Unit 2:National Income and EmploymentObjectives: Explain the importance of Say’s Law in the

neoclassical theory of employment and outline Keynes’ main criticisms of the classical theory

Show how equilibrium national income is determined in the simple Keynesian model, recognising the assumptions upon which the model is build

Explain and illustrate the multiplier effect and derive simple formulas for calculating the value of the expenditure and taxation multipliers

Appreciate the limitations of the simple Keynesian model

Classical theory What determines national income and

employment in an economy?

The classical theory of full employment Classical economists believed that if wages

and prices were flexible, a competitive market economy would always operate at full employment.

That is, economic forces would always be generated so as to ensure that the demand for labour was always equal to its supply.

Classical theory (Cont.) The classical theory of full employment In the classical model the equilibrium levels of

income and employment were supposed to be determined largely in the labour market.

At lower wage rate more workers will be employed. That is why the demand curve for labour is downward sloping.

The supply curve of labour is upward sloping because the higher the wage rate, the greater the supply of labour.

In the following figure the equilibrium wage rate (w) is determined by the demand for and the supply of labour.

Classical theory (Cont.) The classical theory of full employment

W/P

Labour

Demand of labour

Supply of labour

Output

Labour

Labour market equilibrium

Output level

L

Q

L

Q = f(L,K) where K is constant

Classical theory (Cont.)The classical theory of full employment The lower panel of the diagram shows the

relation between total output and the quantity of the variable factor (labour).

It shows the short-run production function which is expressed as Q = f (K, L), where Q is output, K is the fixed quantity of capital and L is the variable factor labour.

Total output Q is produced with the employment of L units of labour.

According to classical economists this equilibrium level of employment is the ‘full employment’ level. So the existence of unemployed workers was a logical impossibility.

Classical theory (Cont.) The classical economists believed that

aggregate demand would always be sufficient to absorb the full capacity output Q. In other words, they denied the possibility of under spending or overproduction. This belief has its root in Say’s Law.

Say’s Law: According to Say’s Law supply creates its own demand.

The very act of producing goods and services generates an amount of income equal to the value of the goods produced. The circular flow of income model suggests this sort of relationship.

Households receive income equal to the value of goods and services produced. Part of this income is spend and part they save.

Classical theory (Cont.) Consumption demand then falls short of the

total value of production by the amount of saving. This short fall is made up by investment demand and so long as investment and saving are equal, aggregate demand will necessarily equal the total value of production.

The classical economists argued that with flexible interest rate and a competitive market for loanable funds, saving and investment would always be made equal by changes in interest rates.

How?

Classical theory (Cont.)

Classical theory (Cont.)In conclusion:Classical system depends upon the following:1. The dependence of investment and

saving on the rate of interest 2. The upward and downward

flexibility of wages, prices and interest rate and;

3. The existence of competitive forces in the economy

Can wages and prices always be flexible? What about interest

rates?

What about other factors?

Are markets always competitive?

Keynes criticism of Classical Theory

Keynes’ Criticism of Classical Theory:1. According to Keynes, saving is a function of

national income and is not affected by changes in the rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out. So Say’s Law will no longer hold.

2. The labour market is far from perfect because of the existence of trade unions and government intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are more inflexible downward than upward. So a fall in demand for labour will lead to a fall in production as well as a fall in employment.

Keynes criticism of Classical Theory (Cont.)

3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would not always be able to achieve automatic full employment.

The Simple Keynesian Theory According to this theory, real national income

and employment is determined by aggregate demand.

This different from the classical model which suggested that supply creates its own demand. In this model it is the demand that determines how much is supplied.

The Keynesian theory argues that if firms are producing more than is demanded, this will results in increase in their inventory of unsold goods and they can only rectify this in the short run by cutting back on production and laying off workers which will cause national income to fall until the value of what is produced is equal to the value of aggregate demand.

The Simple Keynesian Theory (Cont.) If firms are not producing enough to satisfy

demand, they will experience fall in their inventories and this time will try to increase production in the short run by employing more workers. National income will increase until the value of what is produced is equal to the value of aggregate demand.

