INCOME DETERMINATION IN SHORT RUN: BASIC MODEL Deviation of actual from potentia l GDP (Income), that is the GDP

P Gap. ( ex-The Great Depression) The determinatio n of GDP in the short run depends on the behavior of key categories of aggregate spending: Consumption (APC and MPC), Investment (autonomous and induced, intere st rates), Government Spending (Fiscal measures) and Net Exports. Consumption sp ending depends on real interest rates and business confidence. A necessary condi tion for GDP to be in equilibrium is that desired domestic spending equals actua l output. Equilibrium GDP AE= Y AE (C+I) E 45 AE= Y Desired Aggregate Expenditure Real NI (GDP)

Equilibrium GDP S> I I> S

Changes In GDP Shifts in Aggregate Spending Function In E E 1 E 0 In Y o Y Y o 1 Real NI (GDP) A E In E Desired Aggregate Expenditure Desired Aggregate Expenditure AE 1 AE0 In Y Y o Real NI (GDP) Y 1

Consumption, Investment Function and Multiplier 1. Consumption Function and Psychological Law Consumption Function and Propensit y to Consume Consumption function or propensity to consume refers to the general income consumption relationship. Symbolically, it can be expressed as C=f (Y). Consumption refers to the expenditure on consumption at a given level of income, while propensity to consume refers to the schedule showing consumption expendit ure at various levels of income. Psychological Law of Consumption Psychological Law of Consumption contains the following three interrelated propositions(i) Whe n aggregate income increases aggregate consumption also increases, but by a some what smaller amount. (ii) The increase in income will be divided in some ratio b etween saving and consumption. (iii) Both saving and consumption will increase a s a result of the increase in income.

Schedule of Consumption Function INCOME (Y) 0 50 100 150 200 250 CONSUMPTION (C) 20 60 100 140 180 220 Y=C B Dissaving Saving SAVING (S= Y-C) -20 -10 0 10 20 30 Consumption c 0 Y Income

Technical Attributes of Consumption Function Average Propensity to Consume (APC) Average Propensity to Consume is defined as the ratio of absolute consumption to absolute income. APC= C/Y. Marginal Propens ity to Consume (MPC) Marginal Propensity to Consume (MPC) refers to the ratio of small change in consumption to small change in income. MPC= change in Consumpti on/change in Income. c Properties of MPC c 1. MPC is greater than zero but less than one. c 2. MPC falls with successive increase in income. 3. MPC of the poor is greater than that of the rich. INCOME

1. (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Subjective Factors: Subjective factors are endogenous or internal to economic sy stem. According to Keynes, these factors are unlikely to undergo a material chan ge over a short period of time except in abnormal or revolutionary circumstances . Psychology of Human Nature: There are eight motives which lead the individuals to refrain from spending out of their incomes. They areTo build the reserve for unforeseen contingencies (death, diseases,) To provide for anticipated future n eeds.( retirement, higher studies) To enjoy an enlarged future income by investi ng funds out of current income. To enjoy a sense of independence or not to depen d on others. To posses power or to get higher social or political status. To sec ure enough funds to carry out speculation. To bequeath a fortune. To satisfy pur ely miserly instinct. Factors Affecting Consumption Function

 (i) (ii) (iii) (iv) 2. (i) (ii) (iii) (iv) (v) (vi) Institutional Arrangements: with respect to the behavior of business corporation s and governments, Keynes listed the following four motives for accumulation: En terprise- the desire to expand or to do big things. Liquidity- the desire to fac e emergencies successfully. Rising Income the desire to demonstrate successful m anagement. Financial Prudence the desire to ensure adequate financial provisions against depreciation. Objective Factors: Objective factors that cause shift in consumption function are. Changes in Wage Level Distribution of Income Windfall Gains and Losses Fiscal Policy Changes in Expectations Rate of Interest

Investment Function In Keynesian economics, investment means real investment and not financial inves tment. Real investment implies the creation of new machines, new factory buildin gs, roads, bridges, and other forms of productive capital, which directly genera tes new jobs and increases production. Real investment does not include the purc hase of existing stocks, shares and securities, which is merely an exchange of m oney from one hand to another. Such an investment is simply financial investment and has no direct impact on the employment and output of the economy. Types of Investment 1. Induced or Private Investment I 2. Autonomous or Public Investment I 3. Planned Investment and Unplanned Investment 4. Gross and Net Investment: G ross Investment includes a) net investment Income and b) depreciation and Net In vestment includes Gross Investment minus Depreciation Investment

