Keynesian Model of Income Determination

(a) Explain what is meant by the equilibrium level of national income [8]

John Maynard Keynes created a revolution in economics in the 1930s when he argued that the economy is in fact led by demand.

In the Keynesian model which he presented, he demonstrated that the equilibrium level of national income is the position to which the economy will tend, and having reached that position it will be under no pressure to shift, ceteris paribus. Generally, if firms sold all output they planned to sell, and there is no unplanned building up or running down of stocks, the economy will be in equilibrium position. This can be analysed via two approaches: the income-expenditure approach, and the saving-investment approach, and the former will be analysed here in greater detail.

The income-expenditure approach can be presented by the following graph:



At output Y1, there is an excess of expenditure over national income. This means that there is insufficient output to meet the expenditure, and what results is an unplanned inventory disinvestment (running down of stocks). This will send a signal to firms to increase output, causing national income to rise. Such pressure will persist until national income reaches the equilibrium position of NY = YE, where planned savings is equal to planned investment.

At output Y2, expenditure is less than the output produced, and what results is an unplanned inventory investment, or building up of stocks. This then sends a signal to firms to cut down on production, thus national income will fall until it reaches the equilibrium position of YE.

In reality, the economy is rarely in exact equilibrium position; rather, what happens is that the economy is constantly heading towards the equilibrium position, and although it often does not land exactly in that position, the Keynesian Model does explain to us why it continues to move in the direction of the equilibrium.

Analyse the impact on the economy of an increase in (i) income taxes (ii) investment [17]

In order to analyse the impact of a rise in income taxes, we have to first understand the concept of the multiplier and the Marginal Rate of Withdrawals (MRW).

An injection in the economy will cause a bigger increase in national income, and this is often referred to as the multiplier effect. This is because part of the income generated from the injection will be passed on to other sectors of the economy, and this process continues, creating a “snowballing effect” – causing the larger rise in national income. The size of the multiplier hinges crucially on the MRW, which comprises the Marginal Propensity to Save, the Marginal Propensity to Import and the Marginal Rate of Taxation. Generally, the multiplier can be calculated by the formula k = (1/MRW).

Since MRTax forms a component of MRW, an increase in the income tax will cause MRW to rise (ie more ‘leakages’ from the economy), and this can be represented in the following diagram:



An increase in income taxes will increase the gradient of W, causing it to shift from W1 to W2. Thus, a rise in injection (I1 to I2) will only trigger a smaller multiplier effect (change in Y1 is bigger than change in Y2) due to the fact that more money has ‘leaked out’ from the circular flow of income, and not passed on.

Certainly, the extent of the decrease in the size of the multiplier depends on several factors. The bigger the proportion MRTax is of MRW, the sharper the decrease in the multiplier. At the same time, the above analysis can only work if MPS and MPimp remain constant (assume ceteris paribus).

An increase in income taxes may also impact the economy in other ways. For instance, it may lead to a fall in foreign investment as foreign investors are deterred from coming in due to the high rate of direct taxes. A sharp increase in income taxes may also lead to capital flight, as rich people move out of the country. Both these effects may lead to a fall in consumption and/or investment, and consequently national income further decreases. On the other hand, if the increase in income taxes is used to finance further government spending (eg balanced budget multiplier), then national income will rise by the amount of government spending.

Investment is arguably the most volatile component of national income, and broadly speaking it can be classified into two types: capital investment (spending on capital, eg building of factories, roads, etc) or inventory investment, which has been explained earlier on.

Since investment is a component of national income, an increase in investment will lead to a rise in national income, the extent to which will be determined by the multiplier effect. In the short run, a rise in investment will lead to actual growth, as the economy moves out towards the Production Possibilities Curve. Of course, if the economy is already at full employment level, then an increase in investment will only generate inflationary pressure.

If the increase in investment results in a rise in national income, the accelerator effect may kick in: that is, the rise in national income may trigger a (usually bigger) rise in investment.

In the long run, an increase in investment will boost the supply side, leading to potential growth, or a shift outwards of the Production Possibilities Curve. This means that the economy’s capacity to produce goods and services will increase in the long run.

If the rise in investment is a result of foreign investment, in the short run it may be considered a credit on the Balance of Payments, as foreign firms pump money into the economy (eg to build a factory). In the long run, however, it may be a debit on the BoP as the profit derived from the investment is repatriated abroad.

Ultimately, we have to consider if the increase in investment is for a worthwhile purpose. In Japan, for example, there may have been a rise in investment as the government aggressively invests in construction and road building, but many economists believe that such investments are not worthwhile (eg building of ‘roads to nowhere’) – leading us to suspect that the impact on the supply side is dubious at best.