Simple Keynesian Model

National Income Determination

Three-Sector National Income
Model
1

Outline

Three-Sector Model
Tax Function T = f (Y)
Consumption Function C = f (Yd)
Government Expenditure Function G=f(Y)
Aggregate Expenditure Function E = f(Y)
Output-Expenditure Approach:
Equilibrium National Income Ye
2

Outline

Factors affecting Ye
Expenditure Multipliers k E
Tax Multipliers k T
Balanced-Budget Multipliers k B
Injection-Withdrawal Approach:
Equilibrium National Income Ye

Outline

Fiscal Policy (v.s. Monetary Policy)

Recessionary Gap Yf - Ye
Inflationary Gap Ye - Yf
Financing the Government Budget
Automatic Built-in Stabilizers

Three-Sector Model

With the introduction of the government

sector (i.e. together with households C,
firms I), aggregate expenditure E
consists of one more component,
government expenditure G.
E=C+I+G
Still, the equilibrium condition is
Planned Y = Planned E
5

Three-Sector Model

Consumption function is positively

related to disposable income Yd [slide
37 of 2-sector model],
C = f(Yd)
C= C
C= cYd
C= C + cYd
6

Three-Sector Model

National Income Personal Income

Disposable Personal Income
w/ direct income tax Ta and transfer
payment Tr
Yd Y
Yd = Y - Ta + Tr

Three-Sector Model

Transfer payment Tr can be treated as

negative tax, T is defined as direct
income tax Ta net of transfer payment
Tr
T = Ta - Tr
Yd = Y - (Ta - Tr)
Yd = Y - T
8

Three-Sector Model

The assumptions for the 2-sector

Keynesian model are still valid for
this 3-sector model [slide 24-25 of
2-sector model]

Tax Function

T = f(Y)

T = T
T = tY
T = T + tY

10

Tax Function
T = T

T = tY

T = T +tY

Y-intercept=T

Y-intercept=0

Y-intercept=T

slope of tangent=0
slope of tangent=t
slope of tangent=

11

Tax Function

Autonomous Tax T

Proportional Income Tax tY

marginal tax rate t is a constant

Progressive Income Tax tY

this is a lump-sum tax which is independent

of income level Y

marginal tax rate t increases

Regressive Income Tax tY

marginal tax rate t decreases

12

Consumption Function

C
C
C
C

=
=
=
=

f(Yd)
C
C
cYd

C = c(Y - T)
C = C + cYd
C = C + c(Y - T)
13

Consumption Function
C
=
C
+
c(Y
T)
T = T

C = C + c(Y - T) C = C- cT + cY
slope of tangent = c
T = tY
C = C + c(Y - tY) C = C + (c - ct)Y
slope of tangent = c - ct
T = T + tY
C = C+c[Y-(T+tY)]C = C - cT + (c - ct) Y
slope of tangent = c - ct

14

Consumption Function
C = C + c (Y - T)
Y-intercept = C - cT

slope of tangent = c = MPC

slope of ray APC when Y

15

Consumption Function
C = C + c (Y - tY)
Y-intercept = C

slope of tangent = c - ct = MPC (1-t)

slope of ray APC when Y

16

Consumption Function
C = C + c [Y - (T + tY)]

Y-intercept = C -cT

slope of tangent = c - ct = MPC (1-t)

slope of ray APC when Y

17

Consumption Function
C = C - cT + (c - ct)Y

C OR T
y-intercept C - cT C shift upward
t
c(1-t) C flatter
c
c(1-t) C steeper
y-intercept C - cT C shift downward
18

Government Expenditure
Function

G only includes the part of

government expenditure spending
on goods and services, i.e. transfer
payments Tr are excluded.
Usually, G is assumed to be an
exogenous / autonomous function
G = G
19

Government Expenditure
Function
Y-intercept = G
slope of tangent = 0
slope of ray when Y

20

Aggregate Expenditure
Function

E =C+I+G
given C
= C + cYd
T = T + tY
I = I
G = G
E = C + c[Y - (T+tY)] + I + G
E = C - cT + I+ G + (c-ct)Y
E = E + c(1-t) Y
21

