Notes on Income Determination 1 Prelude: A Highly Simplied Economy

In this section, our attention is on how equilibrium national income is determined, and what factors cause a change in national income. Let us recapitulate the model representing the circular of income. At ow the heart of it, we had two economic units: rms and households.1 Firms produce goods and services. To this end, they hire labourers, borrows money from banks, rents land/building from the households, and buysentrepreneurial service from its owners. This generates a stream of income to the households: wage to laborers, interest, rent and prots. The sum of wages, interest payments, rentals and prots constitute the GDP, by income method. Our task here to determine what determines the level of income, or GDP in an economy. Given the income, households (including the entrepreneurs who own the rms) purchase nished goods from the rms. This consists of nal goods and services for consumption as well investment goods like machines etc. It is evident, therefore, the total spending on nal goods and services depend on the total income that the households receive. It is useful to construct, at this stage, the amount the household is willing to spend for each level of income.2 Given that we are considering a closed economy without government, the disposable income of the households constitutes of what they receive from the rms. Let us call it Y . The desired aggregate expenditure, on the other hand, constitutes of desired consumption and desired investment. In symbols.
1 We

can add governments and foreign sector without once we understand how this simple

economy works. 2 A parallel example from microeconomics would be constructing the demand schedule: given the price, how much the households are willing to consume? It turns out that the demand curve is a planningschedule.

AE = C + I

(1.1)

1.1

Desired Consumption

Desired consumption depends many factors. For example, if interest rate increases, it is more attractive to save and cut down consumption. If our wealth (say, a 100000$ bequest from parents) increases, we will, doubtlessly, consume more. An expectation of increased future income stimulates desired consumption. Similarly, anticipation of decreased future income ( rainy days decreases ) current consumption spending. Part of desired consumption that is determined by factors other than income is known as autonomous consumption (C). For example, autonomous consumption might be 100 Rs. If interest rate increases or there is an anticipation of reduced income, this might go down to 50. Increase in wealth and or anticipation of good times may push up autonomous consumption to 150 Rs. Part of desired consumption that is determined by current income is known as induced consumption. An important factor to notice here is that if our income goes up, say, by 100 Rs, we may not ( and generally do not) increase our desired consumption by 100 Rs. We would like to hold a part of it as savings, and spend the rest. Aggregating over the savings behavior of all individuals within the economy, we arrive at a fraction that the economy, saves out of incremental income. This fraction is known as marginal propensity to save and is denoted by mps or simply s. Suppose s = :6. Then, if income increases by 100Rs, the increase in savings for the economy is simply (:6) 100 = 60Rs: The other fraction of incremental income is simply consumed. This fraction is known as marginal propensity of consumption and is denoted by mpc or simply c. If c = :4, and income increases by 100 Rs, desired consumption increases by (0:4 100) = 40 Rs.

Suppose income increases from 0 to Y Rs. Then the induced consumption increases by c (Y 0) = c Y Rs. The total consumption, on the other hand,

is sum of autonomous and induced consumption. Thus, we can write

C =C +c Y The above relationship is called a consumption function.3

(1.2)

For example, if the autonomous consumption is 100 and the mpc is :6, the consumption function is given by

C = 100 + :6Y

(1.2a)

The above relationship can be used to plot a consumption schedule. For example, Y 0 20 40 50 C 100 100 100 100 C 100 112 124 130

Note that, if income increases by 20 Rs (from 0 to 20), desired consumption C 12 increases by 12 Rs. Thus, the MPC is = = 0:6:4 Y 20 If we plot the relationship between C and Y , we can represent the consumption function graphically.
3 More

accurately, a Keynesian consumption function. Keynes (1883-1946) proposed that

current income is the major determinant of desired consumption. 4 The greek letter delta ( ) stands for change in .

