CHAPTER 3

determination
NATIONAL INCOME
EQUILIBRIUM
DETERMINATION NATIONAL INCOME EQUILIBRIUM
CONCEPTS OF EQUIBLIBRIUM AND DISEQUILIBRIUM
CONSUMPTION THEORY : CONVENTIONAL AND ISLAMIC
INVESTMENT THEORY : CONVENTIONAL AND ISLAMIC
DETERMINATION OF EQUILIBRIUM IN 2,3,4-SECTOR ECONOMY
-AGGREGATE DEMAND = AGGREGATE SUPPLY
- LEAKAGES = INJECTIONS
MULTIPLIERAL
-DEFINITION INVESTMENTS, GOVERNMENT AND TAX MULTIPLIER.
- FORMULA AND CALCULATION OF MULTIPLIER
INFLATIONARY AND DEFLATIONARY GAPS - GRAPH ILLUSTRATION
 INCOME EQUILIBRIUM

Definition:
Total quantity of goods and services purchased (AD/AE)) are equals
to total quantity of goods and services produced (AS/Y) in an
economy in a given period.

EQUALIBRIUM ;
AS = AD @ Y = AE

DISEQUALIBRIUMM ;
AS > AD @ Y > AE
AS<AD @ Y<AE
Two approach to determine national income equilibrium
AGGREGATE DEMAND-AGGREGATE LEAKAGE-INJECTION APPROACH
SUPPLY APPROACH (AD=AS)
AD @ aggregate expenditure : Leakage :
- Total demand for goods and services in -A withdrawal from the income-expenditure
the economy. stream.
-4 components : - include :
consumption saving
investment taxes
government sector imports
foreign sector (net export) Injection :
-Additional spending to income-
AS @ aggregate output : expenditure stream.
- Total quantity of goods and services - include :
produced in an economy in any given investment
period of time. government expenditure
exports
equilibrium occurs when AD=AS equilibrium occurs when
LEAKAGE=INJECTION
CONSUMPTION THEORY : CONVENTIONAL AND ISLAMIC
Conventional perspective
Def : refer to the purchase of goods and services by individuals or
household which are produced by firms / the amount of goods and
services the households spend at different level of disposable income.
Keynes theory of consumption :
believed that planned consumption was subject to fundamental
psychological law.
according this law a person would increase his consumption as his
income increase, but the expenditure will be less than the increase in
income.
means consumer will spend only a part of increase in their income
and save the rest.
Income = consumption + saving Y = C+S
 TYPES OF CONSUMPTION

(i) Autonomous consumption (a)

- does not depend on the income level. It is that part of consumption
when the consumers income level is zero.
- the amount determined by other factors, such as wealth and
borrowing.
- e.g : from schedule the value of 1250 shows autonomous
consumption (i.e the value of C when Yd = 0)
- autonomous consumption is a = 1250
(ii) Planned or induced consumption (bYd)
- amount of consumption related to income. As income increases, the
amount will increase as well.
- the amount consumed depends on the value of MPC explains
about tendency or behavior of consumer.
- induced consumption is C = f(Yd) @ b = MPC
 CONCEPTS OF CONSUMPTION
Marginal propensity to consume (MPC)
-Relationship between a change in total
income and change in total consumption MPC = Change in total consumption
- define as: ratio of change in total Change in total income
consumption to change in total income
MPC = C
-E.g : change in income from RM0 RM100 Y
need to a rise in consumption RM100 RM175 =b
So, MPC = 100 0 / 175 100 = 0.75
Means for any change in income the consumer
will spend 75% of it.

Average propensity to consume (APC)

APC = Total consumption
-relationship between total income and total Total income
consumption.
- can be define as : Ratio of total consumption =C
to total income/ fraction of the total income Y
spent on consumption as a whole.
 Consumption Schedule

Disposable Consumption APC MPC

income (Yd) (C) ( C/ Y) ( C / Y)
0 1250 - -

2000 2750 1.38 0.75

4000 4250 1.06 0.75

6000 5750 0.96 0.75

8000 7250 0.91 0.75

10000 8750 0.86 0.75

 Consumption function

-Refer to the relationship between consumption level and income level.