According to Keynesian model, there is only one value of national income at which aggregate demand is equal to the total value of production. This is called equilibrium national income.

Determination of equilibrium national incomeFor us to be able to determine equilibrium national income, there are number of assumptions that have to be made.1. Wages and prices are fixed2. We ignore the money market3. Planned consumption C and planned saving S are both

directly related to income (Y) 4. Planned investment I and planned government spending G

are autonomous5. Taxation T is in the form of lump-sum taxes only6. Planned exports X are autonomous, but planned imports M

depend directly on income7. There is no economic growth

The Simple Keynesian Theory (Cont.)

Withdrawals and injections Determination of equilibrium national incomeEconomy is in equilibrium when the aggregate demand for the economy’s goods and services is equal to the total value of goods and services produced. AD (demand) = Y (income) Where AD = C+I+G+X-M and Y = C+S+TC+I+G+X-M = C+S+TI+G+X = InjectionsS+T+M = WithdrawalsI+G+X = S+T+MThe condition for equilibrium can now be presented as follows:Withdrawals = Injections

Withdrawals and injections (Cont.) Determination of equilibrium national income All the injections (I, G and X) are

independent of income so that when plotted against income on the graph, the injections line will be a horizontal straight line.

Savings and imports are both directly related to income but taxes are lump-sum taxes therefore total withdrawals will be directly related to income with a slope equal to the sum of the marginal propensity to save and the marginal propensity to import

How can I,G & X be independent of

income?

Withdrawals Injections AD

Y C S T M I G X

10 8 0 2 2 4 8 4 4 16 22

20 16 2 2 4 8 8 4 4 16 28

30 24 4 2 6 12 8 4 4 16 34

40 32 6 2 8 16 8 4 4 16 40

50 40 8 2 10 20 8 4 4 16 46

60 48 10 2 12 24 8 4 4 16 52

Withdrawals and injections (Cont.) What is national

equilibrium (Y)?

Withdrawals and injections (Cont.)

I = I + G + X

AD

Y

W= T + S + M

Ye

AD equilibrium

There two ways of identifying the equilibrium national income.1. At a point where total injections equal total

withdrawals.2. At the point where aggregate demand is

equal to national income - this is where AD line cuts the 45 line.

Note that this is the AD-AS short-run model.

AD equilibrium (Cont.)

AD= C + I + G+ X -M

AD

YYe

AD= Y

45

Limitation of Keynesian Theory Stop-go Phenomenon – in period of high

unemployment, the government would expand aggregate demand to reduce unemployment but at the same time create inflationary pressure so that government would have to reduce aggregate demand again, thus all period tended to be followed by stop periods and it become difficult to achieve long-term economic growth (business cycles).

The Keynesian model fails to take adequately into account the problem of inflation.

The Multiplier The Multiplier is a measure of the relationship between the change in the equilibrium national income and the autonomous change that brings it about.

What is likely to happened to national income if investment increases by N$2 million?Equilibrium condition, Y=C+I+G+X-M where I, G and X are autonomous.Multiplier = Y / I Investment multiplier: 1/(1-MPC)

What does this mean?

The Multiplier (Cont.)

The Multiplier: A measure of the relationship between the

change in the equilibrium national income and the autonomous change that brings it about.

The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures.

The number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP.

The essence of a multiplier is that total increase in income, outputs or employment is manifold the original increase in investment.

E.g. if investment of $100 is made, then the income will not rise by $100 only but a multiple of it.

Now consider the first effect of increase in one of the injections. Suppose we increase investment spending on new machinery by $2 million from $8m to $10m.

The immediate effect of the increase will raise income by full $2m because spending of one group in the economy is necessarily income of the other group.

The Multiplier (Cont.)

Increased spending on machinery represents higher incomes for these involved in manufacturing the machines.

The process does not end there, because the increase in income will brings about additional consumption spending in the next period.

