Chapter 4 Determination Of Income In Two - Sector Model

Determination of Income and Employment In a simple economy(two sector) there are only two
sectors namely households and firms. There is no
Ex ante and Ex post government or external sector. So aggregate demand is the
The planned or expected value of variable is called sum of consumption demand and investment demand.
Ex-ante measures.
Eg. Ex-ante consumption,ex-ante investment,ex-ante AD =C+ I
saving. C=C+ cY
The actual or realised value of a variable is called I =I
Ex-post measures.
Eg.ex-post consumption,ex-post investment,ex-post saving.
AD =C+ cY + I
In a simple economy equilibrium is determined by
Marginal propensity to consume (MPC): Effective Demand. It is a situation in which Ex-ante
The ratio of change in consumption to change in aggregate demand is equal to ex-ante aggregate supply.
income is called MPC. It is the change in consumption per That means final goods market is in equilibrium.
unit change in income. It is denoted by “c”
Mathematically, AS=AD
Y=C+I+cY
∆C Y-cY=C+I
c=
∆Y Y(1-c)=C+I
where,
∆C-change in consumption. Equilibrium income=
∆Y-change in income.
Marginal propensity to save (MPS):
The ratio of change in saving to change in income A=C+I
is called MPS. It is the change in savings per unit change in
income. It is denoted by ‘s’

∆S
S=
∆Y
Where,
∆S= change in saving.
∆Y=change in income.
Average propensity to consume (APC):
Consumption per unit of income is called APC.

C In the diagram ex-ante income is marked on x axis.

APC= ex-ante aggregate demand and ex-ante aggregate supply
Y are marked on y axis.450 line AS is the aggregate supply
Average propensity to save (APS): line. AD is the aggregate demand line. AS and AD are equal
at point E. It is the point of effective demand. At this point
Savings per unit of income is called APS. equilibrium aggregate demand is AD* and Y* is the
equilibrium income.
S Effect of autonomous change on equilibrium demand in the
APS=
Y product market.
Consumption function: The changes in autonomous component (A=C+I)
A consumption function describes the relation can bring changes in equilibrium demand and equilibrium
between consumption and income. We can describe this income. Suppose that before change in autonomous
function as component aggregate demand is AD1=A1+cY. In the
diagram AD1 curve cuts AS at point E1.Equilibrium
demand is AD1 and equilibrium income is Y1.Now there is
C=consumption, an increase in autonomous investment by ∆I. As a result
C=Autonomous consumption (level of consumption when aggregate demand curve shifted to AD2 =A2+cY. New
income is zero). equilibrium demand is AD2 and equilibrium income is
c=Marginal Propensity to consume. Y2.That is as a result of an increase in autonomous
Y=Income. investment by ∆I equilibrium income increases from AD 1
Investment function: to AD2.
Investment is defined as addition to the stock of
physical capital and changes in the inventory. For
simplicity, we assume here that firms plan to invest the
same amount every year. We can write the ex ante
investment demand as

I =I(autonomous investment)

Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.