- the general equation for linear consumption function is :
C = a + bYd
Where :
C = consumption expenditure
a = autonomous consumption (autonomous consumption does not depend on
the income level)
b = marginal propensity to consume (MPC)
Yd = disposable income (Y-T), but in 2 sector Yd = Y

From table : the consumption function can be written as :

C = 1250 + 0.75Yd
C (AE)

Y=C * Each point on the 45 line indicates a

point where Yd @ Y = C

C(Y)

Characteristics of Consumption Function:

Positive Slope
- as income increases, Consumption also
increase.
a - The curve intersects the C axis above
zero even at income 0, consumption
still occurs.
45
Y
 SAVING THEORY
DEF : the part of the income that a household does
not consumed in a given period.
TYPES OF SAVING
1. Autonomous savings (-a)
- that part of saving that does not depend on the income level
- incurred by the consumer if there is no income (not related to
income)
- occurs when there is autonomous consumption.
2. Induced Savings (MPS @ 1-b)
- part of the income and it depends on the quantum of the
savings.
- the higher the income, the higher the amount of saving and
vice versa.
 CONCEPT OF SAVING
1. AVERAGE PROPENSITY TO SAVE (APS)
- ratio of total savings to total income.
- formula :
APS = Total Saving = S
Total Income Yd
2. MARGINAL PROPENSITY TO SAVE (MPS)
- ratio of change in total savings to change in total income.
- formula :
MPS = change in total saving
change in Total Income
OR
MPS = 1 b @ 1 MPC
This is because MPS + MPC = 1 and APS + APC = 1
 SAVING FUNCTION
-refer to the relationship between savings and the income
level.

Saving Equation
Y=C+S
S=YC
S = Y ( a + bYd)
S = Y a bYd
S = - a + ( 1 b ) Yd
Where :
S = savings
-a = autonomous savings (autonomous savings
does not depend on the income level)
1-b = MPS because MPC+MPS = 1
Yd = disposable income
 BREAKEVEN INCOME
-Def : is the level at which household consume all their income.
-On the other word savings is equal to zero
-At the breakeven point :
Y=C
S=0
APC = 1
APS = 0
-E.g. : C = 1250 + 0.75 Yd
Y =C
Y = 1250 + 0.75Yd
Y-0.75Yd = 1250
o.25Y = 1250 (Assume Tax = 0; Y = Yd)
Y = 5,000

OR
S =0
-1250+0.25Yd =0
0.25Yd = 1250 (assume Tax = 0; Y = Yd)
Y = 5,000
 C (AE)
Y=C

Breakeven point Saving area C = 1250 + 0.75Yd

a = 1250
Dissaving area

National income (Y)

5000
S

S = -1250 + 0.25Yd

Saving area
National income (Y)
Dissaving area
5,000
-1250

Figure : Consumption and saving curve.

 CONSUMPTION FROM THE ISLAMIC PERSPECTIVE

M. Fahim Khan Muslim consumption is obviously different from

coventional.
Because islam has its own distinct ethical, sociological and cultural
framework.
Spending in islam includes consumption as well as investment
expenditure, transfers, lending and saving in the form to hoarding or
otherwise.
Divide by :
- consumption expenditure for one own self and family (E1)
- consumption expenditure for others (E2)
 Total expenditure is :

E = E1 + E2

E1 = includes present consumption (C1) and future consumption (S1).

E2 = includes present consumption (C2) and future consumption (S2).

free to decide how much of his income will spend on this two expenditure.
Islam gives two guidelines on the spending pattern, which is :
- rational spending
- wealth
- price level
- expectations and others
- degree of God fearness or God-consciousness (Taqwa)
E1
- basket of goods limited to permissible goods.
-The Quran states that wealth is important to man.
-Muslim must rational- because not only spending for world solely.
-Include spending for the way of Allah not only spend now but must save for
the future consumption or investment-improve their economics.

