Module 15

Expansion of simple model by relaxing assumption and including inveasmtsn, gov tax, etc.

15.2 Investment function

Previously we considered that investment as done only by private individuals and that it was
constant at all level of income. This contradicts one of the most important features of
investment behavior instability over time.
Even though investment is quantitatively less important than consumption which is the
biggest part of GNP, the high fluctuations of investment expenditure are very imp to explain
short run behavior of income and output.
Investment instability is due to subjective expectations about future and the objective fact
that changing technology requires large amount of capital.
Investment taking in hope of profit;
1 Cost of investment ( sometimes fixed, sometimes expected if over time)
2 Expected returns/increase income
3 Cost of financing investment. ( rate of interest R)
Returns costs = give is marginal efficiency of investment MEI.
Expectations -> estimates add to instability.
Compound interest means that interest is added to Principal at end of period so that further
interest can be earned on it in following period.

This means that present money ( principal) is more valuable that future money.
Income received in each following year is worth less..
The present value of future dollar is done by discounting future dollars ( a sort of compound
discount).
Present value of future income is

(n is a mathematical function that implies compound, building on each other, it is not a

simple multiplication)( I think n = power..?))
Since the income accurses over time it is important to use this discounted cash flow for
estimating value of future income.
(( this assumes FI is a fixed amount per year whose value is decreasing as explained)

The curve showing the relationship between the marginal efficiency of investment, the
rate of return over cost, and the volume of investment, is drawn sloping downwards from
left to right, as shown in Figure 15.2.
Looking at first part of graph only marginal efficiency decreased as invst increases.
AS volume of investment increase that marginal efficacy of investment declines. As volume
increases, it will put greater pressure on productive capacity, rising costs and driving down
marginal efficiency of investment.
At Io investment has a positive rate of return.
However return must be compared to return of opportunity cost ( next best alternative). This
is taken as interest R i.e. return of the investment funds were loaned out instead.
IF marginal efficiency if investment r is less than market rate of interest R then it would be
better to put money in bank than invest.
The chart will show at what volume of interest the marginal efficiency of investment equals
market rate of interest.
This two are inverse so;
When interest are high, investment re low.
Curve can shift if the two constants of volume of investment ( I ) planned and marginal
efficiency (r) change.
Marginal efficiency is based on estimate of future returns. Assumptions must be made of
future prices and costs, technology, politics)
E.g. If mangers become pessimistic about future business conditions ( e.g. rise in raw
materials) curve shifts A>B.
If they are optimistic egg that future conditions re more profitable than A>C. At given rate
of Interest Ro the investment volume changes.

Since this is ONLY expected the degree of certainability plays a large role.
IE Important both levels of expectation and uncertainty.
Therefor shifts in curve are more important than movement along curve. I.e. much more
affect by expectations and uncertainty then current level of interest rate R.
This is obvious in next chart showing ; marginal efficacy is almost vertical and subject to
large and sudden shifts. Volume of investment is interest elastic. ( little impact). Large
change in R causes small change in I.

Volume of investment is poorly influence by interest rate ( monetary policy). In this case
investment are based on expectations and uncertainty and therefore add this into economy,
more poorly controlled.
Another factor is that investment expenditure is based on idea that some investment are
determined by rate of change of national income/output. ( i.e. they expect to be profitable
more during change). This is known as accelerator principle.
Accelerator principle combined with multiplier effect is thought to be explanatory for
fluctuations in economic activity.
In the below example there is a fixed capital-output ratio which is fixed at all levels out.
Therefore increase in sales will cause increase in capital i.e. investment. Assumptions
capital does not depreciate and new capital investment is instantaneous.

If sales stay same then no investment. The higher the increase in sales the higher the
increase in investment. Therefore volume of investment depends on rate of sales ( income) .
This is expressed as

coefficient.

where is the capital-output ratio sometimes called accelerator

Accelerator principles doesnt include replacement investment or investment relating to new

goods or investment that produce output only in future. Yet income levels do affect
investment levels.
Multipliers d3emonstrates that initial increase in demand has secondary effects on level of
income. The eventual change depends on multiplier which depends on marginal propensity
to consume.

change in income depends on change investment x multiplier k.

