Unit-I

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Keynesian
Principle of
Effective Demand
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Concept of Effective Demand
 In a capitalist economy, the level of employment depends on effective
demand. Thus unemployment results from a deficiency of effective demand
and the level of employment can be raised by increasing the level of
effective demand.

 Keynes used the term ‘effective demand’ to denote the total demand for
goods and services at various levels of employment.

 Different levels of employment represent different levels of aggregate

demand. But there can be a level of employment where aggregate demand
equals aggregate supply.

 This is the point of effective demand.

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Aggregate Demand

 Aggregate demand (AD) refers to the value of final goods and services which
all the sectors of an economy are planning to buy at a given level of income
during a period of one accounting year.

 Aggregate demand is the aggregate expenditure that different sectors of the

economy are willing to incur during a given period.

 AD is the total expenditure that all households, firms, government and the
rest of the world are planning to incur during a given period of time.
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Components of AD
 The equation for aggregate demand adds the amount of consumer spending,
private investment, government spending, and the net of exports and imports.
The formula is shown as follows:

 ​Aggregate Demand = C+I+G+Nx

 where:

 C = Consumer spending on goods and services

 I = Private investment and corporate spending on capital
goods (factories, equipment, etc.)

 G = Government spending on public goods and social
services (infrastructure, Medicare, etc.)

 Nx = Net exports (exports minus imports)
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AD curve
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 AD=C+I so AD is a function of consumption demand and investment demand.

 There is positive Consumption even when income level is zero. So consumption curve starts
from R and not origin. This is called autonomous consumption.

 Autonomous consumption is met either through past savings or borrowings.

 AD curve slopes upwards because as income increases consumption increases though not
proportionately.

 Investment curve is a straight line as it is assumed to be independent of the level of income.

This is called autonomous investment.

 AD curve is above Consumption and investment curve as AD=C+I.

 AD curve has a positive slope.

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Aggregate Supply

 Aggregate Supply (AS) refers to the money value of final goods and
services which all the producers of an economy are willing to supply during
a period of one accounting year.

 When expressed in physical terms, it refers to total output of goods and

services.

 Aggregate Supply and (AS) and National Income (Y) are one and the same.
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Components of AS

 Major portion of income is spent on consumption of goods and

services and the balance is saved

 So National Income (Y) = Consumption ( C ) + Saving (S)

 Y = AS = C + S
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AS curve

 AS curve is obtained by adding

consumption and saving schedules.

 It is a 45◦ upward sloping curve.

 At every point on the curve Y = C + S.

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Consumption Function

 Consumption function refers to the functional relationship

between consumption and national income.

 C = f (Y)

 It is a psychological concept influenced by subjective factors like

consumers’ preferences, habits etc.
 Keynesian Psychological Law of Consumption
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 The Keynesian concept of consumption function stems from the fundamental

psychological law of consumption which states that there is a common
tendency for people to spend more on consumption when income increases,
but not to the same extent as the rise in income because a part of the income
is also saved.

 Some important points are:

i. There is a minimum consumption known as autonomous consumption even

at zero level of national income because survival needs consumption.

ii. As income rises consumption also rises.

iii. Consumption rises at a lesser proportion than income because part of

increased income is also saved.
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Consumption Function
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Average & Marginal Propensity to Consume

 APC refers to the ratio of consumption expenditure to the corresponding

level of income.

 APC =
  
 Marginal Propensity to consume refers to the ratio of change in
consumption expenditure to change in total income.

 MPC =
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Saving Function

 Saving function refers to the functional relationship between saving and

national income. S = f (Y)

 APS refers to the ratio of saving to the corresponding level of income.

 APS =
  
 Marginal Propensity to save refers to the ratio of change in saving to
change in total income.

