TUNKU ABDUL RAHMAN UNIVERSITY OF MANAGEMENT AND TECHNOLOGY

Centre for Pre-University Studies

FPEC1014 Principles of Economics

Topic : 5 – Theory of National Income Determination

1. Circular flow of income

➢ in a closed economy without the government (two-sector economy)

factors of production (land, labour, capital, entrepreneurship)

goods and services

households firms

consumption (C)

factor income (rent, wages, interest, profit)

Note:

physical flows

monetary flows

Explanation

A two-sector economy consists of households and firms.

Households provide factors of production (i.e. land, labour, capital and entrepreneurship) to
firms in producing goods and services. In return, households receive factor income in the
forms of rent, wages, interest and profits.

The firms use the factors of production to produce goods and services and then sell them to
households. Purchases made by households for these goods and services are known as
consumption (or consumer expenditure).

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2. Circular flow of income

➢ in a closed economy with the government (three-sector economy)

factors of production (land, labour, capital, entrepreneurship)

goods and services

saving (S) financial saving (S)

institutions

households taxes (T) investment (I) firms

government taxes (T)

payment for
factors of expenditure on goods
production (G) and services (G)

consumption (C)

factor income (rent, wages, interest, profit)

Note:

physical flows

monetary flows

Explanation

A three-sector economy consists of households, firms and the government.

Households provide factors of production (i.e. land, labour, capital and entrepreneurship) to
firms in producing goods and services. In return, households receive factor income in the
forms of rent, wages, interest and profits. Some of these factors of production, for example,
labour are also taken up by the government sector. Government spending on these factors of
productions is called payment for factors of production and generates part of the income
earned by households.

The firms use the factors of production to produce goods and services and then sell them to
households and the government. Purchases made by households for these goods and services
are known as consumption (or consumer expenditure). Purchases by the government on goods
and services are known as government expenditure on goods and services.

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 Both households and firms have to pay taxes to the government. The income earned but not
spent by households and firms is then deposited into financial institutions and is known as
saving. At the same time, firms do borrow money from the financial institutions for business
purposes and this is known as investment expenditure.

3. Determinants of Aggregate Demand (AD) or Aggregate Expenditure (AE)

According to Keynes, the level of national income and employment are determined largely by the
aggregate demand (AD). Aggregate demand can also be referred as aggregate expenditure (AE).
Aggregate expenditure refers to the total expenditure or total demand for goods and services in an
economy over a period of time. AE consists of few components.

In a two-sector economy : AE = C + I

In a three-sector economy : AE = C + I + G

In a four-sector economy : AE = C + I + G + (X – M)

4. Consumption function and saving function

❖ Household income earned can be spent or to be saved. Therefore,

Y = C + S

❖ Consumption (C) refers to the total planned consumer expenditure of all households in the
economy.

❖ Consumption function shows the relationship between consumption (C) and the level of
income (Y). Consumption is made up of two components:
(i) autonomous consumption
(ii) income-induced consumption

• Diagram:
Consumption
Y=C

C = a + bY
E

45o
0 Ye National income
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 Note:
C = consumption
a = autonomous consumption (i.e. consumption that does not depend on the
income level.) It is the consumption which households would spend even if
income is zero. This amount does not change as income changes.
b = marginal propensity to consume (MPC)
Y = income
bY = income-induced consumption

Explanation
Consumption function shows the relationship between consumption (C) and the income
(Y) level. The consumption function is written as C = a + bY. Consumption curve is an
upward sloping curve indicates a positive relationship between consumption and income
level. Consumption rises when income rises.

❖ Saving (S) refers to the total planned savings of all households in the economy.
Saving is defined as income earned which is not spent. Therefore,

S = Y – C

❖ Saving function shows the relationship between saving (S) and the level of income (Y).

• Diagram:
Saving
S = – a + (1 – b)Y

0 National Income

–a

Note:
S = saving
a = autonomous consumption (or autonomous dissaving) (i.e. consumption that
does not depend on the income level.) It is the amount of savings which
households would withdraw when their income is zero. This amount does not
change as income changes.
b = marginal propensity to consume (MPC)
(1 – b) = marginal propensity to save (MPS)
Y = income
(1 – b)Y = income-induced saving
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 Explanation
Saving function shows the relationship between saving (S) and the income (Y) level. The
saving function is written as S = – a + (1 – b)Y. Saving curve is an upward sloping curve
indicates a positive relationship between saving and income level. Saving rises when
income rises.

5. Concepts of consumption and saving

❖ Average propensity to consume (APC)

• APC is the proportion of income that is spent on consumption.

APC = C
Y
• Example:
Y = RM 5000
C = RM 4000
Therefore,
APC = 4000
5000
= 0.8
This means that from one ringgit of income earned, 80 sen will be spent for
consumption. OR
80% of the income earned will be spent. (The rest of 20% will be saved.)