E2
- The Quran not specify exactly how much we must spend on E2
- the minimum should be the amount of zakat an individual compulsory to pay
yearly if all conditions are satisfied.
- More muslim spends to others advantages/barakah to him in this world and
the hereafter.
 Household
Expectation of
income
the future
income

Factors
Wealth Influencing
consumption

Rate of
interest
Tax
 * Both autonomous and induced constitute the
consumption function :
C = a + b(Yd) ; where a is autonomous consumption and
b is value of MPC

Effect of a change in autonomous Effect of a change in Induced

Consumption Consumption

C C

Y=C Y=C
C = a2 + bYd C = a + b2Yd

C = a1 + bYd C = a + b1Yd
a2

a
a1

Yd Yd
 INVESTMENT THEORY CONVENTIONAL
- Def : spending or purchases and accumulation of capital goods.
- Eg : purchases by firms of a new building, equipment, and additions to
inventories.
- Also refers to expenditure made by private sector (firms).

TPYES OF INVESTMENT
1. Autonomous investment (I)
- fixed and independent of income (not affected by income).
- can be affected by other factors such as interest rate, repayment rates,
business expectation and technology developments.

Investment

Autonomous investment

Income
2. Induced investment [I = f(Y)]
- depends on the national income.
- as national income increase, induced investment will also increase; vice
versa.
- higher national income attracts more investors to invest.

Investment Induced investment

Income
 Expectation of
the future Rate of
interest

Factors
Technological
changes Influencing
@innovation
Investment

Rate of
return @
profit
Government
expectation
policies
 INVESTMENT IN ISLAM

- All resources created by Allah must be manage and exploited to the fullest
(base on Shariah demand).
- Capital is not just wealth also include human factor that is humans
performance, belief, attitude and human motivation (conventional
perspective focuses only in human behavior).
- Wide integration of various dimensions of social, moral, political as well as
spiritual.
- Main objective development in Islam which requires investment to
balance between rapid development and equal distribution base on rule in
Islam.
- Four institutions that encourage process of capital formation/investment :
(i) Family
(ii) Ummah
(iii) Mosque
(iv) Government (base on Dr Aqeel A. Ansari points)
The boundaries/determinants/constraints of investment in Islam are :
(i) Only permissible activities are allowed
(ii) Investment is based on the needs of human and also on the needs of
Dharuriyah, Hajiyah or Kamaliyah. (follow the hierarchy of goods)
(iii)Should emphasize on the welfare of the society not solely on the
profitability.
(iv)Its implementation should not against Syariah principles for examples
exploitation or treachery.
(v) Does not involve any forms of riba, gharar and gambling.
DETERMINATION OF

EQUILIBRIUM IN 2, 3

AND 4 SECTOR

ECONOMIES.
 EQUILIBRIUM IN A TWO-SECTOR ECONOMY

Firms

Investment (I)

Consumption of
Factor domestically BANKS, etc
Payments produced goods (Financial Market)
and services (C)

Net
saving (S)

Households
 Also called the simple economy.
There are two approach to calculate
national income equilibrium which is;
(i) aggregate demand-aggregate supply
approach (AD-AS)
(ii) leakage-injection approach (I-S).
To determination of equilibrium can be
through mathematical equations , tables or
diagrams.
 AD AS APPROACH LEAKAGE - INJECTION
APPROACH
AS = Y Injection = I (investment)
AD = C+I Leakage = S (Saving)
equilibrium is achieved when AD = AS, equilibrium is achieved when injection =
which is: leakages, which is:
AS = AD I=S
Y =C+I

Mathematical equation: Mathematical equation:

