Ch. 3 : National Income Determination (II)

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Ch. 3 National Income Determination (II)
(Simple Keynesian Model)
2
C
CCa cYd
Y
3
I
IIa
Y
4
G
GGa
Y
5
X
XXa
Y
6
T
TTa
Y
7
M
MMa mY
Y
8
AE
AECIG(X-M)
Y
Y
9

STM
IGX
Y
Y
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Fiscal Policy

• 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. Recognition Lag
• 2. Executive 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 any policy 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 of
  recovery

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Balanced-Budget Multiplier

• CCacYd
• GGa
• IIa
• TTa

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• The government expenditure multiplier
• Kg1/(1-c)
• The tax multiplier
• Kt-c/(1-c)
• The balanced-budget multiplier
• Kb1/(1-c) -c/(1-c)
• 1

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• ?Ga by 1 will increase income by
• 1MPCMPC2MPC3 ......---(1)
• ?Ta by 1 will decrease income by
• MPCMPC2MPC3 ......---(2)
• Ga - Ta 1

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Recessionary (Deflationary) Gap and Fiscal Policy
AE
AE
AE
Y
Ye
Yf
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Inflationary Gap and Fiscal Policy
AE
AE
AE
Y
Yf
Ye
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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, that attempt 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 Investment expenditure is autonomous

• Given S -Ca(1-c)Y
• I Ia

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The Paradox of Thrift
I,S
S2
S1
IIa
Y
Y1
Y2
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Example

• S1-20(1-0.75)Y
• I20

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• At equilibrium,
• IS
• 20-20(1-0.75)Y
• 400.25Y
• Y160

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• the realized saving is
• S1-20(1-0.75)Y
• -200.25(160)
• -2040
• 20

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• Suppose the saving function shifts upward,
• S2-10(1-0.75)Y
• I20

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• At equilibrium,
• IS
• 20-10(1-0.75)Y
• 300.25Y
• Y120

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• Now the realized saving is
• S2-10(1-0.75)Y
• -100.25(120)
• -1030
• 20

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Case 2 Investment expenditure is an increasing
function of national income

• Given S -Ca(1-c)Y
• I IaeY

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The Paradox of Thrift
I,S
S2
S1
IIaeY
Y
Y1
Y2
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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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The Paradox of Thrift
I,S
S1
IIa
Y
Y1
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The Paradox of Thrift
I,S
S2
S1
IIa
Y
Y2
Y1
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The Paradox of Thrift
I,S
S2
IIa
S1
IIa
Y
Y1
Y2
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The Paradox of Thrift
I,S
S1
IIa
Y
Y1
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The Paradox of Thrift
I,S
S2
S1
IIaeY
Y
Y1
Y2
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The Paradox of Thrift
I,S
S2
IIaeY
S1
IIaeY
Y
Y1
Y2
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Revision Exercise

• What is the 'paradox of thrift'? Explain, with
  the aid 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 progressive income 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 income
  increases, consumption will also increase. In the
  Keynesian model, the consumption is assumed to
  be C a c Y where a is the intercept and c
  is the marginal propensity to consume.
• If the consumption curve shifts upward, the
  level of income will be increased because of the
  increase of aggregate demand in the economy.
  Therefore the level of income depends on
  consumption.
• There is no circular reasoning it is a case of
  mutual 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 400
• T 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 its expenditure 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 50
• T 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
(CIGX-M)
CIGX-M
D
trade deficit
M
B
X
A
C
450
Y
Y
Y