Equilibrium level of national income and government expenditure

Equilibrium level of national income and government expenditure In an open economy, the circular flow model of national income consists of five sectors as shown in figure 1 below. Figure 1: Circular Flow of National Income in a Five Sector Model The figure above illustrates the five sector circular flow model, which can be described as a model based on income flows from one sector of the economy to another in a circular flow motion, which explains the level of national income. The main sectors of the economy include households and firms. In the two sector model consisting only of households and firms, the economy is always at equilibrium. That is Income (Y) is always equal to consumption (C). However, the economy cannot be limited only to these two sectors. The effects of banks, government and international trade must be taken into consideration. These three sectors bring about withdrawals and injections. The financial sector mobilises savings (S) from households and makes investments (I) to firms. The government sector collects taxes (T) from households and makes expenditure (G) on firms. Finally, in the balance of payments sector, part of household income is spent on imports (M) while some revenue is received as exports (X). Since the two sector model always results to equilibrium, any distortion in equilibrium will result from the impact of the other three sectors. From the figure above, the national income is given by: Y = C +S+T+M à ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬ (I+G+X) For equilibrium to be achieved, total leakages must be equal to total injections. That is, S+T+M = I+G+X. Therefore, the equilibrium level of national income is simply given by: Y=C. The Keynesian cross model shows how consumption is determined. Under normal conditions, households will consume all goods and services produced. In this case, consumption will be exactly equal to income. This is represented by the 45 degree line in figure 2 below. Keynes noted that the relationship between consumption and income could not be perfect as the one depicted by the 45 degree line. He noted that not everybody in the economy earns income but everybody consumes. Therefore, there is a certain amount of consumption that does not depend on income and a certain amount that depends on income. From the foregoing, Keynes suggested the following consumption function (Mankiw, 2009: 497): Where = constant is defined as the consumption that does not depend on income; c is the slope of the consumption function referred to as the marginal propensity to consume. The marginal propensity to consume lies between 0 and 1. This indicates that consumption increases as income increases but the rate of increase in consumption is not as much as the rate of increase in income (Mankiw, 2009: 496). Figure 2: The Keynesian Cross 450 Consumption (C) National income (Y) Y* According to the Keynesian cross model, the equilibrium level of national income Y* is achieved at the point where the consumption function intersects the 45-degree line. At this point, all income that is earned is consumed. This is also the point where the desired level of spending is equal to the national income (Suranovic, 2005). Aggregate demand (AD) is the total or aggregate expenditure of final goods and services in an economy over a given period of time say one fiscal year. The aggregate demand is represented depending on whether it is a closed or open economy. For an open economy, the aggregate demand is given by: Y = AD = C+I+G+X-M For a closed economy, the aggregate demand is given by: Y = AD = C+I+G In the closed economy case, X-M is considered to be zero since there are neither imports nor exports. The aggregate demand curve is downward sloping. It shows the relationship between the quantity of real GDP demanded and the price level (Parkin, 2009: 324). The AD curve is as shown in the figure below. Figure 3: Aggregate Demand (AD) Curve AD Price Level (P) National income (Y) Aggregate supply (AS) refers to the aggregate or total supply of final goods and services or real GDP in an economy over a given period of time. The national income or real GDP is given by: Y = GDP = C+I+G+X-M. Unlike the AD curve, the AS curve is upward sloping. It shows the relationship between aggregate supply of final goods and services and price levels. This is represented in figure 4 below. AS Price Level (P) National income (Y)Figure 4: Aggregate Supply (AS) Curve Figure 5: Aggregate Demand-Aggregate Supply Framework (Macroeconomic Equilibrium) AS Price Level (P) National income (Y) Y* P* AD Macroeconomic equilibrium is defined as a situation where aggregate demand and aggregate supply are equal without any tendency for change (Chiang and Wainwright, 2005: 30). At this point a given price level ensures that the final goods and services demand is exactly equal to the final goods and services supplied. As shown in figure 5 above, this price level is referred to as the equilibrium price level (P*) and the real GDP or national income at this price level is the equilibrium level of national income (Y*). At this level of national income, the aggregate supply curve intersects the aggregate demand curve. Multiplier effect caused by an Increase in Government Expenditure From the circular flow model above, a multiplier effect from government expenditure will lead to an increase in government expenditure. Firms will increase investment in capital goods, employment will increase, and wages will increase. The increase in wages will lead to an increase in consumption, savings and taxes. Both imports and exports will also increase. In the long-run, the total amount of leakages will exactly equal the total amount of injections. There will be an overall increase in national income and the equilibrium level of national income will be higher than before. Using the Keynesian Cross, an increase in government expenditure will result to an increase in national income through increases in wages, consumption, savings, investment, imports and exports. 450 Consumption (C) National income (Y) Y* Y1* As income rises, the average propensity to consume (APC) which measures slope of the line from the origin to the consumption function will decrease (Mankiw, 2007: 497). This will lead to an increase in the equilibrium level of national income from Y1*. AS Price Level (P) National income (Y) Y* P* AD AD1 AS2 In the AD/AS model, an increase in government expenditure will result to an increase in aggregate demand. An increase in aggregate demand will motivate firms to increase investment. Employment will increase leading to an increase in wages. Savings will increase as well as taxes. In addition imports and exports will rise. The overall effect will be an increase in aggregate supply and aggregate demand. This will result to a rightward shift in the aggregate demand and supply curves as shown in figure 6 below. Consumer Confidence If consumer confidence is high, people tend to consume more of current income. In the circular flow model, the multiplier effect will be higher if consumer confidence is high. That is the respond to an increase in government spending will be higher than the case would be if consumer confidence is low. Households will consume more of their current levels of income as they anticipate an increase in future income. In like manner, firms will increase investment, employment will increase, and savings will reduce. Moreover, taxes will increase as well as imports and exports. In the Keynesian cross model, consumer confidence will lead to an increase in the marginal propensity to consume. People will be willing to consume more of their current incomes as they anticipate increases in future incomes. In terms of the AS/AD framework, a higher consumer confidence will lead to a significant increase in aggregate demand. This will in turn result to higher rates of investment spending, taxes, imports and exports. The overall impact will be a rightward shift in the AS and AD curves to establish a new equilibrium level of national income.