The Theory Of National Income Determination

1. Why does the GDP behave as it does?
2. Rising some periods and falling in others
3. what can the government do to influence it?

Answering these questions will need knowledge from the theory of national income. The theory of national income a theory that explains the size of, and changes in national income determination. To build the theory we need to make the following assumptions:

Expenditure Flows

All the expenditure flows are planned or desired (ex Nate) flows. That is what people actually want to spend and not what they really spend(post expenditure).

Actual expenditure may differ from planned expenditure in some instances such as strike effects, production of goods, all these interrupts planned expenditure. All expenditure flows are aggregate flows.

1. Basic Assumptions

• Potential national income is constant
  
• there are unemployed factors of production
  
• interest rate and general price level are constant
  

The Theory of Aggregate Demand

Changes in the national income are due to the level of aggregate demand, not aggregate supply because aggregate supply is driven by the aggregate demand as explained by the Simple Keynesian Model.
Looking back at the circular flow of income, that is the flow of expenditures on output and services between domestic firms and households. We assume that there are only two economic units (domestic firms and households)and only two markets in the economy. (goods and service market and Factors of production market).
Now we assume that the household owns all the factors of production, and they spend all their income on the goods and service market.
So firms produce goods and service and sell it to the household and households also supply the firms with the factors of production.
Now in this two-sector economy, we assume the goods produced in this economy is only two

• Consumer goods: goods sold to households
  
• Investment goods: goods sold to firms by other firms
  
  SOURCE:https://sites.google.com/site/maeconomicsku/home/circular-flow-of-income

Injection and Leakages(Withdrawals)

Any money that gets into the economy, and does not rise from spending of either households or firms is called Injection. While income received by households or firms that was not passed on from either economic unit is a Withdrawal or a Leakage.
Let's relax the assumption of households consuming all their income. So now we are assuming households spend some of their income and keep the rest. If this happens, there will be a contraction force on the flow of income in the economy. Because households choose to save some of their income rather than spend all, it follows that the aggregate expenditure has reduced so aggregate demand in the economy will fall and this will affect aggregate output since firms will face unintended increase in stocks or inventories so in response to that they reduce output and when that happens it means firms will reduce their demand for factors of production and may layoff some factors of production so there will be a fall in household income, so as this cycle goes on so as the income in the economy shrinks. hence contracting the economy.
Investment expenditure creates more income for firms that produce capital goods. This income does not arise from household expenditures. Thus investment expenditure injects income into the economy and this brings about expansionary force on the flow of income because there is an increase in investment expenditure as output increases and this triggers the demand for more factors of production and this provides new income for households.

Summary

If households choose to save their income then they are withdrawing income form the economy and hence contracts the economy.
If investment expenditure increases then income is being injected in the economy and hence expands the economy.
(Remember we said households owns all factors of production
and some firms produce goods for other firms to use for production, and those goods are called capital goods.) 

Autonomous And Induced Expenditures

Autonomous expenditure(exogenous) is an expenditure flow that is not affected by any variable the theory is designed to explain (that is, it is not influenced by the variables in the theory so it's constant though it can change, but not as a result of a change in income).

Induced expenditure(endogenous) is an expenditure flow that is affected by income. Changes in national income cause a variation in the induced expenditure.

Lecture notes:Dr. Monica Lambon-Quayefio, College of Social Sciences,Economics Department,2018/2019 Academic Year

Book Reference:Case,K. E., Fair, R. C., & Oster, S. M. (2012). _ Principles of Economics_ .10th ed, USA: Pearson Education Inc