National Income

Three and four sector model

Introducing Government

Budget Balance = T G
T = Taxes or Government Revenue
G = Government Expenditure (autonomous)
When T > G Budget Surplus
When T < G Budget Deficit
When T = G Balanced Budget
When T > G Positive Government Saving
When T < G Negative Government Saving
Public Saving = Government Revenue
Government Expenditure

Government expenditure and aggregate

demand
When we include the government sector,
aggregate demand can be re-written as

AD C I G
G = govt expenditure on goods and services, another
autonomous component
Government also levies taxes (T) and pays transfer benefits
(B). We define net taxes (NT) as direct taxes minus transfer
benefits

The Public Saving (Budget Surplus) Function

National
Income (Y)

Government Net Taxes

Purchases (G) (T = 0.1Y)

Public Saving
(T-G)

2500

850

250

-600

5000

850

500

-350

8750

850

875

25

10,000

850

1000

150

15,000

850

1500

650

The Public Saving (Budget Surplus) Function

Introducing Net Export = X - M

Exports: depends on spending decision made by foreign
households. Therefore , it will not change as national
income changes. This means that X is autonomous .
Note that as foreign income increases, demand on
domestic product by foreign countries increases
(exports).
Imports: Depends on spending decisions of local
households or domestic consumption. Therefore as Y
rises, M rises, and as Y falls M falls too.
There is a positive relationship between national income
and desired imports .

A Net Export Schedule

National
Income (Y)

Export
(X)

Import
(IM = 0.1Y)

Net Export
(X-IM)

5000

1200

500

700

10,000

1200

1000

200

12,000

1200

1200

15,000

1200

1500

-300

20,000

1200

2000

-800

The Net Export Function

Equilibrium National Income

Aggregate Expenditure Approach We will add the government expenditure and net
expenditure to the aggregate expenditure function so that:
AE = C + I + G + NX
Note that the sum of a, I, G, and X represents the
autonomous expenditure.
The slope of the AE function depends on the marginal
propensity to spend on national income (Z) .
Now, after introducing net taxes and net exports, Z will not
be equal to the marginal propensity to consume.

How to measure Z: Example

Assume that the economy produces Rs.1 of extra income:

10 paise will be collected as net taxes.
The disposable income becomes 90 paise.
Assume that the marginal propensity to consume = 0.8,
then 72 paise will be spent on consumption while 18
paise will be saved.
However, 10 paise of all expenditure goes to imports,
thus, the amount to be spent on domestic goods equals 62
paise only.
This means that Z = 0.62 and 1 Z = 0.38.

 The multiplier now (with taxes and imports) will be

1 / (1-Z) = 1 / (1-0.62) = 2.63.
The higher the marginal propensity to import, the
lower the simple multiplier.
The higher the income tax rate, the lower the simple
multiplier.
Note that we can calculate Z by applying the
following formula: Z = b(1-t) - m,
Where b is the MPC, (1-t) is the percentage of
disposable income out of national income, and m is
the marginal propensity to imports.

The AE Function Approach

Y

C=500+.72Y

I = 1250

G = 850

NX=1200-.1Y AE=C+I+G
+NX

500

1250

850

1200

3800

2500

2300

1250

850

950

5350

5000

4100

1250

850

700

6900

10,000 7700

1250

850

200

10,000

15,000

1250

850

-300

13,100

11300

Equilibrium National Income