A brief analysis of Keynesian model of income determination

1. 1
KEYNESIAN THEORY
OF
INCOME & EMPLOYMENT
DETERMINATION
BY
CHETAN ACHARYA

2. 2
• Product market involves the activities related to buying
and selling of goods and services that satisfy human
needs. In macro economics product market equilibrium
refers to a situation of income and employment
determination. Through the real sector, tow major issues
such as
i. How is the equilibrium level of national income and
employment determined ? and
ii. What factors determine the national income and
employment ?
These questions were first systematically explained by
the economist J.M. Keynes in his famous book “The
General Theory of Employment, Interest and Money” in
1936.

3. 3
• To explain the process of the determination
of equilibrium level of national income and
employment the entire economy is divided
into various sectors such as:
1. Household Sector
2. Business Sector
3. Government Sector
4. Rest of the World ( External Sector)

4. 4
Keynes presented his theory of national income and
employment in the following three models:-
1. Two Sector Economy Model
2. Closed Economy Model (Three Sector)
3. Open Economy Model (Four Sector)

5. 5
Determination of Income &
Employment in Two Sector Economy
• Two sector economy means there are two
economic actors such as:
I. Household Sector
- Supplies factor inputs to business sector
- Receives payments for supplying factor
inputs
- Uses incomes to purchase goods & services

6. 6
II. Business Sector
- Employ factors of production and produce goods &
services
- Make payment for employed factors of production
- Supply goods and services and receive payments
• Assumptions
Two economic actors
 taxes and government expenditure are zero
 Absence of foreign trade
 Total profit is distributed
 Factor and product prices are constant
 Supply of capital and technology given
 AD consists Consumption expenditure plus investment expenditure

7. 7
Provided these assumptions, we have two
approaches to determine equilibrium level of
national income:-
a. AD-AS Approach
According to this approach the equilibrium
level of national income is determined at a
point where AD and AS functions are equals.
AD refers to the amount of maximum sales
revenue expected from the total output in the
economy. It is aggregate expenditure made
by the economy per unit of time. It depends
on the C & I flow of the economy. AD curve is
the graphical representation of AD schedule
and AD schedule is the schedule which shows
the various level of national income,
consumption and investment.

8. 8
Aggregate Demand Schedule
Income
(Y)
Consumption
( C = 50 + 0.5Y)
Investment
(I) C+ I
0 50 50 100
50 75 50 125
100 100 50 150
150 125 50 175
200 150 50 200
250 175 50 225
300 200 50 250
350 225 50 275
400 250 50 300

9. • Similarly, Aggregate Supply (AS) refers to the
total value of goods and services produced and
supplied in an economy per unit of time. AS
includes both consumer and capital goods. To
obtain AS in terms of money value, total goods
and services produced in an economy during
given period of time is multiplied by their
respective prices. It is also called the total
value of national output.
• AS grows at a constant rate of increase in
output where all that is produced is sold. This is
given by a 45° line. This is also called AS
schedule or Aggregate Expenditure (AE)
9

10. • According to Keynes, the equilibrium level of
national income is determined at a point where
AD function intersects AS function. It means
equilibrium level of national income is
determined at point where,
AD = AS
Why not at any other point
AD>AS & AD<AS ??? 10

11. • Mathematical Derivation
AD is a determined by C and I
i.e. AD = C + I -----------1
Similarly, AS is determined by A and S
i.e. AS = C + S ----------2
The equilibrium level of NI is determined at point
where
AD = AS
i.e. C + I = C + S or I = S
Since Y = C + S ----------3
C = a + bY ----------4
11

12. now, from 1, 2, 3, & 4
Y = a + bY + I
or, Y – bY = a + I
or, (1-b)Y = a + I
or, Y = 1/ 1-b (a + I)
therefore,
Y = 1/ 1-b (a + I) as desired.
12

13. 13
AS = C + S
C = a + bY
AD = C + I
e
Y Income
C , I
O
Graphical Presentation
45°
I

14. 14
Saving-Investment Approach
The equilibrium level of national income can also be
determined from saving-investment approach i.e. by
saving-investment equality.
We have,
Y = C + S = AS and AD = C + I
S = Y – C & C = a + bY
Then, S = Y – (a + bY)
or, S = Y – a – bY
or, S = -a + (1-b)Y
or, Y = 1/1-b (S + a)
or, Y = 1/1-b (I +a) …………… as desired