❖ Average propensity to save (APS)

• APS is the proportion of income that is saved.

APS = S
Y

❖ Marginal propensity to consume (MPC)

• MPC is the proportion of increased income that will be spent on consumption.

• MPC refers to the change in consumption as a result of an additional dollar of income or it

is the extra spending out of each extra dollar of income earned.

MPC = ΔC
ΔY

Note: MPC is the slope of consumption curve.

0 < MPC < 1

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 ❖ Marginal propensity to save (MPS)

• MPS is the proportion of increased income that will be saved.

• MPS refers to the change in saving as a result of an additional dollar of income or it is the
extra saving out of each extra dollar of income earned.

MPS = ΔS
ΔY

Note: MPS is the slope of saving curve.

0 < MPS < 1

❖ Since income can only be spent or saved,

APC + APS = 1

MPC + MPS = 1

6. Factors that influence consumption

❖ Level of income

As the level of income increases, the ability to consume will also increase, and vice versa.
Besides, consumption is always positive. However, the increase in consumption is always less
than the increase in income.

❖ Cost and availability of credit

Many goods especially durable goods such as houses and cars are bought with bank loan or
through hire purchase credit. The terms on which loans are available and the cost of borrowing
would have an effect upon the level of consumption. A low rate of interest can stimulate higher
consumption because it is cheaper to borrow money to buy goods. Consumption will also
increase if the period to pay back the loan is longer.

❖ Consumer expectation

Consumer spending is influenced by their expectation about the future. The three main factors
involved are inflation, income level and unemployment. Expectation of price rise will lead to a
rise in current spending while expectation of price fall will lead to a fall in current consumption
as consumers will postpone their consumption now.

If consumers expect their income will rise in the future, they will tend to increase their current
consumption. On the other hand, if consumers expect their income will fall in the future, then
they will tend to reduce their current consumption.

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 If consumers expect future employment level will rise, this will lead to higher current
consumption. If consumers expect future employment level will fall, then this will result in a
lower current consumer spending.

❖ Wealth and savings

The level of wealth and savings of households can influence consumption. A consumer with
more wealth and savings will have a higher level of consumption, and vice versa. This is
because both wealth and savings can generate income in the forms of rent and interest,
therefore increases the consumer’s purchasing power. Since purchases can be made not only
out of current income, but also from consumers’ assets and savings, this can influence
consumption. Therefore, those with wealth and savings generally have higher level of
consumption.

7. Determination of equilibrium national income

❖ Equilibrium national income (Ye) is achieved when there is no tendency for the national
income achieved to change.

❖ There are two approaches to achieve the equilibrium national income:

(i) Income-expenditure approach
(ii) Injections-leakages approach

(i) Income-expenditure approach

• Equilibrium national income is achieved when aggregate demand (AD) i.e. aggregate
expenditure (AE) is equal to aggregate supply (AS).

AE = AS

• Note:

In a two-sector economy : AE = C + I

In a three-sector economy : AE = C + I + G

In a four-sector economy : AE = C + I + G + (X – M)

• Aggregate supply is the total output that firms in an economy are willing and able to
supply in a certain period of time. Therefore, aggregate supply can be referred as national
output (Y).
▪ From the definition, the value of a country’s output is equal to the actual expenditure
on that output and also equal to the actual factor incomes generated by the factors of
production. These are just different ways of looking at a single number, i.e. the value of
total output produced.

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(ii) Injections-leakages approach

• Injections (J) refer to spending on final goods and services in addition to consumer
spending (C). An injection is an addition to the circular flow of income which does not
arise from consumption.

▪ An increase in injections, for examples, higher investment (I), higher government

spending (G) and higher exports (X) will increase aggregate expenditure (AE) and
therefore lead to an increase in national income.

▪ Injections consist of few components.

In a two-sector economy : J = I

In a three-sector economy : J = I + G

In a four-sector economy : J = I + G + X

• Leakages (W) are also known as withdrawals. Leakages refer to any part of income
received which is not passed into the circular flow, meaning the income earned but is
not spent on final goods and services.

▪ An increase in leakages, for examples, higher saving (S), higher taxes (T) and higher
imports (M) will reduce aggregate expenditure (AE) and therefore lead to a decrease in
national income.

▪ Leakages consist of few components.

In a two-sector economy : W = S

In a three-sector economy : W = S + T

In a four-sector economy : W = S + T + M

• Equilibrium national income is achieved when injections (J) are equal to leakages (W).

