Chapter Three

Introduction to Income Determination: The Multiplier

Prepared by:

Mohammad Abu-Zaineh, PhD.

Economics Department , Birzeit University

Please e-mail me any comments or corrections. mzaineh@birzeit.edu

Dr. Mohammad Abu-Zaineh

1 Econ 632

The Basic GDP Identity (I)

GDP can be viewed as a flow of either product or income. In either case the total value of goods & services produced in the economy is the same same. So we have the basic GDP identity. C + I + G + (X M) GDP C + S + T + Rf ( ) (1) For analytical purpose, lets assume that the economy is closed, so we have: C+I+G YC+S+T where Y is the standard symbol for GDP (2)

Dr. Mohammad Abu-Zaineh

2 Econ 632

The Basic GDP Identity (II)

In real term, where each component is deflated by the relevant price index, GDP identity becomes: c+i+gyc+s+t
(3)

Subtract c from both sides, we get the Investment-Saving Balance: i+gy s+t
(4)

where the l f h d side gives the amount of real y d h h left-hand id i h f l does not go to consumption expenditure & the right-hand side gives the amount of consumer s income that is not spent. Rewrite Eq. (4) i (4), i = s + (t g) (5) ( g p ( g g) where (t g) is the government surplus (or net government saving). Eq. (4) stats that the sum of private and public saving must equal private investment in the economy.
Dr. Mohammad Abu-Zaineh

3 Econ 632

Planned and Realized Investment

Investment component in Eq. (4) & (5) consists of two parts: - Intended investment, which is part of producers plans . - Unintended investment, unforeseen changes in inventories (inv) that arise because of unexpected changes in the level of sales. This gives us for i component in Eq (4): Eq. i = + inv
(6)

inv. can be (+), (-) or (0) depending on sales-production discrepancies Rewrite the investment-saving identity by substituting (6): + inv + g = s + t
(7)

& adding c back into (7), converts it into the national income identity: c + + inv + g = c + s + t
Dr. Mohammad Abu-Zaineh

(8)
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This is the first step towards converting the accounting identity of Eq. (4) & (5) into equilibrium conditions determining the level of y. The inv. is now a balancing item in the GDP identity (8) . For instance, if people d id t s and c, th in spending will F i t l decide to d the i di ill bring a drop in inventories as sellers meet the unexpected increase in demand by selling from inventories, so that inv < 0 (unexpected or i l t involuntary d decumulation of i l ti f inventories). t i ) The negative inv in Eq. (8) will balance the in c on the output side, while the s+c changes balance on the income side, maintaining the GDP identity at the pre-existing level of equilibrium. But this involuntary drop in inventory will cause sellers to production, leading to a change in y. Thus, the pre existing level of pre-existing y is no longer at an equilibrium level. So y is at equilibrium only when inv =0, that is when producers are selling as expected and realized investment equal planned investment (i = ).
Dr. Mohammad Abu-Zaineh 5 Econ 632

Basic Function Library

The next step in developing the conditions for income to be in equilibrium is to recognize that tax payments, consumer spending & savings are likely to depend in income (y). Particularly, Particularly tax revenue is a function of gross income

t = t ( y); with t (dt / dy) f 0

Consumption and saving are function of disposable income

(9)

c = c( y t ( y)) with c(d / d ) f 0 )); h dc ds s = s( y t ( y)); with s(ds / dy) f 0

(10) (11)

Dr. Mohammad Abu-Zaineh

6 Econ 632

The Determination of Equilibrium Income

Bring t th th B i together the material developed above into a simple t i ld l d b i t i l model of income determination. The saving-investment identity gives us + inv + g = s + t This E i l Thi Eq. is always true by definition, but income is at t b d fi iti b t i i t equilibrium level when inv=0, so that, + g = s(y t(y)) + t(y) s(y
(12)

The equilibrium level of y determined by (12) is stable, since inv 0. inv=0 If outside forces cause the system to move away from the equilibrium point, it will tend to settle back to equilibrium .

