SESSION 5

Reading
1. This set of slides
2. From the text material :
Chapter 2 page 34
Chapter 3 page 47 - 60

Income Determination

Goods Market : the short run

The Simple Keynesian framework

Setting up the model:

Resources / capacity is under utilized (short run)

No govt. , no foreign trade (simplifying assumption)

Consumption is directly related to income

C = planned consumption expenditure of the households
= C(Y)
As income of the household changes, consumption also
changes. But changes in consumption < changes in income
C=a+c.Y
a : minimum autonomous consumption
c : Marginal propensity to consume = C/Y
c is a positive fraction.

Investment is autonomous

I = Io

Aggregate expenditure is a measure of aggregate

demand (AD) of the economy.
AD = C + I = a + cY + Io
Income is a measure of aggregate output supply
AS = Y
Macroeconomic Equilibrium: AD = AS

Equilibrium level of income Y* = (a + I) / (1-c)

Given under-utilized capacity,

If AD > AS then output will increase.
If AD < AS then output will fall.

AS = Y

AD ,
AS
C

AD = a + I +
c.Y
D
E
A
[a+
I]

Y1

Y*

Y2

AS or
Y

How is the equilibrium reached?

If AS = Y1, AD > AS
Sellers find that there is excess demand in the market. They
revise their production upward in the next period. As a
result agg. Output rises. Demand existing, (AD > AS) all the
output is sold. Income rises. This continues till Y reaches Y*.

If AS = Y2, AD < AS
Sellers find that there isnt enough takers of their products
in the market. They revise their production downward in the
next period. As a result agg. Output falls. If there still
remains some excess supply, output keeps falling till a state
comes when all the output is sold. Income falls. This
continues till Y reaches Y*.

Is the economy then always in equilibrium?

NO.
It can be said that the economy moves towards equilibrium.
There may be shocks or external influences disturbing the
parameters (c, Io etc.) which in turn disturb the equilibrium.
Once disturbed, the economy again moves towards
equilibrium.

What happens to national income if firms decide to

increase investment?
Now I = I1 = I0 + I
I AD Y
Y* = (a + I) / (1 c)
Income should increase to Y = (a + I + I ) / (1 c)
Increase in income = Y = Y Y* = I / (1 c)
Y >

Y / I = multiplier > 1

Why
Why is
is Y
Y >
> I?
I?
II
by
by I
I

AD
AD
by
by I
I

AD
AD >
> AS,
AS, and
and AD
AD AS
AS =
=
I
I

Total
Y
Y
by
by Y
Y =
= I
I
Total increase
increase in
in
output

C
C
by
by cc ..
Y
Y=
= cc .. I
I output
=
= I
I +
+ cc I
I +
+ cc22 I
I +
+ cc33

AD
AD
by
by cc .. I
I
I
I +
+ cc44 I
I +
+

Y
Y
by
by Y
Y =
= cc .. I
I
=
I (1
(1 +
+ cc +
+ cc22 +
+ cc33+
+

I
C
C
by
by cc .. Y
Y =
= cc22 .. =
II
.)
.)

AD
AD
by
by cc22 .. I
I
=
= I
I // (1
(1 -- cc ))

Y
Y
by
by Y
Y =
= cc22 .. I
I

C
C
by
by cc22 .. Y
Y =
= cc33 .. I
I

and
and so
so on
on

Exercise
1. If C = 10 + .9Y and Io = 60, what is the level of
unplanned inventory accumulation at Y = 850?
2. Current consumption by the households is 60% of
GDP. If firms decide to increase investment to $320
million in capital goods this year from of $200
million in the last year. How much will the GDP
increase?

Operation of the multiplier is crucially dependent on the

assumption that unutilized resources are available in
abundance.

Supply side bottle necks adversely affect the multiplier

operation.
If some crucial input is in limited supply, income expansion
will halt.

If AD rises beyond full-employment level of output, then it is

the price level that would rise, not output.

A few events are perceived as indication of growth in the near

future.

A rise the Sensex

strengthening of the Rupee
Many a times such perceptions are misplaced.
Growth is enhanced by sustained increase in I or G or C or XM.
Policies need to encourage / incentivise these sustainably.

When investment is induced:

With increased level of economic activity, firms will be induced
to make planned investments.
Say, I = b + d . Y
Where b = autonomous investment
d. Y = induced investment
How will this affect the multiplier?

Multiplier with induced investment = 1 / (1 c d )

1 / (1 c d )
> 1 / (1 c )

I AD Y
C .
I .

Exercise

a)
b)

c)

Consider an economy with only the household and

the firms.
Aggregate consumption expenditure = C = 100 +
0.8Y; Planned Investment expenditure by firms =
80 + 0.4Y, where Y is the GDP.
What is the equilibrium GDP?
In the year 1996 the total value of aggregate
output was 500, should the economy move towards
the equilibrium?
If the parameters do not change where do you
forecast the output in the future?

Economy with the government and rest of the world

C = a + cY
I = Io say
G = Go decided by the government
X = Xo
M = f + mY
AD = C + I + G + X - M = [a + Io + Go + Xo + f] + (c m)Y
AS = Y
Equilibrium level of income: Y* = [a + Io + Go + Xo + f] / (1
c + m)
Open Economy Government exp. Multiplier = 1 / (1-c+m)