The accelerator effect suggest that the secondary effects will be higher since changes in
come will result in changes in investment!

Autonomous ( independent) investment leads to multiplier effect due to increase demand

and employment which in turns affects capital and income which in turn cause accelerator
effect ( increase of capital investment).

The higher the multiplier (marginal propensity to consume) and the greater the
accelerator ( capital output ratio) , the more explosive the reaction of the
economy to any initial change in aggregate demand and the greater the
duration and strength of the cumulative movements in income, output and
employment that result.

15.3 The government sector.

Gov taxation and expenditure are equivalent to household savings and business investment.
Taxation withdraws from circular flow and expenditure adds.

The circular flow is between F and H. CM ( I and S) and Gov take/add to the circular flow.
National income is at equilibrium when
S+T=I+G
Therefore planned Savings and Investment can diverge if compensated by gov tax and
expenditure.
When T < G there is gov budget deficit i.e. more gov expenditure than taxation -> rise in
national income and employment, as long as there is unemployment
When T>G there is budget surplus, over taxation -> fall in national income and
unemployment.
For national equilibrium therefore

S=I+(GT)

Therefor national income can be rewritten as

Y ( output) Cp + I + G
Y ( income ) Cb + S + T
Economy outputs consumer goods Cp, investment goods I and government goods G.

Economy can use income for consuming goods Cb, savings S and Taxes T.
Cp + I + G = Cb + S + T

since national output must equal national income.

If products produced = products purchased and budget is balance G = T then Savings will
equal planned investments.
However production decisions are made by firms and purchase decision are made by
households.
If there is no balance then national income/output is not balance and national income and
employment will change until equilibrium is reestablished.
If production is more than purchases there will be increase in unintended inventories;
Inv = Cp Cb

->

Cp = Inv + Cb

( production = purchases + Inventories)

But Inventories in national income account are part of investment. Therefore

Yo Cp + I + G
Yo Cb + Inv + I + G
And since national income remains Yi = Cb + S + T, when gov budget is balance G = T,
S = I + Inv . In these circumstances ( Cbuyers < Cproducers) S equals total investment I +
Inv but no longer planned investment I.
In this case firms reduce output, unemployment increase, income decrease until planned
savings = planned investment again. ( if G = T)
Government can increase expenditure to compensate. Gov expenditure also have multiplier
effect.
Government outlays are 2 types ; Expenditure on current goods and services ( the G in
national income accounts) and transfers as welfare ( sort of negative taxes)
Approx. 1/5 of GNP is controlled by gov through gov consumption. This goes up to 1/3 if
transfers are included.
Effect of change in gov exp G and/or taxes T on national income/output and employment
Assumption is that gov has complete control over G.
Gov purchased form private ind and firms. It doesnt sell but taxes. If taxes insufficient gov
can borrow from private.
Assumptions;
Consumption expenditure C is a function of disposable income Yd
Investment I is autonomous ( decided independently).
Gov expenditure is also autonomous
Tax in firm model is autonomous , independent of level of income e- fixed per head. T = T
Tax in second version tax is proportional to Y. in this case gov control is only as rate applied
to Y . T = t(Y)

15.3.1 Version 1 of the Expanded Model .

In this version the following equations are used.

