THE INCOME EXPENDITURE MODEL

TOPIC STRUCTURE

1. Aggregate planned expenditure and output determination

2. Changes in autonomous expenditure and the multiplier process

3. The government and policy in the income-expenditure model

(i) the effects of government spending and taxation on equilibrium output

(ii) the balanced budget multiplier


The income expenditure model provides a simple representation of the ideas
contained in Keynes General Theory.

Central Principle: There is no guarantee that the level of planned expenditure would
be sufficient to purchase full-employment output.

If planned expenditure were equal to full-employment output, the economy would
operate at its full-employment position.

However, if total planned expenditure were to fall below full-employment output,
output itself would fall.

A shortfall of demand leads to a fall in output, creating unemployment.

The central feature of the income-expenditure model is the assumption that if total
planned expenditure is less than full-employment output, output itself will passively
adjust, at constant prices, to the current level of demand.

AGGREGATE PLANNED EXPENDITURE AND OUTPUT
DETERMINATION.

Total planned expenditure

I C E + =

Consumption function

Y c c C
1 0
+ = (1) = Autonomous Consumption
0
c
= Marginal Propensity to consume
1
c
0 1
1
< < c




1

















Implied saving function

C Y S =

Y c c S ) 1 (
1 0
+ = = Marginal Propensity to Save ) 1 (
1
c
0 1 ) 1 (
1
< < c

Investment Function

0
i I = (2) i = exogenously given value of planned investment
0

Total Planned Expenditure

I C E + =

Y c i c E
1 0 0
+ + = (3)















2
Goods Market Equilibrium

E Y = (4)
Alternatively

I S =

Determination of equilibrium output
Combine the diagrammatic representations of equations (3) and (4)
















Equilibrium level of output = Y
1

Any other level of output is associated with either deficient or excess demand

















Y E E Y Y < = = : : for all Y Y E Y < > ,
1


Y E E Y Y > = = : : for all Y Y E Y > < ,
1


3
Algebraic Representation

Combine GME condition (4) with expenditure function (3)

Y c i c E Y
1 0 0
+ + = =

Subtract c from both sides Y
1

0 0 1
i c Y c Y + =

Factorising

0 0 1
) 1 ( i c Y c + =

Dividing through by ( ) 1
1
c

) 1 (
1
0 0
1
c
i c
Y

+
= (5)

Alternative derivation using alternative representation of GME condition i.e.
I S =

0 1 0
; ) 1 ( i I Y c c S = + =

Substituting into I S =

0 1 0
) 1 ( i Y c c = +

0 0 1
) 1 ( i c Y c + =

) 1 (
1
0 0
1
c
i c
Y

+
= (5)

CHANGES IN AUTONOMOUS EXPENDITURE AND THE MULTIPLIER
PROCESS

Initial situation Y
F
Y =

For some reason planned expenditure (e.g. investment) falls

New investment function

i i I + =
0
(2) where 0 < i

4
Total planned expenditure

Y c i i c E
1 0 0
+ + + = (3)


















How does the magnitude of the fall in Y compare with that of the fall in ? ) ( i I

Algebraic Representation

Using expenditure function (3) and GME condition (4).

Y c i i c Y
1 0 0
+ + + =

Subtracting from both sides: Y c
1

) ' 5 (
1
1
0 0
2
c
i i c
Y

+ +
=

Subtracting (5) from (5)

) 1 ( ) 1 (
1
0 0
1
0 0
1 2
c
i c
c
i i c
Y Y Y

+ +
= =

0
) 1 (
1
<

=
c
i
Y for 0 < i

Can write as:

) 1
1
1
c
i Y

=

5
1 ) 1 ( 0 1 0
1 1
< < < < c c

1
) 1 (
1
1
>

c
the multiplier

| Y | > | | i

Fall in output exceeds fall in investment

EG 5
1
1
2 . ) 1 ( , 8 .
1
1 1
=

= =
c
c c

If 50 10 = = Y i

( ) 50 | | 10 | | = = Y i

How does affect the value of the multiplier? As increases in value so does the
multiplier
1
c
1
c

e.g. 9 .
1
= c then 10
1
1
1
=
c


Suppose the MPC were zero i.e. 0
1
= c

Total planned expenditure:
0 0
i c E + =






















6



i.e. i Y =
multiplier = 1
1
1
1
=
c


THE MULTIPLIER PROCESS


Assume Y adjusts with delay of one period to E




Consumption
Function
E
Exogenous Decline in Demand
Y
























i c i c c i Y
i
+ + + =
3
1
2
1 1
..

Providing : 1
1
< c

) 1 (
1
c
i
Y

=

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THE GOVERNMENT AND POLICY IN THE INCOME-EXPENDITURE
MODEL

Real value of government spending

G G =

Real value of taxation

Y t t T
1 0
+ =


0
t = autonomous taxation
Y t
1
= income-related tax revenues
1
t = marginal tax rate

Total planned expenditure

G I C E + + =



Consumption function

D
Y c c C
1 0
+ = (1)

=
D
Y private sector real disposable income
=
D
Y T Y
=
D
Y Y t Y t Y t t Y
1 0 1 0
+ =
=
D
Y Y t t ) 1 (
1 0
+


Substituting expression for Y ,
D
=
D
Y Y t t ) 1 (
1 0
+ into consumption function,

D
Y c c C
1 0
+ =

] ) 1 ( [
1 0 1 0
Y t t c c C + + =
Y t c t c c C ) 1 (
1 1 0 1 0
+ = (1)

A one unit increase in autonomous taxation reduces consumption by units
1
c


A one unit increase in national income increases disposable income by 1 units,
therefore increases consumption by
1
t
) 1 (
1 1
t c units.


