The Simple Keynesian

Model of Income
Determination
Abhishek garg
abhishekgarg98@gmail.com
09962481572
 Session Outline
• Consumption Function
• Planned Investment (I), Government
Purchases (G) and Net Exports (NX)
• Equilibrium Income
• Multiplier
• Income Determination in an Open
Economy and the Foreign Trade Multiplier

11/21/09 2
 Introduction
• Full employment level is one of the many possible
states of the economy i.e., it need not be
automatically at this state.
• The model focuses only on the goods market and
the influence of money market on the goods market
is completely ignored.
• Key assumptions.
– Prices remain constant
– Firms are able to sell any amount of output at given level of
prices (that is, the aggregate supply curve is perfectly
elastic)

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 Determination of Equilibrium
Output

Aggregate demand (AD) = total goods

demanded in an economy.
AD = C + I + G + NX

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 Equilibrium Output
Equilibrium output is the output level at which the quantity of

output produced is equal to quantity of output demanded.

At any output level, Y, is equal to C + I + G + NX.

Does it mean all output levels are equilibrium output levels?

– The answer is ‘No’.

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 Equilibrium Output
The concept of aggregate demand, AD is ‘ex-ante’, national income

accounts are all in the ‘ex-post’ sense.

In other words, aggregate demand refers to the total goods and

services that people want to buy, while national income refers to

the total goods and services that are actually bought.

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 Equilibrium Output
Desired aggregate demand may not be equal to

actual output at all times.

Equilibrium level of output refers to the output at

which total desired spending on goods and

services (desired aggregate demand) is equal to

the actual level of output (Y).

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Determination of Equilibrium Output

• Aggregate Demand (AD):

AD = C + I + G + NX
• Equilibrium Output:
Y = AD
Or,
Y = C + I + G + NX

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 Consumption Function
Consumption expenditure (C) is one of the
important components of aggregate
demand. Although many factors influence
the consumption expenditure, income (Y)
is considered to be the most important
influencing factor.
The relationship between consumption and
income can be described using
consumption function, C = f(Y).

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Consumption and income are positively related i.e.,
greater the income, greater is the consumption.

Let us assume that consumption demand increases

linearly with an increase in the income level. Then
we have, C = a + bY; a > 0, 0 < b < 1
Where ‘a’ is the consumption when the income level
is zero and ‘b’ is the slope of the consumption
function.
‘b’ represents the marginal propensity to consume
(MPC) i.e., the rate at which consumption changes
for a unit change in income.
 Consumption Function
C = a + bY; a > 0, 0 < b < 1
Where b = MPC
C

C = a +bY

Y
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 Derivation of Savings Function
• If we assume a two-sector economy, income has
to be either spent or saved and there are no other
alternatives to use the income.
Thus, Y = C + S (or) S = Y – C
• S = Y – (a + bY)
• S = – a + (1 – b) Y
• Savings increase (decrease) with the increase
(decrease) in income. This relationship can also
be seen from the above equation, S = - a + (1 – b)
Y. In the equation, (1 – b) represents the marginal
propensity to save (MPS). The sum of MPC and
MPS must be equal to one. For example, if MPC is
0.4, then MPS = 0.6
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 Savings Function

Y=C+S
S=Y–C
S = Y – C = Y – a – bY
= - a + (1 – b)Y
Where b = MPC

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Planned Investment (I), Government Purchases
(G) and Net Exports (NX)

For deriving consumption function,

we assume that other components
of aggregate demand I, G and NX
are constant and are independent
of the income level. Let the
constant levels of investment,
government purchases and net
exports be represented by I, G and
NX respectively.
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 Planned (I), Government (G) and
Net Exports (NX)
ADC=+
I+
+N
G X
=
++
a +
b+
Y I GNX
=
+(+
+
a I+
GNX
) bY
=+ A bY
Where
A=
a+
+
I+
GNX
and
=
ACons t tan
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 Planned Investment (I),
Government Purchases (G) and
Net Exports (NX)
AD

