CHAPTER 3

National Income Equilibrium

Dr. Nurul Nadia Abd Aziz

Copyright © Dr. Nurul Nadia Abd Aziz 1

 Syllabus
• 3.1 Two approaches in determine national income equilibrium
• 3.1.1 AD=AS approach
• 3.1.2 Injection=Leakages approach
• 3.2 Consumption theory: Conventional Autonomous and induced
consumption
• 3.3 Islamic consumption theory: Fahim Khan Islamic consumption
• 3.4 Investment theory conventional perspective Autonomous and induced
investment
• 3.5 Calculation Income equilibrium in a 2, 3, and 4-sector economy
• 3.6 Expenditure multiplier and tax multiplier Mr. Steve
• 3.7 Inflationary gap and deflationary gap

Copyright © Dr. Nurul Nadia Abd Aziz 2

 Definition

• Equilibrium refers to the state when total output (also aggregate

supply) is equal to or in balance with total demand (also aggregate
expenditure).

• Disequilibrium refers to the state when total output over total

demand or total demand over total output.

Mr. Steve

Copyright © Dr. Nurul Nadia Abd Aziz 3

 Definition
• There are 2 approaches to determine national income equilibrium:

Planned aggregate expenditure = Aggregate output (AD=AS).

Total planned injection = total planned withdrawal

Copyright © Dr. Nurul Nadia Abd Aziz 4

Circular Flow of Income in a
4-sector Economy
Export (X)
Factor of production: Land, Labor, Capital, Entrepreneur

Income (Y): Rental, Wages & Salary, Interest,

Profit

Taxes (T) Taxes (T) Export (X)

HOUSEHOLDS GOV’T FIRMS FOREIGN SECTOR
Government Government Import (M)
Spending (G) Spending (G)

Financial
Institution
Saving (S) Investment (I)

Consumer Expenditure (C)

Goods and Services

Import (M)

Copyright © Dr. Nurul Nadia Abd Aziz 5

 Formula
ECONOMICS AS=AD APPROACH LEAKAGE = INJECTION
SECTORS APPROACH

1 SECTOR Y=C S=0

2 SECTOR Y=C+I S=I

3 SECTOR Y=C+I+G S+T=I+G

4 SECTOR Y = C + I + G + (X-M) S+T+M=I+G+X

Copyright © Dr. Nurul Nadia Abd Aziz 6

 Consumption Theory
Consumption theory we can be divided into two perspectives:

Conventional Islamic
Perspective Perspective

Copyright © Dr. Nurul Nadia Abd Aziz 7

Conventional Perspective

Consumption function is the relationship between consumption and

income, other thing remain constant.

Saving function showing the relationship between saving and income,

other thing remain constant.

Copyright © Dr. Nurul Nadia Abd Aziz 8

 Consumption Function
C = a + bYd
Autonomous Disposable
Induced income
consumption
consumption
Refers to consumption on basic necessities, Is the amount of consumption
where the amount exists regardless of related to income.
whether income is available or not Change in disposable income leads
to change in consumption.
When Yd=O, consumption of basic The amount of consumption
necessities come from borrowing, depends on the value of MPC. MPC measure the
dissaving or steal. MPC = C change in consumption
that result from change in
Y income

Copyright © Dr. Nurul Nadia Abd Aziz

9
 Example
• Change in income from RM0-RM100 leads to a rise in consumption
RM100-RM175

MPC = 75 = 0.75
100

• Means that for any change in income the consumer will spend 75% of it.

Copyright © Dr. Nurul Nadia Abd Aziz 10

 Saving Function
S = -a + (1-b)Yd
Autonomous Disposable
Induced income
saving
saving
When Yd=0, and a = 100, so, Is the amount of saving related to income.
the consumption 100 is come Change in disposable income leads to change in
from saving. Therefore –a = - saving.
100. The amount of saving depends on the value of MPS.

MPS = S MPS measure the

Y change in saving that
result from change in
income
Copyright © Dr. Nurul Nadia Abd Aziz 11
The Relationship between Consumption
and Saving
C = a + bYd
S = -a + (1-b)Yd
1 = APC + APS 1 = MPC + MPS
Y=C+S Y=C+S
Y=C+S Y= C+ S
Y Y Y Y Y Y
1 = APC + APS 1 = MPC + MPS

Copyright © Dr. Nurul Nadia Abd Aziz 12

 Example
Fill in the blank with the correct answers.

