Transcript Macroeconomics Unit 2x

Unit 2:National Income
and Employment
Objectives:

Explain the importance of Say’s Law in the
neoclassical theory of employment and outline
Keynes’ main criticisms of the classical theory

Show how equilibrium national income is
determined in the simple Keynesian model,
recognising the assumptions upon which the
model is build

Explain and illustrate the multiplier effect
and derive simple formulas for calculating the
value of the expenditure and taxation
multipliers

Appreciate the limitations of the simple
Keynesian model
Classical theory

What determines national income and
employment in an economy?
The classical theory of full employment

Classical economists believed that if wages
and prices were flexible, a competitive
market economy would always operate at
full employment.

That is, economic forces would always be
generated so as to ensure that the demand
for labour was always equal to its supply.
Classical theory (Cont.)
The classical theory of full employment

In the classical model the equilibrium levels of
income and employment were supposed to be
determined largely in the labour market.

At lower wage rate more workers will be
employed. That is why the demand curve for
labour is downward sloping.

The supply curve of labour is upward sloping
because the higher the wage rate, the
greater the supply of labour.

In the following figure the equilibrium wage
rate (w) is determined by the demand for and
the supply of labour.
Classical theory (Cont.)
The classical theory of full employment
Supply of
labour
W/P
Labour market equilibrium
Demand of
labour
Labour
L
Output
Q = f(L,K) where K
is constant
Q
Output level
Labour
L
Classical theory (Cont.)
The classical theory of full employment

The lower panel of the diagram shows the
relation between total output and the quantity
of the variable factor (labour).

It shows the short-run production function
which is expressed as Q = f (K, L), where Q is
output, K is the fixed quantity of capital and L
is the variable factor labour.

Total output Q is produced with the
employment of L units of labour.

According to classical economists this
equilibrium level of employment is the ‘full
employment’ level. So the existence of
unemployed workers was a logical
impossibility.
Classical theory (Cont.)

The classical economists believed that aggregate
demand would always be sufficient to absorb the
full capacity output Q. In other words, they
denied the possibility of under spending or
overproduction. This belief has its root in Say’s
Law.

Say’s Law: According to Say’s Law supply
creates its own demand.

The very act of producing goods and services
generates an amount of income equal to the
value of the goods produced. The circular flow
of income model suggests this sort of
relationship.

Households receive income equal to the value of
goods and services produced. Part of this
income is spend and part they save.
Classical theory (Cont.)

Consumption demand then falls short of the
total value of production by the amount of
saving. This short fall is made up by
investment demand and so long as
investment and saving are equal,
aggregate demand will necessarily equal the
total value of production.

The classical economists argued that with
flexible interest rate and a competitive market
for loanable funds, saving and investment
would always be made equal by changes in
interest rates.

How?
Classical theory (Cont.)
Classical theory (Cont.)
In conclusion:
Classical system depends upon the
following:
1.
The dependence of investment and
saving on the rate of interest
2.
The upward and downward
flexibility of wages, prices and
interest rate and;
3.
The existence of competitive
forces in the economy
What about other
factors?
Can wages and prices
always be flexible? What
about interest rates?
Are markets always
competitive?
Keynes criticism of
Classical Theory
Keynes’ Criticism of Classical Theory:
1. According to Keynes, saving is a function of
national income and is not affected by changes in
the rate of interest. Thus, saving-investment
equality through adjustment in interest rate is ruled
out. So Say’s Law will no longer hold.
2. The labour market is far from perfect because of the
existence of trade unions and government
intervention in imposing minimum wages laws.
Thus, wages are unlikely to be flexible. Wages are
more inflexible downward than upward. So a fall in
demand for labour will lead to a fall in production as
well as a fall in employment.
Keynes criticism of
Classical Theory (Cont.)
3. Keynes also argued that even if wages and prices
were flexible a free enterprise economy would not
always be able to achieve automatic full
employment.
The Simple Keynesian
Theory

According to this theory, real national income
and employment is determined by
aggregate demand.

This different from the classical model which
suggested that supply creates its own demand.
In this model it is the demand that determines
how much is supplied.

The Keynesian theory argues that if firms are
producing more than is demanded, this will
results in increase in their inventory of unsold
goods and they can only rectify this in the short
run by cutting back on production and laying off
workers which will cause national income to fall
until the value of what is produced is equal to
the value of aggregate demand.
The Simple Keynesian
Theory (Cont.)

If firms are not producing enough to satisfy
demand, they will experience fall in their
inventories and this time will try to increase
production in the short run by employing
more workers. National income will increase
until the value of what is produced is equal to
the value of aggregate demand.