Aggregate Expenditure
Function

E = C - cT + I + G + (c - ct)Y
E = E + (c - ct)Y
given E = C - cT + I + G
E is the y-intercept of the
aggregate expenditure function E
c - ct is the slope of the aggregate
expenditure function E
22

Aggregate Expenditure
Function

Derive the aggregate expenditure

function E if T = T
E = C - cT + I + G + cY
y-intercept = C - cT + I + G
slope of tangent = c

23

Aggregate Expenditure
Function

Derive the aggregate expenditure

function E if T = tY
E = C + I + G + (c-ct)Y
y-intercept = C + I + G
slope of tangent = (c-ct)

24

Aggregate Expenditure
Function

Derive the aggregate expenditure

function E if T = T and I = I + iY
E = C - cT + I + G + (c + i)Y
y-intercept = C - cT + I + G
slope of tangent = (c + i)

25

Aggregate Expenditure
Function

Derive the aggregate expenditure

function E if T = tY and I = I +iY
E = C + I + G + (c - ct +i )Y
y-intercept = C + I + G
slope of tangent = (c - ct +i )

26

Aggregate Expenditure
Function

Derive the aggregate expenditure

function E if T = T + tY and I = I
+iY
E = C - cT + I + G + (c - ct +i)Y
y-intercept = C - cT + I + G
slope of tangent = (c - ct +i)

27

Output-Expenditure Approach
w/ T = T + tY
w/ C = 2-Sector
C + cYd
C
C = C + cYd = C + cY
Slope of tangent = c = MPC =C/Yd

Slope of tangent = c (1-t) = (1-t)*MPC M

3-Sector
C

C = C - cT + c(1-t)

C -cT
Y
28

I, G, C, E, Y

Y=E

Y
Planned Y = Planned E
29

Output-Expenditure
Approach
E = E + (c - ct) Y
[slide 21-22]
= I exogenous
InI equilibrium,
planned Y = function
planned E
Y = E + (c - ct) Y
(1- c + ct) Y = E
Y=
E
1
1 - c + ct

E = C - cT + I + G
kE=
1
1 - c + ct

30

Output-Expenditure
Approach
E =I+iY
E + (c - endogenous
ct + i) Y
[slide 27]
I=
In equilibrium, planned Y = planned E
function
Y = E + (c - ct + i) Y

(1- c + ct - i) Y = E
Y=
E 1
1 - c - i + ct

E = C - cT + I + G
kE=

1
1 - c - i + ct

31

Output-Expenditure Approach
T = T exogenous function
I =
I
+
iY
E = E + (c + i) Y
[slide 25]

In equilibrium, planned Y = planned E

Y = E + (c + i) Y
(1 - c - i) Y = E
Y=
E1
1-c-i

E = C - cT + I + G
kE=

1
1-c-i

32

Factors affecting Ye

Ye = k E * E
In the Keynesian model, aggregate
expenditure E is the determinant of Ye
since AS is horizontal and price is rigid.
In equilibrium, planned Y = planned E
E = C - cT + I + G + (c - ct + i) Y
Any change to the exogenous variables will
cause the aggregate expenditure function
to change and hence Ye
33

Factors affecting Ye

Change in E
If C I G E E Y
If T C - c T E by - c TE Y
Change in k E / slope of tangent of E
If c i E steeper Y
If c C - c T E E Y
If t E steeper Y
34

I, G, C, E, Y

Y=E

Y
35

I, E, Y I

E = I

I
Y
Ye = k

36

G, E, YG

Y
37

C, E, Y C

Y
38

C, E, Y T

C by -cT

Y
39

I, E, Y i

Y
40

Digression

Differentiation
y = c + mx
differentiate y with respect to x
dy/dx = m

41

Expenditure Multiplier k

Y=k
kE=
k
k

=
=

* E
1

1 - c + ct
1
1 - c + ct - i
1
1-c-i

E = C - cT + I + G
if I=I & T=T+tY
if I=I+iY & T=T+tY
if I=I+iY & T=T
42

Expenditure Multiplier k

Whenever there is a change in the

autonomous spending C I or G the
national income Ye will change by a
multiple of k E.
It actually measures the ratio of the
change in national income Ye to the
change in the autonomous expenditure E
Ye/E = k E
43

