Keynesian Theory of Income Determination

Keynesian Theory:The equilibrium level of income is

determined where aggregate demand for G & S equals their aggregate supply.

Determination of income in three different models:◦ Two sector model or simple economy

model,◦ Three sector model,◦ Four sector model.

Concepts and Functions

Aggregate Demand Function

Aggregate Supply Function

Consumption Function

Saving Function

Desired expenditure on purchase of domestically produced G&S during an accounting year.

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

Concepts and Functions

Aggregate Demand Function

Aggregate Supply Function

Consumption Function

Saving Function

Flow of G&S as planned by the producers during an accounting year.

AS=C+S.

Concepts and Functions

Aggregate Demand Function

Aggregate Supply Function

Consumption Function

Saving Function

Relation between consumption and income.

C=f(Y).APC = C/Y.MPC= C/ Y.Algebraic Expression of C=C+bY.

Concepts and Functions

Aggregate Demand Function

Aggregate Supply Function

Consumption Function

Saving Function

Excess income over above consumption during an accounting year (S=Y-C).

S=f(Y).APS=S/Y.MPS= S/ Y.Algebraic Expression of S= S+sY.

S= - C

Concepts and Functions

Aggregate Demand Function

Aggregate Supply Function

Consumption Function

Saving Function

Relationship:APS+APC=1MPS+MPC=1

Income Determination- Two Sector Model

National Income

=AD=AS

Y =C+I=C+S

Y = (C+I)/(1-b) (consump.

Function)

Y = (S+I)/(1-b) (saving

function)

Two Sector ModelAssumptions:

1.Only two sectors.2.No govt. intervention.3.Household income = disposable income.4.Closed economy (i.e., no foreign trade).5.In business sector, total profit is distributed

as dividend.6.Prices remain constant.

Multiplier Effect:Investment multiplier:

◦Denoted as ‘m’ or ‘k’.◦m= Y/ I or 1/(1-MPC).

◦Reciprocal of MPS (i.e.,m=1/MPS).◦ Can also be said as 1/(1-b).

Based on purpose of analysis:◦ Static multiplier.◦ Dynamic multiplier.

Income Determination- Three Sector Model

National Income =AD=AS

Y = (C+I+G-bT)/(1-b). (Govt.

spending & taxes)

Y = (C+I+G-bT+bGt)/(1-b).(Transfer

payments)

Y = (C+I+G-bT). (Tax as a function of

income).

1-b(1-t)

Multiplier Effect:Fiscal Multiplier:

◦ Govt. expenditure multiplier: ( Y/ G)

Gm= 1 (1-b)◦ Tax multiplier:( Y/ T)

Tm= -b

1-bo Balanced Budget multiplier: (G=T)

BBm = 1. (always)

Income Determination- Four Sector Model

National Income =AD=AS

Y = (C+I+G-bT+X-M)/(1-b+m).(with lump

sum tax).

Y = (C+I+G-bT+bGT+X-M). (with tax

function).

1-b(1-t) + m

Export multiplier:( Y/ X)Xm = 1/(1-b).

Foreign trade multiplier: ( Y/ X) Fm = 1/(1-b+m).Foreign trade multiplier(with tax func): (

Y/ X) Fm = 1 1-b(1-t)+m

Multiplier Effect:

THAN

K YOU