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NATIONAL INCOME ANALYSIS
Learning Objectives
At the end of the lesson the student should be able to:
 Explain fully the various concepts of national income
...

 Use national income figures to compare the standards of living over
time and between countries and know the problems involved
...

1
...
It can also be defined as the total
money value of all final goods and services produced by the nationals of a country
during some specific period of time – usually a year – and to the total of all incomes
earned over the same period of time by the nationals
...

b) Gross National Product
The sum of the values of all final goods and services produced by the nationals or
citizens of a country during the year, both within and outside the country
...

d) Nominal Gross National Product
The value, at current market prices, of all final goods and services produced within
some period by a nation without any deduction for depreciation of capital goods
...

f) National Income Accounting
This refers to the measuring of the total flow of output (goods and services) and of the
total flow of inputs (factors of production) that pass through all of the markets in the
economy during the same period
...
2 The Circular Flow of Income and Expenditure
This is an economic model illustrating the flow of payments and receipts between
domestic firms and domestic households
...
In return, they get factor incomes
...
These flows can be illustrated diagrammatically as shown in
Figure 1
...

The points at which flows from one sector meets the other sector and generate other
flows are called critical points
...
At A, the flow of factor services from the household’s sector meets the firm sector
and generates the flow of factors incomes from the firms to the households
...
At C, the flow of consumer spending meets the firms sector and generates
the flow of goods and services
...
3 Approaches to Measuring National Income
The compilation of national income statistics is a very laborious task
...
Moreover,
in order to double check and triple check the statistics, the national income
statistician has to work out the figures out in three different ways, each way being
based on a different aspect
...


The national output: - The creation of wealth by the nation’s industries
...


b
...


c
...
Put in its simplest form we can express this as an
identity:
National output  National Income  National Expenditure
...
1 The Circular Flow of Income and Expenditure
I)
Using Total Expenditure for Calculating National Income
The expenditure approach centers on the components of final demand which
generate production
...
It includes all consumers’ expenditure
on goods and services, except for the purchase of new houses which is included in
gross fixed capital formulation
...
This includes all current expenditure by central and local government
on goods and services, including wages and salaries of government employees
...
) either for replacing or adding to the stock of existing fixed
assets
...

In addition, we add the value of physical increases in the stocks, or inventories,
during the course of the year
...
We then add expenditure on exports to the TDE and arrive at a
measure known as Total Final Expenditure
...
However, much of the final expenditure is on
imported goods and we therefore subtract spending on imports
...
To gross
domestic product at market price we subtract the taxes on expenditure levied by the
government and add on the amount of subsidy
...
National Income
however is affected by rent, profit interest and dividends paid to, or received from,
overseas
...
This figure
may be either positive or negative
...
As production takes place, the capital
stock of a country wears out
...
When this has
been subtracted we arrive at a figure known as the net national product
...
This is because each time
something is produced and sold someone obtains income from producing it
...

Incomes earned for purposes other than rewards for producing goods and services are
ignored
...
These payments are known as transfer income (payments)
and including them will lead to double counting
...
Alternatively, we
can say that there should be a “real” flow in the opposite direction to the money flow
...
This is the opposite
case from transfer payments since there is a flow of really goods and services, but no
corresponding money flow
...
Similarly, workers may, in addition to cash income,
receive income in kind; if employees are provided with rent free housing, the rent
which they would have to pay for those houses on the open market should, in
principle, be “imputed” as part of their income from employment
...

This includes incomes earned by
foreigners at home and excludes incomes earned by nationals abroad
...
This gives Gross
National Income
...

Country Y N a t i o n a l I n c o m e r e w a r d s t o f a c t o r s
( in £
millions)from employment
Incomes
Wages and salaries
Pay in cash and kind of HM Forces

1999

143,348
3,121

Employers’ contribution to National Health Insurance

10,632

Employers’ contribution to other funds

12,971

Income

from self-employment

Other Incomes
Profits of companies

170,072
23,123

41,530

Surpluses of public corporations

9,661

Surpluses of other public enterprises (-)
(109)
17,424

Rent
Imputed charge for consumption of capital

2,456

Less: Stock appreciation

264,157
(4,326)

Add: net property income from abroad

259,831
1,948
261,779

Less: Residual error
Estimated depreciation on capital assets

2,342
36,490

(38,832)

222,947m
Table 1
...