Dr. Mohammad Abu-Zaineh

7 Econ 632

The Determination of Equilibrium Income

At y0 (s+t) > ( +g), inv >0 producers output Equilibrium E ilib i At y1 (s+t) < ( +g), inv <0 g producers output Equilibrium At yE (s+t) = (+g), inv = 0 no incentive to output Equilibrium. E ilib i

Dr. Mohammad Abu-Zaineh

8 Econ 632

Shifts in the Saving Function (s) (s

To see how this simple model of income determination works , lets look at the effect of shifts in the saving function. For example consider the effect of an increase in the desire to save. save At y0 (s+t) > ( +g), inv >0 producers output until inv = 0 Equilibrium is reestablished at y1 Note that this brings a return to the original level of saving but a lower level of y y. Thus, when ( +g) is fixed, an exogenous i s l d to unchanged in leads t h d level of (s+t) but a lower level of y.
Dr. Mohammad Abu-Zaineh

9 Econ 632

Shifts in the Saving Function (s) (s

If we change the assumption that ( +g) is fixed independently of y, we can observe the possibility of whats called paradox of thrift . Suppose ( +g) is an increasing function of y. we can see that an autonomous shift upward in saving not only causes a in y but also brings a decrease in the realized s+t. +t Thus, an in the desire to save can lead ultimately to a in the realized s+t since the drop in y reduces planned investment. This is called paradox of thrift
Dr. Mohammad Abu-Zaineh 10 Econ 632

Shifts in the Level of Planned Investment () (

Now suppose that it is planned investment ( ) that shifts. At y0 (s+t) < (0+g) inv < 0 +g), producers production until inv = 0 Equilibrium is reestablished at y1 Thus , an increase in brings an increase in output (y).

Dr. Mohammad Abu-Zaineh

11 Econ 632

Shifts in the Level of Planned Investment () (

The size of the increase in y caused by an autonomous increase in i or g depends on the slope of (s+t) function: The steeper the (s+t) function is, which implies a large increase in (s+t) with a in y, the smaller the in y caused by i or g will be.

With a flat (s+t)0 function, y increases from y0 to y1. i f p (s+t) , With a steep ( )1 function, y increases from y0 to y2.

Dr. Mohammad Abu-Zaineh

12 Econ 632

Derivation of the expenditure multiplier

Changes in lead to a change in equilibrium y. g g q y The relation of the change in y (y1-y0) to the initial change in (i1-i0) depends on the slope of the (s+t) schedule. The ratio dy/d which gives the equilibrium y per unit change dy/d, in , is the multiplier for investment expenditure. Here, we develop the (simple) expenditure/spending multiplier for:
Changes in investment expenditure ( ) g p () Changes in government expenditure (g) Changes in the tax schedule (t)

Dr. Mohammad Abu-Zaineh

13 Econ 632

Derivation of the expenditure multiplier

For simplicity, we begin with a case where tax revenues are fixed sum (i.e., lump-sum tax t ) In this case we have the basic equilibrium condition:

c( y t ) + i + g = y = c( y t ) + s( y t ) + t

(13)

To find the in equilibrium y following a in , differentiate the lefthand side in the equilibrium condition (13), holding (g) and (t) constant: (13) If = 0.7, the multiplier = 3.3, c dy + di = dy di = dy c dy so a billion dollar increase in dy 1 = will yield $3.3 billion increase di = dy (1 c ) di 1 c in y.

