Chapter 13 - The Theory of Income and Employment Determination

Written by: Edmund Quek
CHAPTER 13 THE THEORY OF INCOME AND EMPLOYMENT DETERMINATION
LECTURE OUTLINE 1 2 3 4 4.1 4.1.1 4.1.2 4.1.3 4.1.4 4.1.5 4.2 4.3 4.4 4.5 5 6 THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT THE GREAT DEPRESSION THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT THE KEYNESIAN THEORY IN GREATER DETAIL Planned aggregate expenditure (AE) Consumption expenditure (C) Planned investment expenditure (I) Government expenditure on goods and services (G) Net exports (X M) Distinction between planned aggregate expenditure and actual aggregate expenditure Circular flow of income and expenditure Equilibrium national income Multiplier effect and multiplier Paradox of thrift THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT INFLATIONARY GAP AND DEFLATIONARY GAP
References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
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THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT
Classical economists is a term coined by Karl Marx to refer to economists who include David Ricardo, James Mill and their predecessors. In other words, Classical economists refers to the founders of the theory which culminated in Ricardian economics. John Maynard Keynes included in the Classical school the followers of Ricardo, that is to say those who adopted and perfected the theory of Ricardian economics, including John Stuart Mill, Alfred Marshall, Francis Ysidro Edgeworth and Arthur Cecil Pigou. The above list of names may seem confusing. A simpler but looser definition of Classical economists is the economists who wrote before Keynes. Classical economists believe that prices and wages are totally flexible and hence the economy is a self-correcting mechanism. In other words, Classical economists believe that as prices and wages are totally flexible, the economy is always at the full-employment equilibrium. Suppose that the economy is at the full-employment equilibrium. Further suppose that aggregate demand falls. When this happens, national output will fall below the full-employment level which will lead to unemployment resulting in a downward pressure on wages. Since wages are totally flexible, in Classical economists view, they will fall immediately which will induce firms to increase output resulting in national output returning to the full-employment level. Therefore, the aggregate supply curve is vertical at the full-employment national output. The implication of a vertical aggregate supply curve is that only a change in aggregate supply will affect national output.
In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 does not have any effect national output. It only leads to a rise in the general price level (P) from P0 to P1.
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In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to an increase national output (Yf) from Yf0 to Yf1. Therefore, Classical economists argue that the government should focus on the factors that will increase aggregate supply to increase national output and hence the standard of living. In this sense, Classical economics is supply-side economics. Classical economists treat money only as a medium of exchange. Workers are exchanging labour for goods and services and firms are exchanging goods and services for labour. In this sense, money simply plays an intermediate role that facilitates transactions. This way of thinking leads Classical economists to see every sale as a purchase. Since every sale is a purchase, it is impossible for supply to exceed demand. By producing, firms are spending. This line of thinking is often stated as Say's Law, which states that supply creates its own demand. Say's Law is attributed to the great French economist Jean-Baptiste Say (1767-1832). Say's original version was "products are paid for with products". Classical economists use one or another version of Say's Law when they claim that economic downturns cannot be caused by a deficiency in aggregate demand. A version: Firms employ factor inputs to produce output and hence pay factor income to households. The income received by households is then partly paid back to firms in the form of consumption expenditure and partly withdrawn from the inner flow of the circular flow of income and expenditure in the form of savings, taxes and imports. However, any withdrawals by households are ultimately paid back to firms in the form of injections such as investment expenditure, government expenditure and exports. Therefore, the income generated by the production of firms will be transformed into demand for their goods and services, either directly in the form of consumption expenditure, or indirectly via withdrawals and then injections. There will be no deficiency of demand.
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THE GREAT DEPRESSION
The Classical view was challenged when the market economies were hit by the Great Depression in the 1930s during which there was prolonged and mass unemployment. The Great Depression proved that the economy was not a self-correcting mechanism, not in the short run at least. For instance, the national output of the United States stayed below the full-employment level for most part of the 1930s.
THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT
In 1936, John Maynard Keynes published the book "The General Theory of Employment, Interest and Money to explain the prolonged and massive unemployment in the Great Depression. The book criticises the classical model. Keynes turns Says Law on its head, arguing that aggregate demand determines national output and employment in the economy. In this sense, demand creates its own supply. Unlike the Classical economists, Keynes believes that prices and wages are rigid, especially in the downward direction and hence the economy is not a self-correcting mechanism. In other words, Keynes believes that as prices and wages are rigid, the economy can stay at a below-full-employment equilibrium. Suppose that the economy is at the full-employment equilibrium. Further suppose that aggregate demand falls. When this happens, national output will fall below the full-employment level which will lead to unemployment resulting in a downward pressure on wages. Since wages are rigid, in Keyness view, they will not fall. Therefore, firms will not increase output and hence national output will stay at a below-full-employment level. Keynes attributes the prolonged and high unemployment in the Great Depression to a prolonged and huge deficiency in aggregate demand and downward rigidity of wages. When national output is below the full-employment level, with unemployment in the economy, firms can increase output without bidding up wages. Therefore, although an increase in national output will lead to an increase in the total cost of production in the economy, it will not affect the average cost of production in the economy. Since the average cost of production in the economy will remain the same, firms will not increase prices. Therefore, the aggregate supply curve is horizontal at the current general price level up to the full-employment national output. Once full employment is reached, the economy cannot expand output any further and hence the aggregate supply curve is vertical at the full-employment national output. Therefore, the aggregate supply curve is inverse L-shaped. Keynes believes that unemployment is the normal state of the economy. Therefore, the implication of an inverse L-shaped aggregate supply curve is that only a change in aggregate demand will affect national output.
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In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 does not have any effect national output.
In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase national output (Y) from Y0 to Y1. Therefore, Keynes argues that the government should focus on the factors that will increase aggregate demand to increase national output and hence the standard of living. In this sense, Keynesian economics is demand-side economics. Note: Keynesian economics is short-run economics. Therefore, the Keynesian aggregate supply curve is a short-run aggregate supply curve. There is no long-run aggregate supply curve in Keynesian economics. Classical economists make no distinction between the short run and the long run as they believe that prices and wages are totally flexible. Therefore, the Classical aggregate supply curve is simply an aggregate supply curve.
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4 4.1
THE KEYNESIAN THEORY IN GREATER DETAIL Planned aggregate expenditure (AE)
Planned aggregate expenditure (AE) is the planned total expenditure on the goods and services produced in the economy over a period of time and is comprised of consumption expenditure (C), planned investment expenditure (I), government expenditure on goods and services (G) and net exports (X-M).
AE C I G (X M)
4.1.1 Consumption expenditure (C) Consumption expenditure is the expenditure made by households on goods and services. Savings is the excess of disposable income over consumption expenditure. The consumption function shows the consumption expenditure of households at each disposable income. Mathematically, the Keynesian consumption function can be expressed as C a bYd, where a 0 and 0 b 1. From the above equation, it can be seen that consumption is comprised of two components: autonomous consumption (a) and induced consumption (bYd). Autonomous consumption is the part of consumption that does not depend on disposable income and is determined by consumer confidence, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. Induced consumption is the part of consumption that depends on disposable income (Yd). Keynes believes that consumption will increase with an increase in disposable income (b 0) but the increase in consumption will be less than the increase in disposable income (b 1).
Note: Students can think of autonomous consumption as the consumption of necessities. However, it is important to note that different people may view different goods differently. A necessity to a person may be a luxury to another.
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Consumption function
In the above diagram, (b) is the slope of the consumption function. In Keynesian economics, it is known as the marginal propensity to consume out of disposable income (MPCYd). The MPCYd is the fraction an increase in disposable income that is spent on consumption (C/Yd). Savings is the excess of disposable income over consumption expenditure. The savings function shows the savings of households at each disposable income. Mathematically, the Keynesian savings function can be expressed as S a (1 b)Yd, where a 0 and 0 (1 b) 1. From the above equation, it can be seen that savings is comprised of two components: autonomous savings (a) and induced savings [(1 b)Yd]. Autonomous savings (or dissavings, which some may like to call it) is the part of savings that does not depend on disposable income and is determined by consumer confidence, interest rates, expectations of price changes the distribution of income. Induced savings is the part of savings that depends on disposable income (Yd). Keynes believes that savings will increase with an increase in disposable income [(1 b) > 0] but the increase in savings will be less than the increase in disposable income [(1 b) < 1].
