Macro Economics (Handout) (1).pdf

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Notes
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NATIONAL INCOME AND ITS
MEASUREMENT
Chapter topic list Syllabus reference
1 The concept of national income
2 The circular flow of income in the economy
3 Definition and measurement of national income
Introduction
Businesses operate in the economy as a whole and changes in the macroeconomic
environment can have major implications for them. Management accountants need an
understanding of how the economy as a whole functions and the way in which government
policy operates. A basic understanding of the concept of the economy as a system and an
appreciation of the way the economy performs in terms of employment, output and prices are
essential. Management accountants should also be aware of the debates within economics
about the nature of the macroeconomy, particularly where this affects the conduct of
government economic policy.
We look in this chapter at how we can measure the total amount of economic activity in a
country.
This provides a foundation from which to develop the following chapters on the
macroeconomic environment.
THE CONCEPT OF NATIONAL INCOME
Three key measures are:
(a) national income;
(b) gross national product (GNP);
(c) gross domestic product (GDP).
(d) net national product (NNP)
NNP is the money value of total volume of production i.e. gross national product after
allowance has been made for deprecation.
Exercise 1
These are terms which are often encountered in news reports, and yet are often only vaguely
understood. Jot down what you think is the meaning of each, and review what you have written
once you come to the end of the chapter.
These are related but different measures of the amount of economic wealth that a
country creates or earns over a period of time, usually one year.
165 PB Publications
1
1.1
3.1
3.1
3.1

Notes Part C: Macroeconomic environment l
1.3 Why is nationalincome so important?
(a) National income is an important measure because it is an aggregate of personal
incomes. The bigger the national income in a country, the more income its
individual inhabitants will be earning on average. More income means more
spending on the output of firms, and more spending (ignoring inflation) means
more output of goods and services. !
(b) Growth in national income is an economic policy objective of most, if not all,
governments.
1.4 Who creates economic wealth?
■ Economi'c-wciilth can be viewed as created;!
(a) by the people or organisations that spendmoney to buy the goods and services:
(i) consumers (or'households');
(ii) the government; and 'I
(iii) foreign buyers (the 'overseas sector'); or
(b) by the factors of production, which earn factor incomes.
(c) by the firms (or government departments and corporations) which produce the
goods or services in the national economy.
1.5 The three approaches (a), (b) and (c) give rise to three ways ofanalysing the creation of
eccdomic wealth:
(a) the expenditure approach;
(b) the income approach; and
(c) the value added approach (until recently called the output approach).
These approaches will be explained later.
Exercise 2
Before proceeding, recall from an earlier chapter what the factors of production are, and what
reward is earned by each.
2 THE CIRCULAR FLOW OF INCOME IN THE ECONOMY
2.1 Income in a country's economy flows between households and firms.
(a) The income of firms is the sales revenue from the sales ofgoods and services.
(b) The income of households is the income arising from the ownership of the factors
ofproduction.
2.2 Firms must pay households for the factors of production (productive resources), and
households must pay firms for goods. This creates a circular flow of income and
expenditure, as illustrated in Figure 1.
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9: National income and its measurement Notes
Factor incomes paid by firms
Figure 1 Circular flow of income
2.3 Households earn income. They earn income because they have provided the factors of
production which enable firms to output goods and services. The income earned is used
as expenditure on these goods and services that are made.
2.4 The total sales value of goods produced (output) should equal the total expenditure on
goods, assuming that all goods that are produced are also sold. The amount of
expenditure should also equal the total income of households, because it is households
that consume the goods and they must have income to afford to pay for them.
Withdrawals and injections into the circular flow ofincome '
2.5 Our simplified diagram of the circular flow ofincome needs to be amended to allow for:
(a) withdrawals from the circular flow of income. These are movements offunds out of
the cycle of income and expenditure between firms and households;
(b) injections into the circular flow of income. These are movements of funds in the
other direction.
2.6 There are three types of withdrawal{torn the circular flovv.
(a) Savings (S). Households do not spend all of their income*. They save some, and
these savings out of income are withdrawals from the circular flow ofincome quite
simply because savings are not spent.
(b) Taxation (T). Households must pay,some of their income to the government, as
taxation. Taxes cannot be spent by households, because the fpnds go to the
■
government. .
(c) Imports (M). When we consider national income, we are interested in the economic
wealth jhat a particular country is earning. Spending on imports is expenditure,
but on goods made by firms in other countries. The payments for imports go to
firms in other countries, for output created in other countries. Spending on imports
therefore withdraws funds out of a country's circular flow ofincome.
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Notes Pari C: Macroecdnomic envitonment
2.7 There are three types of injection into the circular flow of income.
(a) Investment (I). Investment in capital goods is a form of spending on output, which
is additional to expenditure by households. Just as savings are a withdrawal of
funds, investment is an injection of funds into the circular flow of income, adding
to the total economic wealth that is being created by the country.
(b) Government spending (G). Government spending is also an injection into the
circular flow of income. In most mixed economies, total spending by the
government on goods and services represents a large proportion of total national
expenditure. The funds to spend come from either taxation income or government
v borrowing.
(c) Experts (X). Firms produce goods and services for export. Exports earn income
from abroad, and therefore provide an injection into a country's circular flow of
income.
2.8 Figure 2 shows the circular flow of income, taking account of withdrawals and
injections.
Factor
Figure 2 Circular flow of income showing withdrawals and injections
Three approaches to measuring national income
2.9 As already mentioned, these are as follows:
(a) The expenditure approach. The economic wealth created in a period can be
measured by the amount of expenditure on the goods and services that are
produced by the nation's economy.
(i) The expenditures will be incurred by consumers, the government and
foreign buyers of exports. Expenditures on imports represent wealth created
by other countries, and so the value of expenditure on imports must be
deducted from the total expenditure figure.
(ii) Expenditures by firms are excluded, to avoid double-oounting. Firms buy
goods and services which become costs of the goods or services that they
produce and sell themselves. If we included expenditure by firms, we would
be double-counting the value of the wealth created by the suppliers of raw
materials and components and the providers of services to other firms.
PB ’ '’''cations 168

9: National income and its measurement
(b) The income approach. This approach measures the income of individuals from
employment and from self-employment, the profits of firms and public
corporations and rent on property. (Interest earnings will be included within the
profits ofcompanies or the income ofindividuals.)
(c) The value added or output approach. This approach is to measure the value added
by all activities which produce goods and services, that is their net output in the
period..
2.10 All three approaches will in theory result in the same total amount for economic wealth
created in the period, which we call gross domestic product (GDP). In practice,
• statistical discrepancies arise which cause differences between the alternative figures.
Exercise 3
*
We stated above that, in the expenditure approach to measuring national income, expenditures by
firms are excluded to avoid double counting. Think carefully about this and ensure that you
understand exactly whatls meant, dot down an explanation.
Solution
Firms buy goods and services which become costs of the goods or services that they produce and
sell themselves. If we included expenditure by firms, we would be double-counting the value of the
wealth created, by the suppliers of raw materials and components and the providers of services to
other firms.
2.11 Examination questions might call for an understanding of the component elements of
GDP, GNP and national income, and it will be useful to look at some simplified
examples which illustrate the three approaches to measuring GDP.
2.12 Examples
First example
Suppose that a Small national economy consists of one firm. During a certain period of
time, the firm:
(a) imports raw materials from abroad, costing Rs.4,000;
(b)- hires labour, who are paid wages of Rs.9.,000;
(c) sells all its output for Rs.20,000 and so makes a profit of Rs.7,000;
(d) pays its post-tax profits of Rs.4,000 to shareholders as dividends.
The country's government taxes the labour force Rs.2,000 and the company Rs.3,000.
.The firm's sales of Rs.20,000 are accounted for by: '
(a) domestic consumers who spend Rs.11,000. This Rs.11,000 is the post-tax wages
earned by the labour force (Rs.7,000) plus the Rs.4,000 in dividends earned by the
company's shareholders;
(b) the government which spends the Rs.5,000 it has raised in taxes;
(c) foreign buyers, who spend Rs.4,000.
Required
Calculate the gross domestic product.
169
Notes
PB Publications

Notes Part C: Macroeconomic environment
2.13 Solution
There are three ways ofcalculating the GDP.
(a) The expenditure approach
/
'onsumers' expenditure
Jovemment expenditure
Add exports
Subtract imports
V GDP
(b) The income approach
Income from employment (here pre-tax wages)
Gross (pre-tax) profit of the firm
GDP
•4,
The income is measured before deducting tax.
(c) The value added or output approach
Output offirm at sales value
less cost (sales value) of goods or services purchased from
outside firms
GDP
The cost of goods and services purchased from outside firms - here just the
imported materials of Rs.4,000 - has to be subtracted so as either to avoid the
double-counting of output, or to remove the value of output produced by firms in
other countries.
2.14 Second example
This second example includes:
(a) two companies instead ofjust one in the national economy; and
(b) a sales tax, such as value added tax.
Suppose that in a country there are two firms A and B. During a period of time:
(a) firm A imports raw materials costing Rs.8,000 and pays its workforce Rs.16,000, to
produce output which it sells to firm B for Rs.30,000;
(b) firm B buys the output of firm A for Rs.30,000 and pays its work force Rs.20,000
to produce output which it sells for Rs.60,000 plus sales tax of Rs.9,000 - i.e.
Rs.69,000 in total;
(c) the workforces of firms A and B pay income tax of Rs.5,000 out of their total
income of Rs.36,000;
(d) firm A makes a pre-tax profit of Rs.(30,000 - 8,000 - 16,000) = Rs.6,000, and pays
a profit tax of Rs.2,000 out of this;
(e) firm B makes a pre-tax profit of Rs.(60,000 - 30,000 - 20,000) = Rs.10,000 and
pays tax of Rs.3,000;
(f) the government's tax income is sales tax of Rs.9,000, income tax of Rs.5,000 and
profits tax of Rs.5,00.°-i.e. Rs.19,000 in total;
Rs.
20,000
(4,000)
16,000
Rs.
9,000
7,000
16,000
Rs.
11,000
5,000
16,000
4,000
20,000
(4,000)
16,000
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(g) firm A and firm B pay their post tax profits of Rs.4,000 and Rs.7,000 respectively
as dividends to shareholders;
(h) the purchasers of the output offirm Bare:
Rs.
Shareholders offirms A and B < 11,000
Workers in firms A and B ' 31,000
The government 19,000
Exports 8,000
i' 69,000
Required
Calculate the gross domestic product.
2.15 Solution
(a) The expenditure approach
Consumer spending (Rs.l 1,000 + Rs.31,000)
Government spending
Total domestic expenditure
Exports
Imports
Gross domestic productat market prices
Less sales tax
Gross domestic product at factor prices
Rs.
42,000
19,000
61,000
8,000
69,000
(8,000)
61,000
(9,000)
52,000
In this calculation, we can make a distinction between GDP at market prices (i.e.
including the sales tax paid on expenditures) and GDP at factor prices (i.e. net of
sales tax). It is GDP at factor prices which will reconcile with the GDP calculated
by the income approach which ignores sales taxes.
(b) The income approach
Rs.
Income from employment (before deducting income tax) 36,000
Profits before tax offirms A and B (Rs.6,000 + Rs.10,000) 16,000
GDP at factor prices 52,000
(c) The value added oroutputapproach
Rs.
'Value added' by firm A ( Rs.30,000 - Rs.8,000) 22,000
'Value added'by firm B (Rs.60,000-Rs.30,000) 3Q,Q00
GDP at factor prices v. 52,000
'Value added' means sales value ofgoods sold minus the cost ofbought-in materials,
components, supplies and services. In this example, the value of firm A's output
must exclude the imported raw materials, and the value of firm B's output must
exclude the cost of goods bought from firm A. (GDP at market prices could have
been calculated by including indirect sales taxes in the value of the output.)
Notes
171 PB Publications

