what is income expenditure model

Demystifying the Income-Expenditure Model A Comprehensive Guide

The income-expenditure model, also known as the Keynesian cross, is a key concept in macroeconomics that explains the relationship between national income and aggregate expenditure in an economy This model provides powerful insights into macroeconomic equilibrium, consumption, and fluctuations in GDP. Read on for a complete overview of how the income-expenditure framework works along with examples

What is the Income-Expenditure Model?

The income-expenditure model aims to determine the equilibrium level of national income in an economy by analyzing the intersection of aggregate expenditure and output. It is based on John Maynard Keynes’ theory that total spending generates income, which further leads to more spending, fueling the circular flow of money.

The main components of the model are:

• National income (Y) – The total income earned by all factors of production in an economy. Measured by GDP.

• Aggregate expenditure (AE) – The total spending on consumption, investment, government spending and net exports at different levels of national income.

• 45-degree line (Y=AE) – The set of points where national income equals aggregate expenditure.

• Macroeconomic equilibrium – The point where aggregate expenditure equals national income. This determines the equilibrium GDP.

The model visually depicts aggregate expenditure as a function of national income and determines equilibrium where AE=Y. Thus, it provides a framework to analyze changes in spending behavior and their impact on GDP growth and contraction.

Key Features and Assumptions

Some salient features of the income-expenditure model are:

• Assumes the economy functions well below full employment, unlike classical economics.

• National income equals aggregate expenditure at equilibrium.

• Changes in autonomous expenditure affect equilibrium income.

• Savings is a function of income (Marginal Propensity to Save).

• Prices are assumed to be static in the short run.

The model relies on some basic assumptions:

• Closed economy with no foreign trade or government.

• Only two sectors – households and firms.

• Constant prices and technology.

• Wages and prices are fixed, so output adjusts to demand.

• Excess capacity exists in factors of production.

The Income-Expenditure Relationship

The fundamental relationship in this model is:

Y = C + I + G + NX

Where,

Y = National income
C = Household consumption spending
I = Business investment spending
G = Government spending
NX = Net exports (exports – imports)

This states that the total national income equals the sum of expenditures by all sectors in an economy.

The consumption component is further broken down as:

C = a + bY

Where ‘a’ is autonomous consumption expenditure independent of income (e.g. basic necessities) and ‘b’ is the Marginal Propensity to Consume (MPC), which indicates the amount consumed per unit of additional income.

Equilibrium GDP in the Model

The income-expenditure model determines equilibrium GDP at the intersection of the aggregate expenditure function and the 45-degree line where Y=AE.

At equilibrium, national income equals total spending. If income exceeds spending, inventories pile up triggering cuts in production and income. If spending exceeds income, inventory stocks deplete leading firms to increase production and income.

Thus, the equilibrium point balances production and consumption at full employment of resources.

How Changes in Spending Affect Equilibrium

The income-expenditure model provides insight into how changes in consumption, investment spending, government spending or net exports affect GDP equilibrium.

For example, an increase in autonomous consumption expenditure would shift the AE curve up vertically by the amount of increased spending. The new equilibrium GDP would occur at the intersection of the shifted AE curve and the 45-degree line at a higher level of national income.

Similarly, a decrease in taxes by the government (expansionary fiscal policy) raises disposable incomes. This causes the aggregate expenditure schedule to shift upwards, resulting in a multiplied increase in equilibrium GDP through the multiplier effect.

The slope of the AE curve is determined by the Marginal Propensity to Consume (MPC). A higher MPC implies a steeper AE curve. This means a given change in autonomous spending leads to a larger change in equilibrium GDP.

Conversely, a decrease in investment spending shifts the AE curve down and lowers equilibrium GDP. This triggers the reverse multiplier effect where a fall in spending contracts income further.

Using the Income-Expenditure Model

The income-expenditure model can analyze the impact of economic events on equilibrium GDP. For example:

• How would a cut in corporate taxes affect equilibrium GDP?

• If consumer confidence declines, what would happen to consumption and growth?

• How will a new stimulus package impact aggregate expenditure and income?

• What is the multiplier effect of increasing government spending by $100 billion?

The model can also determine the amount of expenditure needed to reach full employment GDP by closing the deflationary gap (between equilibrium and full employment).

Overall, the income-expenditure approach provides a framework to understand how equilibrium levels of national income and expenditure are attained and how fluctuations in spending by households, firms, government and foreign sector affect macroeconomic equilibrium.

The Keynesian Cross Diagram

The Keynesian cross diagram combines the aggregate expenditure function and the 45-degree income-expenditure line to depict equilibrium GDP graphically.

The x-axis represents national income and the y-axis measures aggregate expenditure. The point where the AE curve intersects the 45-degree line is the equilibrium GDP (Y=AE).

Figure 1: The Keynesian Cross Diagram

The AE curve slopes upwards from left to right, reflecting the relationship between expenditure and income. Its slope is determined by the Marginal Propensity to Consume (MPC). The flatter the AE curve, the lower the MPC.

A vertical shift in the AE curve leads to a new equilibrium at the intersection with the 45-degree line. An upward shift indicates higher spending at every level of national income.

The Keynesian cross diagram clearly depicts how changes in consumption, investment and government spending impact aggregate expenditure and equilibrium GDP.

Numerical Example

Consider the aggregate expenditure-national income equilibrium data:

National Income Aggregate Expenditure
$1000 $1100
$2000 $1900
$3000 $2500
$4000 $3100
$5000 $3900
$6000 $5000
$7000 $6300

Plotted on the Keynesian cross, the equilibrium occurs at $5000 where AE = Y:

Figure 2: Income-Expenditure Equilibrium Example

The equilibrium GDP is read off the x-axis at the intersection of the AE curve and 45-degree line. If AE exceeded GDP, firms would increase production. If GDP exceeded AE, unsold inventories would trigger cuts in output. Only when AE=Y is macroequilibrium attained.

Summary

In essence, the income-expenditure model:

• Explains macroeconomic equilibrium between national income and aggregate spending

• Shows GDP is determined by the level of aggregate expenditure

• Analyzes the impact of spending on equilibrium income

• Determines the multiplier effects of changes in expenditure

• Provides policy guidance to stabilize economic fluctuations

By visually representing this income-expenditure relationship and equilibrium, the Keynesian cross diagram provides indispensable insights into the workings of the macroeconomy.