CHAPTER
4.1
4
NATIONAL
INCOME
MODELS
(II)
A 3-sector National Income Model
A. Introduction (p.55)
(1) Government can adjust expenditure (G) on goods and services and revenue from
taxes (T) so as to affect national income.
G is
into the circular flow while T is
from it.
(2) G function
G = G*
(
function)
(3) T function
T = T* + tY
(
(4) With tax, the Yd =
B. Income determination
function)
. Not all income received can be spent.
(p.56)
(1) Algebraically
(a) Income-expenditure approach
Given C = a + cYd = a + c (Y-T), I = I*, G = G*, T = T* + tY
Since E = C + I + G in a 3-sector model  E =
Since at equilibrium, Y = E  Y =
Exercise 1
Given C = 40 + 0.5(Y-T), I = 60, G = 55, T = 10 + 0.2Y
What is the value of equilibrium income level ?
(b) Injection-leakage approach
Since Yd = Y - T and Yd = C + S  Y - T =
Y=
Since in equilibrium, E = Y 
1

(2) Graphically
C. Multiplier for a 3-sector model
k=
(p.58)
Remark :
A change in autonomous tax will produce a smaller change in Y than an equal
change in autonomous expenditure.
E.g.
Q. If both autonomous E and T increase by the same amount, equilibrium Y will
increase, decrease or being unchanged ?
D. Government’s role in affecting Y (p.60)
(1) Equilibrium income (Y*) and potential income (Yf)
Y* : it is at where
=
Yf : the level of national income attained by an economy when all
in the
economy are employed.
 Y* may not be equal to Yf !
(a) when Y* < Yf 
/
gap
- It measures the required amount of increase in the planned aggregate expenditure
to
the Y* to the level of Yf.
- It exists when the level of aggregate expenditure is
to maintain the full
employment national income.
(b) when Y* > Yf 
- It measures the required
gap
in the planned aggregate expenditure to lower
the Y* to the level of Yf.
- It exists when the level of aggregate expenditure is in
to maintain the full
employment national income.
- By definition, Y* cannot exceed Yf, so beyond Yf, a higher value of national
income only means a higher
value. It is purely the result of increases
in
(we cannot assume a constant price level in this case). The real
amount of national income stays at
.
2
Concluding from (a) and (b) :
(i) Whenever an economy has a DG, it experiences the problem of
(ii) Whenever an economy has an IG, it experiences the problem of
(iii) Whenever Y* = Yf, it has neither
nor
.
.
.
Exercise 2
In an open economy with government intervention, which of the following will ensure
full employment ?
A. saving = investment
B. saving = government expenditure
C. saving + taxation + imports = investment + government expenditure + exports
D. None of the above
(2) The government can change the amount of G and T to achieve certain goals e.g.,
high employment, price stability in an economy.
 Fiscal policy : (I) discretionary , (II) built-in stabilizers
(I) Discretionary fiscal policy
It involves an
change in G and T with intention of affecting the economy.
(a) Expansionay
when Y*
Yf, either G or T
(b) Contractionary
when Y*
Yf, either G or T
Numerical illustration : refer to the textbook p.64
Conclusion :
Keynesian national income determination models provide a theoretical rationale for
government intervention in economic affairs at the macro level. The government is
able to manage the level of aggregate expenditure. It can “fine-tune” the level of
national income through various
fiscal policies.
(II) Built-in stabilizers (p.65)
- They are
tools of fiscal policy.
- They tend to reduce economic
during periods of low economic activity
(or unemployment) and decreasing Y during periods of
economic
activity (or inflation).
3
- Some important built-in stabilizers :
(a) proportional / progressive tax system
(b) welfare schemes
(c) government purchases
(d) corporate and family savings
Remarks :
(i) Some stabilizers e.g. progressive tax system, welfare schemes create
to work.
(ii) Value of government expenditure multiplier is
with proportional
tax (t) (
)  the existence of t
the responsiveness of
an economy to discretionary changes in G and T.