The government and national income
2.16 The government has several functions within the national economy, and so plays several
different roles in the circular flow ofincome.
(a) It acts as the producer of certain goods and services instead of privately-owned
firms, and the 'production' of public administration services, education and health
services, the police force, armed forces, fire services and public transport are all
aspects of output. The government in this respect acts, like firms, as a producer and
must also pay wages to its employees.
(b) It acts as the purchaser of final goods and services and adds to total 'consumption'
expenditure. National and local government obtain funds from the firms pr
households of the economy in the form of taxation and then use these funds to buy
' goods and services from other firms.
(c) It invests by purchasing capital goods, for example building roads, schools and
hospitals.
(d) It makes transferpayments from one section of economy to another - for example
by taxing working.households and paying pensions, and by paying unemployment
benefits and social security benefits.
3 DEFINITION AND MEASUREMENT OF NATIONAL INCOME
Definition of national income
3.1 (a) National Income as defined by fisher.
“The total amount of goods, arid service which has been produced during the
period ofone year is called National Income”.
(b) National Income as defined by J.R. Hicks: •
“The National Income consists of those goods and services which can be measured
through wealth”.
3.2 The Pakistan national income can be defined as 'the sum of all incomes of residents in
the Pakistan which arise as a result ofeconomic activity, that is from the production of
goods and services. Such incomes, which include rent, employment income and profit,
are known as factor incomes because they are earned by the so-called factors of
production: land, labour and capital'.
3.3 National income is also called netnationalproduct.
(a) The terms 'income' and 'product' are just two different aspects of the same circular
flow of income.
(b) The term 'net' means 'after deducting an amount for capital consumption or
depreciation offixed assets'. (We shall return to this point later.)
Gross domestic product (GDP)
3.4 Most Pakistan national income is derived from economic activity within the Pakistan
Economic activity within the Pakistan is referred to as total domestic income or
domestic product. It is measured 'gross' - i.e. before deducting an amount for capital
consumption or depreciation of fixed assets - and the term gross domestic product
therefore refers in the Pakistan to the total value of income/production from economic
activity within the Pakistan
PB Publications 172

Gross national product (GNP)
3.5 'Some national income arises from overseas investments while some of the income
generated within the Pakistan is earned by non-residents. The difference between these
items is netpropertyincomefrom abroad.'
Gross national income or gross national product (GNP) is therefore the gross domestic
product (GDP) plus the net property income from abroad - or after subtracting the net
property income from abroad, ifit is a negative value.
The relationship between GDP, GNP and national income
3.6 The relationship between GDP, GNP and national income is therefore as follows.
GDP
plus Net property income from abroad
equals GNP
minus Capital consumption
equals National income (net)
Exercise 4
Which of the following may cause an increase in national income?
(a) A rise in exports.
(b) An increase in saving.
(c) A fall in consumer spending.
Solution
Only (a). Both (b) and (c) are reductions in national income.
The expenditure approach to measuring national income
3.7 Probably the most widely used measure of rational income is the measurement of total
spending or expenditure, and it is worth looking at this in some detail. The table below
shows national figures for the economy ofa country.
NATIONAL INCOME: EXPENDITURE APPROACH
Amountin
billion
Atcurrentmarketprices v
Consumers' expenditure 382.7"
General governmentconsumption 132.4
Gross domestic fixed capital formation 92.9
Value ofincrease/(decrease) in stocks and work in progress (2.0) s
Total domestic expenditure 606:0
Exports ofgoods and services 139.8
Imports of goods and services (149.2)
Statistical discrepancy (0.4)
Gross domestic product (GDP) at current market prices 596.2
Taxes on expenditure (indirect taxes) (87.7)
Subsidies 6.1
Gross domestic product (GDP) at factor cost 514.6
Net property income from abroad 5.8
Gross national product (GNP) at current factor cost . 520.4
Capital consumption (depreciation) (64.0)
National income at factor cost 456.4
Notes
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Notes Patl C: Macroeconomic environment
3.8 Note the following points.
(a) National income is calculated by subtracting a fairly arbitrary amount for
depreciation from the total value of GNP;
(b) GNP itself is calculated by measuring total expenditure within the national
economy (GDP) and then adding on amount for income from property (assets)
abroad.
(c) The three measures, national income* GNP and GDP are therefore closely related.
When we distinguish between the expenditure approach, the income approach and
''output approach, we are really talking about three approaches to calculating GDP.
(’d) We might refer to any of the three measures, national income, GNP or GDP.
Where a government seeks to increase national income, it is also seeking increases
. in GDP and GNP.
Notes on the expenditure approach
3.9 Total spending; then, consists of consumption spending, government spending,
investment spending, spending by foreigners on our goods and services minus spending
by us on foreign goods and services. This is often symbolised as C + I + G 4- (X - M)
where:
C =. consumption expenditure
I = investment expenditure
G = government expenditure
X = expenditure on our exports by foreigners
M = expenditure by us on imports
From the table it can be seen that when we calculate C + I + G + (X - M) the total we
arrive at is called the gross domestic product at market prices. This measure (GDP at
market prices) is one way ofexpressing the level of economic activity in the Pakistan
If a government is planning its economic policy, and wishes to increase the country's
GDP and GNP, it might wish to turn its attention to any ofthese items, i.e.:
(a) trying to increase consumer spending, C;
(b) trying to increase private investment, I;
(c) deciding to increase government spending, G and/or I;
(d) trying to improve the balance ofpayments on overseas trade, (X - M).
3.10 Since the prices of many goods and services are distorted by sales taxes - for example
alcohol and cigarettes - and some are distorted by subsidies - for example many
agricultural products - we often wish to view the situation without these distortions and
convert GDP at market prices to GDP at factor cost:
(a) expenditure at market prices - the actual amounts paid for the goods by their
buyers; and
(b) expenditure at factor cost - expenditure at market prices minus indirect taxes plus
any government subsidies.
3.11 As you can see from the table this is still not the end of the story. Many statisticians,
economists, governments and international agencies like to include property income
from abroad to give a fuller picture of what is happening in the domestic economy.
When this extra item is included we now have a measure called gross national product
or GNP.
PB1 Pilblibatidh's 174

One final adjustment can be made to GNP before we obtain the national income (NI).
3.12 National income is technically the gross national product minus an allowance for
depreciation of the nation's capital. In other words, national income is 'net' national
product. Just as firms calculate depreciation in arriving at accounting profits, so too do
economists assess a value for depreciation of the nation's capital (referred to as 'capital
consumption) to arrive at net national.income.
3.13 Although technically national income has a particular definition, generallyyou jvill find
all these measures (GDP, GNP and NI) loosely referred to as 'national income'.
The income approach to measuring national income
3.14 The second method of calculating national income is the income method. Since money
spent by an individual or firm must become income to another we should not be
surprised to find that except for a residual error the results of the two methods are the
same.
NATIONAL INCOME: INCOME APPROACH v
Amountin
; billion
Atcurrentfactorcost
Income from employment (wages and salaries plus employers'
national insurance contributions) ■341.0
Income from self-employment • 58.1
Gross tradingprofits ofcompanies 64.6
Gross trading surplus ofpublic corporations 1.8
Gross trading surplus ofgovernment enterprises • 0.1
Rent 46.8
Imputed charge for consumption ofnon-trading capital 4.2
Total domestic income 516.6
Less stock appreciation (2.2)
GDP - income based 514.4
Statistical discrepancy 0.2
GDP - expenditure based (see earlier table) 514,6
More about the income based approach
3.15 When we refer to 'national income', it might seem more obvious to^consider the income-
based approach rather than an expenditure based approach to measuring the statistics.
3.16 The table showing the income based approach shows as separate items:
(a) income from employment (i.e, wages and salaries before deducting' tax and
including employers' national insurance contributions);
(b) pre-tax profits of companies; ‘*-
(c) pre-tax profits ofpublic corporations (including nationalised industries);
(d) the pre-tax 'surplus' ofother government enterprises.
Interest earned by individuals and companies on any investments they hold is included
in the figures for (a) and (b).
Notes

