Two Sector Model

Simple Keynesian Model
National Income Determination

Two-Sector National Income
Model
1
Outline
Macroeconomics [2.1]
Exogenous & Endogenous Variables
[2.3]
Linear Functions [2.6]
Aggregate Demand & Supply [3.2]
National Income Determination Model
OR Simple Keynesian Model [3.3]
2
Outline
National Income Identities [3.4]

Equilibrium Income [3.5 & 3.11]
Consumption Function [3.6]
Investment Function[3.7]
Aggregate Demand Function [3.8]
Outline
Output-Expenditure Approach to
Income Determination[3.9 ]
Expenditure Multiplier [3.9]
Saving Function [3.10]
Injection-Withdrawal Approach to
Income Determination [3.10]
Paradox of Thrift [3.13]
4
Macroeconomics
National income, general price

level, inflation rate, unemployment
rate, interest rate and the
exchange rate are the economic
measures to be explained in the
macroeconomic models / theories
Exogenous & Endogenous

Variables
Exogenous Variable
the value is determined by forces outside

the model
any change is regarded as autonomous
I, G, X ( Micro: Income/Population)
Endogenous Variable
the value is determined inside the model

factor to be explained in the model
Y, C, M ( Micro: Price/Quantity)
6
Linear Functions
A function specifies the

relationship between variables
y is the dependent variable
x is the independent variable
y=f(x)
Linear Functions
y=f(x)
y= c
y=mx
y=c+mx
m, c are exogenous variables
y, x are endogenous variables
8
Linear Functions
Consumption Functions
C= f(Y)
C= C
C= cY
C= C + cY
Linear Functions
C, c are exogenous variables

C, Y are endogenous variables
Y is independent variables
C is dependent variables
10
Linear Functions
Can you express the 3

consumption functions graphically?
11
Linear Functions
The parameter C is autonomous

consumption
It summarizes the effects of all factors
on consumption other than national
income.
What is the difference between a
change in exogenous variable
(autonomous change) and a change in
endogenous variable (induced change)?
12
Linear Functions
C= f(Y, W)
If wealth is deemed as a relevant
factor but is not explicitly included in
the consumption function C=C+ cY
a rise in wealth W will lead to a
rise in the exogenous variable C
graphically, the consumption
function C will shift upwards
13
Linear Functions
What happens if c ?
What happens if Y ?
14
Linear Functions
Consumption function can also be a

relationship between consumption C
and interest rate r.
What do you think of the relationship
between the variables, i.e.,
consumption C and interest rate r?
Are they positively correlated or
negatively correlated?
15
Aggregate Demand &

Supply
Aggregate Demand
the relationship between the total

amount of planned expenditure and
general price level (v.s. aggregate
expenditure E)
Aggregate Supply
the relationship between the total

amount of planned output and the
general price level
16
Aggregate Demand &

Supply
Price Level
Aggregate Supply
Equilibrium: no tendency to change a
the values of the endogenous variabl
will remain unchanged in the absence

external disturbances
Aggregate Demand
National Outpu
17
Aggregate Demand &

Supply
P
AS When AS is vertical
A shift of AD will cause a
change
In P only but have no effect on

Y
AD2
AD1
Yf
Y
18
Aggregate Demand &

Supply
P
AD1
AD2
When AS is horizontal
A shift of AD will cause a
change in Y only but have no
effect on P
AS
Y
19
Aggregate Demand &

Supply
AS
AD
Ye
Yf
20
Aggregate Demand &

Supply
The Upward Sloping AS
When the economy is close to but

below full employment level Y < Yf,
the attempt to raise output by
increasing aggregate demand will
face supply side limitations
both price and output will increase
21
Aggregate Demand &

Supply
The Vertical AS (slide 18)
When full employment is attained Y =

Yf, an increase in aggregate demand
can only cause prices to rise
22
Aggregate Demand &

Supply
The Horizontal AS (slide 19)
When output is far below Yf, the

equilibrium output is determined by AD
The supply side has no effect on income
level as firms could supply any amount
of output at the prevailing price level
The Keynesian Model analyses the
situation of an economy with fixed prices
and high unemployment Y < Yf
23
National Income
Determination Model
Assumptions:
National income Y is defined as the

total real output Q
A constant level of full national
income Yf
Serious unemployment, i.e., there are
many idle or unemployed factors of
production
24
National Income
Determination Model
Income / output can be raised by
(contd)
using currently idle factors without

biding up prices
Price rigidity or constant price level
There are only households and firms
(2-sector). No government and
foreign trade
25
National Income Identities
An identity is true for all values of the

