ODWAR VINCENT-LIRA UNIVERSITY

TOPIC

KEYNESIAN THEORY OF INCOME DETERMINATION

The Keynesian theory of income determination states that the equilibrium level of income is
determined at appoint where aggregate demand equals aggregate supply of goods and services
(AD=AS).

In other wards the level of economic activity is determined by the aggregate demand for goods
and services.

The nations production and employment depends on the amount of spending may cause inflation.

The simple theory of income determination and proof of national income determination is
provided by the three different models.

I. The 2 sector model (simple model).

II. The three sector model (closed economy).
III. Open economy model

The Keynesian theory assumes that prices remain constant even if aggregate demand and supply
change.

By assumptions we ignore what is happening to the amount of money in the economy

To understand the theory better we have to know the basic concept and assumptions

These include;

1. The aggregate demand function

2. The consumption function
3. The aggregate saving function
4. The investment function
5. The aggregate supply function

The aggregate demand function

In a two sector model, aggregate demand composes of the demand, the household and the
business sector. There is no government and foreign sector.

Therefore the aggregate demand has two components;

The aggregate demand for consumer goods which forms the biggest proportion (C)

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The aggregate demand for capital goods (I)

We assume that aggregate demand for I is autonomous/exogenous

Hence agg dd = C+I

But I=

Autonomous (not influenced by level of income)

CONSUMPTION FUNCTION

This is one of the most important functions under macro-economics. It refers to the final
statement of relationship between consumption expenditure (C) and its determinants.

There are many determinants of consumption eg interest rate, savings, wealth, future expectation
etc but the important determinant is the level of income.

Therefore C = f (Y)

Where Y is the disposable income

There is positive relationship between consumption expenditure and income. It is based on the
fundamental psychological law by Keyness which states that;

“Men are disposed as a rule on average to increase their consumption as their income but not as
much as the increase in income).

This is explained by the concept of marginal propensity to consume.

THE CONCEPT OF MARGINAL PROPENSITY TO CONSUME

It refers to the relationship between marginal income and marginal consumption.

It is the increase in consumption per unit increase in income

I.e .MPC = =

According to Keynes, MPC decreases with increase in income ie people tend to consume at a
decreasing proportion of their income.

The Keynesian theory produces a none linear consumption function relevant for individual
household

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C = f(Y)α

dx

dy

At the agg level, the Keynesian economics use a linear demand function to reconstruct the theory
i.e.

C= + bY

C is agg consumption

Y is disposable income

MPC =

= b =mpc

The consumption function has two attributes ie average propensity to consume APC and
Marginal propensity to consume MPC
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APC is the ratio of consumption expenditure of any given level of income.

APC = =

DETERMINANTS OF CONSUMPTION

 Level of disposable income

 Stock of assets/wealth
 Availability and cost of credit
 Future expectation in price and income change
 Distribution of income
 Government benefits eg transfer payments
 Level of liquidity preference

AGGREGATE SAVINGS FUNCTION

It states the relationship between income and savings ie savings is a function of income S = f(Y)

Beyond a certain level of income not all income is consumed but part of it is saved

Y=C+S

Where Y is the disposable income Yd

Therefore savings is the difference between disposable income and consumption

S= -C

Where C = +b

S= - -b

= (1-b)-

(1-b) is the marginal propensity to save

Therefore mps =

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Savings

Dis-savings disposable income

The saving functions has two technical attributes is APS and MPS

APS is the ratio of saving to any given level of income

Ie APS = = (1-b)- / ………………………………i

But APC + APS = 1

Proof

APC = ………………………………………………………….ii

APS = ……………………………………………………iii

Substitute ii and iii in to i

+ =1

=1

1=1

MPS is the ratio of a change in income

MPC + MPS = a unit (1)

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DETERMINANTS OF SAVING

 Level of taxation
 Banking facilities
 Business investment opportunities available
 Inflationary rate
 Distribution of wealth and income
 Dependency ratio
 The precautionary motive
 Peace and security

THE INVESTMENT FUNCTION

According to Keynes investment refers to real investment which adds to capital equipment e.g.
acquisition of a new plan and equipment, construction of public work etc.

