National Income Determination

Question 1

Consumption demand

Answer 1

In a simple economy people either spend their disposable income or save.
Y=C+S
Consumption is part of income that is not saved
Households buy goods and services ranging from food, cars, TVs, legal services, entertainment, healthcare etc.
Consumption(C) is the single largest components of Aggregate Demand(AD).

Question 2

The Consumption Function

Answer 2

The consumption function shows the level of aggregate desired consumption at each level of income.
According to Keynes, consumption is a function of income i.e. C=f(Y)
In a simple model where there is no government hence no transfer payments or taxes disposable personal income (Yd) is equal national (Y).
The consumption function is a straight line written as C = Co + cY.
Y=mx+c
C=bY
With zero income, desired consumption is Co millions.
This is the autonomous consumption that does not depend on
income.

Question 3

Average Propensity to Consume (APC)

Answer 3

This is the average relationship between consumption and income.
It is the fraction of the income that is devoted to consumption.
It obtained by diving the total consumption by income.
APC= C/Y

Question 4

Marginal Propensity to Consume (MPC)

Answer 4

This is the slope of the consumption function.
It is positive showing that as income increases, consumption also increases.
It is the fraction of the change in income that is spent on consumption.
It obtained by diving the change total consumption by change income.
MPC= change in C/ change in Y
It is given by c in the equation C=Co+cY
For example, if consumption function is given as
C = 80 + 0.7Y;
Eighty (80) shillings is autonomous consumption.
MPC is 0.7 which means that if income increases by one shilling, consumption rises by 70 cents.

Question 5

Savings function

Answer 5

Savings are the amount of income that is not consumed.
It is the difference between consumption and the income
Saving is a function of income i.e. S=f(Y)
But Y=C+S
Hence S=Y-C
If C=C0+cY
Hence S=Y-(C0+cY)
S=-C0+(1-c)Y
Where; -C0=autonomous saving i.e. savings one make without income. It is negative since one cannot without income(dis-saving)
1-c=MPS
c=MPC
MPS=1-MPC
MPC+MPS=1
Thus when Y = 0, S = -a
From the consumption function C = 80 + 0.7Y;
This means that when income is zero savings is –80 shillings. Thus households are dis-saving or running down their assets.
Moreover since 70 cents of every shilling is consumed, 30 cents of every one shilling must be saved.

Question 6

Marginal Propensity to Save

Answer 6

This the slope of the savings function.
It is the fraction of the change in income that is saved.
It is positive showing that as income increases, savings also increases.
It may be expressed as follows;
MPS= change in S/ change in Y

Question 7

Relationship between the saving and consumption propensities

Answer 7

APS + APC = 1; this is because income is either saved or consumed, it follows that the fraction of incomes consumed and saved must account for all income.
Thus Y = C + S.
Dividing all through by Y we get
Y = C + S = 1 = APC + APS
Y Y Y
(ii) MPC + MPS = 1; it also follows that the fractions of any increment to income consumed and saved must account for all of that increment.
Y = C + S= 1 = MPC + MPS

Question 8

Investment Demand

Answer 8

Investment demand consists of the firms desired or planned additions to both their physical capital and to their inventories.
Usually, investment decision is governed by output and/or the rate of interest.
Investment can either be autonomous or induced

Question 9

Autonomous investment

Answer 9

investment that does not depend either on income/output or the rate of interest.
We assume that there is no close connection between the current level of output and the current guesses about how demand for output will change.
That is, firms demand for investment mainly depends on their
expectations about the future demand for their output.
Plotted against income on a graph, therefore it is simply presented by horizontal straight line as shown.

Question 10

Induced investment

Answer 10

This is the investment that is dependent on the level of income or on the rate of interest is called induced investment.

Question 11

Aggregate demand

Answer 11

The concept of aggregate demand (AD) refers to the total demand for goods and services in an economy.
AD is related to the total expenditure flow in an economy in a given period.
Aggregate expenditure and GDP(Y) are both function of consumption, investment, government spending, and net exports. So the equations for the two are identical:
Y(GDP) = C + I + G + X-M, and
AE (aggregate expenditure) = C + I + G + X-M
In our simple closed economy where there is no government and foreign sectors AD(AE) = C + I
The 45-degree line then depicts each point in this diagram in which aggregate production (Y) is equal to aggregate expenditures (AE). For this reason, the 45-degree line is also labeled Y=AE(AD).

