Lecturer: Pn. Siti Hajar Binti Md.Jani

1
Chapter 3

• Determination of Equilibrium National Income

2
BUSINESS CYCLE

• Aggregate Econ. Activity

( ? in real GDP)
Boom/Inflation
Potential Growth Path
Actual Growth Path
Trough/Depression/Slump/Unemployment
years
3
NATIONAL INCOME EQUILIBRIUM

• Keynes argued that an economy could reach
  equilibrium but not necessarily at the full
  employment.

4
Equilibrium and Full-employment

• Equilibrium will occur when there is no tendency
  for an economy to change. It refers to a
  situation when all consumers and firms have no
  incentive to change their behaviour.
•  
• Full employment equilibrium is the situation of
  equilibrium in an economy at the best efficient
  and full utilization of resources.
•  
• An economy can be at the equilibrium but not
  always to be at full-employment.

5
Two approaches  

• To Determine National Income Equilibrium

1. Total Approach.
2. Injection-Leakage Approach.

6
i)  Total Approach

• Equilibrium may occur when planned aggregate
  expenditure is equivalent to planned output.
• (AD AS)
• (aggregate demand aggregate supply).

7
i) Leakage-Injection Approach

• Equilibrium also can be determined when
• INJECTION LEAKAGE
• Injections are additional spending from
• investments (I),
• government
  purchases (G) and
• exports (X).
• Leakages are withdrawals from
• savings (S),
• tax payment
  (T) and
• imports (M).
• So, at equilibrium,
• (IGX STM)
• (INJECTION LEAKAGE)

8
DETERMINATION OF EQUILIBRIUM NATIONAL INCOME

• Keynesian model is drawn based on the
  relationship between income and expenditure
• Y C I G (X M)
• where,
• C f (Yd) ,
• C is a function of Real Disposable Income
• (income after tax), where, Yd Y t .

9
Components of Aggregate Expenditure

• CONSUMPTION, C f (Yd)
• INVESTMENT, I f (i, Y)
• GOVERNMENT EXPENDITURE, G
• NET EXPORT (X M)

10
1. Consumption and Saving

• Disposable Income is used for Consumption
  spending and Saving.
• Yd C S
• and, C f (Yd), S f (Yd)
• Both C and S is a function of income,Y and
  having a positive relationships.
• ( Y rises, C and S also will rise).

11
Given thatConsumption function C a bYd
and Saving function S a (1 b) Yd

• There is (two)2 components of Consumption
  spending by households
• C1, Autonomous Consumption a
• C2, Induced Consumption bYd
• Where,
• b is the Marginal Propensity to Consume
  (MPC).

12
Autonomous Consumption, a and Induced
Consumption, bY

• C2 a is a fixed amount irrespective of the
  income earned,
• is the part of consumption which does not vary
  with the level of income (Y increases but a is
  constant).
• C2 bY is an amount that depends on the
  disposable income,
• is the amount of consumption spending by
  households that is induced by disposable income
  (Y increases, C2 increases).

13
CONSUMPTION, C

• Consumption function, C f (Yd)
• C
• C a bYd
• a
• 
  real output, Y
• The slope of consumption function is given by
• b ?C/ ?Y
• Marginal Propensity to Consume
  (MPC)
• and the value 0 lt b lt 1 (positive but
  less than).

14
Autonomous Consumption,C1 a
C C a b
Yd a
0
real output, Y

• is the vertical intercept of the consumption
  function,
• at a (in the diagram).
• It is the amount of consumption that would occur
  even if the household earned nothing, Y0.
• when Y 0 (no income earned), C a.
• (basic consumption for living).

15
Consumption and Saving schedule
With no income earned, Y 0 , autonomous C a
60 and dissaving - a - 60. While Y C S
, if Y 0 , then C - S.
16

• How is the increase in income will increase
  consumption?
• Consumption is induced by the value of b (that
  is MPC),
• since,
• C a bY

17
FOR EXAMPLE Given that C a bY,
therefore, if b 0.6 , how large is the increase
in consumption if there is an increase in
income? Since C a 0.6Y, thus C will increase
by 0.6Y , (given a fixed or autonomous
consumption) , so, C will increase by 60 out
of total income, Y. Meaning that,
for any increase in income, 40
can be saved and 60 will be spend
on consumption.
18
For example

• a change in income from RM1000 to RM1500 with the
  MPC 0.6,
• ? C b ? Y
• 0.6 (500) 300.
• Therefore, consumption will increase by RM300.