(iii) Built-in stabilizers can reduce fluctuations but when the economy is far
below the Yf,
fiscal policy is still necessary.
(iv) They may reduce the speed of its recovery.
Exercise 3
1. (a) ‘A proportional tax system is often praised for its built-in stabilizing effect.
However, it reduces the responsiveness of an economy to discretionary fiscal
policies.’ Explain.
(b) In the light of (a), comment on the following statement :
‘ The desirability of employing a proportional tax system depends on the state of
the economy.’
2.
Explain what is meant by “automatic stabilizers of fiscal policy.” Give at least 2
examples.
(3) Other issues related to fiscal policy (p.69)
(a) G or T ?
(i) Location of effects
G:
T:
(ii) Duration of time lag
decision lag and executive lag
G:
T:
(iii) Reversibility of the policy
: easy to raise but difficult to cut
: easier to change in both directions
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(iv) Public’s reaction to short-term changes
T:
G:
(b) Ways of financing government expenditure
(i) raising taxes
raising taxes => G can be raised but when T increases => Yd
transfer of purchasing power from
to
(ii) printing more money
if the economy is already at its full employment =>
purchasing power
=> C

=>
(iii) internal debt (a transfer of purchasing power from lenders to itself)
- if the debt is for current consumption (e.g. transfer payment to the
unemployed)  reduction in quantity of capital assets left to future
generation and reduction in private investment  future generations’
real income will be
than otherwise
- if the debt is on creating capital assets e.g. building or renovating
infrastructure  create future income
Still, if the repayment of debt are made from tax revenue => taxpayers in
future generations suffer a reduction in their
(iv) external debt (transfer purchasing power from foreigners to itself)
burden on future generations still depends on :
(c) The concept of efficiency in taxation
- Efficiency in taxation means minimum
burden.
- Whenever a tax distorts prices and hence people’s choices, it produces an
. (Refer to the example on p.71)
E. Balanced-budget multiplier (p.72)
(1) Government multiplier
(2) Tax multiplier
(3) Balanced-budget multiplier (kb)
kb =
If t = 0, i.e., all taxes are autonomous (lump sum)  kb =
F. Problems of the simple Keynesian multiplier
5
Refer to p.67
Exercise 4
Explain why tax-financed government expenditure is expansionary.
4.2
A 4-sector National Income Model
(p.75)
A. Introduction
(1) Economy conducts international
.
(2) - Export function is an autonomous function : X =
- Exports are
into the circular flow of income
- Exports depend on :
(a) the
of commodities in the home economy as compared to
those in other economics
(b) trade policies of other countries e.g. free trade or protectionism measures
(c) the level of national
of other countries
(d) conditions in the foreign exchange market. A change in foreign exchange rate
will change the
of all traded commodities.
(3) Import function is an
function : M = M* + mY
Imports are
out of the circular flow of income.
B. Income determination (p.76)
(1) Algebraically
(a) Income-expenditure approach
Exercise 5
Given C = 40 + 0.5Yd, I = 60, G = 55, T = 10 + 0.2Y, X = 20, M = 10 + 0.2Y
Find out the value of equilibrium national income.
(b) Injection-leakage approach
=
(2) Graphically (p.76)
C. Multiplier for 4-sector model
6
k=
D. Balance of trade
Continue the question in Exercise 5,
At Y = 200, the M =
the balance of trade = X - M =
(trade
)
 Y* may not guarantee external equilibrium
- There is sometimes a conflict between external and internal equilibrium
- It is also not necessary that internal equilibrium implies balance budget. ( T - G =
=
)
Exercise 6
1. In a closed economy with C, autonomous I and G so that in equilibrium Y = C + I
+ G. Suppose consumers of this economy are of 2 groups, half of them having C1
= 0.8 Y1 and the other half having C2 = 0.9Y2.
(a) Find the aggregate consumption function if each group earns half of the
aggregate income. Show your steps.
(b) Assume some income is transferred from those with a low MPC to those with
high MPC,
(i) What will be the effect on equilibrium aggregate income ? Explain
briefly.