variables
In a 2-sector economy, expenditure
consists of spending either on
consumption goods C OR investment
goods I.
Aggregate expenditure (AE OR E) is ,by
definition, equal to C plus I
EC+I
26
National income Y received by

households, by definition, is either
saved S OR consumed C.
YC+S
27
Aggregate expenditure E is, by

definition, equal to national income
Y
YE
C+SC+I
SI
28
Equilibrium Income
Equilibrium is a state in which there is

no internal tendency to change.
It happens when
firms and households are just willing to

purchase everything produced Y = E (v.s.
Micro: Qs = Qd) [slide 30-36]
Income-Expenditure Approach [slide 37-60]
planned saving is equal to planned
investment S = I
Injection-Withdrawal Approach [slide 6174]
29
Equilibrium Income
What is the definition of GNP (/

GDP) in national income
accounting?
The total market value of all final
goods and services currently
produced by the citizens (/within
the domestic boundary) of a
country in a specified period
30
Equilibrium Income
Ex-ante Y > E Excess supply
planned output > planned expenditure
unexpected accumulation of stocks OR

unintended inventory investment OR
involuntary increase in inventories
In national income accounting, this amount

Y-E is treated as (unplanned) investment by
firms
31
Equilibrium Income
Ex-post Y= E
Actual (Realised)= Planned

Expenditure
Expenditure
+
Unplanned
Investment
Actual (Realised) Output = Actual Expenditure
Firms will reduce output

32
Equilibrium Income
Ex-ante Y < E Excess Demand
planned output < planned expenditure
unexpected fall in stocks OR

unintended inventory dis-investment OR
involuntary decrease in inventories
However, in national income

accounting, this amount E - Y
consumed is not currently produced
33
Equilibrium Income
Ex-post Y= E
Actual (Realised)= Planned

Expenditure
Expenditure
Unplanned
Dis-investment
Actual (Realised) Output = Actual Expenditure
Firms will increase output

34
Equilibrium Income
Ex-ante Y= E Equilibrium
There is no unintended inventory
investment OR dis-investment
Ex-post Y=E
35
Equilibrium Income
When there is excess supply, i.e., planned

output > planned expenditure, firms will
reduce output to restore equilibrium
When there is excess demand, i.e., planned
expenditure > planned output, firms will
increase output to restore equilibrium
In the Keynesian model, it is aggregate
demand that determines equilibrium output.
Remember the horizontal AS [slide 19]
36
Consumption Function
Now, we will look at the 1st

component of the aggregate
expenditure E C + I i.e. C
Empirical evidence shows that
consumption C is positively related
to disposable income Yd
Yd = Y since it is a 2-sector model
Remember the 3 consumption
functions [slide 9 & 11]
37
Autonomous Consumption C
It exists even if there is no income.

This can be done by dis-saving, i.e.,
using the past saving
Then, saving will be negative when
income is zero.
It is totally determined by forces
outside the model
What happens to the 3 consumption
functions if C ? Or C ?
38
C = yintercept
In C
C=
C
C = cY
C = C + cY
39
Marginal Propensity to Consume MPC = c
It is defined as the change in consumption per unit

change in income
MPC = C / Y
It is the slope of the tangent of the consumption
function
For a linear function, MPC is a constant
What does the consumption function C look like if
MPC is increasing? Decreasing?
It is assumed that 0 < MPC < 1
What happens to the 3 consumption functions if c ?
or c ?
40
MPC = slope of
tangent
in MPC or in c
C=
C
C = cY
C = C + cY
41
Average Propensity to Consume APC
It is defined as the ratio of total

consumption C to total income Y
APC = C / Y
It is the slope of ray of the consumption
function
When C = C OR C = C + cY, APC
decreases when Y increases.
When C = cY, APC = MPC = c = constant
42
APC = slope of
ray
C=
C
C = cY
C = C + cY
43
Relationship between APC and MPC

C = C Divide by Y
C/Y = C/Y
APC = C/Y
APC when Y
Slope of ray flatter when Y
Slope of tangent = MPC = c = 0
44

C = cY
Divide by Y
C/Y = c
APC = MPC = c
Slope of ray=Slope of
tangent=constant=c
45

C = C + cY Divide by Y
C/Y = C/Y + c
APC = C/Y + MPC C +ve
APC > MPC
Slope of ray steeper than slope of tangent
Slope of tangent constant
Slope of ray flatter when Y
APC when Y
46
Investment Function
Lets look at the 2nd component of

the aggregate expenditure E C + I
An investment function shows the
relationship between planned
investment I and national income Y
It can be a linear function or a nonlinear function
47
Investment Function
Again, there can be 3 investment functions

