Theory of income determination

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Theory of income determination:

Theory of income determination

Slide 2:

National income accounting provides the estimates of the nation’s output but it does not explain the reasons why the national output is at a certain level or why it increases more rapidly in some years than in others. To explore the determinants of the level of economic activity , one must use economic theory. Let us explain it in using a simple Keynesian model of income determination. In order to concentrate on the basic model, let us omit the govt and foreign trade sectors. Let us assume that theories of income determination to be discussed now are short run theories ignoring the effect of investment and technological progress on the nation’s productive capacity. In the long run these effects are very important and log run theories are growth theories of income determination

The model:

The model In the absence of the govt and foreign trade, the attention is focused on consumption and investment. The sum of the society’s expenditure on consumption and investment is the aggregate demand which determines the level of income. Should aggregate demand change, the equilibrium level of income also changes. Hence aggregate demand plays a key role in the model. The consumption function: Many factors like taste, preferences, income, interest rate etc determine consumption. Households vary in their consumption as per the level of income and interest rates. Although many factors affect consumption, aggregate income is the most important one. Accordingly we shall concentrate on the relationship between consumption and income – the consumption function .

Slide 4:

In this model consumption varies directly with income. The model is: C=a+bY ( a > 0, 0 < b < 1 ) Where Y =real income and C= Real consumption, a and b are constant and coefficients respectively, called the parameters. The parameter b is the marginal propensity to consume or MPC, is the slope of the consumption function. If Δ Y denotes a change in income and Δ C denotes the change in consumption associated with the change in income, b , the MPC = Δ C / Δ Y. For example; if income increases by Rs200 and consumption by Rs 150, the MPC is Rs150/Rs200=0.75. In this model we assume that the consumption increases with increase in income but by a smaller amount. This implies that b, the MPC must be between 0 and 1. This assumption is empirically verified also. The parameter a is the portion of consumption which does not vary with income, or, to put it differently, a represents the consumption which would occur if income were zero. Short run studies of consumption function suggest that a is positive

Slide 5:

Y C C=a+bY =100+0.75 Y O a=100 700 800 The consumption Function If there is a change in a , the consumption function will shift so that the new function is parallel to the old. If there is a change in b, the function will rotate about the intercept a.

Savings Function:

Savings Function The savings function may be derived with the help of the consumption function as the decision to save depends on the decision to consume. In the absence of govt and foreign trade income equals to consumption (C)plus saving (S). Y=C+S But C= a+bY and after substituting we get S=-a+(1-b)Y (0<1-b<1), where S and Y represent real savings and real income respectively. The parameter 1-b refers to as the marginal propensity to save or MPS is the slope of the savings function

Slide 7:

Like consumption function if Δ Y denotes the change in income and Δ S denotes the change in savings associated with the change in income, 1-b, the MPS, equals Δ S/ Δ Y. Example if income increases by Rs200 and savings by Rs 50, the MPS is: Rs 50/Rs200=0.25. Since b is MPC is assumed to be between 0 and 1, 1-b , the MPS is also between 0 and 1. This implies that savings increases as income increases but by a smaller amount.

Slide 8:

Y Y 1 Y1,C1 45 0 C= a + b Y a Y 0 S= -a+(1-b)Y o C 0 Y 0 Y,C S 0 C 0 -S -a o Y 1 S 0 S S 0 Y 0 At all point of 45 0 line vertical line income on the vertical axis is equal to income on the horizontal line since the scales are the same on both the axis. Graphically saving is the vertical distance between 45 0 line and the consumption function. When income is Y 0 , consumption is C 0 saving is S 0 . If income is Y 1 , consumption is C 1 (intersection between consumption fn and 450 line) which also equals to Y 1 . The saving is + ve if Y>Y 1 and saving is - ve if Y< Y 1.