Given are following information:
(i) Autonomous consumption = 5000
(ii) MPC = 0.75
(iii) Autonomous investment = 2500.
Given consumption function,
C = 5000 + 0.75Yd; Yd=Y
Y=C+I
Y = 5000 + 0.75Y + 2500
Y-0.75Y = 5000 + 2500
Y = 7500/0.25
Y = 30,000 (EQUILIBRIUM INCOME)
Given are following information:
(i) Autonomous consumption = 5000
(ii) MPC = 0.75
(iii) Autonomous investment = 2500.
Given consumption function,
S = -5000 + 0.25Yd; Yd=Y
S=I
-5000 + 0.25Y = 2500
0.25Y = 7500
Y = 30,000 (EQUILIBRIUM
INCOME)
 AD AS APPROACH I S APPROACH
Graphical analysis Graphical analysis
- Same example as above- translate into - same as example above translate into
graph graph.

AD(C,I) Y=AD Leakage-injection

C+I S = -5000 + 0.25Yd

2500 I
C = 5000+0.75Y
National
7500
income
30,000
5000 -5000

National
30,000 income
 QUESTION (TEST 1/ JULY 2008)

AD
Y =AD
Refer diagram
below and
C+I answer the
following
C = 100 + 0.75Y questions.

Y
Y1 1500 3500

Determine the value of :

(a) Y1 (1 m)
(b) investment (I) (2m)
(c) assume Yfe is at 1500 level of income, how much should
the economy increase its Investment in order to achieve Yfe. (2m)
(d) Based on the question (c), draw national income equilibrium
diagram using the Leakage-Injection approach. (2m)
 EQUILIBRIUM IN A THREE-
SECTOR ECONOMY

INJECTIONS
Firms

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV.
payments produced goods
and services (C)

Net
Net taxes (T)
saving (S)

WITHDRAWALS

Households
 consists of household, firms and the
government.
from graph- shows flow of taxes form
household and firms to G
also the flow of purchases of goods and
services by G and transfer payments to
households.
G expenditure (injections)
Taxes (leakages)
 AD AS APPROACH INJECTION-LEAKAGE APPROACH
AS = Y (Y = Y-T) equilibrium is achieved when injection =
AD = C+I + G leakages, which is:
equilibrium is achieved when AD = AS, Injection = Leakage
which is: I +G = S + T
AS = AD
Y =C+I+G
focus on two types of taxes, which is :

(1) Autonomous taxes

- Amount of tax that is independent of
income (not relate to income).
- income increase/decrease
autonomous taxes remains constant.
- e.g : RM 40
(2) Induced taxes.
- amount of tax that depends on
income
- changes as income changes (income
increase- induced taxes increase; vice
versa.)
- e.g : o.6Y
 AD AS APPROACH
(1) Autonomous taxes (2) Induced taxes.

given the following information. given the following information.

C = 200 + 0.75Yd (disposable income) C = 200 + 0.75Yd (disposable income)
I = 100 I = 100
G = 50 G = 50
T = 100 T = 0.2Y
Taxes have an effect on C Taxes have an effect on C
Y = C+I+G Y = C+I+G
= 200+0.75Yd+100+50 = 200+0.75Yd+100+50
= 350+0.75(Y-T) = 350+0.75(Y-T)
= 350+0.75(Y-100) = 350+0.75(Y-0.2Y)
= 350+o.75Y-75 = 350+o.6Y
Y-0.75Y = 275 Y-0.6Y = 350
Y = 275/0.25 Y = 350/0.4
Y = 1100 (EQUILIBRIUM INCOME) Y = 875 (EQUILIBRIUM INCOME)
(1) Autonomous taxes (2) Induced taxes.

Base on example above: Base on example above

AD(C,I,G) Y =AD
AD(C,I,G) Y =AD
C+I+G
C+I+G

C = 200+0.75Yd
(before tax) C = 200+0.75Yd
275
350 (before tax)
C=
125+0.75Yd C = 200+0.6Yd
I+G 200 (after tax) (after tax)
I+G

125
200
NI
NI
1100 875
 (1) Autonomous taxes (2) Induced taxes.

