The Keynesian Theory of De tcnninntion of Nationa l Income 25

- - ----- - -

Chapter 2
'1 1l1~ l{l~YNl~SI1IN 'l 11l~f)llY ()11
1 1

ltl~'l l~ll)IIN1l'l lf)N f)I~ N1l'l lf)N1ll.. IN(~f)tll~

1 1 1

l cs Ad!ll Pa n t
The Keyn esian Theory of Dete nnina tion of Natio n a l Income 26

2.1 INTRDDUCTION
Keynes believed that there are two major factors that determine the national income of a country.
These two factors are Aggregate Supply (AS) and Aggregate Demand (AD) . Additionally , he believed
that the equilibrium level of National Income estimated when AD = AS. A comprehensive theory
to explain these phenomena was first put forward by the British economist John Maynard Keynes
in his master piece 'The General Theory of Employment Interest & Money ' published in 1936 . The
Keynesian theory of income determination is presented in three models:

Figure 2 . l(a): Value Added Method for National Income Calculation

2.2 CIRCUUR FLOW IN ASIMPLE TWO SECTOR MODEL

The Two Sector Model consists of the household and the business sector. Under this model we
consider a hypothetical simple two sector economy as economy of this kind does not exist in
reality. It just provides a simple and convenient basis for understanding the Keynesian Theory of
income determination.

Factor Payments (Y} .

(Wages, Rent, Interest, Profits)

Households +----Fac-tor-lnp-uts_ _

Goods & Services

~I
-
Firms

Consumption Expenditure (C}

t
Figure 2.2(a): Simple Two Sector Model
The re~ources such as land, labor, capital and entrepreneurial abilities flow from the households
to busmess firms. As against this, money flows from business firms to the households in the form
of factor payments such as rent, wages, profit and interest. The money flows from households to
fi~s as Consumption expenditure for the goods and services produced by the firms . As again st
this, the goods and services flow from business firms to households.
--- - -
lfJ CS Adi ti Pant
 27
The Keynesia n Theory of Dete rmination of National Income
-- --- -- -

Thus, it can be seen that money flows from business firms to households as factor payments and
then it flows form households to firms thereby resulting in a circular flow of money and income.
This circular flow of money will continue indefinitely week by week and year by year. However,
this flow of money income will not always remain the-same in volume.
Factor Payments = Household Income = Household Expenditure = Total Receipts of Firms
= Value of Output
The total income produced, Y, accrues to the households and is equal to their personal disposable
income Yd i.e. Y = Yd

2.3 ISSUMPTIONS OF CIRCUUR HOW IN SIMPlE TWO SECTOR MODEl

• There are only two sectors in the economy
o Household sector o Business sector
• The business sector (firms) hires factors of production owned by the household sector and it is
the sole producer of goods and services in the economy.
• The household sector (households) is the sole buyer of goods and services. It spends its entire
income on the goods and services produced by the business sector. The households are also
the supplier of labor and various other factors of production.
• The business sector sells the entire output to households. It does not store and henc~ there
are no inventories.
• There are no savings and investment in the economy.
• The household sector receives income by selling or renting factors of production owned by it.
• All prices remain constant, which also include factor prices, supply of capital and level of
technology.
• There is no Government intervention for all such practical purposes (No public expenditure , no
taxes, no subsidies, no social insurance contribution , etc.)
• The economy is presumed to be a closed economy i.e. no internationa l trade relation exists.

2.4 DETERMINATION OF EQUlllBRIUM NATIONAl INCOME

Equilibrium means the state of balance or state of no change. By Equilibrium National Income we
refer to that level of national income which remains unchanged at a particular level. At this level
there is no tendency for income or output to rise or fall.
In the two sectors economy the equilibrium output occurs when the desired amount of output
demanded by all the agents in the economy accurately equals the output produced in a given
period of time. To sum up otherwise it can be stated that,
Production plans of firms = Expenditure plans of households

