Chapter 13_the Theory of Income and Employment Determination

7/28/2019 Chapter 13_the Theory of Income and Employment Determination

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Written by: Edmund Quek

2011 Economics CafeAll rights reserved. Page 1

CHAPTER 13

THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION

LECTURE OUTLINE

1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT

2 THE GREAT DEPRESSION

3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT

4 THE KEYNESIAN THEORY IN GREATER DETAIL

4.1 Planned aggregate expenditure (AE)

4.1.1 Consumption expenditure (C)4.1.2 Planned investment expenditure (I)4.1.3 Government expenditure on goods and services (G)

4.1.4 Net exports (X M)4.1.5 Distinction between planned aggregate expenditure and actual aggregate

expenditure4.2 Circular flow of income and expenditure4.3 Equilibrium national income4.4 Multiplier effect and multiplier4.5 Paradox of thrift

5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT

6 INFLATIONARY GAP AND DEFLATIONARY GAP

ReferencesJohn Sloman, EconomicsWilliam A. McEachern, EconomicsRichard G. Lipsey and K. Alec Chrystal, Positive EconomicsG. F. Stanlake and Susan Grant, Introductory EconomicsMichael Parkin, EconomicsDavid Begg, Stanley Fischer and Rudiger Dornbusch, Economics


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1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT

Classical economists is a term coined by Karl Marx to refer to economists who includeDavid Ricardo, James Mill and their predecessors. In other words, Classical economistsrefers to the founders of the theory which culminated in Ricardian economics. John

Maynard Keynes included in the Classical school the followers of Ricardo, that is to saythose who adopted and perfected the theory of Ricardian economics, including John StuartMill, Alfred Marshall, Francis Ysidro Edgeworth and Arthur Cecil Pigou. The above list ofnames may seem confusing. A simplerbut looser definition of Classical economists isthe economists who wrote before Keynes.

Classical economists believe that prices and wages are totally flexible and hence theeconomy is a self-correcting mechanism. In other words, Classical economists believe thatas prices and wages are totally flexible, the economy is always at the full-employmentequilibrium.

Suppose that the economy is at the full-employment equilibrium. Further suppose thataggregate demand falls. When this happens, national output will fall below thefull-employment level which will lead to unemployment resulting in a downward pressureon wages. Since wages are totally flexible, in Classical economists view, they will fallimmediately which will induce firms to increase output resulting in national outputreturning to the full-employment level. Therefore, the aggregate supply curve is vertical atthe full-employment national output. The implication of a vertical aggregate supply curveis that only a change in aggregate supply will affect national output.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 does nothave any effect national output. It only leads to a rise in the general price level (P) from P0to P1.


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In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to anincrease national output (Yf) from Yf0 to Yf1. Therefore, Classical economists argue thatthe government should focus on the factors that will increase aggregate supply to increasenational output and hence the standard of living. In this sense, Classical economics issupply-side economics.

Classical economists treat money only as a medium of exchange. Workers are exchanginglabour for goods and services and firms are exchanging goods and services for labour. Inthis sense, money simply plays an intermediate role that facilitates transactions. This wayof thinking leads Classical economists to see every sale as a purchase. Since every sale is apurchase, it is impossible for supply to exceed demand. By producing, firms are spending.This line of thinking is often stated as Say's Law, which states that supply creates its owndemand. Say's Law is attributed to the great French economist Jean-Baptiste Say(1767-1832). Say's original version was "products are paid for with products". Classicaleconomists use one or another version of Say's Law when they claim that economicdownturns cannot be caused by a deficiency in aggregate demand.

A version:Firms employ factor inputs to produce output and hence pay factor income to households.The income received by households is then partly paid back to firms in the form ofconsumption expenditure and partly withdrawn from the inner flow of the circular flow ofincome and expenditure in the form of savings, taxes and imports. However, anywithdrawals by households are ultimately paid back to firms in the form of injections suchas investment expenditure, government expenditure and exports. Therefore, the incomegenerated by the production of firms will be transformed into demand for their goods andservices, either directly in the form of consumption expenditure, or indirectly viawithdrawals and then injections. There will be no deficiency of demand.
http://www.econ.jhu.edu/people/fonseca/het/say.htmhttp://www.econ.jhu.edu/people/fonseca/het/say.htm


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2 THE GREAT DEPRESSION

The Classical view was challenged when the market economies were hit by the GreatDepression in the 1930s during which there was prolonged and mass unemployment. TheGreat Depression proved that the economy was not a self-correcting mechanism, not in the

short run at least. For instance, the national output of the United States stayed below thefull-employment level for most part of the 1930s.