124 112

100

20

40

Fig 1: A Hypothetical Consumption Function In the jargon of mathematics, we say that the intercept of consumption function is 100. Thus, the geometrical equivalence of autonomous consumption is intercept, and that of the M P C is slope. Consider two consumption functions, one in (1.2a) and another

C = 100 + :8Y

(1.2b)

The only dierence between (1.2a) and (1.2b) is that the mpc is dierent. For the consumption function (1.2b), out of every 100 Rs increase in income, desired consumption increases by 80Rs.5 A possible consumption schedule for the second consumption function is Y 0 20 40 50
5 For

C 100 100 100 100

C 100 116 132 140

a mathematician, the dierence is that the second consumption function has a higher

slope (0:8 as opposed to 0:6)

If we plot both of them in the same graph, we end up with

C 1.2b 1.2a

100

Fig 2: Consumption function with a dierent MPC Thus, with higher MPC, the consumption function rotates up, and represents higher consumption for each level of income. What about higher autonomous consumption? Suppose the autonomous consumption goes up to 200Rs. Let the new consumption function be

C = 200 + :6Y

(1.2c)

The only graphical dierence between (1.2c) and (1.2a) is that the intercept term for the former is higher, and hence there is higher desired consumption for all values of Y (check this). Thus, a higher autonomous term causes an upward, parallel shift in the consumption function.

C 1.2c

1.2a

100

Figure 3: A shift in consumption function due to higher autonomous consumption

1.2

Desired Investment:

Desired investment consists of new plants and equipments, inventory investment and residential investment. They depend upon the interest rate: higher interest rate increases the cost of borrowing from the market and thus dampens investment. It also depends upon rms expectation about the future state of economy. Optimism leads to more desired investment; pessimism leads to less desired investment. Firms also keep a desired level of inventory. If the inventory goes up, it is a signal for the rms to cut back investment. On the other hand, if the inventory decumulates, it is a signal for the rms to cut back production. However, desired investment does not depend on the level of income. Therefore, against Y , it is autonomous.6 We denote is as
6 We

are not making the assumption that investment is constant. Investment is the most

volatile component of aggregate expenditure, and change in investment behaviour is an important explanation for uctuations in national income.

I=I If the desired investment is, say, 500, then the graph is as follows,

(1.3)

=500

Figure 4: Desired investment as autonomous expenditure

1.3

Aggregate Expenditure

Since the aggregate expenditure (in this highly simplied economy) is the sum of consumption and investment expenditures, the equation (1.1) reduces to

AE

= C +I = C +c Y +I = C +I +c Y = A+c Y

(1.4)

Here, A is the sum of autonomous consumption and investment and thus represents the total autonomous expenditure. Example: If the consumption function is given by (1.2a) and the investment by 500, then

AE

= =

100 + :6Y + 500 600 + :6Y

(1.4a)

Here, A = 600. The relation between AE and Y is called the AE function. How do we represent this graphically? Notice that, since investment is an autonomous element, the eect is same as adding an autonomous term to consumption function. Thus, graphically, the AE function is parallel to the consumption function(refer to gure 3). The slope of the AE function is given by MPC. Changes in either autonomous consumption or investment will cause a parallel shift in aggregate expenditure. Change in MPC will cause a rotation of AE function (i.e. make it more or less steep). An AE schedule for our hypothetical economy (equation 1.4a) is presented below. Y 0 20 40 50 C 100 100 100 100 C 100 112 124 130 I 500 500 500 500 AE 600 612 624 630

Equilibrium National Income

Having laid the foundations of the analysis, we proceed to determination of equilibrium national income. In what follows, we make an important assumption about the behavior of rms. We assume that (a) rms are able and willing to supply any amount of output that is demanded, and that (b) changes in their production levels do not require a change in their product prices. These are somewhat extreme assumptions and we will relax them in the future.

Let us remember how we dened a state of equilibrium. When something is in equilibrium, there is no tendency for it to change. The following table illustrates the determination of equilibrium national income for our economy. Y 500 1000 1500 2000 2500 AE 900 1200 1500 1800 2100

Suppose rms are producing a nal output of 500Rs (or, if you like, 500 million Rs).Thus, the national income is 500Rs. At this level of actual national income, the desired expenditure is 900 Rs. This will result into a decumulation of planned inventories. This acts as a signal to the rms to expand the production. As they do so, national income, that is, Y also rises. Thus, any Y which generates an AE higher than itself can not be equilibrium. Repeat the argument with any Y when AE < Y (I leave this as a homework). Such a situation can not be an equilibrium either: there will be a pressure on national income to fall. Finally, look at the national income level of 1500Rs At this level, and only at this level, desired aggregate expenditure is equal to aggregate national income.Purchasers can full their spending plans without causing inventories to change. There is no incentive for the rms to alter output. Thus, the equilibrium condition for our simple model of national income determination is

Y = Desired AE

(1.5)

2.0.1

A Graphical Tool: The 45 line

AE

45

Figure 5: The 45-degree line Figure 5 contains a line on which, everywhere, AE=Y. However, the AE function graphs the desired aggregate expenditure. The point where the desired aggregate expenditure cuts the 45 line is the point of equilibrium.

