Determination of national income

2. Keynesian Income
Determination
Aggregate Demand =Aggregate Supply
=
National Income

3. Aggregate Demand
Aggregate Demand =
 Consumption of goods and services +
Investment ( Demand for capital goods)
AD = C+I

4.  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

5. 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

6. 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)

7. Autonomous Investment: it is
caused by the Exogenous factors than
income and interest rate. As:
Innovation in production technique
Invention of new business process
Expansion plans of business firm
Discovery of new market

8. Autonomous investment largely made
by government. In the following area :
Physical Infrastructure - Transport,
Power and communication network
Human Infrastructure – Health &
Education
Public Goods- Defence

9. 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.

10.  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.

11. Consumption Function
C = 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.)

12.  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

13. 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)

14. Linear Consumption Function
Applicable 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.

15.  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%

16. 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)

17. 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
 Y
If Consumption function assumed to be
form of C = bY
APC = bY = b
 Y
APC= MPC

18. The level of income Rs.1000 crore.
Consumption expenditure Rs.750
APC = 750 = 0.75
1000
If 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

19. Saving Function
It 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 Y
Saving 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

20. 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)

21.  The Saving Function
100
Saving(+) 200 S
300 S = -200+0.25
0 200 400 500 600 700 800
-100
- 200
Dissaving (-) -300

22. 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 spending
When income is Rs. 20,000/-
What is the Saving function of the family.?

23.  C = 2000 +0.80Y
When Y = 20,000/-
C= 2,000 + 0.80 x 20000 = 18000/-
S = -a + (1-b)Y
S = - 2000 + (1-0.80)Y = -2000 + 0.20Y
 S = 2000

24. Aggregate Supply
Aggregate supply (National Product) based on :
1. Supply of final goods and services in a year
2. 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.

25. 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
AS
z
0
Aggregate Supply
Y
X

26. Equilibrium Level of Income
C+I represents the
aggregate demand
OZ line represents
Aggregate supply, which is
450
line. It means
aggregate supply or Nationati-
Onal product equals national
Income.
It shows that value of
aggregate output increases
at constant rate because price
Level, productivity are assumed
to remain constant.
z
E
C+I
Y1
NATIONAL INCOME
Aggregate Demand and
Supply
0
450
Y YF

27. 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
OY1because 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.

28. 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.

29. 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

30. 1. AD-AS Approach
C+I = C+S
Y = C+I
C= a+bY, I is constant
Y= a+a Y+I
Y-b Y = a+I
Y(1-b) = a+I
Y = _a+I_
1- b
Y = __1_ (a+ I)
1- b

31. Numerical Example
 C = 100 +0.75
I = 200
Y= C+I
Y =100+0.75Y+200
Y (1-0.75) 100+200
Y = __1_ (a+ I)
1- b
Y = __1 (300)
 1-0.75 Ans. =
1200

32. 2. Saving –Investment Approach
C +I = C+S
 C +I = C+S
I=S
Investment is remain constant
S= f(Y)
S= Y-C
C=a+b Y
S =Y –(a+b Y)


33.  S =Y –(a+b Y)
S= Y-a-b Y
S= -a+Y-b Y
S= -a+(1-b)Y (Saving Function)
I = S
I = -a+(1-b)Y

34. Example
I =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 =S
200= -100 +(1-0.75)Y
300 =(1-0.75)Y
Y= __300___ 1200
 1-0.75