I = I
I = iY
I = I + iY
Economists usually use the first one, i.e.,
I= I as investment is thought to be
correlated with interest rate r, instead of Y
I , i are exogenous variables
I , Y are endogenous variables
48
Investment Function
Autonomous Investment I
It is independent of the income
level and is determined by forces
outside the model, like interest
rate.
I is the y-intercept of the
investment function
49
Investment Function
Marginal Propensity to Invest i

It is defined as the change in investment
I per unit change in income Y
MPI = I / Y
MPI would not correlate with Yd
It is the slope of tangent of I
It is also determined by forces outside
the model
50
Investment Function
MPI = i =slope of tangent
I = y-intercept
API when
Y
MPI =0
I = I
I = iY
I = I + iY
51
Aggregate Expenditure
Function
Given E = C + I
C = C + cY
I = I
E = I + C + cY
E = E + cY
52
Function
I
C, I, E
Slope of tangent =
c
Slope of
tangent=0
Y
I = I
C = C+cY
E = I + C+
53
cY
Function
Autonomous Change
When C or I E shift upward
When c slope of E steeper
rotate
Induced Change
When Y E move along the
curve
54
Output-Expenditure
Approach
National income is in equilibrium when

planned output = planned expenditure
We have planned expenditure E=C+I
Equilibrium income is Ye=planned E
A 45-line is the locus of all possible
points where Y = E
When E = planned E, Y = Ye
55
Output-Expenditure
Approach
Y=E
C, I, E
Planned E=C
+I
Planned E <
Y
Y=planned E Unintended
inventory
investment
Planned
E>Y
Unintended
inventory
disinvestment
Actual E = Y
Y
Y
Ye
56
Output-Expenditure
Approach
Y = planned E
Y = I + C + cY
Y = E + cY
(1-c)Y = E
Equilibrium condition
1
Y=
E
1-c
57
Output-Expenditure
Approach
If C or I E E Ye
If c E steeper Ye
If we differentiate the equilibrium
condition,
Y/E = 1/(1-c)
Given 0 < c < 1 1/(1-c) > 1
E Ye by a multiple 1/(1-c) of E
58
Expenditure Multiplier 1/
(1-c)
Assume c=0.8, E = 100

The one who receive the $100 as
income will spend 0.8($100)
then the one who receives 0.8($100)
as income will spend 0.8*0.8($100)
The process continues and the total
increase in income is
$100+0.8($100) +0.8*0.8($100) +
59
Expenditure Multiplier 1/
(1-c)
The total increase in income is

actually the sum of an infinite
geometric progression which can
be calculated by the first term
divided by (1- common ratio)
The first term here is E = $100
and the common ratio is c =0.8
The sum of GP is E * multiplier
60
Saving Function
We have Y C + S [slide 27]

Saving function can simply be derived
from the consumption function
S=YC
if C = C + cY
S = Y C cY
S = -C + (1-c) Y
S = S + sY
S= -C
s=1-c
S < 0 if C >0
S = 0 if C = 0
61
Saving Function
S
S = sY
S
S = S+ sY
S = (1c)Y
S =-C+(1-c)Y
Slope of tangent = s
=1- c
Y > Y*
Y*
S+ve
Y
S
Slope of ray = slope of
tangent
Slope of ray < slope of

62
tangent
Saving Function
Autonomous Saving S
Since S= -C + (1-c)Y
If C= 0 when C= cY
S = (1-c)Y S = 0
If C +ve when C = C + cY
S = -C + (1-c)Y S ve
If Y= 0 S = -C Dis-saving
63
Saving Function
Marginal Propensity to Save MPS = s

It is defined as the change in saving per
unit change in disposable income Yd OR
income Y (in a 2-sector model)
MPS = S/ Y
It is the slope of tangent of the saving
function
MPS is a constant if the consumption /
saving function is linear
64
Saving Function
Average Propensity to Save APS

It is defined as the total saving
divided by total income
APS = S/Y
It is the slope of ray of the saving
function
65
Saving Function
Average Propensity to Save APS (contd)

When S= sY
APS = MPS = s = constant
When S=S+ sY
APS < MPS as S ve
APS ve when Y < Y*[slide 62]
APS = 0 when Y = Y*
APS +ve when Y > Y*
APS when Y
66
Saving Function
Y=C+S
Differentiate wrt. Y
Y/Y=C/Y + S/Y
1= MPC + MPS
1 = c + s [slide 61]
S = S + sY Divided by Y
S/Y = S/Y + s
APS=S/Y+MPS [slide 66]
67
How to determine
Ye?
Y=E
C, S, I, E
Planned Y =
planned E
+ve S
Planned
I
-ve
S
Planned
C
Y<C Y*=C
Ye
Y>C
Y
68
Y=E
Y = C S =0
No Dis-saving
E=C+I
Y<E
Y < C Unintended Inventory Dis-investment
Actual I =Planned
I Unintended I C
Planned
Y<E
I
Planned
C
Planned Y <
Planned E
Ye
69
Y=E
Y > C S +ve
Saving
E=C+I
Y>E
Unintended Inventory Investment
Actual I =Planned
I + Unintended I C
Planned
I
Planned
C
How about
Ye
Planned Y > Planned 70

