In this study unit we introduce the basic model of national income determination and the concept of the multiplier. These form the framework for analysing the process of determining the level of total or aggregate output in an economy, and the concept of macroeconomic equilibrium. The Keynesian model of national income determination and the concepts of the multiplier and macroeconomic equilibrium provide: the framework for understanding the means by which governments can use fiscal policy; the power of governments to tax and spend in the economy; and the power of governments to alter the levels of output and employment in the economy. This is such an important part of the syllabus, and a
challenging one when studied for the first time, that the topic is studied in this study unit and in Study Unit 11. This means that the learning outcomes detailed in this unit can only be achieved fully after you have completed your study of both units.
Equilibrium Conditions
We should now remind ourselves of the conditions necessary for national product, income and expenditure to be in equilibrium. Remember the term "equilibrium" refers to a state of rest where there are no pressures acting to disturb and change the balance of forces.
Earlier, we suggested that there would be equilibrium when total income was equal to total expenditure in the economy, and that this implied:
C S T M C I G X where:
C personal or household consumption S savings
T taxation M imports
I business investment
G government spending and X exports.
If we remove C from each side of the equation, we are left with:
S T M I G X
Putting this another way, we could say that total leaks or withdrawals from income equal total injections or additions to aggregate expenditure.
Equilibrium suggests that the state of rest remains for a period of time, so that we should take successive time periods into account. If, for simplicity, we use the symbols:
W total withdrawals (S, T, M) and J total injections (I, G, X),
then, using the usual symbols t, t1, t2, etc. for successive time periods, we can say that a total national product in equilibrium implies that:
Wt Jt+1 Wt+1 Jt+2, and so on.
Pressures Leading to Equilibrium
It seems reasonable to question why a national economy should achieve and maintain this form of equilibrium. If we examine the processes operating within the economy, we can see that there are strong pressures likely to produce such a state. For simplicity, we shall at this stage omit imports and exports from our analysis.
To begin with, we shall also omit taxation and government spending. We are now considering only savings and investment. However we shall reintroduce consumption.
Consider the graph shown in Figure 10.1. Expenditure intentions at the various national income levels are recorded in the curve C I. Remember that we have reduced total spending to consumption and investment, for our present purposes.
Assuming that the scales of both axes are the same, then the 45 dotted line represents all points where total income just equals total expenditure. Remember too that when
expenditure equals income, both are also equal to total output.
The graph illustrates that there is only one level of income where total income, output and expenditure are in fact equal – i.e. where national product is in equilibrium.
This is at the income level Oye, where the intentions curve intersects the dotted 45 line.
However what happens if this equilibrium is disturbed?
(a) Lower National Income
Suppose national income is at the lower level Oy1, where intentions are trying to achieve a higher level of spending than that possible from current total output.
At level Oy1, the combined demand from households (C) and business firms (I) is higher than total output.
It cannot be satisfied at the current level of output. Some firms will have stocks of goods produced earlier, and they will be able to sell from these stocks. Others, finding that they have more customers than goods to sell, will ration sales by putting up the price or promising delivery at a future date. Actual consumption and investment will thus be lower than intended, as some would-be buyers are disappointed, but also money spending will be raised by the increased prices of goods.
Figure 10.1: The national product in equilibrium
Increased money spending will feed into increased money incomes, and so the money value of national income will move up towards Oye. We can also expect that firms, facing high demand and good profits from rising sales, will seek to increase production.
They will hire more labour and pay more wages in order to do this. This will tend to push up production towards Oye. There will be an upward pressure to achieve at least the money level of Oye, even if this still leaves many spending intentions unsatisfied.
(b) Higher National Income
We can apply this reasoning in reverse if national income happened to move out of equilibrium to the higher level Oy2. Here, more is being produced than people want to buy. Warehouse stocks rise, and customers are not around to buy the goods and services on offer. Traders needing money to meet current expenses will cut prices to achieve sales. Firms, seeing stocks of unsold goods rise, will reduce production, lay off workers and cut overtime working. Incomes will fall through declining wages and falling business profits. There will be a movement downwards towards the equilibrium level Oye. Only at this level will there be no pressures for moving either up or down, because only here does total income equal total output equal total expenditure.
Pressures to Change Equilibrium
If we look again at Figure 10.1, we can see that this is only a stable equilibrium, lasting over successive time periods, if the curve of C I remains unchanged. The higher we raise the C I curve, the greater will be the level of Oye.