,wies Pan .Aacroeconouiio environment
3.17 You might notice that these income figures do not include:
(a) income from government pensions or social security payments;
(b) any value for work done by individuals for no monetary reward, such as housework
done by housewives or do-it-yourself home improvements. These are activities for
which no money value can be given, and so are not 'economic' activities.
3.18 Transferpayments are payments such as state pensions and benefits that are made by
government, where the recipient does not make any contribution to output in return.
They are payments which involve the transfer of wealth, rather than a reward for
creating new economic wealth.
Transfer payments do not lead directly to any increase in marketable output of goods
and qre therefore excluded from the income figures.
Exercise 5
Which of the following is or are transfer payments?
(a) Salaries paid to Members of Parliament.
(b) Invalidity benefit.
Solution
(a) are not transfer payments. MPs are like any other employees - they just happen to be
employed by the Government. •
(b) is a transfer payment. It falls within the category of social security payments.
3.19 Rentis an item in the list ofincome earned. It is the profits (or 'operating surplus') from
the ownership of land and buildings. It also includes a value for 'imputed rent' for
owner- occupied homes. This is explained below.
Imputedincome and expenditure
3.20 Although the income figures exclude most work that is done for no monetary reward
(for example housework and do-it-yourself activities) the definition of production/
economic activity in the Pakistan does include some activities which are not carried out
for a money reward.
3.21 The main one of these activities is the provision of owner-occupied houses. When a
person buys his own home and lives in it, no- money will be exchanged between the
owner and the occupier because they are one-and-the-same person. However 'the
services of the house do nevertheless have a value equivalent to the net income which
could have been obtained by letting it commercially. A figure based on this approach is
included in the national income. In effect, the owner-occupier is divided into two
separate transactors. It is supposed that as owner, he lets the house to himself as
occupier for a certain rent.'
3.22 This process of 'inventing a transaction' is known as imputation. In the case of owner-
occupied dwellings an imputed amount of rent is included in the income statistics as
rent (income based approach) or consumers' expenditure (expenditure based approach).
PB Publications 176

The value added method ofmeasuring national income
3.23 The third method of calculating national income is the value added or output method.
Since the goods and services we spend our money on must have been produced by some
industry or another it is not surprising to find the amount we have all spent is the same
as the total value of the output goods and services produced. This total value of output
can be calculated by adding up the 'values added' at the various stages ofthe production
and distribution process. ' . •
3.24 The concept of 'value added', introduced earlier in the chapter, can be appreciated by
considering an example. Suppose that a seed merchant sells a quantity of seeds to a
plant nursery for Rs.50. The nursery uses other raw materials (pots etc.) costing Rs.100
to grow house plants. Eventually, when the plants are ready for sale, they are bought
from the nursery by a supermarket chain for Rs.900. The 'value added' by the nursery is
Rs.750. Supermarket customers buy the plants, their individual expenditures op them
totalling; Rs.1,800.. ,’
3.25 How do we measure the value ofthis output? We might total the various expenditures to
give Rs.50 + Rs.100 + Rs.900 + Rs.1,800 = Rs.2,850. But that would involve double
counting. We are counting the Rs.150 value of the seeds plus pots three times and the
Rs.750 value ofpotting the plants twice. .
3.26 We can instead total the 'value added' at each stage of the process. This produces a
figure of Rs.50 + Rs.100 + Rs.750 + Rs.900 = Rs.1,800, which is ofcourse the same
as the final expenditure on the goods by the eventual consumers - the supermarket
customers.
3.27 The value added approach to calculating national income is illustrated in the table
below: .
NATIONAL INCOME: VALUE ADDED APPROACH
Atcurrentfactorcost
Agriculture, forestry andfishing
Mining and quarrying, oil and gas exploration
Manufacturing
* Electricity, gas and water supply
Construction
Transport, storage and communication
Wholesale and retail trade, hotels, catering, repairs
Financial intermediation, real estate, renting andbusiness activities
Public administration, national defence, compulsory social security
Education, health and social work
Other services
Gross domestic product(GDP) - output based
Adjustmentfor financial services
GDP - income based
Residual error (as with income approach)
GDP - expenditure based
1771
Amountin
billion
9.3
9.8
114.7
13.7
32.0
41.6
72.5
.121.7
3§.6
, 52.5
32.9
537.3 >
(22.9)
514.4
0.2
514.6
Notes

PB Publications

Difficulties in calculating national income
3.28 Since expenditure, income and value added output are three ways oflooking at the same
events, the three ways of measuring GDP and national income ought to produce the
same total value for GDP and national income. In practice, they do not, because
■ collecting statistics is error-prone.
3.29 Estimates have to be made when accurate figures are unobtainable, and there are
omissions in obtaining some figures, and deliberate errors in other - for example,
fiddling tax returns might occur on a large scale. Because oferrors, the three approaches
wiH produce slightly different figures, and one of them must be taken as 'correct'. In
practice, the expenditure based figures are considered most reliable, and the income
based and Output based GDP figures are adjusted to the expenditure based GDP figure,
by inserting a balancing item known as a residual error.
Exercise 6
The following data relates to the economy of a country over a one year period.
Rs. in billion
Consumers'expenditure 18,400
General government final consumption 4,540
Gross domestic fixed capital formation 4,920
Value of physical decrease in stocks 20
Exports of goods and services 6,450
Imports of goods and services 6,240
Taxes on expenditure 2,760*
Subsidies 300
Net property income from abroad 210
Capital consumption 1,750
Required
Calculate the following from the above data.
(a) Gross domestic product (GDP) at factor cost
(b) Gross national product (GNP) at factor cost
(c) National income at factor cost
,
Solution
The calculation below also shows GDP and GNP'at market prices, although these are not
required in the exercise.
Rs. In million
Consumers'expenditure 18,400
General government final consumption 4,540
Gross domestic fixed capital formation 4,920
Value of physical decrease in stocks (20)
Total domestic expenditure 27,840
Exports 6,450
Imports (6,240)
GDP at market prices 28,050
GNP at market prices 28,260
P'S Publications 178

9: National income ancj its measurement Notes
GDP at market prices (see above)
Factor, cost adjustment
. 28,050
Taxes on expenditure . ' (2,760)
Subsidies 300
GDP at factor cost (a) 25,590
GNP at factor cost (b) 25,800
Capital consumption (1,750)
National income at factor cost (c) 24,050
3.30 General difficulties arise in the: calculation of national, income because arbitrary
definitions must be made, for example as follows:
(a) 'Production' includes goods and services paid for but excludes work done by a
person for himself. ■ /
(b) Goods which have a serviceable life of several years are included in national
income at their full value in the year they are bought (with the exception, of.owner-
occupied houses).
(c) Data from which the national income figure is estimated contain errors. The value
of the unmeasured 'black economy1 - economic activity kept hidden from official
dom - could be very high.
(d) Although transfer payments do not affect national income, net income from.abroad
does increase the total size ofa nation's income and must be calculated.
(e) Services provided 'free' to the public by the government, such as policing, health ,
services and much education, are valued at cost whereas output of private firms -I
include profit in their valuation.
National income and inflation
3.31 Inflation is a particular problem in using national, income as a measure of national
wealth. Price inflation increases the money value of national, income; We should be
careful not to interpret this as meaning that there is more economic aptiyity going on in
our economy. All that has happened is that-the prices of the. things we are measuring
have increased. To see if there has been any irea/?change in the leyel ofactivity we must
deduct any influence due to inflation. Although;this, is not.a, simple- operation, the
standard method for turning 'money' GDP or GNf? into 'real' mpasur.es is to use what is
called the 'GDP deflator' in order to take inflation out ofthe figures.
The purpose of calculating national income
3.32 Calculating the national income serves several purposes: ■»
(a) to measure the standard ofliving in a country (national income per head);
(b) to compare the wealth of different countries; >
(c) to measure the improvement (or deterioration) in national wealth and the standard
ofliving;
(d) to assist central government in its economic planning.:
3.33 National income or GNP per head of the population gives: an indication of the trend ■
over time in a country's standard of living, because GNP ismeasuredconsistently from
year to year, whatever the weaknesses of the measurement system that,is used. GNP per
head of population is however less reliable as a, guide to comparing, the standard of
living in different countries. This is for a number ofreasons.