2.5 THE IIIREIITE IEMIND FUNCTION: TWO SECTOR MODEl

In a simple two sector economy the Aggregate Demand (AD) or the Aggregate Expenditure consists
of only two components:
• Aggregate Demand for Consumer Goods (C) • Aggregate Demand for Investment Goods (I)
:. AD= C + I

© CS Adi ti Pan t
 28

Nots

• nw n ~p t'7!dir 11 ,\ ' 0 71 co ll~im1< · r goorls occormts for a su bs tantial part of the GDP of a country .
• l'lh' 11c1n'ul1/t· ·1 · is n~_-;; wntY I to ht> co11 s ta11t in the s hort run . Hence, the s hort run aggregate
, k,rroll(/ .f1111 cti<> n cn 11 Vt' writrtm as Al) =-= C + /

J.I TIE CDNSIMPTION FUNCTION

'l'he C0nsumption !•'unct ion is a n economic formula representing th~ _functioi:ial re lations hip
between Totul Co n~umµtion and Gross Na tional Income. It depicts a positwe relatronship between
C"u 11 s w11p ricm Spe,' 11di11g a nd Disposa ble incom e.
C = f(Y)
Noter: Tl1<-· expc ndittffe 0 11 private de mand for goods and services accounts for a substantial part of
rli c aggn:gMc d e mand in an economy and plays a crucial role in determination of national income.

Ac-cording to Keyn es . the to ta l volume of private expenditure in an economy depends on the total
curre nt ctisposnble income of the p eople and the proportion of income which they decide to spend
on consurncr goods and services . The form of Consumption Income relationship proposed by
Keynes is :

C = a+ bY
Where. C = Aggregate Consumption Expenditure; Y = Total Disposable Income; 'a' is a constant
tenn which denotes the (positive) va lue of consumption at zero level of disposable income and 'b '
is the slope of the function . /1C/ /1Y is the Marginal Propensity to Consume (MPC) i.e . with the
increase in the leve l of disposable income there is an increase in consumption per unit.

C C = f(Y)

'
\6C
I

} a-- --- -- ---------------- ·

y
Figure 2 .6(a): Si.mple Two Sector Model

T~e Consu1:nption Func tio~ shows the level of consumption (C) corresponding to each level of
~1sposable mcome (Y) and 1s expressed through a liner consumption function, depicted by the
lme marked as C ~ f (Y) in Figure 2.6(a). When the income is low, the Consumption Expenditure of
th_e ho_useholds will exceed their disposable income which will result in decrease in savings i.e . they
w1ll either. borrow money or withdra w money from their past s · · ·
aV1ngs m ord er to pure h a se
c~nsumptio~1 goods. Keynes assumed that the consumption increases with an increase in the
disposable mcome, but again the increase in the consumption will always be less than the
increa s e in disposa ble income .

⇒ b < 1 ⇒ 0<b<1

- -
, · CS Adi ti Pant
The Keynesian T heory o f De te rm in atio n o f Natio n al [nco m e 29

2.7 MIRGINll PROPENSln TO CONSUME (MPCJ

Marginal Propensity to Consume is a component of Keynesian macroeconomic theory and is

calculated as the change in consumption divided by the change in income . It is based on the
assumption that there is a constant relationship between consumption and income denoted by a
constant b, which is the Marginal Propensity to Consume .
!1C
MPC=-=b
!1Y _
Although the MPC is not necessarily constant for all changes in the level of income but maximum
analysis of consumption generally works with a constant MPC .
According to Keynesian Theory, an increase in production increases income of consumer resulting
in increased spending on the part of the Consumer. If we know their MPC then we can calculate
how much an increase in production will affect spending. This additional spending will generate
additional production , creating a continuous cycle. The higher the MPC, the higher the multiplier
i.e . the more the increase in consumption from the increase in investment.

