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Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 1
CHAPTER 13
THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION
LECTURE OUTLINE
1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT
2 THE GREAT DEPRESSION
3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT
4 THE KEYNESIAN THEORY IN GREATER DETAIL
4.1 Planned aggregate expenditure (AE)
4.1.1 Consumption expenditure (C)
4.1.2 Planned investment expenditure (I)
4.1.3 Government expenditure on goods and services (G)
4.1.4 Net exports (X M)
4.1.5 Distinction between planned aggregate expenditure and actual aggregate
expenditure
4.2 Circular flow of income and expenditure
4.3 Equilibrium national income
4.4 Multiplier effect and multiplier
4.5 Paradox of thrift
5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT
6 INFLATIONARY GAP AND DEFLATIONARY GAP
References
John Sloman, Economics
William A. McEachern, Economics
Richard G. Lipsey and K. Alec Chrystal, Positive Economics
G. F. Stanlake and Susan Grant, Introductory Economics
Michael Parkin, Economics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 2
1 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT
“Classical economists” is a term coined by Karl Marx to refer to economists who include
David Ricardo, James Mill and their predecessors. In other words, “Classical economists”
refers to the founders of the theory which culminated in Ricardian economics. John
Maynard Keynes included in the Classical school the followers of Ricardo, that is to say
those who adopted and perfected the theory of Ricardian economics, including John Stuart
Mill, Alfred Marshall, Francis Ysidro Edgeworth and Arthur Cecil Pigou. The above list of
names may seem confusing. A simpler but looser definition of “Classical economists” is
the economists who wrote before Keynes.
Classical economists believe that prices and wages are totally flexible and hence the
economy is a self-correcting mechanism. In other words, Classical economists believe that
as prices and wages are totally flexible, the economy is always at the full-employment
equilibrium.
Suppose that the economy is at the full-employment equilibrium. Further suppose that
aggregate demand falls. When this happens, national output will fall below the
full-employment level which will lead to unemployment resulting in a downward pressure
on wages. Since wages are totally flexible, in Classical economists‟ view, they will fall
immediately which will induce firms to increase output resulting in national output
returning to the full-employment level. Therefore, the aggregate supply curve is vertical at
the full-employment national output. The implication of a vertical aggregate supply curve
is that only a change in aggregate supply will affect national output.
In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 does not
have any effect national output. It only leads to a rise in the general price level (P) from P0
to P1.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 3
In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to an
increase national output (Yf) from Yf0 to Yf1. Therefore, Classical economists argue that
the government should focus on the factors that will increase aggregate supply to increase
national output and hence the standard of living. In this sense, Classical economics is
supply-side economics.
Classical economists treat money only as a medium of exchange. Workers are exchanging
labour for goods and services and firms are exchanging goods and services for labour. In
this sense, money simply plays an intermediate role that facilitates transactions. This way
of thinking leads Classical economists to see every sale as a purchase. Since every sale is a
purchase, it is impossible for supply to exceed demand. By producing, firms are spending.
This line of thinking is often stated as “Say's Law”, which states that supply creates its own
demand. Say's Law is attributed to the great French economist Jean-Baptiste Say
(1767-1832). Say's original version was "products are paid for with products". Classical
economists use one or another version of Say's Law when they claim that economic
downturns cannot be caused by a deficiency in aggregate demand.
A version:
Firms employ factor inputs to produce output and hence pay factor income to households.
The income received by households is then partly paid back to firms in the form of
consumption expenditure and partly withdrawn from the inner flow of the circular flow of
income and expenditure in the form of savings, taxes and imports. However, any
withdrawals by households are ultimately paid back to firms in the form of injections such
as investment expenditure, government expenditure and exports. Therefore, the income
generated by the production of firms will be transformed into demand for their goods and
services, either directly in the form of consumption expenditure, or indirectly via
withdrawals and then injections. There will be no deficiency of demand.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 4
2 THE GREAT DEPRESSION
The Classical view was challenged when the market economies were hit by the Great
Depression in the 1930s during which there was prolonged and mass unemployment. The
Great Depression proved that the economy was not a self-correcting mechanism, not in the
short run at least. For instance, the national output of the United States stayed below the
full-employment level for most part of the 1930s.
3 THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT
In 1936, John Maynard Keynes published the book "The General Theory of Employment,
Interest and Money to explain the prolonged and massive unemployment in the Great
Depression. The book criticises the classical model. Keynes turns Say‟s Law on its head,
arguing that aggregate demand determines national output and employment in the
economy. In this sense, demand creates its own supply.
