Keynes’ Income

Determination Model
Dr. Akshay Dhume

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Readings
 4B. Keynes' Income Determination Model

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Consumption Function
 Consumption Function depicts the  Positive relationship between
relationship between consumption consumption and income
expenditure and income

 Consumption Function can be both linear

and non-linear – assume linear
consumption function
 MPC is the additional consumption
resulting an additional unit of income

 According to Keynes Psychological Law,

there is tendency to increase consumption
as income increases, yet the entire increase
in income will not be consumed

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2-Sector Model
 Assumptions

◦ Only 2 sectors in the economy – Consumption and Investment

◦ – no leakages or injection

◦ No Government – no tax, no government expenditure

◦ No external sector

◦ No corporate savings – profits are distributed as dividends

◦ All prices, including factor prices are constant

◦ Supply of capital and technology is given

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2-Sector Model
Income Identity/Aggregate Expenditure:

Consumption Function:

Autonomous Investment:

Equilibrium Income:

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2-Sector Model

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2-Sector Model: Savings Approach
 Savings Function:

 Equilibrium Condition:

 Equilibrium Income:

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2-Sector Model: Savings Approach

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2-Sector Model: Investment Multiplier
 Investment Multiplier gives the change in equilibrium
income due to a unit change in investment

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2-Sector Model: Investment Multiplier
 Uses
◦ Understand impact of one-shot investment on equilibrium level of
income
◦ Helps in planning growth strategies

 Limitations
◦ Leakages from income stream
 Payment of past debts
 Purchase of existing wealth
 Import of goods and services
◦ Non-Availability of Consumer Goods and Services
◦ Full Employment Situation

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2-Sector Model: Paradox of Thrift

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3 Sector Model: Government Expenditure
Income Identity/Aggregate Expenditure:

Consumption Function:

Investment:

Government:

Equilibrium Income:

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3 Sector Model: Government Expenditure

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3 Sector Model: Government
Expenditure, Autonomous Tax
Income Identity/Aggregate Expenditure:

Consumption Function:

Investment:

Government:

Equilibrium Income:

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3 Sector Model: Government Expenditure,
Autonomous Tax

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3 Sector Model: Government Expenditure,
Autonomous Tax, Transfers
Income Identity/Aggregate Expenditure:

Consumption Function:

Investment:

Government:

Equilibrium Income:

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3 Sector Model: Government Expenditure,
Autonomous Tax, Transfers - Multipliers

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4 Sector Model
 Determinants of Exports
◦ Internal Factors
 Availability of exportable surplus
 Foreign trade policy
 Trade and tariff agreements
 International competitiveness
◦ External Factors
 Relative prices
 Price elasticity of demand for
exportable goods in importing countries
 Income level of importing country
 Income elasticity in importing country
 Tariffs and import policy of foreign
country
 Foreign exchange rates
 Determinants of Imports
◦ Relative prices of domestic goods
and import substitutes
◦ Income level
◦ Income elasticity of importable
goods
◦ Tariff rates and import policy
◦ Exchange rate policy and foreign
exchange restrictions
◦ Tastes and preferences for foreign
goods
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4 Sector Model
Income Identity/Aggregate Expenditure:

Consumption Function:

Investment:

Government:

External Sector:

Equilibrium Income:
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4 Sector Model: Multipliers

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