Date: 21th August 2022
New financial model proposes a very important change in the present income equation. In new income equation, income of $100 generates output of more than $100. Elaboration below:
Income equation in Ancient times
Income (food) = Consumption
Income equation in Present Financial Model
Income = Consumption + saving {for consumer} ----- (a)
Income = Consumption + Investment {for investor}
Income equation in New Financial Model
As we have read in the new financial model that consumer will get the future money as an incentive on the consumption of final goods. So Consumption will be
Consumption (C) = Consumption (C) + Present value of Future Money ----- (b)
[Present Value of Future Money = Future Money/ (1+ FM rate) ^N]
[Present Value of Future Money = Consumption*FM Rate/ (1+ FM rate) ^N]
C = C + C * (FM rate/(1+r)^N) [By putting value of Present Value of FM in equ. (b)]
C = C (1 + (FM rate/(1+r)^N)) ----- (c)
By Putting value of C from equation (c) in equation (a), we get Income Equation for New Financial Model
Income = C (1 + (FM rate/(1+r)^N)) + Saving ----- (d) {for consumer}
So, above is the new income equation for consumer in the new financial model. Here (1 + (FM rate/ (1+r) ^N)) is consumption multiplier, whose value depends upon the Future Money rate, N (number of years) and r interest rates.
Let’s take an example 2.
Suppose Income = $100, C = $80, Saving = $20, FM rate = 5%, N = 30 years and rate of interest r = 3%
Put values in Present income equation (a)
Income ($100) = Consumption ($80) + Saving ($20)
Now put the values in New Financial Model’s income equation (d):
Income ($100) = $80 (1 + 0.05/ (1+0.03) ^ 30) + $20
Income ($100) = $80 (1.0206) + $20
Income ($100) = $81.65 + $20
Income ($100) = $ 101.65
Isn’t it amazing, because of consumption multiplier in the new financial model, Income of $100 will add $101.65 in the economic unit.
Income ($100) = Output ($101.65)
Now For investors, Income equation in Present financial Model:
Income = Consumption + Investment
For investors, Income equation in new financial model
Income = Consumption + Present value of Future Money + Saving --- (e) {For investors}
Income = Consumption + Investment
Here the Investment = saving + Present value of future Money.
Let’s see the above example 2. for investors
Suppose Income = $100, C = $80, Saving = $20, FM rate = 5%, N = 30 years and rate of interest r = 3%
Put values in Present income equation (a)
Income ($100) = Consumption ($80) + Investment ($20)
Now put the values in New Financial Model’s income equation (e):
Income ($100) = $80 + $80 * (0.05/ (1+0.03) ^ 30)) + $20
Income ($100) = $80 + 1.65 + $20
Income ($100) = $80 + $21.65
Here investment = $21.65
In the new financial model because future money saved for long term, present value of money available for investment = $21.65 more than $20 which was available in the present model
So, we have derived an new income equation in the new financial model for both consumer and investor and seen from example 2, that because of the consumption multiplier, more value is being added on both sides: consumption as well as investment in the economic unit.
For detail please read the Chapter 6th of New Financial Model.
Research Analyst (Certified)
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