National Income

Determination
 A Three-Sector Spending Model
Model with the Government Sector
Government Expenditures, Transfers and Taxes
 Government expenditure (G) (spending) consists of its
purchase of goods and services
E.g. payments to govt. employees, military personals,
goods purchased to run govt. and the military, etc..
 Government transfers (Tr) include govt. payments that
involve no direct service by the recipient
E.g. unemployment benefits, welfare payments, interest
on public debt, etc.
 Taxes (Tx), can be independent of income or a proportion
of income
 Aggregate Output, Income
 Aggregate output rises when there is an increase in
govt. spending (G) and decreases when there is a fall
in govt. net tax revenue (Tn)

Net tax revenue (Tn) = Gross Tax Revenue (Tx) –

Govt. Transfers (Tr)

 Fiscal policy consists of changes in taxes, transfers

and govt. spending to effect the level of aggregate
output
 Aggregate Output, Income
 Now, aggregate demand (spending),

AD  C  I  G
 Equilibrium occurs when

Y  C →I Aggregate
G spending approach
or
Tn  S  G
→ ILeakage/Injection approach
 Equilibrium Output
Desired
spending

E’ AD’ = C + I + G

AD = C + I

E

45o
Output, Income
 Equilibrium Output, Income
 Assume that the govt. imposes only direct taxes on
households
 We know, C = a + bY, where Y = Yd (disposable
income), when there is no govt. sector
 With govt. sector, Y = Yd + Tn

i.e., disposable income, Yd = Y – Tn

i.e. Yd = Y – (Tx – Tr) = Y – Tx + Tr
 Therefore, C = a + b(Y – Tn) or C = a + b(Y – Tx +Tr)

= a + bY – bTn or C = a + bY – bTx + bTr

 Equilibrium Income, Output
Value of output should equal Actual leakages should equal the
aggregate spending injections

Y  C  I G S  Tn  I  G
substituting in for C Substituting in for S

Y  a  bY  bTn  I  G (a  (1 b)(Y  Tn)  Tn  I  G

and solving for Y
and solving for Y

Y  bY  a  bTn  I  G (1  b)Y  a  Tn  I  G

Y 
 a  bTn  I  G 
1  b 
 Exercise 1
(A) Suppose
 Planned consumption: C=50+0.80Y
 Intended investment: Rs.50
 Government Expenditure: Rs.10
What is the equilibrium level of income and the aggregate
consumption?
(B) Suppose a lump sum tax of Rs.10 is added to the model,
What is the equilibrium level of income the aggregate level of
consumption?
(C) Suppose there is a transfer payments of Rs.5 from the govt.
What is the equilibrium level of income the aggregate level of
consumption?
 Government Sector Multipliers
 Also called Fiscal Multipliers, since associated with
the fiscal operations of the govt.
(1) Government Expenditure Multiplier
 Represents the changes in the equilibrium level of
income as a result of a change in autonomous govt.
spending of G
 We know, a  I  G  bT x  bT r
Y
1 b
Y 1
 Gm  
G 1  b
 Government Sector Multipliers
The Tax Multiplier
 Refers to a change in the equilibrium level of income (
Y) for a change in autonomous tax revenues T x
Y b
Txm  
T x 1  b
 That is, a rise in tax has a negative effect on the
equilibrium level of income. Similarly, a tax cut
results in a rise in the equilibrium level of income
Government Transfer Multiplier
Y b
Trm  
T r 1  b
 Government Sector Multipliers
The Balanced Budget Multiplier
 It shows the effect of equal changes on government
spending (G) and net tax revenue (Tn) on the
equilibrium level of income
 It is also called Unit Multiplier Theorem, because the
balanced budget multiplier is always equal to unity
 Government Sector Multipliers
The Balanced Budget Multiplier
 That is, when ΔG = ΔT, national income increases exactly by
the amount of increase in the government expenditure (ΔG)

Y 1 Y b
 and 
G 1  b  Tx 1  b

Y Y 1  b 1 b
BBm      1
G Tx 1  b 1  b 1  b
 Taxes Related to Income
 Taxes usually are two types:

(i) a lump sum tax (fixed sum) that is independent of

income (exogenous), and

(ii) tax a proportion of income (income related)

 What happens if there is a proportional income tax?
 Taxes Related to Income
 We know, Tn  Tx  Tr now, Tx  T x  tY

Therefore, Tn  T x  tY  T r
Now, disposable income Yd  Y  (T x  tY  T r )

consumption function
C  a  bYd  a  b(Y  T x  tY  T r )
C  a  bY  bT x  btY  bT r
 Taxes Related to Income
 Substituting C in

Y C  I G
 We get

Y  a  bY  bT x  btY  bT r  I  G
 Solving for Y,
a  bT x  bT r  I  G
Y 
1  b  bt
 Multiplier when Taxes Related to Income
 The Government Expenditure Multiplier
Y 1
Gm  
G 1  b  bt
 The Tax Multiplier
Y b
Txm  
 T x 1  b  bt
 The Government Transfer Multiplier
Y b
Trm  
T r 1  b  bt
 The value of b and t determines the size of the multiplier
When the government reduced income tax rates, there is
a greater increase in the equilibrium level of income than
the effect of an equal decrease in the autonomous net tax
revenues
 Exercise 2
 Suppose C=50+0.8Yd; I=50; G=40; t=0.10; Tr=50; Tx=50

(a) What is the equilibrium level of income?

