Macro Economics II Chapter One1

JINKA UNIVERSITY
Jinka University College of Agriculture and Natural Resource 2018

OBJECTIVES
After the end of this chapter, you would be able to:
 Identify components of national income
 Determine equilibrium income
Explain the expenditure multiplier
1
CHAPTER ONE
EQUILIBRIUM INCOME
DETERMINATION
1.1. Components of National Income
The following points highlight the top sixteen components or
constituents of national income.
Component 1. Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within
the country during a year.
GDP at market price as “the market value of the output of

final goods and services produced in the domestic territory
of a country during an accounting year.
2
Cont…d
There are three different ways to measure GDP:
Product Method, Income Method and Expenditure Method.
These three methods of calculating GDP yield the same result.
Because National Product = National Income = National

Expenditure.
Component 2. GDP at Factor Cost:
GDP at factor cost is the sum of net value added by all
producers within the country.
3
Cont…d
GDP at factor cost is the sum of domestic factor incomes and
fixed capital consumption.
GDP at Factor Cost = Net value added + Depreciation.
GDP at factor cost = GDP at market price – Indirect tax +
subsidies.
Component 3. Net Domestic Product (NDP):

NDP is the value of net output of the economy during the
year.
Thus Net Domestic Product = GDP at Factor Cost –
Depreciation.
4
Cont…d
Component 4. Nominal and Real GDP:
When GDP is measured on the basis of current prices, it is
called GDP at current prices or nominal GDP.
When GDP is calculated on the basis of fixed prices in some

year, it is called GDP at constant prices or real GDP.
Component 5. GDP Deflator:
GDP deflator is an index of price changes of goods and
services included in GDP.
5
Cont…d
It is the ratio of nominal GDP in a given year to the real GDP
for the same year and multiplied by 100.
Component 6. Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at
market value from current production during a year in a
country, including net income from abroad.
GNP = GDP + net income from abroad
Component 7. GNP at Market Prices:
Thus GNP at market prices means the gross value of final
goods and services produced annually in a country plus net
income from abroad.
6
Cont…d
GNP at Market Prices = GDP at Market Prices + Net Income
Earned from Abroad.
Component 8 GNP at factor cost is the sum of the money
value of the income produced by and accruing to the various
factors of production in one year in a country.
GNP at factor cost is the income which the factors of

production receive, in return, for their services alone.
It is the cost of production. Thus GNP at market prices is

always higher than GNP at factor cost.
7
Cont…d
GNP at Factor Cost = GNP at Market Prices - Indirect Taxes
+ Subsidies. Or
GNP at factor cost = GDP at factor cost + Net factor payment
from the abroad.
Component 9. Net National Product (NNP):

In order to arrive at NNP, we deduct depreciation from GNP.
The word ‘net’ refers to the exclusion of that part of total

output which represents depreciation.
Thus NNP= GNP - Depreciation. 8
Cont…d
Component 10. Net National Product (NNP) at Market
Prices:
It is the net value of final goods and services evaluated at
market prices in the course of one year in a country.
NNP at Market Prices = GNP at Market Prices- Depreciation.
Component 11. NNP at Factor Cost:

Net National Product at factor cost is the net output evaluated
at factor prices.
NNP at Factor Cost = NNP at Market Prices-Indirect taxes +
Subsidies.
9
Cont…d
National Income (NI) = GNP at Market Prices-Depreciation-
Indirect taxes + Subsidies.
Normally, NNP at market prices is higher than NNP at factor

cost because indirect taxes exceed subsidies.
Component 12. Private Income:
It is income obtained by private individuals from any source,
and the retained income of corporations.
10
Cont…d
Private Income = National Income (or NNP at Factor Cost) +
Transfer Payments +
Interest on Public Debt -
Social Security -
Profits and Surpluses of Public Undertakings.
Component 13. Personal Income:
Personal income is the total income received by the
individuals of a country from all sources before payment of
direct taxes in one year.
11
Cont…d
Personal income = National Income - Undistributed Corporate
Profits-Profit Taxes-Social Security Contribution + Transfer
Payments + Interest of Public Debt.
Personal income differs from private income in that it

excludes undistributed corporate profits.
Personal income = Private Income - Undistributed Corporate
Profits-Profit Taxes.
Component 14. Disposable Income:
Disposable income is the actual income which can be spent on
consumption.
12
Cont…d
Disposable income = Personal Income - Direct Taxes.
Disposable Income = Consumption Expenditure + Savings.
Disposable Income = National Income - Business Savings -