YC+I+G
C = bYd
I=I
G=G
T=T

National Income/output is consumption + investment + gov expenditure

Consumption is a function of disposable income.
Fixed tax per head

Yd = Y T
C = b( Y T )
Y = b( Y T) + I + G
Y bY = -bT + I + G
Y (1 b ) = -bT +I +G

Disposable income is income minus taxes

Consumption is function of disposable income
First equation

And from Module 14

Y
C
Y
Y bY
Y(1-b)

=
=
=
=
=

C+I
bY
bY + I
I
I

Therefore

Where multiplier effects was

In expanded model Let us increase investment by I. Since T and G are autonomous they do not change when Y
changes.
Thus change in I whilst it causes multiplier effects on Y ( and C), it will not affect taxes T or
gov expenditure G.
Therefore

Also however if I is not changed but e.g. G is changed then;

This shows that Invs and Gov exp multipliers are identical because G and I are assumed to
be autonomous.
If however I is not completely autonomous but somewhat related to level of income Y ( to
show this mathematically is very complicated). However graphically this would be
represented by Figure 15.7 .
I = Io + kY

This graph has 2 elements ; Io ( which is independent of the level of Y) and kY ( which is
endogenous).
Original equations;
Y
=C+I
C
= bY

I
Y
Y bY kY
Y ( 1- b- k)

=
=
=
=

Io + kY
bY + Io + kY
Io
Io

Therefore

As expected the multiplier is larger since in autonomous investment Io causes multiplier

effects though Y leading -> C -> Y -> etc. But also because increased autonomous
investment Io leads to induced investment expenditure because of increased Y which
leads to I -> Y until the multiplier process works its way to completion.

15.3.2
Version 2 of the Expanded Model
This attempts to take into account the government sector.
We no longer consider a poll tax; the gov sets an income tax rate. This is assumed constant
rather than tiered ( high tiers of income being taxed more than lower tiers).
Example below has a very high tax rate

Increase in average tax rate is less than increase in marginal tax rate
But back to constant tax rate
T = tY

is t is constant ie linear relationship. Therefore

Yd = Y tY
+ Y ( 1 t)
Original equations ;
Y
C
Yd

= C + I +G
= bYd
= Y(1 t)

I
G

=I
=G

Therefore

Therefore

Since G is autonomous we have;

And since I is also autonomous we have

15.3.3 The Differences

Version 1 poll tax does NOT affect multiples whereas marginal tax rate in version 2 reduces
the value of the multiplier because part of increase income resulting G or I leads from
circular flow in form of tax. This lost income is no longer available for consumption.
Eg back to Version 1 and per capita tax;
Suppose there is unemployment - to reach full employment should gov;
Increase gov expenditure OR cut tax?
Suppose gap between Q and Y is 100 units and that MPC = 0.5 resulting in multiplier of 2
( multiplier = 1/1 MPC). Ie required increase in G is 50 units.
Next Gov exp multiplier VS tax cut multiplier

In 2nd table the first round of income/output is missing. A tax cut of 50 units doesnt generate
any output while an increase in G of 50 does.
In tax cut disposable income increases by 50 and as MPC of 0.5 half of that spent and half is
saved. The 25 spent means Y increases by 25 which in times increases C by 25 and resultant
multiplier rounds. This to reach full emp gov must cut tax by 100 units.
Suppose gov wishes to increase G but for political reason must balance the budget ie must
equal T. what is effect on Y? as first table shows inc G by 50 results in inc Y by 100. In 2 nd
table if instead tax is increased then Y would be -50. Thus an increase of G of 50
accompanies by tax increase of 50 would increase Y by 50. This balanced budget multiplier
= 1 = inc Y is exactly equal to inc in G.

This shows geometric interpretation of version 1 of expanded model.

Equilibrium is achieved where aggregate demand crosses the 45 line ( agg supply).
Thus D1 produces an output level of Y1 and employment level of E1; at this equilibrium
level, consumption expenditures C1, I and G are autonomous. Potential output (Q) would be
reached only if national income/output equaled YF and EF. To achieve full employment,
aggregate demand has to be increased. This is done in Figure 15.9 by increasing G by G.
The increase in G of G causes an increase Y in Y of YF Y1.