Unlike the Classical economists, Keynes believes that prices and wages are rigid,
especially in the downward direction and hence the economy is not a self-correcting
mechanism. In other words, Keynes believes that as prices and wages are rigid, the
economy can stay at a below-full-employment equilibrium.
Suppose that the economy is at the full-employment equilibrium. Further suppose that
aggregate demand falls. When this happens, national output will fall below the
full-employment level which will lead to unemployment resulting in a downward pressure
on wages. Since wages are rigid, in Keynes‟s view, they will not fall. Therefore, firms will
not increase output and hence national output will stay at a below-full-employment level.
Keynes attributes the prolonged and high unemployment in the Great Depression to a
prolonged and huge deficiency in aggregate demand and downward rigidity of wages.
When national output is below the full-employment level, with unemployment in the
economy, firms can increase output without bidding up wages. Therefore, although an
increase in national output will lead to an increase in the total cost of production in the
economy, it will not affect the average cost of production in the economy. Since the
average cost of production in the economy will remain the same, firms will not increase
prices. Therefore, the aggregate supply curve is horizontal at the current general price level
up to the full-employment national output. Once full employment is reached, the economy
cannot expand output any further and hence the aggregate supply curve is vertical at the
full-employment national output. Therefore, the aggregate supply curve is inverse
L-shaped. Keynes believes that unemployment is the normal state of the economy.
Therefore, the implication of an inverse L-shaped aggregate supply curve is that only a
change in aggregate demand will affect national output.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 5
In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 does not have
any effect national output.
In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an
increase national output (Y) from Y0 to Y1. Therefore, Keynes argues that the government
should focus on the factors that will increase aggregate demand to increase national output
and hence the standard of living. In this sense, Keynesian economics is demand-side
economics.
Note: Keynesian economics is short-run economics. Therefore, the Keynesian aggregate
supply curve is a short-run aggregate supply curve. There is no long-run aggregate
supply curve in Keynesian economics. Classical economists make no distinction
between the short run and the long run as they believe that prices and wages are
totally flexible. Therefore, the Classical aggregate supply curve is simply an
aggregate supply curve.
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4 THE KEYNESIAN THEORY IN GREATER DETAIL
4.1 Planned aggregate expenditure (AE)
Planned aggregate expenditure (AE) is the planned total expenditure on the goods and
services produced in the economy over a period of time and is comprised of consumption
expenditure (C), planned investment expenditure (I), government expenditure on goods
and services (G) and net exports (X-M).
AE C I G (X M)
4.1.1 Consumption expenditure (C)
Consumption expenditure is the expenditure made by households on goods and services.
Savings is the excess of disposable income over consumption expenditure. The
consumption function shows the consumption expenditure of households at each
disposable income. Mathematically, the Keynesian consumption function can be expressed
as
C a bYd, where a 0 and 0 b 1.
From the above equation, it can be seen that consumption is comprised of two components:
autonomous consumption (a) and induced consumption (bYd). Autonomous consumption
is the part of consumption that does not depend on disposable income and is determined by
consumer confidence, the wealth of households, interest rates, expectations of price
changes, the availability of credit and the distribution of income. Induced consumption is
the part of consumption that depends on disposable income (Yd). Keynes believes that
consumption will increase with an increase in disposable income (b 0) but the increase in
consumption will be less than the increase in disposable income (b 1).
Note: Students can think of autonomous consumption as the consumption of necessities.
However, it is important to note that different people may view different goods
differently. A necessity to a person may be a luxury to another.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 7
Consumption function
In the above diagram, (b) is the slope of the consumption function. In Keynesian
economics, it is known as the marginal propensity to consume out of disposable income
(MPCYd). The MPCYd is the fraction an increase in disposable income that is spent on
consumption (C/Yd).
Savings is the excess of disposable income over consumption expenditure. The savings
function shows the savings of households at each disposable income. Mathematically, the
Keynesian savings function can be expressed as
S a (1 b)Yd, where a 0 and 0 (1 – b) 1.
From the above equation, it can be seen that savings is comprised of two components:
autonomous savings (a) and induced savings [(1 b)Yd]. Autonomous savings (or
dissavings, which some may like to call it) is the part of savings that does not depend on
disposable income and is determined by consumer confidence, interest rates, expectations
of price changes the distribution of income. Induced savings is the part of savings that
depends on disposable income (Yd). Keynes believes that savings will increase with an
increase in disposable income [(1 b) > 0] but the increase in savings will be less than the
increase in disposable income [(1 b) < 1].