AD = +bY

A
I + G + NX C = a +bY

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 In the figure, we have shown consumption
function and the aggregate demand
function. The parallel line above the
consumption function is the AD line. Part of
the aggregate demand, i.e. is autonomous
and is independent to the income level,
while remaining part ‘bY’ is dependent on
income and output.
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 Equilibrium Income
• Next , we use the aggregate demand function to
determine the equilibrium level of income and
output.
• Equilibrium level of income is the level at which
aggregate demand is equal to output, which in turn
equals income.
• The 450 line drawn serves as a reference line on
which at all points the level of aggregate demand is
equal to the level of output.
• And, the point at which 45 line cuts AD line is the
equilibrium point and the corresponding income
level is the equilibrium income
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At output levels below Y, aggregate demand
exceeds output. Consequently, the level of
inventory with firms decreases. This unintended
(undesired) decline in inventories makes firms
to increase their production, resulting in
increase in income levels.
Conversely, at output levels above Y, the output
exceeds aggregate demand causing increase in
level of inventories. This unintended increase in
inventories makes firms to cut their production.

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 Equilibrium Income
AD

AD = +bY

A
I + G + NX C = a +bY

a
450

Y* Y

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 Deriving Equation for Equilibrium
Level of Income
Y = AD = C + I + G + NX
= (a + bY ) + I + G + NX
= A + bY
= Y (1 − b) = A
A a + I + G + NX
=Y = =
1− b 1− b
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From the above formula, we know that larger

the autonomous components (for a given

b), the higher is the equilibrium level of

income. Similarly, if b (slope of the AD

curve) is less, then higher is the

equilibrium level of income.

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 Multiplier
Multiplier refers to a multiple by which
equilibrium income changes for a unit
change in autonomous spending.
Put differently, multiplier refers to the rate at
which the level of equilibrium income
increases (decreases) for a unit increase
(decrease) in autonomous spending. The
multiplier is denoted by α .
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 Multiplier
AD

AD2 = A 2+bY

∆A AD1 = A 1+bY

450

Y1* Y 2* Y

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 From the above figure it is clear that
for a change in autonomous
expenditure (∆A), there would be a
greater change in equilibrium income
(Y), because of operation of multiplier.

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 Deriving Equation for Multiplier
Y2 − Y1
α=
A2 − A1
Substituting
A
Y=
1− b
A2 A1
−
1 − b 1 − b 1 1
α= = =
A 2 − A1 1 − b MPS
1
Where = MPS
1− b
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 From the above multiplier equation we
know that larger the marginal propensity to
consume, larger is the value of the
multiplier.

Conversely, larger the marginal propensity

to save the lower is the value of the
multiplier.
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 Government Sector
Note: Disposable Income (Yd) = Total Income (Y) – Tax
(T) + Transfer Payments (J).
C = a + bYd
 Yd = Y − T + J
AD = a + b(Y − T + J ) + I + G + NX
Assu min gT = tY
AD = a + b(Y − tY + J ) + I + G
= A + b(1 − t )Y
Where A = a + b J + I + G + NX

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 Deriving Multiplier (with the
inclusion of Government Sector)
AtEquilibr ium
Y = AD
A A
Y = A + b(1 − t )Y = =
1 − b(1 − t ) 1 − b + bt
1
Where = Multiplier
1 − b + bt
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 The Budget
Budget Surplus (BS) = Tax Revenue (T) –
Government Expenditure (G) – Transfer
Payments (J)

BS = T − G − J
SubstitutingT = tY
BS = tY − G − J

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 Income Determination in an Open Economy
and the Foreign Trade Multiplier

How to determine the equilibrium level of output in an open economy?

For determination of income in an open economy, we assume that the

volume of imports (M) is influenced by the total income of the country,

while exports (X) depend on foreign economic conditions that cannot be

influenced by the open economy (that is, exports are exogenous to the

country).

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 Income Determination in an Open
Economy and the Foreign Trade
Multiplier
∆M
M = M (Y ) = m.Y , where' m' = MPI =
∆Y
∴ AD = (C + I + G + X − M )
∴ AD = (a + bYd ) + I + G + X − mY

∴ AD = a + b(Y − tY + J ) + I +G + X − mY
∴ AD = a + I + G + b J + Y (b − bt − m)

∴ AD = a + G + X + b J + Y [b(1 − t ) − m]
1
∴Y = .a + I + G + X + b J
1 − b(1 − t ) + m
1
∴α =
11/21/09 1 − b(1 − t ) + m 32