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The Expanded Model of Income Determination

The Expanded Model of Income Determination . Expanded model of income determination. In chapter 14, a very basic Keynesian model of income determination was introduced This model serves as an introduction to income determination and capacity utilisation in the economy

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The Expanded Model of Income Determination

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  1. The Expanded Model of Income Determination

  2. Expanded model of income determination • In chapter 14, a very basic Keynesian model of income determination was introduced • This model serves as an introduction to income determination and capacity utilisation in the economy • If is far to simple to be of any use in the real world, but it establishes some important points nevertheless

  3. Keynes, John Maynard, 1st Baron Keynes of Tilton(1883-1946)

  4. Expanded model of income determination • Recall when Keynes was writing – mid thirties with massive unemployment • Established theory until then had assumed that this would be a temporary phenomenon • In a world with flexible prices, in the long run equilibrium will exist in all markets • Keynes: In the long run, we are all dead

  5. Expanded model of income determination • Keynes gave politicians theoretically sound arguments for intervening in the economy • Keynes in particular focused on how the authorities could affect aggregate demand through fiscal policy, i.e. government purchases of goods and services and taxes • In chapter 15, this is incorporated into the basic model of income determination.

  6. Expanded Model of Income Determination • We introduce a public sector, with government purchases of goods and services G and taxes T. This model could be labelled a Keynes model for a closed economy with a public sector • Later in the chapter, another sector is introduced – the foreign sector. Only goods transactions takes place, exports (X) and imports (Z) • This chapter also provides a more satisfactory explanation of investment demand

  7. Investment demand • Demand for investment goods (I) very much depends on the outlook for the economy • Profitability depends on: • Investment outlay • Increased income due to the investment • Costs of financing the investment • Increased income – cost of investment = MEI(marginal efficiency of investment) • Cost of financing: R

  8. Time value of money • The investment outlay is paid for ”today” • Income will accrue in the future, and value may be reduced due to: • impatience and postponement of demand • risk • inflation • Income must be discounted by an interest rate R

  9. Net Present Value • Example: • Investment outlay = 10 000 • Income year 1: 6 000 • Income year 2: 2: 6 000 • Interest rate (R) = 5 % (0,05) • What is the PV of the income?

  10. Marginal Efficiency of Investment (MEI) Rate of return (R) Marginal efficiency of investment R2 R1 I0 I2 I1

  11. Expectations change Rate of return (R) Marginal efficiency of investment R0 I2 I0 I1

  12. Keynesian business cycle • The accelerator • changes in national income and induced investment • the accelerator coefficient • the instability of investment • The multiplier / accelerator interaction

  13. Fluctuations in UK real GDP and investment: 1978-2002

  14. Fluctuations in UK real GDP and investment: 1978-2002 GDP

  15. Fluctuations in UK real GDP and investment: 1978-2002 Investment GDP

  16. Accelerator 1970-1999 in Norway

  17. Accelerator theorycapital output ratio = 2

  18. Accelerator theory • Investments are dependent on expected changes in GDP or I =  Y • Accelerator – a small change in income gives a large change in induced investment • This depends on the marginal ratio between capital and production • In addition, we will have multiplier effects between I and Y

  19. Introducing the public sector • Taxes T represent a withdrawal from the economic circulation (like savings S) • The Governments demand for goods and services G represent an injection (like investments I) • Equilibrium when realised withdrawals = realised injections • S + T = I + G

  20. Keynes expanded model - 1 • The public sectors demand for goods and services G is always exogenousTaxes (T) • Version 1: Lump sum taxes T = T • Version 2: Income taxes T = tY, where t is the (average) tax rate

  21. The model version 1

  22. Equilibrium

  23. An example • Assume we have the following: • C = 0,8Yd • I = 60 • G = 50 • T = 50

  24. The multipliers

  25. The model

  26. Haavelmos theorem • What happens if an increase in public spending is financed by an equivalent tax increase, i.e. G= T?

  27. The Model Version 2

  28. Equilibrium

  29. The multipliers

  30. The model

  31. Built in stabilisers Government expenditure and Taxes T G T G Yb

  32. Introducing the foreign sector • Imports: Z and Exports: X • Equilibrium when leakages = injectionsS + T + Z = I + G + X • It is assumed that imports are endogenous and dependent on income • Exports are exogenous

  33. Economic circulation

  34. The model

  35. The multipliers

  36. The open economy model

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