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The document discusses the concepts of income and spending in macroeconomics, detailing the circular flow of economic activity across different sectors including households, businesses, government, and the external sector. It explains various economic models such as one, two, three, and four sector economies, along with national income accounting methods and the calculation of GDP through both the earnings and product approaches. Additionally, it covers aggregate spending, equilibrium output, and the impact of government spending and taxation on economic stability.

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0% found this document useful (0 votes)
4 views

G6A

The document discusses the concepts of income and spending in macroeconomics, detailing the circular flow of economic activity across different sectors including households, businesses, government, and the external sector. It explains various economic models such as one, two, three, and four sector economies, along with national income accounting methods and the calculation of GDP through both the earnings and product approaches. Additionally, it covers aggregate spending, equilibrium output, and the impact of government spending and taxation on economic stability.

Uploaded by

jdelwar29
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 31

SHAHJALAL UNIVERSITY OF

SCIENCE AND TECHNOLOGY , SYLHET

ECONOMICS (ECO-105D)
CHAPTER–06
Submitted to:

Dr Mohammad Sadiqunnabi Chowdhury


. Professor Dept. of Economics, SUST

SUBMITTED BY
2021331089 TOWHEDUZZAMAN
2021331033 MD RAKIB AHMED AKASH
2021331007 S.M. ASHIKUR RAHAMAN
2021331009 MD. ABU BAKAR SIDDIQUE
2021331017 MAZHARUL ISLAM
2021331031 EBRATUL SHAHRIAR
2021331041 MD. THOWFIQUR BARI CHOWDHURY
2021331053 HASAN MAHMUD
Income and Spending:​

The income and spending in macroeconomics deals with the distribution
and use of income

among many sectors like households, business, government, and external


sector.

6.1 Circular Flow of macroeconomic activity:

All the income of society somehow converts into spendings in a economic


society and the

spendings in one part makes income for other. Therefore, this activity
creates an endless circular
flow of economy between all the sectors in a society.

6.1.1 One and two sector economy:


One Sector Economy:

A one sector economy consists of a single person who himself is both


producer and consumer.

For example, Robinson Crusoe in is adventure into the isolated island,


created an one sector

economy as he is the only one who produces and consumes good.


Fig 1: Flow of One Sector Economy

It is an unrealistic economy as this flow diminishes all the branches and


uses of economy in

modern society.​

Two Sector Economy

In this economy there are two sectors involved, one is households and the

other is business.

Fig 2: Flow of Two Sector Economy

Here land, labor, capital, organization are called factors of productions and
rent, wages, interest,

profit are called compensation to factor of production.


6.1.2 Three and four sector economy

Three Sector Economy


In this economy there are three sectors involved: households, business and
government.

Fig 3: Flow of Three Sector Economy


Here income tax from households to government is direct tax.

· Government spendings from business to government refers to


defense, education, medical, roads and highways.

· Direct tax from business to government refers to Business Income


Tax

· Indirect tax from business to government refers to VAT, Fees,


Excise.

Four Sector Economy


In this economy, apart from three sectors of previous one, there is an
external sector.

Here,

Net flow of goods/services = Export(X) – Import(M)


· If, Export(X) > Import(M):

o Net flow of goods and services will be from business to


External Sector

o Net payment will flow from external sector to business

· If, Export(X) < Import(M):

o Net flow of goods and services will flow from External Sector
to business

Net payment will flow from business to external sector

6.2 National income accounting


National Income Accounting is a method of measuring the total value
of goods and services produced in a country over a specific period (usually
one year). It helps track a country's economic activity.

Y = C + I + G + EX – IM

The identity, shown above, says that GDP is the sum of:

C = Personal Consumption Expenditures,

I = Private Investment Expenditures,

G = Government Consumption Expenditures,

NX = Net Export

Measurement of National Income

National Income (GDP) can be measured using two approaches:


1. Earnings Approach (Income Approach) - Focuses on the total
income earned by factors of production.

2. Product Approach (Expenditure Approach) - Focuses on the total


expenditure on goods and services.

6.2.1 Product Approach


This method calculates GDP by summing all expenditures made in an
economy. GDP is the total value of goods and services purchased within a
country in a specific period.

Components of GDP (Expenditure Method):

1. Personal Consumption Expenditures (C):

o Includes all spending by households on goods and services.

o Examples: Food, clothing, healthcare, entertainment.