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Savings function
In the above diagram, (1 b) is the slope of the savings function. In Keynesian economics,
it is known as the marginal propensity to save out of disposable income (MPSYd). The
MPSYd is the fraction of an increase in disposable income that is saved (S/Yd).
Since any additional disposable income will either be spent or saved, the sum of the
marginal propensity to consume out of disposable income and the marginal propensity to
save out of disposable income is equal to one (MPCYd MPSYd 1).
The average propensity to consume out of disposable income (APCYd) is the fraction of
disposable income that is spent on consumption (C/Yd). The average propensity to save out
of disposable income (APSYd) is the fraction of disposable income that is saved (S / Yd).
Since any amount of disposable income will either be spent or saved, the sum of the
average propensity to consume out of disposable income and the average propensity to
save out of disposable income is equal to one (APCYd APSYd 1).
Example
Yd C S MPCYd MPSYd APCYd APSYd
0 20 20 ------- ------- ------- -------
40 50 10 0.75 0.25 1.25 0.25
80 80 0 0.75 0.25 1 0
120 110 10 0.75 0.25 0.92 0.08
160 140 20 0.75 0.25 0.875 0.125
200 170 30 0.75 0.25 0.85 0.15
240 200 40 0.75 0.25 0.83 0.17
The marginal propensity to consume and the marginal propensity to save can be defined
“out of national income”. The marginal propensity to consume out of national income
(MPC) is the fraction of an increase in national income that is spent on consumption
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 9
(C/Y). The marginal propensity to save out of national income (MPS) is the fraction of
an increase in national income that is saved (S/Y). The marginal propensity to tax (MPT)
is the fraction of an increase in national income that is taxed (T/Y). Since any amount of
national income will either be spent, saved or taxed, the sum of the marginal propensity to
consume out of national income, the marginal propensity to save out of national income
and the marginal propensity to tax is equal to one (MPC MPS MPT 1). Similarly, the
average propensity to consume and the average propensity to save can be defined “out of
national income”. The average propensity to consume out of national income (APC) is the
fraction of national income that is spent on consumption (C/Y). The average propensity to
save out of national income is the fraction of national income that is saved (S/Y). Since any
amount of national income will either be spent, saved or taxed, the sum of the average
propensity to consume out of national income, the average propensity to save out of
national income and the average propensity to tax is equal to one (APC APS APT 1).
Relationship between the consumption function and the savings function
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© 2011 Economics Cafe All rights reserved. Page 10
In the above diagram, when disposable income is equal to zero, consumption expenditure
must be financed by dissavings. At Yd0, where consumption expenditure is equal to
disposable income, savings is zero. Below Yd0, where consumption expenditure exceeds
disposable income, savings is negative. Above Yd0, where disposable income exceeds
consumption expenditure, savings is positive.
Induced consumption is positively related to disposable income. In other words, an
increase in disposable income will lead to an increase in induced consumption and vice
versa. An increase in induced consumption can be shown by an upward movement along
the consumption function.
In the above diagram, an increase in disposable income (Yd) from Yd0 to Yd1 leads to an
upward movement along the consumption function (C) resulting in an increase in
consumption expenditure (C) from C0 to C1. The effect of an increase in disposable income
on consumption will depend on the MPCYd. Given any increase in disposable income, the
larger the MPCYd, the larger the increase in consumption.
Determinants of disposable income
National income
Disposable income will increase when national income increases.
Direct taxes and transfer payments
A decrease in direct taxes such as personal income tax and corporate income tax, or an
increase in transfer payments such as unemployment benefits, social security benefits and
interest payments on national debt will lead to an increase in disposable income.
Autonomous consumption is determined by consumer confidence, the wealth of
households, interest rates, expectations of price changes, the availability of credit and the
distribution of income. An increase in autonomous consumption can be shown by a vertical
upward shift in the consumption function.
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© 2011 Economics Cafe All rights reserved. Page 11
In the above diagram, a vertical upward shift in the consumption function (C) from C0 to C1
leads to an increase in consumption expenditure (C) from C0 to C1 at the same disposable
income (Yd0).
Determinants of autonomous consumption
Consumer confidence (Consumer sentiment)
When households are more optimistic about the economic outlook, they will expect their
income to rise and hence increase consumption.
Wealth of households
When the wealth of households increases, consumption will increase.