Using our multiplier formula we know that

MPC being determined by the slope of the consumption function (b). Thus the increase in
Y, (YF Y1), is made up of two components, G and the induced consumption expenditure
C2 C1.
Had the investment function not been autonomous, i.e. had there also been induced
investment expenditure, the amount of G required to achieve full employment would have
been less.
To accommodate version 2 of our expanded model geometrically, we have to shift the
consumption function and consequently the aggregate demand function if the tax is of
the poll tax variety. This must be done such that the slope of the consumption function will
not change. If the tax is a tax on income, then we have to change the slope of the
consumption
function.

15.4
In-built stabilizers
Previous section might suggest that authorities must influence economy through changes in
balance between gov exp and tax. This is not so.
While there is need for discretionary fiscal policy to manipulate exp and tax ( to influence
agg demand), the nature of gov exp and tax regimes crease a degree of automatic
stabilization ( even If authorities remain passive).
Eg
emp and/or income will also raise gov tax relative to expenditure acting as a break
emp and/or income will reduce gov tax relative to expenditure therefore stimulating
economic activity
These come into play without explicit action from Gov.
These inbuilt stabilizers reduce fluctuations in level of economic activity
Inbuilt stabilizers are any aspect of gov taxation or expenditure policies that automatically;
gov exp and/or tax when income + output or
gov exp and/or tax when income+output
Most imp are taxes, transfers and price supports.
Almost all taxes vary directly with level of income , increasing when income inc and dec
when income dec. eg income tax brackets, profit tax etc.
Because of this tax revenue rises more quickly than income as income increases but also
decrease more quickly when income decreases. (( because with rising income more
households fall into higher tax rates)
Most capitalist economies have a comprehensive system of unemployment compensation
finance by employer and employee contribution. In a recession, the amount paid in
unemployment benefits increases and income from contributions falls. The effect of the

unemployment compensation is to reduce the decline in income and therefore allows higher
consumption. This reduces the adverse multiplier effect and will be smaller the more the
benefit is relative to employment income. IN recovery there is then less exp on benefit and
more income form taxes.
Price support example; agriculture. If demand declines ( ie price goes down) the price
support system reduces the decline in agricultural incomes and maintains consumption at
level that wouldnt been possible. This reduces negative multiplier effect. If demand
increases and market prices recover, the prices support declines and agricultural income
grow more slowly than agricultural output

The effect of in-built stabilizers is demonstrated in Figure 15.10. At income level Yb the
budget is in balance, with government expenditure equal to taxation. At income levels below
Yb a budget deficit emerges as transfer payments increase due to increased unemployment
benefits, welfare payments, and price support; and taxation revenue falls with falling
income.
At levels above Yb, a surplus emerges as taxes rise and transfer payments fall.
Inbuilt stabilizers can have desirable and non-desirable effects.
Desirable if economy has small fluctuations around full employment income avoiding high
unemp and inflation inbuilt stabilizers help maintain high level of activity without
inflations.,
Undesirable if heavy fluctuation with low full emp stability and price stability and high
unemp rate and inflation.
Monetarists believe that inbuilt stabilizers apply strong fiscal forces to restore market
economy towards full employment. And that discretionary fiscal policy is damaging. The
propose that the aim of fiscal policy would be to establish a balanced budget at the highest
level of employment that is consistent with price stability.full employment budget balance
at Yb. This combines with sensitive use of inbuilt stabilizers any change from balance would
result in countercyclical forces that restore it. movements away from full employment, i.e.
booms and recessions, would
automatically result in countercyclical surpluses and deficits, reinforcing the tendency of
market forces to restore full employment.

Monetarist believe that explicit action to attempt to stabilize the economy,

by manipulating aggregate demand through government expenditure and taxation, will
increase the amplitude of cyclical fluctuations if a discretionary fiscal policy is applied.
Keynesians are of the opposite persuasion; that is, they believe that discretionary fiscal
policy has a stabilizing influence.
However in case of heavy unemployment and there is an increase in aggregate demand, the
inbuilt stabilizers will prevent full benefit of multiplier caused but initial stimulus and
withdraws through taxation and reduced gov exp may prevent economy regaining full emp.
Another problem in case of un-indexed tax system in which tax thresholds are not adjusted
for changes in price levels. In cases of inflation , if income and prices increase ( but tax
brackets are not adjusted) real disposable income will decrease even if money income and
prices rise by same rate. This is noticeable in high inflation and gov index the taxes to offset
inflation.