(iii) Using the National Output for Calculating National Income
A final method which is more direct is the “output method” or the value added
approach
...
“Value Added” is the value added by each industry to the raw
materials or processed products that it has bought from other industries before
passing on the product to the next stage in the production process
...
Final products will include capital goods as well
as consumer goods since while intermediate goods are used up during the period in
producing other goods; capital goods are not used up (apart from “wear and tear” or
depreciation) during the period and may be thought of as consumer goods “stored up”
for future periods
...

Because subsistence
output is not sold in the market, some assumption has to be made to value them at
some price
...

However, since state education and other governmental services are not sold on the
market we shall not have market prices at which to value them
...
When
calculating the GDP in this matter it is necessary to avoid double counting
...
2 Calculating national income from national output

1
...
These are:
a
...
For example, unpaid services such as those performed
by a housewife are not included but the same services if provided by a paid
housekeeper would be
...
An imputed value is usually assigned to this income
...
It would be impossible to
estimate this value and hence these goods are included when they are first
bought and subsequent services ignored
...
All these provide a service and are included
in the national income at cost
...


b
...
Thus we find that the output of one sector is the
input of another
...
This may be avoided either by only including the value of the final
product or alternatively by summing the values added at each stage which will
give the same result
...
These are transfer payments from the
taxpayer to the recipient and are not included
...
To give the correct figure, the former should not
be counted as an increase in national income for it does not represent any growth
in real output
...


Inadequate Information
The sources from which information is obtained are not designed specifically
to enable national income to be calculated
...
There are also some incomes that have to be
estimated
...

Also information on foreign payments or receipts may not all be recorded
...
5 Factors affecting the size of a National Income
The size of a nation’s income depends upon the quantity and quality of the factor
endowments at its disposal
...
The following points are of interest:
a)

Natural Resources
These include the minerals of the earth; the timber, shrubs and pasturage
available; the agricultural potential (fertile soil, regular rainfall, temperature or
tropical climate); the fauna and flora; the fish; crustacean etc
...


b)

Human Resources
A country is likely to prosper if it has a large population; literate and numerate
sophisticated and knowledgeable about wealth creating processes
...
It should
show enterprise, being inventive, energetic and determined in the pursuit of a
better standard of living
...
This includes not
only tools, plant and machinery, factories, mines, domestic dwellings, schools,
colleges, etc
...

Transport creates the utility of space
...

d) Self-sufficiency
A nation cannot enjoy a large national income if its citizens are not mainly selfsupporting
...

e)
Political Stability
Uses of national income figures


We need national income statistics to measure the size of the "National cake'
of goods and services available for competing uses of private consumers,
government, capital formation and exports (less imports)
...




National Income Statistics provide information on the stability of performance
of the economy over time e
...
a steadily increasing income would be indicative
of increasing national income
...
This is done by
considering the contribution of the various sectors to Gross National Product
over time
...
It therefore becomes
possible to design a development strategy that eventually would overcome
these problems
...



By assessing exports and imports as a percentage of Gross National Product i
...

using national statistics, it is possible to determine the extent to which a
country depends on external trade
...


1
...
These days however, inflation sends the general
price level up and up clearly this means that the yardstick stretches in their hands
every day
...

The price index used to remove inflation (or “deflate’’ the GNP) is
called the GNP deflator
...
It is constructed as follows:
GNP Deflator

=

Nominal GNP
Real GNP

Real GNP

=

Value at current Price
CPI

Where CPI is Consumer Price Index
The GNP deflator is useful because it includes prices on all goods and services in
GNP
...
Income
per capita is simply the National Income divided by the population of the country in
a year
...
The level of
income per capita is determined by the size of a country’s population
...

Per capita income is a theoretical rather than a factual concept
...
In a real world situation there exists considerable inequality in the

distribution of income especially in the third world countries
National Income and Welfare
The relationship between national income and welfare is best explained in terms of
economic growth (By economic growth is meant capacity expansion)
...
This increase in National
Income has several effects on a country’s citizens
...

