CHAPTER 4 NATIONAL INCOME MODELS (II)

4.1 A 3-sector National Income Model

A. Introduction (p.55)
(1) Government can adjust expenditure (G) on goods and services and revenue from
taxes (T) so as to affect national income.
G is into the circular flow while T is from it.
() G function
G ! G" ( function)
(#) T function
T ! T" $ t% ( function)
(&) 'ith tax( the %d ! . )ot all income received can *e spent.
+. Income determination (p.5,)
(1) Alge*raicall-
(a) Income.expenditure approach
Given / ! a $ c%d ! a $ c (%.T)( I ! I"( G ! G"( T ! T" $ t%
0ince 1 ! / $ I $ G in a #.sector model 1 !
0ince at e2uili*rium( % ! 1 % !
Exercise 1
Given / ! &3 $ 3.5(%.T)( I ! ,3( G ! 55( T ! 13 $ 3.%
'hat is the value of e2uili*rium income level 4
(*) Injection.lea5age approach
0ince %d ! % . T and %d ! / $ 0 % . T !
% !
0ince in e2uili*rium( 1 ! %
1
() Graphicall-
/. 6ultiplier for a #.sector model (p.57)
5 !
Remark :
A change in autonomous tax will produce a smaller change in Y than an equal
change in autonomous expenditure.
E.g.
8. If both autonomous E and increase b! the same amount" equilibrium Y will
increase" decrease or being unchanged #
9. Government:s role in affecting % (p.,3)
(1) 12uili*rium income (%") and potential income (%f)
%" ; it is at where !
%f ; the level of national income attained *- an econom- when all in the econom-
are emplo-ed.
%" ma- not *e e2ual to %f <
(a) when %" = %f > gap
. It measures the re2uired amount of increase in the planned aggregate expenditure to
the %" to the level of %f.
. It exists when the level of aggregate expenditure is to maintain the full
emplo-ment national income.
(*) when %" ? %f gap
. It measures the re2uired in the planned aggregate expenditure to lower the %"
to the level of %f.
. It exists when the level of aggregate expenditure is in to maintain the full
emplo-ment national income.
. +- definition( %" cannot exceed %f( so *e-ond %f( a higher value of national
income onl- means a higher value. It is purel- the result of increases in
(we cannot assume a constant price level in this case). The real amount of
national income sta-s at .

/oncluding from (a) and (*) ;