3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT

In 1936, John Maynard Keynes published the book "The General Theory of Employment,Interest and Money to explain the prolonged and massive unemployment in the GreatDepression. The book criticises the classical model. Keynes turns Says Law on its head,arguing that aggregate demand determines national output and employment in theeconomy. In this sense, demand creates its own supply.

Unlike the Classical economists, Keynes believes that prices and wages are rigid,especially in the downward direction and hence the economy is not a self-correctingmechanism. In other words, Keynes believes that as prices and wages are rigid, theeconomy can stay at a below-full-employment equilibrium.

Suppose that the economy is at the full-employment equilibrium. Further suppose thataggregate demand falls. When this happens, national output will fall below thefull-employment level which will lead to unemployment resulting in a downward pressureon wages. Since wages are rigid, in Keyness view, they will not fall. Therefore, firms willnot increase output and hence national output will stay at a below-full-employment level.Keynes attributes the prolonged and high unemployment in the Great Depression to aprolonged and huge deficiency in aggregate demand and downward rigidity of wages.

When national output is below the full-employment level, with unemployment in theeconomy, firms can increase output without bidding up wages. Therefore, although anincrease in national output will lead to an increase in the total cost of production in theeconomy, it will not affect the average cost of production in the economy. Since theaverage cost of production in the economy will remain the same, firms will not increaseprices. Therefore, the aggregate supply curve is horizontal at the current general price levelup to the full-employment national output. Once full employment is reached, the economycannot expand output any further and hence the aggregate supply curve is vertical at thefull-employment national output. Therefore, the aggregate supply curve is inverseL-shaped. Keynes believes that unemployment is the normal state of the economy.Therefore, the implication of an inverse L-shaped aggregate supply curve is that only achange in aggregate demand will affect national output.


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In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 does not haveany effect national output.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to anincrease national output (Y) from Y0 to Y1. Therefore, Keynes argues that the governmentshould focus on the factors that will increase aggregate demand to increase national outputand hence the standard of living. In this sense, Keynesian economics is demand-sideeconomics.

Note: Keynesian economics is short-run economics. Therefore, the Keynesian aggregatesupply curve is a short-run aggregate supply curve. There is no long-run aggregatesupply curve in Keynesian economics. Classical economists make no distinctionbetween the short run and the long run as they believe that prices and wages aretotally flexible. Therefore, the Classical aggregate supply curve is simply anaggregate supply curve.


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4 THE KEYNESIAN THEORY IN GREATER DETAIL

4.1 Planned aggregate expenditure (AE)

Planned aggregate expenditure (AE) is the planned total expenditure on the goods and

services produced in the economy over a period of time and is comprised of consumptionexpenditure (C), planned investment expenditure (I), government expenditure on goodsand services (G) and net exports (X-M).

AE C I G (X M)4.1.1 Consumption expenditure (C)

Consumption expenditure is the expenditure made by households on goods and services.Savings is the excess of disposable income over consumption expenditure. Theconsumption function shows the consumption expenditure of households at eachdisposable income. Mathematically, the Keynesian consumption function can be expressedas

C a bYd, where a 0 and 0 b 1.

From the above equation, it can be seen that consumption is comprised of two components:autonomous consumption (a) and induced consumption (bYd). Autonomous consumptionis the part of consumption that does not depend on disposable income and is determined byconsumer confidence, the wealth of households, interest rates, expectations of pricechanges, the availability of credit and the distribution of income. Induced consumption isthe part of consumption that depends on disposable income (Yd). Keynes believes that

consumption will increase with an increase in disposable income (b 0) but the increase in

consumption will be less than the increase in disposable income (b 1).

Note: Students can think of autonomous consumption as the consumption of necessities.However, it is important to note that different people may view different goodsdifferently. A necessity to a person may be a luxury to another.


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Consumption function

In the above diagram, (b) is the slope of the consumption function. In Keynesianeconomics, it is known as the marginal propensity to consume out of disposable income(MPCYd). The MPCYd is the fraction an increase in disposable income that is spent on

consumption (C/Yd).

Savings is the excess of disposable income over consumption expenditure. The savingsfunction shows the savings of households at each disposable income. Mathematically, theKeynesian savings function can be expressed as

S

a

(1

b)Yd, where a

0 and 0

(1b)

1.

