Lipsey 23. National Income Determination Part I
-- in a Closed Economy with No Government
-- When Prices Are Held Constant
Name___________________
3/8/2016
I. Introduction
First, revisit of Great Depression and Oil Shocks
1) Great Depression: Y and PL moved in opposite direction
2) Oil Shock: Y and PL moved in same direction
3) Can we explain?
4) Why are PL, GDP, and the unemployment rate what they are today? What causes
them to change?
5) PL, GDP similar to price and quantity, maybe should use demand and supply
analysis?
6) Aggregate Demand (AD), Aggregate Supply (AS)
 Why is AD negatively sloped? Different from why D is neg. sloped -- relative
prices.
 GDP gaps - inflationary, recessionary gaps
 Shifts of AD and AS

AD shifts - aggregate demand shock - causes PL and Y to move in same
direction. Example: 1930s, 1985

SRAS shift - aggregate supply shock - PL and Y in diff. direction, e.g. oil
shock and supply-side economics.
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Lipsey 23. National Income Determination Part I
-- in a Closed Economy with No Government
-- When Prices Are Held Constant
Name___________________
3/8/2016
Second, revisit of Circular Flow of Income
So, injections are
 ___________________
 ___________________
 ___________________
Withdrawals are
 ___________________
 ___________________
 ___________________
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Lipsey 23. National Income Determination Part I
Name___________________
-- in a Closed Economy with No Government
-- When Prices Are Held Constant
3/8/2016
II. Desired Expenditure
2.1 Desired vs. Actual

In National Income Accounting, we learn about actual quantities, e.g.
AE = C + I + G + (X - IM).

But in the next chapters, when we study national income theory, we use desired
quantities, e.g.
AE = C + I + G + (X - IM).
The desired and actual quantities are not necessarily equal. Please understand what is
meant by “desired” or “planned” quantities. Most of the time, when I use concepts in the
next few chapters, I mean “desired” quantities.
2.2 Assumptions of a simple model

No government (G = 0).

No foreign sector (X = 0, M = 0).

Prices are held constant
2.3 Desired Consumption Expenditure (C)
1) By definition, Disposable Income Yd = _______________________, where
Yd = ________________ when no gov’t.
2) Keynesian theory of the relationship between income and consumption:
Keynesian Consumption Function: C is a function of current income, e.g.
C = ___________________________________, where

_______ is the autonomous consumption,

_________________, the marginal propensity to consume (MPC).

Yd is _______________________________. (=Y when no gov’t).
3) Terms (see figure for graphical representation):
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
autonomous consumption;

induced consumption;

Marginal Propensity to Consume (MPC) = __________________________;

Average Propensity to Consume (APC) = ___________________________;

Marginal Propensity to Save (MPS) = ______________________________;

Average Propensity to Save (APS) = _________________________________;
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Lipsey 23. National Income Determination Part I
Name___________________
-- in a Closed Economy with No Government
-- When Prices Are Held Constant

3/8/2016
Relationships: MPC + MPS = ______; APC + APS = ______.
4) Shifts of the consumption function

If Y changes, then C changes, but this is _____________ the consumption
function;

Wealth: Wealth is the net money value of aseets they own (stocks, cash, real
estate). Unexpected increase in wealth shifts the consumption function
___________ and the saving function _____________ because people feel
that they are ________________ and can afford to spend ____________ even
if their _________________ is unchanged.

Interest rate: If interest rises, it is ____________________ to buy a car or
purchase goods with a credit card. So consumption function shifts ________.

Expectations: If people expect a higher level of inflation, for example, then
consumption function shifts _________________.

Price level: If price level increases, then purchasing power of wealth
_________. Hence a __________________ shift of consumption function.

Other factors:
. (see Ruffin p144 for details)
2.4. Desired Investment Expenditure

Investment expenditure is the most volatile component of GDP.

One: Investment and Real Interest Rates: Other things being equal, the higher the
real interest rate => the ___________ the cost of borrowing for investment
purposes => the ____________ the desired investment expenditure.
o
o
Inventories:

One of the most volatile

Interest rate is ___________________ of holding inventories
Residential housing construction

Both large and volatile

________________ interest rates is big determinant of residential housing
construction
o


The largest component of Investment

Heavily influenced by ______________________
Two: Investment and Changes in Sales
o
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Plant and Equipment
______________ of inventories is positively related to the __________ of sales
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Lipsey 23. National Income Determination Part I
Name___________________
-- in a Closed Economy with No Government
-- When Prices Are Held Constant
o
3/8/2016
_________________ in the stock of inventories, i.e. current investment, is
therefore positively related to the ______________ in sales
o
In addition to changes in inventories, ____________ to the stock of plant and
equipment (i.e. investment) is positively related to ____________ in sales


Three: Investment and Business Confidence
o
Investment takes time
o
Firms investment if they expect FUTURE sales and profits to be good
o
Investment is therefore positively related to _____________ growth of GDP
However, for the time being, we assume I to be _________________ of Y
2.5. The Aggregate Expenditure Function
1) In our simple model, AE = __________________________.
2) The Marginal Propensity to spend, z = _______________________ (always defined
as out of national income Y, not Yd)
3) In our simple model (and only in our simple model), z = _________. See graph.
III. Determining Equilibrium National Income

When the economy is in equilibrium, Desired Aggregate Expenditure = National
Income, i.e. AE = Y or AE curve crosses the 45 line.

Numerical example:
National Income
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C=100+0.8Y
S=Y-C
I=250
100
250
400
250
1000
250
1750
250
2000
250
3000
250
AE=C+I
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Lipsey 23. National Income Determination Part I
Name___________________
-- in a Closed Economy with No Government
-- When Prices Are Held Constant

3/8/2016
In our simple model with no government and foreign trade,
Y - AE = S - I.

When economy is in equilibrium, ______________ = Leakages.

In our simple model, this implies ________________________.

Refer to figure 23-5.

Remember that for all above, PL is fixed.
IV. Changes in National Income
1. Shifts of AE
1) The AE shifts when any _____________________ shifts. In our simple model, any
shift in _____ and/or _____________ will cause the AE to shift.
2) Two types of shifts: Parallel, i.e. ________ remains constant; or non-parallel, i.e.
_________ changes. (see figure 23-7)
3) Comparison of the change in national income due to shifts in C and I: See Figure
23-8.
Both shifts in C and I cause Y to increase, but the compositions of the new Y are
______________________. There is a larger ________________ and hence
greater ____________________________ in the economy with shift in I.
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Lipsey 23. National Income Determination Part I
Name___________________
-- in a Closed Economy with No Government
-- When Prices Are Held Constant
3/8/2016
2. The Magnitude of Changes in National Income -- Multiplier
1) Definition of Multiplier (k):
The ratio of the change in national income divided by the change in autonomous
expenditure that brought it about.
You are measuring the effect of ____________________________________ on
________________________________________________________________.
2) The Simple Multiplier: when prices are held constant.
3) The size of the simple multiplier depends on the _________________________,
i.e. the marginal propensity to ______________________. The higher _________
is, the larger k is.
k = ______________________________________________.
Figure 23-9.
4) The Multiplier k > 1 (except ________________________). Why?
Example: Automatic expenditure increase by $1billion. Suppose z = 0.8. (Table 23-1)
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