Nat Income

Determination of
National Income
and the Role of
Fiscal Policy
Equilibrium Level of National Income
• The circular flow of income

A simplified circular flow of income model
Cd
Incomes Cd
Incomes Cd
W=S+T+M
J=I+G+X
Incomes Cd
W=S+T+M
• Effect on national income of a change in

injections and/or withdrawals
– J > W : national income rises
– W > J : national income falls
• The Keynesian diagram: the withdrawals

and injections approach
– the withdrawals curve
Deriving equilibrium national income
Cd, W, J
O
Y

– the injections curve
Cd, W, J
O
Y

– the injections curve
– equilibrium
Cd, W, J
a
J
b
O Y1 Y
Cd, W, J
W
c
d J
O Y2 Y
Cd, W, J
x
J
O
Ye Y
• The Keynesian diagram: the income and

expenditure approach
– the 45° line
Cd, W, J
Y = Cd + W
O
Y

– the 45° line
– the expenditure curve
Cd, W, J
Y = Cd + W
E = Cd + J
Cd
J
O
Y

– the 45° line
– the expenditure curve
– equilibrium
Cd, W, J
Y = Cd + W
E = Cd + J
Cd
e
W
f
O Y1 Y
Cd, W, J
Y = Cd + W
g E = Cd + J
h Cd
O Y2 Y
Cd, W, J
Y = Cd + W
E = Cd + J
Cd
z
x
J
O
Ye Y
The Multiplier
• The multiplier: introduction

– the circular flow of income and effects of
changes in injections
– definition of the multiplier: ΔY/ΔJ
• The withdrawals and injections

approach
– graphical analysis: shift in the J line
The multiplier: (a) a shift in injections
W, J
a
J1
O
Ye1 Y
W, J
W
b
J2
a
J1
O
Ye1 Ye2 Y
W, J
Multiplier = ∆ Y /
∆ J
=∆ Y/∆ W
= c−a / b−c
W
b
J2 J2
∆ J a ∆ W
J1 J1
c
O
Ye1 ∆Y Ye2 Y
The Multiplier

approach
– the formula : 1/mpw
– or : 1/(1–mpcd)
W, J
Multiplier = ∆ Y /
∆ J
=∆ Y/∆ W
= c−a / b−c
= 1/mpw
W
b
J2 J2
∆ J a ∆ W
J1 J1
c
O
Ye1 ∆Y Ye2 Y
The Multiplier

approach
– or : 1/(1–mpcd)
– graphical analysis: shift in the W line
The multiplier: (b) a shift in withdrawals
W, J
W1
a
J
O
Ye1 Y
W, J
W1
W2
a c
J
O
Ye1 Ye2 Y
W, J
Multiplier = ∆ Y / ∆ W
= c−a / a−b
W1
W2
a c
J
∆W b
O
Ye1 ∆ Y Ye2 Y
The Multiplier