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Savings function
In the above diagram, (1 b) is the slope of the savings function. In Keynesian economics, it is known as the marginal propensity to save out of disposable income (MPSYd). The MPSYd is the fraction of an increase in disposable income that is saved (S/Yd). Since any additional disposable income will either be spent or saved, the sum of the marginal propensity to consume out of disposable income and the marginal propensity to save out of disposable income is equal to one (MPCYd MPSYd 1). The average propensity to consume out of disposable income (APCYd) is the fraction of disposable income that is spent on consumption (C/Yd). The average propensity to save out of disposable income (APSYd) is the fraction of disposable income that is saved (S / Yd). Since any amount of disposable income will either be spent or saved, the sum of the average propensity to consume out of disposable income and the average propensity to save out of disposable income is equal to one (APCYd APSYd 1). Example Yd 0 40 80 120 160 200 240
C 20 50 80 110 140 170 200
S 20 10 0 10 20 30 40
MPCYd ------0.75 0.75 0.75 0.75 0.75 0.75
MPSYd ------0.25 0.25 0.25 0.25 0.25 0.25
APCYd ------1.25 1 0.92 0.875 0.85 0.83
APSYd ------0.25 0 0.08 0.125 0.15 0.17
The marginal propensity to consume and the marginal propensity to save can be defined out of national income. The marginal propensity to consume out of national income (MPC) is the fraction of an increase in national income that is spent on consumption
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(C/Y). The marginal propensity to save out of national income (MPS) is the fraction of an increase in national income that is saved (S/Y). The marginal propensity to tax (MPT) is the fraction of an increase in national income that is taxed (T/Y). Since any amount of national income will either be spent, saved or taxed, the sum of the marginal propensity to consume out of national income, the marginal propensity to save out of national income and the marginal propensity to tax is equal to one (MPC MPS MPT 1). Similarly, the average propensity to consume and the average propensity to save can be defined out of national income. The average propensity to consume out of national income (APC) is the fraction of national income that is spent on consumption (C/Y). The average propensity to save out of national income is the fraction of national income that is saved (S/Y). Since any amount of national income will either be spent, saved or taxed, the sum of the average propensity to consume out of national income, the average propensity to save out of national income and the average propensity to tax is equal to one (APC APS APT 1). Relationship between the consumption function and the savings function
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In the above diagram, when disposable income is equal to zero, consumption expenditure must be financed by dissavings. At Yd0, where consumption expenditure is equal to disposable income, savings is zero. Below Yd0, where consumption expenditure exceeds disposable income, savings is negative. Above Yd0, where disposable income exceeds consumption expenditure, savings is positive. Induced consumption is positively related to disposable income. In other words, an increase in disposable income will lead to an increase in induced consumption and vice versa. An increase in induced consumption can be shown by an upward movement along the consumption function.
In the above diagram, an increase in disposable income (Yd) from Yd0 to Yd1 leads to an upward movement along the consumption function (C) resulting in an increase in consumption expenditure (C) from C0 to C1. The effect of an increase in disposable income on consumption will depend on the MPCYd. Given any increase in disposable income, the larger the MPCYd, the larger the increase in consumption. Determinants of disposable income National income Disposable income will increase when national income increases. Direct taxes and transfer payments A decrease in direct taxes such as personal income tax and corporate income tax, or an increase in transfer payments such as unemployment benefits, social security benefits and interest payments on national debt will lead to an increase in disposable income. Autonomous consumption is determined by consumer confidence, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. An increase in autonomous consumption can be shown by a vertical upward shift in the consumption function.