(a) In defining GNP, you may remember that 'product' includes goods and services
i which are paid for, but excludes work done by a person for himself. It also excludes
barter trade. In some countries, do-it-yourselfproduction and barter trade are more
common than in othersj atod so the total GNP of the various countries would not be
properly comparable.
(b) In measuring GNP; government services which are not paid for are valued at cost.
Ifone country has a large state-owned sector which provides services free (eg health
and education) whereas another country has only a small state-owned sector, output
which is valued at cost in one country would be valued at market price in the other,
vand so there would be different valuations given to the same physical product.
(c) Spending on items which produce a benefit over several years is included in GNP
in one year only, which is the year the expenditure takes place. If a country is still
enjoying benefits from past investments, this will not be reflected in its current
GNP.
(d) Every country will have difficulty in obtaining accurate data about output and
GNP. Thus a country with a strong 'black economy' will be much wealthier than its
official GNP per head of population might suggest. Given differences in the
strength of the black economy from country to country, their figures for GNP will
not be properly comparable.
(e) The needs of people in one country will differ widely from the needs ofpeople in
another country. This,will be due to differences in social attitudes, customs and
.. habits, religious beliefs, climate, density of population and so on. One country
" might have- thrmng^industries for tobacco and alcoholic goods, for example,
whereas ■another-cduntry might ban these, entirely. A country with a hot climate
inight spend large sums on air conditioning and similar anti-heat products,
whereas a country with a cold climate will want central heating and insulation
products instead. When people in different countries want entirely different things,
it is not really possible to presume that their comparative standards ofliving can be
. . measured on a single money scale.
• '“.O .
(f) Countries will produce items that may be seen as being of little or no relevance to
their immediate standards of living. Spending on defence equipment and space
programmes are examples. These add to GNP per head of the population without
.people in the population getting direct benefit out of them. The GNP per capita of
i a country with high defence spending and one with little such spending would
therefore not be properly comparable.
3.34 These drawbacks to using GNP per head of population for international comparisons
mean that simpler and more direct comparisons are sometimes used instead. One way of
doing this is to select a number of products which are widely in demand. Examples
might be television sets and.mom.r cars. Measurements can then be obtained of:
(a) the average number ofcars or TV sets per household or per head of the population;
■ u
...(b) how long it takes an 'average' worker to earn enough in wages to buy a car or a TV
set.
Economic wealth and economic welfare
3.35 the 'standard of living' might be considered from a purely 'material' point of view.
Alternatively, levels of economic welfare may be seen as indicating the 'standard of
' living' ofindividuals ofa country.
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9: National income and its measurernen] Notes
3.36 Economic welfare is a mcasureof the. well-being or quality of life of society's meptbers,
and takes account of matters such as the amount of leisure time for individuals,
pollution levels and the. quality of the environment, and what items are consumed, as
well as income and wealth. But such-elements of the standard of living are difficult to
put a value on.
3.37 There are forms of wealth which cannot be measured,. such as . the health, of the
population, technical knowledge and the country's heritage of literature and music.
There are also some forms of 'intangible' wealth whose value could be measured, in
approximate terms, but which are not measured, such as the value ofcopyrights,.patents
and'goodwill'. ;■ ..
Personal Income
3.38 Personal Income is the total income which is actually, received by all individuals or
households during a given year,in .a country. Personal income is. always less than
national income because national income is the sum total of all income earned whereas
the personal income is the current income received by persons from all sources. The
students should note here that all the income items which,ajre included in the natipnal
income are not paid to household or individuals as income. For instance, the earnings of
corporation include dividends, undistributed profits and corporate taxes. The
individuals only receive dividends and this forms their income. Corporation taxes are
paid to the government and undistributed profits are retained by firms. There are
certain income item called as transfer payments old.-age , pension,., .iinemplpyment
compensation, relief payments, interest on the national debt which are not included in
the national income but they are income of the individuals. So they are added up to
arrive personal income.
Personal Income = National Income -Undistributed Corporate Profits - Contribution
ofSocial Insurance - Corporate Taxes + Transfer Payments.
Disposablepersonalincome (DPI) •
3.39 Disposable personal income is the amount which is left with the individuals after
paying the taxes to a government. The individuals can spend this amount as they please.
They may spend all this amount on consumption goods or save it. ■ .
. Disposable personal income = Personal Income - Personal taxes . ' ‘
Disposable personal income = Consumption-,L Saving v
The concept of disposable personal income is, very important for studying'the
consumption and saving behaviour of the individuals. ' -
Relationship
3.40 Relation of GNP, NNP, DPI and personal income:
Gross National Product • "
Less Depreciation
Equals Net National Income
' Minus undistributed corporate profits •
Contribution ot Socail Insurance
Plus Govt, and Business transfer payments
Equals Personal Income
Less personal taxes
Equals disposable personal income ■'
Equals saving + consumption.
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Motes Part C: Macroeconomic environment
National income at current arid constant prices:
3.41 National income at current prices (Nominal income) is the sum total of current market
value of all final goods and services produced in the economy during a period of one
year. If price level during the current years is high, the national income is overvalued
and if, on the other hand, the price level is low, the national income is under valued.
Hence, to know the true output, national income is measured at constant prices also
known as real national income.
3.42 To eliminate the effect of price changes over time, price index of selected year (known
as b"ase year) can be used to measure national at constant prices with the help of
following formula.
N.I at constant prices = N.I at current prices x ^ase year index (100)
Current year index
Suppose 1980 as base year and the national income at current prices for 2002 is Rs.3,000
billions. The price index for 2002 is 150. The national income at constant prices (Real
income)Tor 2002 will be
= 3,000 x 100
150
= 2,000
Chapter roundup
i' We started this chapter by observing that there is a circular flow of income in an
economy, which means that expenditure, output and income will all have the same total
value.
• There are withdrawals from the circular flow of income (savings, taxation, import
expenditure) and injections into the circular flow (investment, government spending,
export income). In formula terms:
W = 3 + T + M
J = I + G + X
• We saw that national income can be measured by an expenditure method, income
method or value added (output) method. Allowing for statistical errors in collecting the
data, all three methods should give the same total for GDP, GNP and national income.
• A useful formula to learn is that for the expenditure method: Y = C + I + G + (X-M).
• National income figures can be used to measure growth in the economy, although 'real'
growth can only he measured by 'taking out inflation' and using figures on a common
price basis.
• Economic wealth is perhaps best measured by GDP, GNP or national income per head
of the population. However, national income is a measure of annual income, not the
nation's total stock o! wealth.
• For reasons mentioned in this chapter, national income has serious limitations as a
measure of economic wealth and welfare. It remains an important indicator nonetheless,
and in planning its economic policy, a government will probably seek to improve the
standard of living df its population by setting as targets:
(a) growth in national income; or
(b) growth in national income per head of the population.
PB Publications 182

Test your knowledge
1 Name the three approaches used in calculating national income, (see para 1.5)
2 What are the withdrawals from and injections into the circular flow of income? (2.6,2.7)
3 Define:
(a) national income; (3.2)
(b) Gross Domestic Product; (3.4) .
(c) Gross National Product. (3.5)
4 Explain the relationship between national.income, GDP and GNP. (3.6)
5 What is the meaning of GDP = C +1 + G + (X - M)? (3.9)
6 ‘ What is meant by the term .'capital consumption1? (3.12)
7 What are the difficulties in calculating national income? (3.30)
8 Distinguish between economic wealth and economic welfare. (3.36)
9 What is personal arid disposable personal income. (3.39, 3.40)
Now try illustrative questions 9 and 9A at the end of the Study Text
'•w
183
Notes
PB Publications

Notes
Chapter 10
THE DETERMINATION OF NATIONAL
INCOME
Chapter topic list Syllabus reference
1 Contrasting views on the macroeconomy 3.1
2 The Keynesian approach 3.1
3 Consumption, savings and investment 3.1
4 The multiplier and the accelerator 3.1
5 The business cycle 3.1
Introduction
In this chapter, we study the basic elements of the Keynesian model for national income deter
mination and equilibrium. This involves a consideration of:
(a) consumption savings and investment;
(b) the 'multiplier';
(c) the 'accelerator'.
Remember that in macroeconomics we are looking, not at individual spending decisions,
investment decisions, pricing decisions, employment decisions, and output decisions but at
spending, investment, price levels, employment and output in the economy as a whole and at
total income (national income).
1 CONTRASTING VIEWS ON THE MACROECONOMY
1.1 Macroeconomics is the study and analysis of an economy as a whole, typically a national
economy.
1.2 Broadly speaking, economists can be divided into two camps, the 'Keynesians' and the
'monetarists'. These two camps have had differing ideas about how national income can
be made to grow, how full employment can be achieved and how booms and slumps of
trade cycles can be smoothed out. They differ in their views about the'causes of
inflation, the extent to which inflation creates unemployment and prevents economic
growth, and the effectiveness ofgovernment measures to stimulate the economy.
2 THE KEYNESIAN APPROACH
T he origin of Keynesianism
2.1 Keynesian economics originated with John Maynard. Keynes, an English economist
whose book The General Theory of Employment^ Interest and Money (1936),
revolutionised macroeconomic analysis. Keynes put forward his ideas following a period
in which there was an economic boom (after the First World War), followed by the Wall
Street Crash in 1929, and the Great Depression in the 1930s when unemployment levels
soared.
185 PB Publications

2.2 Pre-Keynesian economists had tried to explain unemployment as a temporary
phenomenon. They believed that if there is a surplus of labour available
. (unemployment) then the forces of demand and supply, through the wages (price)
mechanism, would restore equilibrium by bringing down wage levels, thus stimulating
demand for labour. Any unemployment would only last as long as the labour market was
adjusting to new equilibrium conditions. The pre-Keynesian theory was disproved
during the 1930s. If pre-Keynesian theory was right, wages should have fallen and full
employment restored. However, this did not happen, and the Great Depression
continued for a long time.
2.3 s It is instructive to note that it was during this economic situation that Keynes put
forward his new theory. Its fundamental advance on earlier theory was to explain how
equilibrium could exist in the macroeconomy, but there could still be persistent (long
tbrm) unemployment and slow growth.
2.4 The term full employmentnationalincomeis used to describe the total national income
that a country must earn in order to achieve full employment. By 'full employment' we
mean that the country's economic resources are fully employed. However, as far as
labour is concerned, full employment does not mean that everyone has a job all the time.
There will always be some 'normal' or 'transitional' unemployment as people lose their
job or give up one job for another, and so ’full' employment might mean, say, that 3-5%
ofthe total working population is unemployed at any time.
/
2.5 Keynes also tried to explain the causes of'trade cycles' which are the continuous cycles
of alternating economic boom and slump. Why does an economy not grow at a steady
rate, or remain stable, instead ofsuffering the harmful effects oftrade cycles?
Aggregate demand and aggregate supply
2.6 Keynes argued that the level of overall output and employment depends on the level of
aggregate demand in the economy. His basic idea was that demand and supply analysis
could be applied to macroeconomic activily as well as microeconomic activity.
(a) Aggregate demandmeans the total demand in the economy for goods and services.
(b) Aggregate supplymeans the total supply ofgoods and services in the economy.
2.7 Aggregate supply{AS) depends on physical production conditions - the availability and
cost of factors of production and technical know-how. Keynes was concerned with
short-run measures to affect the economy, and he also wrote in a period of high
unemployment when there was obviously no constraint on the availability of factors of
production. His analysis therefore concentrated on the demand side. 'Supply side
economics' (discussed later) describes the views of economists who do not subscribe to
the Keynesian approach to dealing with the problem of national income and
employment, and prefer instead to concentrate on 'supply side' - in other words,
production factors.
2.8 The aggregate supply curve will be upward sloping, for the reasons applying to the
'microeconomic' supply curves mentioned in earlier chapters. A higher price means that
it is worthwhile for firms to hire more labour and produce more because of the higher
revenue-earning capability. So at the macroeconomic level, an increasing price level
implies that many firms will be receiving higher prices for their products and will
increase their output.
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10: The determination of national income
2.9 In the economy as a whole, supply will at some point reach a labour constraint, when
the entire labour force is employed. When there is full employment, and firms cannot
find extra labour to hire, they cannot produce more even when prices rise, unless there
is some technical progress in production methods. The aggregate supply curve will
therefore rise vertically when the full employment level of output is reached (AS in
Figure 1).
2.10 Aggregate demand (AD) is total desired demand in the economy, for consumer goods
and services, and also for capital goods, no matter whether the buyers are households,
firms or government. Aggregate demand is a concept of fundamental importance in
Keynesian economic analysis. Keynes believed that national economy could be
'managed' by taking measures to influence aggregate demand up or down.
2.11 Aggregate demand is the total desired demand, just as a 'microeconomic' demand curve
represents the desired demand for a particular good at. any price level. However,
aggregate demand - in an economy - is not the same thing as 'market demand', which is
demand at the microeconomic level within a particular market. The AD curve will be
downward sloping because at highei; prices, total quantities demanded will be less.
2.12 Keynes argued that a national economy will reach equilibrium where the aggregate
demand curve and aggregate supply curve intersect.
Figure 1 Equilibrium national income, using aggregate supply arid aggregate demand
analysis
2.13 The actual level of national income will be at the intersection of the AD«curve and AS
curves - i.e. at Y (Figure 1). The difference between the equilibrium national income Y
and the full employment national income Yp shows how much national income coilld be
increased with the resources at . the economy's disposal. This 'gap' between actual
equilibrium national income and full employment national income is called a
deflationary gap. Price levels will be at P. Y therefore represents the level of satisfied
demand in the economy. Note that' the aggregate demand function assumes constant
prices.
2.14 Two points follow on immediately from this initial analysis: .
(a) Equilibrium national income Y might be at a level of national income below full
employment national income Yf. This is the situation in Figure 1.
187
Notes
PB Publications.