2.8 AVERAGE PROPENSln TO CONSUME lAPCJ

The average propensity to consume refers to the percentage of income spent on goods and services
rather than on savings. APC can be determined by dividing the average household consumption
(what is spent) by the average household income (what is earned).
Total Consumption C
APC = =
Total Income Y

RELATIONSHIP BETWEEN INCOME AND CONSUMPTION

MPS
.Income
(Y)
Consumption
(C)
Savings
(S)
APC-
(C/Y)
APS (S/Y)
MPC
(~C/~Y) (~ S/~Y)
- ,; (1 - MPC)
1000 950 50 0.950 0.050 - -
1100 1040 60 0.945 0.055 0.9 0.10
1200 1125 75 0.937 0.063 0.85 0.15
1205 95 . 0.926 0.073 0.80 0.20
1300
1400 1280 120 0.914 0.086 0 .75 0.25

2.9 THE SAVING FUNCTION

·
S avmg . d e fiine d as the excess of income over
is . consumption
. . . concept of saving
expenditure . The
is closely related to the concept of consump~10n . Saving i~ that p~t of the mcom~ which is not
consume d . G enerall y , as the level of income increases , saving also increases and vice versa.
.
Th e saving .
fu nction or th e propensity to save expresses the relationship between saving and the
level of income .
S = {(Y)
S = Y- C Y=C+S

Where , y == Income , S == Saving, C = Consumption

-
r CS Adi ti Pant
 -
The Keynesian Theory of D c trm1i11 11 t1 0 11 o f No rn, n n l l11 <'< 1 11 w
JI)

2.10 TIE lllllllll PIIPIIS ln Tl un l■PIJ

- -
MPS is the proporti on of an UAA'-C'~Hh' inCl'f"l\~C' in pny I trn1 1\ ,· on Runw r ~p("nd ~ on sn ving
rn l'h<'r
than 011 the consump tion of ~nod~ nnd 9t.'t'Vi<'f"' !1 . MPS it-1 " ( ,11nponc nt of Kr y 11(·s i o
n Mu eru
Econom ic Tht'OIJ' and is cn lculnt cd u~ the c h tH\J,{t' in ~u vin f.{~ di vide- by the 1· h 11 n p,t· in int·o
mr .

O< ( ~! = MPS = 1- b ) < t

also, MPC + MPS =1

MPS = 1 - MPC

1 - M PC =1- b ~ M PC =b
and hence.0 < ( MPC = b) < l
Thus , it can be conclud ed
• Saving is an increasi ng function because MPS= 1- b which is a positive figure (snvin~
in crrn~cs
when income increase s) .
• The Keynesi an assumpt ion is that consum ption increase s with an in crease in dis
pos,lbk
income lb> 0), but that the increase in consum ption will be less than the in crcusc in disposabl
e-
income (b < 1).

2.11 TIE 1111111 PIIPEIS ln TD SIii llPSJ

APS refers to the proporti on of income i.e. saved rather than being spent on goods nnc.
1 services .
Also known as the savings ratio, it is expresse d as the ratio of total saving to total in co
me .
Total Saving S
APS=-----=
Total Income Y

y
Y=C+S
C Saving
0
·;:,
0. C =a+ bY
E
::i
<ll
C
0
u

-~-- ----- -x
0 Yt Y1 Dispos.ab le In co m e
00
C: Saving
.>
~ Dissaving 1

s
For deca,lr<J r .wl,l1111' 1v 1 1~1.:r t<l
.1--+--~--..c:..___i..::D.: . : S_ __. X rh e ropir The Co11..su 111 p<w 11 unJ
SuvirtB f'un, ·ncrn ,n ,lµpt- ndu
Dispo sabl e In co m e

Figure 2 . I l(a) : T ltc Co n s 1m111rio r1 w1d Sau111r1 F1rn,·no11

• l' S !\dill P1111t

 ,JI
The KeyneRiun Theory of Dc tc rrnlnuti o n u l Nu 1J,;11u l 11 111111«-

2.12 THE TWO SECTOR MDDH Df NITIDNll lNBOMI DlTEIIMINITION

Now, we will dis c uss t h e d c te rmln11tlon of c q11 ll ll1 rli1rn l~v1'1 11 <11 011t p 111 111 111 liwo111r in th e two
sector model in its forma l form Lrnln~ Th CJ Af,t~n·g11Lc l)e mnrn l l1'111 H'llo11 1111< 1 'l'lw AMWC~11t c 5 11pply
Function . Accord in g to Keyne s , th e cqu lll hriu111 kvc- 1 of Nu l lorw l l1 wo 11 w l11 l1 nl11wtlo11 11 1 wh ic h ,
Aggn!g a.t e /J enumd - · A11111·u11att1 .\ '11p11ty