Interest rates
A fall in interest rates will reduce the incentive to save which will induce households to
increase consumption.
Expectations of price changes
When households expect prices to rise, they will bring forward the purchases of some
durable goods which will lead to an increase in consumption. Note that this is not the same
as consumer confidence which is about expectations of income changes.
Availability of credit
Many consumer durables are purchased with bank loans and hence an increase in the
availability of credit will allow households to increase consumption.
Distribution of income
Lower income groups have higher marginal propensities to consume than higher income
groups and hence a redistribution of income from higher income groups to lower income
groups will lead to an increase in consumption.
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© 2011 Economics Cafe All rights reserved. Page 12
4.1.2 Planned investment expenditure (I)
Investment expenditure is the expenditure made by firms on goods produced not for their
present use but for their use in the future. In economics, investment is comprised of
business fixed investment (new factories and machinery), residential investment (new
houses, apartments and condominiums) and inventory investment (the change in the value
of unsold goods). There are two types of investment: autonomous investment and induced
investment.
Autonomous investment
Autonomous investment is the part of investment that does not depend on national income
and is determined by interest rates, business sentiment, business costs, capital costs,
corporate income tax, technological advancements and the availability of credit. According
to the marginal efficiency of capital theory, or some may prefer to call it the marginal
efficiency of investment theory, the marginal efficiency of capital function is the
investment function. The investment function shows the investment expenditure of firms at
each interest rate.
Note: Students do not need to explain the MEC/MEI theory in the examination. All that
they are required to do is to state that the MEC/MEI function is the investment
function.
The marginal efficiency of a type of capital is the discount rate which equates the cost of
the type of capital to the present value of its stream of expected returns. The marginal
efficiency of capital is the summation of the marginal efficiencies of all the types of capital
in the economy.
Consider a type of capital which will generate returns for three years.
Returns (Year1) Returns (Year 2) Returns (Year 3)
Cost ------------------------ ------------------------ ------------------------
(1 r*) (1 r*)2 (1 r*)
3
r* is the marginal efficiency. It should be obvious that the marginal efficiency of a type of
capital is its internal rate of returns (IRR).
The fund can be loaned out if it is not invested in the type of capital. Therefore, interest
rates are the external rate of returns (ERR).
The marginal efficiency of a type of capital function is downward-sloping due to
diminishing marginal returns. As more and more of a type of capital is employed, each
additional unit of it will have less of other types of capital to work with. Therefore, the
additional expected returns resulting from investing in one more unit of a type of capital
falls. Since the marginal efficiency of capital is the summation of the marginal efficiencies
of all the types of capital in the economy, the marginal efficiency of capital function is also
downward-sloping.
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© 2011 Economics Cafe All rights reserved. Page 13
Marginal efficiency of capital function
In the above diagram, the marginal efficiency of capital (MEC) is higher than the interest
rate (r) r0 to the left of investment (I) I0. Therefore, the optimal level of investment is I0.
Since investment depends on the marginal efficiency of capital, the marginal efficiency of
capital function is the investment function.
A fall in interest rates will lead to more profitable planned investments resulting in an
increase in investment expenditure and vice versa. An increase in investment expenditure
due to a fall in interest rates can be shown by a downward movement along the marginal
efficiency of capital function.
In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward
movement along the marginal efficiency of investment function (MEC) resulting in an
increase in investment expenditure (I) from I0 to I1.
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© 2011 Economics Cafe All rights reserved. Page 14
In addition to a fall in interest rates, the number of profitable planned investments and
hence investment expenditure will also increase when expected returns on planned
investments increase due to stronger business sentiment, lower business costs such as
decreases in oil prices and wages or lower capital costs such as decreases in the costs of
factories and machinery. Further, a decrease in corporate income tax that will increase
expected after-tax returns on planned investments, technological advancements and an
increase in the availability of credit will also lead to an increase in investment expenditure.
An increase in investment expenditure due to a non-interest rate factor can be shown by
rightward shift in the marginal efficiency of capital function.
In the above diagram, a rightward shift in the marginal efficiency of capital (MEC)
function from MEC0 to MEC1 leads to an increase in investment expenditure (I) from I0 to
I1 at the same interest rate (r0).
Induced investment
Induced investment is the part of investment that depends on national income. According
to the accelerator theory of investment, net investment is determined by the rate of change
of national income. When national income rises at an increasing rate, net investment will
increase. However, when national income rises at a decreasing rate, net investment will
decrease.