According to Robinson investment means “an addition to capital which occurs when a new
house is built, a new factory constructed. Investment means making an addition to the existing
stock of goods.”

Precisely it is production or acquisition of real capital asset during any given period of time.

If (I) is investment and K capital, (t) is the given period of time; then

There are basically two types

I. Inducive investment

It is profit motivated, when income increases consumption demand also increases and to cater for
it investment also increases.

Induced investment is the function of income ie, I = f (Y)

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Investment

Income

Induced investment is divided into two parts ie

1. Average propensity to invest

2. Marginal propensity to invest

II. Autonomous investment

This is independently of the level of income. It is exogenously determined/autonomous e.g.

building of the road by the government, dam

Investment

Income

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DETERMINANTS OF THE LEVEL OF INVESTMENT

 Level of income
 Consumer demand
 Stock of capital goods available
 Population growth rate
 Government policy on taxation
 Political climate
 Business expectation
 Marginal efficiency of capital ie rate of expected returns over the cost of new capital

AGGREGATE SUPPLY FUNCTION

It refers to the total supply of goods and services in an economy. The Keynesian aggregate
supply function is derived from the classical aggregate function.

Y = f (kl)

Where Y is real income which depends on the productive resources of capital and labour
assumed to be fixed hence a modified production function.is Y = f (L)

Y2

Y1

O L1 L2 L1 L2

Dig 1

At point A all L1 units of Labour is employed to produce OY1 level of output.

If producers want to increase output OY2 they will employ more units of Labour OL2

This will correspond to point in the diagram 2 where agg supply will increase from Y1 to Y2.
And as a result, Agg demand increases from E1 to E2.

THE PARADOX OF THRIFT

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THE LOANABLE FUND THEORY

According to the classical economist “loanable fund theory of investment, savings is a function
of interest rates not income ie S = f® and S ≠ f(Y)”

The higher the interest rate the more the increase in savings, the more people save the more they
make funds available to financial institutions which would consequently lend it out at a lower
interest rates.

The lower interest rates encourage borrowing for investment purposes.

Investment will not contract; output and employment would be the same as before as the increase
in saving will automatically be compromised by an equal increase in investment.

The economy will always be in equilibrium. However keyness wondered how increased saving
could lead to investment. He added that if household become thrift (increased saving), the level
of income tend to decrease because of two factors

Increased saving caused a reduction in the demand of goods and services which in turn cause a
reduction in investment ie “reversal multiplier”

Investment decision on part of the firm is made not only on the basis of interest rate but also on
the state of confidence

Therefore increase in saving will lead to a contract is as people save, investment will reduce and
output.

This is what is referred to as the paradox of thrift.

In summary keyness viewed savings as a withdraw and a private virtual and a public vice which
leads to a reduction in income, output and employment.

Qtn

“Savings is a private virtual and a public vice” explain the validity of this statement.

EQUILIBRIM INCOME DETERMINATION ACCORDING TO KEYNESS

Two sector model

According to keyness equilibrium income determination in this model can be determined using
two approaches.

1. Aggregate demand equals aggregate supply approach

Equilibrium is determined at a level where agg dd = aggss

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AD, AS

AS

AD

O Income (Output)

Yf

AD = C + I ………………………………………………………………… i

AS = C+S …………………………………………………………………... ii

AD = AS at equilibrium …………………………………………….. iii

Substituting i and ii in iii

C+I=C+S

I=S

According to the classical, but according to keyness equilibrium is viewed from the demand side.

Y=C+I

Recall that C = + bY

I=

Y= + bY +

Y(1-b) = +

Y=

2. Savings investment approach S = I

Recall S = Y (1-b)-

I=

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Y (1-b)- =

Y (1-b) = +

Y=

We can also determine the equilibrium level of consumption C

C= + bY

Where Y =

C= +b

Example: Given that C = 100+0.75Y, I = = 200. Determine Y, S, C and value of the multiplier
and the level of autonomous spending.