Indirect Taxes plus Subsidies –
Direct Taxes on Persons –
Direct Taxes on Business –
Social Security Payments +
Transfer Payments +
Net Income from Abroad.
13
Cont…d
Component 15. Real Income:
Real income is national income expressed in terms of a
general level of prices of a particular year taken as base.
National income is the value of goods and services produced

as expressed in terms of money at current prices.
The national income does not depict the real state of the
country. To rectify such as a mistake, the concept of real
income has been evolved.
14
Cont…d
Real NNP = NNP for the Current Year x Base Year Index (=
100)/Current Year Index.
Component 16. Per Capita Income:

The average income of the people of a country in a particular
year is called Per Capita Income for that year.
This concept also refers to the measurement of income at

current prices and at constant prices.
To find out the per capita income at current prices, the
national income of a country is divided by the population
of the country in that year.
15
Cont…d
1.2. Determining equilibrium income
Fundamental Assumptions:
(1) The flow of output produced by an economy (GDP) in a
given time period is identically equal to income (Y)
generated.
(2) Output is demanded by three types of agents: consumers,

firms, and the government.
Equilibrium (a state in which there is no tendency to change

or a position of rest).
16
Cont…d
Is the condition when the desired amount of output demanded
equals the amount produced in a given time period.
At any level of income, aggregate demand may be (1) greater

than, (2) less than or (3) equal to the actual amount of
goods and services produced by the economy in the period
(i.e., actual GDP).
However, only in the last case (AD = actual GDP) will the
economy be in equilibrium.
17
Cont…d
18
Cont…d
The exogenous variables of primary importance in the Simple
Keynesian model include:
The components of the consumption function (i.e., the

intercept, the marginal propensity to consume, and the
income tax rate).
• Planned investment spending

• Government spending
19
Cont…d
There are four structural equations in the Simple Keynesian
Model, representing the four demands for output and their
sum.
C = c0+ MPC(Y-t0Y)
I = I0
G = G0
AD = C + I + G
20
Cont…d
The final piece to be laid out is the equilibrium condition:
Y = AD
We put the equation in equilibrium condition.
Ye= c0+ MPC(Ye-t0Ye) + I0+ G0
Ye appears on both sides of the equation, We want to solve for

Ye. To do that, we can simply follow these steps:
21
Cont…d
(1) Factor Ye out of (Ye-t0Ye):
Ye= c0+ MPC(1-t0)Ye+ I0+ G0
(2) Put all the terms with Ye on the left hand side:
Ye- MPC(1-t0)Ye= c0+ I0+ G0
(3) Factor out Ye from the left hand side:
[1 - MPC(1-t0)]Ye= c0+ I0+ G0
(4) Solve for Ye:
22
Cont…d
FOR EXAMPLE:
Suppose: C = 200 + 0.8(Y - 0.0625Y), I = 200, G = 100
STEP (1):Write the structural equation(s) and equilibrium
condition(s).
Structural Equations:
C = 200 + 0.8(Y- 0.0625Y)
I = 200
G = 100
AD = 200 + 0.8(Y- 0.0625Y) + 200 + 100
Equilibrium Condition:
Y = AD
23
Cont…d
STEP (2):Force the structural equations to obey the
equilibrium conditions. We do this by writing:
Ye = 200 + 0.8(Ye- 0.0625Ye) + 200 + 100
STEP (3): Solve for the equilibrium value of the endogenous
variable; that is, rearrange the equation in Step 2
Ye = 200 + 0.8(Ye - 0.0625Ye) + 200 + 100
Ye = 200 + 0.8(1 - 0.0625)Ye+ 200 + 100
Ye - 0.8(1 - 0.0625)Ye = 200 + 200 + 100
[1 - 0.8(1 - 0.0625)]Ye = 200 + 200 + 100
Ye = {200 + 200 + 100}/[1 - 0.8(1 - 0.0625)]
Ye= $2000
24
Cont…d
1.3. The expenditure multiplier
Fiscal Policy and the Multiplier: The government purchases
are one component of expenditure,
Higher government purchases result in higher planned

expenditure for any given level of income.
If government purchases rise by G, then the planned-
expenditure schedule shifts upward by G.
That means an increase in government purchases leads to an

even greater increase in income.
25
Cont…d
The ratio Y/G is called the government-purchases multiplier.
An implication of the Keynesian cross is that the government-

purchases multiplier is larger than 1.
Why does fiscal policy have a multiplied effect on income?
The reason is that, according to the consumption function C =

