KEYNESIAN MODEL

OF INCOME
DETERMINATION
 Prof. J. M. Keynes developed a new theory of
employment in his book “General Theory of
Employment, Interest and Money” published in 1936.
 Keynesian theory of employment is based on the
concept of effective demand. Keynes states that
demand creates its own supply.
 Effective demand means the level of income where
aggregate demand and aggregate supply are equal.
 Prof. J. M. Keynes used the approach of aggregate
demand and aggregate supply for the determination
of full employment equilibrium.
 KEYNESIAN CONSUMPTION
FUNCTION

Ca is the intercept of the consumption function on the y-axis. It shows

the level of consumption at zero level of income. It is known as
autonomous consumption.

The constant ‘b’ denotes the slope of the consumption function. It is

known as the marginal propensity to consume, MPC. It indicates the
increase in the consumption per unit of increase in the income.
Aggregate Demand

 The total demand for goods and services in an economy

in a year’s time is called aggregate demand. It is
expressed in terms of total expenditure of the community.
 Goods and services are demanded for two purposes- (1)
Consumption, and (2) Investment.
 Consumption is of two types: private (household)
consumption and public (government) consumption.
Similarly, investment is also of two types: private
(household) investment and public (government)
investment.
 Aggregate Demand (AD) = Consumption Demand (C) +
Investment Demand (I) AD = C + I
 Y=C+I
 Linear Consumption
Function

The average propensity to consume (APC) is defined as

the ratio of consumption to income for different levels of
income. APC=C/Y
The marginal propensity to consume (MPC) is defined
as the increase in the consumption per unit of increase
in the income.
 The Saving Function

In this equation, the constant ‘s’ denotes the slope of the

saving function. It is the marginal propensity to save. It
indicates the increase in the savings per unit of increase in
the income.

As the MPS or s is always positive, savings will be an

increasing function of income.
1 = APC + APS AND 1 = MPC + MPS
 The aggregate demand
function

Substituting for C from Eq. (3) in Eq. (1), we get

DETERMINATION OF EQUILIBRIUM
INCOME OR OUTPUT IN A TWO
SECTOR ECONOMY
Some assumptions
necessary here are as follows:
 There exist only two sectors in the economy, the households and the firms.
There is no government sector and no foreign sector.
 All the factors of production are owned by the households who sell the
factor services to earn an income. With a part of this income, they
purchase goods and services and save the rest.
 As there is no government in the economy, there are no taxes and subsidies
and no government expenditures.
 As there is no foreign sector in the economy, there are no exports and
imports and no external inflows and outflows.
 As far as the firms are concerned, there are no undistributed profits.
 All the prices are constant and do not change.
 Investment is assumed to be autonomous and thus independent of the
income level.
 The technology and the supply of capital are given.
Equilibrium Income and Output:
A Theoretical Explanation
1. Aggregate Demand–Aggregate Supply Approach
At equilibrium AD=AS
2. Saving-Investment Approach
 The equilibrium national income is determined where
not only the aggregate demand and the aggregate
supply are equal but at that level where planned
saving is also equal to planned investment.
 Ex ante(planned ) saving and investmnet may not
always be equal but expost saving is always equal to
investmnet.
Equilibrium Income and Output: An
Algebraic Explanation
Aggregate Demand–Aggregate
Supply Approach
 Saving-Investment
Approach
The equilibrium condition can be written as

I=S

This is the same equation as Eq. (9) above.

Graphical explanation
Shifts in the Aggregate
Demand and the Multiplier
 To be learnt
 A shift in the aggregate demand function results in a
change in the equilibrium income or output. The ratio of
the change in income is a multiple of the change in the
investment.
 The concept of the investment multiplier.
 The importance of the multiplier in planning economic
growth.
 The existence of certain limitations prevents the multiplier
from working.
 The multiplier may not always work, especially in the LDCs.
 If the whole economy saves more, the economy’s
income and output may decrease.
Changes in the equilibrium
income and output in a two
sector model.
 In a two sector economy, the aggregate demand is a
sum of consumption and investment expenditures.
 The aggregate demand curve can either shift upwards or
downwards.
 The amount of the change in the income will be a
multiple of the amount of the shift in the aggregate
demand curve.
 The multiplier is the amount by which there is a change in
equilibrium income or output when autonomous
aggregate expenditure (for example, autonomous
investment since the consumption function is relatively
more stable than the investment function) increases by
one unit since the consumption function is relatively more
stable than the investment function.
Effect of a Change in
Investment on the Equilibrium
Income or Output
 Investment multiplier
We find that increase in income is much more
than the increase in investment expenditure
which was responsible for bringing about that
increase in the income, or in other words ΔY >
ΔI.
Working of the multiplier
MPC=0.8 Consumer Income
spending generation
First round 100(crores0
second 80 80
third 64 64
fourth 51.20 51.20
fifth 40.96 40.96
-----
------
last 0
Total 500
Derivation of the multiplier
RECAP

