INCOME DETERMINATION IN SHORT RUN: BASIC MODEL Deviation of actual from potential GDP (Income), that is the GDP

P Gap. ( ex-The Great Depression) The determination of GDP in the short run depends on the behavior of key categories of aggregate spending: Consumption (APC and MPC), Investment (autonomous and induced, interest rates), Government Spending (Fiscal measures) and Net Exports. Consumption spending depends on real interest rates and business confidence. A necessary condition for GDP to be in equilibrium is that desired domestic spending equals actual output.
Equilibrium GDP AE= Y AE (C+I) E
45

AE= Y

Desired Aggregate Expenditure

Real NI (GDP)

Equilibrium GDP
S> I I> S

Changes In GDP
Shifts in Aggregate Spending Function
In E E 1 E 0 In Y o Y Y o 1 Real NI (GDP) A E In E
Desired Aggregate Expenditure Desired Aggregate Expenditure

AE 1 AE0

In Y

Y o Real NI (GDP)

Y 1

Consumption, Investment Function and Multiplier

1. Consumption Function and Psychological Law Consumption Function and Propensity to Consume Consumption function or propensity to consume refers to the general income consumption relationship. Symbolically, it can be expressed as C=f (Y). Consumption refers to the expenditure on consumption at a given level of income, while propensity to consume refers to the schedule showing consumption expenditure at various levels of income. Psychological Law of Consumption Psychological Law of Consumption contains the following three interrelated propositions(i) When aggregate income increases aggregate consumption also increases, but by a somewhat smaller amount. (ii) The increase in income will be divided in some ratio between saving and consumption. (iii) Both saving and consumption will increase as a result of the increase in income.

Schedule of Consumption Function

INCOME (Y) 0 50 100 150 200 250 CONSUMPTION (C) 20 60 100 140 180 220 Y=C B
Dissaving Saving

SAVING (S= Y-C) -20 -10 0 10 20 30

Consumption

Income

Technical Attributes of Consumption Function

Average Propensity to Consume (APC) Average Propensity to Consume is defined as the ratio of absolute consumption to absolute income. APC= C/Y. Marginal Propensity to Consume (MPC) Marginal Propensity to Consume (MPC) refers to the ratio of small change in consumption to small change in income. MPC= change in Consumption/change in Income. c Properties of MPC c 1. MPC is greater than zero but less than one. c 2. MPC falls with successive increase in income. 3. MPC of the poor is greater than that of the rich.
INCOME

1.

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii)

Subjective Factors: Subjective factors are endogenous or internal to economic system. According to Keynes, these factors are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary circumstances. Psychology of Human Nature: There are eight motives which lead the individuals to refrain from spending out of their incomes. They areTo build the reserve for unforeseen contingencies (death, diseases,) To provide for anticipated future needs.( retirement, higher studies) To enjoy an enlarged future income by investing funds out of current income. To enjoy a sense of independence or not to depend on others. To posses power or to get higher social or political status. To secure enough funds to carry out speculation. To bequeath a fortune. To satisfy purely miserly instinct.

Factors Affecting Consumption Function

(i) (ii) (iii) (iv) 2. (i) (ii) (iii) (iv) (v) (vi)

Institutional Arrangements: with respect to the behavior of business corporations and governments, Keynes listed the following four motives for accumulation: Enterprise- the desire to expand or to do big things. Liquidity- the desire to face emergencies successfully. Rising Income the desire to demonstrate successful management. Financial Prudence the desire to ensure adequate financial provisions against depreciation. Objective Factors: Objective factors that cause shift in consumption function are. Changes in Wage Level Distribution of Income Windfall Gains and Losses Fiscal Policy Changes in Expectations Rate of Interest