THREE SECTOR MODEL

It is a very realistic model because of the government role directly into economic activity.
Government involvement include fiscal policy ie government expenditure/taxation. The
inclusion of the 3 variables complicates the model, however for matters of simplicity we separate
the three sector model into 3 parts ie

I. Three sector model with government and taxes

II. Three sector model with transfer payment
III. Three sector model with taxes as a function of income

THREE SECTOR MODEL WITH GOVERNMENT AND TAXES

Under this the government does not issue out transfer payment therefore;

=Y–T

Given a 3 sector model where

C= +b

T=

I=

=Y–T

G=

Derive the level of income

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Y=C+I+G

Y= +b + +

But =Y–T

Y=

Alternatively we can use the saving investment approach to derive the equilibrium level of
income

S=I

S = Y(1-b) - ,I= , =Y–T

S = Y – Yb – T + bT -

Since S = I

Y=

Since tax is a source of government revenue, then =

Therefore Y =

THREE SECTOR MODEL WITH TRANFER PAYMENT

Under this is specified as Y – T +

Given a closed economy/ sector model where

C= +b

=Y–T+

I=

G=

Derive the equilibrium level of income

Y=C+I+G

But =Y–T+
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Y=

THREE SECTOR MODEL WITH TAXES AS A FUNCTION OF INCOME

The government can levy taxes in two ways ie

I. Progressively tY
II. Proportionately

T= + tY

Given three

C= +b

=Y–T+

T=T= + tY

G=

Derive the equilibrium of income

Y=C+I+G

But C= +b

Y= +b + +

Recall that =Y–T+

Y=

We can therefore get a general equilibrium of the three sector model by incorporating all the
variables at the same time.

Given a three sector model

C= +b

=Y–T+

T=T= + tY

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G=

From Y = C + I + G

Y=

Then multiplier.

Given that;

C = 600 + 0.8

T = 200 + 0.2Y

= = 100

= 150

Required;

I. Equilibrium income
II. Level of autonomous spending
III. The government multiplier
IV. Government budget position
V. How much government revenue can the government collect?
VI. How much government revenue can the government collect from income?
VII. Advice the government

THE FOUR SECTOR MODEL

This is also referred to as the open economy. It involves addition of foreign transactions

Given a four sector model

Where

C= +b

=Y–T+

T= + tY

I= ,G= , = ,X=

M= + mY

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Derive the equilibrium level of income from

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

Y=

Given that = 600, b = 0.8, T = 100, t = 0.25, G = I = 150, = 200, = 100, m = 0.1, =
150.

(mY) How much income is spent on import?

THE MULTIPLIER PRINCIPLE (K)

According to keyness the multiplier principle measures how national/ output changes when there
has been a change in autonomous investment.

It’s often given as K ie k = or

The multiplier is derived from the mpc positively or from the mps negatively

TYPES AND IMPLICATION OF THE MULTIPLIER

Investment multiplier

It measures the number of times a change in investment expenditure brings towards the final
change in national income

It’s given as K =

Derivation

Assume a two sector model

Where C = + bY , I =

From Y = C + I

Y= + bY +

Y= …………………………………………………….i

Assume a =

Then Y + = …………………………………..ii

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Subtract eqtn I from ii

Y – (Y + )= -

Then = 0

Implication

It means that a unit increase in investment expenditure will lead to a final change in national
income by or

It means that a change in investment multiplier will lead to an automatic increase in the
equilibrium output.

Induced investment multiplier

It measures the impact of additional investment on the final level of national income.

C= + bY

I= + iY

Y= + bY + + iY

Y= …………………………………………………………………….i

Assume that =

Then Y + = …………………………………………………….ii

Y+ -Y= -

Implication

It means that the induced investment multiplier is > the autonomous investment multiplier
because the value of 1 – b – i is smaller than

1 – b.

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Government multiplier

It shows the no of times a change in government expenditure contributes to a change in national

income/output

Derivation

Assume a three sector model

Y=C+I+G

C= +b

=Y–T

T=

I= ,G=

Y= +b + +

Y= ……………………………………………………………….(i)

Assuming in government = in Y ( )

Y+ = + …………………………………………….. (ii)

Subtract (i) from (ii)

Implication

It means that a unit increase in government expenditure will lead to a change in national income
by

The tax multiplier

It measures the number of times a change in tax contributes to a change in final income.

