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
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