LECTURE 2

NATIONAL INCOME DETERMINATION

Lecture Outline
2.1 Introduction
2.2 Objectives
2.3 Consumption, Investment, Savings and Tax functions
2.4 Determination of Equilibrium income
2.5 The multiplier
2.6 Summary
2.7 Exercise
2.8 Further Reading

2.1 Introduction
Welcome to lecture 2. Recall that in lecture 1 we had an overview of National Income Accounting.
More importantly we were able to review the national income accounting Identity. In lecture 1, we
identified the four components of GDP as Consumption (C), Investment (I), Government
Purchases (G) and Net Exports (NX). In this lecture we will discuss, the individual components of
the national income identity then see how we determine equilibrium income and also derive the
multiplier.
2.2 Objectives.

2.3

At the end of this lecture you should be able to:

a) Define the Consumption, Investment, Savings and Tax functions
b) Derive the equilibrium Income
c) Define equilibrium in the financial markets
d) Define the multiplier

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Consumption, Investment, Savings and Tax functions

2.3.1Consumption and Savings

We start our discussion of this lecture by considering consumption and savings assuming a closed
economy. A closed economy has three uses for the goods and services it produces. These three
components of GDP are expressed in the national income accounts identity as:
Y=C+I+G
Aggregate demand is the total amount of goods demanded in the economy. Output is at equilibrium
when the quantity of output produced is equal to the quantity demanded. Thus, the national
accounts identity can be expressed as:
AD = Y= C+I+G
In practice the demand for consumption goods increases with income. The relationship between
consumption and income is described by the consumption function. Households receive income
from their labor and their ownership of capital, pay taxes to the government, and then decide how
much of their after tax income they will consume and how much to save.
Assuming that households receive income equal to the output of the economy Y and that the
government then taxes the households an amount T, we can define income after taxes (Y-T), as
disposable income (Yd). Households divide their disposable income between consumption and
savings.

We assume that consumption depends on income assuming absence of taxes. The higher the
income, the greater the level of consumption.

C = co + c1Y co > 0, 0<c1<1 ………… (1)

The variable co, the intercept, represents the level of consumption when income is zero. The
coefficient c1 is known as the marginal propensity to consume. It measures the amount by which
consumption changes when income increases by one shilling. In our case, the marginal propensity
to consume is less than one, which implies that out of a dollar increase in income, only a fraction,
c1 is spent.

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Consumption C
C = co + c1Y

co

Disposable Income, Y
The figure above represents a consumption function.

How much of your income goes to consumption?

After a household spends in consumption what remains must be saved. More formally saving is
equal to income minus consumption. Thus
S = Y-C

The savings function relates to the level of income. Substituting the consumption function in
equation one we get a savings function as follows:

S = Y-C = Y- co - c1Y = -co +(1- c1 )Y ……………………. 2

S = -co + (1- c1)Y ……………………. 3

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From equation 3 we see that saving is an increasing function of the level of income because the
marginal propensity to save, s= (1- c1), is positive. In other words, savings increases as income
rises. For instance, suppose the marginal propensity to consume is 0.8, meaning that 80 cents out
of each extra shilling of income is consumed. Then the marginal propensity to save s, is 0.2,
meaning that the remaining 20 cents of each extra shilling of income is saved.

2.3.2 Investment
Both firms and households purchase investment goods, Firms buy investment goods to add to their
stock of capital and to replace existing capital as it wears out. Households buy new houses, which
are also part of investment. The quantity of investment goods demanded depends on interest rate,
which measures the cost of the funds used to finance investment.

We can distinguish between nominal interest rate, which is interest rate as usually reported, and
the real interest rate which is the nominal interest rate corrected for the effects of inflation. If the
nominal interest rate is 10 percent and the inflation rate is 3 percent, then the real interest rate is 7
percent. Here it is important to note that the real interest rate measures the cost of borrowing, and
thus determines the quantity of investment.
Thus I = I(r)
The figure below shows this investment function. It slopes downwards, because as the interest
rate rises, the quantity of investment demanded falls.
Real interest rate, r

Quantity of investment, I

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2.3.3 Government Purchases and Taxes
The government purchases are a third component of the demand for goods and services. The
governments buys guns, build roads and other public works. It also pays salaries to civil servants.
If government purchases equal taxes then the government has a balanced budget. If G exceeds T
then the government runs into a budget deficit. If G is less than T then the government runs a
budget surplus. For our discussion we take Government purchases and taxes as exogenous
variables (not explained by the model).
Thus: G = Go; T = To

2.4 Determination of Equilibrium Income

Using the above information we are now in a good position to obtain equilibrium Income. We can
approach it in two ways. First using the goods market and secondly using the financial markets.
We then proceed to discuss each of them.