Also find out the equilibrium level of income, when
(b) There is a reduction in income tax rate from 0.10 to
0.08
(c) There is a reduction in autonomous net tax rate from
50 to 40
 Four-Sector Income Determination Model
Income determination in an Open Economy
 We consider only foreign trade (exports and imports) and
the resulting financial flows
Net Export Balance (XM) =
Gross exports (X) –
Gross imports (M)
 Export demand originates outside
(X  X
the
) economy, therefore,
gross exports are exogenous
 Imports have two parts: (i) autonomous imports,
independent of income,
( M  and
M  (ii)
mY )imports tied to the level of
income
m is the marginal propensity to import
 Equilibrium Output, Income
 In an open economy, the aggregate demand equation
is
Y  C  I  G  (X  M )
Where, C  a  bYd ; Yd  Y  (T x  tY  T r )
I  I; G  G; X  X ; M  M  mY
Substituting in Y
Y  a  bY  bT x  btY  bT r  I  G  ( X  M  mY )

a  bT x  bT r  I  G  X  M
Y
1  b  bt  m
Expenditure Multiplier in an Open Economy
 For any autonomous change in a , I , G , X , the
expenditure multiplier is
1
ke 
1  b  bt  m
 For autonomous changes in T x, T r, the net tax revenue
multiplier is
b
kt 
1  b  bt  m
 The income tax t and the marginal propensity to import,
m in the denominator reduce the value of the multiplier
 Exercise 3
 Given, C = 100+0.80Yd; I = 200; G = 10;
t = 0.25; Tx = 100; Tr = 50; X = 20;
M = 10+0.1Y

Find (1) Equilibrium level of income

(2) Equilibrium value of imports
(3) Foreign trade multiplier
(4) Tax multiplier
(5) How much additional government expenditure
will be required to increase the equilibrium level of
national income by Rs.50?
 Paradox of Thrift

“Every ... attempt to save more by reducing

consumption will so affect incomes that the
attempt necessarily defeats itself.”

--from The General Theory, 1936.

 Paradox of Thrift
 Paradox of thrift is important to the Keynesian theory

 When consumers save more, spending decreases and

equilibrium output is lower
 Unemployment would rise and incomes would fall as
people lost their jobs causing both consumption and
saving to fall as well
 Thus, attempts by people to save more lead both to a
decline in output and to unchanged saving. This
surprising pair of results is known as the paradox of
saving (or the paradox of thrift)
Downward Slopping Aggregate Demand Curve
 Represents the relationship between aggregate
demand and the general price level
 Holding other things constant, the level of real
spending (i.e. AD) declines as the overall price level in
the economy rises
Why AD curve slopes downward?
 Primarily because of the Money Supply Effect

 That is, when prices rise, the real money supply (i.e.
nominal money supply divided by price level) must fall
 The AD Curve
Price
level

P0

P1
Aggregate
demand

Y0 Y1 Real output
 Shifts in the AD Curve
 Except for a change in the price level, anything
that changes aggregate expenditures shifts the
AD curve.

 The main shift factors of aggregate demand are

the following:
 Shifts in the AD Curve
(1) Government Policies
 Monetary Policy: The Central Bank may increase the
money supply, which lowers interest rates inducing higher
levels of investment and consumption
→ AD will shift to the right
 Fiscal Policy: An increase in government spending shifts AD
curve to the right.
If the government raises taxes, household incomes will
fall, they will spend less, AD shifts to the left.
 Shifts of the AD Curve

Price
level

AD1
AD0

Real output
 Shifts in the AD Curve
(2) Foreign Income
 When India’s trading partners go into a recession,
the demand for Indian goods (exports) will fall.
 The India’s AD curve shifts to the left.

 A rise in foreign income leads to an increase in

India’s exports and a rightward shift of the AD
curve.
 Shifts in the AD Curve
(3) Asset Values
 Rise in stock prices increases household wealth and
thereby increase consumption

 Also leads to lower cost of capital and increases business

investment

(4) Advances in technology

 Technological advances can open up new opportunities
for business investments. E.g.: Internet
 Shifts in the AD Curve
(5) Exchange Rates
 When a currency loses value relative to other currencies:
 Export goods produced in that country become less
expensive
 Imports into that country become more expensive
 Foreign and domestic demand for its goods increases.
 Its demand for foreign goods decreases.
 The AD curve will shift to the right.
 When a currency gains value, the AD curve shifts to the left
 Shifts in the AD Curve
(6) Expectations about Future Output and Prices
 If businesses expect demand to be high in the future, the
demand for investment will increase. The AD curve will
shift to the right.
 When consumers expect the economy to do well in the
future, they will spend more now. The AD curve shifts to
the right.

(7) Others:
 Political events, free-trade agreements, etc. affect the
spending decisions of the economic entities and thus the
AD curve
Thank You