2) The ordinary households or persons could be able to afford luxury commodities
...
e
...
clothing can be a luxury for
some people
...
e
...

Points 1, 2 and 3 are based on assumption that there exists a fair distribution of the
National cake
...
GNP per
capita e
...
gives no indication of how National Income is actually distributed and
who is benefiting most from the growth of production
...

In fact, the calculation of GNP and especially its rate of growth is in reality largely a
calculation of the rate of growth, of the incomes of upper 20% who receive a
disproportionately large share of the National Product
...

Example: Assuming a 10 people economy and assuming 9 of them had no income
and the 10the person receives 100 units of income the GNP for this economy would be
100 units of income and per capita income would be 10 units
...
However, for the 9 people without income before and
currently such a rise in per capita income provides no cause for rejoicing since the
one rich individual still has the income
...

This exchange though an extreme case is indicative of what happens in the real life
situation where incomes are very unequally distributed
...

People living in industrial towns suffer from the effects of a
polluted atmosphere
...


The manufacture of intoxicants together with urbanization and urban housing
problems leads to an increase in crimes
...
Thus social welfare would be increased if the production and sale of
intoxicants are curtailed
...


While the expansion of the National Income owes a great deal to scientific
research the application of research to new means of destruction add nothing to
social welfare
...


It leads to employment of women in industry leading to children being left
without care or simply maternal care
...
In this argument it is maintained that the rich save and
invests a significant proportion of their incomes while the poor spend all their
incomes on consumer items, and since GNP growth is assumed to be directly related
to the proportion of National Income saved then an economy characterized by highly
unequal distribution of income would save more and grow faster than one with more
equitable distribution of income
...

Limitations of the argument (Against)
Unlike the historical experience of the now developed countries, the rich in
contemporary Third World Countries are not noted for the desire to save and invest
substantial proportions of their income in the local economy
...

Such savings and investments do not add to the National
Productive resources
...

A growth strategy based on sizeable and growing income inequalities may in reality
be nothing more than an opportunistic myth designed to perpetuate the vested
interests and maintain “status quo” of the economic and political elite of the 3rd
...

1) The low income and low levels of living for the poor which are manifested in
poor health, nutrition and education can lower their economic productivity and
thereby lead directly and indirectly to a slower growing economy
...


2) Raising the income level of the poor will stimulate an overall increase in the
demand for locally produced necessity products like food and clothing
...
e
...

This creates a
broader popular participation in that growth
...

3) A more equitable distribution of income achieved through the reduction of mass
poverty can stimulate healthy economic expansion by acting as a powerful
material and psychological incentive to widespread public participation in the
development process
...
In the extreme, it may create conditions for its ultimate
rejection by the masses of frustrated and politically exploitive people notably
the educated
...
7 National Income and Standards of Living
Standard of living refers to the quantity of goods and services enjoyed by a person
...
It also includes the less easily quantifiable
aspects of living such as terms and conditions of employment and general living
environment
...
This is done by working out the per capita income of the
country
...
Per capita income is obtained by dividing the National Income by
the Total population
...

Problems of using per capita income to compare standard of living over time
1) The composition of output may change
...
g
...
Standards of living depend on the quantity of
consumer goods enjoyed
...
The index of retail prices may be used to express the
GNP in real terms but there are well known problems in the use of such methods
...
A small group may be much better off
...

4) Any increase in GNP per capita may be accompanied by a decline in the general
quality of life
...
The environment may
have suffered from various forms of pollution
...


5) Finally the national income increases when people pay for services which they
previously carried out themselves
...
Similarly, a reduction in national income would occur if a man
painted his house rather than paying a professional painter to do the same
...

Per Capita income and International Comparisons
Per capita income figures can also be used to compare the standards of living of
different countries
...
Such
comparisons are made by aid giving international agencies like the United Nations and
they indicate the relevant aid requirements of different countries
...
First there is the whole set of
statistical problems and, secondly, there are a number of difficult conceptual problems
or problems of interpretation
...


Inaccurate estimates of population: The first statistical problem in calculating
income per head particularly in less developed countries are that we do not have
very accurate population figures with which to divide total income
...


