INCOME & EXPENDITURE ANALYSIS

The Keynesian Income-Expenditure Model

what factors cause NNP/GNP/GDP to beat a certain level?
we need to distinguish between actual output and potential output
potential output is the output the economy would produce if all factors of production that could
be employed were fully employed
potential output is not the maximum level of output that could conceivably be produced
even at the potential output level there will be unemployed persons in the economy (the
natural rate of unemployment) - the voluntary unemployed (unable to work or do not wish to
work) and those changing jobs

at the potential output level there are no involuntary unemployed persons – this
level of economic activity is also referred to as the full-employment level of output
whenever actual output is below potential output there will be spare capacity in the economy –
machines will be idle and there will be involuntary unemployed workers
why should output be away from the full employment level?
John Maynard Keynes developed a framework to explain the high levels of unemployment
experienced in the 1920s and 1930s in Great Britain
the naive (simple) Keynesian income expenditure model makes two key
Assumptions:
1. Prices, wages and the interest rate are all fixed
2. Output is demand determined – spare capacity will be used by firms to supply as much output
as customers wish to buy
the level of output depends upon only the total level of demand (aggregate demand)
in the economy as a whole
to start off we will look at an economy in which there are just two sectors – households and
firms
AD = C + I

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Consumption Expenditure by Households
consumption is related to the level of household income – as income increases
then so does household consumption
Consumption (C)

Income (Y)

this relationship between household income and consumption is known as the consumption
function
C = c0 + c1Y
c1Y is affected by the level of income- c1 is known as the marginal propensity to consume
(MPC)
the MPC is the fraction of extra income that households wish to consume
since the MPC is defined as a fraction, its value will run from 0 to 1
- if the MPC = 0, no part of extra income will be consumed
- if the MPC = 1, all extra income will be used for consumption purposes
for example, if the MPC is 0.8 and household income increases by $100,
household consumption will increase by $80 i.e. (100 x 0.8)
Investment Expenditure by Firms
investment expenditure is the planned additions to physical capital and inventories by firms
the chief determinant of investment expenditure will be firms’ expectations of how the demand
for their output will change
there is no close connection between the current level of output and expectations about
changes in the level of demand

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Investment (I)

Income/Output
the level of investment expenditure is determined by business firms expectations about
future demand for goods and services
I = i0
Aggregate Demand

Aggregate Demand
C + I (=AD)

C
I

Income/Output

Example
C = 20 + 0.8Y
I = 10
If Y = 100,
C = 20 + 0.8 (100)
C = 100
I = 10
AD = 100 +10 =110

Equilibrium
planned aggregate spending equals the output that is actually produced
output produced = output demanded

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 Y =AD
Aggregate
Demand Y>AD
Excess Demand

Y> AD
Excess Supply

o
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Income/Output

Aggregate Y = AD
Demand
AD = C + I
AD
E

o
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YE Income/Output
at points to the right of E, output exceeds desired expenditure
at points to the left of E, desired expenditure exceeds output
two concluding points:
1. note the distinction between planned and unplanned investment
2. there is no reason why equilibrium output should be at the full employment output level
a numerical example:
Equilibrium occurs where Y = AD
Since AD = C + I
Y=C+I
if C = 20 + 0.8Y, and
I = 20
Y = 20 + 0.8Y + 20
Y – 0.8Y = 40
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0.2Y = 40
Y = 200

Changes in Autonomous Expenditure

any change in autonomous expenditure will cause a shift in the position of the AD schedule

Aggregate
Demand
AD’

AD

C 0 + i0

Income/Output

thus, if C = 20 + 0.8Y and I = 20,

an increase in planned investment expenditure up to I = 30
will mean that the AD schedule will shift upwards by 10 units
what will happen to the equilibrium level of output?
AD
AD 1

AD

Change in I =10

45 o

Y1 Y2 Y

equilibrium output will obviously increase, but will it also increase by 10?
we have already seen that when I = 20, YE = 200 ...

