UNIT II

Keynesian Theory of Determination of National Income

Paper 8B

Dr. Neelam Tandon

Unit II Outline

1. Keynes Concept of Equilibrium Aggregate Income

2. Describe the components of aggregate expenditure in two, three and four

sector economy model

3. Explain national income determination in two three and four sector economy

models

4. Illustrate the functioning of multiplier

5. Outline the changes in equilibrium aggregate income on account of changes

in its determinants

Some Important Terms

1. Ex- Post Consumption Expenditure: This refers to actual consumption

expenditure of households. Remember, consumption demand is the total

expenditure which all the households in the economy have incurred on

purchase of goods and services for their personal satisfaction.

2. Ex-ante Consumption Expenditure: This refers to planned (desired)

consumption expenditure of households. Remember, consumption demand is

the total expenditure which all the households in the economy are willing to

incur on purchase of goods and services for their personal satisfaction.

3. Ex-Post Investment Expenditure: This refers to actual investment

expenditure of private firms. Remember, investment demand refers to private

actual [ex-post] investment expenditure by the firms.

4. Ex-ante Investment Expenditure: This refers to planned investment

expenditure of private firms. Remember, investment demand refers to private

planned [ex-ante] investment expenditure by the firms.

5. Equilibrium : An economy is in equilibrium when Aggregate Demand is

equal to Aggregate Supply (AD = AS). Aggregate Demand = Aggregate

Income/Output Intended Expenditure = Planned Investment

6. In theory of determination of equilibrium output (income), all variables are

planned (ex-ante) variables.

7. Aggregate Demand in Two sector model

AD consists of Consumption expenditure (C) and Investment expenditure (I).

AD = C + I

8. Aggregate Demand in Three sector model

AD consists of Consumption expenditure (C) and Investment expenditure (I)

and Government Expenditure (G) .

AD = C + I +G

9. Aggregate Demand in Four sector model

AD consists of Consumption expenditure (C) and Investment expenditure (I)

and Government Expenditure (G) and Net Exports (X-M).

AD = C + I +G + (X-M)

10. Classical Theory: Economy is self-regulating and is always capable of

automatically achieving equilibrium at the ‘Natural Level” of Real GDP or

output. Resources are fully employed. In case of fluctuations wages and prices

are flexible to bring the economy back to natural level of real GDP.

Classical theorists held that wages and prices would change proportionately.

Higher wage rate due to high demand leads to more employment. But beyond a

point it is not feasible for a firm to offer higher salary resulting in increase in cost

gets passed on the consumer. Results increase in price and decrease in aggregate

demand for goods and services. This results in layoffs (firm decrease output).

Classical Theory believes that full-employment is the employment level the

economy will return to, and tends to remain at in the long run.

On Tuesday 29th October 1929 the Wall Street Crash caused a cataclysmic

chain of events which affected nearly every country across the globe. The

Great Depression, also known as ‘The Slump’ infiltrated every corner of

society, affecting people’s lives between 1929 and 1939 and beyond. In Britain,

the impact was enormous and led some to refer to this dire economic time as

the ‘devil’s decade’.

Keynes: General Theory of Employment Interest and Money

Aggregate Demand

Great Depression and Low Aggregate Demand

Recession

When Aggregate demand < Aggregate Supply at full employment

Consumer Spending is decreasing /falling results in lower expectations of the

profitability of investment, so businesses will decrease investment

expenditure.

Recessions occur when the level of household and business sector demand for

goods and services is less than what is produced when labor is fully employed.

This seemed to be the case during the Great Depression, since the physical

capacity of the economy to supply goods did not alter much.

No flood or earthquake or other natural disaster ruined factories in 1929 or

1930. No outbreak of disease decimated the ranks of workers. No key input

price, like the price of oil, soared on world markets.

The U.S. economy in 1933 had just about the same factories, workers, and

state of technology as it had had four years earlier in 1929—and yet the

economy had shrunk dramatically. This also seems to be what happened in

2008 and 2020. Although production capacity existed, businesses were not

able to sell their products at the same rate. As a result, real GDP fell below

potential GDP.