1 dy = di 1 c

(15)
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Dr. Mohammad Abu-Zaineh

Derivation of the expenditure multiplier

The multiplier can also be related to [s+t = +g] diagram-shown above diagram shown above.

c( y t ) + i + g = y = s = c( y t ) + s( y t ) + t c( y t ) c( y t ) i + g = y c( y t ) = s( y t ) + t
Differentiate the right-hand side equation, holding t constant:

dy c(dy ) = s(dy ) dy (1 c ) = s(dy ) 1 c = s

So the value of the multiplier () is also, = 1 s

Dr. Mohammad Abu-Zaineh 15 Econ 632

Derivation of the expenditure multiplier

The multiplier can be shown using the [s+t = +g] diagram. The increase in by d raises y to y1. The ratio of the increase in to the y increase is the slope of the (s+t) function (s). That is dy/d = 1/s. s

Dr. Mohammad Abu-Zaineh

16 Econ 632

The multiplier in a dynamic setting p y g

The multiplier can also be viewed in a dynamic setting as the sum of a stream of expenditure increases following from an increase in autonomous spending (e.g., in or in g) (e g g). When expenditure is first raised by d, income & output rise directly by d; more goods are produced & the incomes of factors f f t of producing them go up. With taxes fixed, the net d i th t fi d th t income of these factors rises by d. But they in turn spend (cd) on, say groceries & so on, so that output & income of grocers go up b ( d) A i th recipients of this increment of spending by (cd). Again, the i i t f thi i t f di (cd) will spend (c) of it. This will go indefinitely with the increment becoming smaller:

dy = di + cdi + c(cdi ) +..... y dy = di (1 + c + c 2 + c 3 +...+ c n )

Dr. Mohammad Abu-Zaineh

(16)

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A General Expression of the multiplier p p

Return to the equilibrium condition with taxes exogenously given,

y = c( y t ) + i + g

(13)

A general expression of the can be obtained by differentiating Eq. (13), giving dy as a function of changes in , , g:
d y = c (d y d t ) + d i + d g d y = c d y c d t + d i + d g d y (1 c ) = c d t + d i + d g 1 c d t + d i + d g dy = = [ c d t + d i + d g ] (1 c ) (1 c )
(17)

So for example to obtain the multiplier for d, set d =dg=0. This gives
dy 1 = di (1 c )
Note that the same would also apply to dg, holding d & d constant.
Dr. Mohammad Abu-Zaineh 18 Econ 632

The Balanced-Budget Multiplier BalancedSuppose th t g & are raised by the same amount holding fi d S that i d b th t h ldi fixed. The effect on y can be found by substituting dg= dinto Eq (17):

cdt + di + dg cdg + dg 1 c dy = dg (1 c) (1 c) (1 c) dy = dg
So that the Balanced-Budget Multiplier = 1, implying that an equal increase in dg & d leaving the government surplus or deficit unchanged will raise equilibrium y by the dg increase (dy=dg).

Dr. Mohammad Abu-Zaineh

19 Econ 632

Taxes as a function of income

Return t the original specification of the tax function, which is R t to th i i l ifi ti f th t f ti hi h i t=t(y); tax revenues are an increasing function of gross income. In this more realistic case, the basic equilibrium condition is:

c( y t ( y )) + i + g = y = c( y t ( y )) + s( y t ( y )) + t ( y )
Subtracting c(y-t(y)) from each part of Eq (19) gives: Eq.

(19)

i + g = y c( y t ( y )) = s( y t ( y )) + t ( y )

(20)

To bt i T obtain a general form of the multiplier with a given tax structure, lf f th lti li ith i t t t differentiate the left-hand of Eq. (20) gives
dy = c ( dy t ( dy )) + di + dg dy = c (1 t ) dy + di + dg dy c (1 t ) dy = di + dg dy (1 c )(1 t ) = di + dg dy =
Dr. Mohammad Abu-Zaineh

di + dg (1 c )(1 t )

(21)
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Note that introducing a tax function has reduced the size of the multiplier. Thus a tax revenues that rise with y make the increase in disposable income that a person can either save or spend smaller than the increase in total income. income

di + dg di + dg dy = < dy = ( 1 c )( 1 t ) (1 c )

Dr. Mohammad Abu-Zaineh

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