19
Consumption and Saving schedule
In a 2-sector economy, C a bY . Since C a
0.6Y, and a 60 thus C 60 0.6Y. At income
200, C 60 0.6(200) 60 120 180
and Y C S so , S Y C 200 -180
20.
20
Changes in consumption when income change.

• consumption

Y C
C a b Y
? C
400
Note b ? C
400
? Y
? Y
500
45
income
1000 1500
21
Changes in consumption when income change.
Y C

• consumption

C a b Y
? C
400
Note b ? C
400
? Y
? Y
e
a
45
500
income
1000 1500
22
SAVINGS

• Some part of income earned is saved.
• two components of savings
• autonomous dissaving, S1 a
• induced saving, S2 (1 b)Y
• where,
• (1 b) Marginal Propensity to Save.
• ?S/?Y
• slope of saving function.

23
Dissaving and induced saving.

• Autonomous dissaving, (- a), is the amount that
  households draw out from their wealth to consume
  when no income earned.
• Induced saving, (1 b)Y, is the amount of saving
  that is induced by earnings of disposable income.

24
Saving Function, S
Saving
S a (1 b)Yd
0
Yd (real output)
a
(1 b) is the slope of saving function ?S/?Y


25
Consumption Saving Function,
C,S
Y AD
Y C S, When S 0, Y C at the breakeven,
point, e.
Y C
C a bYd
e
S a (1 b)Yd
a
Yd (real output)
45º
0
a
26
Note that

• MPC MPS 1, thus MPS (1 MPC).
• If MPC b and MPS (1 b),
• Then,
• b (1 b) 1

27
APC, APS

• The fraction of income that is used for
  consumption is the
• Average Propensity to Consume (APC)
• APC C
• Y
• And, the fraction of income that is used for
  saving is the
• Average Propensity to Save (APS)
• APS S
• Y
• and, at any level of income,
• APC APS 1

28
MPC, MPS, APC, APS
CONSUMPTION, C
C a bYd
1200
800
a
INCOME,Y
0
1600
1000
29
MPC
CONSUMPTION, C
C a bYd
1200
?C
MPC ?C 400 ?Y 600 is the
slope of the consumption function.
800
?Y
a
INCOME,Y
0
1600
1000
30
MPC, APC
CONSUMPTION, C
C a bYd
1200
?C
800
MPC ?C 400 ?Y 600 APC
TC 1200 TY 1600
TC
?Y
a
INCOME,Y
0
1600
1000
TY
31
MPC, APC
CONSUMPTION, C
C a bYd
1200
MPC ?C 400 ?Y 600 APC
TC 1200 TY 1600
800
TC
TC
a
INCOME,Y
0
1600
1000
TY
32
MPS, APS
MPS (1 b) ?S/?Y is the slope of saving
function.
Saving
S a (1 b)Yd
?S
?Y
0
Yd (real output)
a
33
MPS, APS
while, APS TS/TY
Saving
S a (1 b)Yd
?S
TS
TS
?Y
0
Yd (real output)
a
TY
34
MPS, APS
while, APS TS/TY
Saving
S a (1 b)Yd
TS
TS
0
Yd (real output)
a
TY
35
APC, APS changes with income MPC, MPS are
constant.

• APC falls and APS will rise as income increases.
• - because as income increases, households
  consumption will rise but with a smaller
  percentage compared to the increase in income,
  while saving will rise with a larger percentage
  instead.

While MPC and MPS is assume constant as long as
the slopes of the consumption and saving curves
are constant or assume to be straight lines.
36
EXAMPLE 1
As income increases, APC falls but APS
rises. Meanwhile, MPC and MPS are constant.
37
Other determinants of Consumption

• Wealth
• The richer the higher is the consumption.
• Interest rates
• Large items were bought on loans that pay
  interest.
• Expectation of future prices
• Price is expected to increase in future, more
  consumption now (may involve in hoarding).