From the above equation, it can be seen that savings is comprised of two components:

autonomous savings (a) and induced savings [(1 b)Yd]. Autonomous savings (ordissavings, which some may like to call it) is the part of savings that does not depend ondisposable income and is determined by consumer confidence, interest rates, expectationsof price changes the distribution of income. Induced savings is the part of savings thatdepends on disposable income (Yd). Keynes believes that savings will increase with an

increase in disposable income [(1 b) > 0] but the increase in savings will be less than the

increase in disposable income [(1 b) < 1].


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Savings function

In the above diagram, (1 b) is the slope of the savings function. In Keynesian economics,it is known as the marginal propensity to save out of disposable income (MPS Yd). The

MPSYd is the fraction of an increase in disposable income that is saved (S/Yd).

Since any additional disposable income will either be spent or saved, the sum of themarginal propensity to consume out of disposable income and the marginal propensity to

save out of disposable income is equal to one (MPCYd MPSYd 1).

The average propensity to consume out of disposable income (APCYd) is the fraction of

disposable income that is spent on consumption (C/Yd). The average propensity to save outof disposable income (APSYd) is the fraction of disposable income that is saved (S / Yd).Since any amount of disposable income will either be spent or saved, the sum of theaverage propensity to consume out of disposable income and the average propensity to

save out of disposable income is equal to one (APCYd APSYd 1).

Example

Yd C S MPCYd MPSYd APCYd APSYd

0 20 20 ------- ------- ------- -------

40 50 10 0.75 0.25 1.25 0.25

80 80 0 0.75 0.25 1 0

120 110 10 0.75 0.25 0.92 0.08160 140 20 0.75 0.25 0.875 0.125

200 170 30 0.75 0.25 0.85 0.15

240 200 40 0.75 0.25 0.83 0.17

The marginal propensity to consume and the marginal propensity to save can be definedout ofnational income. The marginal propensity to consume out of national income(MPC) is the fraction of an increase in national income that is spent on consumption


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(C/Y). The marginal propensity to save out of national income (MPS) is the fraction of

an increase in national income that is saved (S/Y). The marginal propensity to tax (MPT)

is the fraction of an increase in national income that is taxed (T/Y). Since any amount ofnational income will either be spent, saved or taxed, the sum of the marginal propensity toconsume out of national income, the marginal propensity to save out of national income

and the marginal propensity to tax is equal to one (MPC MPS MPT 1). Similarly, theaverage propensity to consume and the average propensity to save can be defined out ofnational income. The average propensity to consume out of national income (APC) is thefraction of national income that is spent on consumption (C/Y). The average propensity tosave out of national income is the fraction of national income that is saved (S/Y). Since anyamount of national income will either be spent, saved or taxed, the sum of the averagepropensity to consume out of national income, the average propensity to save out of

national income and the average propensity to tax is equal to one (APC APS APT 1).

Relationship between the consumption function and the savings function


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In the above diagram, when disposable income is equal to zero, consumption expendituremust be financed by dissavings. At Yd0, where consumption expenditure is equal todisposable income, savings is zero. Below Yd0, where consumption expenditure exceedsdisposable income, savings is negative. Above Yd0, where disposable income exceedsconsumption expenditure, savings is positive.

Induced consumption is positively related to disposable income. In other words, anincrease in disposable income will lead to an increase in induced consumption and viceversa. An increase in induced consumption can be shown by an upward movement alongthe consumption function.

In the above diagram, an increase in disposable income (Yd) from Yd0 to Yd1 leads to anupward movement along the consumption function (C) resulting in an increase inconsumption expenditure (C) from C0 to C1. The effect of an increase in disposable incomeon consumption will depend on the MPCYd. Given any increase in disposable income, thelarger the MPCYd, the larger the increase in consumption.

Determinants of disposable income

National incomeDisposable income will increase when national income increases.

Direct taxes and transfer paymentsA decrease in direct taxes such as personal income tax and corporate income tax, or anincrease in transfer payments such as unemployment benefits, social security benefits andinterest payments on national debt will lead to an increase in disposable income.

Autonomous consumption is determined by consumer confidence, the wealth ofhouseholds, interest rates, expectations of price changes, the availability of credit and thedistribution of income. An increase in autonomous consumption can be shown by a verticalupward shift in the consumption function.