Investment Function
In Keynesian economics, investment means real investment and not financial investment. Real investment implies the creation of new machines, new factory buildings, roads, bridges, and other forms of productive capital, which directly generates new jobs and increases production. Real investment does not include the purchase of existing stocks, shares and securities, which is merely an exchange of money from one hand to another. Such an investment is simply financial investment and has no direct impact on the employment and output of the economy. Types of Investment 1. Induced or Private Investment I 2. Autonomous or Public Investment I 3. Planned Investment and Unplanned Investment 4. Gross and Net Investment: Gross Investment includes a) net investment Income and b) depreciation and Net Investment includes Gross Investment minus Depreciation
Investment

Propensity to Invest 1. Average Propensity to Invest ( API): The ratio between aggregate investment and aggregate income. API= I/Y. 2. Marginal Propensity to Invest ( MPI): The ratio of change in investment to change in income.
I L I2 I1 I T

Investment

Investment

I1

Y1 Income

Y1

Y2

Income

PROBLEMS Recession Aggregate Spending < GDP Recessionary Gap = shortfall Inflation Aggregate Spending > GDP Inflationary Gap = excess

The Multiplier
The concept of Multiplier is an integral part of Keynes Theory of Employment. Keynes believed that an initial increment in investment increases the final income by many times. Keynes gave the name Investment Multiplier which is also known as Income Multiplier or simply Multiplier. Multiplier is expressed as K= Change in Income (Y)/ Change in Investment (I) According to Kurihara, The Multiplier is the ratio of change in income to the change in Investment. According to D.Dillard, Investment Multiplier is the ration of an increase in income to given increase in Investment In short the Multiplier tells us how many times the income increases as a result of an initial increase in investment.

 The multiplier tells us how many times the income increases as a result of increased investment. It applies to autonomous investment. There is closed economy. There is no change in the prices of commodities. There is no time lags. The MPC remains constant. The situation is less than full employment. The factors and resources of production are easily available. The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, growth in spending can expand output by a multiple of the original increase. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).

The Multiplier Principle

Expenditure stage Round 1 Round 2 Round 3 Round 4 Round 5 All others Total Additional income
(Rs)

Additional consumption
(Rs)

Marginal propensity to consume 3/4 3/4 3/4 3/4 3/4 3/4 3/4

1,000,000 750,000 562,500 421,875 316,406 949,219 4,000,000

750,000 562,500 421,875 316,406 237,305 711,914 3,000,000

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

Relation between MPC and Multiplier Total Income = Total Consumption + Total Investment Or Y=C+I Or Change in Income = Change in Consumption + Change in Investment Or Change in Investment = Change in Income -- Change in Consumption By definition, Multiplier is K = Change in Income / Change in Investment Substituting the value of Change in Investment in K equation we get K = Change in Income / Change in Income -- Change in Consumption Dividing both the numerator and denominator by Change in Income, we have 1 Change in Income -- Change in Consumption K= Change in Income 1 K = 1-- Change in Consumption / Change in Income K = 1/ 1MPC, K = 1/ MPS

Y= C + I C+I+G
E1 I

C+I

CONSUMPTION INVESTMENT

E0

INCOME

 The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4). Here, a Rs 1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent etc. until

Leakages of Multiplier
Saving Debt Cancellation Imports Price Inflation Hoarding Purchase of old shares and securities Taxation Undistributed Profits

A Higher MPC Means a Larger Multiplier

MPC
9/10 multiplier 4/5 3/4 2/3 1/2 1/3
1

Size of
10.0 5.0 4.0 3. 2.0 0 1.5

As the MPC increases, more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher MPCs, higher multipliers result. Specifically the relationship follows this equation:

M = 1 - MPC

1. E 1 E 0

AE= Y AE 1 AE 0 Y 1

2. E 1 E 0 Y Y 0 Real NI 1 (GDP) AE 1 AE 0

AE= Y AE 1 AE 0

Desired Expenditure

Desired Expenditure

Y 0 Real NI (GDP)

1. Unity Multiplier 2. An intermediate case. 3. A steep AE, large Multiplier.

3.