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but when I = 30, equilibrium output occurs
where

Y = AD
AD = C + I
Y=C+I
Y = 20 + 0.8Y + 30
Y = 250
the ratio of a given change in autonomous expenditure to the overall change in equilibrium
output is known as the multiplier
M = change in Y = 50
change in E 10

and so the multiplier equals 5

an alternative formula for the multiplier is:
M = 1
1- MPC 

−


M  and so the multiplier equals 5

for any given value of the MPC, the multiplier is constant.
why does an increase in autonomous expenditure cause an even greater increase
in output?
↑Investment ⇒ ↑Output (Income)
↑Output (Income) ⇒↑Consumption
↑Consumption ⇒ ↑Output (Income)
as long as the MPC is greater than 0, the multiplier will be greater than 1 and an increase in
autonomous expenditure will cause an even greater increase in output (income)

The Government Sector

the government has two roles to play within the economy
- it is a purchaser of goods and services (G)
- it is a taxer of household income (T)
there is no reason why the government’s spending and tax revenue should be the same
when spending is equal to revenue (G=T) the government is said to be running a balanced
budget
when spending exceeds revenue (G>T) the government is said to be running a budget deficit
when revenue exceeds spending (T>G) the government is said to be running a budget surplus

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Spending on Goods and Services

Government
Spending (G)

Income/Output
the government is committed to spending money on schools, hospitals, the wages of civil
servants etc, and these types of expenditures are unaffected by short-term fluctuations in the
level of national income
government spending is wholly autonomous i.e. it is unrelated to the level of income G = g0
the total level of demand within the
economy (aggregate demand) is now equal
to:
AD = C + I + G
to satisfy its spending requirements, the government needs to raise money by
taxing household income
Government Taxation
a proportional tax is taken as a fixed fraction of household income
T = t1Y 0<t1<1
t1 is known as the marginal propensity to tax
taxes will have an impact upon household consumption patterns
household consumption expenditure is not related to pre-tax income, but to post-
tax income
Yd = (1 - t1)Y
C = c0 + c1Yd
C = c0 + c1(1 – t1)Y
so consider the following example
C = 20 + 0.8Yd
I = 20
G = 30

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t1 = 0.25
equilibrium output occurs where Y = AD
since AD = C + I + G
Y=C+I+G
Y = 20 + 0.8Yd + 20 + 30
Y = 20 + 0.8(1 – 0.25)Y + 20 + 30
Y = 70 + 0.6Y
0.4Y = 70
Y = 175
note that the MPC is no longer equal to c1
Taxes Consumption Savings
MPT=t1 MPC=1/c1(1-t1) MPS=1/(1-c1)(1-t1)
Household Factor Income

MPC + MPS + MPT = 1

The Keynesian Functions On Consumption, Savings & Investment

The Consumption Function

In its simplest form, this function suggested that the amount of consumption expenditure of the
household sector depends mainly on the amount of ( disposable ) income generated from the
production activities of an economy.

In general, C = f ( income, wealth, taste, expectation on prices, interest rates. )

In its simplified form, C = f ( income )

In a simple mathematical form,

C = a + b. Y

Where : a : autonomous spending or expenditure

b : marginal propensity to consume ( MPC ) which lies between zero and one.

b.Y : induced spending or expenditure

Factors Leading To Changes In Consumption

 the value of liquid assets, e.g. bonds, stocks and gold ;

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  the amount of durable stocks ;
 the expectation on prices ;
 the degree of consumer indebtedness ;
 the attitude of people towards thrift ;
 the government policies like the taxation system ;
 the distribution of income – the APC of the relatively low-income group is greater than the
APC of the high-income group.

Savings Function
 Saving refers to the change of wealth over time. It is a flow. Wealth refers to the amount of
savings or stocks accumulated from the past savings.
 Savings is the amount of money not immediately consumed for any purposes. Saving may
also refer to the act of sacrificing present consumption for the future.

Investment Function
 Investment function is a spending on accumulating capital (goods).
 It is a derived demand affected by the cost of borrowing or holding money. It is an
exogenous (pre-determined) variable in this simplified model, i.e. the money market is
assumed to be in equilibrium.
 Investment also leads to capital formation. The investment function can lead to the optimal
or most desirable level of capital stock which in turn determines the level of output.

The Concept of Multiplier

Production generates income. Income gives rise to consumption expenditure which becomes the income earned

by other firms. The income earned will induce a flow of expenditure again, according to the consumption

function.