Y C S=Y–C MPC MPS APC APS

0 100
100 175
200 250
300 325
400 400
500 475
600 550

Copyright © Dr. Nurul Nadia Abd Aziz 13

 Answers
Y C S=Y–C MPC MPS APC APS
0 100 -100 - - - -
100 175 -75 0.75 0.25 1.75 -0.75
200 250 -50 0.75 0.25 1.25 -0.25
300 325 -25 0.75 0.25 1.08 -0.08
400 400 0 0.75 0.25 1.00 0.00
500 475 25 0.75 0.25 0.95 0.05
600 550 50 0.75 0.25 0.92 0.08

Copyright © Dr. Nurul Nadia Abd Aziz 14

 C Y=C

AS = AD Approach C = 100 + 0.75Yd

BE
100

Y
400
S

S = -100 + 0.25Yd
Leakage = Injection Approach
BE
0 Y
400
-100

Copyright © Dr. Nurul Nadia Abd Aziz 15

 Islamic Perspective
• According to M. Fahim Khan. Muslim consumption is obviously different
from conventional consumption pattern. There are two types of
consumption:
• 1. Consumption expenditure for own and family, E1
• 2. Consumption expenditure for others, E2

Total expenditure = E1 + E2
• E1 includes present Consumption (C1) & Future consumption (S1)
• E2 includes present consumption (C2) & future consumption

Copyright © Dr. Nurul Nadia Abd Aziz 16

• A Muslim are free to decide how much of his income will spend on
these expenditure.
• However Islam give two guideline on the spending pattern.
– Rational spending - wealth, price level, expectation etc.
– Degree of God fearness consciousness

E1 E2
• The basket of goods for
• The Al-Quran does not
Muslim is limited to
specify exactly how much
permissible goods and the
to spend on E2 but the
way of Allah.
minimum amount should be
• Means that a Muslim must the amount of zakat
not only spend now but (compulsory to pay yearly).
must save for future
• However the more Muslim
consumption or
sincerely spend for others,
investment, as to improve
the better it is for him in
their economic condition in
this world and hereafter.
the future.

Copyright © Dr. Nurul Nadia Abd Aziz 17

 Change in Autonomous Change in Induce
Consumption Consumption
• The effect of a change in autonomous • The effect of a change in induced
consumption is that the curve will consumption is that the slope of the
shift upward or downward. curve rotate upward or downward.
• Factor: Non-factor of income • Factor: Disposable income

C Y=C C Y=C

C = 110 + 0.75Yd C = 100 + 0.80Yd

C = 100 + 0.75Yd C = 100 + 0.75Yd
C = 90 + 0.75Yd C = 100 + 0.70Yd
110
100 100
90
Y Y
Copyright © Dr. Nurul Nadia Abd Aziz 18
 Determinants of
Aggregate Consumption

Copyright © Dr. Nurul Nadia Abd Aziz 19

Induced Consumption

1. Household Income

• The higher your income, the higher your consumption likely.

People with money tend to consume more than with less
income.
• So consumption and saving depend directly on disposable
income.

Copyright © Dr. Nurul Nadia Abd Aziz 20

Autonomous Consumption
2. Expected future Income - If we expect future income increase,
consumption expenditure will increase too. Directly related to
expected future income.

3. Wealth - The greater the amount of wealth, the larger will be

the amount of consumption. Directly related to wealth.

4. Interest Rate - If interest rate decrease, consumption

expenditure increase. Inversely related to interest rate.

5. Tax - The higher is your tax rate, the lower is your consumption.
Inversely related to tax.

Copyright © Dr. Nurul Nadia Abd Aziz 21

Investment Theory

Dr. Nurul Nadia Abd Aziz

Copyright © Dr. Nurul Nadia Abd Aziz 22

 Definition
Investment defined as the process of producing and purchasing
capital/investment goods.

Copyright © Dr. Nurul Nadia Abd Aziz 23

 Investment includes

All purchases of real New constructions All change in

or capital goods.
• Examples: tools,
machinery, factory, office,
building, storage facility,
transportation etc.
• Include construction of stock/inventories
factories, warehouse, • Ex: physical increase in the
office, shops, houses etc. amount of goods produced
but unsold.

Copyright © Dr. Nurul Nadia Abd Aziz 24

 Types of Investment
• Amount is fixed and not effected by income (effected
by non-income factors)
Autonomous • Ex: depreciation
Investment

• This amount effected by income, as national income

increase, investment will increase too.
• The value of investment directly related to income
Induced
investment • Ex: investment on capital goods.