Tax Multiplier k T

Y=k
kT =
k
k

=
=

* ( C - cT + I + G)
-c
if I=I & T=T+tY

1 - c + ct
-c

if I=I+iY & T=T+tY

1 - c + ct + i
-c
1-c-i

if I=I+iY & T=T

44

Tax Multiplier k T

Any change in the lump-sum tax T

will lead to a change in the
national income Ye by a multiple of
k T in the opposite direction since k
T takes on a negative value
Besides, the absolute value of k T is
less than the value of k E.
45

Balanced-Budget Multiplier
kB

G E E Ye by k E times
T E E Ye by k T times
If G = T , the change in Ye can be
measured by k B
Y/ G = k E
Y/ T = k T
kB=kE+kT
kB= + =1
1

-c

1-c

1-c

46

Balanced-Budget Multiplier
kB

The balanced-budget multiplier k B =

1 when t=0 & i=0
What is the value of k B if t 0 ?
If k B = 1 an increase in government
expenditure of $1 which is financed
by a $1 increase in the lump-sum
income tax, the national income Ye
will also increase by $1
47

Injection-Withdrawal
Approach

In a 3-sector model, national income is

either consumed, saved or taxed by the
government
Y=C+S+T
Given E = C + I + G
In equilibrium, Y = E
C+S+T=C+I+G
S+T=I+G
48

Injection-Withdrawal
Approach

Since S + T = I + G
SI
TG
I>ST>G
I<ST<G
(Compare with 2-sector model)
In equilibrium S = I
49

Injection-Withdrawal
Approach

T = T + tY
S = -C + (1-c) Yd
S = -C + (1 - c)[Y -_(T + tY)]
S
S
S
S

=
=
=
=

-C
-C
-C
-C

+
+
+
+

(1 - c)[Y - T - tY]
Y - T - tY - cY + cT + ctY
cT -T - tY + Y - cY + ctY
cT - (T + tY) + Y - cY + ctY
50

Injection-Withdrawal
Approach

S + T = -C + cT -(T+ tY) + Y - cY + ctY +T

S + T = -C + cT + Y - cY + ctY
In equilibrium, S + T = I + G
-C + cT + Y - cY + ctY = I + G
(1- c + ct)Y = C - cT + I + G
Ye = k E * E
E = C - cT + I + G
[slide 30]
51

Use the Injection-Withdrawal

Approach to solve for Ye if
T=T

52

Fiscal Policy

The use of government expenditure and

taxation to achieve certain goals, such as
high employment, price stability.
Discretionary Fiscal Policy

Expansionary Fiscal Policy (when Yf > Ye)

Contractionary Fiscal Policy (when Yf < Ye)

Automatic Built-in Stabilizers

Proportional / Progressive Tax System

Welfare Schemes

53

Expansionary Fiscal Policy

Recessionary/Deflationary Gap YfY-line
YeE E Y
G
E = E + (c-ct) Y
E = E + (c -ct) Y
G
Y= k E * E
Recessionary GapYe

Yf

54

Expansionary Fiscal Policy

Recessionary/Deflationary Gap
Yf-Ye
T
E by -c T E YY-line
E = E + (c-ct) Y
E = E + (c -ct) Y
-cT
Y= k E * E = k T * T
Recessionary GapYe

Yf

55

Contractionary Fiscal
Policy
Y=E
Gap Ye - Yf
G Inflationary
E E Y

E = E + (c-ct) Y

E = E + (c-ct) Y

Y= k E * E
Yf

Gap
Ye Nominal Y>Yf Inflationary
56

Contractionary Fiscal
Policy
Y=E
Gap
Ye - Yf
T Inflationary
E by -c T E
Y

E = E + (c-ct) Y

E = E + (c-ct) Y

-cT

Y= k E * E = k T * T
Yf

Gap
Ye Nominal Y>Yf Inflationary
57

Automatic Built-in
Stabilizers

Proportional /Progressive Tax System

Recession: governments tax revenue

Boom: governments tax revenue

The more progressive the tax system, the

greater is its stabilizing effect. But there will
be greater dis-incentives to earn income
With t, k E With proportional tax, the
multiplying effect of a discretionary change
in government expenditure G reduces
58