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In the above diagram, a vertical upward shift in the consumption function (C) from C0 to C1 leads to an increase in consumption expenditure (C) from C0 to C1 at the same disposable income (Yd0). Determinants of autonomous consumption Consumer confidence (Consumer sentiment) When households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption. Wealth of households When the wealth of households increases, consumption will increase. Interest rates A fall in interest rates will reduce the incentive to save which will induce households to increase consumption. Expectations of price changes When households expect prices to rise, they will bring forward the purchases of some durable goods which will lead to an increase in consumption. Note that this is not the same as consumer confidence which is about expectations of income changes. Availability of credit Many consumer durables are purchased with bank loans and hence an increase in the availability of credit will allow households to increase consumption. Distribution of income Lower income groups have higher marginal propensities to consume than higher income groups and hence a redistribution of income from higher income groups to lower income groups will lead to an increase in consumption.
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4.1.2
Planned investment expenditure (I)
Investment expenditure is the expenditure made by firms on goods produced not for their present use but for their use in the future. In economics, investment is comprised of business fixed investment (new factories and machinery), residential investment (new houses, apartments and condominiums) and inventory investment (the change in the value of unsold goods). There are two types of investment: autonomous investment and induced investment. Autonomous investment Autonomous investment is the part of investment that does not depend on national income and is determined by interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. According to the marginal efficiency of capital theory, or some may prefer to call it the marginal efficiency of investment theory, the marginal efficiency of capital function is the investment function. The investment function shows the investment expenditure of firms at each interest rate. Note: Students do not need to explain the MEC/MEI theory in the examination. All that they are required to do is to state that the MEC/MEI function is the investment function. The marginal efficiency of a type of capital is the discount rate which equates the cost of the type of capital to the present value of its stream of expected returns. The marginal efficiency of capital is the summation of the marginal efficiencies of all types of capital in the economy. Consider a type of capital which will generate returns for three years. Returns (Year1) Returns (Year 2) Returns (Year 3) Cost ------------------------ ------------------------ -----------------------(1 r*) (1 r*)2 (1 r*)3 r* is the marginal efficiency. It should be obvious that the marginal efficiency of a type of capital is its internal rate of returns (IRR). The fund can be loaned out if it is not invested in the type of capital. Therefore, interest rates are the external rate of returns (ERR). The marginal efficiency of a type of capital function is downward-sloping due to diminishing marginal returns. As more and more of a type of capital is employed, each additional unit of it will have less of other types of capital to work with. Therefore, the additional expected returns resulting from investing in one more unit of a type of capital falls. Since the marginal efficiency of capital is the summation of the marginal efficiencies of all types of capital in the economy, the marginal efficiency of capital function is also downward-sloping.
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Marginal efficiency of capital function
In the above diagram, the marginal efficiency of capital (MEC) is higher than the interest rate (r) r0 to the left of investment (I) I0. Therefore, the optimal level of investment is I0. Since investment depends on the marginal efficiency of capital, the marginal efficiency of capital function is the investment function. A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure and vice versa. An increase in investment expenditure due to a fall in interest rates can be shown by a downward movement along the marginal efficiency of capital function.
In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward movement along the marginal efficiency of investment function (MEC) resulting in an increase in investment expenditure (I) from I0 to I1.
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In addition to a fall in interest rates, the number of profitable planned investments and hence investment expenditure will also increase when expected returns on planned investments increase due to stronger business sentiment, lower business costs such as decreases in oil prices and wages or lower capital costs such as decreases in the costs of factories and machinery. Further, a decrease in corporate income tax that will increase expected after-tax returns on planned investments, technological advancements and an increase in the availability of credit will also lead to an increase in investment expenditure. An increase in investment expenditure due to a non-interest rate factor can be shown by rightward shift in the marginal efficiency of capital function.
In the above diagram, a rightward shift in the marginal efficiency of capital (MEC) function from MEC0 to MEC1 leads to an increase in investment expenditure (I) from I0 to I1 at the same interest rate (r0). Induced investment Induced investment is the part of investment that depends on national income. According to the accelerator theory of investment, net investment is determined by the rate of change of national income. When national income rises at an increasing rate, net investment will increase. However, when national income rises at a decreasing rate, net investment will decrease. Since It Kt Kt1 and Kt vYt, It It vYt vYt1 or It v(Yt Yt1), where I net investment, K capital, Y national income or national output and v capital-output ratio. It v(Yt Yt1) is the accelerator equation.