15.5 The international Sector

International trade is added to expanded model.
Z is imported products purchased locally
X is exported local products
IN circular flow of income;
Imports ( like Tax and savings) are w withdrawal from domestic economy
Exports ( like investments and gov exp) inject into domestic circular flow of income.

Therefore for equilibrium S + T + Z = I + G + X totals but not necessarily per item.

Previously we could have equilibrium even if {S > I, T < G} and {S < I, T > G}.
With the introduction of imports (Z) and exports (X), then if (S + T) > (I + G) then Z < X, and
if (S + T) < (I + G) then Z > X.
In the former case, the foreign exchange reserves of the domestic economy will be
increasing

and in the latter case they will be falling. In either case, corrective action may be
necessary. The purpose of foreign exchange reserves is to meet some temporary deficit on
the balance of payments account but after some point the accumulating of reserves serves
no purpose but actually holds down the livings standards. Similarly a diminution of reserves
needs correction action as these are finite.
Therefore its imp to notice that;
Imports and exports affect the circular flow of income and
Changes in Z and X affect income equilibrium
The relationship between changes in injections and in withdrawals, and consequent
changes in national income, can be summarized as follows:
(a) A given change in household savings or taxation or imports will have exactly the same
effect on national income. In each case the initial change causes national income to
change in the opposite direction.
(b) A given change in business investment or government expenditure or exports will have
exactly the same effect on national income. In each case the initial change causes national
income to change in the same direction.
(c) The change in income, as the result of some initial change in withdrawals (S, T or Z) or
some initial change in injections (I, G or X) will be some multiple of the initial change,
the size of the change being given by the relevant multiplier.
We thus have to modify the multiplier concept to take account of the withdrawal for the
circular flow of income due to imports and injection due to exports. The national income
identity, including the international sector, becomes
YC+I+G+XZ
As before we shall assume previous relationships, namely

We shall assume X is autonomous, i.e. independent of Y, but that imports Z, are, not
unexpectedly, dependent on the level of Y. The simple linear relationship we shall assume
for imports is

This formula demonstrates that the size of the multiplier is positively related to the marginal
propensity to consume (b). It is negatively related to the marginal tax rate (t) and the
marginal propensity to import (), both of which are leakages from the circular flow of
income. It is clear from the formula that a change in X of 100 units will have the same
impact on Y as would a change in G of 100 or a change in I of 100. It is extremely complex
to attempt to show the impact of the international sector diagrammatically.
If X and Z were both autonomous and equal, then the aggregate demand curve in a
closed economy with a government sector would be exactly the same as one with an

international sector, i.e.

Y=C+I+G
would equal
Y=C+I+G+XZ
With X = Z, X would raise Y by the amount of exports, Z would lower Y by the same
amount. Similarly, if X > Z, Y would be raised by the difference, and if Z > X, Y would be
lowered by the difference. If Z = Y, the slope of the aggregate demand curve would be less
steeply inclined, indicating a smaller multiplier effect due to the import leakage.
International trade causes the national income of any trading nation to be linked through
exports and imports to the national income of other countries. The major factor affecting
the level and rate of growth of a nations exports is likely to be the level and rate of growth
of real incomes in the rest of the world. If, in the rest of the world, real incomes are high and
increasing rapidly, then any nations exports are likely to be high and increasing, other
things
being equal. Conversely, the level of imports of a nation is likely to be closely related to the
level and rate of change of that nations national income. In short, a change in the level of
national income in one economy will, through international trade, have consequences for
other economies, and these consequences will be greater, the greater the level of national
income in the economy considered and the higher the proportion of national income that
enters into international trade.
In the past four decades, most economies have become more open, i.e. exports and
imports have accounted for an increasing share of national income. Part of the reason has
been a general reduction in the barriers to international trade, especially tariffs and quotas.
Figure 15.12 shows exports as a percentage of GNP for a selection of economies.

