Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information:

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1 Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: College of Education School of Continuing and Distance Education 2014/ /2017

2 Session Overview This session builds on the national output concept by focusing on how to determine national income and aggregate expenditure in a closed private economy. We shall assume a simple closed economy (private sector) to make the analysis simple. Here concepts such as consumption, investment expenditures and savings in the economy are introduced. Additionally, the session will discuss the determination of equilibrium output without government using both aggregate expenditure and leakages- injections approaches. Finally, the multiplier effect will then be derived. Priscila T. Baffour Slide 2

3 Session Outline Determination of National Income and Aggregate Expenditure in a simple closed economy (private sector) Components of Aggregate Expenditure. Assumptions of the model. Consumption expenditure Investment expenditure. Determination of equilibrium output. - aggregate expenditure method - injections leakages method. Multiplier effect. Priscilla T. Baffour, PhD. Department of Economics

4 Learning Outcome After completing this session, you should be able to; Explain and illustrate graphically the components of Aggregate Demand for a simple closed economy without government. Distinguish between average and marginal propensities to consume and save. Understand the relationship between consumption and savings and the link between marginal propensities to consume and save Determine the equilibrium level of output for a simple closed economy Understand the link between the components of Aggregate Demand and Aggregate Demand. Appreciate the impact of the multiplier on the equilibrium income or output. Priscilla T. Baffour, PhD. Department of Economics

5 Reading List Read Chapter 15 of John Sloman; Economics, 8th Edition (2011), Pearson Session Slides Watch video on session 3.. Any Other Economics text books available to students Priscila T. Baffour Slide 5

6 Determination of National Income and Aggregate Expenditure The model is built on a simplified assumption that output is demand determined. Thus planned spending or aggregate demand of households and firms determine the output level in the economy. The following assumptions are made in order to focus on the relationship between aggregate demand and output in a simple closed economy (no international trade) These assumptions are only temporary. 1. Price level is assumed constant. 2. The economy is made up of only the goods sector. Thus money and the financial market is being left out of the analysis in the interim. Priscila T. Baffour Slide 6

7 Determination of National Income and Aggregate Expenditure 3. We assume No government This implies there are no taxes and no government spending Implies no influence of government on interest rates 4. As we begin our analysis we will also assume the economy is closed. i.e. no foreign sector. Of course in reality no economy exist in isolation and so we will relax this assumption later to include the foreign sector. Priscila T. Baffour Slide 7

8 Components of Aggregate Expenditures Recall from the circular flow concept from Session (1).pptx that: National Income is equal to the sum of factor payments which is equal to the sum of expenditures on final goods and services. Aggregate expenditure in this case is the total desired spending in the economy Desired spending (AE) is defined as what economic agents want to spend out of the resources at their command. Y = E E = C +I Hence Y = C + I. We would now concentrate on what determines each of these components Priscila T. Baffour Slide 8

9 The Components of Aggregate Expenditure Household Spending (Consumption) the largest component of AE by value typically over half of aggregate expenditures or demand Is made up of two components Autonomous consumption (doesn t depend on Income) Income induced consumption (depends on disposable Income) Consumption in practice grows at roughly the same rate as disposable income in the long run smoother than disposable income in the short run Priscila T. Baffour Slide 9

10 The Components of Aggregate Expenditure What factors influence consumption? disposable income what of responses to short-run or temporary changes in income? and long-run or permanent changes in incomes? expected future income the financial system enabling smoothing of consumption debt servicing costs Priscila T. Baffour Slide 10

11 The Components of Aggregate Expenditure What factors influence consumption? (continued) household balance sheets financial assets physical assets financial liabilities Priscila T. Baffour Slide 11

12 Consumption Function It describes the relationship between household consumption and the variables that influence it. In its simplest form it is determined by current household disposable income (Y) When disposable income is zero, an individual will still consume probably through borrowing or drawing down on savings This is called Autonomous Consumption (C 0 ) The higher the household s income the more the household will want to consume. Thus consumption varies with disposable income This part of consumption is called Income Induced Consumption (c1y D ) c1 is the marginal propensity to consume (MPC) Priscila T. Baffour Slide 12

13 The Consumption Function Consumption (C) More specific form : Linear Function of disposable Y Priscila T. Baffour Slide 13

14 Properties of the Consumption Function Marginal Propensity to Consume (MPC) It relates the change in consumption to the change in disposable income Also defined as the proportion of every additional cedi earned that is consumed MPC = C Y D = c 1 By construction the MPC is constant at all levels of disposable income Given the consumption function, the MPC measures the slope of the consumption function The value of MPC is given as; 0 < MPC 1 Priscila T. Baffour Slide 14

15 Properties of the Consumption Function Cont. Average Propensity to Consume (APC) It is the total consumption spending divided by disposable income APC = C Y D APC falls as disposable income rises The value of APC is given as 0 < APC There is a breakeven level of consumption at which the APC=1 If APC >1, consumption exceeds income so consumers run down on savings or borrow If APC <1, income exceeds consumption, so there is positive savings Priscila T. Baffour Slide 15

16 Consumption and Disposable Income Priscila T. Baffour Slide 16

17 Savings Function Disposable income is either consumed or saved (Y D = C+S) Like consumption savings also depends on disposable Income Marginal Propensity to Save (MPS) The proportion of additional disposable income earned that households want to save. Derived as MPS = S YD = s Average Propensity to Save (APS) The average amount saved out of disposable income earned. Derived as; APS = S Y D Priscila T. Baffour Slide 17