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In the above diagram, a vertical upward shift in the consumption function (C) from C0 to C1leads to an increase in consumption expenditure (C) from C0 to C1 at the same disposableincome (Yd0).

Determinants of autonomous consumption

Consumer confidence (Consumer sentiment)When households are more optimistic about the economic outlook, they will expect theirincome to rise and hence increase consumption.

Wealth of householdsWhen the wealth of households increases, consumption will increase.

Interest ratesA fall in interest rates will reduce the incentive to save which will induce households toincrease consumption.

Expectations of price changesWhen households expect prices to rise, they will bring forward the purchases of somedurable goods which will lead to an increase in consumption. Note that this is not the sameas consumer confidence which is about expectations of income changes.

Availability of creditMany consumer durables are purchased with bank loans and hence an increase in theavailability of credit will allow households to increase consumption.

Distribution of incomeLower income groups have higher marginal propensities to consume than higher incomegroups and hence a redistribution of income from higher income groups to lower incomegroups will lead to an increase in consumption.


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4.1.2 Planned investment expenditure (I)

Investment expenditure is the expenditure made by firms on goods produced not for theirpresent use but for their use in the future. In economics, investment is comprised ofbusiness fixed investment (new factories and machinery), residential investment (new

houses, apartments and condominiums) and inventory investment (the change in the valueof unsold goods). There are two types of investment: autonomous investment and inducedinvestment.

Autonomous investmentAutonomous investment is the part of investment that does not depend on national incomeand is determined by interest rates, business sentiment, business costs, capital costs,corporate income tax, technological advancements and the availability of credit. Accordingto the marginal efficiency of capital theory, or some may prefer to call it the marginalefficiency of investment theory, the marginal efficiency of capital function is theinvestment function. The investment function shows the investment expenditure of firms at

each interest rate.

Note: Students do not need to explain the MEC/MEI theory in the examination. All thatthey are required to do is to state that the MEC/MEI function is the investmentfunction.

The marginal efficiency of a type of capital is the discount rate which equates the cost ofthe type of capital to the present value of its stream of expected returns. The marginalefficiency of capital is the summation of the marginal efficiencies of all types of capital inthe economy.

Consider a type of capital which will generate returns for three years.

Returns (Year1) Returns (Year 2) Returns (Year 3)

Cost ------------------------ ------------------------ ------------------------

(1 r*) (1 r*)2 (1 r*)3

r* is the marginal efficiency. It should be obvious that the marginal efficiency of a type ofcapital is its internal rate of returns (IRR).

The fund can be loaned out if it is not invested in the type of capital. Therefore, interestrates are the external rate of returns (ERR).

The marginal efficiency of a type of capital function is downward-sloping due todiminishing marginal returns. As more and more of a type of capital is employed, eachadditional unit of it will have less of other types of capital to work with. Therefore, theadditional expected returns resulting from investing in one more unit of a type of capitalfalls. Since the marginal efficiency of capital is the summation of the marginal efficienciesof all types of capital in the economy, the marginal efficiency of capital function is alsodownward-sloping.


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Marginal efficiency of capital function

In the above diagram, the marginal efficiency of capital (MEC) is higher than the interestrate (r) r0 to the left of investment (I) I0. Therefore, the optimal level of investment is I0.Since investment depends on the marginal efficiency of capital, the marginal efficiency ofcapital function is the investment function.

A fall in interest rates will lead to more profitable planned investments resulting in anincrease in investment expenditure and vice versa. An increase in investment expendituredue to a fall in interest rates can be shown by a downward movement along the marginalefficiency of capital function.

In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downwardmovement along the marginal efficiency of investment function (MEC) resulting in anincrease in investment expenditure (I) from I0 to I1.


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In addition to a fall in interest rates, the number of profitable planned investments andhence investment expenditure will also increase when expected returns on plannedinvestments increase due to stronger business sentiment, lower business costs such asdecreases in oil prices and wages or lower capital costs such as decreases in the costs offactories and machinery. Further, a decrease in corporate income tax that will increase

expected after-tax returns on planned investments, technological advancements and anincrease in the availability of credit will also lead to an increase in investment expenditure.An increase in investment expenditure due to a non-interest rate factor can be shown byrightward shift in the marginal efficiency of capital function.

In the above diagram, a rightward shift in the marginal efficiency of capital (MEC)function from MEC

0to MEC

1leads to an increase in investment expenditure (I) from I

0to

I1 at the same interest rate (r0).