(b) On the other hand, the AD curve might cut the AS curve above the point at which
it becomes vertical, in which case the economy will be fully employed, but price
levels will be higher than they need tobe and there will be inflationary pressures in
the economy, as shown in Figure 2 below ifaggregate demand is ADj.
Figure 2 Equilibrium national income at full employment, but with inflationary pressures
(an inflationary gap)
Shifts in the AD curve
2.15 As with demand and supply analysis in microeconomics, we can predict in
macroeconomics that equilibrium national income can be increased by:
(a) shifting the AD curve to the right; or
(b) shifting the AS curve to the right;
thus expanding either AD or AS in the economy. As suggested already, Keynesian
economists concentrate on shifts in AD.
2.16 You should also note that a shift in the AD curve or the AS curve will not only change
the national income, it will also change price levels (P). In Figure 2, an inflationary gap
can be removed by shifting the aggregate demand curve to the left, from AD] to AD2.
2.17 Ifyou are not sure about this point, a simple numerical example might help to explain it
better. Suppose that in Pakistan there is full employment and all other economic
resources are fully employed. The country produces 1,000 units of output with these
resources. Total expenditure (that is, aggregate demand) in the economy is 100,000
Pakistani Rs., or 100 rupees per unit. The country does not have any external trade, and
so it cannot obtain extra goods by importing them. Because ofpay rises and easier credit
terms for consumers, total expenditure now rises to 120,000 Pakistani Rs. The economy
is fully employed, and cannot produce more than 1,000 units. If expenditure rises by
20%, to buy the same number of units, it follows that prices must rise by 20% too. In
other words, when an economy is at full employment, any increase in aggregate demand
will result in price inflation.
PB Publications . 188

2.18 The Keynesian argument is that if a country's economy is going to move from one
equilibrium to a different equilibrium, there needs to be a shift in the aggregate demand
curve. To achieve equilibrium at the full employment level of national income, it may
therefore be necessary to shift the AD curve to the right (upward) or the left
(downwards).
Deflationary and inflationary gaps
2.19 In a situation where there is unemployment of resources there is said to be a
deflationary gap (Figure 3). Prices are fairly constant and real output changes as
aggregate demand varies. A deflationary gap can be described as the extent to which the
aggregate demand function will have to shift upward to produce the full employment
level ofnational income. i
Figure 3 Deflationary gap
2.20 In a situation where resources are fully employed, there is said to be an inflationarygap
(Figure 2), for changes in aggregate demand will cause price changes and not variations
in rqal output. An inflationary gap can be described as the extent to which the aggregate
demand function would have to shift downward to produce the full'employment level of
national income without inflation.
The'ideal'equilibrium national income ' -
2.21 If one aim of a country's economic policy is full employment, then the 'ideal'
equilibrium level of national income will be where AD and AS are in balance at the full
employment level of national income, without any inflationary gap - in other words,
where aggregate demand at current price levels is exactly sufficient to encourage firms
to produce at an output capacity where the country's resources are fully employed. This
is shown in Figure 4, where equilibrium output will be Y (full employment level) with
price level P.
189
Notes.
;pBipub1icdti6hs

Figure 4 Equilibrium national income
(A country will also seek economic growth, but to achieve a real increase in living
standards, both AD and AS curves will now have to shift to the right.)
Demand management
2.22 How can the AD curve be shifted? For Keynesian analysis to have practical value for
the management of a national economy, it is necessary to establish how aggregate
demand can be shifted.
2.23 To understand shifts in AD, we need to turn our attention to expenditure in .the
economy. Satisfiedaggregate demand is the actual level ofnational income, and one way
ofexpressing national income is as the total expenditure in the economy.
2.24 A formula for the GNP (= total national expenditure) which was described in the
previous chapter is:
E=C+I+G+ (X-M)
(GNP)
(money spent on consumer goods)
(money spent by private sector
firms and the public sector on capital
items) *
(government 'current' or
'consumption' spending)
(including income from property
abroad)
(including money paid as income to
residents in other countries for
property they hold in the country)
* Alternatively, government investment spending on capital items can be included in G
leaving I to represent investment by firms only.
Demand management policies involve the manipulation of E (eg achieving economic
growth) by influencing C, I, G or net exports.
where E is the total national expenditure
C is the total domestic consumption
I is the total industrial investment
«
G is the total government spending
X is the total exports
M is the total imports
PB Publications 190

10: The determination of national income Notes
2.25 If we ignore capital consumption, we can equate E (GNP) with national income. Jhis is
what we shall do in our analysis ofthe Keynesian model.
Withdrawals and injections into the circular flow of income
2.26 For a national economy, there are certain withdrawals from and. injections into this
circular flow ofincome. Withdrawals divert funds out of the circular flow and injections
add funds into it.
(a) Withdrawals from the circular flow ofincome (W) consist of imports (M), taxation
(T) and sayings (S).
(b) Injections into the circular flow of income (J) consist of exports (X), government
spending (G), and investment spending by firms (I).
2.27 Keynes argued that for an equilibrium to be reached in the national income, not only
must AD = AS, but also total plannedwithdrawals from the circular flow of funds must-
be equal to total plannedrieciions. Thus, for equilibrium:
W = J,and soM + T + S.= X + G.+ I
2.28 In the long term W will always equal J,
(a) The difference between the value of imports M and the value of exports X is the
balance ofpayments deficit (or surplus). Even in the short term, this difference
must be balanced by borrowing (or lending abroad), as we shall see in a later
chapter.
(b) The difference between government spending and taxation can only be made up by
government borrowing. Loans are eventually repaid.
(c) In the long run, savings will also equal investments, even though the people who
save and the firms who invest are not the same 'people'. We shall look more closely
at savings and investment later.
2.29 However, although W and J will be equal retrospectively and in the long run, it does not
follow that planned J and planned W will equal each other in the short run, since
injections and withdrawals are made by different people. .
2.30 This 'frustration of plans1 in the short run causes national income to change over time.
The imbalance between J and W creates factors which can makd- the level of national
income change. Keynes argued that the imbalance between planned withdrawals and
planned injections explained trade cycles * the fluctuations in national income which
give rise to 'booms' and 'slumps' - which prevent an economy from settling down at an
equilibrium level.
Summary so far > ■
2.31 It is worth summarising the main poiivs so far, before continuing with our analysis.
Keynes argued that an equilibrium national income will be reached where aggregate
demand equals aggregate supply -that is, at a price and output level where the AD curve
and AS curves intersect. This may be:
(a) at a level of employment which is below the full employment level of national
income. The difference between actual national income and full employment
national income is called a deflationary gap. To create full employment, the total
national income (expenditure) must be increased by the amount ofthe deflationary
191 PB Publications .
/

jvjies Kill u. „,uaoeconooiic envuonmem
gap. This would be done if the AD curve can be shifted to the right, although some
increase in prices might be necessary to achieve equilibrium at full employment
national income;
(b) at a level of demand which exceeds the productive capabilities of the' economy at
full employment, and there is insufficient output capacity in the economy to meet
demand at current prices. This creates inflationary pressures. There is an
inflationary gap, equal to the actual price ,level where AD = AS, and the lower
price level that could be obtained by reducing AD without reducing the output in
the economy.
2.32 s The equilibrium national income will change if there are shifts in the AD curve, for
example as shown in Figure 5.
Figure 5 Effect of a shift in the AD curve
2.33 Equilibrium national income is where aggregate demand equals aggregate supply. Ifthe
AD curve is ADj, the equilibrium level of national income (in 'real' value terms) is Y,,
where there are still unemployed resources in the economy. Full employment is at the
level of income Yp where the AS curve rises vertically: no further supply is possible
because resources are already fully employed.
2.34 If the AD curve shifts to AD2, the economy will achieve a full employment national
income level Y2, but there will also be Avoidable inflationary increases (as in Figure 5),
because AD now exceeds tlie full employment level without inflation, and there is an
inflationary gap.
2.35 According to the Keynesian analysis:
(a) when there is some unemployment in the economy, the aggregate demand curve
will be further to the left than it could be. In other words, unemployment indicates
a lower than necessary aggregate demand, and so a low AD;
(b) although there might be some inflation when there is unemployment, very high
levels of inflation are associated with full employment and over-strong aggregate
demand.
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10: The determination ofnational income
2.36 You should notice that the aggregate supply curve begins to slope upwards before full
• employment income is reached. This is because the employment of less easily employ
able and less efficient labour, competition by firms for labour, possibly lower plant
efficiency as factories approach capacity output and so on, will raise prices as well as
output. In other words, there can b,e some inflation when there is some unemployment.
2.37 Equilibrium national income also depends on planned withdrawals and planned
injections into the circularflow ofincome being equal:
W = J, i.e.:
M + T + S = X + G + I
Short-term differences between W and ] occur, which prevent national income from
settling at an equilibrium level. These cause trade cycles.
- Keynesian technique of economic analysis and under-developed countries
2.38 Keynes 'General Theory' explains the short period fluctuations in income and
employment of a highly industrialised economy. It also suggests positive measures for
increasing income and curing unemployment. According to Keynes, whenever there is
cyclical unemployment in the country, its main reason is the deficiency of aggregate
effective demand. The deficiency of effective demand can be met by adopting the
following policy measures: ■ 4
2.39 The government should keep a strict watch on the economy. Whenever the signs of
dwindling profits and rising unemployment appear in the economy, immediate state
action should be taken to increase the rate ofcapitalformation.
2.40 The government shouldprepare aplan ofpublic workswhich can be put into execution
at a short notice. When a government finds that the gap between community income
and community expenditure is widening, it should increase investment by starting
public works programme such as construction ofrailways, canals, buildings, roads, etc.
2.41 The government should adopt suitable fiscal and monetary measures for encouraging
increased purchases of output so that the level of business activity and employment is
increased. It can adopt cheap money policy for stimulating business investment. It can
increase tax rates for encouraging induced investment. Deficit financing can also be
adopted to even out the cyclical fluctuations.
2.42 We agree with Keynes that in a developed economy short run ups and downs in.
business activity result from deficiency of aggregate effective demand and temporary
unemployment can be cured by increasing investment. The economic conditions in
underdeveloped countries are different from the advanced countries. The
•^unemployment in backward countries is caused by the dearth of stock of capital in
relation to the requirements ofthe increasing labour force. In addition to this, the-other
main reasons of unemployment in backward countries are (1) Greater.dependence upon
agriculture for livelihood, (2) Faster rate of growth of population than the developed
countries of the world, (3) Old methods of production^. (4) Absence of large scale
industries, (5) Unplanned economic development, (6) Ineffectiveness of monetary and
fiscal policy measures.
2.43 Under the conditions stated above, if we blindly apply Keynesian technique for
removing unemployment in underdeveloped countries, it will prove ineffective. The
cure is to be sought according to the disease. So the following policy measures are
prescribed for healing the economic ills ofthe backward countries: '
193
Notes
PB Publications

