Chapter 3

Determination of National
Income
 What we will learn in this chapter?
1 . Relationship between Aggregate Supply (AS) and Aggregate Demand (AD)
2 . Aggregate Supply (AS)
– Keynesian 45 degree line diagram
3 . Aggregate Demand (AD)
– Consumption (C) and its function
– Withdrawals
 Net savings
 Net taxes
 Import expenditure
– Injections
 Investment
 Government spending
 Exports
4 . Equilibrium National Income
5 . The Multiplier
6 . The Deflationary Gap and The Inflationary Gap
7 . Instability of Investment : The Accelerator
 MACRO EQUILIBRIUM
• The forces of aggregate demand and aggregate
supply confront each other in the marketplace
to determine macro equilibrium
• Equilibrium (macro): The combination of price
level and real output that is compatible with
both aggregate demand and aggregate supply

Aggregate Supply (AS) = Aggregate Demand (AD)

Withdrawal (W) = Injection (J)
 AGGREGATE SUPPLY (AS)
• National Income, (Y) also know as Aggregate
Supply (AS)
• Aggregate Supply showing the level of output
available at each possible price level.
Keynesian 45 degree line diagram
Aggregate demand is the relationship
between the total quantity of goods and
services demanded (from all the four
sources of demand) and the price level,
all other determinants of spending
unchanged.
The aggregate demand curve is a graphical representation of
aggregate demand.
 COMPONENT OF AGGREGATE
DEMAND
• The four components of aggregate demand
are
– Consumption (C)
– Investment (I)
– Government spending (G)
– Net exports (X – M)
A Change in aggregate demand is a
change in the aggregate quantity of goods
and services demanded at every price
level. This can be caused by changes in…

>Consumption,
>Investment,
>Government purchases,
>Net exports.
 CONSUMPTION
• Definition : Expenditure by consumers on final
goods and services
• Function : Relationship between consumption
and income.
• C = f(Y)
• The proportion of total disposable income
spent on consumer goods and services is the
average propensity to consume (APC)
total consumption C
APC  
total disposable income YD

• Marginal propensity to consume (MPC): The

fraction of each additional (marginal) dollar of
disposable income spent on consumption
Change in Consumption C
MPC  
Change in Disposable Income YD
 Types of Consumption
• Keynes distinguished two kinds of consumer
spending
– Spending that is not influenced by current income
(autonomous)
– Spending that is determined by current income
(induce)
 National Income (millions) Consumption (millions)
0 10
10 18
C = f(Y) 20 26
30 34
40 42
50 50
60 58
70 66
80 74
90 82
100 90
 Saving (S)
• An example of Withdrawal.
• Major determinant - income
• What is left over after consumption has taken
place. (S = Yd – C)
• Taxes constant- more spending on
consumption-less saving; vice versa.
• Marginal propensity to save (MPS): The
fraction of each additional (marginal) dollar of
disposable income not spent on consumption
Change in Saving S
MPS  
Change in Disposable Income YD

• The proportion of total disposable income

saved is the average propensity to save (APS)
total saving S
APS  
total disposable income YD
 Determinant of C and S
• Consumption that is independent of income is
influenced by non-income determinants:
– Expectations
– The level of disposable income (Yd)
– Wealth
– Credit
– Taxes
– Price level
 Consumption Theory From the Islamic
Perspective – by M.Fahim Khan
1. 2 types of spending :
• to meet his material needs - E1
• to meet the need of others - E2

2. The total spending E,

• E = E1 + E2
• E1 = C1 (present/ immediate consumption) +
S1 ( saving / investment for consumption in future )
• E2 = C2 (what is immediate consumed by the recipients) + S2 (what is
invested for social purposes or community benefits or what is saved
by the recipients for their own investment )
• Allocation between E1 and E2 will be
determined by :
1.Muslim has to be rational in all his spending
2.Fearing or God – consciousness
3.One should spend from what is left after
meeting one’s needs and not that one should
spend all type that spare.
 INVESTMENT THEORY
The Conventional Perspective
• Second component of AD / AE
• Example of injection whereby increase in
investment will result the level of NI
• Terms related to investment :
– Actual investment appears in GNP accounts include
undesired inventory accumulation
– Planned investment is the desired investment /
investment demand
– Gross investment (I ) is expenditure on new plants,
buying of capital equipment and machinery etc.
Gross Investment = Net Investment + Depreciation ( C)
 TYPES OF INVESTMENT
a) Autonomous investment (I ) O

– Not depend on the level of NI

– Eg : expenditure on national security
– Income increase or decrease, investment
remain same
b) Induced Investment (I)
– Positive relationship with income level
– Eg : expenditure development
– Income increase, investment increase
 DETERMINANT OF INVESTMENT
• Increase Consumer Demand
• Rate of interest
• Cost and efficiency of capital equipment
• Expectations
• Business taxes
 INVESTMENT THEORY FROM ISLAMIC
PERSPECTIVE
• Only permissible (halal) activities are allowed
• Should be based on the need of society
• Should emphasize mostly on the welfare of
society
• The implementation should not go against
syariah principal
• No form riba and gharar
 GOVERNMENT SECTOR
• 3 – sector economy
• Expenditure depend on present and past
government policy
• Expenditure finance by tax revenue
• Yd = Y – T
 FOREIGN SECTOR
• 4 sector economy – export and import.
• Export ( X ):
– Amount foreigner spend on Malaysia
– Autonomous
– An injection because it can increase NI through
the foreign trade multiplier.
• Import (M) :
– Withdrawal
– Higher level of NI, higher level of M
– Has 2 components ;autonomous and induced
 MULTIPLIER
• Ratio of the change in output as a result of a
change in an autonomous component in AD
• Multipier in 2-sector economy=1/1b
• Multiplier in 3-sector economy=1/1-b+bt
• Multiplier in 4-sector economy=1/1-b+bt+m
 INFLATIONARY GAP(IG)
• NI(Ye) excess full employment level of
income(Yf)
• Increase in NI caused by increase in general price
level but there is no real increase in
output/services.
• When AD>AS there exists a DG
• To close IG ,Leakagess must be increased and
injection reduced.
• Eg; decreases in investment/increase in savings
 DEFLATIONARY GAP(DG)
• NI (Ye) is not full employment level of income;
Ye<Yf.
• Not fully due to presence of unemployment
problem and real increase in output/services.
• When AD <AS there exists a DG.
 ACCELERATOR
• Theory-level of investment depends on the
rate of change of NI, result tends to be subject
to substantial fluctuations
• Coefficient- level of induced investment(Ii) as
a proportion of a rise in NI, α=Ii/∆Y
THANK
YOU