Automatic Built-in
Stabilizers

Welfare Schemes
Unemployment benefits, public assistance
allowances, agricultural support schemes

Recession: governments expenditure

Boom: governments expenditure

Again, if the welfare schemes are

generous, the incentives to work will be
weakened.
59

Discretionary Fiscal Policy

v.s.
If the economy is close to Yf, built-in stabilizers
Automatic
are useful
as they can Built-in
stabilize the economy
around
Yf or potential income level.
Stabilizers
However, if the economy is far below Yf,
discretionary fiscal policy is still necessary
(Simple Keynesian model).
Another drawback of the built-in stabilizers is
they may reduce the speed of recovery as
k E Y = k E * E

60

Discretionary Fiscal Policy

Government expenditure G? Tax

T?
Location of effects
If a recession is localized in a
particular industry G
Tax cut will have its impact on the
entire economy
61

Discretionary Fiscal Policy

Government expenditure G? Tax T?

Duration of the time lag

Decision lag : time involved to assess a

situation & decide what corrective actions
should be taken
Executive lag : time involved to initiate
corrective policies & for their full impact to be
felt

tax cut has a much shorter executive lag

62

Discretionary Fiscal Policy

Government expenditure G? Tax T?

Reversibility of the fiscal policy

Government expenditure can easily be increased

but are not so easy to cut as the civil servants who
have vested interests in the present allocation of
government expenditure will resist
Tax is easier to be changed as the civil servants
who administer income tax is independent of the
rate being levied. Of course, voter resistance
should also be considered.

63

Discretionary Fiscal Policy

Government expenditure G? Tax T?

Public reaction to short-term changes
A temporary tax cut raises Yd.
Households, recognizing this situation,
may not revise their current
consumption. Instead, they save a
large part of the tax cut.
64

Financing the Government

Budget
ByIncreasing
increasing taxes,
the government transfers
Taxes

purchasing power from current taxpayers to

itself
Current taxpayers bear the cost
If the revenue is spent on some investment
project, (current / future) taxpayers may
benefit when the project is completed.
How about the revenue is spent on transfer
payment?

65

Financing the Government

Budget
This
Printing
more
Money
will create
inflationary
pressure.

Households and firms will be able to

buy less with each unit of money. Fewer
resources are available for private
consumption and investment.
Those whose incomes respond slowly to
changes in price levels will bear most of
the cost of the government activity
66

Financing the Government

Budget
The
Internal
Debt
government
can transfer purchasing

power from any willing lenders to itself in

return for the promise to repay equivalent
purchasing power plus interest in future.
Since, repayment of the debt are made from
tax revenue, future taxpayers will suffer.
However, if the debt raised today is spent on
creating capital assets, the burden on future
generation will be lighter.
67

Financing the Government

Budget
Borrowing
External
Debt
from abroad transfers

purchasing power from foreigners

to the government.
The burden on future generations
will once again depend on how the
debt raised is used (investment
project / transfer payment)
68

The Problems of the

Simple Keynesian
Y = k E * G
Multiplier k E

There are several problems with this

method of analysis, i.e., Y may be
less

Sources of financing G
Effects on private investment I
Productivity of government projects
69

The Problems of the

Simple Keynesian
Sources
of financing
Multiplier
k GE
Increasing Tax

Increasing Money Supply

will exert a contractionary effect on the economy

will generate an inflationary pressure

Increasing Debt

will increase the demand for loanable fund as

well as interest rate affect private investment
70

The Problems of the

Simple Keynesian
Effects
on Private Investment
I
Multiplier
kE

Private investment may be crowded out when

government increases its expenditure
It is questionable that the government can
really produce something which is desired by
the consumers
Besides, government investment projects are
usually less productive than private
investment projects
71

The Problems of the

Simple Keynesian
Productivity of Government
Multiplier k E

Projects
Government projects may not yield
a rate of return (MEC / MEI)
exceeding the market interest rate.

72