Slide 9:

Investment function: Investment depends on many variables including the interest rates. At present let us assume that investment is an exogenous variable, a variable whose value is determined outside the model. Let us assume Investment is constant, I 0 and the investment function is: I=I 0 (I 0 > 0) where I is the real investment and I 0 is given, positive level of investment. Say the investment is Rs 50lakhs. The income and investment are plotted at the horizontal and vertical lines respectively. Investment does not vary with income.

Slide 10:

Y O I I=I 0 =50 I 0 =50 C=a+bY (a>0, 0<b<1) (i) I=I 0 (I 0 >0) (ii) These are behavioural equations which explains the behaviour of consumers and investors. To complete the model we must specify the equilibrium condition i.e the condition necessary for a particular level of income to be in equilibrium. The condition is: (i) Aggregate supply =Aggregate demand. ( ii) I=S I=investment and S=savings Income investment

Slide 11:

Equilibrium level of income using AD-AS approach: Aggregate supply represents the nation’s output of goods and services and Aggregate demand represents society’s demand for those goods and services. The income to be in equilibrium the nation’s output of goods and services must equal the demand for those goods and services. If nations output equals the demand for goods and services firms will be able to sell their entire output. Hence no incentive exists for them to alter their production and income remains at the equilibrium level. If nations output exceeds the demand for goods and services , firms are unable to sell their entire output and experience a buildup in their inventories. An incentive exists in this case for the firms to reduce their production. As a result the production falls until it equals the demand for goods and services. Likewise if the nation’s output is less than the demand for goods and services, firms sell more than they are producing and experience a depletion of their inventories. Here also an incentive exists for them to increase production and the output increases until it equals the demand for goods and services.

Slide 12:

C=a+bY C+I=a+I 0 +bY Y Y,C C+I Y 0 a a+I 0 C 0 Y0, C 0 +I 0 45 0 Aggregate supply is depicted by the 45 0 line. It indicates that any amount from 0 to infinite may be produced which (is not possible practically as the nations resources and technology is limited. However for the development of the model, it is helpful to think of the line 45 0 as an aggregate supply curve. Aggregate demand is the society’s demand for goods and services (for consumption and investment goods) which is equal to C+I=a+bY+I 0. E The equilibrium level of income is at Y 0. At income > Y 0 , AS> AD, income tends to fall and at income <Y 0 , AS<AD, income tends to rise. C=Y

Slide 13:

When AS=AD, all the output produced are sold and there is no need to alter the production. If for example production is 680 crores and the demand (both consumption and investment) is 660 crores. The remaining 20 crores worth of goods and services are added to business inventories. If the production were to continue at 680 the inventories would continue to increase. So the mangers would reduce their production. If managers would cut back their production to say 640 crores and the AD at that level is 630 crores. Hence AS> AD, the unsold goods and services worth Rs 10 crores is added to the inventories. If the demand is more and the production plus some inventories will meet the demand, the inventories are being depleted and there is a signal for the mangers to produce more. If AS> AD, income tends to fall because of inventories If AD>AS , income tends to increase because of the depletion of inventories. Income is at equilibrium only when AS=AD. To conclude, since income tends to fall when AS>AD and rise when AD>AS, income eventually gravitates to its equilibrium level.

Slide 14:

The alternative of equilibrium of income is Investment-savings approach: Y=C+I Y=C+S hence I=S, necessary for a level of income to be in equilibrium level. Intended and realised investment: Realised investment equals saving at every level of income and intended investment equals saving at the equilibrium level of income. Ex ante investment is intended investment : the amount of investment which firms intended or planned to invest.

Slide 15:

Unintended investment is the change in business inventories due to a discrepancy between aggregate supply and aggregate demand. Ex-post investment is the realised investment: It is the sum of intended and unintended investment. Since the NI accountants can not distinguish between intended and unintended investment, no distinction is made between them in the NI accounts.

Slide 16:

C=a+bY C+I=a+bY+I 0 +IY Y Y,C C+I Y 0 a a+I 0 45 0 E C=Y C+I’=a+bY+I 1 +IY a+I 1 Y 1 Δ Y Δ I

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