Specific items which are difficult to estimate: Another data problem, as already
mentioned, is that data for depreciation and for net factor income from abroad are
generally unreliable
...
Inventory investment and work-in-progress are
also difficult items to calculate
...


Non-marketed subsistence output and output of government: some output like
subsistence farming and output of government are not sold in the market
...
In one country, however, salary of
doctors for instance, might be higher and their quality low compared to another
country
...
Since “public consumption” is an
important element in national income, this could affect comparisons considerably
...
This is not
necessarily the case
...
The
national figures of such a country will, therefore, be less accurate than those of a
country whose economy is largely monetary or cash economy
...


Different degrees of income distribution: If the income of one country is evenly
distributed, the per capita income of such a country may be higher than that of
another country with a more evenly distributed income, but this does not
necessarily mean that most of its people are at a higher living standard
...


Different Types of Production: If one country devotes a large proportion of its
resources in producing non-consumer goods e
...
military hardware, its per capita
income may be higher than that of another country producing largely consumer
goods, but the standard of living of its people will not necessarily be higher
...


Different forms of Published National Income figures: The per capita income
figures used in international comparisons are calculated using the published
figures of national income and population by each country
...
e
...
On the other hand, if both sets are in money terms the countries being
compared should have the same level of inflation
...


vii
...
To make international comparisons, therefore, the national income
figures of different countries must have been converted into one uniform
currency
...
Strictly speaking, these
apply to internationally traded commodities, which normally form a small
proportion of the national production
...
e
...


viii
...
The people in poor countries probably are not nearly as badly
off as national income statistics would suggest, because the basic foodstuffs,
which form an important part of their total consumption, are actually priced very
low
...


Income in relation to Effort: The first conceptual problem in calculating
income per head is to look at goods and services produced in relation to the
human effort that has gone into producing them
...
Indeed, the amount of leisure that people want depends in part on their
level of income
...
It is largel y because this would be statisticall y awkward
that economists prefer to take real income per head
...


Differences in size: A problem which is both conceptual and statistical is due
to the transport factor
...
This
will be reflected in its national income, but the standard of living of its people
will not necessarily be higher than that of smaller country, which does not
need these facilities to the same extent
...


Differences in Taste: Another formidable difficulty is that tastes are not the

same in all countries
...
Expensive tastes are to some extent artificial and
their absence in poor countries need not mean a corresponding lack of welfare
...


Different climatic zones: If one country is in a cold climate, it will devote a
substantial proportion of its resources to providing warming facilities, e
...

warm clothing and central heating
...


xiii
...
For instance, if per capita income increases, material welfare will
increase; but we cannot say by how much it has increased, and certainly that it
has increased in proportion
...
8 Consumption, Saving and Investment
Aggregate Demand
This refers to the total planned or desired spending in the economy as a whole in a
given period
...

I
...

The consumption function is one of the most important relations in Macro-economics
...
Thus it is important to take a closer look at the consumption
...

Rate of Interest Is contained in the argument of the classified economists
who argued that rational consumers will save more and consume less if the rate of
interest is high
...

Relative Prices Influences the aggregate consumption
...

Capital Gains Keynes observed that there is a possibility of windfall gains or
losses influencing consumption
...
This is true of the stock minded speculative economy
...

Wealth The possession of liquid assets influences the amount that you have to
save
...
The larger the stock
of wealth, the lower its Marginal Utility and consequently the weaker the desire to add
to future wealth by curtailing present consumption
...

5
...

6
...


Normally i n f l u e n c e s

7
...
The expectations attained by the consumer
about income increases will affect the consumer behavior
...
N/B
...

8
...
Consumption will be affected if customers are subject to money
illusion
...

It is known as Pigou Effect which talks of real balance
...

Suppose price and Money Income increases by 10%, for the families which regard
their real income unchanged and do not suffer from money illusion they would take
their real incomes as unchanged and would only increase their consumption by 10%
...

Distribution of Income If the Marginal Propensity to consume among the poor
is high, then redistribution of wealth from the rich to the poor leads to higher
consumption
...