15. O
Income
S, I S = -a+(1-b)Y
I
E
Y
S=I S>I
S<I

16. Income Determination in Three
Sector Economy
• Three sector economy means there are three
economic actors such as,
1. Household Sector
- Supplies factor inputs to business sector
- Receives payments for supplying factor inputs
- Uses incomes to purchase goods & services
- Pays taxes to the government 16

17. 2. Business Sector
- Employ factors of production and produce
goods & services
- Make payment for employed factors of
production
- Supply goods and services and receive
payments
- Pays taxes to the government
3. Government Sector
- Provides public utility services
- Receives taxes from business and households
- Makes transfer payments 17

18. • In three sector economy AD consists C, I & G
i.e. AD = C + I + G and AS consists C & S
i.e. AS = C + S + T
For the sake of simplicity, the equilibrium level
of income will be explained in the following
three models;
Model I. Income Determination with
Government Spending and Lump-sum
Tax
It is the extension of two sector economy
model. This model includes the variables such
as government expenditure and lump sum tax.
18

19. Assumptions:
There are three economic actors
 Lump-sum taxes and government expenditure
are given
 Absence of foreign trade
 No transfer payment
 Factor and product prices are constant
 Supply of capital and technology given
 AD consists Consumption, investment and
government expenditure
19

20. • AD-AS Approach
under this three sector economy model
equilibrium level of income is determined at AD
equals AS.
i.e. Y = C + I + G ………..1
C = a + bYd ……………2
Yd = Y – T ………………3
I = Ia ……………4
G = Ga ………….5
T = Ta ……………6
Substituting in 1 we get; 20

21. Y = a + bYd + Ia + Ga
or, Y = a + b(Y- Ta) + Ia + Ga
or, Y = a + bY - bTa + Ia + Ga
or, ……………………………………
Therefore,
Ye = 1/1-b (a - bTa + Ia + Ga)
as desired
21

22. Model II. Income Determination with
Transfer Payment
It is the extension of model I. This model
includes the variables such as government
expenditure, lump-sum tax and government
transfer payment.
• AD-AS Approach
under this three sector economy model
equilibrium level of income is determined at AD
equals AS.
i.eY = C + I + G ………..1
C = a + bYd ……………2
22

23. Yd = Y – T + GT ………………3
I = Ia ……………4
G = Ga ………….5
T = Ta ……………6
Now,
Y = a + bYd + Ia + Ga
or, Y = a + b(Y- Ta + GT) + Ia + Ga
or, Y = a + bY - bTa + bGT + Ia + Ga
or, ……………………………………
Therefore,
Ye = 1/1-b (a - bTa + bGT + Ia + Ga)
23

24. Model III. Income Determination with Tax
as a Function of Income
It is the extension of model II. This model
includes the variables such as government
expenditure, tax function and government
transfer payment.
• AD-AS Approach
under this three sector economy model
equilibrium level of income is determined at AD
equals AS.
i.eY = C + I + G ………..1
C = a + bYd ……………2
24

25. Yd = Y – T + GT………………3
I = Ia ……………4
G = Ga ………….5
T = Ta + tY ……………6
Now,
Y = a + bYd + Ia + Ga
or, Y = a + b(Y- Ta - tY + GT) + Ia + Ga
or, Y = a + bY - bTa - tY + bGT + Ia + Ga
or, ……………………………………
Therefore,
Ye = 1/1-b + bt (a - bTa + bGT + Ia + Ga)
25

26. • Income Determination in Four Sector
Economy
---------------------------------------------
---------------------------------------------
Class Work:
1. Suppose structural equations of an
economy are given as follows
C = 100 + 0.75Y & I = 100, Find the
equilibrium values of Y and C
2. Compute Y , C, S and Yd with the help of
following information:
C = 100 + 0.8Yd , I=500, G=100 and T=80

27. • From question no. 1 calculate equilibrium level of income
from S-I approach.
• Present all situations in a figure.
• Construct AD & AS schedule from the given information.
3. Suppose structural equations are given as follows:
C = 100 + 0.75Yd, I = 200, T = 100 + 0.1Y,
G = 100, GT = 50. Estimate equilibrium level of Y, C, T and
present all information in a graph.
What happens in the equilibrium level of income if
government expenditure increases from 100 to 150?
4. Given that, C = 150+0.75Yd, I= 100, G = 115, T = 20
+0.2Y, GT = 50, X= 35, M= 15 + 0.1Y.
Estimate equilibrium level of income, consumption, value
of tax and Net exports.
Also, present all information graphically. 27

28. 28