Tax is a leakage and therefore it reduces the size of national income/output.

Derivation

Assume a 3-sector model

Where

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C= +b

=Y–T

T=

I= ,G=

We make taxes autonomous because we assume government expenditure comes from

only autonomous income ie T =

Y= +b + +

Y= ……………………………………………………………….(i)

Assume that =

Y+ = …………………………………………..ii

Y+ –Y= -

Implication

It implies that an increase in taxation will lead to a reduction in the final value of income hence
the negative sign.

The balanced budget multiplier

It measures the net impact on the economy when a change in government is financed by an equal
change in taxation (G = T)

Is government expenditure always equal to taxes? , NO because it depends on the government

policy is a supplementary budget or a deficit budget policy or balanced budget policy.

The BBM is always equal to 1. If the taxes are autonomous ie

If the taxes are induced the it would be < 1 ie T = + tY

Derivation

Assume a 3 – sector model

C= +b

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Y=Y–T+

I= ,G= ,T= , =

Y=C+I+G

= +b + +

= + b(Y – T + )+ +

Assume = =

=-

But =

=-

=-

=1

Implication

An increase in government expenditure is financed by an equal change in taxes.

The export multiplier/ foreign trade

It is the same as foreign trade multiplier

It measures a change in export expenditure with a change in income.

It therefore shows how income changes as a result of a change in the export.

When export change the income of the people associated with export industry also change.

Derivation

Assume a 4 – sector model

C= +b

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=Y–T+

T= + tY

I= + iY, G = , = ,X=

M= + mY

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

Therefore k =

Implication

A unit increase in export expenditure will result into a final change in national
income/output by

The import multiplier

NATIONAL INCOME AND FISCAL POLICY

Under this we try to explain the situations that lead to a deflationary gap and an inflationary gap
in relation to how the fiscal policies can be applied in an attempt to bring an economy to
equilibrium.

We try to analyze how government can increase or reduce the level of taxation in order to
achieve full employment and how much.

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INFLATIONARY GAP

Is a situation where aggregate demand is greater than aggregate supply at full employment level
of national income?

AD, AS AS

AD

IG

O Ye Yf Income (Output)

= is full employment of national income

= equilibrium level of income

- Inflationary gap (-ve output)

Policies to close the gap

 Reduce government expenditure

 Increase taxation
 Apply both policies at the same time (policy mix)
 Increase import and reduce export
 Use restrictive monetary policy

Example

Given that; C = 100 + 0.6 , I = 50, T = 200, G = 250, = 600.

Required:

I. GDP, or N.Y, disposable income, consumption

II. Is the economy under a deflationary or an inflationary gap
III. Advice the government

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A DEFLATIONARY GAP

Is a situation whereby the aggregate demand is less than Aggregate Supply or Aggregate supply
Aggregate demand at full empty of national income?

Illustration

AD, AS

AS

DG AD

O Yf Ye Income (Output)

= is full employment

= equilibrium level of income

- Deflationary gap (+ve output)

Policies to close the gap

I. Increase government expenditure

II. Reduce taxation
III. Apply both at the same time
IV. Use an expansionary monetary policy

Example

Assume that: C = 100 + 0.6 , I = 50, G = 250, = 1850.

Get;

I. GDP, or N.Y, consumption

II. Is the economy under a deflationary or an inflationary gap

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III. Advice the government on closing the gap.

LIMITATIONS OF THE MULTIPLIER

 The number of leakages the higher the leakages the less the multiplier
 MPC, the higher the mpc the lower the multiplier
 Existence of full empty situation. It assumed that a situation exist then the multiplier will
be low
 Time log is the gap between must and output /benefit. The small the gap the more the
multiplier
 Existence of induced investment. It’s assumed that the multiplier works best with
autonomous investment
 MPS. MPS cataracts mpc which in the long run affects the multiplier

There are also outer potential withdraws from the income stream which tend to weaken the
multiplier on new investment.

These include;

1. Savings
2. Strong liquidity preference
3. Debt payment
4. Inflation
5. Purchase of old stock and security
6. Taxation
7. Undisputed growth

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