(i) 'henever an econom- has a 9G( it experiences the pro*lem of .
(ii) 'henever an econom- has an IG( it experiences the pro*lem of .
(iii) 'henever %" ! %f( it has neither nor .
Exercise $
In an open econom- with government intervention( which of the following will ensure
full emplo-ment 4
A. saving ! investment
+. saving ! government expenditure
/. saving $ taxation $ imports ! investment $ government expenditure $ exports
9. )one of the a*ove
() The government can change the amount of G and T to achieve certain goals e.g.(
high emplo-ment( price sta*ilit- in an econom-.
@iscal polic- ; (I) discretionar- ( (II) *uilt.in sta*iliAers
(I) 9iscretionar- fiscal polic-
It involves an change in G and T with intention of affecting the econom-.
(a) 1xpansiona-
when %" %f( either G or T
(*) /ontractionar-
when %" %f( either G or T
)umerical illustration ; refer to the text*oo5 p.,&
%onclusion :
&e!nesian national income determination models pro'ide a theoretical rationale for
go'ernment inter'ention in economic affairs at the macro le'el. he go'ernment is
able to manage the le'el of aggregate expenditure. It can (fine)tune* the le'el of
national income through 'arious fiscal policies.
(II) +uilt.in sta*iliAers (p.,5)
. The- are tools of fiscal polic-.
. The- tend to reduce economic during periods of low economic activit- (or
unemplo-ment) and decreasing % during periods of economic activit- (or
inflation).
#
. 0ome important *uilt.in sta*iliAers ;
(a) proportional > progressive tax s-stem
(*) welfare schemes
(c) government purchases
(d) corporate and famil- savings
Remarks :
(i) +ome stabili,ers e.g. progressi'e tax s!stem" welfare schemes create to
work.
(ii) -alue of go'ernment expenditure multiplier is with proportional tax .t/
. / the existence of t the responsi'eness of an econom! to
discretionar! changes in 0 and .
(iii) 1uilt)in stabili,ers can reduce fluctuations but when the econom! is far
below the Yf" fiscal polic! is still necessar!.
(iv) he! ma! reduce the speed of its reco'er!.
Exercise 2
1. (a) BA proportional tax s-stem is often praised for its *uilt.in sta*iliAing effect.
Cowever( it reduces the responsiveness of an econom- to discretionar- fiscal
policies.: 1xplain.
(*) In the light of (a)( comment on the following statement ;
B The desira*ilit- of emplo-ing a proportional tax s-stem depends on the state of
the econom-.:
. 1xplain what is meant *- Dautomatic sta*iliAers of fiscal polic-.E Give at least
examples.
(#) Fther issues related to fiscal polic- (p.,G)
(a) G or T 4
(i) Hocation of effects
G ;
T ;
(ii) 9uration of time lag
decision lag and executive lag
G ;
T ;
(iii) Ieversi*ilit- of the polic-
; eas- to raise *ut difficult to cut
; easier to change in *oth directions
&
(iv) Ju*lic:s reaction to short.term changes
T ;
G ;
(*) 'a-s of financing government expenditure
(i) raising taxes
raising taxes !? G can *e raised *ut when T increases !? %d !? /
transfer of purchasing power from to
(ii) printing more mone-
if the econom- is alread- at its full emplo-ment !? !? purchasing
power
(iii) internal de*t (a transfer of purchasing power from lenders to itself)
. if the de*t is for current consumption (e.g. transfer pa-ment to the
unemplo-ed) reduction in 2uantit- of capital assets left to future
generation and reduction in private investment future generations: real
income will *e than otherwise
. if the de*t is on creating capital assets e.g. *uilding or renovating
infrastructure create future income
0till( if the repa-ment of de*t are made from tax revenue !? taxpa-ers in
future generations suffer a reduction in their
(iv) external de*t (transfer purchasing power from foreigners to itself)
*urden on future generations still depends on ;
.
.
(c) The concept of efficienc- in taxation
. 1fficienc- in taxation means minimum *urden.
. 'henever a tax distorts prices and hence people:s choices( it produces an
. (Iefer to the example on p.K1)
1. +alanced.*udget multiplier (p.K)
(1) Government multiplier
() Tax multiplier
(#) +alanced.*udget multiplier (5*)
5* !
If t ! 3( i.e.( all taxes are autonomous (lump sum) 5* !
@. Jro*lems of the simple Le-nesian multiplier
5
Iefer to p.,K
Exercise 3
1xplain wh- tax.financed government expenditure is expansionar-.
4.2 A 4-sector National Income Model (p.75)
A. Introduction
(1) 1conom- conducts international .
() . 1xport function is an autonomous function ; M !
. 1xports are into the circular flow of income
. 1xports depend on ;
(a) the of commodities in the home econom- as compared to those in
other economics
(*) trade policies of other countries e.g. free trade or protectionism measures
(c) the level of national of other countries
(d) conditions in the foreign exchange mar5et. A change in foreign exchange rate
will change the of all traded commodities.
(#) Import function is an function ; 6 ! 6" $ m%
Imports are out of the circular flow of income.
+. Income determination (p.K,)
(1) Alge*raicall-
(a) Income.expenditure approach
Exercise 4
Given / ! &3 $ 3.5%d( I ! ,3( G ! 55( T ! 13 $ 3.%( M ! 3( 6 ! 13 $ 3.%
@ind out the value of e2uili*rium national income.
(*) Injection.lea5age approach
!
() Graphicall- (p.K,)
/. 6ultiplier for &.sector model
,
5 !
9. +alance of trade
/ontinue the 2uestion in 1xercise 5(
At % ! 33( the 6 !
the *alance of trade ! M . 6 ! (trade )
%" ma- not guarantee external e2uili*rium
. There is sometimes a conflict *etween external and internal e2uili*rium
. It is also not necessar- that internal e2uili*rium implies *alance *udget. ( T . G !
! )
Exercise 5
1. In a closed econom- with /( autonomous I and G so that in e2uili*rium % ! / $ I
$ G. 0uppose consumers of this econom- are of groups( half of them having /1
! 3.7 %1 and the other half having / ! 3.G%.
(a) @ind the aggregate consumption function if each group earns half of the
aggregate income. 0how -our steps.
(*) Assume some income is transferred from those with a low 6J/ to those with
high 6J/(
(i) 'hat will *e the effect on e2uili*rium aggregate income 4 1xplain *riefl-.
(ii) 0uppose investment is dependent on the r. +riefl- explain what 5ind of
investment function will lead to results similar to the in (i).
. Ieview 1xercise 1 8.1&
4.3 Aggregate Demand (AD) and Aggregate Sppl! (AS)
(p.77)
"#e $asic AS and AD model
A. Introduction
In macroeconomics( the general price level (J) and the aggregate output (8) are
determined *- the interaction of and .
(1) A9 is the 2uantit- of output that is at ever- price level.
() A0 is the 2uantit- of output that will *e at ever- price level.
(#) The e2uili*rium price level and aggregate output occur when the