Induced investmentInduced investment is the part of investment that depends on national income. Accordingto the accelerator theory of investment, net investment is determined by the rate of changeof national income. When national income rises at an increasing rate, net investment willincrease. However, when national income rises at a decreasing rate, net investment willdecrease.

Since It KtKt1 and Kt vYt, It It vYtvYt1 or It v(YtYt1), where I net

investment, K

capital, Y

national income or national output and v

capital-outputratio.

It v(YtYt1) is the accelerator equation.


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Example

Time Period (t) Yt Yt1 It

0 $100 --- ---

1 $110 $100 $25

2 $140 $110 $75

3 $180 $140 $1004 $200 $180 $50

* Assume that v = 2.5

From t = 0 to t =3, because national income rises at an increasing rate, net investmentincreases. From t = 3 to t = 5, because national income rises at a decreasing rate, netinvestment decreases.

The size of the accelerator effect depends on the capital-output ratio (v), also known as theaccelerator coefficient. The higher the capital-output ratio, the larger the accelerator effect.For instance, due to the high capital-output ratio in the United States, the accelerator effect

is large.

Note: In the Keynesian model, planned investment expenditure is assumed to beautonomous as it cannot be expressed as a linear function of national income. Inreality, planned investment expenditure is affected by national income.

4.1.3 Government expenditure on goods and services (G)

Government expenditure on goods and services is the expenditure on goods and servicesmade by the government. It includes expenditure on both consumer goods and capital

goods. It does not include government expenditure on transfer payments. Transferpayments are payments made by the government to the recipients not in exchange for anygoods or services and they include social security benefits, unemployment benefits andinterest payments on national debt. About two-thirds of the US federal governmentexpenditure is made on transfer payments.

The government can also influence aggregate expenditure by controlling consumptionexpenditure through changing direct taxes or transfer payments. In addition to the effect onconsumption expenditure, a change in corporate income tax will also affect investmentexpenditure and hence aggregate expenditure.

Disposable income National income Transfer payments Corporate income tax Other direct taxes Undistributed corporate profit Personal income tax

Taxes T tY, Yd YTtY, where T autonomous taxes, tY induced taxes and t marginal propensity to tax (MPT).

Assuming no transfer payments and undistributed corporate profit.


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Since C a bYd, C a b(Y T tY) or C abT b(1 t)Y, where a autonomous

consumption, bYd induced consumption, b the marginal propensity to consume out of

disposable income (MPCYd) and b(1 t) the marginal propensity to consume out ofnational income (MPC).

An increase in t will decrease the MPC and hence make the consumption function(plotted against national income) flatter. Therefore, the AE function will become flatter.However, an increase in T will shift the consumption function (plotted against nationalincome) vertically downwards. Therefore, the AE function will shift vertically downwards.

Note: In the Keynesian model, government expenditure on goods and services is assumedto be autonomous as it cannot be expressed as a linear function of national income.In reality, government expenditure is affected by national income. In a recession, thegovernment may increase expenditure on goods and services to increase economicgrowth and hence reduce unemployment. When the economy is overheating, thegovernment may decrease expenditure on goods and services to reduce inflation.

4.1.4 Net exports (X M)

Exports (X) are the expenditure made by foreigners on domestic goods and services. Thefollowing are the determinants of exports.

Foreign incomeAn increase in foreign income will lead to a rise in exports. The converse is also true.

Domestic general price level relative to foreign general price level

When the domestic general price level falls relative to the foreign general price level,domestic goods and services will become relatively cheaper than foreign goods andservices. When this happens, exports will rise. The converse is also true.

Exchange rateWhen domestic currency depreciates, domestic goods and services will become relativelycheaper than foreign goods and services. When this happens, exports will rise. Theconverse is also true.

Other factorsFactors such as comparative advantage, trade policy, quality and tastes will also affect

exports.

Imports (M) are the expenditure made by domestic residents on foreign goods and services.The following are the determinants of imports.

National incomeAn increase in national income will lead to a rise in imports. The converse is also true.


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Domestic general price level relative to foreign general price levelWhen the domestic general price level rises relative to the foreign general price level,domestic goods and services will become relatively more expensive than foreign goodsand services. When this happens, imports will rise. The converse is also true.

Exchange rateWhen domestic currency appreciates, domestic goods and services will become relativelymore expensive than foreign goods and services. When this happens, imports will rise. Theconverse is also true.

Other factorsFactors such as comparative advantage, trade policy, quality and tastes will also affectimports.

