ECN30305 Principles of Economics

Lecture 13
Lecture 13
Income Determination in a Two
Sector Simple economy Part 2
 Y=C+I+G+X–M

Consumption Investment
 Income determination in a Two Sector
Economy

• A simple economy consists of

C Consumption
I Investment
 Concept of equilibrium

Aggregate Expenditure = C + I

• Equilibrium Condition is:

Aggregate = Real GDP
Expenditure

AE = Y
Therefore, Y=C+I

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Consumption Function and Saving Function
• Consumption function (C) is the relationship
between consumption expenditure and disposable
income (Yd), other things remaining the same.
• Saving function (S) is the relationship between
saving and disposable income, other things
remaining the same.

Consumption and Savings are related as Y – C = S

Yd = Y
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 AE with Investment
What happens when we add investment?
 Investment is
Autonomous autonomous of
te
consumption
AE = C + I bsti
tu income
su
C = a + bY Investment
determined by
interest rates,
AE = [a + bY] + I expectations

AE = a + I + bY
autonomous induced
expenditure expenditure
 New Aggregate Expenditure Curve
with Investment
Aggregate Expenditure $trillions

Y=AE
AE1 = a + bY + I
E
1
C = a + bY

I 
E

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Real Output, Y $trillions
Y0 Y1

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New Aggregate Expenditure Curve
with change in induced component of Consumption
Aggregate Expenditure $trillions

Y=AE
AE1 = a + b*Y + I
e1
 b C = a + bY


e

45o
Real Output, Y $trillions
Y0 Y1
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 Equilibrium & The Multiplier
• What is equilibrium income, Y?
• At equilibrium: Y = AE
Given AE = a + I + bY
 Y = a + I + bY
Y - bY = a + I
(1 – b)Y = a + I
Y= 1 x a+I
(1 – b)
Multiplier, k
Y=k. A
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 The Multiplier, k
• Is the amount by which a change in autonomous
expenditure is magnified or multiplied to determine the
change in equilibrium expenditure and real GDP.

• Multiplier effect – equilibrium expenditure (GDP) increases

by more than the increase in autonomous expenditure.

•k > 1

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 Application Ex. 1: Simple Closed Economy
Eg 1 I = $60b a = $10b mpc, b = 0.9
(a) Consumption function
(b) Determine the aggregate expenditure, AE function
(c) Calculate equilibrium real GDP, Y
(d) Multiplier, k
c) AE = 70 + 0.9Y
a) C = a + bY Given equilibrium is Y = AE
= 10 + 0.9Y  Y = 70 + 0.9Y
= 70/1-0.9
b) AE = C + I = 700
Given C = 10 + 0.9Y
(d) k = 1 .
 AE = 10 + 0.9Y + 60 1 - b
= 70 + 0.9Y = __
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 Application Ex. 1: Diagram

Aggregate Expenditure
($ trillions) Y=AE

AEAE
= 70
= a++0.9Y
I + bY

AE0
700 e
a +70I

45o
700 Real GDP, Y ($ trillions)
Y0

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 Changes in Equilibrium, Y

To calculate Y in a given period:

Y=k. A

To calculate change in Y between one year to the next

Y =  . A
Application Ex 2. Changes in Equilibrium, Y

From Ex 1: a = $10b mpc, b = 0.9 I1 = 60

In Year2 Investment rises to $80b
Calculate / determine with detailed workings:
(a) The change in planned expenditure, AE
(b) The change in real GDP, Y
(c) The new AE (AE2) function for Year 2
(d) Real GDP (Y2) for Year 2

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 Application Ex. 2 ….cont
If a = 10 mpc, b = 0.9 I1 = 60 I2 = 80

(a)AE = I2 – I1
(c) AE2 = C + I
= a + bY + I
= 80 – 60
90 ++0.9Y
= ___ __Y
= 20

b) Y =  x E (d) Y2 = Y1 + Y where Y1 = 700

= 1 x E 200 = 900 (see Ex 1)
= 700 + __ = __
(1 – b) OR
90 +
AE2 = ___ + 0.9Y
___Y
= 1 x 20
Given equilibrium is AE = Y
90 ++0.9Y
Y = ___ ___Y
200
= ___
(1 – 0.9) 900
= ___ 15
 Application Ex. 2: Diagram

Aggregate expenditure ($
Y=AE

AE2 = 0.9Y + 90
billions) b

AE1 = 0.9Y + 70
90 a
I = A = 20 
70
 Y=  .A = 200
45o

Y1 = Y2 Real GDP ($ billions)

700 900

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 NEXT LECTURE 13

Inflation and Unemployment

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 Inflation and Unemployment

Inflation and Unemployment are problems brought about by

business cycle fluctuations

Both are not welcome:

Inflation – means economy’s GDP is growing above its full
employment GDP. Result – shortages. Prices rise

Unemployment – economy is below its full employment GDP

Result – people becomes unemployed
 Unemployment

3 Types of Unemployment:

• Frictional – people out of jobs searching for better career

• Structural – people out of jobs because their skill sets no

longer required

• Cyclical – People unemployed because of recession where

there is insufficient demand to sustain their
unemployment
 Inflation

Inflation is not good for the economy:

• Price increases makes good more expensive

• Reduces buying (purchasing) power

• Reduces standard of living – we become worse off