National Income

Three and four sector model

Introducing Government• Budget Balance = T – G• T = Taxes or Government Revenue • G = Government Expenditure (autonomous) • When T > G Budget Surplus • When T < G Budget Deficit • When T = G Balanced Budget• When T > G Positive Government Saving • When T < G Negative Government Saving• Public Saving = Government Revenue –

Government Expenditure

Government expenditure and aggregate demand

• When we include the government sector, aggregate demand can be re-written as

G = govt expenditure on goods and services, another autonomous component

• Government also levies taxes (T) and pays transfer benefits (B). We define net taxes (NT) as direct taxes minus transfer benefits

GICAD

• This then allows us to write disposable income as:

• We assume net taxes are proportional to national income which can be expressed as:

tYNT

tYYYD • orYtYD )1(

NTYYD

Where t = tax rate

The Public Saving (Budget Surplus) Function

National Income (Y)

Government Purchases (G)

Net Taxes(T = 0.1×Y)

Public Saving(T-G)

2500 850 250 -600

5000 850 500 -350

8750 850 875 25

10,000 850 1000 150

15,000 850 1500 650

The Public Saving (Budget Surplus) Function

Introducing Net Export = X - M

• Exports: depends on spending decision made by foreign households. Therefore , it will not change as national income changes. This means that X is autonomous .

• Note that as foreign income increases, demand on domestic product by foreign countries increases (exports).

• Imports: Depends on spending decisions of local households or domestic consumption. Therefore as Y rises, M rises, and as Y falls M falls too.

There is a positive relationship between national income and desired imports .

A Net Export Schedule

National Income (Y)

Export(X)

Import(IM = 0.1×Y)

Net Export(X-IM)

5000 1200 500 700

10,000 1200 1000 200

12,000 1200 1200 0

15,000 1200 1500 -300

20,000 1200 2000 -800

The Net Export Function

Equilibrium National Income• Two main approaches could be used in determining the

equilibrium national income: the Aggregate Expenditure approach and the Saving-Investment approach.

• We will add the government expenditure and net expenditure to the aggregate expenditure function so that:

AE = C + I + G + NX• Note that the sum of a, I, G, and X represents the

autonomous expenditure. The slope of the AE function depends on the marginal

propensity to spend on national income (Z) . Now, after introducing net taxes and net exports, Z will not be

equal to the marginal propensity to consume.

How to measure Z: Example

• Assume that the economy produces Rs.1 of extra income:• 10 paise will be collected as net taxes.• The disposable income becomes 90 paise.• Assume that the marginal propensity to consume = 0.8,

then 72 paise will be spent on consumption while 18 paise will be saved.

• However, 10 paise of all expenditure goes to imports, thus, the amount to be spent on domestic goods equals 62 paise only.

• This means that Z = 0.62 and 1 – Z = 0.38.

• The multiplier now (with taxes and imports) will be 1 / (1-Z) = 1 / (1-0.62) = 2.63.

• The higher the marginal propensity to import, the lower the simple multiplier.

• The higher the income tax rate, the lower the simple multiplier.

• Note that we can calculate Z by applying the following formula: Z = b(1-t) - m,

• Where b is the MPC, (1-t) is the percentage of disposable income out of national income, and m is the marginal propensity to imports.

1- The AE Function Approach

Y C=500+.72Y I = 1250 G = 850 NX=1200-.1Y AE=C+I+G+NX

0 500 1250 850 1200 3800

2500 2300 1250 850 950 5350

5000 4100 1250 850 700 6900

10,000 7700 1250 850 200 10,000

15,000 11300 1250 850 -300 13,100

Figure 24-4The Aggregate Expenditure Funnction

Equilibrium National Income

The Saving/Investment Approach to Equilibrium

•Because aggregate income must either be saved or spent, by definition, Y ≡ C + S. The equilibrium condition is Y = C + I, but this does not hold when we are out of equilibrium. •By substituting C + S for Y in the equilibrium condition, we can write:

C + S = C + I

Because we can subtract C from both sides of this equation, we are left with:

S = I

Thus, only when planned investment equals saving will there be equilibrium.

• Leakages-Injections approach• -equilibrium GDP occurs where savings (S) = planned gross

investment (Ig)• -leakages - savings reduce the amt. of income spent so

savings is a leakage from income-expenditures stream• -injection - business spending on investment goods can be

seen as an injection into income-expenditures stream because it is spending above that of households

Saving – Investment Approach

National Income

Inve

stm

ent &

Sav

ing

O

IE

Y0

S

Y1 Y2

Saving – Investment Approach

a0 y’

45 o

-a

Consumption C

Saving S

0

Saving

y*

y*Income

Investment

E*

E*

Consumption

Consumption + Investment