38
Consumption in Islam (according to M. Fahim Khan,
1922)

• A Muslim has to be rational in their spending.
• The rationality of consumption in Islam is
• to spend wisely and moderately
• to consume only enough goods for healthy living.
• Excessive indulgence in luxurious living is
  discouraged Israf (extravagant or overspending
  on goods excessively are wasteful and prodigal.

39

• to follow the hierarchy of needs Dharuriyat,
  Hajiyat, Kamaliat and not to consume the Tarafiat
  goods.
• to consume only permissible goods (halal) but not
  prohibited goods (haram).
• part of his expenditure is also spend for
  fi-sabilillah (spending for the betterment of
  Islamic livings)
• part of his income is also saved for future
  expenditure.
• Conclusion spending by Muslim consumers is to
  achieve the satisfaction in this world and also
  to earn reward in the hereafter.

40

• BREAK-EVEN INCOME
• is a situation when all the income is just nice
  for consumption purposes while no saving at all.
• thus,
• Y C and S 0.

C,S
ASAD
S gt 0
C a bY
e
S - a (1 b)Y
S lt 0
45º
Y
S 0
41
QUESTION TO PONDER look out in the manual
1. Use the given data to answer the following
questions. (All figures are in RM million)
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140
200 260
400 20
600 500
800
1000
a) Fill up the blank with appropriate values.
42
QUESTION TO PONDER ANSWER
1. Use the given data to answer the following
questions. (All figures are in RM million)
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140 ? 140
200 260 ? 60
400 120 260 380 20
600 500 100
800 120 500 620 180
1000 120 620 740 260

• Fill up the blank with appropriate values.
• ?Y 200 and ?C 120 , ?S
  80

43

1. What are the values of MPC and MPS?
2. Write down the consumption function and saving
   function.
3. What is the amount of break-even income?

44

• What are the values of MPC and MPS?
• MPC ?C 260 - 140 0.6
  
  ?Y 200 0
• MPS 1 MPC 1 0.6 0.4

45

• c) Write down the consumption function and saving
  function.
• C 140 0.6Y
• S - 140 0.4Y

46

• What is the amount of break-even income?
• is a point at e, when S 0, so Y C.
• S - 140 0.4Y
• Since S 0, 0 -140 0.4Y
• 140 0.4Y
• Y 140/0.4 350

C,S
C 140 0.6Y
e
S -140 0.4Y
45º
Y
S 0
47
Additional Question
Use the given data to answer the following
questions. (All figures are in RM million)
INCOME(Y) CONSMPTN (C) SAVING(S)
0 140 ? 140
200 260 ? 60
400 380 20
600 500 100
800 620 180
1000 740 260
Calculate the APC and APS at each level of
income.
48
ANSWER
INCOME (Y) CONSMPTN (C) SAVING (S)
0 140 ? 140
200 260 ? 60
400 380 20
600 500 100
800 620 180
1000 740 260
APC APS
- -
1.3 - 0.3
0.95 0.05
0.83 0.17
0.78 0.23
0.74 0.26
The values for APC and APS at each level of
income.
49
2. INVESTMENT

• Definition
• Investment is defined as the spending or
  purchase of plants, machineries, buildings and
  inventories by firms for the purpose of producing
  goods and services.

50
2 types of INVESTMENT - Keynes

• two(2) types of investment spending 
• i)   Autonomous Investment
• what firms may had intended to plan or desired
  or has been fixed and does not depend on income.
• ii) Induced Investment
• actual investment expenditures used to produce
  newly produced goods, and depends on the level
  of
• I f ( i, ?e, Y, t)

51

• Investment depends on the level of
• I f ( i, ?e, Y, t .)
• interest rate,
• future expected profitability,
  
• income,
• technology,
• capacity and
• business taxes.

52
1. Autonomous Investment

• As assume by Keynes
• - is a fixed investment that does not change
  with the change in income,
• but
• there will be a shift in the autonomous
  horizontal function, up or down when therere
  other factors that affect it.