J = W

In a two-sector economy : I = S

In a three-sector economy : I + G = S + T

In a four-sector economy : I + G + X = S + T + M

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Diagram:
➢ Equilibrium national income in a two-sector economy

Aggregate expenditure
Y = AE

AE = C + I Diagram 1

E (income-expenditure approach)

45o
0 Ye National income

Injections, Leakages

W = S

Diagram 2

E J = I (injections-leakages approach)

0 Ye National income

Explanation
A two-sector economy consists of households and firms. In the two-sector economy,
aggregate expenditure is the sum of consumption (C) by households and investment
expenditure (I) by firms. Referring to Diagram 1, the aggregate expenditure (AE) curve is
shown by AE = C + I while the aggregate supply (AS) curve is indicated by Y = AE.
Equilibrium point is achieved at point E when aggregate expenditure is equal to aggregate
supply. The equilibrium national income is achieved at Ye.

In Diagram 2, equilibrium point is achieved at point E when injections (J) are equal to
leakages (W) i.e. when investment expenditure (I) is equal to saving (S). The equilibrium
national income is achieved at Ye.

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Diagram:
➢ Equilibrium national income in a three-sector economy

Aggregate expenditure
Y = AE

AE = C + I + G Diagram 1

E (income-expenditure approach)

45o
0 Ye National income

Injections, Leakages

W = S+T

Diagram 2

E J = I+G (injections-leakages approach)

0 Ye National income

Explanation
A three-sector economy consists of households, firms and the government. In the three-sector
economy, aggregate expenditure is the sum of consumption (C) by households, investment
expenditure (I) by firms, and government spending (G) by the government. Referring to
Diagram 1, the aggregate expenditure (AE) curve is shown by AE = C + I + G while the
aggregate supply (AS) curve is indicated by Y = AE. Equilibrium point is achieved at point E
when aggregate expenditure is equal to aggregate supply. The equilibrium national income is
achieved at Ye.

In Diagram 2, equilibrium point is achieved at point E when injections (J) are equal to
leakages (W) i.e. when investment expenditure (I) plus government spending (G) are equal to
saving (S) plus taxes (T). The equilibrium national income is achieved at Ye.

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8. Effect of a rise in investment on equilibrium national income

❖ Diagram

Aggregate expenditure
Y = AE

E1 AE1 = C + I1 + G
∆I
AEo = C + Io + G

Eo

45o
0 Yo Y1 National income

Explanation

The initial equilibrium point is achieved at point Eo when initial aggregate expenditure (AEo)
is equal to aggregate supply (Y). The initial equilibrium national income is achieved at Yo.

A rise in investment (I) increases aggregate expenditure and therefore causes the AE curve to
shift upwards from AEo curve to AE1 curve. The new equilibrium point is achieved at point
E1 when new aggregate expenditure (AE1) is equal to aggregate supply (Y). The new
equilibrium national income is achieved at Y1.

In conclusion, an increase in investment will lead to a rise in national income from Yo to Y1.

8. Effect of a rise in government spending on equilibrium national income

❖ Diagram

Aggregate expenditure
Y = AE

E1 AE1 = C + I + G1
∆G
AEo = C + I + Go

Eo

45o
0 Yo Y1 National income

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 Explanation

The initial equilibrium point is achieved at point Eo when initial aggregate expenditure (AEo)
is equal to aggregate supply (Y). The initial equilibrium national income is achieved at Yo.

A rise in government spending (G) increases aggregate expenditure and therefore causes the
AE curve to shift upwards from AEo curve to AE1 curve. The new equilibrium point is
achieved at point E1 when new aggregate expenditure (AE1) is equal to aggregate supply (Y).
The new equilibrium national income is achieved at Y1.

In conclusion, an increase in government spending will lead to a rise in national income from
Yo to Y1.

9. Multiplier principle

❖ The multiplier principle states that a change in the level of injections or leakages will bring
about a relatively greater change in the level of national income. For example, if the multiplier
(which is denoted by the alphabet k) is 5, then an increase in injection e.g. investment or
government spending will result in an increase in national income by five times of the
increase in injection.

• Example:
Investment has increased by RM50 million. This has the effect of raising the level of
national income by RM 250 million (= RM50 million X 5).

❖ The multiplier (k) shows the number of times by which a change in injections (or
leakages) is multiplied to get the change in national income.

few times
∆ in AE  ∆ in Y

Therefore, ∆ in Y > ∆ in AE

❖ Formulae for multiplier: (for two-sector economy)

k = Δ Y
Δ AE

k = 1
1 – MPC

k = 1
MPS

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• Example:

The marginal propensity to consume (MPC) is 0.8. Investment has increased by

RM200 million, what is the outcome on national income?

Answer:
Step 1: Find k
k = 1
1 – MPC

= 1
1 – 0.8

= 1
0.2

= 5

Step 2: Find Δ Y

k = Δ Y
Δ AE

which is

k = ΔY
ΔI

Therefore,

∆Y = ∆I X k
= RM200 million X 5
= RM1000 million

The national income increases by RM1000 million.

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