TUNKU ABDUL RAHMAN UNIVERSITY OF MANAGEMENT AND

TECHNOLOGY Centre for Pre-University Studies

Course : Foundation in Arts/Foundation in Business

Unit : FPEC1014 Principles of Economics
Topic : 5 – Theory of National Income Determination
LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE
TO - Identify the circular flow of income in a two sector economy
- Identify the circular flow of income in a three sector economy
- State the consumption function and saving function

1. Circular flow of income (2 Sector Economy)

Diagram

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A two-sector economy consists of households and firms. Based on the circular flow of
income diagram, the households will provide factors of production to the firms like land,
 labour, capital and entrepreneurship. In return, the households receive rent, wage, interest
and profits which are their source of income. The firms use the factors of production to
produce goods and services that are then sold to the households. Purchases made by
households for these goods and services is known as consumption expenditure.

2. Circular flow of income (3 Sector Economy – Closed Economy)

Diagram

Factors of production (Land, Labour, Capital, Entrepreneurship)

Rent, Wage, Interest, Profit

Savings Savings Firms Households

Financial
Institution
Investment

Taxes Taxes

Expenditure on Payments for goods and services factors of production

Government

Consumption Expenditure

Goods and services

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A three-sector economy consists of households, firms and the government. Based on the
circular flow of income diagram, the households will provide factors of production to the
firms like land, labour, capital and entrepreneurship. In return, the households receive
 rent, wage, interest and profits which are their source of income. Some of these factors of
production is also taken up by the government sector for example labour. Government
spending on these factors of productions is called payment for factors of production and
generate part of the income earned by households.

The firms use the factors of production to produce goods and services that are then sold to
both the households and the government. Purchases made by households for these goods
and services is known as consumption expenditure. Purchases by the government on goods
and services is known as government expenditure on goods and services. Both households
and firms have to pay tax to the government. The income not spent by households and
firms is then deposited into financial institutions and is known as savings. At the same time,
firms do borrow money from the financial institution for business purposes and this is
known as investments.

3. Determinants of Aggregate Demand (AD) / Aggregate Expenditure (AE) According to Keynes,

the level of national income and employment is determined largely by the aggregate demand.
Aggregate demand or aggregate expenditure (AD = AE) refers to the total expenditure or total
demand for goods and services in an economy over a period of time. It consists of:

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4. Consumption function and Saving function
• Household can do one of two things with their income, either to spend or to save.
Therefore, Y = C + S.

The consumption function shows the total planned consumption expenditure of all households in the
economy. Consumption function is made up of:
(i) Autonomous consumption
(ii) Induced consumption

Diagram: Consumption function

 Consumption
Y=C

C = a + bY

0 Yo National Income

C = consumption function
a = autonomous consumption (consumption level that does not depend on the income level. It is part
of the consumption when consumers’ level of income is zero)

b = marginal propensity to consume (MPC)

Y = National income

The consumption function indicates the relationship between the income level and the
consumption level. The consumption function curve C = a + bY is upward sloping indicating
that consumption rises when income rises.

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• Saving is defined as income not spent. Therefore, S = Y – C.
As income increases, consumption and saving also rise. The saving function shows the amount
saved at each level of income.

Diagram: Saving function

Saving

S = -a + (1-b)Y

0 National Income
 -a

S = saving function

-a = autonomous saving (autonomous saving does not depend on the income level. It is part of the
savings used when consumers’ level of income is zero)

1 - b = marginal propensity to save (MPS)

Y = National income

The saving function indicates the relationship between the income level and the saving level.
The saving function curve S = -a + (1-b)Y is upward sloping indicating that saving rises when
income rises.

5. Consumption and Saving Concepts

• Average propensity to consume (APC)

- The proportion of income devoted to consumption.
APC = C
Y

• Average propensity to save (APS)

- The proportion of income devoted to savings.
APS = S
Y

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• Marginal propensity to consume (MPC)
- The proportion of any addition to income that is devoted to consumption.
MPC = Δ C
ΔY

• Marginal propensity to save (MPS)

- The proportion of any addition to income that is devoted to savings.
MPS = Δ S
ΔY
 APC + APS = 1

MPC + MPS = 1
LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE
TO - Identify the factors that influence consumption
- Determine the national income equilibrium level using AD-AS and
injection-leakage approach

6. Factors that influence consumption

• Level of income
As the level of income increases, the ability to consume will also rise vice versa. The increase
in consumption is always less than increase in income. Therefore, consumption is always
positive.

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• Cost and availability of credit
Many goods especially durables such as houses and cars are bought with bank loan or through hire purchase
credit. The terms on which loans are available and their costs would have an effect upon the level of
consumption. A low rate of interest can also stimulate higher consumption because it is cheaper to borrow
money. Consumption also rises when the period to pay back the loan is longer.
• Consumer expectation
Consumer spending is influenced by their expectation of the future. The three main factors involved are
inflation, unemployment and income. Expectation of price rise will lead to rise in current spending while
expectation of price fall will lead to a fall in current consumption as consumers will postpone their
consumption.

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

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

• Distribution of income
Different income groups have different MPC. The MPC of lower income tends to be much
higher than of the rich. A movement to a more even distribution of income through progressive
tax should lead to a higher MPC for the economy and this will lead to higher consumption.

• Wealth and savings

One’s wealth and savings can influence consumption. A consumer with more wealth and
savings will have a higher level of consumption vice versa. This is because both wealth and
savings can generate income in the form 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, the quantity of these can influence consumption.
Example, those with wealth and savings generally have higher level of consumption.

7. Determination of Equilibrium Level and National Income

Equilibrium income exists when there is no tendency towards a contraction or expansion of national
income.