2. Private Investment Expenditures (I):

o Includes spending by businesses on capital goods such as


machinery, tools, and construction.

o Also includes changes in business inventories.

3. Government Consumption Expenditures (G):

o Includes spending by federal, state, and local governments


on public services.

o Examples: Infrastructure projects, defense, education.

4. Net Export (NX = Exports - Imports):

o Exports (EX): Goods and services sold to foreign countries.


o Imports (IM): Goods and services purchased from foreign
countries.

o Formula: NX = EX - IM (A positive NX means more exports


than imports.)

Formula for GDP Calculation:

GDP = C + I + G + (EX - IM)

Key Economic Terms Explained:

1. Net National Product (NNP):

· The total monetary value of goods and services produced by a


country’s citizens, both domestically and internationally.

· Formula: NNP = National Income - Indirect Business Tax.

2. Gross National Product (GNP):

· The total value of all final products and services produced using
resources owned by a country’s residents, including income
earned abroad.

· Formula: GNP = NNP + Depreciation.

3. Gross Domestic Product (GDP):

· The market value of all final goods and services produced within
a country in a specific period.

· Formula: GDP = GNP + (Outward Remittance - Inward


Remittance).
6.2.2 Earnings Approach
National Income (NI) is calculated as the sum of earnings from the four
factors of production:

· Compensation for Labor (Wages): Payments to employees for their


work, including salaries, wages, and benefits.

· Rent from Land: Income earned by property owners for the use of
their land.

· Interest: Income earned by individuals or businesses from lending


money.

· Profit:

o Proprietor’s Income: Earnings of self-employed individuals


and small businesses.

o Corporate Profit: Earnings of corporations after paying


expenses, taxes, and dividends.

Formulas for National Income Calculation:

· National Income (NI) = Wages + Rent + Interest + Profit

· Net National Product (NNP) = NI - Indirect Business Tax (NNP


accounts for tax deductions from NI.)

· Gross National Product (GNP) = NNP + Depreciation (GNP includes


the value of capital depreciation.)

· GDP = Outward Remittance - Inward Remittance

o Outward Remittance: Money sent out of the country.

o Inward Remittance: Money received from other countries.


Conclusion:

National income measurement helps in understanding the economic


performance of a country. The Income Approach calculates GDP based on
income earned by production factors, while the Product Approach
calculates GDP based on expenditures in different sectors. Both methods
provide insights into a nation’s economic health.

6.3 Aggregate spending in a two-sector model


6.3.1 Consumption and saving functions, MPC and
MPS
Consumption Function: It illustrates the relationship between
consumption expenditures and the level of disposable personal income.
We can define consumption function as,
C = F(Y)
= C₀ + cY
Here, C = autonomous consumption
c = dC/dY = Marginal Propensity to Consume (MPC)
Y = Income
Saving Function: This refers to the standard equation of savings, which
defines the relationship between savings and income. The value of savings
can be derived at each level using the value of income.
We can define the saving function as,
S = F(Y)
= Y - C ; net income of consumption
= Y - C₀ - cY
= -C₀ + (1 - c)Y
= -C₀ + βY
Here, β = dS/dY = Marginal Propensity to Save (MPS)
Here, 0 < c < 1 and 0 < β < 1
Now, MPC + MPS = 1
There are two types of people :
1. Wealthy: They tend to save a larger portion of their income, leading to a
higher MPS and a lower MPC.
2. Poor: They tend to spend a larger portion of their income, leading to a
higher MPC and a lower MPS.
Exercise:
Find the equilibrium level of income.
Soln :
We know, Here,
Y=C+I
or, Y = C₀ + cY + I₀
or, Y - cY = C₀ + I₀
or, (1 - c)Y = C₀ + I₀
or, Y* = (C₀ + I₀) / (1 - c)
Here, dY/dI = 1 / (1 - c) = Expenditure multiplier
Y* = Equilibrium level of income
I = Investment
C₀ + I₀ = Autonomous Spending
Therefore, from the above equation, we can state that “The change of
income to an instantaneous change in income is called Expenditure
Multiplier”.

