national income equilibrium

TOPIC 3 : 1 TOPIC 3 NATIONAL INCOME EQUILIBRIUM

3.1 Concepts of Equilibrium and Disequilibrium : 2 3.1 Concepts of Equilibrium and Disequilibrium Equilibrium Occurs when there is no tendency for change Refers to the situation in which neither consumers nor firms have any incentive to change their behavior Refers to the state when: AGGREGATE OUTPUT (AS) AGGREGATE EXPENDITURE (AD) = INJECTIONS (I) = WITHDRAWAL (S)

Aggregate Demand (AD) : 3 Aggregate Demand (AD) Or Aggregate Expenditure The total demand for goods and services in economy 4 components in AD : consumption, investment, government purchases, net exports

Aggregate Supply (AS) : 4 Aggregate Supply (AS) Or Aggregate Output The total quantity of goods and services produced in an economy AS and income thus tend to increase

AS and AD : 5 AS and AD When AD > AS producers will increase output to meet the excess demand When AS > AD sellers are unable to sell everything they produced Firms cut back production and output Income earned in the nation will tend to fall So equilibrium will occur when AD = AS

Injections (I, G, X) : 6 Injections (I, G, X) Addition of spending to the income Include investment, government purchase and exports

Leakages (S, T, M) : 7 Leakages (S, T, M) Withdrawals of potential spending from the income-expenditure stream Includes savings, tax payment and imports

Injections and Leakages : 8 Injections and Leakages Any excess of leakages over injection will cause a shortage of total spending forcing producers to cut back production Any excess of injection over leakages will cause an excess of total spending inducing producers to increase output So equilibrium is reached when total injection = total leakages

3.2 Consumption Theory : Conventional and Islamic : 9 3.2.1 Keynesian Theory of Consumption and Saving ( conventional ) Consumption Spending on goods and services by consumer The main component of aggregate expenditure Most important determinant of consumer spending is disposal income (Yd) 3.2 Consumption Theory : Conventional and Islamic

3.2.1 Keynesian Theory of Consumption and Saving : 10 3.2.1 Keynesian Theory of Consumption and Saving Saving The part of the income that a household does not consume Basic thing for consumer to use their income is to consume or to save So we have the simple conclusion: Income = Consumption + Saving Y = C + S

3.2.1 Keynesian Theory of Consumption and Saving : 11 Average Propensity to Consume (APC) That fraction of total income which is consumed How to calculate APC: 3.2.1 Keynesian Theory of Consumption and Saving APC = Consumption Income C Y =

3.2.1 Keynesian Theory of Consumption and Saving : 12 3.2.1 Keynesian Theory of Consumption and Saving Average Propensity to Save (APS) That fraction of total income which is saved How to calculate APS: APS = Saving Income S Y =

3.2.1 Keynesian Theory of Consumption and Saving : 13 3.2.1 Keynesian Theory of Consumption and Saving Relation between APC and APS APC will fall and APS will increase as Income increase Because as income rises, consumption will increase but by a smaller amount APC + APS = 1

3.2.1 Keynesian Theory of Consumption and Saving : 14 3.2.1 Keynesian Theory of Consumption and Saving Marginal Propensity to Consume (MPC) Is the ratio of a change in consumption to a change in income MPC = Change in Consumption Change in Income C Y =

3.2.1 Keynesian Theory of Consumption and Saving : 15 3.2.1 Keynesian Theory of Consumption and Saving Marginal Propensity to Save (MPS) Is the ratio of a change in savings to a change in income The sum of MPC and the MPS for any given change in income must always be 1 MPS = Change in Saving Change in Income S Y = MPC + MPS = 1

3.2.1 Keynesian Theory of Consumption and Saving : 16 Consumption Function Mathematical relationship between consumption spending and disposal income General form of the consumption: Where : C – consumption Expenditure Yd - disposal income a – autonomous consumption * b – slope of the consumption function which corresponds to the MPC 3.2.1 Keynesian Theory of Consumption and Saving C = a + b Yd *That part of consumption when the level of income is 0

