Simple Keynesian Model

National Income Determination

Two-Sector National Income
Model
1

Outline

Macroeconomics [2.1]
Exogenous & Endogenous Variables
[2.3]
Linear Functions [2.6]
Aggregate Demand & Supply [3.2]
National Income Determination Model
OR Simple Keynesian Model [3.3]
2

Outline

National Income Identities [3.4]

Equilibrium Income [3.5 & 3.11]
Consumption Function [3.6]
Investment Function[3.7]
Aggregate Demand Function [3.8]

Outline

Output-Expenditure Approach to
Income Determination[3.9 ]
Expenditure Multiplier [3.9]
Saving Function [3.10]
Injection-Withdrawal Approach to
Income Determination [3.10]
Paradox of Thrift [3.13]
4

Macroeconomics

National income, general price

level, inflation rate, unemployment
rate, interest rate and the
exchange rate are the economic
measures to be explained in the
macroeconomic models / theories

Exogenous & Endogenous

Variables

Exogenous Variable

the value is determined by forces outside

the model
any change is regarded as autonomous
I, G, X ( Micro: Income/Population)

Endogenous Variable

the value is determined inside the model

factor to be explained in the model
Y, C, M ( Micro: Price/Quantity)
6

Linear Functions

A function specifies the

relationship between variables
y is the dependent variable
x is the independent variable
y=f(x)

Linear Functions

y=f(x)
y= c
y=mx
y=c+mx
m, c are exogenous variables
y, x are endogenous variables
8

Linear Functions

Consumption Functions
C= f(Y)
C= C
C= cY
C= C + cY

Linear Functions

C, c are exogenous variables

C, Y are endogenous variables
Y is independent variables
C is dependent variables

10

Linear Functions

Can you express the 3

consumption functions graphically?

11

Linear Functions

The parameter C is autonomous

consumption
It summarizes the effects of all factors
on consumption other than national
income.
What is the difference between a
change in exogenous variable
(autonomous change) and a change in
endogenous variable (induced change)?
12

Linear Functions

C= f(Y, W)
If wealth is deemed as a relevant
factor but is not explicitly included in
the consumption function C=C+ cY
a rise in wealth W will lead to a
rise in the exogenous variable C
graphically, the consumption
function C will shift upwards
13

Linear Functions

What happens if c ?
What happens if Y ?

14

Linear Functions

Consumption function can also be a

relationship between consumption C
and interest rate r.
What do you think of the relationship
between the variables, i.e.,
consumption C and interest rate r?
Are they positively correlated or
negatively correlated?
15

Aggregate Demand &

Supply

Aggregate Demand

the relationship between the total

amount of planned expenditure and
general price level (v.s. aggregate
expenditure E)

Aggregate Supply

the relationship between the total

amount of planned output and the
general price level
16

Aggregate Demand &

Supply
Price Level

Aggregate Supply

Equilibrium: no tendency to change a

the values of the endogenous variabl

will remain unchanged in the absence

external disturbances

Aggregate Demand

National Outpu
17

Aggregate Demand &

Supply
P

AS When AS is vertical
A shift of AD will cause a
change

In P only but have no effect on

Y
AD2
AD1
Yf

Y
18

Aggregate Demand &

Supply
P

AD1

AD2

When AS is horizontal
A shift of AD will cause a
change in Y only but have no
effect on P
AS

Y
19

Aggregate Demand &

Supply
AS

AD

Ye

Yf
20

Aggregate Demand &

Supply

The Upward Sloping AS

When the economy is close to but

below full employment level Y < Yf,
the attempt to raise output by
increasing aggregate demand will
face supply side limitations
both price and output will increase

21

Aggregate Demand &

Supply

The Vertical AS (slide 18)

When full employment is attained Y =

Yf, an increase in aggregate demand
can only cause prices to rise

22

Aggregate Demand &

Supply

The Horizontal AS (slide 19)

When output is far below Yf, the

equilibrium output is determined by AD
The supply side has no effect on income
level as firms could supply any amount
of output at the prevailing price level
The Keynesian Model analyses the
situation of an economy with fixed prices
and high unemployment Y < Yf
23

National Income
Determination Model

Assumptions:

National income Y is defined as the

total real output Q
A constant level of full national
income Yf
Serious unemployment, i.e., there are
many idle or unemployed factors of
production
24

