Keynesian model of national incom

1. Chapter 8:
KEYNESIAN EMPLOYMENT THEORY
The purpose of this topic is to analyze how aggregate expenditure and aggregate
output can be represented, establish why equilibrium may be present below full
employment, and identify the process of the multiplier.
KEYNESIAN EMPLOYMENT THEORY
The purpose of Keynesian employment theory is to offer a solution to periods of
excessive unemployment (i.e. recession). This solution is tied to the idea that
employment depends on what firms need to produce, and their production level, in
turn, depends on what individuals and firms plan to buy: this is what Keynes calls
aggregate expenditure.
During the great depression, people were afraid to spend. Businesses were
reluctant to hire workers because they could not expect any pick up in
sales. This was especially true for key sectors of the economy such as
automobile purchases.
AGGREGATE EXPENDITURE
Aggregate expenditure (in the opinion of Keynes) is the key to economic activity.
That is, what households, businesses and government plan to buy will be the
determinant of what firms will eventually produce. In the first step of the analysis,
a simplified model excludes government, assumes that no foreign sector is present,
and the level of real income (not prices) is the major determinant of aggregate
expenditure.
When a family is planning to buy a car or put new appliances in the house,
that would be a carefully thought out decision which considers the long
term situation of the family. Such purchases are key items of aggregate
expenditure.
AGGREGATE EXPENDITURE COMPONENTS
Aggregate expenditure AE is the sum of what households plan to buy (or
consumption C), and what businesses plan to buy in terms of capital (or investment
I): AE=C+I Later, the model will also include government purchases (G).
Purchases from all sources should be included in aggregate expenditure:
both foreign and domestic, public and private. For instance, what foreign
consumers could buy from American computer manufacturers next year,
would be an important element. However, government and foreign
purchases are affected by other than purely domestic economic conditions.

2. CONSUMPTION
Consumption is what individuals (or households) want to (or plan to) buy. Their
ability to consume is entirely dependent on their income. What is not consumed (in
income) is set aside for future consumption: this is saving.
What is of interest is not the physical consumption, such as the use of a
car, but the time pattern of purchases. If members of a family need to
drive to work, they will have to have a car whether it is brand new or very
old. The purchase of the car can be postponed. What prompts a family to
buy a car now is a great interest to economists: such purchase is
consumption.
CONSUMPTION DETERMINANTS
The major determinant of consumption is the willingness or propensity to use the
real income to buy goods and services. Thus consumption and income are directly
related. Other determinants of consumption are the price level, wealth, stock of
durables, level of indebtedness and expectations about the future.
The perception of a family's income is what allows it to be confident that
it will be able to make the necessary payments or to afford to take out the
savings, to buy a car. If it does not feel confident about its level of current
and future income, it may want to use the car one more year.
CONSUMPTION STABILITY
The pattern of consumption tends to be quite stable. Consumption shifts upward
through time: the proportion of consumption out of income remains about the
same.
Statistics show that consumption, i.e. purchases of households, is the most
stable component of aggregate expenditure.
AVERAGE PROPENSITY TO CONSUME
The willingness to use a proportion of income (Y) for consumption (C) is known
as average propensity to consume (APC): APC=C/Y As income increases, the
average propensity to consume decreases. This is indeed observable in the fact that
wealthy individuals consume a smaller proportion of their income than to poorer
people who may in fact be force to receive money from others.
If the income of a family is $50,000 and that family spends $45,000 per
year, the average propensity to consume is APC = 45,000/50,000 = .9 or
90%.
MARGINAL PROPENSITY TO CONSUME
The marginal propensity to consume (MPC) is the proportion of additional
consumption (dC) which will be taking place out of an increase in income (dY):

3. MPC=dC/dY MPC is the slope of the consumption line. It is constant throughout
reflecting a stable pattern of consumption in our society.
If the income of the family increases by $1,000 and the family decides to
buy an additional television worth $600 with that new income, the
marginal propensity to consume is MPC = 600/1000 = .6 or 60%.
SAVING
Saving is what is left from income after consumption is taken out. Saving is
primarily determined by the level of real income. The higher the income, the more
individuals are willing and able to save.
Saving is what will permit consumption in the future. In today's society, a
lot of saving is institutional. For instance, social security contributions and
pension plan deductions are a form of saving.
AVERAGE PROPENSITY TO SAVE
The willingness of individuals to save (S) a proportion of their income is called
average propensity to save (APS): APS=S/Y.
If a family earns $50,000 and saves $5,000 each year, the average
propensity to save is APS = 5,000/50,000 = .1 or 10%.
MARGINAL PROPENSITY TO SAVE
The marginal propensity to save (MPS) is the proportion of additional saving (dS)
out of an additional income (dY): MPS=dS/dY The marginal propensity to save is
the slope of the savings line. Since income can only be consumed or saved, the
sum of the marginal propensities to consume and to save is one: MPC+MPS=1.
If a family has an increase in income of $1,000 and decides to save $400
of that increase, the marginal propensity to save is MPS = 400/1,000 = 0.4
or 40%.
INVESTMENT DETERMINANTS
Investment is determined by the rate of return from various possible projects and
the cost of borrowing (or interest rate). The pattern of rate of return gives the
demand for investment (also known of the marginal efficiency of investment): it is
inversely related with interest rates. The cost of borrowing or interest rate is
determined in the money market and is essentially the product of monetary policy.
Most companies determine their current investment plans with the help of
long range planning and capital budgeting. Forecasts of future sales are
the major determinants in these calculations.