3.2.1 Keynesian Theory of Consumption and Saving : 17 Saving Function As savings is that part of disposal income that is not spent General form of the consumption: Where : S – Saving Yd - disposal income -a – financed out of savings when Y = 0 1- b – is (1 – MPC) which is the MPS 3.2.1 Keynesian Theory of Consumption and Saving S = -a + (1-b) Yd

Consumption and Saving Function (graphically) : 18 Consumption and Saving Function (graphically) E Y= C 45° C = a + bYd AD = AS Yd Yd a -a S C S = -a +(1- b)Yd Ye Dissaving area Saving area Dissaving area Saving area

Consumption and Saving Function (graphically) : 19 The 45º line shows all the points where C = Yd (Y=Yd in an economy with no government -no tax) The vertical distance between the C line and the C=Yd line, therefore represent S for any level of Yd When Yd less than Ye, C > Yd, so S is negative (dissavings) When Yd equals to Ye, C=Yd, so S is 0, the C line intersects with the 45º line When Yd exceeds Ye, C

Non Income Determinants of consumption and saving : 20 Non Income Determinants of consumption and saving Wealth – includes real assets The greater amount of wealth households have accumulated The larger will be the amount of consumption The weaker the incentive to save Interest rate Lower interest rate reduce the cost of borrowing Likely to stimulate spending Household expectation about the future Expectation of increasing price and product shortage triggers more spending now Expectation of rising money income also make them freer in their current spending

Shift in the Consumption and Saving Schedule : 21 Shift in the Consumption and Saving Schedule 45° C0 C2 C1 S1 S0 S2 Disposal Income Disposal Income C S Y = C Y2 Y1 Y0

Shift in the Consumption and Saving Schedule : 22 A change in any one or more of non income determinants will cause the C and S schedule to shift If household consume more, they are saving less So that, C shift up (C0 to C1 ) but S will downward shift (S0 to S1 ) Conversely, if household consume less, they are saving more So that, C shift downward (C0 to C2 ) but S will shift up (S0 to S2 ) Shift in the Consumption and Saving Schedule

3.2.2 Fahim Khan’s Theory of Consumption and Saving (Islamic Perspective) : 23 According to Fahim Khan, Muslim consumption is obviously different from that of a conventional consumption pattern Islam has own distinct ethical, sociological, cultural framework Islam associates belief in the day of judgement and the life hereafter Spending in Islam includes consumption as well as investment expenditure, transfer lending and saving 3.2.2 Fahim Khan’s Theory of Consumption and Saving (Islamic Perspective)

Objective of Consumption is Islamic Perspective : 24 Objective of Consumption is Islamic Perspective Every individual should consume enough economic goods to lead an efficient life Certain prohibited goods should not be consumed Consumption of economic goods must not be extravagant, just as excessive indulgence in luxurious living is discourage Consumption of economic goods and consequent satisfaction, must not be ultimate objective of individuals

Time-scale of Consumption in Islamic Perspective : 25 Consumption today has its immediate effects in life-to-come An increase in income may lead to an increase in consumption and benefits now and in the hereafter If the alternative uses of the consumption is used which is encouraged in Islam such as Free loan, sedeqah,spending for welfare etc Muslim has to expand some of the time in the remembrance of God Time-scale of Consumption in Islamic Perspective

Ethic of Consumption in Islamic Perspectives : 26 Ethic of Consumption in Islamic Perspectives According to Islam, Allah’s bounties belong to all mankind Some of these bounties may be under the authority of particular people Doesn’t mean they can utilize them for themselves alone The act of uses or consumption of goods things is in itself considered as a virtue in Islam The Islamic teaching recommend a moderate and balance pattern of consumption and spending The pattern which lies in between miserliness and extravagance