approach
– or : 1/(1–mpcd)
• The income and expenditure approach
The Multiplier

• The withdrawals and injections approach
– or : 1/(1–mpcd)
• The income and expenditure approach
– graphical analysis: shift in the E line
The multiplier: (c) a shift in the expenditure curve
E, W, J
E1
O Ye1 Y
E, W, J
Y
E2
E1
O Ye1 Ye2 Y
E, W, J
Multiplier = ∆ Y / ∆ J Y
E2
= c−a / b−a
E1
c
∆Y
b
∆ J
a
O Ye1 Ye2 Y
Keynesian Analysis of
Unemployment and Inflation
• 'Full-employment' national income
• 'Gap' analysis
– the deflationary gap
The deflationary gap
W, J
J
O
Ye Y
W, J
Deflationary gap
W
c
d J
O YF
Ye Y
W, J, E
O YF
Ye Y
W, J, E
E
a
Deflationary gap
O YF
Ye Y
W, J, E
E
a
Deflationary gap
W
c
d J
O YF
Ye Y
• 'Gap' analysis
– the inflationary gap
The inflationary gap
W, J
W
J
O Ye Y
W, J
W
J
O YF Ye Y
W, J
Inflationary gap
W
g
J
h
O YF Ye Y
W, J, E
Y
E
O Ye Y
W, J, E
Y
E
O Ye Y
W, J, E
Y
E
Inflationary gap f
O YF Ye Y
W, J, E
Y
E
Inflationary gap f
W
g
J
h
O YF Ye Y
• 'Gap' analysis
– policy implications
• 'Gap' analysis
• Inflation and unemployment together
• 'Gap' analysis
– inflationary pressures before the full-
employment level of income
• 'Gap' analysis
– implications for shape of AS curve
Unemployment and inflation
AS1
Price level
O YF Y
Unemployment and inflation
AS2 AS1
Price level
O YF Y
• 'Gap' analysis
– implications for shape of AS curve
– effect of an increase in aggregate demand
The effects of increases in aggregate demand
on national output
AS
Price level
O YP
National output
The effects of increases in aggregate demand
on national output
AS
Price level
AD4
AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
National output
• The Phillips curve
– the shape of the curve
The original Phillips curve
9
7
Wage inflation (%)
1
Unemployment
– the position of the curve

The original Phillips curve
9
7
Wage inflation (%)
1
Unemployment
– policy implications of the curve

– the breakdown of the curve

– the breakdown of the curve
– recent relationship between inflation and

unemployment
Inflation (%) The breakdown of the Phillips curve?
26
24
22
20
18
16
14
12
10
8 65
6662
61 64 67
6
63
60
4
2 Unemployment (%)
26
24
22
20
18
16
14
12
10
65 Original Phillips curve

8
6662
61 64 67
6
63
60
4
2 Unemployment (%)
26
24
22
20
18 74
16
14
12 7 7
3 1
7
10 7 2
0
69
8 65
68
6662
61 64 67
6
63
60
4
2 Unemployment (%)
26
75
24
22
20
76
18 74 77
16 79
14
12 7 7
3 1 78
7
10 7 2
0
69
8 65
68
6662
61 64 67
6
63
60
4
2 Unemployment (%)
26
75
24
22
20
80
76
18 74 77
16 79
81
14
12 7 7
3 1 78 82
7
10 7 2
85
0
69 84
8 65 83
68
6662
61 64 67
6
63
60
4
2 Unemployment (%)
26
75
24
22
20
80
76
18 74 77
16 79
81
14
7 90
12 7
3 1 78 89 82
7
10 7 2
91 85
0
69 84
65 88
8 68 87 83
6662 95 86
92
61 64 67 94
6 93
63
60
4
2 Unemployment (%)
26
75
24
22
20
80
76
18 74 77
16 79
81
14
7 90
12 7
3 1 78 89 82
7
10 7 2
91 85
0
69 84
65 88
8 68 87 83
6662 00 98
95 86
03 97 92
61 64 67 94
6 96
63 02 99 93
60 01
4
2 Unemployment (%)
Keynesian Analysis of the Business Cycle
• The accelerator
– changes in national income and induced
investment
– the accelerator effect

The accelerator effect
• The accelerator
investment
– the instability of investment

(a) EU-15 Growth in GDP and business Investment
%
10
GDP growth (%)

2
-2
-4
-6
-8
(a) EU-15 Growth in GDP and business Investment
%
10
Business investment
8 (% change)
GDP growth (%)

2
-2
-4
-6
-8
(b) EU-15 Industry confidence indicator
10
-5
-10
-15
-20
-25
-30
• The accelerator
investment
• The multiplier/accelerator interaction

• The accelerator
investment
• The multiplier/accelerator interaction
• Fluctuations in stocks
• Determinants of the course of the

business cycle
– why do booms and recessions persist?
• time lags
• 'bandwagon' effects
– why do booms and recessions end?
• ceilings and floors
• echo effects
• the accelerator
• random shocks
• changes in government policy
The Role of Fiscal Policy
• The purpose of fiscal policy