According to Keynesian model, there is only
one value of national income at which
aggregate demand is equal to the total value
of production. This is called equilibrium
national income.
The Simple Keynesian
Theory (Cont.)
Determination of equilibrium national income
For us to be able to determine equilibrium national
income, there are number of assumptions that have
to be made.
1.
Wages and prices are fixed
2.
We ignore the money market
3.
Planned consumption C and planned saving S are both
directly related to income (Y)
4.
Planned investment I and planned government spending G
are autonomous
5.
Taxation T is in the form of lump-sum taxes only
6.
Planned exports X are autonomous, but planned imports M
depend directly on income
7.
There is no economic growth
Withdrawals and injections
Determination of equilibrium national income
Economy is in equilibrium when the aggregate demand
for the economy’s goods and services is equal to the
total value of goods and services produced.
AD (demand) = Y (income)
Where AD = C+I+G+X-M and Y = C+S+T
C+I+G+X-M = C+S+T
I+G+X = Injections
S+T+M = Withdrawals
I+G+X = S+T+M
The condition for equilibrium can now be presented as
follows:
Withdrawals = Injections
Withdrawals and injections
(Cont.)
Determination of equilibrium national
income
How can I,G & X be
independent of income?

All the injections (I, G and X) are
independent of income so that when plotted
against income on the graph, the injections
line will be a horizontal straight line.

Savings and imports are both directly
related to income but taxes are lump-sum
taxes therefore total withdrawals will be
directly related to income with a slope equal to
the sum of the marginal propensity to save and
the marginal propensity to import
Withdrawals and injections
(Cont.)
Withdrawals
Injections
I
G
X
AD
Y
C
S
T
M
10
8
0
2
2
4
8
4
4
16
22
20
16
2
2
4
8
8
4
4
16
28
30
24
4
2
6
12
8
4
4
16
34
40
32
6
2
8
16
8
4
4
16
40
50
40
8
2
10
20
8
4
4
16
46
60
48
10
2
12
24
8
4
4
16
52
What is national
equilibrium (Y)?
Withdrawals and injections
(Cont.)
AD
W= T + S + M
I=I+G+X
Y
Ye
AD equilibrium
There two ways of identifying the equilibrium
national income.
1.
At a point where total injections equal total
withdrawals.
2.
At the point where aggregate demand is
equal to national income - this is where AD
line cuts the 45 line.
Note that this is the AD-AS short-run model.
AD equilibrium (Cont.)
AD
AD= Y
AD= C + I + G+ X -M
45
Y
Ye
Limitation of Keynesian
Theory

Stop-go Phenomenon – in period of high
unemployment, the government would
expand aggregate demand to reduce
unemployment but at the same time
create inflationary pressure so that
government would have to reduce aggregate
demand again, thus all period tended to be
followed by stop periods and it become
difficult to achieve long-term economic
growth (business cycles).

The Keynesian model fails to take adequately
into account the problem of inflation.
The Multiplier
The Multiplier is a measure of the relationship
between the change in the equilibrium national
income and the autonomous change that brings
it about.
What is likely to happened to national
income if investment increases by N$2
million?
Equilibrium condition, Y=C+I+G+X-M where I,
G and X are autonomous.
Multiplier =  Y /  I
Investment multiplier: 1/(1-MPC)
What does this
mean?
The Multiplier (Cont.)
The Multiplier:

A measure of the relationship between the
change in the equilibrium national income
and the autonomous change that brings it
about.

The ratio of the change in the equilibrium
level of real national income to the change in
autonomous expenditures.

The number by which a change in
autonomous real investment or autonomous
real consumption is multiplied to get the
change in equilibrium real GDP.
The Multiplier (Cont.)

The essence of a multiplier is that total increase
in income, outputs or employment is manifold
the original increase in investment.

E.g. if investment of $100 is made, then the
income will not rise by $100 only but a multiple
of it.

Now consider the first effect of increase in one
of the injections. Suppose we increase
investment spending on new machinery by $2
million from $8m to $10m.

The immediate effect of the increase will
raise income by full $2m because spending
of one group in the economy is necessarily
income of the other group.
The Multiplier (Cont.)

Increased spending on machinery represents
higher incomes for these involved in
manufacturing the machines.

The process does not end there, because the
increase in income will brings about additional
consumption spending in the next period.

With 0.8 MPC and 0.2 MPM, consumption will
rise by $1.6m of which $0.4m will be additional
expenditure in imports.

Thus consumption of home produced goods will
rise by $1.2m.
The Multiplier (Cont.)

This rise in consumption will create a further
increase in income in the next period of $1.2m
over and above the initial increase and this in
turn will bring forth more consumption spending.