National Income
Determination Model
Income / output can be raised by
(contd)

using currently idle factors without

biding up prices
Price rigidity or constant price level
There are only households and firms
(2-sector). No government and
foreign trade

25

National Income Identities

An identity is true for all values of the

variables
In a 2-sector economy, expenditure
consists of spending either on
consumption goods C OR investment
goods I.
Aggregate expenditure (AE OR E) is ,by
definition, equal to C plus I
EC+I
26

National Income Identities

National income Y received by

households, by definition, is either
saved S OR consumed C.
YC+S

27

National Income Identities

Aggregate expenditure E is, by

definition, equal to national income
Y
YE
C+SC+I
SI

28

Equilibrium Income

Equilibrium is a state in which there is

no internal tendency to change.
It happens when

firms and households are just willing to

purchase everything produced Y = E (v.s.
Micro: Qs = Qd) [slide 30-36]
Income-Expenditure Approach [slide 37-60]
planned saving is equal to planned
investment S = I
Injection-Withdrawal Approach [slide 6174]
29

Equilibrium Income

What is the definition of GNP (/

GDP) in national income
accounting?
The total market value of all final
goods and services currently
produced by the citizens (/within
the domestic boundary) of a
country in a specified period
30

Equilibrium Income

Ex-ante Y > E Excess supply

planned output > planned expenditure

unexpected accumulation of stocks OR

unintended inventory investment OR
involuntary increase in inventories

In national income accounting, this amount

Y-E is treated as (unplanned) investment by
firms
31

Equilibrium Income

Ex-post Y= E

Actual (Realised)= Planned

Expenditure
Expenditure

+
Unplanned
Investment

Actual (Realised) Output = Actual Expenditure

Firms will reduce output

32

Equilibrium Income

Ex-ante Y < E Excess Demand

planned output < planned expenditure

unexpected fall in stocks OR

unintended inventory dis-investment OR
involuntary decrease in inventories

However, in national income

accounting, this amount E - Y
consumed is not currently produced
33

Equilibrium Income

Ex-post Y= E

Actual (Realised)= Planned

Expenditure
Expenditure

Unplanned
Dis-investment

Actual (Realised) Output = Actual Expenditure

Firms will increase output

34

Equilibrium Income

Ex-ante Y= E Equilibrium
There is no unintended inventory
investment OR dis-investment
Ex-post Y=E

35

Equilibrium Income

When there is excess supply, i.e., planned

output > planned expenditure, firms will
reduce output to restore equilibrium
When there is excess demand, i.e., planned
expenditure > planned output, firms will
increase output to restore equilibrium
In the Keynesian model, it is aggregate
demand that determines equilibrium output.
Remember the horizontal AS [slide 19]
36

Consumption Function

Now, we will look at the 1st

component of the aggregate
expenditure E C + I i.e. C
Empirical evidence shows that
consumption C is positively related
to disposable income Yd
Yd = Y since it is a 2-sector model
Remember the 3 consumption
functions [slide 9 & 11]
37

Consumption Function

Autonomous Consumption C

It exists even if there is no income.

This can be done by dis-saving, i.e.,
using the past saving
Then, saving will be negative when
income is zero.
It is totally determined by forces
outside the model
What happens to the 3 consumption
functions if C ? Or C ?
38

Consumption Function
C = yintercept
In C

C=
C

C = cY

C = C + cY

39

Consumption Function

Marginal Propensity to Consume MPC = c

It is defined as the change in consumption per unit

change in income
MPC = C / Y
It is the slope of the tangent of the consumption
function
For a linear function, MPC is a constant
What does the consumption function C look like if
MPC is increasing? Decreasing?
It is assumed that 0 < MPC < 1
What happens to the 3 consumption functions if c ?
or c ?