. If the e2uili*rium is *elow full emplo-ment( there is a gap.
K
. If the e2uili*rium is a*ove full emplo-ment( there is an gap.
. If the e2uili*rium is at the full emplo-ment level( the econom- is operating
at emplo-ment.
+. A9
(1) 'h- does A9 curve slopes downward 4
(a) Income and wealth effect (or real.*alance effect)

(*) 0u*stitution of foreign goods effect
(c) Interest rate effect
() 'h- does A9 curve shift 4
(a) Government expenditure( taxation( consumption( investment( export( import
(*) 1xpectations a*out the future state of the econom-
(c) Jopulations
(d) 6one- suppl-
/. A0 (p.K7)
(1) Three different points of view a*out the shape of A0 ;
(a) Le-nesian (5in5ed) A0 curve (p.KG fig.7a)
1xplanation for such a shape ;
. The horiAontal segment is caused *- the existence of wor5ers and idle
resources.
. It is possi*le to raise the real output *- simpl- emplo-ing the unemplo-ed
wor5er at the existing wage rate and can leave the unchanged.
. As income level (8f) is reached( no matter what the prices are( the
output cannot *e increased an-more.
%onclusion :
(i) At an output le'el than the 6f" changes in A7 can expand the real
output without causing the general le'el to change.
(ii) 8nce the econom! has reached 6f" an! changes in A7 will onl! raise the
general while output remains at .
7
Implication :
In the simple &e!nesian model" changes in AE .i.e."A7/ will result in
changes in the le'el of national income. he A+ is irrele'ant to the
determination of real national income.
(*) Npward.sloping A0 curve (0IA0) (p.KG( fig.7*)
1xplanation ;
In the short run as the 2uantit- of aggregate output supplied increases( the
costs of production will go up as well (due to the law of
) price increases with rising output.
(*) /lassical A0 curve (p.73( fig.7c)
1xplanation ;
If there are no idle mone- *alances( mone- is used simpl- as a medium of
exchange( when people earn income *- suppl-ing their factor services( the
entire sum will *e spent to *u- exactl- the same amount of goods and
services. (0a-:s Haw ; 0uppl- creates its own demand . p.1G3)
@or the societ- as a whole( there will *e no or .
The A0 curve is a vertical straight line starting from the level of
income.
() 'h- does A0 curve shift 4
(a) @actors of production
prices of the factors of production rises

(*) Technolog- and productivit-
Technolog- improvement

(c) 1xpectation
If expectation a*out the future state of the econom- is more positive

9ote : he equilibrium price le'el and aggregate output occur when A7 intersects A+.
In other words" when A7 or:and A+ change" the equilibrium ; and 6 change"
too.
9. /omparing A9.A0 model with Le-nesian model
(1) The A9.A0 model esta*lished the e2uili*rium level of national income through the
G
intersection of the and curves.
The income.expenditure model (Le-nesian model) uses the intersection of the
to find the e2uili*rium level of national income.
() A9.A0 model has the advantage of allowing the general price level to *e
determined and the A0 curve to shift.
Income.expenditure model assumes that the price level is and allows the
components of the A1 (i.e.( /( I( G( net exports) to *e examined.
4.4 Multiplier Effect With Changing Price Level (p.82)
(1) Nnder Le-nesian A0 curve
(a) when there is unemplo-ment( the multiplier effect remains unchanged (same
as that under simple Le-nesian model).
8. 7o !ou know wh! #
(*) when there is full emplo-ment( the multiplier will have no effect on real
income when expenditure increases autonomousl- (A9 shifts). Fnl- and
income will increase.
() Nnder classical A0 curve
The multiplier effect will *e the same as that in .
(#) Npward.sloping A0 curve
A rise in A9 will lead to a rise in purchasing power consumers: spending
the siAe of the multiplier effect will *e .
13