Consumption and Saving (Islamic Perspective) : 27 Consumption and Saving (Islamic Perspective) Islamic consumption expenditure (spending) is divided into two types Consumption expenditure for one own self and family (E1) Consumption expenditure for others (E2) Total expenditure is: E = E1 + E2 E1 – includes present consumption C1 and future consumption S1 E2 – includes present consumption C2 and future consumption S2 E1 = C1 + S1 E2 = C2 + S2

Consumption and Saving (Islamic Perspective) : 28 A muslim consumer free to decide how much of his income will be spend on these two expenditure Rational spending Degree of God fear ness or God consciousness (Takwa) A rational Muslim will never hoard his savings because with zakat, his saving will slowly reduce Thus, all savings will be invested resulting an Islamic economy will have a higher rate of saving and higher rate of investment compared to the conventional economy Consumption and Saving (Islamic Perspective)

3.3 Investment Theory : Conventional and Islamic : 29 3.3.1 Investment Theory : Conventional Process of producing and purchasing capital or investment goods, also the creation of any output that is not immediate consumption Purchase by firms of new buildings and equipment and addition to inventories Inventories : Stock of finished goods waiting to be sold 3.3 Investment Theory : Conventional and Islamic

Slide 30 : 30 Types of Investment in Relation to Income Autonomous Investment Amount is fixed and not effected by income Others factors can effected such as interest rate, profit or business expectation(Y I unchange ) Ex: depreciation on capital goods Induced Investment [I = f (Y)] As national income increase, the population will increase too People will demand more goods It will induce investment to meet the demand The value of investment directly related to national Income (Y I )

Autonomous Investment and Induce Investment : 31 Autonomous Investment and Induce Investment Induced Investment Income Autonomous Investment Investment

Slide 32 : 32 Concepts Gross Investment Net Investment = Replacement Investment or Depreciation + Net Investment = Gross Investment - Replacement Investment or Depreciation

Determinant Of Investment : 33 Determinant Of Investment Firm spend money on new investment if they expect the investment to yield a profit over all of its cost The price and the productivity of capital goods The price and productivity of capital equipment influence the profitability of investment in that equipment When the price of capital goods reduce its mean investment more profitable If the capital equipment more productive will make investment more attractive

Slide 34 : 34 Expectation of the future Investment decision depends on the future demand condition and future cost condition Expected demand important because the profit we made depends on how much we can sell Cost also important to make sure profit will maximum when cost is reduce Lower cost can motivate the firms to produce more and but it depend to a market price

Slide 35 : 35 Innovations The changes in constantly and dramatically as inventions are put into commercial use We call it as innovations New innovations, new ways of producing and embodied in new equipment So we need the investment either for modify existing equipment or create whole new equipment More innovation, more to invest

Slide 36 : 36 Profits We use the past profit as re-investment So the firm are not paid out to the owners They use the profit to invest for the next production in new capital equipment Higher current profits provide a larger flow of funds available for re-investment The rate of Interest The rate of interest measures the opportunity cost of capital to the firm The lower interest rate the more firms will invest

Slide 37 : 37 Government Policies This depends on the policies that government is undertaking To promote local as well as foreign investment, the government can give tax exemption or reduction Various forms of incentives could also be given to investors Rate of return Any investment will be taken if it is profitable If the cost of investment is higher than the expected return from investment, its mean unprofitable

NET PRESENT VALUE CONCEPT : 38 NET PRESENT VALUE CONCEPT The values that will be earned in the future value at present cost of price This mean that the future Ringgit have price today Present value : compound and discounted value Compound Discounted R = PV . (1+ r)t PV = R/ (1+ r)t

NET PRESENT VALUE CONCEPT : 39 NET PRESENT VALUE CONCEPT Compound we use PV to get the future amount of investment, with interest rate and time given Discounted We calculate the PV using the future amount of investment with interest rate and time given R = PV . (1+ r)t PV = R/ (1+ r)t

