Keynesian Income Determination Aggregate Demand =Aggregate Supply =

National Income

Aggregate Demand

Aggregate Demand = Consumption of goods and services

+ Investment ( Demand for capital goods)

AD = C+I

Acquiring or buying physical or financial assets for the purpose of making profit.

In Macroeconomics, investment is the sum of spending made by business firm per unit of time (one year) to build stock of Capital.

. Capital is stock of productive assets : machinery and equipments Residential land and building Inventories

Investment

Investment is flow concept:

It is measured per unit of time, generally one year.

Investment refers to addition to the physical stock of capital,

Capital = K Investment = K

Type of Investment :

Induced Investment - It is caused by the increase in income and decrease in interest rate.

I = f (Y, i) Y is assumed to remain constant

I = f (i)

Autonomous Investment: it is caused by the Exogenous factors than income and interest rate. As:

Innovation in production techniqueInvention of new business processExpansion plans of business firmDiscovery of new market

Autonomous investment largely made by government. In the following area :

Physical Infrastructure - Transport, Power and communication network

Human Infrastructure – Health & Education

Public Goods- Defence

Investment Demand

Investment Demand based on :

1. Rate of interest ( does not change in short run)

2. Marginal efficiency of capital: Replacement cost of the capital goods. Profit expectations of entrepreneurs.

Hence, Investment demand is remain constant in short run .

_Therefore : AD = C + I (CONSTANT INVESTMENT)

Consumption : Based on various factors:

Income , wealth, interest rate, expected future income , consumer credit, age and sex.

Income is primary determinant of consumption and saving.

Consumption FunctionC = f (Y) (Consumption is positive

function of income) Consumption increases with increases

in income.As per Keynes, relationship between

income and consumption is based on:

“ Psychological Law” (with increase of income consumption does not

increase in same proportion of increment of income.)

But, increase in what proportion?> Proportionately < Proportionately = Proportionately

Increase can be explained by Marginal Propensity to Consume (MPC)

MPC = Relationship between Marginal income and Marginal Consumption

MPC = C/ Y

MPC increased at decreasing proportion with the increase in marginal income because people like to save also income

(non-linear consumption function applies to individual house holds)

Linear Consumption FunctionApplicable to economy as a whole or at aggregate level

C = a+b Y Y = Total disposable income a = Intercept is positive constant. (denotes the

level of consumption at ZERO level of income on the basis of past saving, called “AUTONOMOUS CONSUMPTION” )

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)

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

past saving)Increase in income induce additional consumption

at fixed proportion of 75%.Aggregate consumption increase with the increase

in aggregate income, at a constant rate of 75%

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 Consumption ( C ) 500

400 C = 2 00 + 0.75 (Consumption Function)

300 200

100 200 300 400 500 600 INCOME (Y)

Average Propensity to Consume (APC):

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

APC = C/Y C = a+bY

APC = a+bY YIf Consumption function assumed to be form of C = bY

APC = bY = b Y

APC= MPC

The level of income Rs.1000 crore. Consumption expenditure Rs.750

APC = 750 = 0.75 1000If income increases to Rs.1200 crore

and Consumption rises to Rs.900 crore and APC = 0.75 same at all level.

Hence APC is the same At all levels of income.

Example

Saving FunctionIt is counter Part of the consumption function. AS:

Y =C+S Therefore: S = f (Y)

Saving rises at increasing rate at upward movement of the national income

If consumption function is given as : C = a+b YSaving function can be derived as :

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

1-b gives MPS where b = MPC

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

Saving function as: S =Y- (200+0.75Y)=Y – 200 - 0.75Y= -200+(1-0.75)Y

= -200+0.25Y(saving function)

A

The Saving Function

100

Saving(+) 200 S

300 S = -200+0.25

0 200 400 500 600 700 800

-100 - 200Dissaving (-) -300

Example

Suppose that a family would spend Rs.2000/- at Zero level of income.

When income increases it spends 80% of it on consumption.

Find out the family’s consumption spendingWhen income is Rs. 20,000/-

What is the Saving function of the family.?

C = 2000 +0.80YWhen Y = 20,000/-

C= 2,000 + 0.80 x 20000 = 18000/-

S = -a + (1-b)YS = - 2000 + (1-0.80)Y = -2000 + 0.20Y

S = 2000

Aggregate Supply Aggregate supply (National Product) based on :

1. Supply of final goods and services in a year2. Output of capital goods.

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.

OZ line measures the distance between X-axis National income is given and Y-axis aggregate supply is given which is equal at every point of line.

Therefore, aggregate supply or national product equals national income.

Resultantly, OZ line is AS Curve

NATIONAL INCOME

ASz

0

Aggregate Supply

Y

X

Equilibrium Level of IncomeC+I represents the aggregate demandOZ line represents Aggregate supply, which is 450 line. It means aggregate supply or Nationati-Onal product equals nationalIncome. It shows that value of aggregate output increasesat constant rate because priceLevel, productivity are assumed to remain constant.

z

EC+I

Y1NATIONAL INCOME

Aggregate Demand and Supply

0 450

Y YF

At point E where aggregate supply and demand intersects each other income level is OY1, which represents equilibrium level of income.

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 : 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.

The process of expansion in output under the pressure of excess demand will continue till national income OY1 is reached.

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.

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 = C+IC= a+bY, I is constant

Y= a+a Y+IY-b Y = a+I Y(1-b) = a+I

Y = _a+I_ 1- b

Y = __1_ (a+ I) 1- b

Numerical Example C = 100 +0.75

I = 200 Y= C+I

Y =100+0.75Y+200Y (1-0.75) 100+200

Y = __1_ (a+ I) 1- b

Y = __1 (300) 1-0.75

Ans. = 1200

2. Saving –Investment Approach C +I = C+S

C +I = C+SI=S

Investment is remain constantS= f(Y)S= Y-C

C=a+b YS =Y –(a+b Y)

S =Y –(a+b Y)

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

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

I = SI = -a+(1-b)Y

ExampleI =200, c = 100+0.75

Given the value of a and b Saving function :

S= -a+(1-b)Y S= -100+(1-0.75)Y

I =S200= -100 +(1-0.75)Y

300 =(1-0.75)Y Y= __300___ 1200

1-0.75