Figure 15.12 and Figure 15.13 show that exports as a proportion of GNP for the USA
and Japan are lower than for all other major capitalist economies. The sheer size of the US
and Japanese economies make their international sectors play a very important part in the
economics of all nations with which they trade. In contrast to the USA, many small
economies such as Belgium, Ireland, the Netherlands and the Asian Tigers are highly
dependent on international trade. In the late 1990s China entered the international arena as
one of the worlds major trading nations. In 2003, China replaced Japan as the leading
exporter to the US. Economic policy makers must take the trade effect into account when
conducting economic policy. To this topic we shall return in a later module.

15.6 Business Savings

We started off our analysis by assuming that all factors of production are owned by
households and all factor incomes are received by households as personal income. Clearly,
this is not an accurate description of developed economies. Whereas all factors of
production
are owned by households, this ownership is often indirect. In consequence, some of the
income that is generated in the process of production is kept by firms in the form of
business
savings or undistributed profits and not distributed to households, although each firm is
owned
collectively, often by thousands of households. Through the business decision-making
process, the households that own businesses may choose to keep part of their income in
their businesses to spend collectively.
The gross profit of businesses is divided into three parts:
(a) capital consumption allowances (depreciation);
(b) undistributed profits; and
(c) dividends.
Gross profits less capital consumption allowances equal net profits. Capital consumption
allowances plus undistributed profits make up earnings retained by business. Dividends are
an element of disposable personal income.
Undistributed profits are equivalent in their effect on the circular flow of income to
household savings, representing a withdrawal from the circular flow of income that, if not

offset by some planned injection, will result in a decline in national income.

Having introduced the government sector, international trade and undistributed profits,
we are now able to build a complete model of the circular flow of income that approximates
to the situation we observe in a developed economy. Part of gross national income is paid to
the government in the form of taxes. Total tax revenue is composed of households taxes
(primarily personal income taxes), direct business taxes (primarily corporate profits taxes),
and indirect business taxes (primarily sales taxes). Some of the income received by the
government is passed on to households in the form of transfer payments (including welfare
payments). The difference between tax revenue and transfer payments is net taxes. Gross
national income consists of disposable personal income, business retained earnings, and net
taxes. Thus
(a) disposable personal income = wages, salaries, rents, interest + dividends taxes +
transfer payments;
(b) business retained earnings = net profit + capital consumption allowances direct
business taxes dividends; and
(c) net taxes = indirect business taxes + direct business taxes + personal taxes transfer
payments.
Put another way, the disposable income of households equals gross national income, less
business retained earnings and net taxes. This distribution of spendable income among
households, businesses and government can be seen by studying the income half of the
circular flow diagram, as shown in Figure 15.14. Figure 15.15 shows the breakdown of total
expenditure, the output side, added to the total income flow for Figure 15.14.

Figure 15.15 summarizes the circular flow of income and expenditure. Income accrues to
business in retained earnings, to government in taxes, and to households in personal
disposable income. In turn, firms undertake expenditure on investment (I), which is
enhanced from private savings and business retained earnings or by borrowing from the
capital market; government expenditure is G; and household expenditure is C. Some part of
these expenditures is on goods and services from foreign producers (imports, represented
by
Z) and foreigners purchase goods and services from domestic producers (exports,
represented
by X).
The sum of expenditures (GNE) = Consumption + Investment + Government Expenditure +
(Exports - Imports)

Thus, the flow of factor incomes to the various decision-making units in the economy
businesses, government and households and the flow of expenditures consumption,
investment, government expenditure and exports less imports can be summarized within
the single figure of the circular flow of income (Figure 15.15).