 Shift in the investment function results in a change in

the equilibrium income or output.
 The ratio of the change in income is a multiple of the
change in the investment.
 ΔY = m Δl where m is the investment multiplier and has
a value greater than 1.
 The larger the marginal propensity to consume the
larger will be the multiplier.
USES AND LIMITATIONS OF THE
MULTIPLIER

 The multiplier plays an important role even in a two

sector economy in that it is able to determine the
investment, which would be required for a certain
planned growth in the national income.
 The multiplier suffers from many limitations, which may
prevent it from working.
 LIMITATIONS OF THE MULTIPLIER
 Existence of leakages from the income stream
 The availability of the consumer goods:
 There may exist time lags:
 The full employment ceiling:
 In the Indian Economic Review, February 1953, Dr V. K. R. V. Rao
raised doubts regarding the applicability of the multiplier principle to
the less developed countries.
 The reason for this, according to Dr V. K. R. V. Rao, is that the
conditions necessary for the multiplier principle to work do not exist in
the LDCs. They are satisfied only in the developed countries.
conditions necessary for the
multiplier principle to work
 There should exist only involuntary unemployment and
no other form of unemployment:
 It must be mainly an industrial economy with an
upward sloping supply curve for the consumer goods:
 There should exist excess capacity in the consumer
goods industries:
THE MULTIPLIER AND THE
PARADOX OF THRIFT
 Suppose the marginal propensity to consume is (i)
0.40, (ii) 0.50, (iii) 0.80, (iv) 1.0 and (v) 0,
1.Calculate the marginal propensity to save.
2.Calculate the value of the multiplier.
3.Using the values of the marginal propensity to consume,
find the effect of an increase in the equilibrium income
when autonomous investment increases by 40 crores.
 Y=500 billion, mpc=0.4. Suppose the govt wants to
increase the income to Rs. 800 billion. By how much
should the autonomous investment be increased?
m=1.67, chg in I=300/1.67=179.6 billion
 C=150+0.8Y and I=180cr. Find equilibrium Y. Find eq
income when planned investment increases by 20 cr.
Y=C+I, Y=150+0.8Y+180, Y=1650
Chg in I=20, b=0.8, m=5, chg in Y=100cr
The Keynesian Model of Income
Determination in a Three Sector
Economy:
 This chapter focuses on :
 Extending the theory of income determination and the
multiplier to a three sector model, the third sector being
the government sector.
 In a three sector model taxes, like saving, are income
leakages whereas government expenditures, like
investment, are injections.
 Introduction of taxes and Government Transfer Payments
 The expansionary effect on the income level will be
smaller with a proportional income tax than with a lump
sum income tax.
 The Government Expenditure Multiplier, Tax Multiplier and
the Balanced Budget Multiplier—
Assumptions for the analysis

 The government purchases factor services from the

household sector and goods and services from the
firms.
 Transfer payments include subsidies to the firms and
pensions to the household sector.
 The government levies only direct taxes on the
household sector.
Aggregate Demand–Aggregate
Supply Approach
T = tax (lump sum income
= tax)

Equation (2) gives the equilibrium

income in a three sector economy.
Leakages Equal Injections
Approach

Hence, both the approaches yield the

same equilibrium level of income.
Equilibrium Income and Output:
A Graphical Explanation
 Keynesian cross- where AD and AS intersect-

 The term was coined by Samuelson

 AD1-AD before a tax
 AD2- AD after a tax
 E1- the three sector equilibrium where the aggregate
demand curve AD1 (C + I + G) and aggregate supply
curves intersect
 E2- the three sector equilibrium where the aggregate
demand curve AD2 (C′ + I + G) and aggregate supply
curves intersect
 The entire government expenditure is financed by
taxes or that G = T. In other words, it is a balanced
budget.
Balanced budget multiplier

 If chg in G=chg in Tax

 The contractionary effect of taxes is less than the
expansionary effect of government expenditure even
though ΔG = ΔT.
 The govt. expenditure multiplier= 1/(1-b) whereas
lumpsum tax multiplier= -b/(1-b)
 Some part of the increase in T involves a reduction in
the savings whereas the rest is absorbed by a
reduction in consumption and, hence, in aggregate
demand.
(Introducing Government
Transfer Payments)
 Transfer payments increase the spending capacity of
the households leading to, ultimately, an increase in
the equilibrium level of income.

