National Income Determination (II)

7/28/2019 National Income Determination (II)

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Ch. 3 : National Income

Determination (II)

(Simple Keynesian Model)


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C=Ca + cYd

C

Y


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I=Ia

Y

I


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G=Ga

Y

G


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X=Xa

Y

X


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T=Ta

Y

T


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M=Ma + mY

Y

M


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

Y

AE

Y*


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Y

$

I+G+X

S+T+M

Y*


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Fiscal Pol icy

Discretionary Fiscal Policy

expansionary fiscal policy

(1) increased government spending,

(2) lower taxes, or

(3) a combination of the two.


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contrationary fiscal policy

(1) decreased government spending,

(2) higher taxes, or

(3) a combination of the two.


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Problems of Fiscal Policy

1. Recogn it ion Lag

2. Execu tive Lag

3. Response Lag


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Changing Government

Expenditure or Taxes? 1. Location of Effects

2. Time Lag

3. The Reversibility of the Policy

4. The Publics Reaction to Short-term

Changes


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Built-in stabilisers

Built-in stabilisers are those institutional

arrangements that automatically increase

government deficit (or decrease surplus)during slumps/recessions, and increase

surplus (or decrease deficit) during booms,

without the government having to make anypolicy decision.


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Examples of built-in stabilizers

Progressive Tax System

Welfare Scheme

Government Purchases

Corporate and Family Savings


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Some built-in stabilizers that may

create disincentives: progressive taxation

unemployment and welfare benefits


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Some built-in stabilizers that do

not create disincentives:

corporate savings

family savings


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Limitations of built-in stabilizers:

Built-in stabilisers can reduce fluctuations

but cannot maintain full stability.

built-in stabilisers may reduce the speed ofrecovery


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Balanced-Budget Multipl ier

C=Ca+cYd

G=Ga

I=Ia

T=Ta


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The government expenditure multiplier:

Kg=1/(1-c) The tax multiplier :

Kt=-c/(1-c)

The balanced-budget multiplier:Kb=1/(1-c) + -c/(1-c)

=1


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Ga by $1 will increase income by:

1+MPC+MPC2+MPC3 ......---(1)

Ta by $1 will decrease income by:

MPC+MPC2+MPC3 ......---(2)

Ga - Ta = 1


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Recessionary (Deflationary) Gap and F iscal Policy

AE

Y

Ye Yf

AE

AE


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I nf lationary Gap and F iscal Policy

AE

Y

Yf Ye

AE

AE


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Paradox of Thrift

Thriftiness, while a virtue for the individual,

is disastrous for an economy.


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If consumers seek to save a larger amount

out of any given level of income, thatattempt to save more may lead to a fall in

income leaving the amount of savings

unchanged or even decreased.


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Case 1:

I nvestment expenditure is autonomousGiven: S = -Ca+(1-c)Y

I =Ia


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The Paradox of Thr if t

I,S

I=Ia

S1

Y1

S2

Y2

Y


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Example

S1=-20+(1-0.75)Y

I=20


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At equilibrium,

I=S

20=-20+(1-0.75)Y

40=0.25Y

Y=160


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the realized saving is:

S1=-20+(1-0.75)Y

=-20+0.25(160)

=-20+40

=20


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Suppose the saving function shifts upward,

S2=-10+(1-0.75)Y

I=20


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At equilibrium,

I=S

20=-10+(1-0.75)Y

30=0.25Y

Y=120


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Now the realized saving is:

S2=-10+(1-0.75)Y

=-10+0.25(120)

=-10+30

=20


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Case 2:

I nvestment expenditure is an increasingfunction of national income

Given: S = -Ca+(1-c)Y

I = Ia+eY


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I,S

I=Ia+eY

S1

Y1

S2

Y2

Y


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How the paradox can be resolved?

If planned investment increases as a result

of the increase in planned saving, then there

may not be a decrease in national output.


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I,S

I=Ia

S1

Y1

Y


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I,S

I=Ia

S1

Y1

S2

Y

Y2


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I,S

I=Ia

S1

Y1

S2

Y

I=Ia

Y2


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I,S

I=Ia

S1

Y1

Y


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I,S

S1

Y1

S2

Y2

Y

I=Ia+eY


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I,S

I=Ia+eYS1

Y1

S2

Y2

Y

I=Ia+eY


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Revision Exercise

What is the 'paradox of thrift'? Explain, with theaid of diagrams, how this paradox can be resolved.

Compare the magnitudes of the income multipliers

of the simple Keynesian model under the

following tax systems: lump sum income tax,proportional income tax and progressive tax.


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What are automatic stabilizers? Give two

examples to illustrate your answer.

Compare the effectiveness of the

proportional income tax and the progressiveincome tax in reducing economic instability.


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'Consumption depends on the level of

income.''The level of income depends on

consumption.'

With the aid of diagrams, reconcile these

two statements with reference to the

Keynesian model.


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Answer:

In the consumption curve, consumption is a

function of the level of income. As incomeincreases, consumption will also increase. In theKeynesian model, the consumption is assumed to

be: C = a + c Y where a is the intercept and c isthe marginal propensity to consume.

If the consumption curve shifts upward, thelevel of income will be increased because of theincrease of aggregate demand in the economy.Therefore the level of income depends onconsumption.

There is no circular reasoning: it is a case ofmutual determination of income and consumption.

Mutual dependence is not an inconsistency.


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Consider the following information about

Country A:C = 0.8Yd

I = 260

G = 400T = 0.5Y

X = 300

M = 0.2Y


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Find:

i. the equilibrium level of national income

ii. the income multiplier

iii. the tax multiplier


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Answer a. Find the equilibrium income.

In equilibrium, Y = AE

Y = C + I + G

= 400 + 0.8(Y-T) + 50 + 32

= 482 + 0.8(Y - 40 - 0.375Y)

= 450 + 0.5Y

0.5Y = 450

Y = 900

In equilibrium, Y = 900


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b. b. Find the income multiplier.

Income multiplier = 1/(1-c-ct)

= 1/[1-

0.8+(0.8)(0.375)]

= 2

The income multiplier is equal to 2.


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c.

Given that the existing income level is

900, and that the income multiplier is 2,

the government has to increase itsexpenditure by 50 for full employment to

be attained.


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Consider the following information:

Labour force (L) = 600

Production function = 3L

Find:

i. the full-employment income level

ii. the no. of labour that is unemployed


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Suppose the government is planning to

increase her expenditure in order to

stimulate the economy. How much

expenditure should the government increase

to achieve full-employment?


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In a closed economy, private consumption

(C), investment (I), government expenditure

(G), transfer payments (TR) and tax revenue

(T) are as follows:

C = 50 + 0.8Yd

I = 50

G = 100

TR = 50T = 0.25Y


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a.

(i) What is the equilibrium value of Y?

(ii) What is the value of the multiplier for

government expenditure?(iii) What is the balance of the government

budget?


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b. Assume that government expenditure is

now increased by 20, from 100 to 120.

If the government wants to pursue a

balanced budget, what should be the

amount of transfer payments?


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AL Questions


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AL 2000/5

AD, X, M

Y

X

C+I+G+X-M

450

trade deficitM

(C+I+G+X-M)

Y* Y**

A

B

C

D

National Income Determination (II)

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