Sticky Wages

The sticky wage theory hypothesizes that employee pay tends to respond

slowly to changes in company performance or to the economy. According to

the theory, when unemployment rises, the wages of those workers that remain

employed tend to stay the same or grow at a slower rate rather than falling

with the decrease in demand for labor. Specifically, wages are often said to

be sticky-down, meaning that they can move up easily but move down only

with difficulty.

Two Sector Model

Households and Firms

When AD is not equal to output there is unplanned inventory investment or

disinvestment: (where IU is unplanned additions to inventory

If IU > 0, firms cut back on production until output and AD are again in

equilibrium

The Keynes’ consumption function

Aggregate Demand = C+ I

Investment is exogenous and constant in the short term

Consumption expenditure is the major factor to affect AD

Consumption is a function of Disposable Income

C= Yd

C = a + bYd

Where C is consumption expenditure and Yd is the real disposable income which

equals gross national income minus taxes,

where a is the intercept term, that is, the amount of consumption expenditure at

zero level of income. Thus, a is autonomous consumption.

The parameter b is the marginal propensity to consume (MPC) which measures

the increase in consumption spending in response to per unit increase in disposable

income.

Thus MPC = ΔC/ΔY Since the average propensity to consume falls as income

increases, the marginal propensity to consume (MPC) is less than the average

propensity to consume (APC).

Keynes pointed out that when income increases consumption also increases. But

consumption also depends on another factor, known as propensity (tendency) to

consume. The key concept is the marginal propensity to consume (henceforth

MPC). It indicates how much consumption increases (ΔC) when income

increases by a certain amount (ΔY), other things being equal.

One characteristic of the consumption function is the MPC. It is an important

determinant of the stability of the economy in the’ simple Keynesian model of

income determination. In general, the smaller the MPC, the more stable is the

economy with respect to changes in government spending, investment, net

exports, or money.

A related concept is average propensity to consume (APC) which is the ratio

of total consumption to total income. To start with we have to note the

difference between the amount of consumption and the consumption function.

While the amount of consumption means the level of consumption at a certain

level of income, the consumption function is a much broader concept. It is the

whole schedule which relates the amount of consumption to different levels of

income.

Dissaving = Autonomous Consumption

Y= C+S

National Income = Consumption + Savings

In above graph : Left to Y1 is Dissaving Because Aggregate Consumption >

Aggregate Income

MPC+ MPS =1

MPC 0 > b < 1

AS = C+ S

Question What will be APS?

If C= 200 Y=1000

Solution :

APS = S/Y

Y= C+S

S= Y-C

S = 1000-200

S= 800 Crore

At Point E

Y0 level of Output; AD(C+I) =AS(C+S)

Planned Spending= Planned Output

Where, Investment is exogenous and constant and does not depend on Income

At Point A

Y1 level of Output; AD(C+I) >AS(C+S)

Planned Spending> Planned Output

S= Zero (No Dissaving)

From Y1 to Y0

Since Planned Spending> Planned Output

Inventories decreases, firms will increase its output with increase in inventory

investment resulting in increase in national employment and national Income

Planned Investment < Actual Investment

Intended Saving < Planned Investment

From Y2 to Y0

Y2 level of Output; AD(C+I) < AS(C+S)

Planned Spending < Planned Output

Inventories increases, firms will decrease its output due to increase in

inventory investment resulting in decrease in national employment and

national Income

Planned Investment > Actual Investment

Intended Saving > Intended Investment

Low consumption demand due to Leakages> Injection

OQ* Full Employment level of output at Equilibrium point F and Aggregate

demand at (C+I)1

But actual aggregate demand (C+I) 0 < (C+I)1

Low aggregate demand increases Inventories, reduces output and income in

the economy till it reaches at Point E at OM Level of output

OM Level of Output< OQ* level of output due to deflationary gap of FG

Results in Under employment or Cyclical Unemployment

OQ* Full Employment level of output at Equilibrium point F and Aggregate

demand at (C+I)1

But actual aggregate demand (C+I) 0 > (C+I)1

High aggregate demand decreases Inventories, increase nominal output and

Income in the economy till it reaches at Point E at OM Level of output

OM Level of Output> OQ* level of output due to Inflationary gap of FG

Inflationary gap results in no increase in real income and employment but

nominal increase in income and output.

Questions