 Yd = Y – T + R = disposable income

 R =R = transfer payments (assumed to be

autonomous)
 Y=1/1-b(Ca+I+G-bT+bR)
 G and R
 Both the transfer payments and the government expenditure have an
expansionary effect on the income level.
 However, the expansionary effect of an increase in the transfer payments will be
less than the effect of an increase in the government expenditure even though ΔG
= ΔR (as long as the marginal propensity to consume is less than 1). Thus the
transfer payment multiplier is less than the govt. expenditure multiplier.

 This is because while the entire increase in government spending is an addition to

the aggregate demand, only a part of the increase in R will be an addition to the
aggregate demand (through an increase in the consumption spending). Some
part of the increase in R is directed towards savings.

 It is important to note that though a change in government expenditure affects

aggregate demand directly, a change in transfer payments affects aggregate
demand indirectly through a change in disposable income.
Including Government Expenditures, Transfer Payments and Introducing Tax as a
Function of the Income Level)
 Lumpsum and unit tax
 In the second model where the tax receipts are independent of the
income level, the multiplier is larger than the multiplier in the third
model where the tax receipts are dependent on the income level.
Lumpsum tax multiplier (-b/(1-b))is larger than the unit tax multiplier {-
b/(1-b(1-t))}
 Given an increase in government expenditure, the expansion in
income will be smaller with a proportional income tax than for a lump
sum income tax.
 C=50+0.8Yd
 I=100, G=50, T=20
 Yd=Y-T+R
 Yd=Y-20
 Y=C+I+G
 Y=50+0.8(Y-20)+100+50
 Y=200+0.8Y-16=184+0.8Y
 0.2Y=184
 Y=184*5=920
MULTIPLIERS IN A THREE SECTOR
ECONOMY—THE FISCAL
MULTIPLIERS
 To be done-

 Government Sector Multipliers with Lump Sum Tax

 Tax Multiplier (Lump Sum Tax)
 The Balanced Budget Multiplier
Government Sector Multipliers with Lump Sum Tax
 Tax Multiplier (Lump Sum
Tax)

As the tax multiplier is negative, an increase in tax leads to a

decrease in the equilibrium level of income.
The Balanced Budget
Multiplier
 Balanced budget multiplier

 Whatever the value of b, the sum of the government

expenditure multiplier and the tax multiplier will always
be equal to unity.

The budget is in balance when the government

expenditures plus transfer payments equal the gross tax
receipts, or in other words, G = T.
Multipliers (in short)

 Govt. exp multiplier= 1/(1-b)

 Govt. expenditure multiplier (in case of unit tax)= 1/(1-
b+t)
 Transfer payment multiplier= b/1-b
 Tax payment multiplier (in case of unit tax)= -b/(1-
b+t)
 LumpsumTax multiplier= -b/1-b
 Balanced budget multiplier= 1
The Keynesian Model of Income
Determination in a Four Sector
Economy
 To be learnt
 In a four sector economy, the export and Import of goods and
services affect the level of aggregate demand.
 There are two approaches to the determination of the
equilibrium Income and output, the aggregate demand—
aggregate approach and supply leakages equals injections
approach.
 Transfer payments increase the equilibrium level of income.
 The four sector equilibrium exists where the C + I + G + X –
M curve and aggregate supply curve intersect.
 A zero marginal propensity to import implies a multiplier, which
has the same value as the ordinary multiplier.
 In an open economy, the value of the multiplier is less than that in
a closed economy.
DETERMINATION OF EQUILIBRIUM
INCOME OR OUTPUT IN A FOUR
SECTOR ECONOMY
 The volume of exports in any economy depends on the
following factors:
 The prices of the exports in the domestic economy
relative to the price in the other economies.
 The income level in the other economies.
 Tastes, preferences, customs and traditions in the other
economies.
 The tariff and trade policies between the domestic
economy and the other economies.
 The domestic economy’s level of imports.
 Thus, the level of exports is assumed to be an
autonomous variable.
Imports

 the volume of imports in any economy depends on the

following factors:
 The prices of the imports relative to the domestic prices.
 The income level in the domestic economy.
 The tastes and preferences for imports as compared to
the domestic goods.
 The tariff and trade policies of the domestic economy vis
á vis the other economies.
 The domestic economy’s exchange rate policies.+
 To simplify our analysis, we assume that the imports in any
economy are determined by the income level in the
domestic economy.
import function,

 M = Ma + mY
 The Import and Export
Functions

A change in the factors that influence the exports such that there is an
upward shift in the exports function will lead to an increase in the net
export balance or a decrease in the net import balance at each income
level.