With 0.8 MPC and 0.2 MPM, consumption will rise by $1.6m of which $0.4m will be additional expenditure in imports.

Thus consumption of home produced goods will rise by $1.2m.

The Multiplier (Cont.)

This rise in consumption will create a further increase in income in the next period of $1.2m over and above the initial increase and this in turn will bring forth more consumption spending.

This process will continue with both consumption and income rising, but the actual increases become smaller and smaller overtime until eventually they become insignificant.

The Multiplier (Cont.)

The Multiplier Process

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Multiplier Formula

The slope of withdrawals line = MPS + MPM, which can be written as ΔI/ΔY,

By rearranging we have ΔY = Substituting figures ΔY = = $5m This means national income will rises by $5m

following an increase in investment of $2m. This is called multiplier effect

The multiplier = amount change in spending has to be multiplied by to obtain the change in income

Multiplier = = = 2.5

MPS = 1 – MPC

Algebraic derivation of the multiplier Equilibrium condition, Y = C+ I’+ G’ + X – M Consumption, C = a+b(Y-T’) Import function, M = c+d(Y-T’) Where Y = National income, C = planned

consumption expenditure, I’ = Planned investment expenditure, G’=Planned government expenditure, X’= planned exports, M=planned imports, T’= lump-sum tax. The constants a,b,c and d specify the positions and shapes of the consumption and import functions; b=MPC and d=MPM

Imports are a function of

Yd

I’, G’, T’ and X’ are assumed to be autonomous or exogenous.

C, M and Y are endogenous To find equilibrium national income, we solve the

system for Y Y= a+bY-bT’+I’+G’+X’-c-dY+dT’ Collecting like terms Y-bY+dY=a-bT’+I’+G’+X’-c+dT’ Y(1-b+d)=a-bT’+I’+G+X’-c+dT’ Dividing both side by (1-b+d) gives Y=

Algebraic derivation of the multiplier (Cont.)

Deducing the effect on national income of a change in I’ ceteris paribus, we have

ΔY = = = Changes in G’ and X’ will have the same

multiplier effect on national income as change in I’

Algebraic derivation of the multiplier (Cont.)

The Balanced Budget multiplier

Shows the effect on the equilibrium national income of an increase in government expenditure that is financed by equal increase in taxation

Increase in equilibrium national income following an increase in government spending (in a closed economy with lump-sum taxes only) is ΔY1= , where b is MPC

The fall in equilibrium national income following an increase in lump-sum taxation is:

ΔY2 = - If the tax and government spending changes

occur simultaneously, the combined effect on income is:

ΔY2 = -, But if the budget is balanced so that ΔG=ΔT, we

can write ΔY = - = ()ΔG = ΔG, The balanced budget multiplier is therefore equal

to 1

The Balanced Budget multiplier (Cont.)

Gap Analysis Gap analysis is the simple way of describing the

main policy implication of the Keynesian theory.

Deflationary gap: • The amount by which

aggregate demand must be increased to raise the equilibrium national income to the level of full employment.

• Since the equilibrium income Ye is bellow full employment national income Yf, the economy will be suffering from demand-deficient unemployment.

45

AD

Deflationary gap

0 Ye Yf

Full employmentAD

The deflationary gap is the amount by which aggregate demand must be increased to push the equilibrium national income via a multiplier, to the full employment national income.

How can the increase in aggregate demand be achieved?

Increase government spending or Reduce tax

Changing government spending and/or taxation is known as fiscal policy.

Deflationary Gap

Inflationary Gap The amount by which aggregate demand must

be decreased to reduce equilibrium national income to its full employment value.

If we relax wages and price, the equilibrium national income is above full employment level and so cannot actually be attained.

The economy will be at full employment value output; but excess demand will still exist so that the general price level will be forced upwards.

Appropriate fiscal policies to combat this demand-pull inflation is to cut government spending or increase taxation.

Inflationary Gap (Cont.)

AD45

AD

0 Yf Ye

National Income

FullEmployment

Inflationary gap