6.3.2 Investment function


The investment function is a summary of the variables that influence the
levels of aggregate investments. In the measure of national income and
output, "gross investment" (represented by the I) is a component of GDP,
given in the formula.
GDP = C + I + G + NX
C = Consumption
G = Government spending
NX = Net Export = X – M
X = Export
M = Import
Thus, Investment is everything that remains of total expenditure after
consumption, government spending, and net exports are subtracted.
I = GDP − C − G − NX
Investment is often modeled as a function of income and interest rates,
given by the relation
I = f(Y, r)
with the interest rate negatively affecting investment.
I = Investment
Y = GDP (Gross Domestic Product)
r = Interest rate
As the investment function is related to ‘r’
I = I₀ - r * h
I₀ = Autonomous Investment
r = interest rate
h = interest sensitivity
Relation between Investment Rate and Investment:

Higher interest rates tend to reduce investment because they increase


borrowing costs. When borrowing is more expensive, businesses need
higher returns to justify the investment. On the other hand, lower interest
rates make borrowing cheaper, encouraging more investment in the
economy.
Autonomous investment: Autonomous investment is capital expenditure
that remains unaffected by changes in income, interest rates, or profit
levels. It is income-inelastic, meaning it stays constant at all income levels,
and its curve is horizontal, parallel to the X-axis.
6.3.3 Equilibrium output in the two-sector model

▼ What is equilibrium in two sector economy?

In a two-sector economy, saving is the only way money is taken out, and
investment is the only way money comes in. An economy is in balance
when saving matches investment.

▼ How do you calculate equilibrium in two sector economy?

The equilibrium level of income in a two-sector economy can be derived


mathematically; equilibrium occurs when aggregate output equals
aggregate expenditure.

Now,​
Y=C+I

or, Y = C₀ + bY + I₀ (C = C₀ + bY and I = I₀)

or, Y(1 - b) = C₀ + I₀

or, Y = 1/(1 - b) (C₀ + I₀)*

Here, C₀ + I₀ is known as autonomous spending and (1 - b) is multiplier .

Investment Function

6.3.4 Expenditure Multiplier

▼ What is Expenditure Multiplier?

When investment goes up by 1%, the change in income is called the


"expenditure multiplier. This multiplier shows how much a country's GDP
changes due to an increase in overall spending compared to the initial
increase in spending.

Here,

Δy = m * ΔI

Where,

Δy = percentage change in income

m = expenditure multiplier

ΔI = percentage change in investment


▼ Four assumptions of Expenditure Multiplier

Before calculating the expenditure multiplier, it is essential to consider the


following four assumptions:

1.​ Price of Goods is constant.


2.​ Interest rate is constant.
3.​ Government spendings is zero.
4.​ Imports and exports are zero.

▼ Mathematical Explanation

From the equilibrium in two-sector model, we know,

Y = 1/(1-b) (C₀ + I₀)

So, Expenditure Multiplier = dY/dI = 1/(1-b) = 1/(1-MPC) = 1/MPS

6.4 Aggregate Spending in a Three-Sector Model

6.4.1 Government spending and tax. Disposable income

The three-sector economy involves three sectors namely,households,


business, and government.
The addition of the government in an economy results in bringing two variables in
an economy.These variables are government expenditure (act as injections to
income) and taxation (act as
withdrawals from income).

Aggregate spending in a three-sector model includes households, businesses,


and the government. It consists of consumption (C), investment (I), and
government spending (G). The equation is AE = C + I + G, representing total
economic expenditures. Government intervention through taxation and spending
influences economic stability. This model helps analyze fiscal policies and
economic fluctuations.

So, the government expenditure increases the aggregate demand (AD),


while taxation reduces the aggregate demand.

Aggregate Demand and Aggregate Supply


Aggregate Demand, AD = C + I + G
Aggregate Supply, AS = C + S + T
Here,
C = Income Consumption
I = Investment Spending
G = Government Expenditure
S = Savings
T = Lumpsum Tax

6.4.2 Equilibrium and output in the three-sector model

At the equilibrium point,

AD = AS
C+S+T=C+I+G
Income, Y = C + I + G
Where,
C = C0+ bYd

Here,

C = Income Consumption,

C0 = Autonomous Consumption,

b = Marginal Propensity to Consume

Yd = Disposable Income(After Tax Income)

Now,
Yd = Y − T
T = T0
I = I0
G = G0

Here,
Y = Income,
T0 = Autonomous Tax
I0 = Autonomous Income
G0 = Autonomous Government Spending