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Example Time Period (t) 0 1 2 3 4 * Assume that v = 2.5
Yt $100 $110 $140 $180 $200
Yt1 --$100 $110 $140 $180
It --$25 $75 $100 $50
From t = 0 to t =3, because national income rises at an increasing rate, net investment increases. From t = 3 to t = 5, because national income rises at a decreasing rate, net investment decreases. The size of the accelerator effect depends on the capital-output ratio (v), also known as the accelerator coefficient. The higher the capital-output ratio, the larger the accelerator effect. For instance, due to the high capital-output ratio in the United States, the accelerator effect is large. Note: In the Keynesian model, planned investment expenditure is assumed to be autonomous as it cannot be expressed as a linear function of national income. In reality, planned investment expenditure is affected by national income.
4.1.3
Government expenditure on goods and services (G)
Government expenditure on goods and services is the expenditure on goods and services made by the government. It includes expenditure on both consumer goods and capital goods. It does not include government expenditure on transfer payments. Transfer payments are payments made by the government to the recipients not in exchange for any goods or services and they include social security benefits, unemployment benefits and interest payments on national debt. About two-thirds of the US federal government expenditure is made on transfer payments. The government can also influence aggregate expenditure by controlling consumption expenditure through changing direct taxes or transfer payments. In addition to the effect on consumption expenditure, a change in corporate income tax will also affect investment expenditure and hence aggregate expenditure. Disposable income National income Transfer payments Corporate income tax Other direct taxes Undistributed corporate profit Personal income tax Taxes T tY, Yd Y T tY, where T autonomous taxes, tY induced taxes and t marginal propensity to tax (MPT). Assuming no transfer payments and undistributed corporate profit.
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Since C a bYd, C a b(Y T tY) or C a bT b(1 t)Y, where a autonomous consumption, bYd induced consumption, b the marginal propensity to consume out of disposable income (MPCYd) and b(1 t) the marginal propensity to consume out of national income (MPC). An increase in t will decrease the MPC and hence make the consumption function (plotted against national income) flatter. Therefore, the AE function will become flatter. However, an increase in T will shift the consumption function (plotted against national income) vertically downwards. Therefore, the AE function will shift vertically downwards. Note: In the Keynesian model, government expenditure on goods and services is assumed to be autonomous as it cannot be expressed as a linear function of national income. In reality, government expenditure is affected by national income. In a recession, the government may increase expenditure on goods and services to increase economic growth and hence reduce unemployment. When the economy is overheating, the government may decrease expenditure on goods and services to reduce inflation. Net exports (X M)
4.1.4
Exports (X) are the expenditure made by foreigners on domestic goods and services. The following are the determinants of exports. Foreign income An increase in foreign income will lead to a rise in exports. The converse is also true. Domestic general price level relative to foreign general price level When the domestic general price level falls relative to the foreign general price level, domestic goods and services will become relatively cheaper than foreign goods and services. When this happens, exports will rise. The converse is also true. Exchange rate When domestic currency depreciates, domestic goods and services will become relatively cheaper than foreign goods and services. When this happens, exports will rise. The converse is also true. Other factors Factors such as comparative advantage, trade policy, quality and tastes will also affect exports. Imports (M) are the expenditure made by domestic residents on foreign goods and services. The following are the determinants of imports. National income An increase in national income will lead to a rise in imports. The converse is also true.
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Domestic general price level relative to foreign general price level When the domestic general price level rises relative to the foreign general price level, domestic goods and services will become relatively more expensive than foreign goods and services. When this happens, imports will rise. The converse is also true. Exchange rate When domestic currency appreciates, domestic goods and services will become relatively more expensive than foreign goods and services. When this happens, imports will rise. The converse is also true. Other factors Factors such as comparative advantage, trade policy, quality and tastes will also affect imports. Mathematically, the import function can be expressed as M m0 m1Y, where m0 autonomous imports, m1Y induced imports, m1 the marginal propensity to import (MPM). Net export function
In the above diagram, as exports are independent of national income and imports rise with national income, the net export function is downward-sloping. 4.1.5 Distinction between planned aggregate expenditure and actual aggregate expenditure Actual aggregate expenditure, or national expenditure, is always equal to national income or national output. However, planned aggregate expenditure is not necessarily equal to actual aggregate expenditure and therefore is not necessarily equal to national income or national output.