Multiplier Mechanism.
An initial increase in investment which leads to Chapter 5
multiple increase in income is known as multiplier Government Budget and the Economy
mechanism. This can be explained with the help of the
following table. Government budget-meaning and its components
The annual financial statement of income and
expenditure of the government for a financial year is called
Round Consumption Aggregate Output/
government budget.(Financial Year-1 april to march 31).
Demand Income The budget is classified into revenue budget and capital
Round 1 0 10(Autonomous 10 budget.
Increment) 1-Revenue budget: It consists of revenue receipts and
Round 2 (0.8)10 (0.8)10 (0.8)10 revenue expenditure.
Round 3 (0.8)210 (0.8)210 (0.8)210 2-Capital budget: It consists of capital receipts and capital
Round 4 (0.8)310 (0.8)310 (0.8)310 expenditure.
. . . . Objectives of Government Budget
. . . 1-Allocation Function: The distribution of public
. goods effectively among the people of a nation is called
. . . . allocation function. Goods like defence,police,public park,
. . . . public roads etc are known as public goods.
etc 2-Redistribution Function: It refers to the activities
of the government to reduce inequality in income and
In the table an increase in autonomous expenditure wealth. For this the government tax the rich and transfer
(I)leads to an increase in aggregate demand by Rs 10.This money to the poor.
leads to an increase in planned output by Rs.10.The 3-Stabilisation Function: It refers to the the
producers will distribute the excess income among the intervention of the government whether to expand demand
factors of production. In this first round of multiplier or reduce it to stabilise the economy.
process income of factors of production increases by Rs.10. Public goods private goods
The MPC of the people is 0.8.That means the people use Goods and services provided by the government to
0.8 times of Rs.10 (0.8*10) for consumption in the second the people are called public goods. Eg. National defence,
round. In the third round consumption demand increases roads, goverment administration etc. Public goods cannot
by 0.82 *10. The process continues for several rounds. The be provided by the market mechanism.
increase in outputs are gradually decreasing in successive Goods and services supplied by the private sector is
rounds. After a large number of rounds,it becomes closer to called private goods. Eg. Clothes,food items,cars etc.
zero. This process can be written in a form of an infinite
geometric progression. Public goods Private goods
Provided by government Provided by Private parties
Common use eg: road, Individual use eg: car, cloth,
railway, bridges . food items.
An increase in autonomous investment by Rs10
Non-rival in consumption rival in consumption
leads to an increase in income Rs 50 .That means income
has doubled 5 times. Non-Exclusion principle Exclusion principle
The investment multiplier applicable. applicable.
It is the ratio of change in output to the change in
autonomous expenditure. Mathematically, Classification of Government Budget

Paradox of Thrift
If all the people of the economy increase the
proportion of income they save (i.e. if the mps of the
economy increases) the total value of savings in the
economy will not increase – it will either decline or remain
unchanged. This result is known as the Paradox of Thrift.
Full employment level
The level of income where all factors of production
are fully employed in the production process.
Deficient demand
It is a situation in which aggregate demand is less
than aggregate supply(AD<AS).
Excess Demand
It is a situation in which aggregate demand is more than
aggregate supply(AD>AS).

Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.