2.4.1 Equilibrium in the market for goods

Using the relationships discussed above we can get the equilibrium level of income or output as
follow:
Y=C+I+G
C = co + c1Y
I = I (r)
G = Go
T = To
We can combine these equations to obtain equilibrium level of income.
Y = co + c1 (Y-To) + I(r) + Go
Y = co - c1To + I(r) + Go
1- c1
When aggregate demand is equal to level of income then we can obtain equilibrium level of income
as above. The above model of income determination is known the Keynesian model of income
determination.

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 What determines the amount of output of an economy?

2.4.2 Equilibrium in the Financial Markets

To obtain equilibrium in the financial markets we consider savings and investments. Savings
represent the supply for loanable funds whereas investments represent the demand for loanable
funds. The discussion is developed clearly in the sections below.

2.4.2.1 The supply and demand for loanable funds

We can be able to analyze the financial markets by examining the interest rate, which is the cost
of borrowing and the return to lending in the financial markets.
We can rewrite the national income identity
Y=C+I+G as Y-C-G = I
The term on the left- hand side is the output that remains after the demands of consumers and the
governments have been satisfied. It is called national saving. In this form the national income
accounts identity shows that saving equal investment. Savings represent the supply of loanable
funds while investment represents the demand for these funds. The quantity of investment
demanded will depend on the cost of borrowing. At equilibrium interest rate the households’ desire
to save balances firms’ desire to invest and the quantity of loans supplied equals the quantity
demanded.

2.5 The Multiplier

This is the amount by which equilibrium output changes when autonomous aggregate demand
increases by one unit. Assuming the absence of the government and foreign sector the multiplier
is defined as
α= 1
1-c1
From the above equation you observe that the larger the marginal propensity to consume the larger
the multiplier. The multiplier suggests that output changes when autonomous spending changes
and that the change in output can be larger than the change in autonomous spending.

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2.6 Summary
In this lecture the following points are worth remembering.
1. The economy’s output is used for consumption, Investment and government purchases.
Consumption depends positively on disposable income. Investment depends negatively
on the real interest rate. Government purchases and taxes are the exogenous variables.
2. The real interest rate adjusts to equilibrate the supply and demand for the economy’s
output or equivalently, to equilibrate the supply of loanable funds (savings) and the
demand for loanable funds (investment).
3. The Multiplier is the amount by which equilibrium output changes when autonomous
aggregate demand increases by one unit

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2.7 Exercise
1. Suppose that the consumption function is given by C = 100 + .8Y, while investment is given
by I = 50
a) What is the level of income in this case?
b) What is the level of savings in equilibrium?
c) If I rise to 100, what will be the effect on the equilibrium?
2. Consider an economy described by the following equations:
Y=C+I+G
Y = 5000
G = 1000
T = 1000
C = 250 + 0.75 (Y-T)
I = 1000-50r
a) In this economy compute national savings
b) Find equilibrium interest rate
3. Draw the economy’s supply and demand for loanable funds. How does this policy affect
the supply and demand for loans? What happens to the equilibrium interest rate?
4. Define the multiplier. What is its importance?
5. Define the Consumption, Investment and savings functions

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2.8 Further Readings:
The following books are available for further readings. It would be important for you to read
some if not all so that you can broaden your understanding on the topic. Where later editions
exist, the information may not be found in the exact chapters.

Branson, Williams H, (1989), Macroeconomic theory and policy, 3rd Edition, Chapter 3
Dernburg, Thomas Fredrick,(1985), Macroeconomics: concepts, theories and policies, 7th
Edition, Mc Graw-Hill, Chapter 1 and 2.
Donbusch, Rudiger et al, (2001), Macroeconomics, 8th Edition, Tata Mc Graw-Hill, Chapter 9.
Mankiw, N. Gregory, (1999), Macroeconomics, 4th Edition, Worth Publishers, Chapter 3.