(a) The scarce resources of the countries should be utilized through planned
programme of development.
(b) The rate ofgrowth ofpopulation should be reduced by introducing family planning
methods,
(c) In order to encourage savings, prize bonds and internal loans should be issued.
(d) Banking, insurance, trading and commerce should be encouraged in the country so
that there is less dependence on agriculture.
(e) Small scale industries should be encouraged with large scale industries.
(f) Foreign loans should be obtained so that the unemployed resources are utilized at a
rapid rate.
(g) Special institutions should be opened for providing technical knowledge to the
workers.
(h) The monetary and fiscal measures should be adopted with utmost care as they are
liable to create inflation rather than cure unemployment in the country. This is
because Of the fact that economic conditions of backward countries are basically
different from that of the advanced countries. In advanced countries of the world
unemployment occurs because of deficiency of aggregate demand; whereas in
backward countries, unemployment results from the glaring deficiency of stock of
capital. So if monetary and fiscal measures are applied unintelligently to increase
capital equipment and technical knowledge, it is liable to create inflation in .
underdeveloped countries. Similarly, deficit financing is also very delicate tool to
be used for increasing the productive capacity of the country. If it is not wisely
applied, it will also lead to inflation.
2.44 From the above discussion, it can be easily concluded that the first two measures, i.e.,
vigilance and plan of public works as suggested by Keynes can be applied in solving the
problems of underdeveloped countries, but the third measure, i.e., monetary and fiscal
< policy is to be very carefully used. The other tools ofeconomic analysis such as marginal
propensity to consume, multiplier, liquidity preference, marginal efficiency of capital,
etc., developed by Keynes are very useful for the developed as well as underdeveloped
countries.
3 CONSUMPTION, SAVINGS AND INVESTMENT
Consumption and savings (C and S)
3.1 Let us now go into a bit more detail on Keynesian analysis, and concentrate particularly
on consumption, savings and investment. I> simplify our analysis, we shall ignore
government spending, taxation, impoits and exports for the time being. By ignoring
imports and exports, we are concentrating on a closed economywhich is not in any way
dependent on foreign trade.
3.2 If we ignore G, T, X, and M, we can leak at a circular flow of income in which
households divide all their income between two uses:
(a) consumption on goods and service; or
(b) saving.
Pun ~ jlcem iw. t
PB Publications 194

/
10: The determination of national income Notes
3.3 Provided that national income is in equilibrium, we will have:
ysc+s
where Y = national income, C = consumption and S = saving.
This should seem logical to you. Income can only be either spent or saved. Since we
have a closed economy, consumption must be ofgoods produced by the economy itself.
Savings ’
3.4- There are two ways of 'saving*
1. One is to hold the income as money (banknotes and coin,
or in a current bank account). The other way is put money into some form of
interest-bearing 'investment1.
In the long run, there is no reason for people to hold banknotes or keep money in a
current bank account, unless they intend to spend it fairly soon. If this is so, income
that is not spent will be saved and income that is saved will, eventually, be invested.
(The people who put their money into interest-bearing 'savings' are not making any
investment themselves in capital goods, but the institutions with whom they 'save' will
use the deposits to lend to investors and so indirectly there will be a real increase in
'investment' when people save money in this way.)
Exercise 1
What do you think are the main factors which influence the amount that people will save?
Solution i
The amount that people save will depend on:
(a) how much income they are getting, and how much of this they want to spend on.
consumption;
(b) how much income they want to save for precautionary reasons, for the future;
(c) interest rates. If the interest rate goes up we would expect people to consume less of their
income, and to be willing to save and invest more.
3.5 We can therefore conclude that in conditions ofequilibrium for national income:
Y s C + S and ■*.
Y = C + I and so
I s S
In the short run, however, savings and investment might not be equal jind so there
might not be equilibrium.
s
__
The propensities to consume and save
3.6 In aggregate, the population will spend a certain proportion of total income on
consumption. This proportion is known as the averagepropensity to consume(APC). -
3.7 If there is an increase in total income, some of this extra income will be spent and the &
rest saved. The proportion of the additional total income spent is called the marginal
propensity to consume (MPC). The proportion ofthe increase in income that is saved is
the marginalpropensity to save(MPS).
195 P& Publications

3.8 Since in our analysis (ignoring G, T, X and M) saving and consumption are the only two
uses for income, MPC + MPS = 1.
3.9 These terms may seem unusual at first and an example might help to explain them more
clearly.
3.10 Suppose than an individual household, spends 65% of its total income of Rs.400 per
week (i.e. Rs.260) and saves 35% ( Rs.140). However, if the income of the household
rises to Rs.420 per week, it might spend 80% of the extra Rs.20(i.e. Rs.16) and save
20% (Rs.4).
(a) The average propensity to consume (APS) was initially 65% and is now
■(260 4- 16) -
. ' 420 .
(b) The average propensity to save was 35% and is now (140 + 4) - 34%,
420
(c) The marginal propensity to consume (MPC) is 80% and the marginal propensity to
save (MPS) is 20%.
(d) MPC + MPS = 80%+ 20% =100%, or 1.
Whatever the values ofMPC or MPS, the sum ofMPC + MPS must always be 1.
3.11 It is often assumed that the marginal propensity to consume and the marginal
propensity to save are constant proportions, and that a household will spend (consume):
(a) a fixed amount ofmoney every period (Rs. a);
(b) plus a constant percentage ofits income (b% ofY);
Similarly, a national economy as a whole will spend a fixed amount Rs. a, plus a
constant percentage (b%) ofnational income Y.
We can then state a consumption function as C = a + bY.
3.12 Given a consumption function C = a + bY:
ii
(&) the marginal propensity to consume is b, where b is the proportion spent on
consumption ofeach extra Rs.l earned.
(b) the average propensity to consume will be the ratio ofconsumption to income, i.e.:
C = a + bY
Y Y
3.13 For example, suppose an individual household has fixed spending of Rs.100 per month,
plus extra spending equal to 80% ofits monthly income.
(a) When its monthly income is Rs.800, its consumption will be:
Rs. 100 + 80% of Rs.800 = : Rs.740
(b) When its monthly income is Rs.l,000 its consumption will be:
Rs.100 + 80% of Rs.l,000 = Rs.900
3.14 The household's marginal propensity to consume is 80%.
PB Publications: 196

Exercise 2
l
Calculate the household's average propensity to consume:
(a) when its income is Rs.800; and
(b) when its income is Rs.1,000.
Solution
(a) APC = 740 • =92.5%
800
(b) APC = 900 = 90%
1,000
3.15 Changes in the marginal propensity to consume and the marginal propensity to save
will involve a change of preference by households between current consumption and
saving for future benefits. A cause of such a change might be a change in interest rates,
which makes the investment ofsavings more or less attractive than before.
What factors influence the amount of consumption?
3.16 There will always be a minimum fixed amount of total consumption. Total
consumption, however, is affected by:
„ (a) changes in disposable income, and the marginal propensity to consume. Changes in
disposable income are affected by matters such as pay rises and changes in tax
rates; ,
(b) changes in the distribution of national income. Some sections of the population
will have a higher marginal propensity to consume than others and so a
redistribution of wealth might affect consumption. (A redistribution of wealth
might be accomplished by taxing the rich and giving to the poor in the form of
more government allowances);
(c) the development of major new products. When such developments happen, they
can create a significant increase in spending by consumers who want to buy the
goods or services;
(d) interest rates. Changes in interest rates will influence the amount of income that
households decide to save, and also the amount that they might elect to borrow for
spending. v
3.17 One of the determinants of the MPC is taste and attitude. If a household believes that
saving is a virtue it will save as much as possible and spend as little as possible; and in
the economy as a whole, a general beliefin the Value ofthrift may mean that the AJPC is
low. Nowadays the prestige attached to the possession of consumer goods„may have
overcome the admiration for thrift, making the MPC higher than it once was.
Hi
3.18 A further determinant of MPC is the attractiveness ofsavings. Ifinterest rates are high,
households will wish to save more of.their income to benefit from the higher rates of
interest. The more they save, the less they, consume. Conversely some goods are so
* expensive that they tend to be bought on credit; if interest rates are high there is less
incentive to borrow and thus a lower tendency to purchase high-cost goods.
■;, /
3.19 Given C .= a + bY, the value of b may also be affected by the value of a. If the cost of
essential commodities rises in relation to all other commodities, the value of a will rise.
• " This means that -a1 greater proportion of household consumption becomes fixed and
there is less available for variable consumption bY. Thus a rise in a causes a fall in b.
Notes

