Lecture 1:

Simple Keynesian Model

National Income Determination
Two-Sector National Income Model

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Outline
 Introduction
◦ Preliminaries definitions and concepts
 National Income Determination Model OR
Simple Keynesian Model
◦ Consumption Function
◦ Investment Function
◦ National Income Identities
◦ Expenditure Function
 Equilibrium condition

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Macroeconomics
 Recall that the study of macroeconomics
focuses on a set of issues and goals:
◦ National income, general price level and inflation
rate, unemployment rate, interest rate and the
exchange rate

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Macroeconomics
 What is GDP?
 Rising long term trend in GDP ensures

continuous growth
 However, short term characterized by

oscillations.
 Why does GDP behave as it does?

◦ Rising in some periods and falling in others?

◦ What can governments do to influence it?
 To answer, we need a theory of national income
◦ i.e. a theory that explains the size of and changes in
national income

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Key Concepts
 Expenditure flows
◦ Expenditure flows are real (not nominal) flows
 i.e. measured in constant prices because we are
concerned with real changes
◦ All expenditure flows are planned (or desired) flows
 i.e. what people intend to spend, and not what they
actually spend
◦ All expenditure flows are aggregate flows
 We are not concerned with the behaviour of individual
households or firms

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Basic Assumptions
 Potential national income is constant
◦ An economy’s productive capacity changes slowly from year
to year
 There are unemployed supplies of all factors of
production
◦ i.e. output can be increased by increasing use of unemployed
land, labour or capital, without bidding up prices
 The interest rate and general price level are constant
◦ Assumption relaxed in later studies
 There are only households and firms (2-sector).
 No government and foreign trade

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Recap: Circular Flow Model
 Underlying
assumptions?
◦ Only two economic
units and only two
markets
◦ Households own all
factors of production
◦ Households spend all
their resources in the
market for goods and
services

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The Circular Flow of Income
 This refers to the flow of expenditures on output
and factor services passing between domestic
firms and households
 Any other flow that is not a part of this model is

either an injection or a withdrawal/ leakage

 Injection

◦ Income received, either by households or firms, that does

not arise from the spending of the other group
 Withdrawal
◦ Income received, either by households or firms, that is
not passed on to the other group by buying goods or
services from it

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The Circular Flow of Income
 Only domestic households and firms
 Economy produces only 2 kinds of

commodities
◦ Consumer goods- produced by firms and sold to
households
◦ Investment goods- produced by firms and sold to
other firms that use them

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The Basic Model:
The Effects of Savings and Investments
 Households receive income from firms and pass back
through consumption expenditure
 Savings is income received by households that they do

not pass back

◦ Savings an injection or withdrawal?
◦ Exerts a contractionary force on the flow of income
 Investments expenditure creates incomes for the firms
that produce capital goods and for the factors they
employ
◦ This income does not arise from household expenditures
◦ Investment expenditures injection into the economy or a
withdrawal?
◦ Exerts an expansionary force on the flow of income

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Definitions
 Given assumptions, total output wholly
dependent on total demand
◦ Not supply since we assume unemployed factors
 Total demand comprises
◦ Desired consumption expenditure, C
◦ Desired investment expenditure, I
 Aggregate desired expenditure refers to total
amount of purchases that all spending units
(firms and households) within the economy
wish to make
 i.e. E= C + I

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Behavioural Assumptions about C
and I
 Autonomous vs Induced expenditures
◦ Autonomous/ exogenous- expenditure flows that
are not influenced by any variable the theory is
designed to explain
◦ Theory explains variations in national income so
any expenditure that does not vary with national
income is exogenous
◦ Also called constants. Can change, but not for
reasons explained by the national income theory

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Behavioural Assumptions about C
and I
 Autonomous vs Induced expenditures
◦ Induced/ endogenous expenditures- any
expenditure that is related to national income
◦ Variations in these expenditure flows are induced
by changes in national income

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Behavioural Assumptions about C
and I
 The Investment, I, component
◦ For now, we assume investment fixed
 Firms plan to spend a constant amount on plants and
equipment each year
 Firms plan to hold their inventories constant
 Planned housing construction is constant from year to
year
◦ Investment is therefore an autonomous/ exogenous
expenditure flow
◦ i.e. I= I*
 Graphical Illustration