C (Y − T), higher income causes higher consumption.
26
Cont…d
27
Cont…d
Expenditure rises by G, which implies that income rises by G

as well.
An increase in income in turn raises consumption by MPC ×

G.
This increase in consumption raises expenditure and income
once again.
This second increase in income of MPC × G again raises

consumption, this time by MPC ×(MPC × G), which again
raises expenditure and income, and so on.
28
Cont…d
Y/G =1/(1 − MPC).
For example, if the marginal propensity to consume is 0.6, the
multiplier is Y/G =1 +0.6 +0.62+0.63+. . . = 1/(1 −0.6)=2.5.
In this case, a $1.00 increase in government purchases raises

equilibrium income by $ 2.5
 Fiscal Policy and the Multiplier: Taxes
Now consider how changes in taxes affect equilibrium

income.
29
Cont…d
A decrease in taxes of T Immediately raises disposable
income Y – T by T.
Therefore, increases consumption by MPC × T.
For any given level of income Y, planned expenditure is now

higher.
The overall effect on income of the change in taxes is

Y/T = −MPC/(1 − MPC).
30
Cont…d
This expression is the tax multiplier, the amount income
changes in response to a $1 change in taxes.
The negative sign indicates that income moves in the opposite

direction from taxes.
For example, if the marginal propensity to consume is 0.6,

then the tax multiplier is Y/T = −0.6/(1 −0.6) = −1.5.
In this example, a $1. cut in taxes raises equilibrium income

by $1.50.
31
Cont…d
32
!!!
N D…
E E
T H
33

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JINKA UNIVERSITY

Jinka University College of Agriculture and Natural Resource 2018

 Identify components of national income

 Determine equilibrium income

Explain the expenditure multiplier

Component 1. Gross Domestic Product (GDP):

GDP at market price as “the market value of the output of

Product Method, Income Method and Expenditure Method.

These three methods of calculating GDP yield the same result.

Because National Product = National Income = National

Component 3. Net Domestic Product (NDP):

When GDP is calculated on the basis of fixed prices in some

Component 6. Gross National Product (GNP):

GNP at factor cost is the income which the factors of

It is the cost of production. Thus GNP at market prices is

Component 9. Net National Product (NNP):

The word ‘net’ refers to the exclusion of that part of total

Component 11. NNP at Factor Cost:

Normally, NNP at market prices is higher than NNP at factor

Personal income differs from private income in that it

Disposable Income = National Income - Business Savings -

National income is the value of goods and services produced

Component 16. Per Capita Income:

This concept also refers to the measurement of income at

(2) Output is demanded by three types of agents: consumers,

Equilibrium (a state in which there is no tendency to change

At any level of income, aggregate demand may be (1) greater

The components of the consumption function (i.e., the

• Planned investment spending

We put the equation in equilibrium condition.

Ye= c0+ MPC(Ye-t0Ye) + I0+ G0

Ye appears on both sides of the equation, We want to solve for

(4) Solve for Ye:

Higher government purchases result in higher planned

That means an increase in government purchases leads to an

The ratio Y/G is called the government-purchases multiplier.

An implication of the Keynesian cross is that the government-

Why does fiscal policy have a multiplied effect on income?

The reason is that, according to the consumption function C =

Expenditure rises by G, which implies that income rises by G

An increase in income in turn raises consumption by MPC ×

This second increase in income of MPC × G again raises

In this case, a $1.00 increase in government purchases raises

 Fiscal Policy and the Multiplier: Taxes

Now consider how changes in taxes affect equilibrium

Therefore, increases consumption by MPC × T.

For any given level of income Y, planned expenditure is now

The overall effect on income of the change in taxes is

The negative sign indicates that income moves in the opposite

For example, if the marginal propensity to consume is 0.6,

In this example, a $1. cut in taxes raises equilibrium income

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