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Firms will experience an unplanned increase in inventory investment if they sell less of their output than expected, in which case, actual aggregate expenditure, national output or national income will exceed planned aggregate expenditure. Conversely, if firms sell more of their output than expected, they will experience an unplanned decrease in their inventory investment, in which case, planned aggregate expenditure will exceed actual aggregate expenditure, national output or national income.
4.2
Circular flow of income and expenditure
The circular flow of income and expenditure shows the flow of income and expenditure between the different sectors in the economy.
In the above diagram, households provide factor inputs which include labour, land, capital and enterprise to firms and in return, they receive factor income (Y) in the form of wages, rent, interest and profits. Firms provide goods and services to households and in return, they receive payments known as consumption expenditure on domestic goods and services (CD). However, not all the factor income received by households return to domestic firms as revenue. Rather, some go to the government in the form of taxes (T), some go to the financial sector in the form of savings (S) and some go to the external sector in the form of imports (M). Taxes, savings and imports are known as withdrawals, which are basically the factor income received by households that does not return to domestic firms as revenue. Further, some of the payments received by domestic firms do not come from households. Rather, they come from the government in the form of government expenditure on goods and services (G), the financial sector in the form of loans to finance investment expenditure (I) and the external sector in the form of exports (X). Government expenditure, investment expenditure and exports are known as injections, which are basically are the payments received by domestic firms that do not come from households.
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4.3
Equilibrium national income
The equilibrium national income is the national income that has no tendency to change and it can be determined in three ways: the expenditure-income approach, the injections-withdrawals approach and the AD-AS approach. Expenditure-income approach (AE Y) According to the expenditure-income approach, which is also known as the expenditure-output approach, the equilibrium national income is the national income where planned aggregate expenditure is equal to national income or national output.
In the above diagram, the equilibrium national income is Y0 where planned aggregate expenditure (AE) is equal to national income (Y). At a national income lower than planned aggregate expenditure, such as Y2, firms whose output is insufficient to meet the planned expenditure of the economy will experience an unplanned decrease in their inventories, and to bring their inventories up to the planned levels, they will increase output which will lead to an increase in national income. At a national income higher than planned aggregate expenditure, such as Y1, firms whose output is more than sufficient to meet the planned expenditure of the economy will experience an unplanned increase in their inventories, and to bring their inventories down to the planned levels, they will decrease output which will lead to a decrease in national income. At Y0, firms will not experience any unplanned changes in their inventories and hence there will be no incentive for them to change output. Note: Since AE C I G (X M) and Y = C S T, when AE Y, C I G (X M) C S T. Therefore, when AE Y, I G X = S T M. Injections-withdrawals approach (J W) According to the injections-withdrawals approach, the equilibrium national income is the national income where planned injections are equal to withdrawals. Injections are the payments received by domestic firms that do not come from households and they comprise
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government expenditure on goods and services, investment expenditure and exports. Withdrawals are the factor income received by households that does not return to domestic firms as revenue and they comprise taxes, savings and imports.
In the above diagram, the equilibrium national income is Y0 where planned injections (J) are equal to withdrawals (W), because at this national income, planned aggregate expenditure is equal to national income. At a national income where planned injections are higher than withdrawals, planned aggregate expenditure is higher than national income, and vice versa. Aggregate demand-aggregate supply approach (AD AS) According to the aggregate demand-aggregate supply approach, the equilibrium national income is the national income where aggregate demand is equal to aggregate supply.
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In the above diagram, the equilibrium national income is Y0 where aggregate demand (AD) is equal to aggregate supply (AS). At Y0 where there is neither a shortage nor surplus, firms will not experience any unplanned changes in their inventories and hence there will be no incentive for them to change output. 4.4 Multiplier effect and multiplier
The multiplier effect is the effect of an increase in autonomous expenditure leading to a larger increase in national income.