AE

AE

Y*

10

Figure 6: Equilibrium national income Mathematical Note :7 What is the value of equilibrium national income? The equilibrium condition is Y = AE (Y ), which implies Y = 600 + :6Y , solving for Y; we get Y = 1500:0

Adding Government

Typically, a government has three functions : it purchases goods and services (G), makes transfer payments (T r) and collects tax (T x) to nance purchases and transfers. Purchase of goods and services adds directly to aggregate expenditure as an autonomous element. Transfer payments and taxes drive a wedge between the national income and the disposable income. More specically, consumers now receive YD = Y + T r T x. So if the national income is 100 Rs, tax

is 20 Rs and transfer payments are 30 Rs, the disposable income is 100+30-20 =110Rs. Let us consider the same example as before, i.e. C = 100 + :6Y . In presence of government, this has to be modied as C = 100 + :6YD : Suppose, again, that the tax and transfer are autonomous. We, for the sake of example, use the following values: G = 1000; T x = 500; T r = 200: Then, AEjwith govt = C +I +G = = 100 + :6(Y + 200 1420 + :6Y 500) + 500 + 1000 (1.6)

Compare this with the AE without government. The only change is in the autonomous part. Thus, adding government does not change the slope of AE line. Note: With government, the output is Y = 3550:0
7 You

can skip the section without any inconvenience whatsoever.

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3.1

Comparative Statics: The Multiplier Eect

Comparative statics examine the eects of changes in the factors that we hold constant (here the autonomous expenditures and the MPC) on the equilibrium level of income. Now let us be more specic about these changes. We would like to know the size of these changes, especially those which arose due to changes in autonomous expenditure. Remember that, autonomous expenditure consists of autonomous consumption, investment, and government scal tools such as government expenditure, taxes and transfers. In this simple economy, the change in equilibrium national income due to a change in autonomous expenditure is always larger than the latter. This principle is known as the multiplier principle. To see how it operates, assume the AE function in 1.6. Now suppose that government expenditure goes up by 400. With this, the new AE function is (call it AE1 )

AE1

= =

1420 + 400 + :6Y 1820 + :6Y

Now try to determine equilibrium national income for this economy. This is given by Y 3550 4050 4500 4550 5050 12 AE1 3950 4250 4520 4550 4850

Comment: A less painfull way of doing this is to solve for Y in Y = 1820+:6Y: Note that, as autonomous expenditure increases by 400 unit, the equilibrium national income increases by 1000 Rs. Thus, if autonomous expenditure increases by 1 Rs, national income increases by value of multiplier is 2:5. The value of the multiplier depends on the MPC (remember the example done in-class). If we want to consume higher proportion of incremental income, the increase in aggegate expenditure is higher.8
1000 400:0

= 2:5 Rs. We say that the

Adding the Foreign Sector: Open Economy

The foreign sector comprises of export and import of goods and service. The impact of foreign sector on aggregate expenditure is measured by adding net exports to the aggregate expenditure. Net export is denoted by X Net export depends on the following factors a) Foreign income: higher foreign income increases exports (foreignersdemand for domestic goods and services). b) Domestic income: This determines import. The higher the income, the higher the import (e.g. if Indian income is high, we will buy more cars, and import more oil). The relationship is depicted in the following equation9 M.

M =M +m Y
8 If

you are alert enough, you will notice that, the value of the multiplier in the above
1 :4

example was 2:5 =

1 1 :6

1 . 1 MP C

This is no accident and can be derived. The

derivation, however, is way beyond the scope of this module. A note of caution: the tax multiplier in this example is
mpc : 1 mpc

The negetive sign signies

that if taxes are reduced, equilibrium income increases. In this example, if taxes are reduced by 100e, then national income increases by
:6 1 :6

100 = 150:0 e.You can see that taxes are

less eective in increasing the output. Why? I leave this as a homework. 9 Notice the similarity with consumption function.

