# Income-expenditure model and the multiplier - The IS-LM Model

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## Table of Contents

1.) Income-expenditure model and the multiplier
a) Please explain the income-expenditure model for a closed economy whithout a government with the help of a figure
b) The following data for consumption (C) and private net investment is given: C = 50 + 0.9Y, I = 100. Please calculate the equilibrium values for income, consumption, saving and investment, and derive the investment-income multiplier.
c) Please explain the paradox of thrift making use of the example in 1b.
d) What happens to equilibrium income, consumption, saving and investment, when we introduce government spending (G = 100), completely financed by a tax on wealth, into the model? Explain your results.

2. ) The IS-LM model
a) Please explain the IS-LM model with the help of a figure. What are the basic assumptions and what are the main conclusions?
b) Please explain how fiscal and monetary policies can affect the equilibrium. Which policy should be applied in a deep recession?
c) Which are the problems of the IS-LM model in your view?

3. ) Money and credit market from a modern Keynesian perspective
a) Explain the relationship between the money and the credit market from a Keynesian perspective making use of a 4-quadrant figure.
b) How can the central bank affect the equilibrium on the credit market?
c) Discuss the effectiveness of expansionary monetary policies in a severe crisis.

“Ideas shape the course ofhistory.”

John Maynard Keynes'

## 1.) Income-expenditure model and the multiplier

### a) Please explain the income-expenditure model for a closed economy whithout a government with the help of a figure

The income-expenditure model is like all other models a good method to analyze and demonstrate complex (economical or non- economical) coherencies. Like the architect draws a model of something he wants to build, we set up a model for an economical environment (e.g.), for both it is easier to have an overview on the models as to either build the whole house e.g. or for us to analyze the real macroeconomic situation of an economy with all its details.

Before explaining the income-expenditure model we will have a look at John Maynard Keynes' General Theorie. There is no doubt that Kenyes is one of the most important figures in the history of economics. His book,,The General Theorie ofEmployment,

Interest and Money", which was published in 1936, had a huge impact on the world of economics and influenced many thinkers and economists not just in that era and in the 20th century, but also until today, and it will definitively be important in the future of mankind as well, especially regarding economics and the role of government in society.

Keynes introduced several models, criticizing the neo-classical view, e.g. Say's Law, which states that aggregate supply in a market economy will equal aggregate demand. In contrast to that Keynes stated the possibility not the whole income is spent for output, but possibly held liquid.

One of the models Keynes introduced was the income-expenditure model. In this model the interrelation of income and expenditure of an economy are demonstrated.

The basic assumptions of this model are the follwing:

The Consumption function

The Linear Consumption function

The Income function

The Saving function

The Effective Demand function

The Consumption function C = C(Y)

The Linear Consumption function Abbildung in dieser Leseprobe nicht enthalten]

Keynes statet that the income affects on the conumption behaviour of the households, not the interest rate, as the neo­classical therie states. Therefor there is 'c' in the linear consumption function which is dC/dY (0<dC/dY<l). 'c' is the multiplier which is multiplied by the income and shows us how much of every marginal earned l money unit (in the following Dollar) is spent. 'Ca' is the autonomous consumption, which is the amount of money people will spent for consumption no matter how much income they have, even if they have no income, for an easier understanding it is sometimes recommended to assume that households without any income spent their Ca out of savings they have, but this is just mentioned for an easier understanding. Fortunately in our example the households do have an income.

The Income function Y = C(Y)+S(Y)

The Income function shows the income which is either consumed or saved. Therefor we can also say that every Dollar which isn't consumed, will be saved. Y-C=S

The Saving function S = Abbildung in dieser Leseprobe nicht enthalten]

In the saving function the autonomous consumption is negative. The reason is that up to this amount, the household cannot save money, this is the amount they will consume definitively, as mentioned earlier. The term in parentheses (l-c) shows us the marginal propensity to save. This multiplier is calculated by substituting c from l, this is because the money that isn't spent for consumption will be saved.

The Effective Demand functionAbbildung in dieser Leseprobe nicht enthalten]

The effective demand function is the linear consumption function with the investments of the firms added.

The multipliers MPC and MPS sum up to l.

MPC+MPS = l

MPC and MPS depend on the behavior of the households.

Normally, in a situation were the households have bad expectations regarding the future, MPC will decrease and MPS will raise. This happens because the households want to keep their autonomous consumption in the future, so they consume less.

The income-expenditure model is shown in figure l below:

illustration not visible in this excerpt

Figure 1 - The income-expenditure model

The abscissa shows the national income, which we also can define as the production or as the output (Y). The ordinate shows the consumption of the households (C), as well as the investments of firms (I) and the output (Y). The 45 degree line starting in the origin of the coordinate shows the equilibrium where aggregate demand is equal to aggregate supply which is the same as if we should state that the whole income will be spent. 'C' is the consumption function, it doesn't start in the origin of the coordinate because of the autonomous consumption 'Ca', which is the interception with the ordinate. 'C+I' is the effective demand function, which shows us the sum of investments of the firms and the linear consumption function. The expenditure of the households is the linear consumption function with the investment of the firms added (because their expenditure is consumption plus savings and savings equal investment of firms). In this figure Yo is the interception between the equilibrium 45 degree line and the effective demand function 'C+I', this point is the equilibrium of the goods market. And here is one of the key assumptions ofKeynes income-expenditure model, which states in contrast to the neo-classical view, that the equilibrium in the goods market doesn't depend on the equilibrium in the labour market.

In figure 2 we see the saving function, 'S' starts in a negative section of the ordinate because of the autonomous consumption.

illustration not visible in this excerpt

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Details

Title
Income-expenditure model and the multiplier - The IS-LM Model
Subtitle
And: Money and credit market from a modern Keynesian perspective
College
Berlin School of Economics and Law
Grade
2,3
Author
Year
2010
Pages
21
Catalog Number
V207714
ISBN (eBook)
9783656351368
ISBN (Book)
9783656352020
File size
764 KB
Language
English
Tags
is-lm model model, income expenditure model, macroeconomics, money, credit, market, modern, keynesian, view, perspective, business, cycle
Quote paper
Mohammad Hossein Zavareh (Author), 2010, Income-expenditure model and the multiplier - The IS-LM Model, Munich, GRIN Verlag, https://www.grin.com/document/207714

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