This process will continue with both consumption
and income rising, but the actual increases
become smaller and smaller overtime until
eventually they become insignificant.
The Multiplier Process
1227
Multiplier Formula
MPS = 1 – MPC

The slope of withdrawals line = MPS +
MPM, which can be written as ΔI/ΔY,

By rearranging we have ΔY =
∆𝐼
𝑚𝑝𝑠+𝑚𝑝𝑚

Substituting figures ΔY =
= $5m

This means national income will rises by $5m
following an increase in investment of $2m.
This is called multiplier effect

The multiplier = amount change in spending
has to be multiplied by to obtain the change
in income

Multiplier =
1
𝑚𝑝𝑠+𝑚𝑝𝑚
=
$2𝑚
0.2+0.2
1
0.2+0.2
= 2.5
Algebraic derivation of the
multiplier

Equilibrium condition, Y = C+ I’+ G’ + X – M

Consumption, C = a+b(Y-T’)

Import function, M = c+d(Y-T’)

Where Y = National income, C = planned
consumption expenditure, I’ = Planned
investment expenditure, G’=Planned
government expenditure, X’= planned
exports, M=planned imports, T’= lump-sum
tax. The constants a,b,c and d specify the
positions and shapes of the consumption and
import functions; b=MPC and d=MPM
Imports are a
function of Yd
Algebraic derivation of the
multiplier (Cont.)

I’, G’, T’ and X’ are assumed to be autonomous or
exogenous.

C, M and Y are endogenous

To find equilibrium national income, we solve the
system for Y

Y= a+bY-bT’+I’+G’+X’-c-dY+dT’

Collecting like terms

Y-bY+dY=a-bT’+I’+G’+X’-c+dT’

Y(1-b+d)=a-bT’+I’+G+X’-c+dT’

Dividing both side by (1-b+d) gives

Y=
𝑎−𝑏𝑇 ′ +𝐼 ′ +𝐺 ′ +𝑋 ′ −𝑐+𝑑𝑇 ′
1−𝑏+𝑑
Algebraic derivation of the
multiplier (Cont.)

Deducing the effect on national income of a
change in I’ ceteris paribus, we have

ΔY =

Δ𝑌
ΔI′

=
Δ𝐼 ′
1−𝑏+𝑑
1
(1−𝑏+𝑑)
=
1
(𝑚𝑝𝑠+𝑚𝑝𝑚)
Changes in G’ and X’ will have the same
multiplier effect on national income as change
in I’
The Balanced Budget
multiplier

Shows the effect on the equilibrium national
income of an increase in government
expenditure that is financed by equal
increase in taxation

Increase in equilibrium national income
following an increase in government
spending (in a closed economy with lumpΔ𝐺
sum taxes only) is ΔY1=
, where b is MPC
1−𝑏
The Balanced Budget
multiplier (Cont.)

The fall in equilibrium national income following
an increase in lump-sum taxation is:
𝑏Δ𝑇 ′
1−𝑏

ΔY2 =

If the tax and government spending changes
occur simultaneously, the combined effect on
income is:
∆𝐺 𝑏Δ𝑇 ′
,
1−𝑏 1−𝑏

ΔY2 =

But if the budget is balanced so that ΔG=ΔT, we
can write

ΔY =

The balanced budget multiplier is therefore equal
to 1
∆𝐺 𝑏Δ𝐺
1−𝑏 1−𝑏
1−𝑏
)ΔG
1−𝑏
=(
= ΔG,
Gap Analysis
Gap analysis is the simple way of describing the
main policy implication of the Keynesian theory.

Deflationary gap:
• The amount by which
aggregate demand must
be increased to raise the
equilibrium national
income to the level of full
employment.
•
Since the equilibrium
income Ye is bellow full
employment national
income Yf, the economy
will be suffering from
demand-deficient
unemployment.
AD
Full employment
45
AD
Deflationary gap
0
Ye
Yf
Deflationary Gap

The deflationary gap is the amount by which
aggregate demand must be increased to push
the equilibrium national income via a
multiplier, to the full employment national
income.

How can the increase in aggregate demand be
achieved?
 Increase
 Reduce

government spending or
tax
Changing government spending and/or
taxation is known as fiscal policy.
Inflationary Gap

The amount by which aggregate demand must
be decreased to reduce equilibrium national
income to its full employment value.

If we relax wages and price, the equilibrium
national income is above full employment level
and so cannot actually be attained.

The economy will be at full employment value
output; but excess demand will still exist so
that the general price level will be forced
upwards.

Appropriate fiscal policies to combat this
demand-pull inflation is to cut government
spending or increase taxation.
Inflationary Gap (Cont.)
AD
Full
Employment
45
AD
Inflationary
gap
0
Yf
Ye
National Income