4. INVESTMENT INSTABILITY
In addition to the rate of return, investment demand is determined by state of
technology, maintenance and level of existing capital, as well as expectations about
future sales. Some of these components are highly unstable, such as new
inventions and innovations and changes in future sales expectations. Thus, it is not
entirely useful to model investment with other elements than investment demand
and the given interest rate.
Historically, the investment component of aggregate expenditure and of
gross national product has been the most erratic of all. In periods of
economic slow down, it is often negative. It jumps back up as soon as
expectations of future sales look brighter.
AGGREGATE OUTPUT
Real aggregate output (or net national product NNP) is the 45 degree line in the
Keynesian model because total income is equal to total output since taxes and
transfer payments are omitted, and total output can be shown vertically as the 45
degree line.
Graph G-MAC8.1
Aggregate output is very closely correlated to national income; in fact, if
there were no government, it would be almost identical.
KEYNESIAN EQUILIBRIUM
The equilibrium occurs where aggregate expenditure (AE) is equal to aggregate
real output (NNP):

5. AE=NNP. Should firm produce more, they will be forced to cut back production
because of excess inventories. Should they produce less, they will have to increase
production because their inventories will be depleted. The equilibrium may very
well occur below the full employment level of output.
Graph G-MAC8.2
Businesses adjust their production to sales by observing their inventories.
If the inventories are insufficient, production is increased. If the
inventories are excessive, production is cut back.
LEAKAGE
Saving can be viewed as a leakage of funds out of the circular flow model. (Taxes
are also a form of leakage, so are imports).
If the economy is looked upon as a circular flow of funds similar to an
engine with the funds as fuel, a loss of funds to saving would slow down
the economy just as a loss of fuel would slow down the engine.
INJECTION
Investment can be viewed as a form of injection of funds in the circular flow
model. (Exports would also be an injection).
In the circular funds and engine comparison, a new input of funds speed
up the economy just as an additional fuel injection into the motor.

6. LEAKAGE-INJECTION EQUILIBRIUM
The equilibrium in the leakage-injection graph is where saving is equal to
investment:
I=S. Should firms produce more an unintended saving would be present in the
form of inventory accumulation. Should firms produce less, dissaving would occur
in the form of inventory depletion.
Graph G-MAC8.3
Many modern automobiles are equipped with vapor recirculation devices:
what is lost to gasoline evaporation in the tank and carburetor is returned
to the engine with that device so that the motor does not lose power. A
similarity can be established with the circular fund flow model.
MULTIPLIER EFFECT
The multiplier effect comes from the fact that a positive change in planned
expenditure by households or businesses will require a change in production
putting new employees to work. This will result in new income that will cause a
second round of increased aggregate demand. Successive rounds will add up so
that a small change in aggregate demand (dAE) causes a multiple (M) change in
real output (dNNP)
M=dNNP/dAE.
Just think about how many hands the money one has in one's wallet, has
gone through! A payment for one additional purchase will not stop there,
but will create income for several successive persons. That is the
multiplier effect.

7. MULTIPLIER
The value of the multiplier is equal to the inverse of the marginal propensity to
save or M=1/MPS=1/(1-MPC)
If the marginal propensity to save is .4, the multiplier is M = 1/MPS =
1/0.4 = 2.5.
COMPLEX MULTIPLIER
Empirical estimates of the multiplier when all other forms of leakage are included,
such as taxes, exports as well as saving, give a value of the complex multiplier of
close to 2.
All forms of funds usage other than spending reduce the multiplier. Taxes
and import are two such diversions.
PARADOX OF THRIFT
If a society attempts to save more, its aggregate expenditure will decrease causing
the equilibrium and real output to also decrease. As real output and income have
shrunk, the society will not be able to save more, but only the same amount (or
may be even less).
The great depression is a vivid and regrettable example of the paradox of
thrift. People tried to put more money aside because they were afraid. But,
their very reluctance to spend caused income to decrease.
RECESSIONARY GAP
The extent to which the aggregate expenditure falls short of the full employment
level of aggregate expenditure is called the recessionary gap. This is also the
amount by which aggregate expenditure should be increased to achieve full
employment.
The administration calculates the potential GNP or full-employment income,
which is presented in the Economic Report of the President.
INFLATIONARY GAP
The extent to which the actual aggregate expenditure exceeds the full employment
level of aggregate expenditure is called the inflationary gap because such excess
demand can only cause inflation as businesses already are producing at full
capacity.
. The SIMPLE KEYNESIAN MODEL OF INCOME DETERMINATION
2. Session Outline Consumption and savings function Investment function Multiplier analysis
(incl. Multiplier process) Acceleration principle 06/07/09