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 Investment Function:
Graphical Illustration
Investment expenditure

I = I*

Real National Income

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Behavioural Assumptions about C
and I
 The Consumption, C, component
◦ Consumption is a function of national income
◦ We assume that consumption is always a constant
fraction of national income
◦ i.e. C= cY, 0<c<1
 Where c is the fraction of income spent on
consumption
◦ Households also decide how much of their income
to consume and save
◦ i.e. S= sY, 0<s<1 and s= 1-c
 Where s is the fraction of income saved
 Graphical Illustration of consumption function

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 Consumption Function:
Graphical Illustration
Consumption expenditure

C = cY
Consumption expenditure
C = C’

Real National Income Real National Income

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Consumption Functions
 We know that C= cY
 What happens if c  ?
 What happens if Y  ?

 But what exactly is c?

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Propensities to Consume and Save
 Consumption propensities summarize the
relationship between consumption and
income

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Consumption Function
 Marginal Propensity to Consume MPC = c
◦ It is defined as the change in consumption per unit
change in income
◦ It is the proportion of each new increment of income
that is spent on consumption
◦ C= cY
◦ MPC = C / Y
 Average Propensity to Consume APC= c
◦ It is defined as the ratio of total consumption C to
total income Y
◦ It is the average amount of all income spent on
consumption
◦ APC = C / Y

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 Consumption Function
 Relationship between APC and MPC
 C = cY
 Divide by Y to obtain APC

◦ C/Y = c
 Differentiate by Y to obtain MPC
◦ C / Y = c
 Therefore, when C= cY, APC = MPC = c

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National Income Identities
 An identity is true for all values of the
variables
 In a 2-sector economy, expenditure consists
of spending either on consumption goods C
OR investment goods I.
 Aggregate expenditure (AE OR E) is ,by
definition, equal to C plus I
 E  C + I

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National Income Identities
 National income Y received by households, by
definition, is either saved S OR consumed C.
 Y  C + S

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National Income Identities
 In equilibrium, aggregate expenditure E is, by
definition, equal to national income Y
 Y  E (output- expenditure approach)
 C + S  C + I
  S  I (withdrawals- injections approach)

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Equilibrium Income
 Equilibrium is a state in which there is no
internal tendency to change.
 It happens when
◦ firms and households are just willing to purchase
everything produced Y = E (v.s. Micro: Qs = Qd)
 This is the Income-Expenditure Approach
◦ planned saving is equal to planned investment S = I
 This is the Injection-Withdrawal Approach

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Equilibrium Income

 Y > E  Excess supply

◦ planned output > planned expenditure 
 unexpected accumulation of stocks OR
 unintended inventory investment OR
 involuntary increase in inventories
◦ Firms will reduce output

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Equilibrium Income
 Y < E  Excess Demand
◦ planned output < planned expenditure 
 unexpected fall in stocks OR
 unintended inventory dis-investment OR
 involuntary decrease in inventories
 Firms will increase output

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Equilibrium Income
 Y= E  Equilibrium
 There is no unintended inventory investment

OR dis-investment
 Y=E

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Equilibrium Income: Summary
 When there is excess supply, i.e., planned
output > planned expenditure, firms will
reduce output to restore equilibrium
 When there is excess demand, i.e., planned

expenditure > planned output, firms will

increase output to restore equilibrium

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Aggregate Expenditure Function
 Aggregate expenditure is comprised of
consumption, C, and Investment, I
i.e. E = C + I
 Using functional forms,
 C = cY and I = I*
  E = I* + cY

◦ Graphical representation

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Aggregate Expenditure Function:
Graphical Illustration
Slope of tangent = c
C, I, E
I C

Slope of tangent=0

Y
I = I* C = cY E = I* + cY
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Readings
 Lipsey and Chrystal
◦ Pp: 467- 480

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Next Class
 Output-Expenditure Approach to Income
Determination
◦ Expenditure Multiplier
 Saving Function
 Injection-Withdrawal Approach to Income

Determination
 Paradox of Thrift

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