Since It Kt – Kt1 and Kt vYt, It It vYt – vYt1 or It v(Yt – Yt1), where I net
investment, K capital, Y national income or national output and v capital-output
ratio.
It v(Yt – Yt1) is the accelerator equation.
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© 2011 Economics Cafe All rights reserved. Page 15
Example
Time Period (t) Yt Yt1 It
0 $100 --- ---
1 $110 $100 $25
2 $140 $110 $75
3 $180 $140 $100
4 $200 $180 $50
* Assume that v = 2.5
From t = 0 to t =3, because national income rises at an increasing rate, net investment
increases. From t = 3 to t = 5, because national income rises at a decreasing rate, net
investment decreases.
The size of the accelerator effect depends on the capital-output ratio (v), also known as the
accelerator coefficient. The higher the capital-output ratio, the larger the accelerator effect.
For instance, due to the high capital-output ratio in the United States, the accelerator effect
is large.
Note: In the Keynesian model, planned investment expenditure is assumed to be
autonomous as it cannot be expressed as a linear function of national income. In
reality, planned investment expenditure is affected by national income.
4.1.3 Government expenditure on goods and services (G)
Government expenditure on goods and services is the expenditure on goods and services
made by the government. It includes expenditure on both consumer goods and capital
goods. It does not include government expenditure on transfer payments. Transfer
payments are payments made by the government to the recipients not in exchange for any
goods or services and they include social security benefits, unemployment benefits and
interest payments on national debt. About two-thirds of the US federal government
expenditure is made on transfer payments.
The government can also influence aggregate expenditure by controlling consumption
expenditure through changing direct taxes or transfer payments. In addition to the effect on
consumption expenditure, a change in corporate income tax will also affect investment
expenditure and hence aggregate expenditure.
Disposable income National income Transfer payments Corporate income tax –
Other direct taxes Undistributed corporate profit Personal income tax
Taxes T tY, Yd Y – T – tY, where T autonomous taxes, tY induced taxes and t
marginal propensity to tax (MPT).
Assuming no transfer payments and undistributed corporate profit.
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Since C a bYd, C a b(Y T tY) or C a – bT b(1 t)Y, where a autonomous
consumption, bYd induced consumption, b the marginal propensity to consume out of
disposable income (MPCYd) and b(1 t) the marginal propensity to consume out of
national income (MPC).
An increase in “t” will decrease the MPC and hence make the consumption function
(plotted against national income) flatter. Therefore, the AE function will become flatter.
However, an increase in “T” will shift the consumption function (plotted against national
income) vertically downwards. Therefore, the AE function will shift vertically downwards.
Note: In the Keynesian model, government expenditure on goods and services is assumed
to be autonomous as it cannot be expressed as a linear function of national income. In
reality, government expenditure is affected by national income. In a recession, the
government may increase expenditure on goods and services to increase economic
growth and hence reduce unemployment. When the economy is overheating, the
government may decrease expenditure on goods and services to reduce inflation.
4.1.4 Net exports (X M)
Exports (X) are the expenditure made by foreigners on domestic goods and services. The
following are the determinants of exports.
Foreign income
An increase in foreign income will lead to a rise in exports. The converse is also true.
Domestic general price level relative to foreign general price level
When the domestic general price level falls relative to the foreign general price level,
domestic goods and services will become relatively cheaper than foreign goods and
services. When this happens, exports will rise. The converse is also true.
Exchange rate
When domestic currency depreciates, domestic goods and services will become relatively
cheaper than foreign goods and services. When this happens, exports will rise. The
converse is also true.
Other factors
Factors such as comparative advantage, trade policy, quality and tastes will also affect
exports.
Imports (M) are the expenditure made by domestic residents on foreign goods and services.
The following are the determinants of imports.
National income
An increase in national income will lead to a rise in imports. The converse is also true.
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© 2011 Economics Cafe All rights reserved. Page 17
Domestic general price level relative to foreign general price level
When the domestic general price level rises relative to the foreign general price level,
domestic goods and services will become relatively more expensive than foreign goods
and services. When this happens, imports will rise. The converse is also true.
Exchange rate
When domestic currency appreciates, domestic goods and services will become relatively
more expensive than foreign goods and services. When this happens, imports will rise. The
converse is also true.
Other factors
Factors such as comparative advantage, trade policy, quality and tastes will also affect
imports.
Mathematically, the import function can be expressed as M m0 m1Y, where m0
autonomous imports, m1Y induced imports, m1 the marginal propensity to import
(MPM).
