The 45 degree line shows the relationship between National Income and consumption, withdrawals and injections. Consumption and withdrawals are endogenous - their value is determined by the model. However injections are exogenous, meaning their value is determined independently of the model.
At ever point on the 45 degree line (Y), the items on each axis equal each other. The C line is consumption. It differs from Cd because it doesn't contain taxes and export spending. Consumption is a function of National Income: C = f(Y). As National Income rises, so does consumption - hence the upwards slope. It crosses the 45 degree line because poorer people may be required to spending above their earnings to survive where as richer people spend less than they earn, therefore at the end of the line it is below the Y line. The slope is given by the marginal propensity to consume - the proportion of any increase in National Income that goes on consumption. It is the change in consumption divided by the change in National Income.
Consumption is determined by a whole bunch of different things:
- Taxes
- Expected future incomes
- Expected future prices
- Consumer confidence
- Household wealth
- Attitudes of the lenders
- Age of 'durables'
- Distribution of income
Any changes in these cause a shift in the consumption function whereas a change in National Income causes a movement along the consumption function.
Now onto the withdrawals. The amount saved depends on the marginal propensity to save (mps). The proportion of an increase in National Income that is saved. Mps = Change in savings / Change in N.I. Taxes is pretty much the same - it depends on the marginal propensity to tax (mpt), or changes in tax / changes in N.I. It tends to rise as National Income rises because income tax is progressive. Finally imports - depending on the marginal propensity to import. Or, mpm = change in imports / change in National Income.
Total withdrawals will look something like this:
Injections now and we'll start with investment. It is determined by the following things: Consumer demand, expectations, interest rate, availability of finance and cost/efficiency of capital equipment. Replacing new equipment will rely on National Income. Government spending is independent of National Income in the short term, Exports is also classed as independent on National Income to keep the model simpler.
That's it for the background on the theory. Next we'll be moving on to how National Income is determined from all of this. Stay tuned.
Sam.
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