Mathematically, the import function can be expressed as M m0 m1Y, where m0

autonomous imports, m1Y induced imports, m1 the marginal propensity to import

(MPM).

Net export function

In the above diagram, as exports are independent of national income and imports rise withnational income, the net export function is downward-sloping.

4.1.5 Distinction between planned aggregate expenditure and actual aggregateexpenditure

Actual aggregate expenditure, or national expenditure, is always equal to national incomeor national output. However, planned aggregate expenditure is not necessarily equal toactual aggregate expenditure and therefore is not necessarily equal to national income ornational output.


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Firms will experience an unplanned increase in inventory investment if they sell less oftheir output than expected, in which case, actual aggregate expenditure, national output ornational income will exceed planned aggregate expenditure. Conversely, if firms sell moreof their output than expected, they will experience an unplanned decrease in their inventoryinvestment, in which case, planned aggregate expenditure will exceed actual aggregate

expenditure, national output or national income.

4.2 Circular flow of income and expenditure

The circular flow of income and expenditure shows the flow of income and expenditurebetween the different sectors in the economy.

In the above diagram, households provide factor inputs which include labour, land, capitaland enterprise to firms and in return, they receive factor income (Y) in the form of wages,rent, interest and profits. Firms provide goods and services to households and in return,they receive payments known as consumption expenditure on domestic goods and services(CD). However, not all the factor income received by households return to domestic firmsas revenue. Rather, some go to the government in the form of taxes (T), some go to thefinancial sector in the form of savings (S) and some go to the external sector in the form ofimports (M). Taxes, savings and imports are known as withdrawals, which are basically thefactor income received by households that does not return to domestic firms as revenue.Further, some of the payments received by domestic firms do not come from households.Rather, they come from the government in the form of government expenditure on goodsand services (G), the financial sector in the form of loans to finance investment expenditure(I) and the external sector in the form of exports (X). Government expenditure, investmentexpenditure and exports are known as injections, which are basically are the paymentsreceived by domestic firms that do not come from households.


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4.3 Equilibrium national income

The equilibrium national income is the national income that has no tendency to change andit can be determined in three ways: the expenditure-income approach, theinjections-withdrawals approach and the AD-AS approach.

Expenditure-income approach (AE Y)According to the expenditure-income approach, which is also known as theexpenditure-output approach, the equilibrium national income is the national incomewhere planned aggregate expenditure is equal to national income or national output.

In the above diagram, the equilibrium national income is Y0 where planned aggregateexpenditure (AE) is equal to national income (Y). At a national income lower than plannedaggregate expenditure, such as Y2, firms whose output is insufficient to meet the plannedexpenditure of the economy will experience an unplanned decrease in their inventories,and to bring their inventories up to the planned levels, they will increase output which willlead to an increase in national income. At a national income higher than planned aggregateexpenditure, such as Y1, firms whose output is more than sufficient to meet the plannedexpenditure of the economy will experience an unplanned increase in their inventories, andto bring their inventories down to the planned levels, they will decrease output which willlead to a decrease in national income. At Y0, firms will not experience any unplannedchanges in their inventories and hence there will be no incentive for them to change output.

Note: Since AE C I G (X M) and Y = C S T, when AE Y, C I G (X

M) C S T. Therefore, when AE Y, I G X = S T M.

Injections-withdrawals approach (J W)According to the injections-withdrawals approach, the equilibrium national income is thenational income where planned injections are equal to withdrawals. Injections are thepayments received by domestic firms that do not come from households and they comprise


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government expenditure on goods and services, investment expenditure and exports.Withdrawals are the factor income received by households that does not return to domesticfirms as revenue and they comprise taxes, savings and imports.

In the above diagram, the equilibrium national income is Y0 where planned injections (J)are equal to withdrawals (W), because at this national income, planned aggregateexpenditure is equal to national income. At a national income where planned injections arehigher than withdrawals, planned aggregate expenditure is higher than national income,and vice versa.

Aggregate demand-aggregate supply approach (AD AS)

According to the aggregate demand-aggregate supply approach, the equilibrium nationalincome is the national income where aggregate demand is equal to aggregate supply.


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In the above diagram, the equilibrium national income is Y0 where aggregate demand (AD)is equal to aggregate supply (AS). At Y0 where there is neither a shortage nor surplus, firmswill not experience any unplanned changes in their inventories and hence there will be noincentive for them to change output.