In the above diagram, an increase in AE leads to a larger increase in national income. Suppose that MPCD 0.8, MPW 0.2 and AE $1000. When aggregate expenditure increases by $1000, firms will employ more factor inputs to produce more output and hence pay more factor income to households. Household income and hence consumption expenditure on domestic goods and services will increase by $1000 and $800 (0.8 $1000) respectively. Due to the increase in consumption expenditure on domestic goods and services of $800, firms will employ even more factor inputs to produce even more output and hence pay even more factor income to households. Household income and hence consumption expenditure on domestic goods and services will increase further by $800 and $640 (0.8 $800) respectively. However, each time household income rises, savings, taxes and imports will rise, and when these withdrawals have increased by $1000 to the level that matches injections, equilibrium will be restored and national income will stop increasing. Note: The marginal propensity to withdraw (MPW) is the fraction of an increase in national income that is withdrawn from the inner flow of income and expenditure. Therefore, MPW MPS MPT MPM. The marginal propensity to consume domestic goods and services out of national income (MPCD) is the fraction of an increase in national income that is spent on domestic goods and services. Therefore, MPCD MPC MPM.
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Round 1 2 3 Sum
Y $1000 $800 $640 $5000
CD $800 $640 $4000
W $200 $160 $1000
In the above table, Y $1000 $800 $640 . Therefore, Y $1000 (0.8)($1000) (0.8)2($1000) . Applying geometric progression, Y $1000/(1 0.8) $5000 AE $1000. The multiplier is the number of times by which national income increases due to an increase in autonomous expenditure. Since Y = AE/(1 MPCD), Y/AE 1/(1 MPCD).
Multiplier Y/AE 1/(1 MPCD)

Since MPS MPT MPM MPCD 1, Y/AE 1/MPW.
Multiplier Y/AE 1/MPW

Since the multiplier is the inverse of the MPW, it will be larger the lower the savings, the lower the income taxes and the lower the imports. The multiplier in Singapore is small due to the high savings and high imports. The high savings in Singapore are due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The high imports in Singapore are due to lack of factor endowments. Note: In reality, when aggregate expenditure rises, real national income will not rise by the full multiplier effect due to a rise in the general price level (which will be explained later).
4.5
Paradox of thrift
Classical economists argue that saving is desirable for the economy. An increase in savings will lead to lower interest rates which will result in higher consumption and investment and hence higher economic growth. However, Keynes argues that an increase in savings is undesirable for the economy. The fallacy of composition is the wrong belief that if something is good for an individual, it is also good for the nation. However, just because something is good for an individual, it does not follow that it is good for the nation.
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If an individual increases savings, he will increase his future consumption. However, if the nation increases savings, it will decrease its future income and future consumption. Given any amount of disposable income, an increase in savings will lead to a decrease in consumption expenditure. Further, the decrease in consumption expenditure will weaken business sentiment which will lead to a decrease in investment expenditure. The decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand and hence national income. The phenomenon of higher savings leading to lower national income is known as the paradox of thrift. Keynes idea is that when the economy is in a recession, people should not tighten their belts. Rather, they should spend their way out of the recession. 5 THE NEO-CLASSICAL THEORY OF INCOME AND EMPLOYMENT
Classical economics and Keynesian economics are traditional schools of thought in macroeconomics. Today, no economist subscribes to these precise collections of views. Instead, what is taught to students today is neo-classical economics which is mainstream economics. Neo-classical economists believe that although prices and wages are totally flexible in the long run, they are rigid in the short sun. Therefore, although the economy will be at the full-employment equilibrium in the long run, it can stay at an above-full-employment equilibrium or a below-full-employment equilibrium in the short run. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. The aggregate demand curve shows the total demand for the goods and services produced in the economy at each general price level over a period of time. Aggregate Demand Curve
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In the above diagram, the aggregate demand (AD) curve is downward-sloping. The AD curve will shift rightwards if there is an increase in C, I, G or (X M). Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the quantity and the productivity of factor inputs, given factor prices. The aggregate supply curve shows the total supply of goods and services in the economy at each general price level over a period of time. Aggregate Supply Curve
In the above diagram, the aggregate supply (AS) curve is upward sloping. The AS curve will shift rightwards if there is a decrease in factor prices or an increase in the quantity or the productivity of factor inputs in the economy. Long-run aggregate supply is the total supply of goods and services in the economy when all factor prices have fully adjusted in the long run and is determined by the quantity and the productivity of factor inputs. The long-run aggregate supply curve shows the total supply of goods and services in the economy when all factor prices have fully adjusted in the long run.