(ii) Suppose investment is dependent on the r. Briefly explain what kind of
investment function will lead to results similar to the in (i).
2.
Review Exercise 1 Q.14
4.3
Aggregate Demand (AD) and Aggregate Supply (AS)
The basic AS and AD model
(p.77)
A. Introduction
In macroeconomics, the general price level (P) and the aggregate output (Q) are
determined by the interaction of
and
.
(1) AD is the quantity of
output that is
at every price
level.
(2) AS is the quantity of
output that will be
at every price
level.
(3) The equilibrium price level and aggregate output occur when the
7
- If the equilibrium is below full employment, there is a
gap.
- If the equilibrium is above full employment, there is an
gap.
- If the equilibrium is at the full employment level, the economy is operating
at
employment.
B. AD
(1) Why does AD curve slopes downward ?
(a) Income and wealth effect (or real-balance effect)
(b) Substitution of foreign goods effect
(c) Interest rate effect
(2) Why does AD curve shift ?
(a) Government expenditure, taxation, consumption, investment, export, import
(b) Expectations about the future state of the economy
(c) Populations
(d) Money supply
C. AS (p.78)
(1) Three different points of view about the shape of AS :
(a) Keynesian (kinked) AS curve (p.79 fig.8a)
Explanation for such a shape :
- The horizontal segment is caused by the existence of
workers and
idle resources.
- It is possible to raise the real output by simply employing the unemployed
worker at the existing wage rate and can leave the
unchanged.
- As
income level (Qf) is reached, no matter what the prices are, the
output cannot be increased anymore.
Conclusion :
(i) At an output level
than the Qf, changes in AD can expand the real
output without causing the general
level to change.
8
(ii) Once the economy has reached Qf, any changes in AD will only raise the
general
while output remains at
.
Implication :
In the simple Keynesian model, changes in AE (i.e.,AD) will result in changes
in the level of national income. The AS is irrelevant to the determination
of real national income.
(b) Upward-sloping AS curve (SRAS) (p.79, fig.8b)
Explanation :
In the short run as the quantity of aggregate output supplied increases, the
costs of production will go up as well (due to the law of
) price increases with rising output.
(c) Classical AS curve (p.80, fig.8c)
Explanation :
If there are no idle money balances, money is used simply as a medium of
exchange, when people earn income by supplying their factor services, the
entire sum will be spent to buy exactly the same amount of goods and
services. (Say’s Law : Supply creates its own demand - p.190)
For the society as a whole, there will be no
or
.
The AS curve is a vertical straight line starting from the
level of income.
(2) Why does AS curve shift ?
(a) Factors of production
prices of the factors of production rises 
(b) Technology and productivity
Technology improvement 
(c) Expectation
If expectation about the future state of the economy is more positive 
Note : The equilibrium price level and aggregate output occur when AD intersects AS.
In other words, when AD or/and AS change, the equilibrium P and Q change,
too.
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D. Comparing AD-AS model with Keynesian model
(1) The AD-AS model established the equilibrium level of national income through
the intersection of the
and
curves.
The income-expenditure model (Keynesian model) uses the intersection of the
to find the equilibrium level of national income.
(2) AD-AS model has the advantage of allowing the general price level to be
determined and the AS curve to shift.
Income-expenditure model assumes that the price level is
and allows the
components of the AE (i.e., C, I, G, net exports) to be examined.
4.4
Multiplier Effect With Changing Price Level
(p.82)
(1) Under Keynesian AS curve
(a) when there is unemployment, the multiplier effect remains unchanged (same
as that under simple Keynesian model).
Q. Do you know why ?
(b) when there is full employment, the multiplier will have no effect on real
income when expenditure increases autonomously (AD shifts). Only
and
income will increase.
(2) Under classical AS curve
The multiplier effect will be the same as that in
.
(3) Upward-sloping AS curve
A rise in AD will lead to a rise in
 purchasing power
spending
 the size of the multiplier effect will be
10
 consumers’
.