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A Simple Model of Income Determination

A Simple Model of Income Determination. The most influential economist of all times. A Simple Model of Income Determination. This module gives a first introduction to macroeconomic models

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A Simple Model of Income Determination

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  1. A Simple Model of Income Determination

  2. The most influential economist of all times

  3. A Simple Model of Income Determination • This module gives a first introduction to macroeconomic models • The model is way too simple to be of much practical use, but still some of the most important topics are introduced • In constructing models, which variables do we include and what is the relationship between them • exogenous variables • endogenous variables

  4. Important assumptions • There is excess capacity (unemployment) in the economy • The price level is fixed • Technology is given • Investments only affect demand, not supply • Aggregate demand determine the equilibrium level of income • Firms will supply whatever is demanded without raising prices • This is a short term model

  5. Closed economy, no public sector • We only have two sectors in the economy, households and firms. The only demand is therefore consumption and investment • Y = C + I • How do these affect each other, or what determine: • Private consumption, C ? • Private investment, I?

  6. Private consumption • Keynes postulated that consumption demand depends on income • Keynes consumption function • C = a + bYd • a = income independent consumption • b = marginal propensity to consume = MPCC/ Yd • C/Yd = average propensity to consume = APC (APC > MPC) • Yd = disposable income

  7. C = 10 + 0.8Yd

  8. Keynes consumption function C C = 100 + 0,8Yd Slope = C/ Yd= MPC = 0,8 100 Income (Yd)

  9. Long-run and short-run consumption functions C10 years’ time C5 years’ time Cnow Y Consumption (£bn) Y (£bn)

  10. UK consumption and saving Saving £m Disposable income Consumer expenditure

  11. Investments are exogenous I 60 Income (Yd)

  12. Equilibrium • How do we find equilibrium values for the endogenous variables? • Which values on Yd and C will ensure that Y = C + I ? • Graphical solution • Algebraic solution

  13. Algebraic solution • The structural version of the model • I = I • C = a + bYd • Y = C + I • The model on reduced form:

  14. Macroeconomic equilibrium

  15. Equilibrium graphically Y=AD C + I C + I C 160 100 450 800 Income (Yd)

  16. The multiplier • Our model was: • I = 60 • C = 100 + 0,8Yd • Y = 800 • What happens to Y if I increases by 10, i.e.  I = 10?

  17. The multiplier C + I +I Y=AD C + I C + I C 170 I 160 100 450 Income (Yd) 800 850

  18. The Model

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