Propensity to Invest 1. Average Propensity to Invest ( API): The ratio between a ggregate investment and aggregate income. API= I/Y. 2. Marginal Propensity to In vest ( MPI): The ratio of change in investment to change in income. I L I2 I1 I T Investment Investment K I1 Y1 Income Y1 Y2 Income

PROBLEMS Recession Aggregate Spending < GDP Recessionary Gap = shortfall Inflation Aggregate Spending > GDP Inflationary Gap = excess

The Multiplier The concept of Multiplier is an integral part of Keynes Theory of Employment. Ke ynes believed that an initial increment in investment increases the final income by many times. Keynes gave the name Investment Multiplier which is also known as I ncome Multiplier or simply Multiplier. Multiplier is expressed as K= Change in Inco me (Y)/ Change in Investment (I) According to Kurihara, The Multiplier is the ra tio of change in income to the change in Investment. According to D.Dillard, Inve stment Multiplier is the ration of an increase in income to given increase in In vestment In short the Multiplier tells us how many times the income increases as a result of an initial increase in investment.

 The multiplier tells us how many times the income increases as a result of incre ased investment. It applies to autonomous investment. There is closed economy. T here is no change in the prices of commodities. There is no time lags. The MPC r emains constant. The situation is less than full employment. The factors and res ources of production are easily available. The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate incom e. An increase in spending by one party increases the income of others. Thus, gr owth in spending can expand output by a multiple of the original increase. The m ultiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier incre ases with the marginal propensity to consume (MPC).

The Multiplier Principle Expenditure stage Round 1 Round 2 Round 3 Round 4 Round 5 All others Total Addit ional income (Rs) Additional consumption (Rs) Marginal propensity to consume 3/4 3/4 3/4 3/4 3/4 3/4 3/4 1,000,000 750,000 562,500 421,875 316,406 949,219 4,000,000 750,000 562,500 421,875 316,406 237,305 711,914 3,000,000 For simplicity (here) it is assumed that all additions to income are either spen t domestically or saved.

Relation between MPC and Multiplier Total Income = Total Consumption + Total Inv estment Or Y=C+I Or Change in Income = Change in Consumption + Change in Investm ent Or Change in Investment = Change in Income -- Change in Consumption By defin ition, Multiplier is K = Change in Income / Change in Investment Substituting th e value of Change in Investment in K equation we get K = Change in Income / Chan ge in Income -- Change in Consumption Dividing both the numerator and denominato r by Change in Income, we have 1 Change in Income -- Change in Consumption K= Ch ange in Income 1 K = 1-- Change in Consumption / Change in Income K = 1/ 1MPC, K = 1/ MPS

Y= C + I C+I+G E1 I C+I CONSUMPTION INVESTMENT E0 C Y 0 INCOME

 The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity t o consume (here assumed to be 75% = 3/4). Here, a Rs 1,000,000 injection is spen t, received as payment, saved and spent, received as payment, saved and spent et c. until

Leakages of Multiplier Saving Debt Cancellation Imports Price Inflation Hoarding Purchase of old sha and securities Taxation Undistributed Profits

A Higher MPC Means a Larger Multiplier MPC 9/10 multiplier 4/5 3/4 2/3 1/2 1/3 1 Size of 10.0 5.0 4.0 3. 2.0 0 1.5 As the MPC increases, more and more money of every injection is spent (and so rec eived as payment and then spent again, received as payment and spent again, etc. ). The effect is that for higher MPCs, higher multipliers result. Specifically th e relationship follows this equation: M = 1 - MPC

1. E 1 E 0 AE= Y AE 1 AE 0 Y 1 2. E 1 E 0 Y Y 0 Real NI 1 (GDP) AE 1 AE 0 AE= Y AE 1 AE 0 Desired Expenditure Desired Expenditure Y 0 Real NI (GDP) 1. Unity Multiplier 2. An intermediate case. 3. A steep AE, large Multiplier. 3. E 1 AE= Y Desired Expenditure E 0 Y 0 Y 1 Real NI (GDP)

Real-World Significance of The Multiplier In evaluating the importance of the multiplier, one should remember: taxes and spending on imports will dampen the size of the multiplier; it takes t ime for the multiplier to work; and, the amplified effect on real output will be valid only when the additional spending brings idle resources into production w ithout price changes.