– correcting a fundamental disequilibrium
– fine tuning
• Deficits and surpluses
– central government deficits and surpluses
– public-sector deficits and surpluses
– the PSNCR
– the national debt
UK public-sector borrowing
Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA




General government deficits/surpluses
and debt as % of GDP
General government deficits/surpluses
and debt as % of GDP
The Role of Fiscal Policy
• The use of fiscal policy

– automatic fiscal stabilisers
– discretionary fiscal policy

Effectiveness of Fiscal Policy
• Factors determining the effectiveness of

fiscal policy
– accuracy of forecasting
– effect on J and W
– effect of changes in J and W on national

income
– timing of the effects
– effects on the various macro objectives

• Discretionary policy
– problems of forecasting the magnitude of
the effects
• effects of changes in government expenditure
• crowding out
• effects of changes in taxes
• size of the multiplier and accelerator effects
• random shocks
– problems of timing and time lags
• various time lags
• policy may be destabilising
Fiscal policy: stabilising or destabilising?
Path (a): no intervention

Real national income
4
3
2
4
2 1
O
Time

Path (b): policy stabilises
4
3
2
4
2 1
O
Time

Path (b): policy stabilises
Path (c): policy destabilises

3
4
3
2
4
2 1
O
Time
• Side-effects of discretionary policy

– cost inflation
– welfare and distributive justice
– incentives
• A rules-based approach to fiscal policy
– a 'steady-as-you-go' policy
– the EU Stability and Growth Pact
Getting budget deficits down
9
Budget deficits as a % of GDP
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
3 France
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
Germany France
3
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
7 Italy
Germany France
3
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
7 Spain Italy
Germany France
3
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
Belgium
7 Spain Italy
Germany France
3
-11992 1993 1994 1995 1996 1997 1998 1999 2

9
Belgium
7 Spain Italy
Germany France
3
Netherlands
-11992 1993 1994 1995 1996 1997 1998 1999 2

• Side-effects of discretionary policy

– cost inflation
– welfare and distributive justice
– incentives
• A rules-based approach to fiscal policy

– a 'steady-as-you-go' policy
– the EU Stability and Growth Pact
– UK Labour government's 'Golden Rule'

Nat Income

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Nat Income

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Determination of

• The circular flow of income

• Effect on national income of a change in

– W > J : national income falls

• The Keynesian diagram: the withdrawals

• Effect on national income of a change in

• Effect on national income of a change in

• The Keynesian diagram: the income and

• The Keynesian diagram: the income and

• The Keynesian diagram: the income and

• The multiplier: introduction

– definition of the multiplier: ΔY/ΔJ

• The withdrawals and injections

• The multiplier: introduction

• The multiplier: introduction

• The multiplier: introduction

• The multiplier: introduction

– the shape of the curve

– the position of the curve

– the shape of the curve

– the position of the curve

– policy implications of the curve

– the shape of the curve

– the position of the curve

– policy implications of the curve

– the breakdown of the curve

– the shape of the curve

– the position of the curve

– policy implications of the curve

– the breakdown of the curve

– recent relationship between inflation and

65 Original Phillips curve

– the accelerator effect

– the accelerator effect

– the instability of investment

GDP growth (%)

GDP growth (%)

– the accelerator effect

– the instability of investment

• The multiplier/accelerator interaction

– the accelerator effect

– the instability of investment

• The multiplier/accelerator interaction

• Determinants of the course of the

• The purpose of fiscal policy

Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA

Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA

Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA

Source: www.statistics.gov.uk (National Statistics): Series RURQ and YBHA

• The use of fiscal policy

– discretionary fiscal policy

• Factors determining the effectiveness of

– effect of changes in J and W on national

– timing of the effects

– effects on the various macro objectives

Path (a): no intervention

Path (a): no intervention

Path (a): no intervention

Path (c): policy destabilises

• Side-effects of discretionary policy

-11992 1993 1994 1995 1996 1997 1998 1999 2

-11992 1993 1994 1995 1996 1997 1998 1999 2

-11992 1993 1994 1995 1996 1997 1998 1999 2

-11992 1993 1994 1995 1996 1997 1998 1999 2