.', C + ' E r: + s
hence,

C, I
V• C+S

l~l
"Cl C+ I
~
s
Cl.I
Q
...
Cl.I C
"'
DD
Cl.I
g°E /11 A119re11nte /Jcmmul (iraJJh
< • Al fi: (: ,, I • (.' ,, S
• Al fi 1: (.' ,,, I .:, f.' ~ S
• At /s'i : (.' + I < r: ,, S

0 Y, y Yi /11 Sn v/11y//11ve.\·tm e11t Gr t1JJh

• Al H: S ... ,
S, I
... 1:or dc lallc:tl exp la11 allo11 ref e r t o
=
Cl.I s £Ill: loplr: Dt1 L1: m1/11al/011 11f
s
(I)
Cl)
E2
[:;qulllhr/11 m /11 c11mc llndur two
Soctor Moch:/ In Appendix.
>
= E,
'DD
·s:=
"' 0
V)
X
Y, y Yi
ln co 111 e

Pi.gure 2 . 12(a): Determination of Equilibrium Incom e under '/'u)() Sector Modal

Note
• According to Keynes, aggregate demand will not always he equal to aggregate s upply .
• Aggregate demand depends on household's plan to consume and to save . Aggregate s upply
depends on the producers p lan to produce goods and services .
• The households p lan must coincide with produce rs plan in orde r attain equilibrium.
• At equilibriu m level, the exp ected value equals the realized va lue .

l• l 'S l\d11i 1'11 111

The Keyn esin n Th eo ry o f Dcte nnina tio n of Na ti o n al Inco m e 32

2.13 TII INIISTMINT ■llTIPllER

An investment multiplier refers to the concept that any increase in public or private investment
spending has a more than proportionate positive impact on aggregate income and the general
economy. The multiplier attempts to quantify the additional effects of a policy beyond those
immediately measurable.
An increase in an autonomous investment shifts the aggregate demand schedule from c + J to
c + J + M. Correspondingly, the equilibrium shifts from E to £ and the equilibrium income
1

increases more than proportionately from Y0 to Y1 . This occ1,1rs due to the operation of the
investment multiplier.
The multiplier effect refers to the phenomenon whereby a change in an injection of expenditure
will lead to a proportionately larger change in the level of national income.
If as a result of the investment of INR 100 crores, the national income increases by INR 300
crores , multiplier is equal to 3. If as a result of investment of INR 100 crores, total national income
increases by INR 400 crores, multiplier is 4. The multiplier is, therefore, the ratio of increment in
income to the increment in investment. If ll/ stands for increment in investment and LlY stands
for the resultant increase in income, then multiplier is equal to the ratio of increment in income
(LlY) to the increment in investment (ll/) .
LlY
k =- where, k stands for multiplier
M