4.4 Multiplier effect and multiplier

The multiplier effect is the effect of an increase in autonomous expenditure leading to alarger increase in national income.

In the above diagram, an increase in AE leads to a larger increase in national income.

Suppose that MPCD 0.8, MPW 0.2 and AE $1000. When aggregate expenditureincreases by $1000, firms will employ more factor inputs to produce more output andhence pay more factor income to households. Household income and hence consumptionexpenditure on domestic goods and services will increase by $1000 and $800 (0.8 $1000)respectively. Due to the increase in consumption expenditure on domestic goods andservices of $800, firms will employ even more factor inputs to produce even more outputand hence pay even more factor income to households. Household income and henceconsumption expenditure on domestic goods and services will increase further by $800 and$640 (0.8 $800) respectively. However, each time household income rises, savings, taxesand imports will rise, and when these withdrawals have increased by $1000 to the level thatmatches injections, equilibrium will be restored and national incomewill stop increasing.Note: The marginal propensity to withdraw (MPW) is the fraction of an increase in

national income that is withdrawn from the inner flow of income and expenditure.

Therefore, MPW MPS MPT MPM. The marginal propensity to consumedomestic goods and services out of national income (MPCD) is the fraction of anincrease in national income that is spent on domestic goods and services. Therefore,

MPCD MPCMPM.


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Round Y CD W

1 $1000 $800 $200

2 $800 $640 $160

3 $640

Sum $5000 $4000 $1000

In the above table, Y $1000 $800 $640 .

Therefore, Y $1000 (0.8)($1000) (0.8)2($1000) .

Applying geometric progression, Y $1000/(1 0.8) $5000 AE $1000.

The multiplier is the number of times by which national income increases due to anincrease in autonomous expenditure.

Since Y = AE/(1 MPCD), Y/AE 1/(1 MPCD).

Multiplier Y/AE 1/(1 MPCD)Since MPS MPT MPM MPCD 1, Y/AE 1/MPW.

Multiplier Y/AE 1/MPWSince the multiplier is the inverse of the MPW, it will be larger the lower the savings, thelower the income taxes and the lower the imports. The multiplier in Singapore is small due

to the high savings and high imports. The high savings in Singapore are due to the cultureof thrift, the compulsory savings scheme and the absence of a generous welfare system.The high imports in Singapore are due to lack of factor endowments.

Note: In reality, when aggregate expenditure rises, real national income will not rise by thefull multiplier effect due to a rise in the general price level (which will be explainedlater).

4.5 Paradox of thrift

Classical economists argue that saving is desirable for the economy. An increase in savingswill lead to lower interest rates which will result in higher consumption and investment andhence higher economic growth. However, Keynes argues that an increase in savings isundesirable for the economy.

The fallacy of composition is the wrong belief that if something is good for an individual, itis also good for the nation. However, just because something is good for an individual, itdoes not follow that it is good for the nation.


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If an individual increases savings, he will increase his future consumption. However, if thenation increases savings, it will decrease its future income and future consumption. Givenany amount of disposable income, an increase in savings will lead to a decrease inconsumption expenditure. Further, the decrease in consumption expenditure will weakenbusiness sentiment which will lead to a decrease in investment expenditure. The decrease

in consumption expenditure and investment expenditure will lead to a decrease inaggregate demand and hence national income. The phenomenon of higher savings leadingto lower national income is known as the paradox of thrift. Keynes idea is that when theeconomy is in a recession, people should not tighten their belts. Rather, they should spendtheir way out of the recession.

5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT

Classical economics and Keynesian economics are traditional schools of thought inmacroeconomics. Today, no economist subscribes to these precise collections of views.Instead, what is taught to students today is neo-classical economics which is mainstream

economics. Neo-classical economists believe that although prices and wages are totallyflexible in the long run, they are rigid in the short sun. Therefore, although the economywill be at the full-employment equilibrium in the long run, it can stay at anabove-full-employment equilibrium or a below-full-employment equilibrium in the shortrun.

Aggregate demand is the total demand for the goods and services produced in the economyover a period of time and is comprised of consumption expenditure, investmentexpenditure, government expenditure on goods and services and net exports. Theaggregate demand curve shows the total demand for the goods and services produced in theeconomy at each general price level over a period of time.

Aggregate Demand Curve


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In the above diagram, the aggregate demand (AD) curve is downward-sloping. The ADcurve will shift rightwards if there is an increase in C, I, G or (XM).