Now,
Y≡C+I+G
= C0 + bYd + I + G
= C0 + b(Y − T0 ) + I0 + G0
Y − bY = C0 − bT0 + I0 + G0
Equilibrium Income, Y*=1/1-b(Co-bTo+Io+Go)

Graphical Representation of Three-Sector Economy

6.4.3 Government sector multipliers

1️⃣Investment Multiplier or Expenditure Multiplier,

dy/dI=1/1-b
2️⃣Government Spending Multiplier,
dy/dG=1/1-b
3️⃣Government Spending Multiplier,
dy/dT=-b/1-b
4️⃣Balanced Budget Multiplier (When G=T),
dy/dG=1-b/1-b=1

Value of Balanced Budget Multiplier is 1

6.5 Aggregate Spending in a Four-Sector Model

In the study of MacroEconomics, the basic foundation consists of four


aggregate sectors: households, businesses, government, and the foreign
sector. These sectors collectively represent the primary components of
gross domestic product (GDP) expenditures, highlighting the various
economic transactions and contributions made by domestic consumers,
businesses, public institutions, and international trade partners.

6.5.1 Export and import functions, net export

Import: Imports encompass the purchase of goods and services by


residents of a nation from foreign countries. These transactions occur when
domestic consumers or businesses choose to obtain foreign-produced
items, contributing to the flow of international trade and the exchange of
commodities across borders.

Export: Exports encompass the sale of domestically produced goods and


services to foreign consumers. These transactions contribute to the global
exchange of commodities and services, allowing domestic businesses to
reach international markets and generate revenue from foreign customers.
Things to be mentioned, Imports result in an outflow of financial resources
from a nation, as these transactions require payments to foreign suppliers.
In contrast, exports bring about an inflow of funds, as these transactions
involve revenue from selling domestic goods and services to international
markets.

Within the four-sector economic model, exports (X) are regarded as


additions to national income, while imports (M) are seen as withdrawals
from national income.

The concept of net export (NX) is derived by subtracting imports from


exports, represented by the formula:

NX=X−M

Net export quantifies the extent to which a country's total exports surpass
its total imports, and a positive net export indicates a trade surplus.

1. Export Function (X):

●​ X = f(Y): This states that exports (X) are a function of national income
(Y).
●​ X = X₀: You've simplified this by assuming exports are autonomous,
meaning they are independent of national income. Therefore, exports
are a constant value (X₀). This could represent factors like global
demand for a country's goods, exchange rates, or trade agreements.
2. Import Function (M):

●​ M = f(Y) = M₀ + mY: This states that imports (M) are a function of


national income (Y).
●​ M₀: This is autonomous imports, the level of imports that occurs even
when national income is zero. This could include essential goods or
imports driven by factors other than income.
●​ m: This is the marginal propensity to import (MPM). It represents the
change in imports resulting from a one-unit change in national
income. In other words, it's the fraction of each additional dollar of
income that is spent on imports.
3. Net Export Function (NX):

●​ NX = X - M: Net exports (NX) are the difference between exports (X)


and imports (M).
●​ NX = X₀ - (M₀ + mY): Substituting the export and import functions:
●​ NX = X₀ - M₀ - mY: Distributing the negative sign.
●​ NX = (X₀ - M₀) - mY: This is the final form of the net export function.

6.5.2 Equilibrium and output in the four-sector


model

The equilibrium output is the point where planned aggregate expenditure


equals national income (output).
Components of the Four-Sector Economy:

●​ Consumption (C):
○​ C = C₀ + bY₀ (Note: It should be C = C₀ + bY_d where
Y_d is disposable income)
○​ C₀ represents autonomous consumption (consumption when
income is zero).
○​ b is the marginal propensity to consume (MPC).
●​ Disposable Income (Yd):
○​ Yd = Y - T
○​ Y is national income.
○​ T is taxes.
●​ Lump Sum Tax (T):
○​ T = T₀
○​ Taxes are a fixed amount (lump sum).
●​ Investment (I):
○​ I = I₀
○​ Investment is autonomous (independent of income).
●​ Government Expenditure (G):
○​ G = G₀
○​ Government spending is autonomous.
●​ Net Export (NX):
○​ NX = NX₀ - mY
○​ NX₀ is autonomous net exports.
○​ m is the marginal propensity to import (MPM).