There are 2 approaches to national income equilibrium:

(i) Income expenditure approach
(ii) Leakage - injection approach

Income – Expenditure approach

National income equilibrium occurs when aggregate demand = aggregate supply
AD = AS
or
National income equilibrium occurs when aggregate expenditure = aggregate supply
AE = AS

In a two-sector economy, aggregate demand (aggregate expenditure)

AE = C + I

In a three-sector economy, aggregate demand (aggregate expenditure)

AE = C + I + G

In a four-sector economy, aggregate demand (aggregate expenditure)

AE = C + I + G + (X – M)

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Leakage - Injection approach
Injection refers to expenditure which increases the income in the circular flow leading to an
increase in the national income. In a two-sector economy, injection consists of investment (I). In a
three-sector economy (closed economy), injection consists of investment and government
expenditure (I + G). In a four-sector economy (open economy), injection consists of investment,
government expenditure and exports (I + G + X).

Leakage or withdrawal refers to any part of income received which is not passed into the circular
flow meaning that the income earned is not spent on final goods and services. This will lead to a
decrease in the national income level. In a two-sector economy, leakage consists of savings (S). In
a three-sector economy (closed economy), leakage consists of savings and taxes (S + T). In a
four-sector economy (open economy), leakage consists of savings, taxes and imports (S + T + M).

National income equilibrium occurs when:

injection = leakage

National income equilibrium in a two-sector economy I = S

National income equilibrium in a three-sector economy I + G = S + T National income

equilibrium in a four-sector economy I + G + X = S + T + M

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Diagram (National income equilibrium in a two-sector economy: AE = AS Approach)

Aggregate Expenditure
Y = AE

AE = C + I

(1) Eo

0 Yo National Income

Leakage, Injection

S (Leakage)

(2) Eo I (Injection)

Yo National Income

Referring to diagram (1), in a two-sector economy, aggregate expenditure is the sum of

household consumption(C) and investment by firms(I). The aggregate expenditure curve is
shown by AE = C + I and the aggregate supply curve is indicated by Y = AE. The national
income equilibrium is achieved at point Eo when aggregate expenditure is equal to aggregate
supply (AE = AS) and the national income equilibrium level is at Yo. In diagram (2), the
national income equilibrium is achieved at point Eo when leakage is equal to injection (S = I)
and the national income equilibrium level is at Yo.

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Diagram (National income equilibrium in a three-sector economy: AE = AS Approach)
(Closed economy)
Aggregate Expenditure
Y = AE

AE = C + I + G

(1) Eo

0 Yo National Income

Leakage, Injection

S + T (Leakage)

(2) Eo I + G (Injection)

Yo National Income

Referring to diagram (1), in a three-sector economy, aggregate expenditure is the sum of

household consumption(C), investment by firms(I) and government expenditure(G). The
aggregate expenditure curve is shown by AE = C + I + G and the aggregate supply curve is
indicated by Y = AE. The national income equilibrium is achieved at point Eo when aggregate
expenditure is equal to aggregate supply (AE = AS) and the national income equilibrium level
is at Yo. In diagram (2), the national income equilibrium is achieved at point Eo when leakage
is equal to injection (S + T = I + G) and the national income equilibrium level is at Yo.

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 LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE
TO - Identify the effect of a rise in investment on national income equilibrium -
Determine the effect of a rise in government expenditure on national income
equilibrium
- State the multiplier principle

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

Diagram: Aggregate Expenditure = Aggregate Supply (AE = AS)

The national income equilibrium is achieved at point Eo when aggregate supply equals to aggregate
expenditure (AS = AE). The national income equilibrium level is at Yo. A rise in investment
will cause the aggregate expenditure curve AE = C + I + G to shift upwards to AE 1 = C + I1 +
G. The new national income equilibrium is achieved at point E 1 when aggregate supply equals
to the new aggregate expenditure (AS=AE 1). The national income equilibrium rises from Yo
to Y1.

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9. Effect of a rise in government expenditure on national income equilibrium

Diagram: Aggregate Expenditure = Aggregate Supply (AE = AS)

The national income equilibrium is achieved at point Eo when aggregate supply equals to aggregate
expenditure (AS = AE). The national income equilibrium is at Yo. A rise in government
expenditure will cause the aggregate expenditure curve AE = C + I + G to shift upwards to
AE1 = C + I + G1. The new national income equilibrium is achieved at point E1 when aggregate
supply equals to the new aggregate expenditure (AS=AE1). The national income equilibrium
rises from Yo to Y1.

10. The Multiplier Principle

The multiplier principle states that a change in the level of injection or leakage (withdrawal) brings
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 a rise in an injection component such as investment (I) or
government spending (G) will result in a rise of national income five times this magnitude.

For example, investment has increased by RM50 million. This has the effect of raising the level of
national income by RM50 million X 5 = RM 250 million. The numerical value of the change is known
as the multiplier (K).

The Multiplier Formula

K=1K=1
----------- or -----------
1 - MPC MPS

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Example:

1. The marginal propensity to consume is 0.8 and the rate of investment has risen by RM200 million,
what is the outcome on national income?

2. If Y = RM5000 and C = RM4000, compute the value of average propensity to consume

(APC).
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.)

3. The table below indicates the national income level and the consumption level for a country.
National Income (RM) Consumption (RM)

0 300
100 370
200 440
300 510
400 580

a) Based on the table above, calculate the value of the marginal propensity to consume (MPC)
and marginal propensity to save (MPS).

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b) Identify the value of autonomous consumption. c) State

the consumption function and the saving function.

d) Calculate the value of the multiplier.

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