LEARNING UNIT 6 INCOME DETERMINATION IN A SIMPLE KEYNESIAN MODEL pdf

These are notes on Central Macroeconomic flows. They cover the following concepts:

-Cental Macroeconomic flows
-Consumption Spending
-Investment Spending
-The simple keynesian model of a closed economy
-The impact of a change in investment spending

1. LEARNING UNIT 6 : INCOME DETERMINATION IN A SIMPLE KEYNESIAN
MODEL

Theme 1 : Central macroeconomic flows
LO1:Distinguish between production, income and spending in the national
accounts and macroeconomic theory.

In national accounts and macroeconomic theory, production, income, and spending
are distinct but interconnected concepts:
Production
- Definition: The process of creating goods and services within an economy.
- Measurement: Gross Domestic Product (GDP) measures the value of goods and
services produced.
- Focus: Emphasizes the supply side of the economy, highlighting the creation of output.

Income
- Definition: The earnings generated by factors of production, such as labor and capital.
- Measurement: Gross National Income (GNI) measures the total income earned by a
country's citizens.
- Focus: Highlights the distribution of earnings among factors of production.

Spending
- Definition: The expenditure on goods and services within an economy.
- Measurement: GDP can be measured using the expenditure approach, summing
consumption, investment, government spending, and net exports.
- Focus: Emphasizes the demand side of the economy, highlighting aggregate demand.

Theme 2: Consumption Spending
LO2: Explain , with the aid of a diagram , the three main characteristics of the
consumption function

2. 1. Consumption at Zero Income
• At zero income, individuals still tend to have some level of consumption,
represented by the intercept of the consumption function with the vertical axis.
• This is denoted as C₀, which represents autonomous consumption.
2. Marginal Propensity to Consume (MPC)
• The slope of the consumption function represents the marginal propensity to
consume (MPC).
• It indicates the change in consumption resulting from a change in income.
• The MPC is less than 1, showing that consumption increases with income but at
a decreasing rate.
3. Consumption Function
• The consumption function shows the relationship between consumption and
income.
• It is typically represented as a positively sloped line, indicating that as income
increases, consumption also increases.
• However, the slope is less than 1, reflecting the diminishing marginal propensity
to consume.
4. The consumption function has a positive slope: As income increases,
consumption also increases, but at a slower rate. This is because individuals
tend to save a portion of their income.
5.The consumption function starts from a positive intercept: Even when income
is zero, individuals still have some level of consumption. This is known as
autonomous consumption and represents the minimum level of consumption
required for basic needs.
6.The consumption function is less than 1: The marginal propensity to consume
(MPC) is the change in consumption resulting from a change in income. It is
always less than 1 because individuals save a portion of their income. The slope
of the consumption function represents the MPC.

LO3: List the non-income determinants of consumption
Non-Income Determinants of Consumption Spending

3. Consumption spending is influenced by factors other than income. Some non-
income determinants of consumption spending include:
• Wealth: Individuals with higher wealth levels tend to have higher consumption
spending, as they have more resources to allocate towards consumption.
• Interest Rates: Lower interest rates can encourage borrowing and increase
consumption spending, while higher interest rates may discourage borrowing
and reduce consumption.
• Consumer Confidence: When consumers are optimistic about the economy
and their future income, they are more likely to increase their consumption
spending.
• Expectations of Future Income: Anticipated future income levels can impact
current consumption decisions. If individuals expect their income to rise, they
may increase their spending.
• Debt Levels: High levels of debt may limit consumers' ability to spend, while low
debt levels can free up more income for consumption.
• Demographics: Factors such as age, family size, and education can influence
consumption patterns. For example, younger individuals and larger families may
have higher consumption needs.
• Taxes: Changes in tax policies can affect disposable income, influencing
consumption spending.
• Government Transfers: Social welfare programs and government assistance
can impact disposable income and, consequently, consumption spending.
These non-income determinants play a significant role in shaping consumption
patterns alongside income levels.

• Consumer Expectations: Concerning the expected future wage rates, if a
person believes that there will be a wage cut in the future, they may decide to
save more and consume less in the present.
• Inflation: When consumers expect prices to rise significantly in the future, they
may decide to buy now rather than wait for prices to go up. This is also known as
the 'Consumption Smoothing' hypothesis.
• Demographic factors: Older individuals generally consume less than younger
people while families with children tend to consume more.

4. • Social and psychological factors: Peer pressure, social status, and customary
habits can also influence consumption levels.

LO4: Explain the relationship between consumption and saving
Savings are the portion of income that is not spent on consumption. There is an
inverse relationship between savings and consumption:
• When consumers save more (increase savings), they spend less on
consumption.
• When consumers save less (decrease savings), they spend more on
consumption.
Real-World Example: During economic booms, people often feel more
financially secure and may reduce their savings rate, leading to increased
consumer spending on items like luxury goods, travel, and dining out.


• Savings and Consumption are two key components of an economy's circular
flow of income.
• Consumption refers to the use of goods and services by households,
while Savings is the portion of income that is not spent on consumption.
• The relationship between the two is inverse: when consumption increases,
savings decrease, and vice versa.
• Higher savings can lead to lower consumption in the short term, but it can also
contribute to investment and economic growth in the long term.
• Conversely, higher consumption can lead to lower savings, potentially
reducing funds available for investment and future economic growth.

5. Theme 3: Investment Spending
LO5: Explain the role of investment spending in the Keynesian model

In the Keynesian model, investment spending plays a crucial role in determining
aggregate demand and economic activity.

## Key Aspects
1. *Autonomous Investment*: Investment spending is considered autonomous,
meaning it's independent of current income levels.
2. *Aggregate Demand*: Investment spending (I) is a component of aggregate demand
(AD = C + I + G + NX).
3. *Multiplier Effect*: Changes in investment spending have a multiplier effect on
income and output.
4. *Volatility*: Investment spending is often volatile, driven by business expectations
and animal spirits.

## Role in the Keynesian Model
1. *Driving Economic Fluctuations*: Fluctuations in investment spending can drive
business cycles.

6. 2. *Equilibrium Output*: Investment spending influences equilibrium output and
income levels.
3. *Gap Analysis*: Investment spending can help address output gaps (recessionary or
inflationary).
4. *Policy Implications*: Fiscal policy can target investment spending to stabilize the
economy.

Theme 4: The simple Keynesian model of a closed economy
LO6: List the basic assumptions and implications of the simple Keynesian model .

The simple Keynesian model is a macroeconomic framework that analyzes the
relationship between aggregate demand and output in the short run. It is based on three
basic assumptions:
1. Aggregate demand determines output: In the simple Keynesian model,
aggregate demand is the primary driver of output. Changes in aggregate demand,
such as changes in consumption, investment, government spending, or net
exports, directly impact the level of output in the economy.
2. Prices are sticky: The model assumes that prices are sticky or inflexible in the
short run. This means that prices do not adjust immediately in response to
changes in demand or supply. Instead, they remain fixed or adjust slowly, leading
to a temporary mismatch between aggregate demand and output.
3. Output adjusts to demand: In the short run, the level of output adjusts to match
aggregate demand. If aggregate demand exceeds the economy's capacity to
produce, output will increase. Conversely, if aggregate demand falls short of the
economy's capacity, output will decrease. This adjustment in output occurs
through changes in employment and production levels.
These three assumptions form the basis of the simple Keynesian model and help
explain how changes in aggregate demand affect output and employment in the short
run.

Theme 5: The impact of a change in investment spending
LO7: Explain the role of investment spending