This document discusses key concepts in Keynesian economics including aggregate demand, aggregate supply, and their relationship. It explains that according to Keynesian theory, output and employment are determined by aggregate demand. The aggregate demand curve slopes positively, showing the total quantity demanded at each price level in the economy. The aggregate supply curve can be upward-sloping in the short-run due to sticky wages and prices. The intersection of the aggregate demand and supply curves indicates the general equilibrium in the economy.

1. Aggregate demand and
aggregate supply

2. Keynesian theory
 General theory of employment, interest and
money
 Level of output/income and employment
depends on level of aggregate demand
 Increase in aggregate demand – increase in
output – increase in employment – full
employment
 Full employment output can be produced if
there is sufficient aggregate demand
 Inadequate aggregate demand leads to
unemployment

3. Concept of aggregate demand
 Total amount of goods and services demanded in
the economy
 AD = C + I + G + NX
 Actual and planned aggregate demand
 Actual demand in accounting context
 Planned or desired demand in economic context
 Equilibrium income/output when quantity of output
produced = quantity of output demanded
 In equilibrium, AD = C + I + G + NX = Y
 Y = AD means actual AD = planned AD at
equilibrium level of income/output

4. Consumption demand
 Keynes – psychological law of consumption
– C varies with the level of disposable
income
 Franco Modigliani – life cycle theory of
consumption – individuals plan consumption
over long periods to allocate it over entire
lifetime – C as a function of wealth and
labour income
 Milton Friedman – permanent income theory
of consumption – consumption related to
longer term estimate of income called
permanent income

5. Consumption function
 Demand for consumption goods depends mainly on
level of income in Keynesian analysis
 C = a + cY where a > 0 and 0 < c < 1
 a – intercept representing minimum level of
consumption when income is zero
 c – slope of consumption function known as
marginal propensity to consume
 MPC – additional consumption out of additional
income – increase in C per unit increase in Y
 MPC = dC / Dy

6. Consumption and savings
 S=Y–C
 S = Y – (a + cY)
 S = - a + (1 - c)Y
 (1 – c) – marginal propensity to save
 MPS = dS / dY
 Savings increase as income increases
 Paradox of thrift

7. Investment demand
 Investment is the flow of spending that adds to
physical stock of capital
 Gross and net investment
 Financial and real investment
 Planned and unplanned investment
 Induced and autonomous investment
 Induced investment – depending on profit expectations /
anticipated changes in demand and level of income / rate
of interest
 Autonomous investment – not depending on income or
rate of interest – e.g. Government investment in
infrastructure

8. Investment function
 Keynesian investment function
 Volume of induced investment
depends on
 MEC – marginal efficiency of capital –
determined by expected income flow
from capital asset and its purchase price
 Market rate of interest

9. Consumption, planned
investment and AD
 Assuming planned investment spending
constant and equal to I and also assuming
G and NX equal to zero,
AD = C + I
= (a + I) + bY
= A + bY
where A – part of AD independent of
income or autonomous

10. Contd….
AD
AD = Y
E AD = A + cY
C = a + cY
In equilibrium, without
A G and NX
I Y = AD
Y = A + bY
a
Y = (1 / 1-c) A
Planned I = S
Y

11. Multiplier
 An increase in autonomous spending brings about
more than proportionate increase in equilibrium
level of income
 Multiplier effect – known as investment or income
multiplier
 Ratio of change in income due to change in
autonomous investment
 Amount by which equilibrium output changes for
change in autonomous aggregate demand by one
unit

12. Derivation
Y = AD
dY = dAD
dAD = dA + cdY
dA – change in autonomous spending
dY – change in income
dY = dA + cdY
dY = (1/1-c) dA
α = 1 / 1 – c – multiplier
Larger the MPC, greater the multiplier

13. Graphical derivation
AD
AD = Y
E AD1 = A1 + cY
AD = A + cY
A1
dA
A
Y
Y0 Y1

14. Government spending
 Governments affect AD in two ways
 G – government spending
 Taxes and transfers affecting YD
 Consumption now depends on YD and not Y
 C = a + cYD = a + c (Y + TR – TA)
 TA = t Y
 C = a + cTR + c (1-t) Y
 Assuming that G and TR are constant,
AD = (a+ cTR+ I+ G) + c(1-t) Y
= A + c(1-t) Y

15. Contd….
 In equilibrium, Y = AD
 Y = A + c(1-t) Y
 Y [1-c(1-t)] = A where A = a+ cTR+ I+ G
 Y = A / 1-c(1-t)
 Multiplier in presence of taxes = α = 1 / 1–c(1-t)
 Government spending can increase A by the
amount of purchases G and by the amount of
induced spending out of transfers bTR
 Increased A will increase Y depending on the value
of MPC and tax rate
 When tax rates (t) are higher, value of multiplier is
lower

16. Government budget
 Plan of the intended expenses and revenues of the
government
 Budget surplus = TA – G – TR
 BS = tY – G – TR
 At low levels of income, budget is in deficit, since
govt spending (G+TR) > tax collection (tY)
 At high levels of income, budgets are in surplus
 Budget deficits typically persist during recessions
when tax collections are low and transfers like
unemployment allowances increase

17. AD curve
 Represents the quantity of goods and services households,
firms and government want to buy at each price level
 When prices fall
 real wealth of households increases inducing more
consumption
 Interest rates fall inducing more investment
 Exchange rates depreciate inducing more exports
P
AD
Y

18. Aggregate supply
 Total amount of goods and services produced in the
economy over a specific time period
 Classical AS – vertical line indicating that same
amount of goods and services will be supplied
irrespective of price level
 Assumption – labour market is always in equilibrium with
full employment
 Keynesian AS – horizontal line indicating that firms
will supply whatever amount of g & s is demanded
at existing price level
 Assumption – unemployment leading to hiring labour at
prevailing wage rate
 In practice, AS is positively sloped lying between
Keynesian and classical AS

19. Contd….
 Upwards sloping AS in the short run
 Misperceptions – changes in price level can mislead the
suppliers about individual markets in which they sell their
output, resulting in changes in supply
 Sticky wages – nominal wages are sticky or slow to adjust
in the short run - slow adjustments can be due to long-
term contracts or work/social norms
 When P falls, W/P (real wage) rises, increasing the real cost to the
firm, thus making employment and production less profitable
 Firms cut down on employment and production and thus on supply
 Sticky prices – prices of some goods and services are
slow in adjustment – they lag behind when overall price
level declines thus affecting their demand – this induces
firms to reduce supply in the short run

20. AS curve
 Represents the quantity of goods and services firms choose
to produce and sell at each price level
P
AS
Y

21. Equilibrium
P
AS
E
AD
Y