Chap -3: The model of National Income

What Determines the Demand for Goods and Services?

Consumption (C)
Investment (I )
Government purchases (G)
Net exports (NX).
Y = C + I + G………. (1) [If external sector is dropped. NX=0]
Consumption spending: C =C (Y-T)…… (2)
Classic Keynesian ‘c’ function is linear and upward sloping.
 MPC is the slope of the consumption function. 0< MPC<1.
Investment spending: Investment function is downward sloping. The
investment function is: I =I(r).
r = real interest rate = real cost of capital
Govt. purchase (G) = Three cases:
1. Budget deficit: G> T
2. Budget Surplus: G< T
3. Balanced Budget: G=T
4. Transfer Payments are not included in G.
• In the model of national income: G =
T=
The two sector macro-model of national income is the following:
Y =C+ I+G …….. (1)
C= C(Y-T) ………. (2)
I=I(r)……… (3)
G = ……….(4)
T = ……….(5)
 What Brings the Supply and Demand for
Goods and Services Into
We add the following production function:
Equilibrium?
Y =F( , )….(5a) , Y = supply of GDP , = fixed capital, = fixed labour
Therefore,
If we substitute the consumption function and the investment function into
the national income accounts identity, we obtain
Y = C(Y − T ) + I(r) + G…….. (6)
Rewriting national income accounts identity (equation: 1) we obtain,
Y − C − G = I. ……….. (7)
Y − C(Y − T ) − G = I(r).
– C( − ) − = I(r)
= I(r). S =National Savings (Fixed), , [ Y-C-G =S] is the amount of output
that remains after the demands from ‘H’ and ‘G’ are satisfied.
Equilibrium condition = I (r) in graph (In the
market for loanable funds L.F.)
• r S

• Market for L.F. = Financial market

• Equilibrium interest rate = r*
r* E At E , supply of loanable funds =
I(r) Demand for loanable funds:
0 I* S,I At E , S bar = I(r).
Q1.Derive and explain the equilibrium
condition in the two sector macro- model.
Q2.How does adjustment in interest rate help
attain equilibrium in market for loanable funds?
•r S
At r1 interest rate, DD for L.F. = r1C

r1 C F SS for L.F. = r1F

CF = excess supply of L.F. So interest rate
r* E keeps falling till it reaches equilibrium
r2 K L

I(r) level. At E = No excess supply of LF.

0 I S, I At 0r2 DD for L.F. = r2L
and SS for L.F. = r2K , KL= Excess
demand for L.F. So interest rate keeps rising until supply
and demand for LF. are equal.
Q3.a) Examine the impact of increasing G(govt
purchase) on equilibrium condition = I (r).

• National Income accounts identity:

• Y=C+I+G
Y – C- G = I []
(Y-T-C) + (T-G) = I(r) (Taxes are constant)
Private savings + Public savings = national savings = I(r).
(Y-T-C) + (T-G) = NS……… (a)
When G rises public savings fall , since private savings is unchanged ,
National savings fall. NS function will shift leftward.
Graph
•r 500 S2 S1 = 750

• S1 = Original Savings function

• r2 B

• r1 A Equilibrium interest rate rises. So

• I ( r) investment demand reduces.
• 0 I2 I1 S, I
Q3b) Examine the impact of decreasing G(govt
purchase) on equilibrium condition = I (r).
•
rr r S1 S2

r1 A

r2 B I (r)
• 0 I1 I2 S,I
Q4.a)Examine the impact of decreasing T(G=
constant) on equilibrium condition = I (r).
Y=C+I+G
Y-C-G=I(r)
(Y-T-C) + (T-G) = I(r )
△ Private S+ △ Public S = △ NS
If Govt reduces taxes by △T, Public savings will go down by △T,
Disposable income goes up by △T . But Private savings goes up by △T
× MPS. [MPS= Marginal propensity to save]. Since 0< MPS<1. We
can conclude change(decrease) in public savings is greater than
change(increase) in private savings. Because △T × MPS < △T. So the
net impact on National savings is such that it REDUCES.
Graph of decreasing Taxes.(G= Constant)
•r S2 S1
Equilibrium interest rate rises and
this reduces the investment demand.
• r2 B

• r1 A I(r )

• 0 I2 I1 S,I
Q4b) Examine the impact of increasing T(G=
constant) on equilibrium condition = I (r).
Y=C+I+G
Y-C-G=I(r)
(Y-T-C) + (T-G) = I(r )
△ Private S+ △ Public S = △ NS
If Govt raises taxes by △T, Public savings will go up by △T, Disposable
income goes down by △T . But private savings goes down by △T ×
MPS. [MPS= Marginal propensity to save]. Since 0< MPS<1. We can
conclude rise in public savings is greater than fall in private savings.
Because △T × MPS < △T. So the net impact on National savings is
such that it increases.
Graph of increasing Taxes. G=constant
•r S1 S2

• National savings function shifts rightward

• r1 A and and equilibrium interest rate falls and
• r2 B increases investment demand.
• I (r )

• 0 S,I
Problems to solve from Chapter -3
• Problem Numbers: 7 and 9
• Page number: 77.

• PAGE NUMBERS FROM CHAP-3: From Page : 60 to Page 70.