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ECONOMICS 11
TOPIC 10
DETERMINATION OF NATIONAL INCOME
U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB
OBJECTIVE
Explain fluctuations in national income
Helps understand changes in national income
Helps in formulating policy and business
decisions
The road ahead
Basic framework
Consumption and income
Two sector economy
Three sector economy
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BASIC FRAMEWORK
Tasks
Define aggregate expenditure and
equilibrium income
Describe how the economy adjusts to
equilibrium
Explain how changes in aggregate
expenditure affect equilibrium income
Aggregate expenditure (AE)
total amount that all economic agents
want/plan to spend on domestic
goods/services
Agents: households, firms, govt, foreigners
Common formulation
AE = C + I + G + X M
C = consumption, I = investment, G = govt
spending, X = exports, M = imports
Note: AE is not the same as GDP.
AE = planned spending
GDP = actual spending/output
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AE and National output (Y)
There is no reason to expect that Y and AE are
equal.
Firms formulate production plans armed only with an
estimate of how much economic agents want to buy.
If AE is not equal Y, then firms adjust production
AE > Y, increase production
AE < Y, decrease production
Discrepancies between AE and Y reflected in
unintended inventories
AE > Y, firm inventories fall
AE < Y, firms accumulate inventories
Equilibrium: Y = AE
Why? No longer an incentive to adjust
production
Illustration
Assume AE does not respond to changes in
income
Horizontal line in (Y,AE) space (AE schedule)
Highly unrealistic but sufficient for now
45
0
line: illustrates all potential equilibrium
positions (Y = AE)
Equilibrium: intersection of the 45
0
line and AE
schedule
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45
E
0
AE
20
AE
0
20
Y
Y*
Equilibrium
45
E
0
AE
20
AE
0
20
Y
Y*
AE > Y
raise production
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45
E
0
AE
20
AE
0
20
Y
Y*
AE < Y
Reduce production
45
E
1
AE
1
30
AE
0
30
Y
Y
1
Higher AE raises equilibrium income (Y*)
20
20
Y
0
AE
0
E
0
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Keynes (1936)
suggested that
consumption
spending tends to
increase with
income
Higher income leads
to higher
consumption
spending
Income Consumption
(Y) (C)
0 200
200 350
400 500
600 650
800 800
1,000 950
1,200 1,100
1,400 1,250
1,600 1,400
CONSUMPTION AND INCOME
Low levels of Y
C > Y
Y C
0 200
200 350
400 500
600 650
800 800
1,000 950
1,200 1,100
1,400 1,250
1,600 1,400
Break-even level:
C = Y
High levels of Y
Y > C
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Autonomous
consumption
Y C
0 200
200 350
400 500
600 650
800 800
1,000 950
1,200 1,100
1,400 1,250
1,600 1,400
Marginal propensity
to consume (mpc) =
change in
consumption
spending for a one
peso increase in
income
mpc = C / Y
Example
Y C
0 200
200 350
400 500
600 650
800 800
1,000 950
1,200 1,100
1,400 1,250
1,600 1,400
C = 500 350 = 150
Y = 400 - 200 = 200
mpc = C / Y
= 150/200 = 0.75
a 1 peso increase in
Y leads to 75 centavo
increase in C
Note: 0 < mpc < 1
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Completing the table
Y C Y C C/Y
0 200 _
200 350 200 150 0.75
400 500 200 150 0.75
600 650 200 150 0.75
800 800 200 150 0.75
1,000 950 200 150 0.75
1,200 1,100 200 150 0.75
1,400 1,250 200 150 0.75
1,600 1,400 200 150 0.75
Consumption schedule (based on values
in the previous table)
0
200
400
600
800
1000
800 1200
1600
400
1200
1400
1600
C
Y
C
Autonomous
consumption
Slope is the
mpc
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Drawing a 45
0
line helps identify some
important regions
0
200
400
600
800
1000
800 1200
1600
400
1200
1400
1600
C
Y
C
45
0
Break-
even
Y > C
Y < C
Mathematical representation:
Consumption function
Autonomous
consumption
Example consistent with the
numbers in the table:
C = 200 + 0.75 Y
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TWO-SECTOR MODEL
Two sectors: Households and firms
No govt and no foreign trade
Implication
AE = C + I
Assumption: I is autonomous and equal to
100
Next slide: Integrate to previous table on
consumption and income
Y C I AE
400 500 100 600
600 650 100 750
800 800 100 900
1,000 950 100 1,050
1,200 1,100 100 1,200
1,400 1,250 100 1,350
investment
AE = C + I
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Y C I AE
400 500 100 600
600 650 100 750
800 800 100 900
1,000 950 100 1,050
1,200 1,100 100 1,200
1,400 1,250 100 1,350
Equilibrium: Y = AE
Example, equilibrium income (Y*) = 1,200
Graphical treatment: Revised AE
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Graphical treatment: Equilibrium
Experiment: What
if I investment
rises from 100 to
200? I.e. I =
100
Equilibrium
income rises from
1,200 (our original
value) to 1,600
Y C I AE
400 500 200 700
600 650 200 850
800 800 200 1000
1,000 950 200 1150
1,200 1,100 200 1300
1,400 1,250 200 1450
1600 1400 200 1600
1800 1550 200 1750
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Graphical treatment
Summary: The 100 peso increase in
investment led to a 400 peso
increase in equilibrium income.
Question: Why is the increase in Y
bigger than the increase in I?
The answer lies in the notion of the
multiplier.
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Multiplier ()
Measures the change in income for a
unit change in an autonomous
component of aggregate expenditure
investment in the previous experiment
Mathematical representation for the
change in investment
How is the multiplier calculated?
Applied to our example:
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Using the multiplier to infer the
effects of a change in investment:
This explains why a 100 peso increase
in investment led to a 400 peso
(=4*100) increase in Y*
Why is the multiplier greater than 1?
Round C I Y
1 0 100 100
2 mpc[100] 0 mpc100
3 mpc [mpc100] 0 mpc
2
100

n mpc[ mpc
n-2
100] 0 mpc
n-1
100
Initial increase in
investment
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Mathematical derivation
Algebraic treatment of income
determination
Key equations
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Substituting the consumption and
investment equations into the
equilibrium condition:
Solving for Y:
Applied to our example
Key equations
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Substituting the consumption and
investment equations into the
equilibrium condition:
Solving for Y:
Question: Where in all this is
saving?
Saving represents that component of
income which is not spent on consumption
(i.e. S = Y-C)
The story on how savings fits into the
current topic will be discussed in another
course (Econ 101).
WAKAS