8. 3. Consumption and Savings Function The level of private disposable income is the chief
determinant of private consumption and saving , which, in the absence of government is equal
to total income. i.e., at higher levels of income the private sectors will both consume more and
save more and vice versa. But, consumption and saving are determined by many factors in
addition to the level of disposable income. Other important factors that influence the
consumption and savings function are: Stock of Wealth Expectations Taxation Policy
Distribution of Income Age Composition 06/07/09
4. Investment Function Investment is the most volatile of all the major components of aggregate
demand (output), because of the multiplier mechanism. Capital investments (new buildings,
new machineries, inventory etc) are made either out of own resources or borrowings . If
borrowing is used, interest has to be paid on the sum borrowed. This is called `Debt financing‟.
That does not mean that in the case of self- financing, own resources, come free of cost. With
`self financing‟ the investor sacrifices the interest that he could otherwise have earned.
06/07/09
5. Investment Function…. Investments are made with an objective to earn profit. Interest is the
price , profit is the reward for investment. The expected rate of profit from investment is called
„marginal efficiency of capital‟ or „marginal productivity of investment‟. A rational investor will
compare the profits earned with the rate of interest to be paid on the funds borrowed. The
investor would decide to invest only if the expected profit from investment (marginal efficiency
of capital) is higher than the rate of interest to be paid. 06/07/09
6. Investment Function… We conclude that the volume of investment in an economy mainly
depends on two important factors: Marginal efficiency of capital Interest rates Of the two factors
, MEC has a greater influence on the volume of investment 06/07/09
7. Other Factors Affecting Investment Demand Acquisition and operating cost The initial
expenditure incurred on capital goods and the cost of maintenance of these goods, are
important aspects for estimating the rate of net profitability of any investment. Such initial
expenses increase the cost of installation , with limited return on investment. If these costs
decline, the expected net profits go up. 06/07/09
8. Other Factors Affecting Investment Demand Operating costs are often company specific,
while the company may not have any control on its initial expenses. Operating costs are driven
by wage rates, which are influenced by the trade union policies of the company. Thus, an
increase in the acquisition and operating cost reduces the expected net profitability, thereby
reducing investment demand. 06/07/09
9. Other Factors Affecting Investment Demand Taxes Profits earned by a business after paying
all the charges against Interest and Taxes, is the true yardstick for measuring prospective
investment. Therefore, an increase in the rates of taxes would reduce the profitability of an
investment, while a decrease would make the investment attractive 06/07/09