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M is autonomous import, i.e. import that is based on all factors other than domestic income. The marginal propensity to import is denoted by the letter m. We can use numerical values, e.g. D = 100 and m = :2. This means, if domestic income goes up by 100Rs, import increases by 20Rs. Numerical Example: Suppose X = 200 and M = 100+:2Y . Then net export

M = 200

:2Y

Notice that, if Y > 500Rs net export is negative, that is, the country is importing more than it is exporting. Let us add the net export to the closed economy AE to obtain a complete picture.

AEjOE

= =

1420 + :6Y + (200 1620 + :4Y

:2Y )

(1.7)

Compare with (1.6). Notice two things10 a) The autonomous part has gone up. Not surprisingly, because we are adding autonomous export and import. Notice that, if autonomous imports are very high ( say, 300 instead of 200), then net export is negative, and as a result, the autonomous AE goes down. b) The coe cient of Y has gone down to :4. So, if the government increases its expenditures by 100Rs; the recepients of these incomes spend only 40 Rs on domestic goods and services in the rst round, and the rest is spent on foreign goods and services. As a result, the stimulus on domestic economy is reduced, re ected in a lower value of the multiplier. Government actions (or, for that matter, an increase in autonomous investment) thus aect a closed economy more than an open economy.
1 0 Draw

the AE schedule here and compare with the closed economy case.

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4.1

Expectations and Economic Fluctuations:

Expectation about future plays a big role in macroeconomics. Imagine a situation in which many rms begin to feel optimistic about future economic prospects. The optimism may lead to increase their desired investment, thus shifting up the AE function. As we have seen, however, any upward shift in AE function will lead to an increase in national income. So, if enough rms are optimistic about the future and take actions based on their optimism, their action will create the economic situation they expected. Now if many rms begins to feel pessimistic about future economic conditions, this pessimism may lead them to scale down or cancel investment decision. This will lead to a downward shift in AE function and hence a decrease in national income through the multiplier process. Thus, an explanation of economic uctuations is the a change in expectations. How these expectations are formed is an area of active research.

Aggregate Demand And Aggregate Supply

So far, we have considered the simplest macro model. The crucial assumption was that if demand (that is AE) exceeds supply (that is Y, the value of output generated by suppliers, which is also total income), then suppliers will expand production (and hence generate more Y) without increasing the price. In such a world, change in AE (that is aggregate demand) explains the change in equilibrium Y. Such an output is called demand determined output. Notice that, even if the model was simple, it was extremely useful to have a rst look at the government scal policy, linkage of economies through foreign trade and the role of expectations in an economy. Our next aim in this chapter is to expand the model further and see if we can explain price formation within an economy.

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The Demand Side of the Economy

Consider the AE schedule once again. A typical AE schedule is drawn with a constant price level. If the price level changes, AE will shift up (or down). Suppose price level decreases. This leads to a) An increase in real wealth, especially increase in real money balances ( the total money held in wallet and banks divided by the price level). Since increased wealth increases autonomous consumption, this results into an upward shift of the AE schedule. b) Since domestic price level falls, the export increases and the import decreases. This provides further impetus to autonomous aggregate expenditure. The net eect of (a) and (b) is thus an increase in autonomous aggregate expenditure, which is re ected in an upward shift of the AE curve and a higher Y.

AE AE2 (P= 10)

AE1 (P= 15)

Y1

Y2

Figure 7: Price level and AE Therefore, a decrease in price level causes an increase in output. Similarly, an increase in price level will shift the AE schedule down and decrease the output. If we trace out the relationship between price and output (or, equilibrium aggregate demand), we get an inverse relationship. Plotting the inverse 16

relationship against price gives us the aggregate demand (AD) curve.

15

10 AD

Y1

Y2

Figure 8: Aggregate demand curve A change in price level thus causes a movement along the AD curve.