Net export function
In the above diagram, as exports are independent of national income and imports rise with
national income, the net export function is downward-sloping.
4.1.5 Distinction between planned aggregate expenditure and actual aggregate
expenditure
Actual aggregate expenditure, or national expenditure, is always equal to national income
or national output. However, planned aggregate expenditure is not necessarily equal to
actual aggregate expenditure and therefore is not necessarily equal to national income or
national output.
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Firms will experience an unplanned increase in inventory investment if they sell less of
their output than expected, in which case, actual aggregate expenditure, national output or
national income will exceed planned aggregate expenditure. Conversely, if firms sell more
of their output than expected, they will experience an unplanned decrease in their inventory
investment, in which case, planned aggregate expenditure will exceed actual aggregate
expenditure, national output or national income.
4.2 Circular flow of income and expenditure
The circular flow of income and expenditure shows the flow of income and expenditure
between the different sectors in the economy.
In the above diagram, households provide factor inputs which include labour, land, capital
and entrepreneurship to firms and in return, they receive factor income (Y) in the form of
wages, rent, interest and profits. Firms provide goods and services to households and in
return, they receive payments known as consumption expenditure on domestic goods and
services (CD). However, not all the factor income received by households return to
domestic firms as revenue. Rather, they go to the government in the form of taxes (T),
some go to the financial sector in the form of savings (S) and some go to the external sector
in the form of imports (M). Taxes, savings and imports are known as withdrawals, which
are basically the factor income received by households that does not return to domestic
firms as revenue. Further, some of the payments received by domestic firms do not come
from households. Rather, they come from the government in the form of government
expenditure on goods and services (G), the financial sector in the form of loans to finance
investment expenditure (I) and the external sector in the form of exports (X). Government
expenditure, investment expenditure and exports are known as injections, which are
basically are the payments received by domestic firms that do not come from households.
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4.3 Equilibrium national income
The equilibrium national income is the national income that has no tendency to change and
it can be determined in three ways: the expenditure-income approach, the
injections-withdrawals approach and the AD-AS approach.
Expenditure-income approach (AE Y)
According to the expenditure-income approach, which is also known as the
expenditure-output approach, the equilibrium national income is the national income
where planned aggregate expenditure is equal to national income or national output.
In the above diagram, the equilibrium national income is Y0 where planned aggregate
expenditure (AE) is equal to national income (Y). At a national income lower than planned
aggregate expenditure, such as Y2, firms whose output is insufficient to meet the planned
expenditure of the economy will experience an unplanned decrease in their inventories,
and to bring their inventories up to the planned levels, they will increase output which will
lead to an increase in national income. At a national income higher than planned aggregate
expenditure, such as Y1, firms whose output is more than sufficient to meet the planned
expenditure of the economy will experience an unplanned increase in their inventories, and
to bring their inventories down to the planned levels, they will decrease output which will
lead to a decrease in national income. At Y0, firms will not experience any unplanned
changes in their inventories and hence there will be no incentive for them to change output.
Note: Since AE C I G (X M) and Y = C S T, when AE Y, C I G (X –
M) C S T. Therefore, when AE Y, I G X = S T M.
Injections-withdrawals approach (J W)
According to the injections-withdrawals approach, the equilibrium national income is the
national income where planned injections are equal to withdrawals. Injections are the
payments received by domestic firms that do not come from households and they comprise
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government expenditure on goods and services, investment expenditure and exports.
Withdrawals are the factor income received by households that does not return to domestic
firms as revenue and they comprise taxes, savings and imports.
In the above diagram, the equilibrium national income is Y0 where planned injections (J)
are equal to withdrawals (W), because at this national income, planned aggregate
expenditure is equal to national income. At a national income where planned injections are
higher than withdrawals, planned aggregate expenditure is higher than national income,
and vice versa.
Aggregate demand-aggregate supply approach (AD AS)
According to the aggregate demand-aggregate supply approach, the equilibrium national
income is the national income where aggregate demand is equal to aggregate supply.
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In the above diagram, the equilibrium national income is Y0 where aggregate demand (AD)
is equal to aggregate supply (AS). At Y0 where there is neither a shortage nor surplus, firms
will not experience any unplanned changes in their inventories and hence there will be no
incentive for them to change output.
4.4 Multiplier effect and multiplier
An increase in autonomous expenditure will lead to an increase in national income.
Furthermore, due to the multiplier effect, the increase in national income will be larger than
the initial increase in autonomous expenditure.