(BUSINESS CYCLES) Peak Cont Peak sion Peak n Ex pa ns io Peak Peak n Exp ans io Peak Level of GNP i on n ans io sio ans n Contrac Cont Cont Cont Cont Expa n an n ractio Exp Ex p Exp n ractio n ractio n ractio

n ractio Throug Throug h h Depression tion Throug h TIME Throug Throug Through h Depression h

Phases of Business Cycles Business Cycles has different phases. 1. Expansion (Boom, Upswing or Prosperity) 2. Peak ( upper turning point) 3. Contraction (Downswing, Recession or Depressi on) 4. Trough (lower turning point)

Anti Cyclical Policies MONETARY FISCAL EXIM POLICY-DEVALUATION/APPRECIATION

Inflation and Unemployment Models of the short term determination of GDP explain why actual GDP deviates fr om potential GDP. Actual GDP above potential can be associated with inflation, w hile actual GDP below potential is associated with unemployment and lost output. What determines aggregate spending? Desired aggregate spending includes desired consumption, and desired government spending, plus desired net exports. It is t he amount that economic agents want to spend on purchasing the national product. A change in personal disposable income leads to a change in private consumption and saving. The responsiveness of these changes is measured by the MPC and MPS, which are both positive and sums one. A change in wealth tends to cause a chang e in the allocation of disposable income between consumption and saving. The cha nge is consumption is positively related to the change in wealth, while the chan ge in saving is negatively related to this change. Investment depends, among oth er things, on real interest rates and business confidence. The part of consumpti on that responds to changes in income is called induced spending.

Price Stability Types of price rise1. Creeping-2 percent annually 2. Walking-5 percent annually 3. Running-10 percent annually 4. Galloping or Hyper Inflation-more than 10 perc ent annually On the basis of time1. Peace time 2. War time 3. Post war time Main causes 1. Demand Pull 2. Cost-push-wage push, profit push, material push

Demand Pull Inflation The Monetarist Theory S P3 P2 P2 D2 D1 D M Output d d1 P1 s d2 Output d4 d3 Keyn esian Theory s Price Level P1 P m m1 m3 m4

Cost Push Inflation S E1 P1 P S1 S M1 M D E Price Level Output

INFLATIONARY GAP According to Keynes, inflationary gap exists when, at full employment income lev el, aggregate demand exceeds supply. This means that due to increase in investme nt and government expenditure, the money income increases, but production does n ot increase because of the limitations of productive capacity. As a result, an i nflationary gap comes to exist, causing the prices to rise. The prices continue to rise so long as the inflationary gap exists.

Inflationary and Deflationary Gaps Inflationary gap occurs when AD exceeds AS at full employment level of output. I n this case, money rises to a higher equilibrium, but real income being at full employment output level remains unchanged. As a result there is an upward rise i n prices because the consumers compete for limited supply of output and bid pric es up. Inflationary gap A B E AS or Y=C+I+G AD or C+I+G Deflationary gap prevails when AD is less than AS at full employment level of ou tput. Income equilibrium occurs while resources are unemployed. EXPENDITURE (C+I+G) O Income (Y) Yf YO B A AD or C+I+G Deflationary gap E AS or Y=C+I+G EXPENDITURE (C+I+G) O Income (Y) YO Yf

Equilibrium GDP Equilibrium GDP: At the Equilibrium level of GDP, purchasers wish to buy exactly the amount of national output that is being produced. At GDP above equilibrium, desired spending falls short of national output, and output will sooner or late r be curtailed. At GDP below equilibrium, desired spending exceeds national outp ut, and output will sooner or later be increased. In a closed economy with no go vernment, desired saving equals desired investment at equilibrium GDP. Changes i n GDP: With constant price level, equilibrium GDP is increased by a rise in the desired consumption or investment spending that is associated with each level of NI. Equilibrium GDP is decreased by a fall in desired spending. Changes in equi librium is also because of Multiplier effect.