Income Determination

GNP can be viewed as a flow of either product or

income. The basic GNP identity :

C+I+G+(X-M)=C+S+T+Rf=GNP
Where, C: total value of consumption expenditure, I:
total value of investment expenditure, G: govt.
purchases of goods and services,(X-M):net
exports, S:gross private savings (business savings,
personal savings and depreciation, Rf:transfers to
foreigners.

Income Determination
We assume a closed economy I.e
C+I+G=C+S+T=Y=GNP.
National income Y is measured at current
price levels and is referred to as money or
nominal GNP.
Nominal Y can be broken down into a price
component P and a real component y.
Y=Py.

Income Determination
In national income accounts real output is
measured on a disaggregate basis by dividing
the various components (C,I,G) of output in
nominal terms by relevant price indices. This
(c,i,g)is then added up to obtain real output y.
We then have a real output identity:
c+i+g=y=c+s+t
Changes in employment are always related to y.
Changes in P refer to inflation.

Income Determination
It is likely that tax payments,consumer spending and
saving are all likely to depend on level of income. In
fact each will be an increasing function of income.
t=t(y),t>0;c=c(y-t(y)),c>0;s=s(y-t(y)),s>0.
If consumer spending and saving exhaust disposable
income then c+s=1.
In other words a change in disposable income must
be allocated between c and s.
y=c(y-t(y))+i+g

Demand side equilibrium

We now develop a basic model of income
determination.
The model will show how the price level,the
interest rate and levels of output and employment
are determined in an economy that operates under
full employment.
We proceed by identifying supply and demand
functions in various markets and then finding the
equilibrium price and output in each market.

Demand side equilibrium

To understand the demand side of the
economy we need to find equilibrium values
of the interest rate and the output demanded
by consumers,firms and government given a
price level.
What determines i (investment)?
Will planned investment depend on the
market rate of interest,r?

Demand side equilibrium

Present Discounted Value of future income from
investment:
PDVt= -C+Rt + Rt+1/(1+r) + Rt+2/(1+r)2 ++ Rt+n/
(1+r)n
i=i (r), i<0.
Firms can rank projects in terms of their PVs.
With an elastic supply of funds schedule firms will
invest in all projects with PDV>0.Diagram.
i=i( r), i<0.
y=c(y-t(y))+g+i(r) : IS curve

Demand side equilibrium

The IS curve represents the pairs of r and y that
will keep the product market in equilibrium, in
the sense that planned investment plus govt.
purchases equals planned saving plus tax
revenue at that level of income.
What will shift the IS curve?
Increase in desire to save
Downward rotation of s+t function.
Increase in govt. purchases.

Demand side equilibrium

Up till now we have only one equilibrium
equation in r and y yielding an infinite potential
equilibrium points (IS curve).
In order to locate a single equilibrium point on
this curve we need another equation in the same
two variables (r and y) that can be solved
simultaneously.
To this end we need to introduce the money
market.

Demand side equilibrium

In what follows we define money as currency and
demand deposits.
All other liquid assets are aggregated into a single asset
called a bond, which yields a return to the holder
but cannot be directly used as a medium of
exchange.
A person thus holds his liquid assets either as money or
bonds.
Let us consider the demand side of the money market
first.

Demand side equilibrium

An increase in interest rates will induce people to put
money in bonds and hold less as money. And the
converse.
This we can call the speculative demand for
moneyl(r ), and l<0.
Money Balances are also held to smooth out the cash
flow (I.e. bridge the difference between receipt of
income and payments to be made) which we call
the transactions demand for money k(y),k>0.

Demand side equilibrium

Both speculative and transactions demands are
demands for real balances M/P=m.
We represent the demand for money as the sum
M/P=m=l(r )+k(y).
We should recognize that the two demands cannot in
general be summed and the correct way to
represent this would be
M/P=m(r,y) and m/r<0, m/y>0.

Demand side equilibrium

We use the sum because it helps in graphical
analysis.
When we plot the demand for real balances
against the interest rate we get a different
curve for each level of income.
At very high rates of interest speculative balances
would be very small giving a minimum
demand for money with rising interest rates.