-~

§ S, I
r/) I' F
~ }------------------------- .-----I '
~ . ~I E \
§ . ' I

~y

National Income

Figure 2 . 13(a): Detennination of Equilibrium Income under Two Sector Model

Further, the MPC is the determinant of the value of the multiplier and there exists a direct
relationship between MPC and the value of multiplier. Higher the MPC, more will be the value of
th e multiplier, and vice versa. On the contrary, higher the MPS, lower will be the value of
multiplier and vice versa.
The maximum value of multiplier is infinity when the value of MPC is 1. Alternatively, it can be
concluded that the value of multiplier is the reciprocal of MPS.
LlY 1 1
M
= ----=
1-MPC MPS
The five Major Leakages with Multiplier Process are described in the following sections.
- - -----
--~~ -CSAditi Pa n t
 The Keynesian Theory of Determination of Natio nal Inco me 33
-- . - - -
2.13.1 PAYING Off DEBTS
The first leakage in the multiplier process occurs in the form of payment of de bts by the people ,
especially by businessmen . In the rea l world, a ll income rece ived by the peo pl e as a result of some
increase in investment is not consumed.
A part of the increment in income is used for paying back the debts which the people have take n
from moneylenders, banks or other financial institutions. The incomes used for paying back the
debts do not get spent on consumer goods and services and therefore leak away from the income
stream. This reduces the size of the multiplier.
2.13.2 HOLDING Of IDLE CASH BALANCES
If the people hold a part of their increment in income as idle cash balances and do not use them
for consumption, they also constitute leakage in the multiplier process. As we have seen, people
keep a part of their income for satisfying their precautionary and speculative motives , money kept
for such purposes is not consumed and therefore does not appear in the successive rounds of
consumption expenditure and therefore reduces the increment in total income and output .
2.13.3 IMPORTS
In our above analysis of the working of the multiplier process we have taken the example of a
closed economy, that is, an economy with no foreign trade. If it is an open economy as is usually
the case, then a part of increment in income will also be spent on the imports of consumer goods .
The proportion of increments in income spent on the imports of consumer goods will generate
income in other countries and will not help in raising income and output in the domestic economy .
Therefore, imports constitute another important leakage in the multiplier process.
2.13.4 TAXATION
Taxation is another important leakage in the multiplier process. The increments in income which
the people receive as a result of increase in investment are also in part used for payment of taxes.
Therefore, the money used for payment of taxes does not appear in the successive rounds of
consumption expenditure in the multiplier process, and therefore multiplier is reduced to that
extent. However, if the money raised through taxation is spent by the Government, the leakage
through taxation will be offset by the increase in Government expenditure. But it is not necessary
that all the money raised through taxation is spent by the Government as it happens when
Government takes a surplus budget.
No doubt, if the Government expenditure increases by an amount equal to the taxation, it would
not have any adverse effect on the increase in income and investment and in this way there would
be no leakage in the multiplier process.
2.13.5 INCREASE IN PRICES
Price inflation constitutes another important leakage in the working of the multiplier process in
real terms. As we have noted above, the multiplier works in real terms only when as a result of
increase in money income and aggregate demand, output of consumer goods is also increased .
When output of consumer goods cannot be easily increased, a part of the increase in the money
income and aggregate demand raises prices of the goods rather than their output. Therefore, the
multiplier is reduced to the extent of price inflation.

,· CS Adili Pant
T h" K,·vnr11 ln n The ory of D(•lc rm ln a tion of Nation a l Income 34

spent on food grains

In d e ve loping countr ies like India the extra income s and deman d are mostly
d raise the prices
whose output cannot be increas ed so easily . Theref ore, the increm ents in deman
of goods to a greater extent than the increas e in their output . Beside
s, in develop ing countri es
ies, especia lly in
like India. there is not much excess capaci ty in many consum er goods industr
agricu lture and other wage-g oods industr ies.
ent, it general ly
Theref ore, when income and deman d increas e as a result of increas e in investm
ns the workin g of
raises the prices of these goods rather than their output and therefo re weake
the multip lier in real terms.

2.1C IETEIMINITION OF NITIONAl INCOME IN THREE-SECTOR ECONOMY

ss, and governm ent.
The three-s ector econom y involve s three sectors namely , househ olds, busine
es in an economy.
The additio n of the govern ment in an econom y results in bringin g two variabl
) and taxatio n (act as
These variabl es are govern ment expend iture (act as injecti ons to income
iture increas es the
leakag e or withdr awals from income ). In other words, the govern ment expend
aggreg ate deman d, while taxatio n reduce s the aggreg ate deman d.
the level of nationa l
Let us unders tand the effect of govern ment expend iture and taxatio n on
In such a case, the
income assum ing that the govern ment is followi ng a balanc ed budget policy.
govern ment expend iture (G) and govern ment taxatio n (T) is equal.
Aggre gate Deman d, AD =C +I+ G

Aggre gate Supply , AS= C + S + T

1200 C+ I+ G
C+ I
Et:
~
Q)
.... 850 ..
B
ii 400
C
Q)
0. 150 ···· I+ G
><
til 100 .... ·························· ... I
Income (INR)
0
850 1200 1400
-150