E
Injection-Withdrawal
Approach
Remember the national income

identity S I [slide 28]
The equilibrium income happens
when planned Y= planned E as
well as planned S = planned I
[slide 29]
71
Approach
S+ sY = I
sY = I S
S=-C s=1-c
(1-c)Y = I + C = E
Equilibrium condition [slide 57]
1
Y=
E
1-c
72
Equilibrium Income
No matter which approach you

use, you will get the same
equilibrium condition.
Can you derive the equilibrium
condition if investment I is an
induced function of national
income Y, using the 2 approaches?
73
Equilibrium Income
Write down the investment function I first.

Then write down the saving function S.
Remember planned S = planned I when Y is
in equilibrium {Injection-Withdrawal}
Write down the investment function I as well

as the consumption function C. Together
they are the aggregate expenditure function
E. Remember planned Y = planned E when
Y is in equilibrium {Output-Expenditure}
74
Approach
75
Output-Expenditure
Approach
76
Y<C
Y=C
Y>C
Y=E
E=C+I
C=C+cY
E=C+I
C
I
S=- C
S = S + sY
I=I
77
Planned Y=Planned
E
Unintende
d
Inventory
Investmen
t E=C+I
S=S+sY
E=C+I
Unintended
Inventory
Disinvestment
Unintended
Inventory
Disinvestment
Planned
S=Planned I
Unintend
ed
Inventory
Investme
I=I
nt
78
Paradox of Thrift
This is an example of the fallacy of

composition
Thriftiness, while a virtue for the
individual, is disastrous for an economy
Given I = I
Given S = S + sY OR S = -C + (1-c)Y
Now, suppose S
Will Ye increase as well?
79
A rise in thriftiness causes a

decrease in national income but
no increase in realised saving.
S=S +sY
S= S+ sY
Excess Supply
I=I
Ye
80
Paradox of Thrift
If a rise in saving leads to a reduction in

interest rate and hence an increase in
investment (Think of the loanable fund
market), national income may not decrease
Ye will increase if I increase more than S

Ye will remain the same if I increase as much
as S
Ye will decrease if I increase less than S
81
I > S
S=S +sY
S= S+ sY
I=I
I=I
Ye
82
I = S
S=S +sY
S= S+ sY
I=I
I=I
Ye =Ye
83
I < S
S=S +sY
The reduction in Ye is
less than the case
when I does not
increase
S= S+ sY
I=I
I=I
Ye
What about the case if I is an induced function
of Y?
84

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Simple Keynesian Model

National Income Determination

National Income Identities [3.4]

National income, general price

Exogenous & Endogenous

the value is determined by forces outside

the value is determined inside the model

A function specifies the

C, c are exogenous variables

Can you express the 3

The parameter C is autonomous

Consumption function can also be a

Aggregate Demand &

the relationship between the total

the relationship between the total

Aggregate Demand &

Equilibrium: no tendency to change a

the values of the endogenous variabl

will remain unchanged in the absence

Aggregate Demand &

In P only but have no effect on

Aggregate Demand &

Aggregate Demand &

Aggregate Demand &

The Upward Sloping AS

When the economy is close to but

Aggregate Demand &

The Vertical AS (slide 18)

When full employment is attained Y =

Aggregate Demand &

The Horizontal AS (slide 19)

When output is far below Yf, the

National income Y is defined as the

using currently idle factors without

National Income Identities

An identity is true for all values of the

National Income Identities

National income Y received by

National Income Identities

Aggregate expenditure E is, by

Equilibrium is a state in which there is

firms and households are just willing to

What is the definition of GNP (/

Ex-ante Y > E Excess supply

planned output > planned expenditure

unexpected accumulation of stocks OR

In national income accounting, this amount

Actual (Realised)= Planned

Actual (Realised) Output = Actual Expenditure

Firms will reduce output

Ex-ante Y < E Excess Demand

planned output < planned expenditure

unexpected fall in stocks OR

However, in national income

Actual (Realised)= Planned

Actual (Realised) Output = Actual Expenditure

Firms will increase output

When there is excess supply, i.e., planned

Now, we will look at the 1st