Composition of the Population: In sex and age
...
9 The Keynesian Theory of Consumption Function
The theory was developed during the Great Depression which plagued Europe and
America
...
e
...
The
determination of aggregate demand, then, was of crucial significance in Keynes
analysis
...
Average Propensity to Consume:
The average Propensity to Consume [APC] is defined as the fraction of aggregate

national income which is devoted to consumption
...

ii
...
Thus if S denotes
savings then,
APS = S
Y
In a closed ungoverned economy, where income is spent or saved, APC = APS = 1
iii
...

Thus, if ΔS denoted changes in savings, and ΔY change in income, then,
MPC = ΔC/ Δ y
An increase in income is partly consumed and partly saved
...


Investment
Investment is the process of increasing the productive capital stock of a country,
or can be defined as the production of goods not for immediate consumption
...


Definitions
Induced Expenditure Also called endogenous expenditure is any expenditure that is
determined by, and thus varies with, economic variables within our theory
...
For
instance, in the simple theory of the determination of national income, investment is
assumed to vary directly with national income
...
This concept is given the symbol YF
...

Intended or planned Investment: Expenditure on investment depends on business
expectations on the chance of making profits and on the availability of funds for the
purchase of producer goods
...

iii
...
For while the initial increase in Y,
ΔY, will equal ΔI, this change in Y itself produce a change in C, which will increase Y
still further
...
This process is
called the multiplier process
...
This is because the
Multiplier can be defined as the coefficient (or ratio) relating a change in GDP to the
change in autonomous expenditure that brought it about
...

For example, suppose there is an autonomous increase in investment which comes
about as a result of decisions by businessmen in the construction industry to increase
the rate of house building by, say, 100 houses, each costing £1,000 to build,
investment will increase by £100,000
...
There will thus be a
series of further rounds of expenditure, or Secondary Spending, in addition to the
initial primary spending, which constitutes further increases in GDP
...
GDP increases through the Expenditure – Income –
Expenditure cycle
...
This does not
happen because each secondary round of increased expenditure gets progressively
smaller, which is explained by the fact that the Marginal Propensity to spend the
national income is less than one
...

Suppose in our example, an average of three fifths of any increase in income is spent
by the people receiving it:
The Marginal Propensity to consume or save will be 3/ 5 or 2/ 5 respectively
...
This is because for
any value z between 0 and 1, the series
1 + z + z2 z3 …
...
In our example we have the series (in thousands)
100 + 60 + 36 + 21
...

Or
100 { 1 + (3/5) + (3/5) + …
...
If we write c for ∆C/∆T and s for
∆S/∆Y, we have

k=

∆Y
----------∆I

=

1
--------1–c

1
= -------s

The multiplier is thus the reciprocal of the MPS (marginal propensity to save)
...
It is not a long run model of growth
since savings are the source of investment funds for growth
...
e
...

It is not a suitable model for a developing economy because:
i
...


ii
...


iii
...


iv
...


The Acceleration Principle
Suppose that there is a given ratio between the level of output Y t at any time t, and the
capital stock required to produce it Kt and that this ratio is equal to α, hence:
K t =αY t
The coefficient is the capital-output ratio, α, = K/ Y and is called the accelerator coefficient
...

This may lead to further investment called Induced Investment in the production of
goods and services
...

The ratio of induced investment to the increase in income resulting from an initial
autonomous increase in investment is called the accelerator
...

From the Keynesian model ∆Y = ∆1
...
1/ s
Thus, the higher the multiplier and the higher the accelerator, the higher will be the

level of induced investment from an initial autonomous increase
...
10 Determination of Equilibrium National Income
National income is said to be in equilibrium when there is no tendency for it either to
increase or for it to decrease
...

For there to be equilibrium, firm spending must be equal to firm’s receipts
...
Hence, for there to be equilibrium:
Factor Incomes = Consumer Spending
Income Models
1) The Spendthrift Economy: This assumes a circular flow of income in a closed
economy with no Government sector and no foreign trade
...

Firms make the commodities that households consume
...

It is assumed firms sell all of their output to households and receive money in return
...
Part goes to households
that sell factor services to firms, and the rest is profit paid out as Dividends to the
owners of the firm
...
Expenditure is the rule of the day!
The input Factor

Household

The output Expenditure
Income Approach

Factor
Services

Approach
Wages
Rent
interest
Profit

Firms

Figure 1
...
We can
do this based on either side of the circular flow shown in the figure above
...