40

Consumption Function
MPC = slope of
tangent
in MPC or in c

C=
C

C = cY

C = C + cY

41

Consumption Function

Average Propensity to Consume APC

It is defined as the ratio of total

consumption C to total income Y
APC = C / Y
It is the slope of ray of the consumption
function
When C = C OR C = C + cY, APC
decreases when Y increases.
When C = cY, APC = MPC = c = constant
42

Consumption Function
APC = slope of
ray

C=
C

C = cY

C = C + cY

43

Consumption Function

Relationship between APC and MPC

C = C Divide by Y
C/Y = C/Y
APC = C/Y
APC when Y
Slope of ray flatter when Y
Slope of tangent = MPC = c = 0
44

Consumption Function

Relationship between APC and MPC

C = cY
Divide by Y
C/Y = c
APC = MPC = c
Slope of ray=Slope of
tangent=constant=c
45

Consumption Function

Relationship between APC and MPC

C = C + cY Divide by Y
C/Y = C/Y + c
APC = C/Y + MPC C +ve
APC > MPC
Slope of ray steeper than slope of tangent
Slope of tangent constant
Slope of ray flatter when Y
APC when Y
46

Investment Function

Lets look at the 2nd component of

the aggregate expenditure E C + I
An investment function shows the
relationship between planned
investment I and national income Y
It can be a linear function or a nonlinear function
47

Investment Function

Again, there can be 3 investment functions

I = I
I = iY
I = I + iY
Economists usually use the first one, i.e.,
I= I as investment is thought to be
correlated with interest rate r, instead of Y
I , i are exogenous variables
I , Y are endogenous variables
48

Investment Function

Autonomous Investment I
It is independent of the income
level and is determined by forces
outside the model, like interest
rate.
I is the y-intercept of the
investment function
49

Investment Function

Marginal Propensity to Invest i

It is defined as the change in investment
I per unit change in income Y
MPI = I / Y
MPI would not correlate with Yd
It is the slope of tangent of I
It is also determined by forces outside
the model
50

Investment Function
MPI = i =slope of tangent
I = y-intercept
API when
Y
MPI =0

I = I

I = iY

I = I + iY

51

Aggregate Expenditure
Function

Given E = C + I
C = C + cY
I = I
E = I + C + cY
E = E + cY

52

Aggregate Expenditure
Function
I

C, I, E

Slope of tangent =
c
Slope of
tangent=0

Y
I = I

C = C+cY

E = I + C+
53
cY

Aggregate Expenditure
Function

Autonomous Change
When C or I E shift upward
When c slope of E steeper
rotate
Induced Change
When Y E move along the
curve
54

Output-Expenditure
Approach

National income is in equilibrium when

planned output = planned expenditure
We have planned expenditure E=C+I
Equilibrium income is Ye=planned E
A 45-line is the locus of all possible
points where Y = E
When E = planned E, Y = Ye
55

Output-Expenditure
Approach
Y=E

C, I, E

Planned E=C
+I
Planned E <
Y

Y=planned E Unintended
inventory
investment

Planned
E>Y
Unintended
inventory
disinvestment

Actual E = Y
Y
Y

Ye

56

Output-Expenditure
Approach

Y = planned E
Y = I + C + cY
Y = E + cY
(1-c)Y = E
Equilibrium condition
1
Y=
E
1-c
57

Output-Expenditure
Approach

If C or I E E Ye
If c E steeper Ye
If we differentiate the equilibrium
condition,
Y/E = 1/(1-c)
Given 0 < c < 1 1/(1-c) > 1
E Ye by a multiple 1/(1-c) of E
58

Expenditure Multiplier 1/
(1-c)

Assume c=0.8, E = 100

The one who receive the $100 as
income will spend 0.8($100)
then the one who receives 0.8($100)
as income will spend 0.8*0.8($100)
The process continues and the total
increase in income is
$100+0.8($100) +0.8*0.8($100) +
59

Expenditure Multiplier 1/
(1-c)

The total increase in income is

actually the sum of an infinite
geometric progression which can
be calculated by the first term
divided by (1- common ratio)
The first term here is E = $100
and the common ratio is c =0.8
The sum of GP is E * multiplier
60

Saving Function

We have Y C + S [slide 27]

Saving function can simply be derived
from the consumption function
S=YC
if C = C + cY
S = Y C cY
S = -C + (1-c) Y
S = S + sY
S= -C
s=1-c
S < 0 if C >0
S = 0 if C = 0
61

Saving Function
S

S = sY

S
S = S+ sY

S = (1c)Y

S =-C+(1-c)Y

Slope of tangent = s
=1- c

Y > Y*

Y*

S+ve
Y

S
Slope of ray = slope of
tangent

Slope of ray < slope of

62
tangent

Saving Function

Autonomous Saving S
Since S= -C + (1-c)Y
If C= 0 when C= cY
S = (1-c)Y S = 0
If C +ve when C = C + cY
S = -C + (1-c)Y S ve
If Y= 0 S = -C Dis-saving