53
1. Autonomous Investment Function
refers as a fixed investment that does not change
with the change in income.

• Investment
• I1
  
• Autonomous
• Investment I0
• Diagram Autonomous Investment
• A shift in autonomous investment upward to I1 may
  cause by an increase in expected profit or a fall
  in interest rate but does not depend on real
  income.
• Example the government planned spending to
  provide public goods.

Real Income
54
2. Induced Investment Function

• real interest rate (i)
•  
•  
• 
  I f(i, ?e)
•  
• 
  I f(i)
• I
  I Investment
  
•   Diagram Induced Investment
• Induced investment has a negative relationship
  with real rate of interest.
• If future profit is expected to increase, at any
  given level of real interest rate the investment
  function will increase and shift the curve to the
  right.

refers to an investment that changes with the
interest rate, income or expected profitability
etc.
i2
i1
55
2. Induced Investment Function

•   investment
• 
  I f(Y)
•  
• 
  
  
  
• 
  Income
  
•  
• Diagram Induced
  Investment
• Induced investment has a positive relationship
  with aggregate income.
• Example is capital investment by the purchase of
  new plants and equipments.

is the actual investment that is induced by
changes in income.
56
Investment From Islamic Perspective

• Investment is permissible in Islam but
  extravagant and maximizing profit in doing any
  business activities is not allowed.
• Muslims are not allowed to freeze their wealth.
• Islam encourages Muslim to produce goods and to
  attain profit but also to give the emphasis on
  the welfare benefits to the society.
• This means, Muslim entrepreneurs were not allowed
  to maintain maximum profit but only satisfactory
  profit or responsibility profit, which includes
  their responsibility to Allah and the
  responsibility for the benefits of the society.

57
Investment From Islamic Perspective

• According to Siddiqui (1979), a relevant profit
  returns for a Muslim in production is a
  satisfactory profit earning, whereby it lies
  between the maximum profit that could be allowed
  by the Islamic principles and the minimum limit
  that could cover the cost.
• Meaning that, it is the profit that gives
  satisfaction to the investor in terms of the well
  beings and money returns that could afford to
  maintain his business and future business
  expansion, for the long term benefit of the
  consumers, society and government.

58
Investment From Islamic Perspective

• Underlying constraints in business activities in
  Islam involves
• Avoid the monopoly profit making. Any control of
  output and prices are strictly not allowed.
• Producing only the permissible (halal) goods but
  not the forbidden (haram) goods.
• Avoid transactions which involve the gharar and
  gambling activities.
• Does not involve in any misused of powers,
  injustice, suppress others and manipulation
  must emphasis on the welfare of the society.

59
Investment From Islamic Perspective

• Production of goods must follow the hierarchy of
  needs Dharuriyat
• Hajiyat and
• Kamaliat goods
• but not the Tarafiat (Tassiniyat)(haram)
  goods.
• Does not involves interest payment or any riba
  activities, both the riba al-nasiah (the addition
  to the capital) and the riba al-fadhal (an
  addition to the exchange of goods or other
  objects which is of the same nature e.g. padi,
  wheat and money). Instead to avoid riba, Muslims
  are encouraged to have alternatives profit
  sharing in terms of mudharabah (sharing profit)
  or musyarakah (joint-venture).

60
Factors that influence Investment in Islam are

1. Income
2. Expected returns
3. Viability of the projects.
4. Facilities available or provided by the
   government.
5. The respond of market demand.
6. Availability of fund.

