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Theory of Income and Employment Determination

Background:

1. Up to the 1930s. Says Law: Supply creates its own demand. The process of productioncreates simultaneously creates the product and the income to purchase it. Short termimbalances may lead to temporary unemployment or inflation, but markets adjust to restoreequilibrium, eliminating excess supply or demand. Imbalance in savings and investment willbe resolved by shifts in the interest rate.

2. Keynesian Economics. Economy is led by demand. Long-term unemployment is created

when Aggregate Demand is at equilibrium below the level to generate full employment, thisis demand deficient unemployment. Wages are sticky downwards, so labour markets do notautomatically adjust. Savings and Investments are resolved by changes in National Incomerather than Interest Rates.

3. Milton Friedonomics. Supply-side policy, stagflation (high inflation and high unemploymentdespite Fiscal and Monetary Policy) due to structural unemployment. Focus on increasingmarket flexibility by lowering tax rates, reducing the power of unions, privatizing as much ofthe public sector, lowering unemployment benefits, making wages flexible and providing theinfrastructure to support private enterprise.

Aggregate Expenditure/Income Approach:key assumptions: fixed price level, fixed rate of interest

AE = C + I + G + (X M)

Where C = ConsumptionI = Investment (both capital and inventory investment)G = Govt ExpenditureX = Exports

M = Imports

Consumption/Savings: Act of using Income for the purchase of consumption goods. Savings (S) is anything not spent.

Average Propensity to Consume (APC). The proportion of total income spent, and can be calculatedby APC = C/YMarginal Propensity to Consume (MPC). The change in C for any given change in Y and can becalculated by MPC = change in C/change in Y.

Consumption Function: C = A + bY. Where A is autonomous consumption and b is the MPC.

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Graphical:when C>Y, dissavingwhen C = Y, saving is zerowhen C < Y, savings are positive.

Savings (S) = Y - C

Determinants of Shifts in the Consumption Function:

Note: a movement along the consumption function can only be caused by a change in income.

1. Wealth. Pigou Effect. If wealth rises then C will rise, and if wealth falls C will fall too even if Yremains the same. E.g. Stock Markets or Property Markets fa lling or crashing. Peoples real wealthalso falls with inflation.

2. Expectations: Optimism about future economic growth means C will rise, whereas pessimismregarding the future means C will fall. Expectations about future inflation are also important, ifprices are expected to rise, C will increase. They tend to be self-fulfilling (e.g. demand increasing fora particular good drives up the price).

3. Interest Rates: Affects consumer durables and other goods that require borrowing. At higherinterest rates C is likely to fall. However, this is not symmetrical as at lower rates, it may notnecessarily rise.

4. Distribution of Income: If the rich have a lower MPC than the poor then a redistribution of Y fromrich to poor will cause C to rise for a given level of NY (and vice versa).

5. Tastes and Attitudes: Some countries are more frugal than others. Gross savings as % of GDP:Singapore 46%, S.Korea 32%, Japan 22%, USA 12%, UK 11%, Greece 10%. Attitudes can change overtime.

6. Durable Goods: 1) Echo cycle as worn out durables are replaced. 2) After a recession everyonereplaces the durable goods they are holding on to.

7. Taxation: Increase/Decrease in Taxation will cause a similar shift of the consumption functiondown/up. If C is plotted against disposable Y, taxation will cause a movement along the consumptionfunction.

DWITTED.

Alternative Views of the Consumption Function (useful for evaluation/end of essay):

Permanent Income Hypothesis(Friedman): People look at their incomes over a long period and adjusttheir spending based on what they feel they will earn in the long term. This reduces the impact ofshort-term boosts to income (like tax cuts) on consumption. See: Barro-Ricardian Equivalence.

Lifecycle Hypothesis (Modigliani): Expenditu re varies according to what stage of life youve reached.Households adjust spending according to that more than current income. Also implies that shortterm changes in Y will have little impact on C

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Investment:Investment is expenditure on new plant and capital equipment (including housing) and changes instocks (inventory)

Generally I is very volatile, especially inventory investment, and changes in I have a big impact oninstability in the economy. It is very important to remember that Investment affects AD in the shortrun but AS in the long run.