8


















Investment

o
i I = (2)

Government Expenditure

G G = (3)

Expenditure Function

G I C E + + =

Y t c G i t c c E ) 1 (
1 1 0 0 1 0
+ + + = (4)

Goods Market Equilibrium

E Y = (5)

Determination of equilibrium output
Combine the diagrammatic representations of equations (4) and (5):











9



















Algebraic derivation of equilibrium output
Substitute (4) into (5):

Y t c G i t c c Y ) 1 (
1 1 0 0 1 0
+ + + =

Subtract c from both sides ) 1 (
1 1
t

G i t c c Y t c Y + + =
0 0 1 0 1 1
) 1 (

Factorise the LHS

| | G i t c c Y t c + + =
0 0 1 0 1 1
) 1 ( 1

| | ) 1 ( 1
1 1
0 0 1 0
1
t c
G i t c c
Y

+ +
= (6)

Differences compared to corresponding expression in model without government
spending or taxation

1. presence of G and t in numerator
o
2. presence of t in denominator
1


Changes in government spending and the autonomous expenditure multiplier

| | ) 1 ( 1
1 1
0 0 1 0
1
t c
G i t c c
Y

+ +
= (6)

10
Increase in government spending

G G G + =

| | ) 1 ( 1
1 1
0 0 1 0
2
t c
G G i t c c
Y

+ + +
= (6)

subtracting (6) from (6)

| | ) 1 ( 1
1 1
t c
G
Y


=

or

| |
G
t c
Y

=
) 1 ( 1
1
1 1



The autonomous expenditure multiplier with income-related taxes

Multiplier
| | | |
|
|
.
|

\
|
+
=

=
1 1 1 1 1
1
1
) 1 ( 1
1
t c c t c


Has two important properties

1. Is greater than one in value
2. Is smaller than in the absence of income-related taxes, i.e.

| | ) 1 (
1
) 1 ( 1
1
1
1 1 1
c t c
<

<

EG 25 . 8 .
1 1
= = t c

1
1
1
c
= 5
2 .
1
=


| | | |
5 . 2
6 . 1
1
) 75 (. 8 . 1
1
) 1 ( 1
1
1 1
=

=
t c


Income-related taxes act as an automatic stabiliser

11
Changes in autonomous taxation and the autonomous tax multiplier

| | ) 1 ( 1
1 1
0 0 1 0
1
t c
G i t c c
Y

+ +
= (6)

Increase in autonomous taxation

0 :
0 1 0 0
> + + = t Y t t t T

| | ) 1 ( 1
) (
1 1
0 0 0 1 0
2
t c
G i t t c c
Y

+ + +
=

Subtract (6) from 6:

| | | |
(

+ +

+ + +
=
) 1 ( 1 ) 1 ( 1
) (
1 1
0 0 1 0
1 1
0 0 0 1 0
t c
G i t c c
t c
G i t t c c
Y

| | ) 1 ( 1
1 1
0 1
t c
t c
Y


=

or

| |
o
t
t c
c
Y


=
) 1 ( 1
1 1
1


Autonomous tax multiplier:
| | ) 1 ( 1
) (
1 1
1
t c
c





Autonomous tax multiplier Autonomous expenditure multiplier

| | ) 1 ( 1
1 1
1
t c
c

<
| | ) 1 ( 1
1
1 1
t c


Explanation:

One unit increase in government spending on goods and services increases total
planned expenditure directly by one unit.

One unit increase in taxation reduced total planned expenditure by units.
1
c

The Balanced Budget Multiplier

Effect on economy of change in government spending financed entirely by change in
taxation.
12

Equilibrium output

| | ) 1 ( 1
1 1
0 0 1 0
1
t c
G i t c c
Y

+ +
=

Consider increase in G combined with identical increase in
0
t

New values of G and taxation

Y t t t T G G G
1 0 0
: + + = + =

New equilibrium level of income

)] 1 ( 1 [
) (
1 1
0 0 0 1 0
2
t c
G G i t t c c
Y

+ + + +
=

| | ) 1 ( 1
1 1
0 1
t c
t c G
Y


=

For balanced budget fiscal expansion G t =
0


| | ) 1 ( 1
1 1
1
t c
G c G
Y


= =
)] 1 ( 1 [
) 1 (
1 1
1
t c
G c


>0

i.e. the policy induces an expansion in output.

















The actual shift of the expenditure function is the net effect of the shifts from E, to E
and from E, to E

13















The Role for Policy in the Income-Expenditure Model

The income-expenditure model has no mechanism which ensures that the economy
equilibrates at full-employment: therefore there is a positive stabilisation role for
macroeconomic policy.

This role is played by fiscal policy. By adjusting government spending and/or
taxation the government can manipulate total planned expenditure to bring about full
employment equilibrium.

Expansionary fiscal policies need not be at the expense of increased government
budget deficits.













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