61
Investment and Saving

• Investment is an injection could increase
  aggregate expenditure (AD) and boost up economic
  growth (income).
• Investment spending will multiply through the
  multiplier effect to increase income.
• Saving is a leakage could lower aggregate
  expenditure (AD) and income.
• Saving becomes an outflow of money (leakage)
  from an economy. It becomes a stock of money that
  is not spent.
• At equilibrium,
• Saving will be equal to Investment,
• ( S I )

62
Equilibrium in 2 sector economy
YAD
C,S,I
C I
e2
Y CI
C a bYd
e1
S a (1 b)Yd
a
S I
I
45º
0
Yd (real output)
Y2
Y1
a
In 2 sector econ equilibrium Y C I
63
Equilibrium in 2 sector economy
YAD
C,I
C I
e2
equilibrium Y C I (in 2 sector economy)

45º
0
Yd (real output)
Y2
64
Equilibrium in 2 sector economy
C,S,I
S a (1 b)Yd
e2
S I
I
0
Yd (real output)
Y2
In 2 sector econ equilibrium S I
65
QUESTION TO PONDER

• 1e) If investment is RM150 millions, calculate
  the equilibrium income and sketch a diagram to
  show this.
• I 150
• C 140 0.6Y

66
ANSWER

• At equilibrium (in 2 sector economy)
• (Using Total Approach)
• Y C I
• Y 140 0.6Y 150
• Y 0.6Y 290
• 0.4Y 290
• Y 290/0.4
• Y 725

67
ANSWER
C,I
Y AD
C I
e
45º
Y
Ye 725
68
Example Question to Ponder
Look out in the manual
69
3. GOVERNMENT EXPENDITURE
G will be autonomously fixed according to
Government Budget Policy for each year.

• Government
• Expenditure
• 
  Real Income
• Diagram Autonomous Government Expenditure

G1
G0
70
Equilibrium in 3 sector economy
YAD
e3
C I G
AD
C I
e2
C
e1
ST
I G
I
ST IG
45º
0
Yd
Y2
Y1
Y3
71
Equilibrium in 3 sector economy
YAD
e3
C I G
AD
ST
I G
ST IG
45º
0
Yd
Y2
Y1
Y3
72
4. NET EXPORT (X M)

• Export is an injection and could increase the
  national income through the foreign trade
  multiplier, but import is a leakage.
• Thus, net export (X-M), means the real foreign
  sector minus the total import of goods and
  services into the economy.
•  

73
NATIONAL INCOME EQUILIBRIUM in 4 sector
YE
Expenditure
Y1CIG(X-M)
(RM)
e1
YfeCIG(X-M)
Y0 CIG(X-M)
ef
e0
45
Real Output (National Income)
Ye0
Yfe
Ye1
74
KEYNESIAN EQUILIBRIUM NATIONAL INCOME

• Keynesian assume that equilibrium output can be
  reached not necessarily at the full-employment.
• - the equilibrium can be less or more
  than the full-employment equilibrium, causing the
  economy with the inflationary or deflationary-gap.

75
Inflationary Deflationary Gaps
YE
Expenditure
Y1CIG(X-M)
(RM)
e1
YfeCIG(X-M)
?
Inflationary Gap
Y0 CIG(X-M)
ef
?
Deflationary Gap
-GDP Gap
e0
Inflationary gap Yfe lt Ye. Deflationary gap Yfe
gt Ye
45
Real Output (National Income)
Ye0
Yfe
Ye1
GDP Gap
76
NATIONAL INCOME EQUILIBRIUM with inflation
YE
Expenditure
Y1CIG(X-M)
(RM)
e1
YfeCIG(X-M)
?
Inflationary Gap
ef
Inflationary gap Yfe lt Ye1
45
Real Output (National Income)
Yfe
Ye1
77
NATIONAL INCOME EQUILIBRIUM with unemployment
YE
Expenditure
(RM)
YfeCIG(X-M)
Y0 CIG(X-M)
ef
?
Deflationary Gap
e0
Deflationary gap Yfe gt Ye0
45
Real Output (National Income)
Ye0
Yfe
78
NATIONAL INCOME EQUILIBRIUM
YE
Expenditure
Y1CIG2(X-M)
(RM)
e1
YfeCIG1(X-M)
Spending multiplier , m ?Y Yfe Y0 Thus
, ?Y m ?G
ef
Y0 CIG0(X-M)
?
?G

e0
?G
G1 G0
?
?Y
45
Real Output (National Income)
Y0
Yfe
Y1
GDP Gap
79
MULTIPLIERS

• Any Injection will multiply positively,
• while
• any Leakage will multiply negatively.

