inrupees)

Y

S

Propensity to Save


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The determination of equilibrium income in a

two-sector economy

Two sector economy - households and firms only

Implies that AE is given by:

AE = C + I Assume that I is autonomous and equal to 100

In equilibrium, Y = AE p equilibrium income (Y*) =

1200


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Table 9.3 Consumption, Investment and Equilibrium

Income.

Y C S I AE

400 500 -100 100 600

600 650 -50 100 750

800 800 0 100 900

1,000 950 50 100 1,050

1,200 1,100 100 100 1,200

1,400 1,250 150 100 1,350


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E0

S

I

-200

100

0800 1,200 1,600

Income

Y

Y*

(B)

S, I

(A)

E0

yy

C+I = AE

C

0 400 800 1,200 1,600

Y45

AE

300

200

y

Y*

y


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Investment andM

ultiplier Suppose that investment I increases from

100M rupees to 200M rupees

What happens to equilibrium income?

Equilibrium income Y* will increase

Not by 100M

But by a multiplied amount!!

WHY???


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Table 9.4 Effects of a 100 rupee increase

in investment.

Y C S I AE

400 500 -100 200 700

600 650 -50 200 850800 800 0 200 1000

1,000 950 50 200 1150

1,200 1,100 100 200 1300

1,400 1,250 150 200 1450

1600 1400 200 200 1600

1800 1550 250 200 1750


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Ag

gregateExpenditure(inpesos)

AE0

AE1

Y0

Y*0 Y*1

A

B

E1

E0

1200 1600

I=100

Theeffect ofan increase in investment

AE Y

45o

300

400

Y=400


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Calculation of equilibrium income

In numerical example,

* 1( ).

1Y C I

mpc

!

1 multiplier

1 mpcE! n

C 200, I 100,mpc 0.75! ! !

! !

1Y* (200 100) 1,200

1 0.75


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For I = 200, Y* = 1,600

Hence, if Io from 100 to 200 p Y*o from 1200

to 1600.

In other words,

( !

( !I 100

Y* 400


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The concept of the multiplier Increase in Y is greater than increase in I. Why?

Multiplier (E) - measures the change in

equilibrium income as a result of a one-rupeechange in the sum of the autonomous components

ofAE;

*

YI

(E !(


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Calculation of the multiplier:

1 1

1 mpc mpsE ! !


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Calculation of multiplier

With the mpc = 0.75,

The multiplier is used determine the amount by

which Y* changes in response to a change in

investment.

141 0.75

E ! !

Y* IE( ! (

( ! ( ! E (

1Y I I

1 mpc


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The Paradox of

Thrift

Many people believe that higher savingslead to higher income.

In the present model, we get a result thatis contrary to this belief.

In other words, equilibrium income fallswhen people want to save more.

Idea: the attempt to achieve highersavings may reduce equilibrium income


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S0

Income

Savings

Y

S,I S1

I

Y0Y10

The Paradox of Thrift

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Unemployment and Inflationthe Phillips Curve


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NAIRU(non-accelerating inflation rate of unemployment)

arose to explain how Stagflation could occur.

The latter theory, also known as the natural rate of

unemployment", distinguished between the "short-term"Phillips curve and the "long-term" one.

The short-term Phillips Curve looked like a normal

Phillips Curve, but shifted in the long run as

expectations changed.

In the long run, only a single rate of unemployment (the

NAIRU or "natural" rate) was consistent with a stable

inflation rate.

The long-run Phillips Curve was thus vertical, so therewas no trade-off between inflation and unemployment.

Edmund Phelps won the Nobel Prize in Economics in 2006

for this.

G


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GDP and Unemployment

The negative relationship between unemployment and output is

called Okuns law:

Typically, as per US statistics, for every percentage point the

unemployment rate rises, real GDP growth typically falls by 2

percent


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Inflation (respectively, deflation) is a sustainedincrease (respectively, decrease) in the general price level

over a period of time.

Disinflation is a slowing of the rate of inflation.

Demand pull inflation is inflation caused by sustained

or continual increases in aggregate demand.

Cost push inflation is inflation caused by sustained orcontinual decreases in SR aggregate supply.


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Concept of business/trade cycle

According to J.M.Keynes

A trade cycle is composed of periods of good trade characterised

by rising prices & low unemployment percentages with periods of bad

trade characterised by falling prices & high unemployment rate.

Business cycles are recurrent but irregular fluctuations ineconomic activity & occurs one after another

The time span of the period & phases may vary


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The Business cycle is therise and fall ofeconomic activity

Business cycle is therise and fall ofeconomic

activityrelativeto thelong-term growthtrend ofthe

economy

The Business Cycle


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Features of Business Cycles

Business cycles are irregular in nature

Fluctuations occur in a number of other variables simultaneously

apart from production

Investment & Consumption of durable goods are more affectedInvestment & Consumption of non durable goods are much less

affected

Immediate effect on the level of inventory stock

Profits fluctuate more than any other incomes

Phases of Business Cycles

Expansion (Boom, Upswing or Prosperity)

Peak (Upper Turning Point, when economic activity begins to slow

down)Contraction (Downswing, Recession or Depression)

Trough (Lower Turning Point, when economic activity begins to

rise)


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Causes ofBusiness Cycles

There are many theories suggesting explanations for business cycles.

Climatic changes

Under consumption

Over Investment

Keynes theory of effective demand, particularly investment

Booms/recessions can be generated by rise/fall in governmentexpenditure, fiscal policy.

Similarly, a wave of optimism/pessimism can cause consumers to spend

more/less than usual.

Similarly, firms may invest more (build up new capacities)/disinvest.

Another possible cause of recessions and booms is monetary policy.

A firm faced with high interest rates may decide to postpone building a

new factory.

Households may be lured by cheap housing loans, and construction

activities may boom.


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Movements of Certain Macro economic Variables during Business

Cycles

Procyclical- Variables have positive correlation...

Countercyclical- Variables have negative correlation.

Unemployment is countercyclical.

Acyclical- Variables have zero correlation,.

Variables can be classified as leading, coincident or lagging

variable.

Leading Indicator: which occurs ahead of the occurrence of

business cycle variable.

Coincident Indicator:which move up and down along with thebusiness cycle variable.

Lagging Indicator: which follow the business cycle variable after

some time lag.


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Leading Indicators

Housing starts

New orders for plant and equipment

stock prices

demand for consumer durablesconsumer expectations

New employment

Deliveries by Companies

Index of consumer confidence

Money growth rate (M2)

Coincident Indicators

Nonagricultural employment

Index of industrial production

Personal income

Manufacturing and trade sales

Lagging IndicatorsWage rates

Rate of inflation

Consumer credits

Lending rates

Outstanding loans


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Cross Classification of Indicators

Items Direction of change Time of occurrence

Industrial output procyclical coincident

Capacity utilization procyclical coincident

Employment procyclical coincident

Unemployment countercyclical coincident

Inflation rate procyclical lagging

Corporate profits procyclical coincident

Short-term interest procyclical lagging

Share price procyclical Leading

Capital stock acyclical lagging


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2. Income Determination in Short Run

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