18 Savings Function MPC + MPS = 1 APC + APS = 1 If Y D = C + S S = Y D - C If C = C 0 + C 1 Y D S = Y D (C 0 + C 1 Y D ) S = - C 0 + (1 - C 1 ) Y D S = - C 0 + sy D Where -c o is the autonomous savings sy D is the income-induced savings. s or (1 c 1 ) is the marginal propensity to save. Priscila T. Baffour Slide 18

19 Savings Function S S= - C 0 + sy D O Priscila T. Baffour Slide 19 Y D

20 The Components of Aggregate Expenditures What factors influence investment? increased consumer demand expectations cost and efficiency of capital equipment rate of interest availability of finance We would assume for now that Investment spending is autonomous(independent) of income. Priscila T. Baffour Slide 20

21 Investment Spending Investment is the second major component of aggregate demand. It consists of firm s desired or planned additoins to inventories (stocks) and addition to physical capital like machinery, plants, equipment and factories. The basic determinants to investment expenditure are: - Autonomous investment ( which is not influenced by disposable income but by factors like technological progress and population growth). I = I O - Income- induced investment. I = gy D Priscila T. Baffour Slide 21

22 Investment Spending cont. Where g is the marginal propensity to invest. In this model, we are only going to consider autonomous investment. Since investment only consists of autonomous component, the diagram for investment spending will be parallel to the horizontal axis. This means that the firm will invest irrespective of their income level. The factors that determine autonomous investment are: - rate of interest (negative relationship) -stability in the political and social environment (positive relationship). - macroeconomic stability (positive relationship). Priscila T. Baffour Slide 22

23 Investment Spending I I 0 O Priscila T. Baffour Slide 23 Y

24 Determining Equilibrium Real GNP (Output) There are two approaches in determining equilibrium output and these are: The aggregate expenditure approach (by John Maynard Keynes). Injections- Leakages approach( savings and investment in equilibrium). Priscila T. Baffour Slide 24

25 Determining Equilibrium Real GNP (Output) AGGREGATE EXPENDITURE APPROACH. This approach considers consumption and investment in equilibrium. Since both consumption and investment determine aggregate demand they are crucial in the determination of equilibrium output. AE = C + I. It is also known as the income-expenditure approach. Priscila T. Baffour Slide 25

26 Determining Equilibrium Real GNP (Output) INJECTIONS- LEAKAGES APPROACH. In the circular flow model we realize that some of the income earned by households are saved. income (Y) = consumption(c) + savings(s). In a closed private economy, saving represent an outflow and this is known as a leakage or a withdrawal. Aggregate output produced by firms is taken up in the form of consumption and investment. AD = C + I Investment is used in an economy in order to improve and increase economic activities hence it is known as an injection. The injections - leakages approach is also known as the augmented investment-saving approach. Priscila T. Baffour Slide 26

27 Determining Equilibrium Real GNP (Output) In equilibrium, the aggregate demand is equal to the income level (AD = Y) hence; Y = C + S AD = C + I C + S = C + I C - C + S = I S = I. Priscila T. Baffour Slide 27

28 Determination of Equilibrium Real GNP: The Aggregate Expenditure Approach Algebraically: AD = C + I I = I O C = c 0 + c 1 Y D Y D = Y T. BUT, without government spending T = 0 hence Y D = Y AD = c 0 + c 1 Y D + I O In equilibrium, AD = Y Hence, Y = c 0 + c 1 Y + I O Y c 1 Y = c 0 + I O. Y(1- c 1 ) = c 0 + I O. Y = (1/(1- c 1 )) (c 0 + I O ). (1/(1- c 1 )) is the simple Keynesian multiplier. (c 0 + I O ) is the autonomous spending. Priscila T. Baffour Slide 28

29 Determination of Equilibrium Real GNP: Injections - Leakages Approach Algebraically, Y = C + S AD = C + I Given in equilibrium Y = AD, C + S = C + I C - C + S = I S = I S = - C 0 + sy D I = I O S = - C 0 + (1- c 1 )Y I O = - C 0 + (1- c 1 )Y Y = (1/(1- c 1 )) (I O + C 0 ). (1/(1- c 1 )) is the simple Keynesian multiplier. (c 0 + I O ) is the autonomous spending. Priscila T. Baffour Slide 29

30 The Multiplier Effect A multiplier is the ratio of a change in income to an initial change in autonomous spending that causes a change in real output. The value of the multiplier is greater than one (1). The simple multiplier, which is also the autonomous spending multiplier is given as: Autonomous spending multiplier = δy = δy = δy =1/(1- c δg O δc o δi o ). O That is, a change in income as a result of a change in government spending or autonomous consumption or investment. Priscila T. Baffour Slide 30

31 Changes in Equilibrium Output The factors that change equilibrium output are: The multiplier and multiplier effect. Changes in autonomous expenditure Changes in autonomous consumption Changes in the investment (autonomous) In a closed private economy, the multiplier is the reciprocal of marginal propensity to save(mps). Priscila T. Baffour Slide 31

32 Changes in Equilibrium Output An increase in autonomous consumption and/or autonomous investment will increase aggregate expenditure and aggregate demand. This will increase equilibrium output (GNP) and vice versa. An increase in the multiplier value will increase the equilibrium output holding autonomous spending constant. An increase in the MPS reduces the value of the multiplier and an increase in the MPC will cause an increase in the multiplier. Priscila T. Baffour Slide 32

33 Review Question Given the following model: C = c 0 +c 1 Y = Y I = I 0 = Determine the equilibrium levels of income, consumption and savings. 2. Suppose investment increases by 10 billion, find the resulting change in income, consumption and savings. 3. Would output be higher or lower if the consumption function was C=0.7Y?

2. THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME

Ph: 98851 25025/26 www.mastermindsindia.com 2. THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME Q.No.1. Define Keynes concepts of equilibrium aggregate Income and output in an economy. (A) The