2) The Frugal Economy: In the Frugal economy, households and firms look to the
future, and as a result undertake both Saving and Investment
...
Both
households and firms can save
...
Firms save when they
elect not to pay out to their owners some of the profits that they have earned
...

Investment is defined as the production of goods not for immediate consumption
...
They are produced by firms and they may
be bought either by firms or by households
...

The total investment that occurs in the economy is called Gross Investment
...
The remainder is called net investment
...
First, there are consumption goods and services actually sold to
households
...
The symbols C
and I can be used to stand for currently produced consumption goods and currently
produced investment goods respectively
...

Gross National Income (or Gross National Product, GNP); It is the sum of the values
of all final goods produced for consumption and investment, and thus it is also the sum
of all factor incomes earned in the process of producing the National output
...
NPP is thus a measure of the Net output of the economy
after deducting from gross output an amount necessary to maintain the existing stock
of capital intact
...
A withdrawal is any income that is not passed on in the
circular flow
...
Similarly, if
firms receive money from the sale of goods and do not distribute it as payments to
factors,
this
is
a
withdrawal
from
the
circular
flow
...

The effects of withdrawals and injections is to interfere with Equilibrium income
...

If, for example, households decide to increase their savings and correspondingly
reduce the amount they used to spend buying consumption goods from firms, this
reduces the incomes of firms, and reduces the payments they will make to factors of
production
...
If, for example, firms sell machines to other firms, their incomes and
payments to household for factor services will rise without there having been an
increase in household expenditure
...
Thus, denoting consumption by C, saving by S and Investment by I, there is
equilibrium if:
C+S=C+I
Or
S=I
i
...
there is equilibrium when savings are equal to investments
...
3 Equilibrium National Income in a Frugal Economy
To measure the national income in a frugal economy, through the output and
Expenditure approach, the National Income Accountant includes production of goods
for inventories as part of total expenditure since the firm certainly spends money on
the factor services necessary to produce goods for its own inventories
...
This definition makes total expenditure the same thing as the value
of all final commodities produced and thus ensures that the measured value of
expenditure is identical with the value of total output in any economy
...

When the government produces goods and services that households desire such as
roads and air traffic control, it is obviously engaged in a useful activity and is
obviously adding to the sum total of valuable output
...

Definitions:
Transfer Payments: Are any payments made to households by the government that
are not made in return for the services of factors of production i
...
there is no Quid pro
Quo
...

Disposable Income: This is the income which households actually have available to
spend or to save
...

First, all those elements of the value of output that are not paid out to households must
be deducted: business savings represent receipts by firms from the sale of output that
are withheld by firms for their own uses, and corporation taxes are receipts by firms
from the sale of output that are paid over to the government
...

Finally, it is
necessary to add government transfer payments to households
...
Thus disposal income is:
GNP minus any part of it that is not actually paid over to households, minus the
personal income taxes paid by households, plus transfer payments received by
households
...

Changes from one year to another are then a compound of changes in physical
quantities and prices
...
In this case,
each year’s quantity is priced at its base-year prices and then summed
...
Changes in constantprice GDP give a measure of real or quantity changes in total output
...
If the government taxes firms, some of what firms earn is not available to
be passed on to households
...
Whatever subsequently
happens to money raised, taxes withdraw expenditure from the circular flow
...

Such expenditure creates income for a firm that does not arise from the spending of
households, and it creates income for a household that does not arise from the
spending of firms
...

Letting G stand for Government Expenditure, T for Taxes, J for injections and W for
withdrawals, we can say the National Income is in equilibrium when total
withdrawals, savings plus taxes, is equal to total injections, investment plus
government expenditure
...
4 The equilibrium for national income
Open Economy: None of the three economies considered so far are engaged in trade
with Foreign Countries
...

In contrast, open economies engage in significant amounts of foreign trade, so that
some of the goods produced at home are sold a broad while some of the goods sold at
home are produced abroad
...