Determinants of Investment:

1. Rate of Interest: Classical Theory holds that I is inversely related to the i/r through theMarginal Efficiency of Investment (MEI). However, Keynes felt that the MEI was bothinelastic and unstable. Hence i/r may not be that important.

2. Business Confidence/Expectations: Keynes famous Animal Spirits. Businessmen will invest

regardless of how high the i/r is if they are confident, whereas a low i/r may not make theminvest because of low confidence. Current state of the economy, political factors, globalsituation and gut instinct.

3. Cost and Availability of Capital Goods: New technology or breakthroughs in technology canaffect I. Innovation stimulates I and there can be an echo cycle when one round of newtechnology ages.

4. Rate of Change of Income: Accelerator Effect. An increase in sales can cause a more thanproportional increase in I, it responds to the rate of increase in NY.

Assumption: I is exogenous.

The Paradox of Thrift:Fallacy of Aggregation

As the great depression formed, people chose to save a larger proportion of their income; howeverthe drop in interest rate did not cause investment to increase. Instead, the rise in the savingsfunction had in fact caused a fall in the equilibrium level of income, hence although a largerproportion if income was saved, real income had fallen. This has the effect of worsening ordeepening a recession.

The Multiplier:The multiplier is the amount NY will increase for a given increase in J assuming price levelsand interest rates remain fixed.

In an open economy, the multiplier can be looked at as 1/[MPW], where MPW = MPT +MPImp + MPS

Due to the circular flow of income, one injection in the form of Government Spending orInvestment in one area can cause a ripple effect where injections create jobs, that createsmore income that can be spent on other things, which results in more employment so on

and so forth. Magnitude of increase depends on the rate of leakages in the economy.

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Income-Expenditure Graph

1) At Y2 : AE < Output, There will be an unplanned build up of stocks, (unplanned inventoryinvestment, realized I will exceed planned I). Consequently firms will reduce production inthe next time period and NY will fall

2) At Y1 : AE > Output. There will be an unplanned running down of stocks (unplanned inventorydisinvestment, realized I will fall short of planned I). Firms will increase production in thenext time period and NY will rise.

3) At Ye: AE = Output. There will be no unplanned changes in stocks, Firms will continue toproduce the same level of output, and the economy is in equilibrium.

Withdrawal-Injections Graph

The above applies for the W-J graph as well, but it can be explained by how S > I, hence leading to anunplanned build up of stocks etc, instead of Income and Expenditure.

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Circular Flow of Income:

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Equilibrium and Full Employment:

1. Deflationary Gapthe amount by which AE falls short to secure full employment

Unemployment caused by a lack of demand (demand-deficient unemployment). Thedeflationary gap demonstrates the amount AE needs to be boosted in order to secure fullemployment

2. Inflationary GapThe amount by which AE exceeds that necessary to ensure full employment.

Equilibrium in the economy is beyond the level of full employment, so there will be inflationin the economy caused by an excess of demand (known as demand pull inflation).

Both models assume that the AS curve is right angled.

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Aggregate Demand and Aggregate Supply

AD: the total level of spending in the economy, it is like AE but the price level is part of the modeland is in itself an influence on AD.

It is inversely proportionate to price because of:

1) The Income Effect. At higher prices the real value of wages falls, so households will not beable to afford to spend as much.

2) Substitution Effect: which has three elementsa. At higher prices foreigners are less inclined to buy our exports and we are more

inclined to buy, so (X-M) falls.b. The wealth effect- real balance effect at higher prices the value of existing wealthis

reduced so people save more (spend less) to top up their wealth

c. Higher process often result in higher interest rates, which will choke off somespending by households and firms.

AS: the total amount of output in the economy. The SRAS(short run aggregate supply) curve isdrawn on the assumption that wage rates, other input prices, technology and the quantity of inputsavailable are all fixed.

It is not perfectly elastic as:

Variable factors become scarce as output expands, raising the costs of production. Therefore although firms want to increase output as the price level rises, they can only do so

at a higher and higher cost to themselves.