UNIT 9 CLASSICAL AND KEYNESIAN

SYSTEMS
Structure
9.0 Objectives
9.1 Introduction
9.2 The Classical Approach
9.3 Output and Employment in the Classical System
9.3.1Production Function
9.3.2Labour Demand
9.3.3Labour Supply
9.4 Equilibrium Level of Output and Employment
9.5 Aggregate Supply Function
9.6 The Keynesian Approach
9.7 Let Us Sum Up
9.8 Answers/ Hints to Check Your Progress Exercises

*
9.0 OBJECTIVES
After going through this Unit, you should be in a position to:

 bring out the salient features of classical economics;

 explain the demand for and supply of labour with the help of diagrams;
 explain the relationship between output and real wages;
 explain the concept of aggregate supply curve as per classical view;
 bring out salient features of Keynesian economics; and
 distinguish between classical and Keynesian views on the macroeconomy.

9.1 INTRODUCTION

During the 1930s the world economy was passing through severe economic crisis
– there was widespread unemployment, unintended accumulation of inventories,
and persistent decline in prices, output and income. The overall economic
atmosphere was pessimistic. This period is termed as ‘the Great Depression’,
because of the extent and duration of the downslide in global economic
environment. There have been periodic decline in output and employment in
countries; however the severity of the Great Depression is un-matched in
economic history. Prevalent economic theory around that time was neither in a
*
Dr. Kaustuva Barik, IGNOU and Dr. Nidhi Tewathia, Assistant Professor, Gargi College,
University of Delhi
109
The Closed Economy position to explain the ongoing developments nor to provide a solution to the
in the Short-run problem.

In the midst of the Great Depression, J M Keynes came up with the book,
‘The General Theory of Employment, Interest and Money (published in 1936)’,
which provided fresh insights to the problem. Keeping in view its radical nature
of analysis, fundamentally different explanations, and distinct remedial measures
it is often termed as ‘Keynesian Revolution.

The Keynesian ideas further developed into a vast literature during the next three
decades, which provided further insights and a new school of thought, the
Keynesian economics. It was only during the 1970s that Keynesian economics
lost its glory and gave way to a new school of thought, the New Classical
Economics, which was a revival of classical economics. In this Unit we will
discuss the salient features of classical economics and Keynesian economics.

9.2 THE CLASSICAL APPROACH

Keynes termed all economists prior to him as ‘classical’. The classical period,
generally taken as the period before 1930, was dominated by the work of Adam
Smith (Wealth of Nations, 1776), David Ricardo (Principles of Political
Economy, 1817) and John Stuart Mill (Principles of Political Economy, 1848).
Neoclassical economists such as Alfred Marshall and A. C. Pigou extended the
classical ideas. Important features of the classical ideas are as follows:

(i) Microeconomic Issues: Classical economists dealt mostly with

microeconomic issues pertaining to behavior of economic agents such
as firms and households. In classical view, a firm maximizes its
profits subject to a resource constraint. Similarly, households try to
maximize their utilities or economic gains given their budget
constraints. Classical economists believed in the optimising
tendencies of the market mechanism. Variables such as price level,
wage rate and output level should be determined by market forces
(supply and demand).

(ii) Laissez Faire: Classical economists believed in the philosophy of

‘laissez faire’, which is a French term meaning ‘leave alone’ or ‘let
you do’. According to this view, there should be minimal intervention
from the government in business affairs. In fact, Adam Smith
suggested that government should confine itself to three main duties,
viz., (i) national defense, (ii) administration of justice (law and order),
and (iii) establishing and maintaining certain public works
(infrastructure, education, etc.).

(iii) Invisible Hand: Adam Smith introduced the concept of the ‘invisible
hand’. According to him, the economy will function well if everyone
pursues his/ her own interest. “It is not from the benevolence of the
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 butcher, the brewer, or the baker that we expect our dinner, but from Classical and Keynesian
their regard to their own interest.” Individuals pursuing self-interest Systems
seem to be led by an ‘invisible hand’ to maximise the general welfare
of everyone in the economy. It is not the generosity of a producer in
selling a commodity; it is his/ her self interest. Similarly, I am not
doing a favour to the producer; I am pursuing my own interest in
buying the commodity. The philosophy of the invisible hand confined
classical economists to the analysis of the behavior of economic
agents; they failed to see any conflict between interest of economic
agents and that of the economy as a whole.

(iv) Continuous Market Clearing: Classical economists assumed that

prices and wage rates are flexible. As you know from
microeconomics, equilibrium price is determined at the level where
supply and demand are equal. Given the supply and demand curves, if
demand is more compared to supply, price will increase. Similarly, if
supply is more compared to demand, price will decrease. This
principle applies not only to commodities, but also to wage rate. If
supply of labour is more than its demand, there will be a decline in
wage rate till supply of labour equates its demand. An implication of
the above is that there is no unemployment in the economy – wage
rate will decline till all workers are employed. There is no
disequilibrium in the market.

(v) Perfect Competition: Calssical economists assumed that there is

perfect competition in the market so that markets function smoothly.
As there is full employment (due to flexibility in wage rate),
production is always at the full employment level. An implication of
the above is that there is no scope for ups and downs in the level of
output. Going by this logic, the classical economists ruled out the
possibility of ‘business cycle’.