Notes
I
PB Publications
Part C: Macroeconomic environment
We can shdW the consumption function in a graph, which shows the relationship
between consumption, savings and (disposable) income (Figure 6). •
Figure 6 Income, consumption and savings (closed economy).
3.20 As we have seen, in a closed economy with no government sector, income must equal
the sum of consumption and savings. Consumption will always be a minimum amount,
and at lower levels of national income (below X in Figure 6) consumption will exceed
national income. This means that households will be using up savings to buy goods.
Investment (I)
3-21 The total volume of desired investment in the economy depends on factors similar to
those influencing 'micro-level' investment decisions by firms:
(a) the rate ofinterest on capital;
(b) the marginal efficiency of capital invested (discussed earlier, in Chapter 6);
(c) expectations about the future and business confidence;
(d) the strength of consumer demand for goods. Strong consumer demand should
result in higher business profits and a greater willingness by firms to invest in
more plant and machinery (etc.) to meet the demand.
3.22 The demand for funds to invest by firms and the willingness of investors to lend their
savings for investment (the supply of funds) should adjust to one another through the
'price mechanism' ofthe interest rate.
(a) Higherinterestrates should make firms less willing to invest, because the marginal
efficiency of capital will have to be higher to justify the higher interest cost.
However, firms cannot always cut their investment plans quickly and at short
notice.
Higher interest rates should also:
(i) tempt individuals to consume less of their income and save more, with a
view to investing it;
(ii) tempt individuals to invest more of their savings - that is, to hold less cash
and more interest-bearing investments.
198

10: The determination ofnational.inconpe Notes
(b) Lowerinterestratesshould have the oppositeeffect. '•
3.23 An investment involves the acquisition of more buildings, machinery, plant and
equipment or stocks of goods and so on. The impomnce of the interest rate for
investment should therefore be apparent in the marginal efficiency of capital. Firms
should go on adding to their capital provided that the marginal efficiency of capital
exceeds the interest rate, which is its marginal cost.
3.24 Taking individual investment decisions one at a time, a firm's management should
assess the expected returns from the particular investment, and ifthese appear to exceed
the interest cost of the investment (having allowed for the extra ’rewards' that must also
he paid in rent, wages and profit for any extra lattd, labour and entrepreneurship that
the investment will also entail) the decision will be to go ahead with the investment.
3.25 You might hear investment analysts or accountants referring to the 'expected rate of
return' or the 'required rate ofreturn' on an investment. In such cases the return that is
being discussed will probably be a return measured in accounting terms rather than
economic terms. Nevertheless, the basic principle is the same to an economist or an
accountant - namely that an investment should not be undertaken unless its expected
rate ofreturn exceeds (or equals) the required rate ofreturn, which will be the marginal
cost ofthe funds invested. ;
Appraisal of investment: payback and discounted cash flows
3.26 Because investment 'projects' will generally be long-term ventures, firms will have to
wait perhaps several years for full benefits and returns. Management will try when they
make their investment decision to assess what the value of their returns will be. But
managers cannot predict the future with accuracy, and what actually happens might
turn out worse or better than expected. Investment decisions therefore involve taking a
risk, and a firm's attitude towards this investment risk will influence their decision.
(a) If business confidence is high, and firms expect strong consumer demand, they will
be more likely to invest in new projects.
(b) Risk will be greater when a firm is entering a totally new market which it has never
produced for before. For example:
(i) Risk will be high if a Pakistan firm is deciding whether or not to invest in
opening up a new factory in another country, to supply’that country's market
for the first time.
(ii) Risk will be even higher if a firm is deciding whether or not to produce an,
entirely new product, eg if a computer manufacturer is deciding y/hether or
not to start making motor cars too, or ifan advertising agency^ere to, decide
to diversify into banking or financial services.
When risk is unacceptably high, because the potential josses are tqo high, the firm
might decide not to invest.
(c) The amount of risk involved will also depend on the size of the investment (and
potential losses) relative to the size of the firm. A firm can risk a loss on a small
investment much more easily than it can risk failure on what for the firm is a major
■ ■ investment.
499 -PB Pubii

3.27 Time is another risk factor. The longer an investment will take to earn its returns, the
greater will be the uncertainty about how much, if anything, it will earn. Many firms
will be reluctant to invest in long-term projects with a distant 'payback' date. The
paybackperiodis th&time required for an investment to generate sufficient increments
ofcash to recover the initial capital expenditure.
3.28 Investment decisions will also be influenced by a firm's current level of income and
business profits. If a firm is earning high profits from its operations, it will be more
inclined towards undertaking new investments. For example, ifa firm produces good X,
and if the demand for X is strong and the firm is making high profits, it is likely to
•want to invest in extra production capacity so as to be able to make and sell more X.
3.29 The concept ofa payback period does not take account ofthe pattern offlows ofincome
before and after the 'payback date'. Discounting, on the other hand, takes account of the
fact that an investment at a particular time is likely to give rise to income at different
times. The technique of discounting applied in the evaluation of capital expenditure
projects is known as discounted cash flow, or DCF.
Si
3.30 The basic principle of discounting is that ifwe wish to have Rs. S in n years' time, we
need to invest a certain sum now(year 0) at an interest rate ofr% in order to obtain the
required sum ofmoney in the future.,
For example, if we wish to have Rs.14,641 in four years time, how much money would
we need to invest now at 10% interest per annum?
Let P be the amount ofmoney invested now.
Rs.14,641 = P(1.10)4
P = Rs.14,641 x 1 = Rs.10,000.
• 1.104
3.31 Rs.10,000 now, with the capability of earning a return of 10% per annum, is the
equivalent in value of Rs.14,641 after four years. We can therefore say that Rs.10,000 is
the present valued Rs.14,641 at year 4, at an interest rate of 10%.
The term 'present value' simply means the amount of money which must be invested
now for n years at an interest rate of r%, to earn a given future sum ofmoney at the time
it will be due.
DCF methods
3.32 In summary, discounted cash flow (DCF) involves the application of discounting
arithmetic to the estimated future cash flows (receipts and expenditures) from a project
in order to decide whether the project is expected to earn a satisfactory rate ofreturn.
New technology and investment
3.33 When new technology emerges which changes methods of production (such as robotics)
or provides opportunities to produce new types of good, there will be a boost to
investment.
(a) New technology which reduces the unit costs of production will increase
profitability. The supply curve for the goods that are affected by the new
production methods will shift to the right. Firms will invest in the new technology
in order to achieve lower costs and remain competitive.
PB Publications 200

(b) New technology which leads to new types of gopd will give a stimulus to
consumption demand. Firms will invest to make the product and meet the
consumer demand.
i
Investment and econoniic recovery
3.34 Investment represents one of the major injections in the circular flow of income.
Variations in the level of investment can, through the multiplier, affect the level of
national income and the level qfaggregate demand in the economy. A major conclusion
from Keynesian analysis is that in' order to achieve economic recovery from a recession,
there should be major investment, which will create further growth through the
workings ofthe multiplier.
3.35 Investment can be in either the public or the private sector of the economy, although
the money to finance the investment might need to come from different sources.
(a) Private sector investment will come from retained profits, new issues of shares, or
borrowing. However, in an economic recession profits might be low, and investors
might lack confidence in a recovery, so that new shares issues are impossible on a
large scale.
(b) Public sector investment might be financed by higher taxation, or by an increased
deficit between government income and expenditure, that is, a higher public sector
borrowingrequirement(PSBR).
(i) Public sector spending should have socially valuable 'spin-off effects, such as
improved roads, sewers and public buildings.
(ii) However, a high PSBR, meaning large government borrowings, might force
up interest rates in the capital markets and 'crowd out' private sector
investment, by making it too expensive for firms to borrow and invest
profitably. (Keynesian economists deny that such crowding out takes place,
however).
3.36 Thete are two additional reasons why investment is very important.
(a) The act ofinvestment represents consumption forgone now in order to increase tie
capacity to produce, and therefore to consume, in the future. If is through
investment (or lack ofit) that the future shape and pattern ofeconomic activity is
pre-determined.
(b) The growth rate of the economy is determined not only by the technological
progress or the increases in the size and quality of the labour force but also by the
rate at which the capital stock is increased or replaced. Investment represents an
addition to the existing capital stock. If that addition is greater than the amount by
which the capital stock depreciates, then the capital stock of'the economy is
growing and so is the capacity ofthe economy to produce more goods and services.
Hence investment is an important determinant of the long-term, growth rate of an
economy. ;
2Q!
Notes
pp,'Rub!jchli9n?r

Government influence on investment
3.37 The government can influence the level of private investment in several ways.
(a) It can attempt to control interest rates. By keeping interest rates low, for example,
the government might encourage a higher volume of investments, whereas by
allowing interest rates to rise, the government would probably cause the volume of
investment to fall. Governments can influence interest rates.
(1-p It can provide direct encouragement to investing firms, by offering investment
grants, perhaps directed at particular regions, or by providing tax incentives. A
grant involves a cash payment by the government towards the cost of the
‘'investment. Tax incentives may also take the form of capital allowances. The size
of grants or tax allowances can be varied, according to government policy. It is
questionable, however, whether the widespread use of grants and generous capital
allowances have a significant effect on the volume of investment.
(c) The government can seek to stimulate business confidence, for example by
developing and announcing an economic policy for continued growth, and then
achieving policy targets. The success ofthe government in stabilising the economy,
controlling inflation and preventing industrial unrest provides a very important
influence on business confidence.
(d) The government can try to encourage technological developments, perhaps by
financing research schemes of its own, and perhaps by entering into a research
partnership with private firms. In the long run, investment in education might be
significant for the strength of innovative research and development by the
country's industries.
(e) Government policy might be directed towards influencing the volume of
consumption. A policy to control the growth in the money supply, for example,
would involve trying to reduce the growth in credit. Credit control in turn would
affect consumer spending, especially in consumer durable goods. Changes in
consumption affect investment levels, with the influence ofthe accelerator.
(f) The government can spend money itself, and higher government spending might
stimulate investment by the private sector.
4 THE MULTIPLIER AND THE ACCELERATOR
The multiplier
4.1 Keynes wanted to suggest why the volume of national income might change, by how
much, and what would be the consequences of such a change. When national income
grows, we have economic growth. Since economic growth might be an economic
objective of government, the reasons for economic growth will obviously be of crucial
importance for the government's economic planners.
4.2 The level of national income might increase or decrease for a number of reasons-, for
example, there might be a pay rise for workers or an increase in the country's exports.
Keynes showed that if there is an initial change in expenditure, say an initial increase
in exports, or government spending or investment or consumer spending, a new
equilibrium national income level will be reached.
PB Publications 202