Copyright © Dr. Nurul Nadia Abd Aziz 25

 Total Investment =
Autonomous Investment
+ Induced Investment

This amount effected by income,

Investment Total as national income increase,
Induced investment will increase too.
Investment
Investment

Amount is fixed and not

effected by income (effected
by non-income factors)
Autonomous
Investment

National
Income
Copyright © Dr. Nurul Nadia Abd Aziz 26
Determinants of Investment
1. National Income
• As national income
increase, investment will
increase too.
• The value of investment
is directly related to
national income . Ex:
capital consumption.
Copyright © Dr. Nurul Nadia Abd Aziz
2. Interest Rate 3. Profit Expectation
• The higher the real • The higher the expected
interest rate, the smaller profitability of new
is the quantity of capital equipment, the
investment demanded greater the amount of
and vice versa. investment.
• Firm invest only when • Profits earned on past
they expect to earn a sales are retained by the
rate of profit that firm are reinvested in
exceeds the real interest new capital investment.
rate. Thus the higher Higher current profit, a
interest rate, the fewer larger flow of fund
projects that are available for re-
profitable, so the investment.
smaller is the amount of
investment demanded.
27
Determinants of Investment
4. Expected rate of
return
• Is the annual rate of
return that a firm
expects to obtain
through capital
investment.
• If the expected rate of
return from investment
is much lower than the
cost of investment firms
are not interested to
invest.
Copyright © Dr. Nurul Nadia Abd Aziz
5. Government policies 6. Innovation
• Depends on the policies • Product innovating
that the government involve creating the
undertaking. Ex: to capacity to produce
promote local new product which
investment the requires investment
government can give tax expenditure either to
exemption or reduction modify existing
or other incentives equipment or to create
could also be given to new equipment.
investor.
28
Investment in Islam
• Dr. Aqed A. Ansari pointed out that capital formation from the
conventional is rather limited since only focus on human behavior.
• In Islam it includes wide integration of various dimensions of social,
moral, political as well as spiritual.
• There are 4 institution that encourage the process of capital
formation/investment:
• Family
• Ummah
• Mosque
• Government
• The need to invest not only lies on government
but every individual in the economy.

Copyright © Dr. Nurul Nadia Abd Aziz 29

The Boundaries of Investment in Islam

Investment
Only should Does not
permissible emphasize on involve any
activities are welfare form of riba
allowed. besides and gharar.
profitability
Investment is
based on the
Its
needs of
implementatio
human that is
n should not
Dharuriyah,
against syariah
hajiyah and
kamaliyah

Copyright © Dr. Nurul Nadia Abd Aziz 30

Multiplier

Copyright © Dr. Nurul Nadia Abd Aziz 31

 Definition

Multiplier indicates how many times the change in national

income due to change in variable aggregate expenditure
/spending (investment, government, taxes, import).

Copyright © Dr. Nurul Nadia Abd Aziz 32

 Types of Multiplier

Government multiplier
Investment multiplier Tax multiplier indicates
indicates how many the
indicates how many the how many times the
change in national
change in national change in national
income due to change
income due to change income due to change
in government
in investment. in taxes.
spending

Copyright © Dr. Nurul Nadia Abd Aziz 33

 Formula
AD Autonomous/constant/lump sum tax
multiplier or without tax
Investment K I= 1/1-b or 1/mps
multiplier
Government K g= 1/1-b or 1/mps
multiplier
Tax multiplier K t= -b/1-b or -b/mps

Copyright © Dr. Nurul Nadia Abd Aziz 34

Inflationary Gap

Copyright © Dr. Nurul Nadia Abd Aziz 35

 Inflationary Gap
• Situation where national income exceeds the full employment level Yfe.
• The increase is only in the increase of nominal income but no real increase in
goods and services.
• Y : C + I + G + (X-M) exceeds full employment
• To eliminate inflation, the inflationary gap must closed by either raising
withdrawals/ lowering injections/ combinations until Ye=Y.
• Example:
• Deflationary fiscal policy:
• Lowering government expenditure/raising taxes
• Deflationary monetary policy:
• reducing the amount of money and raising interest rate

Copyright © Dr. Nurul Nadia Abd Aziz 36

Inflationary Gap Using AS=AD Approach

AD
AS = AD

ADE

ADFE
Inflationary gap

AS
YFE YE

Copyright © Dr. Nurul Nadia Abd Aziz 37

Deflationary Gap

Copyright © Dr. Nurul Nadia Abd Aziz 38

 Deflationary gap
• Situation where the equilibrium level of income is not a full employment level of
national income.
• Resources are not fully utilized and any increase in national income shows an increase in
goods and services
• To close this gap, government must implement
• Expansionary monetary policy:
• Increase the supply of money
• Expansionary fiscal policy;
• Reduces tax, increase government expenditure. This will increase AD since spending
increases. The deflationary gap will be reduced.

Copyright © Dr. Nurul Nadia Abd Aziz 39

Deflationary Gap Using AS=AD Approach

AD
AS = AD

ADFE

Deflationary ADE
gap

AS
YE YFE

Copyright © Dr. Nurul Nadia Abd Aziz 40

Copyright © Dr. Nurul Nadia Abd Aziz 41
Copyright © Dr. Nurul Nadia Abd Aziz 42