6.1

Shifts in the AD Curve

For a given price level, any change in an autonomous component of aggregate expenditure causes the AD curve to shift. The change in autonomous expenditure could be the result of a change in government policy,such as the levels of government purchases and taxation. Or the change in autonomous expenditure could be caused by something beyond the governments control, such as a change in household consumption expenditure, rmsinvestment behavior or foreignersdemand for Indian exports. Such an increase in autonomous expenditure and the subsequent increase in equilibrium output is depicted in the following (hopefully, now familiar) diagram.

17

AE AE2 (P= 15)

AE1 (P= 15)

Y1

Y2

Figure 9: Change in AE with constant price This leads to a rightward shift in AD, because for all price level, AD has increased.

15 AD2

AD1 Y1 Y2 Y

Figure 10: A shift in AD For a given price level, an increase (decrease) in autonomous expenditure shifts the AE curve upward (downward) and AD curve to the right (left). The shifts in AD are called aggregate demand shocks.

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The Supply Side of the Economy

The aggregate supply curve relates the price level to the quantity of output that rms would like to produce and sell on the assumption that technology and the prices of all factors of production remain constant. The shape of the AS schedule depends on cost of production. suppose that the cost of producing one more unit is very high. Then to provide adequate incentive for the producers to supply more, the unit price must be higher. In other words, price and quantity supplied are positively related: the AS curve is positively sloped. However, the slope also depends on the state of the economy. When output is very low (a phase of depression), there are unemployed people and perhaps unused machinery as well. So the incremental cost is not very high. A modest increase in price will induce the producers to produce more output. On the other hand, if output is higher, then to increase output, probably a supplier has to hire people who are already employed elsewhere (by oering higher wages) and also build up new machines. Thus the incremental cost is high, and therefore, price must rise su ciently to induce the suppliers to supply one more unit of output. Thus, the slope of AS increases with output. A typical AS curve is depicted in the following diagram.

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P AS

Figure 11: AS curve

7.1

Shifts in AS Curve

An aggregate supply curve is drawn on the assumption that input prices and technology remains the same. If these factors change, AS shifts. Such shifts are called supply shocks. (a) If factor prices fall, rms will nd the protability of their current production increased. Thus, at each price, they will supply more. For the economy as a whole, there will be more output supplied at each price level. This causes a rightward shift of the AS curve. Similarly, an increase in factor prices will cause a leftward shift of the AS schedule. (b) If technology improves, productivity per labourer increases. This reduces the cost of supply and increases rmssupply for same prices. Thus AS shifts to right.

20

P AS1

AS2

Figure 12: Shift in AS schedule

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs where aggregate demand intersects aggregate supply. It determines the equilibrium values of real GDP and price level.

P AS

P* AD

Y*

Figure 13: Macroeconomic Equilibrium

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8.1

Changes in Macroeconomic Equilibrium

Shifts in AD and AS curves change the macroeconomic equilibrium. The shifts (shocks) that increase equilibrium GDP are called positive shocks, while those that reduce equilibrium GDP are called negative shocks. For example, increased investment or government purchases, a reduction of tax, an increase in autonomous consumption or an increase in foreigners purchase of Indian goods and services will shift the AD curve to right. These are examples of positive demand shock. As a result of positive demand shock, price goes up and output increases. We say that there are two eects of a demand shock: a quantity adjustment (from Y1 to Y2 ) and a price adjustment ( from P1 to P2 ).

P AS

AD1

P2 P1

AD2

Y1

Y2

Figure 14 A positive demand shock The following problem summarizes the eect of supply shock. Make sure you understand it. Problem 1 Suppose that input prices rise. As a result, AS curve shifts to_________ (right/left). Equilibrium price _____________ (rises/falls) and GDP ____________ (rises/falls). This is an example of ________________ (positive/negative) supply shock.

22

Problem 2 Suppose that there is a technological revolution that increases productivity. Diagrammatically, show the e ects on price and GDP. The slope of AS is important about the e cacy of demand shocks. When the AS is (almost) a positive demand shock entails mostly quantity adjustments at, and (almost) no price adjustment. Compared to that, if the AS is relatively steeper, the eect of demand shock is met through price adjustment rather than quantity adjustment. In the limiting case, if the AS curve is completely then there is no price at, adjustment. A completely AS schedule is often called a Keynesian AS curve. at

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