Aggregate supply is the total supply of goods and services in the economy over a period oftime and is determined by the quantity and the productivity of factor inputs, given factor

prices. The aggregate supply curve shows the total supply of goods and services in theeconomy at each general price level over a period of time.

Aggregate Supply Curve

In the above diagram, the aggregate supply (AS) curve is upward sloping. The AS curvewill shift rightwards if there is a decrease in factor prices or an increase in the quantity orthe productivity of factor inputs in the economy.

Long-run aggregate supply is the total supply of goods and services in the economy whenall factor prices have fully adjusted in the long run and is determined by the quantity andthe productivity of factor inputs. The long-run aggregate supply curve shows the totalsupply of goods and services in the economy when all factor prices have fully adjusted inthe long run.


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Long-run Aggregate Supply Curve

In the above diagram, the long-run aggregate supply (LRAS) curve is vertical at thefull-employment national income. The LRAS curve will shift rightwards if there is anincrease in the quantity or the productivity of factor inputs in the economy.

Note: The full-employment national income is the national income where there is nodemand-deficient unemployment (which will be discussed in greater detail later).

If the economy is at an above-full-employment equilibrium, national income will fall.

Above-full-employment equilibrium


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In the above diagram, the equilibrium national income (Y0) is above the full-employment

national income (Yf), creating a positive output gap (Y0 Yf). When national income isabove the full employment level, unemployment will be below the natural rate. In such astate of the economy, firms will find it difficult to employ workers but workers will find iteasy to get jobs which will lead to an upward pressure on factor prices. When factor prices

and hence the cost of production in the economy rise in the long run, aggregate supply (AS)will fall from AS0 to AS1 and hence national income will fall from Y0 to Y1.

If the economy is at a below-full-employment equilibrium, national income will rise.

Below-full-employment equilibrium

In the above diagram, the equilibrium national income (Y0) is below the full-employment

national income (Yf), creating a negative output gap (Y0 Yf). When national income isbelow the full employment level, unemployment will be above the natural rate. In such astate of the economy, firms will find it easy to employ workers but workers will find itdifficult to get jobs which will lead to a downward pressure on factor prices. When factorprices and hence the cost of production in the economy fall in the long run, aggregatesupply (AS) will rise from AS0 to AS1 and hence national income will rise from Y0 to Y1.

If the economy is at the full-employment equilibrium, national income will remainunchanged, other things being equal.


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Full-employment equilibrium

In the above diagram, the equilibrium national income (Y0) is equal to the full-employmentnational income (Yf). When national income is at the full-employment level,unemployment will be at the natural rate. Therefore, there will be neither upward nordownward pressure on factor prices and hence the short-run equilibrium will be thelong-run equilibrium, other things being equal.

6 INFLATIONARY GAP AND DEFLATIONARY GAP

In the short run, the equilibrium national income may not be equal to the full-employmentnational income.

If the equilibrium national income is higher than the full-employment national income, theeconomy is at an above-full-employment equilibrium. The output gap, which is the excessof the equilibrium national income over the full-employment national income, is positive.A positive output gap is also known as an inflationary gap.


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Above-full-employment equilibrium

In the above diagram, the equilibrium national income (Ye) is higher than the

full-employment national income (Yf). The output gap (Ye Yf) is positive.

If the equilibrium national income is lower than the full-employment national income, theeconomy is at a below-full-unemployment equilibrium. The output gap, which is theexcess of the equilibrium national income over the full-employment national income, isnegative. A negative output gap is also known as a deflationary gap.

Below-full-employment equilibrium


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In the above diagram, the equilibrium national income (Ye) is lower than the

full-employment national income (Yf). The output gap (Ye Yf) is negative.If the equilibrium national income is the same as the full-employment national income, theeconomy is at the full-employment equilibrium.

Full-employment equilibrium

When the economy is at the full-employment equilibrium, there is neither inflationary gapnor deflationary gap.

Note: In Keynesian economics, inflationary gap and deflationary gap do not refer topositive output gap and negative output gap. An inflationary gap is the excess ofplanned aggregate expenditure over national income at the full-employmentnational income. In other words, it is the decrease in planned aggregate expenditurewhich is needed to close a positive output gap. A deflationary gap is the shortfall ofplanned aggregate expenditure below national income at the full-employmentnational income. In other words, it is the increase in planned aggregate expenditurewhich is needed to close a negative output gap.

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Chapter 13_the Theory of Income and Employment Determination

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