A change in the factors that influence the imports such that there is
a downward shift in the imports function (a decrease in Ma) or a
decrease in the slope of the import function (decrease in m) will
lead to an increase in the net export balance or a decrease in the
net import balance at each income level.
 EQUILIBRIUM INCOME AND
 Aggregate Demand–Aggregate Supply ApproachAggregate
demandOUTPUT
= Total value of output (or income)
 Y=C+I+G+X-M (where I, exports and G are autonomous and T
is lumpsum tax)
Leakages Equal Injections
Approach
 AD = AS Or
 C + I + G + X = C + S + T + M (In a four sector model,
the injections include investment, government
expenditures and exports whereas the leakages
include saving, taxes and imports.)
 Thus I+G+X=S+T+M
 INTRODUCTION OF
GOVERNMENT TRANSFER
 R = = transfer payments (assumed to be autonomous)

PAYMENTS IN A FOUR SECTOR
Y=C+I+G+X–M
MODEL
Determination of Equilibrium Income
and Output: A Graphical Explanation
 AS -AD approach
Leakages Equals Injections
Approach
MULTIPLIER IN A FOUR SECTOR
ECONOMY—THE FOREIGN
TRADE MULTIPLIER
 THE FOREIGN TRADE MULTIPLIER
 The value of the multiplier in an open economy is less than that in a
closed economy.
 This is because in the open economy, there is an additional leakage
in the form of imports.
 Thus as long as the marginal propensity to import is positive, the size
of the multiplier gets reduced.
 A zero marginal propensity to import implies a multiplier, which is the
same as the ordinary multiplier, 1/1 – b.
 Another way of analysing the effect of the marginal propensity to
import on the multiplier is by expressing the multiplier as 1/1 –(b – m)
where b-m=marginal propensity to purchase domestically produced
goods
THE FOREIGN TRADE MULTIPLIER

 It is to be observed that
1. If b = m, the value of the multiplier is equal to
2. If b > m, the value of the multiplier would be greater
than 1.
3. If the value of m were zero, then the multiplier would
become equal to the ordinary multiplier.
Practice Ques

 Explain the effect of multiplier. How does it work? (2 )

 What is paradox of thrift? (2 )
 What increase in investment is required to rise income
by Rs. 4000 cr. if mpc is0.50.? (2)
 C= 100+0.75Yd, I=200, G=T=100, TR=50. (a) Find the
equilibrium level of income. (b) Calculate government
expenditure multiplier and transfer payment multiplier
(4)
Practice Ques

 1. Derive an expression for equilibrium income in a two sector

economy.
 2. In an economy, the tax rate is 10% and mpc is 0.75 find the
change in equilibrium income when there is
 a) an increase in govt. expenditure by 100
 b) an increase in investment multiplier by 50
 c) an increase in transfer payment by 150.
 3. If C=4+0.75Yd, R=8, T=0.2Y, G=120, I=110, X=55, M=5+0.1Y
 A) Calculate the difference between the income of the
closed economy and open economy.
 B) what should be the level of government spending and the
rate of tax if the government wanted to achieve full
employment level of income and have a balanced budget
i.e. G+R=T.
 Foreign trade multiplier= 1/1-b+m
 Foreign trade multiplier(with tax)=
1/1-b(1-t)+m
 Numerical Problem
 In an economy, the full employment output occurs at Rs.
1000 crores. The marginal propensity to consume is 0.80
and the equilibrium level of output is currently at Rs. 800
crores. Suppose the government aspires to achieve the
full employment output, find the change in
 the level of government expenditures
 net lump sum tax
 the level of government expenditures and the net lump
sum tax when the government aims at bringing the
output to the full employment while keeping the budget
balanced.
 If C=100+0.8Yd
 I=100, G=100, T=100
 Find eq. level of income
 How much increase in income will take place if govt.
expenditure on goods and services increases by 60
crores?
 Find the tax multiplier and balanced budget multiplier
 Find the equilibrium income if T= T+tY=100+0.25Y
 C=1000+0.5(Y-T)
 I=2000
 G=1000
 Taxes=1000
 Find eq level of GDP without taxes
 Find eq level of GDP with taxes
 Calculate tax multiplier using i) and ii).
 Explain the working of tax multiplier intuitively
a. Find the equilibrium level of income.
b. Find the net exports at equilibrium level of income.
c. Find the equilibrium level of income and the net exports
when there is an increase in investment from 160 to 170.
d. Find the equilibrium level of income and the net exports
when the net export function becomes 140 – 0.05 Y.
Y=130+0.8(Y-150)+160+150+150-0.05Y
Soln.
m=1/1-b(1-t)= 1/ 1-0.75(1-.1)= 1/1-0.675=1/0.325=3.076
Chg in Y= 3.076* 100=307.6
ii) Im=3.076
Chg in Y=3.076* 50=
iii) b/1-b(1-t)= 0.75/0.325= 2.307
Chg in Y= 2.307 * 150=346.05