Base on example above: Base on example above

Leakage/injections Leakage/injections
S+T = -200+0.25Yd S+T = -200+0.25Yd
(before tax) (before tax)
S+T = -225+0.25Yd S+T = -200+0.2Yd
(after tax) (after tax)
150 150
I+G I+G

NI NI
-200 1100 875

-225 -200
 EQUILIBRIUM IN A FOUR-SECTOR
ECONOMY

INJECTIONS
Firms
Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (C)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS

Households
 consists of household, firms,
government and foreign sectors.
Also knows as open economy.
export (injections)
import (leakages)
 AD AS APPROACH INJECTION-LEAKAGE APPROACH
AS = Y equilibrium is achieved when injection =
AD = C+I + G + (X-M) leakages, which is:
equilibrium is achieved when AD = AS, Injection = Leakage
which is: I +G+X = S + T+M
AS = AD
Y = C + I + G + (X-M)
given the following information. Equilibrium income is:
C = 200 + 0.75Yd (disposable income) I+G+X = S+T+M
I = 100 G = 50 100+50+100 = -200+0.25(Y-100)+100+50
T = 100 X = 100 M = 50 250 = -75+0.25Y
Equilibrium income is: 0.25Y = 325
Y = C+I+G+ (X-M) Y = 325/0.25
= 200+0.75Yd+100+50+(100-50) Y = 1300 (EQUILIBRIUM INCOME)
= 400+0.75(Y-T)
= 400+0.75(Y-100)
= 400+o.75Y-75
Y-0.75Y = 325
Y = 325/0.25
Y = 1300 (EQUILIBRIUM INCOME)
 AD AS APPROACH LEAKAGE-INJECTION APPROACH
Graphical analysis Graphical analysis
- Same example as above- translate into - same as example above translate into
graph graph.

AD Leakage/injection
Y=AD S+T+M

C+I+G+(X-M) I+G+X
250

NI
325

NI -75

1300
 MULTIPLIER

Ratio of the change in income to the

change in AD
Shows how many times the effect of an
initial change in AD is multiplied by
causing changes in consumption and
finally in the aggregate income.
Formula :
K= change in Income ( Y)
change in Aggregate demand ( AD)
 Size depends upon the size of MPC
The higher the MPC- the higher the
size of multiplier.
The lower the MPC the lower the
multiplier.
K can be found using :

K= 1
1-MPC
 TYPES OF INVESTMENT GOVERNMENT TAX
MULTIPLIER
Ratio of the change in Ratio of the change in Ratio of the change
the equilibrium income the equilibrium income in the equilibrium
to a change in to a change in income to a change
investment. government expenditure in taxes assuming
DEFINITION assuming there is no there is no change in
change in taxes government
expenditure.
Ki = change in Income Kg = change in Income Kt = change in Income
change in investment change in government change in Taxes
expenditure

Y
Ki Y Y
I Kg Kt
FORMULA G T
Also can be derived by: Also can be derived by: Also can be derived by:

1 1 1 1 MPC
Ki Kg Kt
1 MPC MPS 1 MPC MPS MPS

Q? Given C = 200+0.75Y and Given C = 200+0.75Y and Given C = 200+0.75Y

I=100, what the equilibrium
income level when there is
an increase in I by 50
million?
I=100, what the equilibrium
income level when there is an
increase in G by 100 million?
and I=100, G=50 and
T=100, what the
equilibrium income level
when tax cut of 50
million?
e.g Y K i xI Y K g xG Y K t xT
(calculation)
1 1 MPC
xI xG xT
1 MPC 1 MPC MPS
1 1 0.75
x50 x100 x(50)
1 0.75 1 0.75 0.25
Y 200million Y 400million Y 150million
New equilibrium New equilibrium income New equilibrium
income level is 1300 level is 1500 million. income level is 1250
million. The government million.
The investment multiplier is : The taxes
multiplier is : 1 multiplier is :
Kg
Ki
1 1 MPC
1 MPC MPC

1 Kt
1 1 0.75 MPS

1 0.75 Kg 4 0.75

Ki 4 0.25
K t 3
**This means : the **This means : the
aggregate income aggregate income will
will increase by 4 increase by 4 times the
times the increase increase in government
in investment expenditure
INFLATIONARY GAP AND DEFLATIONARY
GAP
**Inflationary gap and deflationary are the situations of disequilibrium.

