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Model of National Income as developed by Keynes

As with many other aspects of economics, one is unlikely ever to see an economy is equilibrium, in this case AE = AS. But what is more important is to understand what happens when the economy is not in equilibrium.

This is best explained on the hand of a diagram. Here equilibrium occurs when national income is valued at OY1. At point E the aggregate expenditure = aggregate supply point of equilibrium, all goods and services produced are sold. But if the national income is either below or above OY1 the macro-economy is in disequilibrium and the national income, or supply, will change. If the aggregate expenditure had to equal BY and aggregate supply is AY this would mean that people where consuming more than was being supplied. The distance between AB would be the amount in which stocks were being used up. In other words people where buying more than producers were supplying, and in order to meet the extra demand stocks were being depleted. The producers would see this as an opportunity to increase profits. Producers demand for extra factors of production would increase production helping to combat the falling stock level. As production increases, AS increases and producers move towards the point of equilibrium E. This would also boost the national income from OY to OY1. This increase in income would lead to a raise in consumption expenditure so that AE increase from B to E. the reverse of the above in also possible. That being when income exceeds expenditure.

But Keynes also included a new concept into this model �that of full capacity. Keynes assumed that the full capacity level of output represents a situation of full employment, also a very unlikely to be seen event in an economy. The full employment line would act as a constraint in the economy, as the national income would be constrained to a maximum of OY4. Only an increase in productivity capacity and in the labour force would allow income to increase beyond OY. This helped people to understand unemployment better and also helped government formulate policies which would help them in a case of a recession.

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The total aggregate expenditure is made up of four components � consumption, investments, government expenditure and net exports. Aggregate expenditure function is defined as

AE = C + I + G + (X � M)

= (a + bY) + I + G + (X � mY)

Should nation income be zero, the total AE which is taking place will constrict of autonomous consumption expenditure (a), investments (I), Government expenditure (G), and export (X). a + I + G + X gives initial starting point of the AE function when Y is zero. Only consumption and imports are sensitive to changes in income. The difference between ( b � m ) determines the slope of the AE function. The slope of the consumption function is given by the MPC (b) and that of imports by the MPM (m).

Tools of Monetary Policy

Direct policy instruments

• Open market operations (OMO)

The South African Reserve Bank buys and sells government bonds influencing the money base and therefore the money supply. If the SARB wanted to increase the money supply it would conduct an open market purchase. In other words, the SARB would purchase bonds from the banks after which the bonds would be released into the market in form of central bank cheques. Once deposited, these funds will increase the money supply through the money creation process. The price of bonds is increased and interest is decreased to facilitate this process.

To decrease the money supply the SARB sells bonds on the open market. The price is decreased and interest earned on bonds increased to encourage the open market to buy bonds.

• Discount policy or Changes in the bank rate

There are times when commercial banks are forced to borrow from the central banks due to money shortages. They borrow from the SARB as lender of last resort. Banks may be granted an overnight loan by SARB (at very high rates of interest) or they may discount securities at the accommodation window of the SARB. The interest rate which the SARB charges on these funds is known as the bank rate (repo rate) or discount rate. The most likely reason for the banks having to lend from the SARB is the withdrawal of cash from a bank which are fully loaned out, which is illegal due to reserve requirements set by the SARB. The SARB increases the bank rate to decrease the money supply. By decreasing the bank rate, the SARB allows commercial banks to lower their lending rates and thus encouraging borrowing. Increasing the bank rate will have the opposite effect.

• Direct controls

Direct control consist of direct legislation attempts to control the money creation ability of banks. The most common one in South Africa is the institution of credit ceilings. Credit ceilings are used by the SARB to try and restrict the quantity of loans made by commercial banks irrespective of their reserves. The SARB may also force banks to hold liquid assets against their deposits, known as liquid asset requirement. These assets usually include government bonds of differing maturity. These direct controls are not currently used as they restrict the working of the market mechanism.

• Changes in the cash reserve requirements

A change in the reserve requirements of banks impacts directly on the size of the money multiplier and therefore the money creation process. The SARB stipulates what percentage of all demand deposits must be held as a reserve by commercial banks. A small change in the reserve requirement can result in large change in the money supply. If the SARB increases the reserve requirement (CRR), the money multiplier becomes smaller, less credit is created and the money supply decreases. Decreasing the CRR would have the opposite effect.

Indirect policy instruments

• Moral suasion

Moral suasion, or moral persuasion, refers to the practice by which the SARB appeals to the commercial banks in an economy to conduct business in a certain way. The real impact of moral suasion is difficult to measure.

Tools of Fiscal Policy

Fiscal policy refers to changes in government expenditures and/ or taxes to achieve particulars economic goals, such as controlling the rate of inflation or decrease unemployment and stimulating economic growth.

Tools of fiscal policy are taxation and government expenditure. In cases of high inflation governments will use concretionary fiscal policy � decreases in government expenditure and/ or increase in taxes to achieve in lowering inflation.

When combating unemployment money must be pumped into circulation in order to increase the aggregate demand. This can be done by the government increasing its expenditure budget. Aggregate expenditure shift upwards and aggregate demand shift to the right. Firm’s stock levels decrease therefore production must increases in order to increases stock levels more people are hired, prices increase. Unemployment decreases.



Money creation process

South African Reserve Bank

Open market

Bank rate

Market mechanism

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