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Long-run Aggregate Supply Curve
In the above diagram, the long-run aggregate supply (LRAS) curve is vertical at the full-employment national income. The LRAS curve will shift rightwards if there is an increase in the quantity or the productivity of factor inputs in the economy. Note: The full-employment national income is the national income where there is no demand-deficient unemployment (which will be discussed in greater detail later). If the economy is at an above-full-employment equilibrium, national income will fall. Above-full-employment equilibrium
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In the above diagram, the equilibrium national income (Y0) is above the full-employment national income (Yf), creating a positive output gap (Y0 Yf). When national income is above the full employment level, unemployment will be below the natural rate. In such a state of the economy, firms will find it difficult to employ workers but workers will find it easy to get jobs which will lead to an upward pressure on factor prices. When factor prices and hence the cost of production in the economy rise in the long run, aggregate supply (AS) will fall from AS0 to AS1 and hence national income will fall from Y0 to Y1. If the economy is at a below-full-employment equilibrium, national income will rise. Below-full-employment equilibrium
In the above diagram, the equilibrium national income (Y0) is below the full-employment national income (Yf), creating a negative output gap (Y0 Yf). When national income is below the full employment level, unemployment will be above the natural rate. In such a state of the economy, firms will find it easy to employ workers but workers will find it difficult to get jobs which will lead to a downward pressure on factor prices. When factor prices and hence the cost of production in the economy fall in the long run, aggregate supply (AS) will rise from AS0 to AS1 and hence national income will rise from Y0 to Y1. If the economy is at the full-employment equilibrium, national income will remain unchanged, other things being equal.
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Full-employment equilibrium
In the above diagram, the equilibrium national income (Y0) is equal to the full-employment national income (Yf). When national income is at the full-employment level, unemployment will be at the natural rate. Therefore, there will be neither upward nor downward pressure on factor prices and hence the short-run equilibrium will be the long-run equilibrium, other things being equal.
INFLATIONARY GAP AND DEFLATIONARY GAP
In the short run, the equilibrium national income may not be equal to the full-employment national income. If the equilibrium national income is higher than the full-employment national income, the economy is at an above-full-employment equilibrium. The output gap, which is the excess of the equilibrium national income over the full-employment national income, is positive. A positive output gap is also known as an inflationary gap.
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Above-full-employment equilibrium
In the above diagram, the equilibrium national income (Ye) is higher than the full-employment national income (Yf). The output gap (Ye Yf) is positive. If the equilibrium national income is lower than the full-employment national income, the economy is at a below-full-unemployment equilibrium. The output gap, which is the excess of the equilibrium national income over the full-employment national income, is negative. A negative output gap is also known as a deflationary gap. Below-full-employment equilibrium
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In the above diagram, the equilibrium national income (Ye) is lower than the full-employment national income (Yf). The output gap (Ye Yf) is negative. If the equilibrium national income is the same as the full-employment national income, the economy is at the full-employment equilibrium. Full-employment equilibrium
When the economy is at the full-employment equilibrium, there is neither inflationary gap nor deflationary gap.
Note: In Keynesian economics, inflationary gap and deflationary gap do not refer to positive output gap and negative output gap. An inflationary gap is the excess of planned aggregate expenditure over national income at the full-employment national income. In other words, it is the decrease in planned aggregate expenditure which is needed to close a positive output gap. A deflationary gap is the shortfall of planned aggregate expenditure below national income at the full-employment national income. In other words, it is the increase in planned aggregate expenditure which is needed to close a negative output gap.
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Chapter 13 - The Theory of Income and Employment Determination

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Chapter 13 - The Theory of Income and Employment Determination

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Written by: Edmund Quek