4.3 The eventual total increase in national income will be greater in size than the initial
increase in expenditure.
This is an important point. A small initial increase in expenditure will result in a bigger
total increase in national income before equilibrium is re-established.
i
^ rati° tile total increase in national income to the initial increase in national
income is called the multiplier.
Multiplier = .. .
total increase m national income
initial increase in national income
4.5 The multiplier can thus be defined as a measure ofthe effect on total national income of
a unit change in some component of aggregate demand, in particular, I, G or X
(investment spending, government spending or exports).
Numerical illustration ofthe multiplier
4.6 A numerical illustration, of the multiplier might help to explain it more clearly. In this
example, we shall again ignore taxes, government spending, exports and imports, and
assume a simple closed economy in which all income is either spent on consumption (C)
or saved (S). Let us suppose that in this closed economy, marginal propensity to
consume (MPC) is 90% or 0-9. Then, out of any addition to household income, 90% is
consumed and 10% saved.
(a) If income goes up by Rs.200, Rs.180 would be spent on consumption, and Rs,20
saved.
(b) The Rs.180 spent on consumption increases the income ofother people, who spend
90% (Rs.162) and save Rs.18.
(c) The Rs.162 spent on consumption in turn becomes additional income to others, so
that a snowball effect on consumption (and income and output) occurs, as follows:
Increasein Increasein
expenditure savings
1 Income rises 200.00 -
2 90% is consumed 180.00 20.00
3 A further 90% is consumed 162.00 18.00
4 tt 145.80 " 16.20
5 II 131.22 14.58
etc... .... ....
Total increase in income 2,000.00 200.00
4.7 In this example, an initial increase in income of Rs.200 results in5 a final increase in
national income of Rs.2,000. The multiplier is 10.
4.8 This multiplier is the reciprocal of the marginal propensity to save. Since MPC - 0.9,
MPS = 0.1.
Multiplier .
Increase in national income = initial increase in expenditure _ = fo.2,000
MPS 0.1
Note that at the new equilibrium, savings of Rs.200 equal the initial increase in
expenditure of Rs.200 but national income has risen Rs.2,000.
203
Notes
PBPiibiicatiohs •

4.9 Ifthe marginal propensity to consume were 80%, the marginal propensity to save would
he 20% and the multiplier would only be 5. Because people save more of their extra
income, the total increase in national income through extra consumption will be less.
4.10 The multiplier in a national economy works in the same way. An initial increase in
expenditure will have a snowball effect, leading to further and further expenditures in
the economy. Since total expenditure in the economy is one way of measuring national
income, it follows that an initial increase in expenditure will cause an even larger
increase in national income. The increase in national income will be a multiplier of the
initial increase in spending, with the size of the multiple depending on factors which
include the marginal propensity to save.
V
4.11 If you find this hard to visualise, think of an increase in government spending on the
construction of roads. The government would spend money paying firms of road
contractors, who in turn will purchase raw materials from suppliers, and sub-contract
other work. All these firms employ workers who will receive wages that they can spend
on goods and services of other firms. The new roads in turn might stimulate new
economic activity, for example amongst road hauliers, housebuilders, shop builders,
estate agents and house buying.
4.12 Depending on the size ofthe multiplier, an increase in investment would therefore have
repercussions throughout the economy, increasing the size of the national income by a
multiple ofthe size ofthe original increase in investment.
4.13 If, for example, the national income were Rs.10,000 million and the average and the
marginal propensity to consume were both 75%, in equilibrium, ignoring G, T, X and
M:
Y = Rs.10,000 million
C = Rs.7,500 million
I = S = Rs.2,500 million
Since MPC = 75%, MPS = 25%, and the multiplier is 4.
4.14 An increase in investment of Rs.1,000 million would upset the equilibrium, which
would not be. restored until the multiplier had taken effect, and national income
increased by 4 x Rs.1,000 million = Rs.4,000 million, with:
Y = Rs.14,000 million
C= Rs.10,500 million (75%)
I = S= Rs.3,500 million (25%)
4.15 A 'downward multiplier’ or 'de-multiplier' effect also exists. A reduction in investment
will have repercussions throughout the economy, so that a small disinvestment
(reduction in expenditure/output) will result in a multiplied reduction in national
income.
A simplified formula for the multiplier (closed economy with no government
sector)
4.16 Ignoring imports and taxation as withdrawals from the circular flow of income, and
regarding investment as given, a formula for the size ofthe multiplier is as follows.
Multiplier ------ ------- = —-—
1 - MPC* MPS
PB Publications 204

*(1 - MPC) is sometimes referred to algebraically as (1 - b).
In a simple model ignoring imports and tax as withdrawals, the size of the multiplier is
the reciprocal ofthe marginal propensity to save (MPS).
4.17 You should also be aware of factors which might influence the MPC and MPS in any
economy, for example the age distribution of the population, the income distribution of
the population, expectations of the future and other socio-economic factors.
The importance of the multiplier
4.18 The importance of the multiplier is that an increase in one of the components of
aggregate demand will increase national income by more than the initial increase itself.
Therefore if the government takes any action to increase expenditure (for example by
raising government current expenditure, or lowering interest rates to raise investment)
it will set ofT a general expansionary process, and the eventual rise in national income
will exceed the initial increase in aggregate demand.
This can have important implications for a government when it is planning for growth
in national income. By an initial increase in expenditure, a government can 'engineer'
an even greater increase in national income, (provided that the country's industries can
increase their output capacity), depending on the size ofthe multiplier.
The multiplier in an open economy .
4.19 In an open economy, the size of the multiplier depends on:
(a) the marginalpropensity to save (MPS)
(b) the marginalpropensity to import, because imports reduce national income, and if
households spend much of their extra income on imports, the 'snowball' increase in
total national income will be restricted because imports are a 'withdrawal' out of the
circular flow ofincome. •
I
(c) tax rates, because taxes reduce the ability of people to consume and so are likely to
affect the marginal propensity to consume and the marginal propensity to save.
4.20 The marginal propensity to consume for example in UK. has been estimated to be 83%,
the multiplier is not 5 but nearer 2 or 3. Any increase in income is subject to tax,
thereby reducing the amount available for consumption, an4 a large proportion of extra
' consumption is on imported goods, which benefits other countries and does not increase
national income. The existence of T and M, in addition to S, as withdrawals from the
circular flow ofincome reduce the size of the multiplier. /
4.21 Whereas the multiplier in a closed economy is the reciprocal of the marginal propensity
to save, the multiplier in an open economy, taking into account government spending
and taxation, and imports and exports, will be less. This is because government taxation
and spending on imports reduces the multiplier effect on a country s economy.
4.22 For an open economy:
Multiplier = ---- -------
s + m + t
where s is the marginal propensity to save
m is the marginal propensity to import
t is the marginal propensity to tax - i.e. the amount ofany increase in
income that will be paid in taxes.
Notes
205 PB Publications

NOitfS Part L. tt.ttu oeconomic environment
4.23 For example, if in a country the marginal propensity to save is 10%, the marginal
propensity to import is 45% and the marginal propensity to tax is 25%, the size of the
multiplier would be
1 1.25
0.1 + 0.45 + 0.25 0.8
Changes in equilibrium national income and the multiplier: a graphical
representation
4.24 The multiplier has been illustrated with a numerical example, and by formula, but you
might also find it useful to be able to show the multiplier effect in the form of a
diagram. '•«
4.25 In Figure 7, the y axis represents total expenditure in the economy E, and the x axis
represents total national income Y.
(a) Since actual expenditure and national income are the same, we can draw a line Y =
E (= AD), bisecting the origin of the graph.
(b) We can also express the total expenditure function asE = C+ G + I + (X- M).
4.26 If we assume that G, I and (X - M) are fixed amounts, but that the consumption
function varies with national income (due to the marginal propensity to consume), the
line E = C + G + I + (X-M) will cut the Y axis at zero national income, but then rise
gradually as national incomes rises.
Expenditure ^
-----—-------------►
National income (Y)
E = C + G + I+(X-M)
C = a + bY
0
Figure 7 Equilibrium national income
4.27 Equilibrium national income in Figure 7 is at Y , where Y = E = C+ G + I + (X
MY
PB Publications 206

National
expenditure
(E)
Figure 8 Multiplier effect
4.29 If injections were made to increase from Jj to J2 (for example, an increase in government
spending or extra exports) then there would be a shift upwards in the E curve from Ej to
E2- Ie Figure 8, the equilibrium level of income has now increased from Yj to Y2.
Notice however that the increase in the level of income from Yj to Y2 is bigger than the
increase in injections (Jj to J2).
In other words, total national income has increased by more than the amount of the
initial increase in expenditure, and this is a portrayal ofthe multiplier effect.
Limitations of the multiplier
4.30 Keynes developed the concept of the multiplier in order to argue that extra government
spending on public works, financed by a budget deficit, would have a 'pump-priming'
effect on a demand-deficient economy, so that:
(a) demand would be increased and national income would increase by more than the
amount of the initial injection into the economy ofthe extra government spending;
and
(b) because demand would be increased, unemployment would be reduced.
4.31 However, there are several important factors that limit the significance ofthe multiplier
for economic management.
(a) It is of more relevance to a demand-deficient economy with high unemployment of
resources than to an economy where there is full employment. If there is full
employment, any increase in demand will be inflationary.
(b) The leakages from the circular flow of income might make the value of the
multiplier very low, and so 'pump priming' measures to inject extra spending in the
economy would have little effect. This is relevant to the Pakistan , where there is a
high marginal propensity to import.
(c) There may be a long period of adjustment before the benefits of the multiplier are
felt. If a government wants immediate action to improve the economy, relying on
demand management and the multiplier could be too slow.
Notes
207 PB Publications

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