The multiplier effect is the effect of an increase in autonomous expenditure leading to a
larger increase in national income.
In the above diagram, an increase in AE leads to a larger increase in national income.
The marginal propensity to withdraw (MPW) is the fraction of an increase in national
income that is withdrawn from the inner flow of income and expenditure. Therefore, MPW
MPS MPT MPM. The marginal propensity to consume domestic goods and services
out of national income (MPCD) is the fraction of an increase in national income that is
spent on domestic goods and services. Therefore, MPCD MPC – MPM.
Suppose that MPCD 0.8, MPW 0.2 and AE $1000. When aggregate expenditure
increases by $1000, firms will employ more factor inputs to produce more output and
hence pay more factor income to households. Household income and hence consumption
expenditure will increase by $1000 and $800 (0.8 × $1000) respectively. Due to the
increase in consumption expenditure of $800, firms will employ even more factor inputs to
produce even more output and hence pay even more factor income to households.
Household income and hence consumption expenditure will increase further by $800 and
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© 2011 Economics Cafe All rights reserved. Page 22
$640 (0.8 × $800) respectively. However, each time household income rises, savings, taxes
and imports will rise, and when these withdrawals have increased by $1000 to the level that
matches injections, equilibrium will be restored and national income will stop increasing.
Round Y CD W
1 $1000 $800 $200
2 $800 $640 $160
3 $640 „ „
„ „ „ „
„ „ „ „
„ „ „ „
Sum $5000 $4000 $1000
In the above table, Y $1000 $800 $640 ……….
Therefore, Y $1000 (0.8)($1000) (0.8)2($1000) ……….
Applying geometric progression, Y $1000/(1 0.8) $5000 AE $1000.
The multiplier is the number of times by which national income increases due to an
increase in autonomous expenditure.
Since Y = AE/(1 MPCD), Y/AE 1/(1 MPCD).
Multiplier Y/AE 1/(1 MPCD)
Since MPS MPT MPM MPCD 1, Y/AE 1/MPW.
Multiplier Y/AE 1/MPW
Since the multiplier is the inverse of the MPW, it will be larger the lower the savings, the
lower the income taxes and the lower the imports. The multiplier in Singapore is small due
to the high savings and high imports.
Note: In reality, when aggregate expenditure rises, real national income will not rise by the
full multiplier effect due to a rise in the general price level (which will be explained
later).
4.5 Paradox of thrift
Classical economists argue that saving is desirable for the economy. An increase in savings
will lead to lower interest rates which will result in higher consumption and investment and
hence higher economic growth. However, Keynes argues that an increase in savings is
undesirable for the economy.
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© 2011 Economics Cafe All rights reserved. Page 23
The fallacy of composition is the wrong belief that if something is good for an individual, it
is also good for the nation. However, just because something is good for an individual, it
does not follow that it is good for the nation.
If an individual increases savings, he will increase his future consumption. However, if the
nation increases savings, it will decrease its future income and future consumption. Given
any amount of disposable income, an increase in savings will lead to a decrease in
consumption expenditure. Further, the decrease in consumption expenditure will weaken
business sentiment which will lead to a decrease in investment expenditure. The combined
decreases in consumption expenditure and investment expenditure will lead to a decrease
in aggregate demand and hence national income. The phenomenon of higher savings
leading to lower national income is known as the paradox of thrift. Keynes‟ idea is that
when the economy is in a recession, people should not tighten their belts. Rather, they
should spend their way out of the recession.
5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT
Classical economics and Keynesian economics are traditional schools of thought in
macroeconomics. Today, no economist subscribes to these precise collections of views.
Instead, what is taught to students today is neo-classical economics which is the
mainstream economics.
Neo-classical economists believe that although prices and wages are totally flexible in the
long run, they are rigid in the short sun. Therefore, although the economy will be at the
full-employment equilibrium in the long run, it can stay at an above-full-employment
equilibrium or a below-full-employment equilibrium in the short run.
Aggregate demand is the total demand for the goods and services produced in the economy
over a period of time and is comprised of consumption expenditure, investment
expenditure, government expenditure on goods and services and net exports. The
aggregate demand curve shows the total demand for the goods and services produced in the
economy at each general price level over a period of time.
Aggregate Demand Curve
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In the above diagram, the aggregate demand (AD) curve is downward-sloping. The AD
curve will shift rightwards if there is an increase in C, I, G or (X – M).