INFLATIONARY GAP
occurs when national income exceeds full employment level Yfe.
full employment achieved when resources are all used with max
efficiency increased in aggregate expenditure.
Also measure as the excess of aggregate expenditure over full
employment aggregate supply, Yfe (Y>Yfe) .
When aggregate expenditures are greater than the full employment
level causing demand-pull inflation.
Government might use contractionary fiscal policy to close the
inflationary gap by either decreasing (reduces) its spending or by
rising taxes
Aggregate demand
Y=AD
Inflationary gap E C+I+G+(X-M)
A The inflationary
C+I+G(X-M)fe
gap A to B will
B
increase general
price level
NI
Only disappears
Leakage/injection when aggregate
S+T+M money increase
Inflationary gap
A E from OYfe to OY-
I+G+X
raising general
B prices.
NI
Yfe Y

Yfe<Y = inflationary
gap
 DEFLATIONARY GAP

Occurs when national income is not full

employment .
Is a situation which the national income below
the full employment level-resources are not fully
utilized (unemployment).
To reduce expansionary policies must be
apply.
Expansionary fiscal policy through increase in
government expenditure and tax cuts.
Aggregate demand Deflationary gap
Y=AD
C C+I+G(X-M)fe
The deflationary
C+I+G+(X-M) gap C to D where
E D the equilibrium
income level is
NI below full
employment.
Leakage/injection
S+T+M
D
I+G+X

C Deflationary gap
NI
Y Yfe

Yfe>Y = Deflationary
gap
Q (Final/oct 2007)
I,S (RM Million)
S=-400+0.3Y

I=250

National Income
Yo Yf Ye

Where :
Yf = full-employment national income
Ye=equilibrium national income

a) How much is Ye (2m)

b) Does the economy experience the problem of inflation or unemployment at
equilibrium? Why? (2m)
c) Calculate the investment multiplier, if Yf = Rm2000, how much should investment
change to achieve Yf? Use the multiplier principle (3m)
d) Briefly explain two(2) factors that can shift the investment curve upward. (3m)
a) The following are levels of spending and taxes in a country.

C = 7500 + 0.8Yd
I = 8000
G = 4500
T = 4000
(all figures are in RM Billion)

(i) Calculate the equilibrium level of national income for the above
economy. (2m)

(ii) If the full employment level of income is RM100,000 billion, is

there inflationary gap or deflationary gap? Why? (1m)

(iii)How much should the government change its spending to close the
gap in (ii) above? (2m)
b) The data in the first two columns below are for closed economy. Use this table
to answer the following question:
Real GDP Aggregate Exports Imports Net exports Aggregate
expenditure expenditures
(closed (open
economy) economy)
80 100 $15 $5

120 130 15 5

160 160 15 5

200 190 15 5

240 220 15 5

280 250 15 5

320 280 15 5

360 310 15 5

(i) Fill in the blanks and determine the equilibrium GDP for the closed economy.

(ii) Determine the equilibrium GDP for the open economy

(iii) What will happen to equilibrium GDP if exports were RM10 billion larger at
each level of GDP?
 Exercise
National Income (RM Consumption (RM Saving (RM billion)
billion) billion)
0
2000
4000
6000
8000

a) Using equation S = -80 + 0.25Yd

b) What is the amount of breakeven income?
c) Based from answer (b), if full employment income is RM200b, what problem is this
country facing? Draw the situation.
d) What the relationship between income and consumption?