63

Saving Function

Marginal Propensity to Save MPS = s

It is defined as the change in saving per
unit change in disposable income Yd OR
income Y (in a 2-sector model)
MPS = S/ Y
It is the slope of tangent of the saving
function
MPS is a constant if the consumption /
saving function is linear
64

Saving Function

Average Propensity to Save APS

It is defined as the total saving
divided by total income
APS = S/Y
It is the slope of ray of the saving
function

65

Saving Function

Average Propensity to Save APS (contd)

When S= sY
APS = MPS = s = constant
When S=S+ sY
APS < MPS as S ve
APS ve when Y < Y*[slide 62]
APS = 0 when Y = Y*
APS +ve when Y > Y*
APS when Y

66

Saving Function

Y=C+S
Differentiate wrt. Y
Y/Y=C/Y + S/Y
1= MPC + MPS
1 = c + s [slide 61]
S = S + sY Divided by Y
S/Y = S/Y + s
APS=S/Y+MPS [slide 66]
67

How to determine
Ye?
Y=E
C, S, I, E
Planned Y =
planned E

+ve S
Planned
I

-ve
S

Planned
C
Y<C Y*=C

Ye

Y>C

Y
68

Y=E

Y = C S =0
No Dis-saving
E=C+I
Y<E
Y < C Unintended Inventory Dis-investment
Actual I =Planned
I Unintended I C
Planned
Y<E
I

Planned
C
Planned Y <
Planned E

Ye

69

Y=E

Y > C S +ve
Saving
E=C+I
Y>E
Unintended Inventory Investment
Actual I =Planned
I + Unintended I C
Planned
I

Planned
C
How about

Ye

Planned Y > Planned 70

E

Injection-Withdrawal
Approach

Remember the national income

identity S I [slide 28]
The equilibrium income happens
when planned Y= planned E as
well as planned S = planned I
[slide 29]

71

Injection-Withdrawal
Approach

S+ sY = I
sY = I S
S=-C s=1-c
(1-c)Y = I + C = E
Equilibrium condition [slide 57]
1
Y=
E
1-c

72

Equilibrium Income

No matter which approach you

use, you will get the same
equilibrium condition.
Can you derive the equilibrium
condition if investment I is an
induced function of national
income Y, using the 2 approaches?
73

Equilibrium Income

Write down the investment function I first.

Then write down the saving function S.
Remember planned S = planned I when Y is
in equilibrium {Injection-Withdrawal}

Write down the investment function I as well

as the consumption function C. Together
they are the aggregate expenditure function
E. Remember planned Y = planned E when
Y is in equilibrium {Output-Expenditure}
74

Injection-Withdrawal
Approach

75

Output-Expenditure
Approach

76

Y<C

Y=C
Y>C

Y=E

E=C+I
C=C+cY
E=C+I
C
I

S=- C

S = S + sY
I=I

77

Planned Y=Planned
E

Unintende
d
Inventory
Investmen
t E=C+I
S=S+sY

E=C+I

Unintended
Inventory
Disinvestment
Unintended
Inventory
Disinvestment
Planned
S=Planned I

Unintend
ed
Inventory
Investme
I=I
nt
78

Paradox of Thrift

This is an example of the fallacy of

composition
Thriftiness, while a virtue for the
individual, is disastrous for an economy
Given I = I
Given S = S + sY OR S = -C + (1-c)Y
Now, suppose S
Will Ye increase as well?
79

A rise in thriftiness causes a

decrease in national income but
no increase in realised saving.
S=S +sY
S= S+ sY
Excess Supply
I=I

Ye

80

Paradox of Thrift

If a rise in saving leads to a reduction in

interest rate and hence an increase in
investment (Think of the loanable fund
market), national income may not decrease

Ye will increase if I increase more than S

Ye will remain the same if I increase as much
as S
Ye will decrease if I increase less than S

81

I > S
S=S +sY
S= S+ sY
I=I
I=I

Ye

82

I = S
S=S +sY
S= S+ sY
I=I
I=I

Ye =Ye

83

I < S

S=S +sY

The reduction in Ye is
less than the case
when I does not
increase

S= S+ sY
I=I
I=I

Ye
What about the case if I is an induced function
of Y?
84