An initial change in expenditure will induce income of a sector. The circular flow of income and products
starts its circulation with the second round, third round.

This leads to a multiplier effect on the national income within a period. The economy is stimulated by
the initial round of spending.

The Paradox of Thrift

People traditionally think that the more a person saves his income or wealth, the more the amount
of income gained in the future. Savings can increase future income as well as output.
The more we save, the more income we shall have.

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 Based on the Keynesian functions, savings depends on income. We have to cut our consumption
expenditure in order to save more. By the multiplier effect, the fall in consumption will lead to a
fall in income or GNP. And with this smaller amount of income, we can then save less than before.
The more we save, the less income we shall have as a result.

It is paradoxial to find that : If people try to increase their savings, they will end up saving less.

It then follows that: When times are tough (economically unfavourable), we should not tighten our
belts.

It is called a paradox (of thrift) because the act of a single person to save more for the future is not
directly applicable to the whole economy.

Thrift for an individual is fine but not for the economy. Why?

Why is there a paradox ?

 Fallacy of Composition ( What is good for one is also good for all. )
What is good for one may not be good for all. A good example is the taking of medicine. What is good?
for you to take a certain medicine may not be good for others.

 Saving is good for a person but is not desirable for the whole economy.
 Economic Situation
The traditional view carries the concept of self-adjustment of the economy with savings and investment moved in the same
direction to maintain an equilibrium output.

Whereas the Keynesian view argued that there is no apparent linkage between savings and
investment. That is, when savings rises and consumption expenditure falls, the multiplier

effect leads to a fall in income also. The amount of investment is not affected by income. As a result,
the paradox may exist.

The Balanced-Budget Multiplier

It refers to the multiplier effect of a change in government expenditure, together with an equal change
in taxes so as to maintain a balanced budget at the same time.

That is, an increase in government spending, accompanied by an equal increase in taxes, increases the
level of income by exactly the amount of the increase in government spending. The major point is that a
balanced budget change (say, a cut) in government spending changes (lowers) the equilibrium income.
The change in government spending has a stronger impact on equilibrium income than the same
amount of change in taxes. A dollar cut in taxes leads only to a fraction of a dollar’s increase in

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consumption spending, the rest being saved, while the government spending is reflected dollar for
dollar in a change in aggregate demand.

The balanced budget multiplier is exactly 1.

Government with a Proportional Tax

A proportional tax is a tax based on a fixed percentage of the income earned. With a fixed percentage, the
higher the income earned, the greater the absolute amount of tax will be. The effect of a proportional tax
on income is calculated by the value of the proportional tax multiplier.

Government activity acts as an exogenous variable in the model. At the same time, government
expenditure is financed by taxation. The amount and form of tax bears an offsetting effect (compared
with the effect of G) on the level of equilibrium income. Any variable carrying such an offsetting effect
on income is termed a built-in stabilizer of the economic model.

The Automatic or Built-in Stabilizers

They are also called automatic tools of fiscal policy.

They refer to all those institutional arrangements that automatically increase the government deficit (or
decrease the government surplus) during recessions; and increase the government surplus during
booms; without any decisions on government policy.

They are called stabilizers because they reduce the response of national income to any economic shocks
in the economy.

They are anything that reduces the marginal propensity to consume out of national income and hence,
reduce the multiplier. They lessen the magnitude of fluctuation in national income caused by
autonomous changes in such expenditures like investment expenditure.

Examples of these stabilizers include: progressive (income) tax system; social security allowances;

unemployment insurance; agriculture support programmes; income-support programmes.

They are built-in because once they are used; they will automatically exist in an economy to affect the
fluctuation in national income of that economy.

4 The 4 Sector Model With International Trade

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 The above analysis is confined to a closed economy. For an open economy, the effect of export
and import had to be considered. The value of export depends mainly on foreign demand
condition. So, export is an exogenous variable. Import depends on the local demand and income
earned.

5 The Potential & Actual GNP

Potential GNP is the level of income under full-employment. Any economy has its potential to
fully employ its resources to reach this level of output and income.

If demand is insufficient, the economy may reach an equilibrium state with its actual income
smaller than the potential income. In a graph, there exists a so-called deflationary gap.
If demand is in excess of supply even at the potential output, the opposite exists and it is called
an inflationary gap.

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