A mathematical approach to national income equilibrium
...
A simple
Keynesian national income model may be expressed as follows:

Y = C + IO + G O

……………………………………………………

(i)

C = a + bY ………………………………………
...
Io
And G o, on the other hand, represent exogenously determined investment and
government expenditure respectively
...
C = a + b Y represents a
consumption function where a and b stand for autonomous consumption and the
marginal propensity to consume, respectively
...

_
Y = a + Io + G o …………………………
...

_
_
C = a + bY = a + b (a + Io + G o )
1–b
 a (1 - b) + b (a + Io + G o )
1–b
A numerical example
Assume a simple two sector model where Y = C + I C = a + bY and I = I o
...
45 and Io = 55
...
45Y + 55
Y – 0
...
55Y = 140
Y = 255
This simple model can be extended to include government expenditure and foreign
trade
...
Equilibrium national income in this case is
represented by
Y = a + Io + G o + X o - M o
1 – b + mo
Numerical example
...
8 and m = 0
...
8 + 0
...
11 Fluctuations in National Income and the Business Cycles
Business Cycles The business cycle is the tendency for output and employment to
fluctuate around their long-term trends
...
The continuous line shows the steady growth in
trend output over time, while the broken line indicate the actual output over the time
period
...
5 Business Cycles
Point A represents a slump, the bottom of a business cycle while point B suggests the
economy has entered the recovery phase of the cycle
...
Then as the line
dips via D towards the trend line with output growing less quickly during the recovery
and least quickly (perhaps even falling), during a recession
...
In the simplest Keynesian model an
increase in investment leads to a larger increase in income and output in the short run
...
A process known as the multiplier
...
Firms invest when
their existing capital stock is smaller than the capital stock they would like to hold
...
This present value can be increased either by
a fall in interest rates at which the stream of expected profits is discounted or by an
increase in the future profit expected
...
If
real interest rates and real wages change only slowly, the most important source of
short term changes in beliefs about future profits is likely to be beliefs about future
levels of sales and real output
...
This kind of explanation is known as the
accelerator model of investment
...
While constant output growth leads
to a constant rate of growth of capital stock, it takes accelerating output growth to
increase the desired level of investment
...

Just how firms respond to changes in output will depend on a number of things
including the extent to which firms believe that current growth in output will be
maintained in the future and the cost of quickly adjusting investment plans
...

The underlying idea of the multiplier-accelerator model is that it takes an accelerating
output growth to keep increasing investment, but it must be noted that once output
growth settles to a constant level investment also becomes constant
...

The limits of the fluctuations around the trend path of output are referred to as ceilings
and floors
...
This will in turn produce a more than proportionate increase in investment
because of the effect of the accelerator which will produce a more than proportionate
rise in incomes and so on
...
The process then goes into reverse
with an accelerated decline in the absolute level of net investment, followed by a
multiplied reduction in income and so on
...

It is argued that modern economies do not fluctuate as much as they did in the past
because of built in stabilizers which operate automatically and the use of discretionary
measures which are available to governments
...
The taxation system is said to act as a stabilizer in the
following way: As income rises a progressive taxation system takes larger and larger
proportions of that increased income; when income falls revenue drops more than
proportionately
...

Despite these built-in stabilizers and the actions of government in their use of
discretionary measures to stabilize the economy, the cycle is still with us as recent
experience
has
demonstrated
...

1
...
A hypothetical closed economy has a national income model of the form y = C + I +
G where C = 30 + 0
...
Compute the
national equilibrium level of income for this economy using aggregate income equals
aggregate expenditure and withdrawals and equal injection methods
...
What are some of the limitations using Gross National Product as a measure of
economic performance?
3
...
Briefly explain the following concepts i)
Gross domestic product ii)
Gross national product iii)
Net
national product
iv)
Nominal gross national product v)
Real gross national product
vi)
National income accounting
5
...


Explain the difficulties in measuring national income

7
...


Explain the problems of using per capita income to compare standard of living over
time

9
...
Briefly define the following economic terms i)
Propensity to consume
ii)
Marginal propensity to save iii)
Investment
iv)
Actual income and full employment income v)
Autonomous Expenditure
vi)
The Multiplier



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