Demand side equilibrium

As interest rates fall very low people would
become indifferent between holding money
and bonds. The demand for money may be
flat at low interest rates.
The demand curves would converge at very low
and very high interest rates.
On the supply side we assume that money supply
is exogenously fixed.M=M
Diagram

Demand side equilibrium

As income falls from y0 to y1 the money market
equilibrium interest rate falls,given the level of
real money supply.
When income falls there is a decrease in the
transactions demand for money.
Present holders of money may want to shift it to
bonds due to lower transaction needs.
This increase in the demand for bonds drives bond
prices up and interest rates down.

Demand side equilibrium

M/P=m(r,y)l(r ) +k(y)
Derivation of LM curve (Diagram)The LM curve
represents the pairs of r and y that will keep
money market in equilibrium with a given
level of money supply,M and a given price
level P.
0=ldr+kdy; dr/dy= -k/l and we know
k>0 and l<0. dr/dy>0.

Demand side equilibrium

Suppose supply of money rises.
This will shift the M/P line out creating an excess
supply of money at the old level of y and r.
As at the old level of income transactions demand
for money is already met more is now
available for speculative purposes.
For the money market equilibrium this implies a
lower r at each level of income. The LM
curve shifts to the right.

Demand side equilibrium

A change in the price level works symmetrically
opposite to a change in money supply.
By placing the IS and LM curves in the same
quadrant ie solving them simultaneously we
can determine a single pair of r and y that
gives equilibrium in both markets.
At the point of intersection there will be no
reason for r and y to be changing.

Demand side equilibrium

Suppose we start from a disequilibrium situation.
Say point A.
If the point is not on the IS curve it tends to move
horizontally towards the IS curve with y
changing.
At A (s+t)>(i+g) so y is falling.
If a point is not o the LM curve it tends to move
vertically towards the LM curve with r
changing.

Demand side equilibrium

As A is below the LM curve for given y there is an
excess demand for money and excess supply of
bonds which pushes bond prices down and r rises.
Once the LM curve is reached r no longer changes as
money market is in equilibrium.
But y is still falling so r,y point moves left.
When the point hits the IS curve r is falling but y is not
changing so the trajectory is down.
This movement continues till r0,y0 is reached.

Demand side equilibrium

Excess demand in money market rising r
falling i falling y reduced
demand in money market.
Excess saving in product market falling y
falling r rising i reduced excess
saving.

Demand side equilibrium

We are now in a position to derive to derive the
economys demand curve by varying the price
level,P and tracing what happens to
equilibrium real income y.
Our two equilibrium conditions are:
s(y-t(y))+t(y)=i(r )+g for the product market and
M/P=l(r )+k(y) for the money market.

Demand side equilibrium

We have assumed P to be given exogenously so we
have two equations in two unknowns r,y and
we thus are able to solve for r and y.
Suppose from initial price P0 which yields
equilibrium r0 and y0 the price level increases to
P1. Real money supply falls.
This shifts the LM curve to the left and moves
equilibrium to r1 and y1
The price level increase reduced real money supply.

Demand side equilibrium

So at any level of y less money is now available for
transaction purposes.
There is thus an excess demand for money in the money
market and r rises to r1 and new equilibrium y I.e. y1
is less than y0.
Varying the exogenously given price level produces an
opposite variation in the equilibrium level of output
demanded.
This can be represented as the economys demand
curve.

Demand side equilibrium

This demand curve shows that as price level P
increases the equilibrium output demanded in the
economy decreases.
We have derived this relationship by asking how
equilibrium y changes when P changes allowing
other variables like r to adjust to their equilibrium
levels.
Changes in equilibrium variables on the demand side
of the economy as a result of price changes are
movements along the demand curve.

Demand side equilibrium

Changes in exogenous variables on the
demand side (g,M,tax schedule,shifts in
the savings function or demand for
money function) shift the demand curve.
This is a different demand curve than the
one encountered in microeconomics.
A Pleads to a y due to a tightening money
market, r and reducing i.