80
i) Investment Multiplier mI
1/MPS 1/(1 MPC)
MULTIPLIERS
Spending Multipliers, m

• Therefore, ?Y 1/MPS x ?I
• mI x ?I
• ?Y mI

?I
81
Example Investment Multiplier

• Given, I RM10 million
• and MPC 0.75
• Therefore,
• ?Y 1/MPS x ?I
• 1/0.25 X 10 mil.
• 4 X 10 mil.
• 40 mil.
• Thus, New Y Y 40 mil.
• If the initial income, Y 2000, then
• New Y 2000 40
• 2040 mil.

in the manual
82
MULTIPLIERS

• ii) GOVERNMENT SPENDING MULTIPLIER
• ?Y 1
• MPS
• (assume an economy without tax, Yd Y)
• Therefore, ?Y 1/MPS X ?G
• Thus, national income increases by the amount of
  ?Y as Government increases spending.
• That is, new Y2 Y1 ?Y

?G
83
iii) Government Multiplier with tax

• 1
• MPSt
• 1
• 1

1 b(1 t)
(1 b) bt
Look at example 7 and exercise 3 and 4 in the
manual.
84
iv) Simple Tax Multiplier, if tax, T a

• Tax Multiplier, mT 1 Spending Multiplier
• 1 1/MPS
• MPC/MPS
• b
• (1 b)
• And, ?Y mT ?T ?T ?Y

?
mT
85
Example

• Assume that, to achieve full-employment
  equilibrium, the GDP has to be increased by
• RM 5 billion and MPS is 0.5. Calculate the tax
  cut required to achieve this full-employment.
• tax multiplier, mT 1 (1/MPS)
• 
  MPC/MPS
• 
  1 (1/0.5)
• 
  1 2
• 
  1
• tax cut, ?T ?Y
• (-1)
• - 5/(-1)
• - 5
• By reducing the tax RM5 billion, GDP then will
  increase by RM 5 billion.

?
86
v) If tax, T a tY

• Tax Multiplier - b
• - b

1 b(1 t)
(1 b) bt
Now, C a b(1-t)Y
Look at example 7 and 8 in the manual.
87
The effect of a change in Income Tax

• A tax reduction may caused to an increase in
  consumption and thus effect towards a higher
  income.
• Assume, T a tY
• And the slope of AD is now b(1 t).

AD
AD1 Ct a b(1 t)Yd
a tax cut may increase income
AD0 C a bYd
?Y b . ?T 1 b(1 t)
Y
Y0 Y1
88
vi) OPEN ECONOMY MULTIPLIER

• 1
• (MPS MPT MPM)

89
Accelerator Principle

• state that
• a change in Consumption would lead to a
  greater change in Investment.
• i.e. a small change in DD (consumption on
  output) would lead to a great change in
  Investment.
• ? C great ?I

90
Relationship between multiplier and accelerator

• The effect with multiplier is that
• The effect with accelerator is that

I
greater
Y
by the multiplier, k
? Y k ? I
greater
C
I
by the accelerator, a
? I a ? C
91
This means that

• with the multiplier, m and the accelerator, a
  working together

C
I
Y
I
AD
92
ACCELARATOR J.M. CLARK

• it was then incorporated into Keynesian theory.
• - cos it was closely related to multiplier
  
• effect.
• (an increase in C would lead to the increase
  in Investment and Aggregate Demand and thus
  towards an increase in Income.)

Y
C
I
93

• THANK YOU FOR LEND ME YOUR EARS.
• Thats all for today.

94
3. Balanced Budget Policy

• When government expenditure is just equivalent to
  the tax revenue collection.
• A balanced budget is also used to increase real
  output and economic growth.
• Any increase in government expenditure (which is
  equal to the amount of tax collection) will
  increase the real output by the same amount. Its
  multiplier is equivalent to one (1).
•   ?Y 1 . ?G
• Thus, the resulting increase in the equilibrium Y
  is exactly equal to the increase in G or T
  itself.
• ?Y ?G -?T
• It can be conclude that, although the government
  does not spend more than what it collects in tax
  revenue, she still can stimulate the economy,
  since the spending multiplier effect is larger
  than the tax multiplier effect.