Keynesian Income Determination

Aggregate Demand =Aggregate Supply = National Income

Aggregate Demand

y Aggregate Demand = y Consumption of goods and services +

Investment ( Demand for capital goods)

y AD = C+I

Investment Demand
Investment Demand based on : Rate of interest ( does not change in short run) 2. Marginal efficiency of capital: y Replacement cost of the capital goods. y Profit expectations of entrepreneurs. y Investment is treated autonomous not the function of income.
1.
I

y Hence, Investment demand is remain constant in short run .

y Therefore : AD = C + I (CONSTANT INVESTMENT)

y

Consumption : Based on various factors:

y Income , wealth, interest rate, expected future

income , consumer credit, age and sex.

y Income is primary determinant of consumption and saving.

Consumption Function
y C = f (Y) (Consumption is positive function of

income) y Consumption increases with increases in income. y As per Keynes, relationship between income and consumption is based on:
y

Psychological Law (with increase of income consumption does not increase in same proportion of increment of income.)

But, increase in what proportion?

y > Proportionately y < Proportionately y = Proportionately y Increase can be explained by MPC y MPC = C/ Y y MPC increased at decreasing proportion with the increase in income because people like to save also ( non-linear consumption function applies to individual house holds)

Linear Consumption Function

y Applicable to economy as a whole or at

aggregate level y C = a+b Y y Y = Total disposable income y a = Intercept is positive constant. (denotes the
level of consumption at ZERO level of income on the basis of past saving, called AUTONOMOUS CONSUMPTION )

y b = is positive constant (mathematically

represents slope of linear consumption function.

b denotes constant MPC =

C/

y MPC = 0<b<1 (MPC is inevitably positive)

y Example :
y Consumption = Rs. 200 when Y = 0 (finance out

by past saving) y Increase in income induce additional consumption at fixed proportion of 75%. y Aggregate consumption increase with the increase in aggregate income, at a constant rate of 75%

y When aggregate income increases from Rs. 200 to

Rs. 300, aggregate consumption increases from Rs. 250 to 325. Linear Aggregate Consumption Function Y 600 C
500 400

Consumption ( C )

C = 2 00 + 0.75 (Consumption Function)

300 200 100 200 300 400 INCOME (Y) 500 600

y Average Propensity to Consume (APC):

APC is the ratio of the amount of the Consumption to total income.

APC = C/Y
y Example :
y The level of income Rs.1000 crore. y Consumption expenditure Rs.750 y APC = 750 = 0.75

1000 y If income increases to Rs.1200 crore and Consumption rises to Rs.900 crore and APC 0.75 same at all level. y Hence APC is the same At all levels of income.

Saving Function
y It is counter Part of the consumption function. AS:

y Y =C+S
y Therefore: S = f (Y) y Saving rises at increasing rate at upward movement of

the national income

y If consumption function is given as : C = a+b Y y Saving function can be derived as : y Y = C+S y S = Y-C or y S= Y (a+bY) y = -a+(1-b)Y y 1-b gives MPS where b = MPC

y If consumption function is C = a+ b Y, y C = 200+0.75

y Saving function as: y S =Y- (200+0.75Y) y =Y 200 - 0.75Y y = -200+(1-0.75)Y y = -200+0.25Y(saving function)

The Saving Function

100 Saving(+) 200 300 0 -100 - 200 Dissaving (-) -300

S S = -200+0.25 200 400 500 600 700 800

Example
y Suppose that a family would spend Rs.2000/- at

Zero level of income.

y When income increases it spends 80% of it on

consumption.
y Find out the familys consumption spending y When income is Rs. 20,000/y What is the Saving function of the family.?

y C = 2000 +0.80Y y When Y = 20,000/y C= 2,000 + 0.80 x 20000 = 18000/y S = -a + (1-b)Y y S = - 2000 + (1-0.80)Y = -2000 + 0.20Y y

S = 2000

Aggregate Supply
y Aggregate supply (National Product) based on :
1. Supply of final goods and services in a year 2. Output of capital goods.

y Aggregate supply or money value of national

product of goods and services is distributed among the various factors of production. Therefore it is National income also.

y OZ line measures the

AS X

Aggregate Supply z

distance between X-axis National income is given and Y-axis aggregate supply is given which is equal at every point of line.
y Therefore,

aggregate supply or national product equals national income. y Resultantly, OZ line is AS Curve

0 NATIONAL INCOME

Equilibrium Level of Income

y C+I represents the

Aggregate Demand and Supply z

aggregate demand y OZ line represents Aggregate supply, which is 450 line. It means aggregate supply or NationatiOnal product equals national Income. y It shows that value of aggregate output increases 45 0 at constant rate because price Level, productivity are assumed to remain constant.

C+I

Y1 Y YF NATIONAL INCOME

y At point E where aggregate supply and demand intersects each other income level is OY1, which represents equilibrium level of income. y Income can not be in equilibrium at levels smaller than OY1 because in this case aggregate demand (C+I) curve exceeds aggregate supply (OZ) curve. The effect would be : y Which will lead to the decline in inventories of goods below the desired level because of mismatch between supply and demand, firms will expand their output of goods and services to meet the demand consequently income increases.
y The process of expansion in output under the pressure of

excess demand will continue till national income OY1 is reached.

y On the contrary, the level of national income

can not be greater than OY1 level beyond this level aggregate demand below the aggregate supply which will lead unintended inventories of goods.
y Resultantly, firm will reduce production to keep

desired level inventories. The net effect would be unemployment will be induced and fall in national income and output till OY1 level. Thus OY1 is the equilibrium level of national income.

Formal Model of Income Determination

AD = AS C+I = C+S C+I = C+S I=S There can be two approaches to determine National Income: 1. AD-AS Approach 2. S-I Approach

1.

AD-AS Approach
C+I = C+S y Y = C+I y C= a+bY, I is constant y Y= a+b Y+I y Y-b Y = a+I y Y(1-b) = a+I y Y = _a+I_ 1- b Y = __1_ 1- b (a+ I)

Numerical Example
C = 100 +0.75 y I = 200 y Y= C+I y Y =100+0.75+200 y Y (1-0.75) 100+200
y

Y = __1_ (a+ I) 1- b y Y = __1 (300) 1-0.75 Ans. = 1200

2. Saving Investment Approach

y

C +I = C+S C +I = C+S

I=S Investment is remain constant S= f(Y) S= Y-C C=a+b Y S =Y (a+b Y)

y

y S =Y (a+b Y)

S= Y-a-b Y S= -a+Y-b Y

S= -a+(1-b)Y (Saving Function) I=S I = -a+(1-b)Y

Example
y I =200, c = 100+0.75 y Given the value of a and b y Saving function : y S= -a+(1-b)Y y S= -100+(1-0.75)Y y I =S y 200= -100 +(1-0.75)Y y 300 =(1-0.75)Y y Y= __300___
y
1-0.75

1200