So although there are strong pressures to bring national income to equilibrium, there may also be forces operating to change the position of the C I curve, and so change the equilibrium. In order to understand these forces, we need to examine more closely the decisions that lead to any given level of desired or intended household consumption and desired or intended business investment.
O Y1 Ye Y2
45
C I National
expenditure (E) and intended expenditure
National income (Y) (CS)
(a) Influences on Aggregate Consumption and Saving
Remember that we have dropped imports and exports from our simplified model, and at the moment we are ignoring taxes and government spending. Therefore all income can be considered to be made up of consumption and saving. To emphasise this, we adopt a wide definition of saving, seeing it as any income (net of tax) not consumed.
Thus for each unit of income:
C S I or, S I C
Why then do people spend on consumption and why do they save? We can identify the following motives:
(i) They spend because they have income available for spending and perhaps because they expect future incomes to rise.
(ii) They spend because there is credit available.
(iii) They may also spend because they expect prices to rise and the cost of credit may be less than the amount of the expected price rise.
(iv) Pressure to spend may also come from advertising and the marketing efforts of firms wishing to maintain high levels of production and sales. Social attitudes may also encourage a high level of spending, especially in a period when the level of social security payments is high and money is losing its value and discouraging saving.
(v) On the other hand, saving may be encouraged and spending discouraged by falling incomes and rising unemployment, by controls on credit and the expansion of money, and by expectations that prices may fall.
(vi) People may also be forced to spend less and save more in order to pay off or reduce the burden of past debts after a period of high spending. This tendency was clearly evident during the early years of the 1990s after the spending and house purchase boom of the 1980s.
(vii) The depressed, low consumption years of the early 1990s also showed the importance of house purchase as a foundation for general household
consumption. When house purchase and building activity is high and people are moving homes, they also spend on house furnishings, household equipment and so on. When there is little activity in the housing market all these associated household consumer durable markets are depressed. Employment and incomes fall in the affected industries and the economic depression deepens.
(viii) Savings may also be contractual, i.e. people undertake to save regular amounts out of income through schemes arranged with insurance companies, building societies, etc. The motives for contractual saving are to provide for retirement, for substantial future purchases, for precautionary motives, or simply because of social habit – the belief that saving is a moral duty.
Some of these motives correspond with the influences on the demand for products, which we identified in earlier study units. The general influences on total or aggregate spending and saving can change over time, so that the amount saved from any given volume of income can also change. Relationships between the amount consumed and saved and total incomes are examined later in this unit.
(b) Business Production and Investment
Just as (leaving aside government spending, taxes, and foreign trade) we find that total income is either spent on consumption or saved, so we see total production as being sold either for consumption or for investment or capital accumulation. Here we have a slight problem: we cannot, in practice, distinguish between the purchase of new equipment to replace old and worn-out equipment, and that purchased to increase productive capacity. Moreover, some equipment may also be acquired simply to replace labour, with no significant increase in production planned or desired. Also, when we define investment in terms of production not sold for consumption, this includes stocks of goods.
So not all total investment could really be called "productive investment", able to increase the ability of business organisations to produce more. Yet, it is productive investment that really interests us. For simplicity, at this stage we shall assume that all or most investment does have a productive element (after all, most firms replace machines with better machines). This enables us to link the desire of firms to invest with their desire to produce more output. Thus, we can suggest that the main motive for investment is the belief of business firms that it will be in their interests to increase productive capacity. They are more likely to believe this if:
(i) current consumer demand is rising and expected to continue to rise (ii) current profits are rising and expected to continue to rise
(iii) the cost of investment is falling and expected to continue to fall – the main element in this being the level of interest rates charged on borrowed finance.
Notice here that the influences on the level of investment are mostly not directly related to the level of current income. So for our purposes at this stage, we do not regard the level of investment as being dependent on income levels. This is in contrast to the level of saving which, provided other influences are constant, is directly related to the level of income.
Note that business firms, in making investment decisions, stress the importance of estimates of future revenues related to present costs and how these are affected by expectations of future demand levels and the costs of capital (linked to market rates of interest). You should remember that investment decisions involve making judgments about the future, about future markets and about future economic conditions and government policies. The future can never be forecast with accuracy, but the greater the degree of uncertainty about the future, the higher are the risks of business investment and the less the amount of investment undertaken. Political uncertainties and lack of confidence in the government can be as damaging to investment as market uncertainties; in practice the two are closely related.