Components of Government Budget:
1.Revenue account: It consist of revenue receipt and
revenue expenditure
Revenue receipt: revenue receipts are recurring in
nature which do not create liability or reduce asset (eg:
Tax like income tax, wealth tax, sales tax, service tax
and non -tax like fees, fine, penalty etc.)
Revenue expenditure: It is expenditure of govt.
which are recurring in nature which do not
create liability or reduce asset. (eg: salary of govt.
employees, pension, interest on loan etc.)
2.Capital account: It consist of capital expenditure and
capital receipt.
Capital receipt: These are receipt of government
which create liability or reduce asset. (eg: borrowings
(create liability), disinvestment (nondebt) etc.)
Capital expenditure: These are expenditure of
govt. which reduce liability or create asset (eg:
repayment of borrowing,expenditure on infrastructure
etc)
Budget and Deficit
Based on the relation between expenditure and revenue,
budget are classified into three-
i) Surplus Budget = Revenue > Expenditure
ii) Balanced Budget = Expenditure = Revenue
iii) Deficit Budget = Revenue < Expenditure
Measures of Government budget Deficit.
Revenue Deficit: The revenue deficit refers to the excess of
government’s revenue expenditure over revenue receipts
Revenue deficit = Revenue expenditure – Revenue
receipts
Fiscal Deficit: Fiscal deficit is the difference between the
government’s total expenditure and its total receipts
excluding borrowing
Gross fiscal deficit = Total expenditure – (Revenue
receipts +
Non-debt creating capital receipts)
Gross fiscal deficit = Net borrowing at home + Borrowing
from
RBI + Borrowing from abroad
Primary Deficit: It is simply the fiscal deficit minus the
interest payments
Gross primary deficit = Gross fiscal deficit – Net interest
liabilities
Net interest liabilities consist of interest payments
minus interest
receipts by the government on net domestic lending.
Determinance of equilibrium in a three sector model
A three sector economy consist of house holds , firms ,
and, government. Under three sector model Aggregate
demand consist of consumption demand(C),investment
demand(I) and government demand(G).
Therefore aggregate demand AD=C+I+G
Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.
consumption demand
Consumption demand depends on disposable income of the
people. To get disposable income we deduct tax from total
income and add transfer payments.
Therefore consumption function is -
C=C +cYD
since YD=Y-T+TR
C= C+c(Y-T+TR)
We assume that investment demand in a three sector
economy is fixed . Therefore
Investment Demand (I)=I
In the economy government demand is also assumed fixed .
Therefore,
Government demand (G)=G
The aggregate demand of the economy is the sum total of
consumption demand(C), Investment demand of firms(I)
and government expenditure(G).
AD=C+I+G
AD=C+cY-cT+cTR+I+G
In a closed economy reaches equilibrium when
aggregate supply is equal to aggregate demand.
AS=AD
Since AD =C+cY-cT+cTR+I+G, AS=Y
Y= C+cY-cT+cTR+I+G
Y-cY= C-cT+cTR+I+G
Y(1-c)=C-cT+cTR+I+G
If Y is equilibrium income
or
Y=
In the diagram AS is the aggregate supply
curve.AD is aggregate demand curve.AS=AD at point E.At
that equilibrium point equilibrium income is Y*.
Government expenditure multiplier
When there is an increase in government expenditure ,the
demand schedule shifts upward. This means equilibrium
level of income increases. This is called government
expenditure multiplier. It is the ratio of change in income
(∆Y)to a change in government expenditure ( ∆G ).
Tax multiplier
It is a ratio of change in income(∆Y) to the change in
tax(∆T). If we reduce tax, equilibrium income will increase.
Therefore it is a negative multiplier. The value of tax
multiplier is smaller than the government expenditure
multiplier.
Balanced budget multiplier
It is the sum of government expenditure multiplier and tax
multiplier.
Balanced budget multiplier is equal =
It implies that an increase in government expenditure is
matched exactly equal to increase in tax(G=T).
Transfer payment multiplier
It is the ratio of change in income(∆Y)tochange in transfer
payment(∆TR ).
Automatic stabilisers
Policies that work automatically without any deliberate
action in the economy are called automatic stabilisers. Eg.
Proportional tax.In the case of proportional tax ,income
will increase or decrease according to the fluctuations in
GDP.
Fiscal Policy
The deliberate fiscal measures of the government to
stabilise the economy is called discretionary fiscal policy.
The main tools used by the the government are
1-Public investment.
2-Public Expenditure.
3-Changes in tax rates
4-Public borrowing.
Government debt
The borrowing of the government to finance the deficit in
budget is called public debt. Borrowing leads to
accumulation of debt. When the government goes on
borrowing ,debts accumulate and increase debt burden. It
imposes burden on future generation.
Recardian Equivalence
Consumers present spending depends not only on the
present income but also on the expected income in the
future. They know that today`s debt will lead to more taxes
in future. Therefore the people increase their savings. So
that the government should not bring about changes due to
the shortage of national income. That is the national income
remains the same without any change.
Deficit Reduction:
The government can reduce budget deficit through
increasing taxes or by reducing public expenditure. The
government of India tries the following measure to reduce
budget deficit.
Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.
1-Increase the direct taxes as far as possible and
thus increase the tax revenue.
2-Increase the revenue by the sale of the shares of PSU's
3-Reducing the government expenditure by proper
planning and through efficient administration.
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Chapter-6
Open Economy Macroeconomics
An economy which has economic relations with the
rest of the world is known as an open economy. In an open
economy we see three international linkages. They are-
