Income Determination

in
Closed and Open Economy
Two Sector Model
A two sector model consists only household sector and
business Sector.
Assumptions:
1. There is existence of only two sectors (i.e. households and
business sectors) in an economy.
2. Due to absence of government intervention in the economy,
there are no taxes and expenditure.
3. There is absence of foreign trade.
4. The total profit is distributed as dividend with zero retained
earnings.
5. Both prices, factor and product, remain constant.
6. The supply of capital and technology are given.
Two Sector Model
This model can be explained in the following two approaches:
1. AD-AS Approach
2. Saving-Investment Approach
Two Sector Model
This model can be explained in the following two approaches:
1. AD-AS Approach
Aggregate supply (AS) of final product is GDP or Y. As Y is either
consumed or saved at all level of income Y = C + S
Thus, AS curve is a 45 line showing Y = C+S at all level of
income.
Aggregate demand (AD) for final product is aggregate
expenditure (AE) which consists of consumption expenditure
and investment expenditure. i.e., AD = AE = C + I
Consumption (C) curve is upward slopping started from the
vertical axis implying that consumption is not zero at zero level
of income.
Here, investment refers to autonomous investment. Hence, AD
curve is parallel to consumption curve.

Two Sector Model
In the figure, C + I curve represents
AD and C + S curve represents AS.
point E is the equilibrium point
where AD curve intersects AS
curve.
Thus, OY is the equilibrium level of
output.
At any level of output more than or
less than OY there is no equilibrium
in the economy.
E
C
Y
O
C+I
Y=C+S
X
Y
National Income
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Autonomous Consumption
Two Sector Model
At any level of output less than OY, AD>AS
since C + I curve lies above C+ S curve.
When AD>AS, there will be decline in
inventories of goods below the desired
levels. This unintended fall in inventories
will induce the firms to expand their
output of goods at the desired levels.
This process of expansion in output under
the pressure of excess demand will
continue till national income is reached at
OY.
On the contrary, the level of national
income cannot be greater that OY because
at any level greater than OY, AD<AS of
output. This will cause the increase in
inventories of goods with the firms
beyond the desired levels.
This will reduce total output or national
income until the level OY is reached.
Thus, OY is the equilibrium level of
national income.
E
C
Y
O
C+I
Y=C+S
X
Y
National Income
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Autonomous Consumption
Two Sector Model
2. Saving = Investment Approach
Under this approach, national income (Y) is
determined at the point where S = I.
In the figure, point E is the equilibrium where
autonomous investment function (I) equals saving
function (S). Hence, equilibrium level of income is
OY.
At any level of output more than OY, S>I. It means
that people are consuming and spending less. Thus,
AD<AS. This will lead to the accumulation of
unintended inventories with businessman. To avoid
further accumulation of inventories, business will
reduce production.
Consequently, output, income and employment
will be reduced till the equilibrium level of income
OY is reached where S = I.
On the contrary, at any level of output less than OY,
investment exceeds saving. It implies that AD>AS.
As a result, business firms will decrease inventories
held by them. To stop further reduction in their
inventories, they will increase production.
Consequently, output, income and employment
will increase in the economy and the equilibrium
level of income OY will be again reached.
E
I
Y
O
S
X
Y
National Income
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