Question 12

Equilibrium national income

Answer 12

Equilibrium is the state of rest in which there is no tendency for it to change.
In the simple model where there is no government sector and no foreign sector Y= Yd.
Firms produce output and pay out the proceeds to households as
factor incomes.
Whenever AD falls below its full employment level, firms are unable to produce as much as they would like i.e. there would be involuntary excess capacity. There would be involuntary unemployment.
The Short run equilibrium in the goods market is achieved when AD just equals the output i.e. when AD = Y (where Y is the output) i.e Y=C+I
There is neither shortage nor surplus in the economy.
Equilibrium national income occurs where the AD schedule crosses the 45o line which represents the set of points where aggregate expenditure in the economy is equal to output, or national income
Y= a + Io
1- b
Where Y is the equilibrium value of national income; a
= autonomous consumption while b = marginal propensity to consume.
Equilibrium condition requires that the AD should just be equal to the total value of goods and services produced represented by Y.
Thus at equilibrium AD = Y.
Taking into account the government and foreign sector:
AD = C+ I + G + (X – M).
When national income (Y) is either spent on consumer goods, saved or paid out as taxes.
Thus Y = C + S + T
Thus the condition for equilibrium can be written as AD = Y
C + I + X – M = C + S + T
I + G + X = S + T + M

Question 13

Changes in national income

Answer 13

AD plays a central role in determining the value of national income.
Shifts in AD function cause changes in national income.
For any specific AD function, there is a unique level of equilibrium national income (Y).
If AD function shifts, equilibrium will be disturbed and national income will change.
The AD function shifts when one of its components shifts.
In a simple closed economy it will shift if consumption or the investment expenditure changes.
I, G, and X are called injections (J) into the flow of income and expenditure. They are autonomous.
Thus total injections are also autonomous, so that when plotted against income on a graph, it will be a horizontal straight line.
S, T and M are called withdrawals (W).
Thus, the condition for equilibrium can be written J = W
Of the withdrawals, savings and imports are both directly related to income but taxes are lump sum.
This means that total withdrawals will be directly related to income.

Question 14

Inflationary gap

Answer 14

It arises when an increase in spending moves the economy away from the equilibrium at full employment position.
It is the amount by which aggregate demand rises above the level necessary for full employment in the economy

Question 15

Closing inflationary gap

Answer 15

Reduction in government spending

Increase in taxation to reduce aggregate demand

Question 16

Deflationary gap

Answer 16

This refers to a situation where aggregate expenditure falls short of that required to produce a level of national income that would ensure full employment.
This is shown by aggregate expenditure function which cuts 45 degree line at less than full employment level of national income

Question 17

Closing deflationary gap

Answer 17

Increasing people’s incomes through reduction of income taxes
Reducing prices through reduction of indirect taxes
Increase in government expenditures.

Question 18

Government expenditure

Answer 18

The government expenditure is assumed to be autonomous i.e. the government decides on how much it wishes to spend and holds on to this plan no matter the level of income.

Question 19

Tax revenues

Answer 19

Tax payments reduce disposable income hence reduces AD.
Net taxes are defined as total tax revenue minus total transfer payments made by the government denoted by T.
The difference between total government revenue (T)and total government spending (G) i.e. net taxes minus government spending, (T- G) is called the budget balance.
When government revenue (T) exceeds government expenditure (G), the government is said to be running a budget surplus.
When government expenditure (G) exceeds government revenue (T), the government is said to be running a budget deficit.
Whenever there is a deficit the government must borrow the excess spending over revenue).
It does this by selling government bonds to the public.
When (T = G), the budget surplus and budget deficit is zero and the government is said to be running a balanced budget.

Question 20

Tax functions

Answer 20

(i) Lump sum: the amount of tax that does not depend on income written as To .
(ii) Proportional tax rate written as tY:
Proportional tax rates are also assumed to be autonomous i.e. the government sets its tax rates and does not vary them as national income varies.
This however implies that the tax revenues are induced
i.e. the tax revenues rises with Y.
(iii) Taxes can be combined i.e. T = To + tY , where
To = lump sum tax and t = proportional tax rate.
The presence of taxes changes the consumption function which becomes:
C=a+bY
C = a + bYd
Disposable income = National income minus net taxes
(Yd = Y – T).

