MACROECONOMICS
Lecture 5: Income Determination- Keynesian Theory
TOPICS TO BE DISCUSSED
Keynes Model of income determination
Aggregate Demand and Aggregate Supply
1
Aggregate Demand
AD refers to the effective demand that is equal to the actual expenditure.
Aggregate effective demand refers to the aggregate expenditure of an
economy in a specific time frame.
AD consists of:
• AD for consumer goods (C)
• AD for capital goods (I).
Thus, AD = C + I
AD schedule: It is also called the C + I schedule
• I is assumed to remain constant in short run analysis at all levels of
income.
2
Aggregate Demand
Consumption function can be expressed as follows:
Consumption is a function of Y
• C = f(Y)
•C = a + bY
•Where, a = constant (representing consumption when income is zero)
•b = proportion of income consumed = ∆C/∆Y
Aggregate Demand
AD = C+I
Expenditure
Income
Aggregate Supply
Aggregate Supply (AS) : the amount of goods and services produced in
an economy. The value of AS = factor payments
According to Keynes theory of national income determination, the
aggregate income is always equal to consumption and savings.
AS Schedule: If all that is produced is sold, then AS grows at a constant
rate of growth of output. This is shown by the 450 line.
The line is called the AS schedule or the C+S schedule (because as per
Keynesian analysis; AS = C + S (assumption that all income is spent; it is
thus also called the Aggregate Expenditure )
5
Aggregate Supply
Expenditure
AS= C+S
450
Income
Equilibrium- Income, consumption and savings
relationship
Y = C+S
Expenditure
At equilibrium, AS = AD
C+S = C+I C
S=I E
Dissaving, when AD is greater than
AS
Saving, when AD is less than AS
Saving
O Y
Income
Equilibrium- Income Determination
Expenditure
Y = C+S
At equilibrium, AS = AD
C+I
C+S = C+I
S=I 100
E
Dissaving, when AD is greater than
AS
Saving, when AD is less than AS
O 200
Income
Determination of Equilibrium Level of Income
• According to Keynes equilibrium level of employment (income) in the short
run is determined by the level of effective demand.
• Higher the level of effective demand, the greater would be the level of
income and employment and vice versa.
• Equilibrium takes place at less the full employment level.
• Government intervention required to achieve full employment.
• Intervention in the form of monetary & fiscal policy.
• Government can push AD up and reach full employment level
9
Equilibrium- Income Determination
Expenditure
Equilibrium Y = C+S
At equilibrium, AS = AD
C+I
C+S = C+I
S=I 100
Dissaving, when AD is greater than
AS
Saving, when AD is less than AS
O 200
Income
Equilibrium- Change in AD
Expenditure
Equilibrium Y = C+S
At equilibrium, AS = AD
C+I+ ∆I
C+S = C+I
S=I 100
Dissaving, when AD is greater than C+I
AS
Saving, when AD is less than AS
O 100 200
Income
Summary
Equilibrium is achieved at less than full employment level
Keynes argued that adequate economic stimulus to shift the AD upwards
can be created through:
Monetary Policy: A reduction in interest rates
Fiscal Policy: A rise in government expenditure
However, monetary policy is ineffective during recession as interest rate is
already low
Hence, expansionary fiscal policy is more effective where government
expenditure can be increased
1
THANK YOU