9. 10. Other Factors Affecting Investment Demand Change in Technology Technological
progress, process of development of new products, improvement in the quality of performance
of the existing products and development of a new method of production- all these, act as a
stimulant to the investment climate. Development of a new machine, for instance would help to
reduce the cost of production, improve the quality of the product and increase the expected rate
of profit earned from such an investment. In short, a rapid degree of technological innovation
drives the demand for new investment in the economy. 06/07/09
11. Other Factors Affecting Investment Demand Stock of Capital Goods in Hand Stock of
capital goods in hand influences the investment demand in just the same way as the stock of
consumer goods in hand affects the household consumption-savings decision. To the extent
that a given industry is well equipped with productive facilities and inventory of finished goods,
money remains blocked in that industry, thus affecting return on investment. Any industry with
such a kind of problem would be forced to accept lesser profits. With lower rates of return,
incremental investments into the industry would also be less. Thus an excess or inadequate
availability of stock of capital determines investment demand in the economy. 06/07/09
12. Other Factors Affecting Investment Demand Ratchet effect is the commonly observed
phenomenon that some processes cannot go backwards once certain things have happened,
by analogy with the mechanical ratchet that holds the spring tight as a clock is wound up.
06/07/09
13. Steady State Level of Consumption in the Long Run Consumption function, C t = a + bY d t
+ gC t -1 [Where Ct = Consumption expenditure for the current year; a = Autonomous
consumption; b = Short run MPC; Y d t = Disposable personal income for the current year; g =
Coefficient indicating the relation between current period consumption and previous period
consumption ; C t-1 = Previous period consumption expenditure] Since C t = C t-1 Ct = a + bY d
t + gC t Or, C t (1 – g) = a + bY d t Or, C t = [{a/(1-g)} + {b/(1-g). Y d t }] 06/07/09
14. Process of Multiplier How does the process of multiplier work beginning from the initial
injection? Increase in autonomous spending adds to incomes, which in turn are spent partly on
other goods and services, leading to increase in income. Part of this increased income is again
spent on goods and services, causing further increase in income. This process continues
uninterruptedly with a smaller sum of income passed on at each phase. The magnitude of this
increase is determined by how much income is passed on at each phase. This in turn is
dependent on the rise in consumption spending ( Δ C/ Δ Y) or the marginal propensity to
consume for a unit rise in disposable income. 06/07/09
15. Process of Multiplier The change in total income ( Δ Y) = Change in autonomous
expenditure ( Δ E) + the induced change in consumption ( Δ C). Symbolically, Δ Y = Δ E + Δ C
We know that MPC =
Or, Δ Y (1 06/07/09
= Δ C/ Δ Y Or, Δ C = MPC. Δ Y Thus, Δ Y = Δ E + Δ C = Δ E +
) = Δ E Or, k (multiplier) = Where, MPS = the marginal propensity to save
.ΔY

10. 16. Multiplier Analysis 06/07/09 Illustration: If consumption function is given by C = 50 + 0.5Y,
what is the change in equilibrium income for an increase of Rs.100 crores in autonomous
government expenditure? Solution: With the increase of autonomous government expenditure
by Rs.100 crores, the demand income increases by Rs.100 crores in the first phase. This
induces a demand of Rs.50 crores in the second phase due to consumption of 0.5 or 50% of
increased income; Rs.25 crores in the third phase; Rs.12.5 in the fourth phase; Rs.6.25 in the
fifth phase; 3.125 in the sixth phase; and so on. Thus, the total increase in equilibrium income (
Δ Y) = 100 + 50 + 25 + 12.5 + 6.25 + 3.125 + 1.5625 + 0.78125 + … = 200 Multiplier x Δ E =
17. Multiplier Process (For an Increase of Rs.100 in Autonomous Investment) 06/07/09 Stages
MPC x Change in Income Rise in Income Total Income 1 100 100 100 2 0.5x 100 50 150 3 0.5x
50 25 175 4 0.5x 25 12.5 187.5 5 0.5x 12.5 6.25 193.75 6 0.5x 6.25 3.125 196.875 7 0.5x 3.125
1.5625 198.4375 8 0.5x 1.5625 0.78125 199.2188 9 0.5x 0.7815 0.39 199.6088
18. 06/07/09
19. Uses and Limits of the Multiplier Uses The Multiplier process by indicating different phases
of trade cycles helps the business community to plan its transactions accordingly. Multiplier
analysis acts as an important tool for the modern governments in formulating economic
policies. A government, by multiplier analysis, can know the quantity of investment that has to
be made to reach full employment level. The Multiplier principle shows the importance of deficit
budgeting 06/07/09
20. Uses and Limits of the Multiplier Limitations Multiplier process works only when there is
adequate availability of consumer goods. Full value of multiplier is achieved only when various
increments in investments are repeated at regular intervals. The full value of the multiplier can
be achieved only when there is no change in the MPC during the process of income
propagation. While estimating the multiplier in a country, we assume that the country has no
trade relations with others. If there are trade relations with other countries, then the multiplier
estimated may be more or less than its real value. To realize the full value of multiplier, it is
assumed that there are no time lags between the receipt of income and its spending. But, this is
not possible in real life. 06/07/09
21. Acceleration Principle Acceleration principle is concerned with the changes in investment
and its ultimate effect on gross product or income. Although J.M. Keynes discussed the
principle of multiplier, he did not make any reference to acceleration principle in his General
Theory. Acceleration principle (principle of magnified derived demand) is based on the induced
investment; the principle states that the demand for durable goods (investment) is derived from
the demand for final goods and services produced by them. For example, if demand for
consumption goods increases, it induces an additional demand for capital goods. Thus the
concept of acceleration shows the functional relationship between changes in demand for final
goods (consumption goods) and the consequent changes in the demand for capital goods
(capital goods – e.g. machines). 06/07/09

11. 22. Acceleration Principle This functional relationship can be expressed as Acceleration
principle = Δ K/ Δ Y (Change in Investment „divided by‟ Change in Income) The working of “
Acceleration Principle ” is similar to that of “ Multiplier Principle ”. 06/07/09