Question 21

Foreign sector

Answer 21

Exports (X) depend on spending decisions made by foreigners (consumers and firms) to buy domestic output.
Therefore, exports will not change as a result of changes in national income i.e. they are autonomous.
Imports (M) however depend on spending decisions of domestic residents i.e. imports will rise with an increase in income.
The difference between the value of exports and imports
(X-M) is called net exports or trade balance.
When exports exceed imports, the country has a trade surplus. When imports exceed exports, the country has a trade deficit.
Exports (X) depend on spending decisions made by foreigners (consumers and firms) to buy domestic output.
Therefore, exports will not change as a result of changes in national income i.e. they are autonomous.
Imports (M) however depend on spending decisions of domestic residents i.e. imports will rise with an increase in income.
The difference between the value of exports and imports
(X-M) is called net exports or trade balance.
When exports exceed imports, the country has a trade surplus. When imports exceed exports, the country has a trade deficit.
X=X0
M=M0 +mY

Question 22

The multiplier

Answer 22

It is a measure of the relationship between the change in the equilibrium national income and the autonomous expenditure or change that brought it about.
It is the ratio of the change in GDP to the change in autonomous expenditure i.e. change in national income divided by the change in autonomous expenditure that brought it about.
The size of the simple multiplier depends on the slope of the AD function given by the marginal propensity to spend.
Multiplier/investment multiplier/government multiplier = total change in national income/initial change in autonomous expenditure/investment/government spending

Question 23

Balanced Budget Multiplier

Answer 23

Although an increase in government expenditure is the same as a decrease in taxes, the effect of the increase in government spending will always outweigh the effect of the taxes.
Because of this the tax multiplier will always be less than the government multiplier.
Balanced budget implies that planned government expenditures equal revenue. That is, G = T
When G > T , the budget is in deficit
When G < T , the budget is in surplus
When G = T , the budget is balanced
Increase in equilibrium income due to an increase in government spending, in a closed economy with lump sum taxes only
The fall in the equilibrium income due to the increase in lump-sum taxation to meet the revenue needs of increase in G

Question 24

Multiplier when Tax Depends on Income

Answer 24

T = t0+t1Y
t0 =autonomous tax
t1 =tax rate
t1Y =tax dependent on y

Question 25

The Business Cycles

Answer 25

The business cycle is the tendency for output and employment to fluctuate around their long-term trends.
A business cycle is a cycle of fluctuations in theGross Domestic Product(GDP) around its long-term natural growth rate.
It explains the expansion and contraction ineconomic activitythat an economy experiences over time

Question 26

stages of business cycle

Answer 26

Expansion
Peak/boom
Recession 
Depression 
Trough
Recovery

Question 27

Expansion

Answer 27

There is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services.
Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high.
This process continues as long as economic conditions are favorable for expansion.

Question 28

Peak

Answer 28

The maximum limit of growth is attained.
The economic indicators do not grow further and are at their highest.
Prices are at their peak.
This stage marks the reversal point in the trend of economic growth.
Consumers tend to restructure their budgets at this point.

Question 29

Recession

Answer 29

The demand for goods and services starts declining rapidly and steadily in this phase.
Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market.
Prices tend to fall. All positive economic indicators such as income, output, wages, etc., consequently start to fall.

Question 30

Depression

Answer 30

There is a commensurate rise in unemployment.

The growth in the economy continues to decline, and as this falls below the steady growth line.

Question 31

Trough

Answer 31

In the depression stage, the economy’s growth rate becomes negative.
There is further decline until the prices of factors, as well as the demand and supply of goods and services, reach their lowest point.
The economy eventually reaches the trough. It is the negative saturation point for an economy.
There is extensive depletion of national income and expenditure.

Question 32

Recovery

Answer 32

In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate.
Demand starts to pick up due to the lowest prices and, consequently, supply starts reacting, too.
The economy develops a positive attitude towards investment and employment and production starts increasing.
Employment begins to rise and, due to accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investments in the production process.
Recovery continues until the economy returns to steady growth levels. It completes one full business cycle of boom and contraction. T
The extreme points are the peak and the trough.

Question 33

There are a number of explanations of the business cycle but changes in the level of investment seem to be the most likely.

Answer 33

• An increase in investment leads to a larger increase in income and output in the short run. Higher investment not only adds directly to aggregate demand but by increasing income adds indirectly to consumption demand. A process known as the multiplier. The reasons for change in investment may be explained as follows.
• Firms invest when their existing capital stock is smaller than the capital stock they would like to hold.
• When they are holding the optimal capital stock, the marginal cost of another unit of capital just equals its marginal benefit, this is the present operating profits to which it is expected to give rise over its lifetime.
• This present value can be increased either by a fall in interest rates at which the stream of expected profits is discounted or by an increase in the future profit expected.
• In practice, it is generally believed that changes in expectations about future profits are more important than interest rate changes.
• If real interest rates and real wages change only slowly, the most important source of short term changes in beliefs about future profits is likely to be beliefs about future levels of sales and real output
• Other things being equal, higher expected future output is likely to raise expected future profits and increase the benefits from a marginal addition to the current capital stock