E 1

AE= Y

Desired Expenditure

E 0 Y 0 Y 1 Real NI (GDP)

Real-World Significance of The Multiplier

In evaluating the importance of the multiplier, one should remember:
taxes and spending on imports will dampen the size of the multiplier; it takes time for the multiplier to work; and, the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

(BUSINESS CYCLES)

Peak
Cont

Peak
sion

Peak
n Ex pa ns io

Peak

Peak
n Exp ans io

Peak

Level of GNP

i on

ans io

sio

ans

Contrac

Cont

Cont

Cont

Cont

Expa n

an

n ractio

Exp

Ex p

Exp

n ractio

n ractio

n ractio

n ractio

Throug Throug h h Depression

tion

Throug h TIME

Throug Throug Through h Depression h

Phases of Business Cycles

Business Cycles has different phases. 1. Expansion (Boom, Upswing or Prosperity) 2. Peak ( upper turning point) 3. Contraction (Downswing, Recession or Depression) 4. Trough (lower turning point)

Anti Cyclical Policies

MONETARY FISCAL EXIM POLICY-DEVALUATION/APPRECIATION

Inflation and Unemployment

Models of the short term determination of GDP explain why actual GDP deviates from potential GDP. Actual GDP above potential can be associated with inflation, while actual GDP below potential is associated with unemployment and lost output. What determines aggregate spending? Desired aggregate spending includes desired consumption, and desired government spending, plus desired net exports. It is the amount that economic agents want to spend on purchasing the national product. A change in personal disposable income leads to a change in private consumption and saving. The responsiveness of these changes is measured by the MPC and MPS, which are both positive and sums one. A change in wealth tends to cause a change in the allocation of disposable income between consumption and saving. The change is consumption is positively related to the change in wealth, while the change in saving is negatively related to this change. Investment depends, among other things, on real interest rates and business confidence. The part of consumption that responds to changes in income is called induced spending.

Price Stability
Types of price rise1. Creeping-2 percent annually 2. Walking-5 percent annually 3. Running-10 percent annually 4. Galloping or Hyper Inflation-more than 10 percent annually On the basis of time1. Peace time 2. War time 3. Post war time Main causes 1. Demand Pull 2. Cost-push-wage push, profit push, material push

Demand Pull Inflation

The Monetarist Theory S P3 P2 P2 D2 D1 D M Output d d1 P1 s d2 Output d4 d3 Keynesian Theory s

Price Level

P1 P

m m1 m3 m4

Cost Push Inflation

S

E1 P1 P S1 S M1 M D E

Price Level

Output

INFLATIONARY GAP
According to Keynes, inflationary gap exists when, at full employment income level, aggregate demand exceeds supply. This means that due to increase in investment and government expenditure, the money income increases, but production does not increase because of the limitations of productive capacity. As a result, an inflationary gap comes to exist, causing the prices to rise. The prices continue to rise so long as the inflationary gap exists.

Inflationary and Deflationary Gaps

Inflationary gap occurs when AD exceeds AS at full employment level of output. In this case, money rises to a higher equilibrium, but real income being at full employment output level remains unchanged. As a result there is an upward rise in prices because the consumers compete for limited supply of output and bid prices up.

Inflationary gap A B E

AS or Y=C+I+G AD or C+I+G

Deflationary gap prevails when AD is less than AS at full employment level of output. Income equilibrium occurs while resources are unemployed.

EXPENDITURE (C+I+G)
O

Income (Y) Yf YO B A AD or C+I+G Deflationary gap E AS or Y=C+I+G

EXPENDITURE (C+I+G)
O

Income (Y) YO Yf

Equilibrium GDP
Equilibrium GDP: At the Equilibrium level of GDP, purchasers wish to buy exactly the amount of national output that is being produced. At GDP above equilibrium, desired spending falls short of national output, and output will sooner or later be curtailed. At GDP below equilibrium, desired spending exceeds national output, and output will sooner or later be increased. In a closed economy with no government, desired saving equals desired investment at equilibrium GDP. Changes in GDP: With constant price level, equilibrium GDP is increased by a rise in the desired consumption or investment spending that is associated with each level of NI. Equilibrium GDP is decreased by a fall in desired spending. Changes in equilibrium is also because of Multiplier effect.