Derivation of Equilibrium Income (Y):*

1.​ National Income Identity:​

○​ Y = C + I + G + NX
2.​ Substituting the Equations:​
○​ Y = C₀ + b(Y - T₀) + I₀ + G₀ + NX₀ - mY
3.​ Solving for Y:​

○​ The equation is rearranged and solved for Y to find the


equilibrium income (Y*):
○​ Y* = 1 / (1 - b + m) * (C₀ - bT₀ + I₀ + G₀ +
NX₀)

Interpretation of the Equilibrium Income Equation:

●​ The term 1 / (1 - b + m) represents the multiplier. It shows how


much equilibrium income changes in response to a change in
autonomous spending.
●​ The term (C₀ - bT₀ + I₀ + G₀ + NX₀) represents the total
autonomous spending in the economy.

Multipliers

1.​ Expenditure Multiplier:​

○​ Definition: The impact of a change in income following a


change in autonomous expenditure is called the expenditure
multiplier.
○​ Formula: dY/dI = 1 / (1 - b + m)
■​ Where:
■​ dY is the change in income (Y).
■​ dI is the change in autonomous expenditure (I).
■​ b is the marginal propensity to consume (MPC).
■​ m is the marginal propensity to import (MPM).
○​ Interpretation: This formula shows how much total income
changes for every one-unit change in autonomous spending
(like investment).
2.​ Government Spending Multiplier:​
○​ Definition: The impact of a change in income following a
change in government spending is called the government
expenditure multiplier.
○​ Formula: dG/dI = 1 / (1 - b + m)
■​ Where:
■​ dG is the change in government spending.
■​ dI is the change in autonomous expenditure.
■​ b is the marginal propensity to consume (MPC).
■​ m is the marginal propensity to import (MPM).
○​ Note: The formula in the image is incorrect. It should be dY/dG
= 1 / (1 - b + m)
○​ Interpretation: This formula shows how much total income
changes for every one-unit change in government spending.
3.​ Lump Sum Tax Multiplier:​

○​ Definition: The lump-sum tax multiplier is the value that tells


how a tax percentage change would affect the GDP.
○​ Note: The image gives a definition but does not provide the
formula.
○​ Formula: dY/dT = -b / (1 - b + m)
■​ Where:
■​ b is the marginal propensity to consume (MPC).
■​ m is the marginal propensity to import (MPM).
○​ Interpretation: This formula shows how much total income
changes for every one-unit change in lump-sum taxes. The
negative sign indicates that an increase in taxes reduces
income.
4.​ Foreign Trade Multiplier (Export Multiplier):

Definition: The foreign trade multiplier, also known as the export


multiplier, is defined as the amount by which the national income of a
country will be raised by a unit increase in domestic investment on
exports.​
Formula: dY/dNX = 1 / (1 - b + m)
●​ Where:
○​ dY is the change in income (Y).
○​ dNX is the change in net exports (NX).
○​ b is the marginal propensity to consume (MPC).
○​ m is the marginal propensity to import (MPM).

Multipliers in Macroeconomics

In macroeconomics, a multiplier refers to the phenomenon where a


change in one component of aggregate demand (like investment,
government spending, or net exports) leads to a proportionally larger
change in national income (or GDP).

The Equations:

The following equations illustrate the concept:

●​ ΔY = μ ⋅ ΔI
●​ ΔY = μ ⋅ ΔG
●​ ΔY = μ ⋅ ΔNX

Where:

●​ ΔY represents the change in national income.


●​ μ (the Greek letter "mu") represents the multiplier.
●​ ΔI represents the change in investment.
●​ ΔG represents the change in government spending.
●​ ΔNX represents the change in net exports.

The Logic:

The multiplier effect arises because an initial change in spending triggers a


chain reaction throughout the economy. For example, if the government
increases its spending (ΔG), this directly increases demand for goods and
services. Businesses respond by increasing production and hiring more
workers, which in turn leads to higher incomes for those workers. These
workers then spend a portion of their increased income, further boosting
demand and creating a ripple effect throughout the economy.

The Result:

The final impact on national income (ΔY) is larger than the initial change in
spending (ΔI, ΔG, or ΔNX). The size of the multiplier (μ) depends on factors
like the marginal propensity to consume (MPC), the marginal propensity to
import (MPM), and the marginal propensity to save (MPS).

🌹 🥀 THE END

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