Figure 2 . 14(a): Nationa l Income Determ ination in Three Sector Model

At the equilib rium point, AD= AS

c+s+ T=C+ I+G ⇒ Y=C+ l+G

h er a t Point E · This thet
In the Figure 2.14(a) , C + S + T and C +I+ G schedu les interse ct each ot th e -~rbe~en
8SO in
equilib rium point at which the nation al income is determ ined, which. isalINR • me at equil1 num
G schedu les also provid e the same level of nation mco
ca se . The S + T and/+
point E'.
---
------c cs- Aditi -Pant
---

1?
-
35

Z.15 IOEl■ INITIIN IF NITIINll lNCO■E IN FDIII-SECTOI ECONOMY

Y = C + I + G + (X - M) at Ez

c + I + G+ (X - M)
c+ I+G

45·
Income
Y1 Y2
Figure 2. 1 S(a): Nationa l Income Determ ination in Four Sector Model

Let us detenn ine the equilib rium in an open econom y in which the econom
ic transa ctions take
place among differe nt countr ies. A four-se ctor model of econom
y includ es househ olds,
busine sses, govern ment, and foreign trade. In four-se ctor econom y, export
s are the injecti ons in
the nation al incom e, while import act as leakag es or outflow s of
nation al incom e. While
determ ining nation al incom e, the differe nce betwee n net export s
and impor ts (X - M) is
consid ered. The injecti ons are respon sible for increa sing the nation al
incom e while leakag es or
outflows result in decrea se in nation al income . When X > M, there is net
injecti on; therefo re, there
would be an increa se in nation al income . On the other hand, in case X
< M, there is net leakag e,
the nation al incom e would decrea se. For determ ining the nation al incom
e with foreign sector in
a four-se ctor econom y, let us learn about export and import functio ns
in next section s .
Y = C + I + G + (X - M)
2.15.1 EXPORT FUNOI0N
The growth of any econom y and distrib ution of incom e and wealth
in a countr y are directl y
associ ated with export s. Expor ts play a crucia l role in interna l trade and
econom ic stabili ty of a
countr y. Moreo ver, it helps in increa sing foreign exchan ge reserv es
in a countr y. But when
import s are greate r than export s i.e. X < M, there is net withdr awal
and nation al incom e
decrea ses. The Figure 2. 15.1 (a) depict s the case of X < M.

Y=C+ S+T
C+ I+ G
C + I + G + (X - M)
C+I
C

Y!i Yo
I
~_...___ _ ____..;:.:...._. .......:'--+ Income (Output )
Figure 2. 15.1 (a): Export functio n

Note:

• The autono mous expend iture multiplier in a four sector model includ
es the effects of foreign
transa ctions and is stated as 1/(1- b + v) where vis the propen sity to
import which is greate r
than zero. Th.e multiplier in a closed econom y is 1/(1 - b)

© CS Ad i ti Pant
The Keynesian Theory of Determination of National Income 36
-- - ·- - -- - - ---- - ·-- - - -
• The greater the value of v, the lower will be the autonomous expenditure multiplier. The more
open an economy is to foreign trade; (the higher the v is) the smaller will be the response of
income to aggregate demand shocks
• An increase in the demand for a country's exports has an expansionary effect on equilibrium
income, whereas an autonomous increase in imports has a contractiona,y effect. But this does
not mean that imports always have a negative impact on the growth of the economy. Countries
import goods that can be more efficiently produced abroad, and trade increases the overall
efficiency of the worldwide allocation of resources.

PRACTICE QUESTIONS
• What are the components of aggregate expenditure in Two Sector Economy?
• Explain in brief the effects of income leakages on the working of the multiplier.
• Briefly explain the concepts of consumption function and savings function.
• Differentiate between National Income determination in Three and Four Sector Economy.
• Elaborate the importance of import and export on the level of income and output.
Notes

---- - - - - - - - - - - - - - · - - - - - - - • - -;;-CsAditiPant