NET PRESENT VALUE CONCEPT : 40 Q: What is the amount of investment in five years if present value is RM 6209.2 with interest rate 10% ? Q: What is the present value of a claim on RM10 000 in five years with interest rate 10%? NET PRESENT VALUE CONCEPT

NET PRESENT VALUE CONCEPT : 41 NPV is calculated to determine the estimate net return from an investment project, where the value discounted at PV Investor will accept the project if NPV > 0 Investor reject the the project if NPV < 0 Formula : NET PRESENT VALUE CONCEPT NPV = Rn / (1+ r ) t + Rn / (1+ r ) t + Rn / (1+ r ) t – COST OF PROJECT

NET PRESENT VALUE CONCEPT : 42 Example: A machine with life of 5 years, cost RM25000. Interest rate is 10% The machine is estimated to produce income as follows: Year 1 = RM6000, Year 2 = RM7000, Year 3 = RM7500, Year 4 = 8000, Year 5 = RM6000 Calculate the NPV. NET PRESENT VALUE CONCEPT

MARGINAL EFFICIENCY OF CAPITAL : 43 MARGINAL EFFICIENCY OF CAPITAL Also called as Marginal Efficiency of Investment It refers to the % of return from initial investment in a year of the estimated earnings discounted at PV At any moment in time different investment projects will have different marginal efficiency of capital Assuming that firms aim to maximize profit, the MEC will show the demand for capital at various stages of interest

MARGINAL EFFICIENCY OF CAPITAL : 44 The diagram show that when interest rate is lower and investment is greater, its mean the greater investment, the lesser expected rate of return. MARGINAL EFFICIENCY OF CAPITAL MEC Interest rate (%) Investment MEC is lower (lesser expected rate of return) Lower interest rate Greater investment

MARGINAL EFFICIENCY OF CAPITAL : 45 The negative relation between Interest rate and investment is due to several reason: The law of diminishing returns to capital will apply, as increases in investment will reduce capital productivity thus reducing revenue Higher prices of input paid due to competition among the firms Excess of outputs supplied compared to demand, it will reduce market price of the output MARGINAL EFFICIENCY OF CAPITAL

ACCELARATOR PRINCIPLE : 46 ACCELARATOR PRINCIPLE Possible for changes in the level of income to have a powerful effect on the level of investment, depend on the rate of interest Accelerator principle shows that a change in national output can lead to a greater change in investment Formula : w = ΔI / ΔY ΔI = Net investment ΔY = Change in national output

ACCELARATOR PRINCIPLE : 47 Formula : Assumption for this theory At initial year, added or net investment is not needed Depreciation is estimated at a fixed of amount The value of accelerator is fixed Weakness of this theory To rigid, the value of accelerator is fixed, reality is not Depreciation difficult to measure correctly Added investment for year 1 may not be zero ACCELARATOR PRINCIPLE Net investment = w (ΔY) = w ( Y1-Y2) Gross investment = Net investment + Depreciation = w (ΔY) + R

INVESTMENT IN ISLAM : 48 INVESTMENT IN ISLAM Islam encourages investment and not allow Muslims to freeze their wealth Not only to attain profit but Islam also emphasis on the welfare of the society Investment in Islam must be based on the following elements Religion Life Intelligence Descendent wealth

Constrain of Investment In Islam : 49 Constrain of Investment In Islam Halal wal Haram Islam forbidden any economic activity that is against the Islamic Law or Shariah Any goods that are forbidden or haram, the price also haram The benefit of investment Benefit to the producer and society Not element of interest or riba Riba mean exess, additional or growth Riba al-nasi’ah – an addition to the capital loaned out Riba al-fadhal – an addition to the exchange of goods or other objects which is of the same nature

Alternatives of investment : 50 Alternatives of investment Mudharabah Together venture into business, the owner of capital Musyarakah Joint venture.