Aggregate supply is the total supply of goods and services in the economy over a period of
time and is determined by the amount and the productivity of factor inputs, given factor
prices. The aggregate supply curve shows the total supply of goods and services in the
economy at each general price level over a period of time.
Aggregate Supply Curve
In the above diagram, the aggregate supply (AS) curve is upward sloping. The AS curve
will shift rightwards if there is a decrease in factor prices or an increase in the amount or the
productivity of factor inputs.
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Long-run aggregate supply is the total supply of goods and services in the economy when
all factor prices have fully adjusted in the long run and is determined by the amount and the
productivity of factor inputs. The long-run aggregate supply curve shows the total supply
of goods and services in the economy when all factor prices have fully adjusted in the long
run.
Long-run Aggregate Supply Curve
In the above diagram, the long-run aggregate supply (LRAS) curve is vertical at the
full-employment national income. The LRAS curve will shift rightwards if there is an
increase in the amount or the productivity of factor inputs.
Note: The full-employment national income is the national income where there is no
demand-deficient unemployment (which will be discussed in greater detail later).
If the economy is at an above-full-employment equilibrium, national income will fall.
Above-full-employment equilibrium
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In the above diagram, the equilibrium national income (Y0) is above the full-employment
national income (Yf), creating a positive output gap (Y0 Yf). When national income is
above the full employment level, unemployment will be below the natural rate. In such a
state of the economy, firms will find it difficult to employ workers but workers will find it
easy to get jobs which will lead to an upward pressure on factor prices. When factor prices
and hence the cost of production in the economy rise in the long run, aggregate supply (AS)
will fall from AS0 to AS1 and hence national income will fall from Y0 to Y1.
If the economy is at a below-full-employment equilibrium, national income will rise.
Below-full-employment equilibrium
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In the above diagram, the equilibrium national income (Y0) is below the full-employment
national income (Yf), creating a negative output gap (Y0 Yf). When national income is
below the full employment level, unemployment will be above the natural rate. In such a
state of the economy, firms will find it easy to employ workers but workers will find it
difficult to get jobs which will lead to a downward pressure on factor prices. When factor
prices and hence the cost of production in the economy fall in the long run, aggregate
supply (AS) will rise from AS0 to AS1 and hence national income will rise from Y0 to Y1.
If the economy is at the full-employment equilibrium, national income will remain
unchanged, other things being equal.
Full-employment equilibrium
In the above diagram, the equilibrium national income (Y0) is equal to the full-employment
national income (Yf). When national income is at the full-employment level,
unemployment will be at the natural rate. Therefore, there will be neither upward nor
downward pressure on factor prices and hence the short-run equilibrium will be the
long-run equilibrium, other things being equal.
6 INFLATIONARY GAP AND DEFLATIONARY GAP
In the short run, the equilibrium national income may not be equal to the full-employment
national income.
If the equilibrium national income is higher than the full-employment national income, the
economy is at an above-full-employment equilibrium. The output gap, which is the excess
of the equilibrium national income over the full-employment national income, is positive.
A positive output gap is also known as an inflationary gap.
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© 2011 Economics Cafe All rights reserved. Page 28
Above-full-employment equilibrium
In the above diagram, the equilibrium national income (Ye) is higher than the
full-employment national income (Yf). The output gap (Ye Yf) is positive.
If the equilibrium national income is lower than the full-employment national income, the
economy is at a below-full-unemployment equilibrium. The output gap, which is the
excess of the equilibrium national income over the full-employment national income, is
negative. A negative output gap is also known as a deflationary gap.
Below-full-employment equilibrium
In the above diagram, the equilibrium national income (Ye) is lower than the
full-employment national income (Yf). The output gap (Ye Yf) is negative.
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© 2011 Economics Cafe All rights reserved. Page 29
If the equilibrium national income is the same as the full-employment national income, the
economy is at the full-employment equilibrium.
Full-employment equilibrium
When the economy is at the full-employment equilibrium, there is neither inflationary gap
nor deflationary gap.
Note: In Keynesian economics, inflationary gap and deflationary gap do not refer to
positive output gap and negative output gap. An inflationary gap is the excess of
planned aggregate expenditure over national income at the full-employment national
income. In other words, it is the amount of decrease in planned aggregate
expenditure which is needed to close a positive output gap. A deflationary gap is the
shortfall of planned aggregate expenditure below national income at the
full-employment national income. In other words, it is the amount of increase in
planned aggregate expenditure which is needed to close a negative output gap.