 MPS =


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Formulae

 (I) S= Y-C

 (ii) APC = C/Y = 1- APS

 (iii) APS = S/Y = 1 – APC

 (iv) MPC = ∆C/∆Y =1- MPS

 (v) MPS= ∆S/∆Y = 1- MPC

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Equation of Consumption Function
 The Consumption Function can be put into two parts:

 (i) Even when income (Y) is zero, there is some minimum consumption, known
as autonomous consumption (a) which is always positive.
 (ii) When income increases, consumption also increases. But, the rate of
increase in consumption is less than rate-of increase in income. The MPC (or b)
shows how consumption expenditure (C) changes with changes in income. This
portion of consumption is termed as Induced Consumption.
 (iii) So, Consumption Function can be represented as: C = a + b(Y)

 (Where: C = Consumption; a = Autonomous Consumption; b = MPC; Y =

Income)
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INVESTMENT FUNCTION

 Investment refers to the expenditure incurred on creation of new capital

assets.

 Investment expenditure is classified under two heads:

 (i) Autonomous Investment – Investment which is not affected by

changes in the level of income and not induced solely by profit motive.
Usually made by Government on infrastructural activities.

 (ii) Induced Investment – Investment which depends on profit

expectations and is directly influenced by income level.
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Determinants of Investment

 According to Keynes private investment depends on:

 Marginal Efficiency of Capital (MEI) – refers to the expected rate

of return from an additional investment.

 Rate of Interest (ROI) – Cost of borrowing money for financing

the investment. There is inverse relationship between ROI and
investment. Higher the ROI lower will be the investment.
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Equilibrium Income
 An economy is in equilibrium when aggregate demand for goods and services is
equal to aggregate supply during a period of time.

 Equilibrium is achieved when AD = AS ….(1)

 We know, AD is the sum total of Consumption (C) and Investment (I):

 AD = C + I … (2)

 Also, AS is the sum total of consumption (C) and saving (S):

 AS = C + S … (3)

 Substituting (2) and (3) in (1), we get:

 C+S=C+I

 Or, S = I
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Equilibrium Income Determination

Emp (Lakhs) Income (Y) Consumption Saving (S) Investment AD C + I AS C + S Remarks

(C) (Y)

0 0 40 -40 40 80 0 AD>AS
10 100 120 -20 40 160 100 AD>AS
20 200 200 0 40 240 200 AD>AS
30 300 280 20 40 320 300 AD>AS
40 400 360 40 40 400 400 AD=AS
50 500 440 60 40 480 500 AD<AS
60 600 520 80 40 560 600 AS<AS
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 Point E is the equilibrium point

where AD = AS.

 OY is the equilibrium level of output.

 Below point E, AD>AS.

 Above point E, AD<AS

 Point E is the point of Effective

Demand when planned spending is
equal to planned output.
 z Concept of Multiplier

 The concept of multiplier was first of all developed by F.A. Kahn in the early
1930s. But Keynes later further refined it.

 In practice it is observed that when investment is increased by a certain amount

the subsequent change in income is several times more than the change in
investment.

 Multiplier is the ratio of the final change in income to the initial change in
investment.

 K = ∆Y/∆I, i.e., K (multiplier)

 where ∆ (delta) stands for increases or changes, Y for national income, K for
Multiplier and I for investment.
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Value of Multiplier & MPS

 Multiplier can also be represented in terms of MPS.

 Since MPS = 1-MPC and k=

 Multiplier
  can also be written as k =

 Multiplier is directly related to MPC and inversely related to MPS

– when MPC is more value of k is more and when MPS is more
value of k is less.
 Value of Multiplier & MPC
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 The concept of multiplier is based on the fact that one person’s expenditure is another
person’s income.

 When investment is increased it also increases the income of people. People spend a
part of this increased income on consumption. Which leads to further increase in
  income.
 The amount of income spent on consumption depends on the value of MPC.

 The relationship between the multiplier and marginal propensity to consume is

expressed as: k=
 Additional Investment (∆I) of 100 crores
First round increase in income 100 crores

MPC=0.90
Second round increase in income 90 crores (90% of 100crs)

MPC=0.90
Third round increase in income 81 crores(90% of 90 crs)

MPC=0.90
Fourth round increase in income 72.90 crores (90% of 81 crs)

Process Continues

MPC=0.90

Total increase in Income (∆Y) 1000 Crores (100+90+81+72.90+…)

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Contd….

 the value of multiplier k=

 In this example it is
  
 Final increase in income ∆Y = k ∆I

 In this example ∆Y = 10 * 100 crores = 1000 crores