Ch. 3 : National Income
Determination (II)
(Simple Keynesian Model)
C
C=Ca + cYd
Y
I
I=Ia
Y
G
G=Ga
Y
X
X=Xa
Y
T
T=Ta
Y
M
M=Ma + mY
Y
AE
AE=C+I+G+(X-M)
Y
Y*
$
S+T+M
I+G+X
Y
Y*
Fiscal Policy
•
•
•
•
•
Discretionary Fiscal Policy
expansionary fiscal policy
(1) increased government spending,
(2) lower taxes, or
(3) a combination of the two.
•
•
•
•
contrationary fiscal policy
(1) decreased government spending,
(2) higher taxes, or
(3) a combination of the two.
• Problems of Fiscal Policy
1. Recognition Lag
2. Executive Lag
3. Response Lag
Changing Government
Expenditure or Taxes?
•
•
•
•
1. Location of Effects
2. Time Lag
3. The Reversibility of the Policy
4. The Public’s Reaction to Short-term
Changes
Built-in stabilisers
• Built-in stabilisers are those institutional
arrangements that automatically increase
government deficit (or decrease surplus)
during slumps/recessions, and increase
surplus (or decrease deficit) during booms,
without the government having to make any
policy decision.
Examples of built-in stabilizers
•
•
•
•
Progressive Tax System
Welfare Scheme
Government Purchases
Corporate and Family Savings
Some built-in stabilizers that may
create disincentives:
• progressive taxation
• unemployment and welfare benefits
Some built-in stabilizers that do
not create disincentives:
• corporate savings
• family savings
Limitations of built-in stabilizers:
• Built-in stabilisers can reduce fluctuations
but cannot maintain full stability.
• built-in stabilisers may reduce the speed of
recovery
Balanced-Budget Multiplier
• C=Ca+cYd
• G=Ga
• I=Ia
• T=Ta
• The government expenditure multiplier:
Kg=1/(1-c)
• The tax multiplier :
Kt=-c/(1-c)
• The balanced-budget multiplier:
Kb=1/(1-c) + -c/(1-c)
=1
• Ga by $1 will increase income by:
1+MPC+MPC2+MPC3 ......---(1)
• Ta by $1 will decrease income by:
MPC+MPC2+MPC3 ......---(2)
Ga - Ta = 1
Recessionary (Deflationary) Gap and Fiscal Policy
AE
AE’
AE
Y
Ye
Yf
Inflationary Gap and Fiscal Policy
AE
AE
AE’
Y
Yf
Ye
Paradox of Thrift
• Thriftiness, while a virtue for the individual,
is disastrous for an economy.
• If consumers seek to save a larger amount
out of any given level of income, that
attempt to save more may lead to a fall in
income leaving the amount of savings
unchanged or even decreased.
Case 1:
Investment expenditure is autonomous
Given:
S = -Ca+(1-c)Y
I =Ia
The Paradox of Thrift
I,S
S2
S1
I=Ia
Y
Y2
Y1
Example
• S1=-20+(1-0.75)Y
• I=20
• At equilibrium,
•
•
•
•
I=S
20=-20+(1-0.75)Y
40=0.25Y
Y=160
the realized saving is:
S1=-20+(1-0.75)Y
=-20+0.25(160)
=-20+40
=20
Suppose the saving function shifts upward,
S2=-10+(1-0.75)Y
I=20
At equilibrium,
I=S
20=-10+(1-0.75)Y
30=0.25Y
Y=120
Now the realized saving is:
S2=-10+(1-0.75)Y
=-10+0.25(120)
=-10+30
=20
Case 2:
Investment expenditure is an increasing
function of national income
• Given:
•
•
S = -Ca+(1-c)Y
I = Ia+eY
The Paradox of Thrift
I,S
S2
S1
I=Ia+eY
Y
Y2
Y1
How the paradox can be resolved?
• If planned investment increases as a result
of the increase in planned saving, then there
may not be a decrease in national output.
The Paradox of Thrift
I,S
S1
I=Ia
Y
Y1
The Paradox of Thrift
I,S
S2
S1
I=Ia
Y
Y2
Y1
The Paradox of Thrift
I,S
S2
I=Ia’
S1
I=Ia
Y
Y2
Y1
The Paradox of Thrift
I,S
S1
I=Ia
Y
Y1
The Paradox of Thrift
I,S
S2
S1
I=Ia+eY
Y
Y2
Y1
The Paradox of Thrift
I,S
S2
S1
I=Ia’+eY
I=Ia+eY
Y
Y2
Y1
Revision Exercise
• What is the 'paradox of thrift'? Explain, with the
aid of diagrams, how this paradox can be resolved.
• Compare the magnitudes of the income multipliers
of the simple Keynesian model under the
following tax systems: lump sum income tax,
proportional income tax and progressive tax.
•
• What are “automatic stabilizers”? Give two
examples to illustrate your answer.
• Compare the effectiveness of the
proportional income tax and the progressive
income tax in reducing economic instability.
'Consumption depends on the level of
income.'
'The level of income depends on
consumption.'
With the aid of diagrams, reconcile these
two statements with reference to the
Keynesian model.
Answer:
•
In the consumption curve, consumption is a
function of the level of income. As income
increases, consumption will also increase. In the
Keynesian model, the consumption is assumed to
be: C = a + c Y where a is the intercept and c is
the marginal propensity to consume.
•
If the consumption curve shifts upward, the
level of income will be increased because of the
increase of aggregate demand in the economy.
Therefore the level of income depends on
consumption.
•
There is no circular reasoning: it is a case of
mutual determination of income and consumption.
Mutual dependence is not an inconsistency.
• Consider the following information about
Country A:
C = 0.8Yd
I = 260
G = 400
T = 0.5Y
X = 300
M = 0.2Y
Find:
i. the equilibrium level of national income
ii. the income multiplier
iii. the tax multiplier
Answer
• a. Find the equilibrium income.
•
In equilibrium, Y = AE
•
Y=C+I+G
•
= 400 + 0.8(Y-T) + 50 + 32
•
= 482 + 0.8(Y - 40 - 0.375Y)
•
= 450 + 0.5Y
•
0.5Y = 450
•
Y = 900
• In equilibrium, Y = 900
b.b. Find the income multiplier.
Income multiplier = 1/(1-c-ct)
= 1/[10.8+(0.8)(0.375)]
=2
The income multiplier is equal to 2.
c.
Given that the existing income level is
900, and that the income multiplier is 2,
the government has to increase its
expenditure by 50 for full employment to
be attained.
Consider the following information:
Labour force (L) = 600
Production function = 3L
Find:
i. the full-employment income level
ii. the no. of labour that is unemployed
Suppose the government is planning to
increase her expenditure in order to
stimulate the economy. How much
expenditure should the government increase
to achieve full-employment?
In a closed economy, private consumption
(C), investment (I), government expenditure
(G), transfer payments (TR) and tax revenue
(T) are as follows:
C = 50 + 0.8Yd
I = 50
G = 100
TR = 50
T = 0.25Y
a.
(i) What is the equilibrium value of Y?
(ii)
What is the value of the multiplier for
government expenditure?
(iii) What is the balance of the government
budget?
b. Assume that government expenditure is
now increased by 20, from 100 to 120.
If the government wants to pursue a
balanced budget, what should be the
amount of transfer payments?
AL Questions
AL 2000/5
AD, X, M
(C+I+G+X-M)’
C+I+G+X-M
D
M
B
A
trade deficit
X
C
450
Y
Y*
Y**