➔ Output Market linkages :- consumers can buy
domestic and foreign products.
➔ Financial market linkages :-Investors can
invest both within the country and in foreign
countries.
➔ Labour Market linkages :-Firms can choose where
to locate production .Workers can choose where to
work.
The balance of payments (BoP)
BoP is the record of transactions in goods, services
and assets between residents of a country with the rest of
the world for a specified time period, typically a year.
It is the summary record of a country’s monetary
transaction with the rest of the world in a year. There are
two main accounts in the BoP -
the current account and the capital account.
Current Account
Current Account is the record of all trade in goods and
services and transfer payments. Trade in goods includes
exports and imports of goods.
Trade in services includes factor income and non-
factor income transactions.
Transfer payments are the receipts which the
residents of a country get for ‘free’, without having to
provide any goods or services in return. They consist of
gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.
Balance on Current Account
CurrentA/c Surplus Balanced current a/c Current account
deficit
Receipts>Payments Receipts=Payments Receipts<Payments
Balance on Current Account has two components:
• Balance of Trade or Trade Balance
• Balance on Invisibles
➔ Balance of Trade (BOT) is the difference between
the value of exports and value of imports of goods
of a country in a given period of time.
➔ BOT is said to be in balance when exports of goods
are equal to the imports of goods.
➔ Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports.
➔ Deficit BOT or Trade deficit will arise if a country
imports more goods than what it exports.
➔ Net Invisibles is the difference between the value of
exports and value of imports of invisibles of a
country in a given period of time.
Capital Account
Capital Account records all international transactions
of assets. An asset is any one of the forms in which wealth
can be held.
Balance on Capital Account
➔ Capital account is in balance when capital inflows
are equal to capital outflows.
➔ Surplus in capital account arises when capital
inflows are greater than capital outflows.
➔ Deficit in capital account arises when capital
inflows are lesser than capital outflows.
Autonomous transactions
All international financial transactions made
independently without considering balance of
payments are called autonomous transactions.
(Eg.Export,Import)
Accommodating transactions
International financial transactions by
considering balance of payment position is called
accommodating transactions. They are
transactions in the official reserve accounts.
Errors and omissions
It is the third element of BOP. Certain errors and
omissions arise in the accounts due to inaccurate
information. This is recorded in the Errors and omissions
account.
Foreign exchange rate
The rate at which one currency is exchanged for another
currency is exchange rate.
Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.
Nominal exchange rateThe amount of domestic currency
required to purchase one unit of foreign currency is known
as Nominal exchange rate. (Rs 50=1dollars)
Real exchange rate
It is the relative price of foreign goods in terms of domestic
goods.It is the ratio of foreign prices to domestic prices
measured in the same currency.
Determination of exchange rate
There are three exchange rate systems .They are,
(1) Flexible Exchange Rate
(2) Fixed Exchange Rate
(3) Managed Floating Exchange Rate
1. Flexible Exchange Rates
Under this system foreign exchange rate is determined by
the forces of demand and supply of foreign currency.The
equilibrium exchange rate is determined at a point where
thedemand curve and the supply curve of foreign exchange
cross each other.
In the diagram demand and supply of foreign
exchange measured on x axis. Market determined exchange
rate is e* ,where market demand and supply of foreign
currency is equal.
2. Fixed Exchange Rate(Pegged exchange rate system)
In this system exchange rate system ,the exchange rate is
fixed by the government at a particular level.
the market determined exchange rate is ‘E’. the
new exchange rate set by the Government is e 1 ,where e1> e.
At this exchange rate, the supply of dollars exceeds the
demand for dollars. The RBI intervenes to purchase the
dollars for rupees in the foreign exchange market in order
to absorb this excess supply which has been marked as AB
in the figure. Thus, through intervention, the Government
can maintain any exchange rate in the economy. On the
other hand if the Goverment was to set an exchange rate at
a level such as e2 , there would be an excess demand for
dollars in the foreign exchange market. To meet this excess
demand for dollars, the government would have to
withdraw dollars from its past holdings of dollars.
3. Managed floating:-
The combined form of fixed and flexible exchange
rate is called as managed floating. It is also known as dirty
floating.
Appreciation of currency
Under flexible exchange system there may be an
automatic increase in the value of the domestic currency in
terms of other currencies. This is termed as appreciation of
currency. This happens when exchange rate falls.

Depreciation of currency
Under flexible exchange system there may be an
automatic decrease in the value of the domestic currency in
terms of other currencies. This is termed as depreciation of
currency. This happens when exchange rate rises.

Devaluation of currency
Deliberate decrease in the value of domestic
currency in terms of other currencies under fixed exchange
rate system is known as devaluation. Here the government
fixed exchange rate is above the market exchange rate.

Revaluation of currency
Deliberate increase in the value of domestic
currency in terms of other currencies under fixed exchange
rate system is known as revaluation. Here the government
fixed exchange rate is below the market exchange rate.

Dileepkumar Puthiyatath & Sreejith Ponnambath, EKNS GHSS Vengad, Kannur.