(vi) Say’s Law of Market: Classical economists believed that production

or supply is the key to economic prosperity. Thus they emphasized
more on the supply side of the economy. This approach is
summarized very well in the Say’s law, named after the prominent
classical economist J B Say. According to J B Say, ‘supply creates its
own demand’. Whenever some production takes place, there is a
stream of income in the hands of people, which generates demand.
A person should have produced something to sell (say, for example,
labour) and thereby earned certain income. Thus in the classical
viewpoint, there is no scope of deficiency of demand in the economy.
Therefore, primary concern before an economy is production or
supply, not consumption.

According to classical economists, economic growth of an economy is due to

increase in the factors of production and technological advancements. Money is
just a medium of exchange; and it facilitates transactions among economic
111
The Closed Economy agents. According to classical economists, increase in money supply does not
in the Short-run affect the level of output – it only leads to increase in prices. They believed that
there is dichotomy between monetary variables such as money supply and real
variables such as output and employment. Thus the classical economists stressed
the role of real factors in deciding the real variables such as output and
employment. As mentioned earlier, the classical economists believed in free
market systems without government intervention. Determination of output,
employment and interest rate in the classical system is given below.

9.3 OUTPUT AND EMPLOYMENT IN THE

CLASSICAL SYSTEM
In the classical system, decision-making by economic agents such as firms and
households was very important. Aggregation of output and employment over
firms constituted total output and total employment. Similarly, aggregation of
supply of labour by individuals constituted total labour supply in the economy.

9.3.1 Production Function

As you know from microeconomics, a production function gives the

technological relationship between inputs and output. It can be written as


Y  F L, K 
where Y is the total product (TP) produced, L is the quantity of labour used in
production, and K is the stock of capital (assumed to be fixed in the short run). It
is assumed that in the short run the state of technology and capital stock cannot
be changed; thus they are constant. Output varies according to the amount of
labour employed. The change in output due to an additional unit of labour is
known as Marginal Product of Labour (MPL) and it is given by the expression

ΔY
MPL = .
ΔL

We present the relationship between TP (given by Y in the figure) and MPL in

Fig. 9.1. We observe that Y increases at an increasing rate for certain initial units
of labour employed. Subsequently the curvature changes and Y starts increasing
at a decreasing rate (point a). At point b, TP is at its maximum level; at this level
of output MPL touches zero.

The underlying idea is that as the amount of labour increases, MP L of the

additional labour remains positive but is lower than that of the labour hired
previously. When the TP starts falling, i.e., beyond point b, the MPL becomes
negative. You should note that MPL is the slope of the TP curve. Classical

112
economists assumed that the quantity of labour employed would be dependent Classical and Keynesian
upon the demand for and supply of labour in the labour market. Systems

b TP is maximum

Point of
Inflexion
TP
Outupt

L
MPL L1 L2
Labour

Phase 1 Phase 2 Phase 3

Marginal Product of Labour

MP is maximum

b
L
0 L1 L2 MPL
Labour

Fig. 9.1: Total Product and MPL

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The Closed Economy 9.3.2 Labour Demand
in the Short-run
Labour is demanded because it contributes to production of goods and services;
thus it is a derived demand. If the demand for commodity A increases, then the
producer of commodity A will hire more labour. Labour as a factor of production
carries an advantage as compared to capital – it is relatively easy to change the
units of labour employed compared to capital.

Classical economists assumed that there is perfect competition in markets. In

perfect competition, as you know, the firms are price takers – they cannot decide
the price. Firms choose the output level at ongoing prices in order to maximize
profits. Further, choice of the level of output and quantity of labour used are one
decision. Now, the question is how a firm decides on the level of production,
given the labour cost. A firm will increase output until the Marginal Cost (MC)
of producing a unit of output is equal to the Marginal Revenue (MR) received
from its sale. For such a firm, MR is equal to the price (MR = P). The MC will be
equal to the ratio of wages (W) to the number of units of output produced by the
additional unit of labour.

W
MC 
MPL

As per the condition for short run profit maximization, in perfectly competitive
W W
market, P = MC. Hence, P  , or,  MPL .
MPL P

W/P
MPL

a
W/P
Real Wage

L
O L1
MPL

Fig. 9.2: Demand for Labour

Thus a firm will hire up to the point where the additional output obtained by
hiring one more unit of labour (MPL) is equal to the real wage (W/P) paid to
labour. Fig. 9.2 shows this condition where employment (number of labour units)
is depicted on the x-axis and real wage (W/P) is shown on the y-axis along with
MPL.

114
 W Classical and Keynesian
At point ‘a’ in Fig.. 9.2 we observe that  MPL . To the left of point a we Systems
P
W W
have MPL  and to the right of point a, MPL  . The labour demand
P P
curve is downward sloping due to the law of diminishing returns. With an
W
objective of profit maximization, the firm employs more labour when MPL 
P
W
and reduces the number when MPL  . The aggregation of the individual
P
firms’ demand curves for labour gives economy wide demand curve for labour.

So the aggregate labour demand function (Ld) can be written as

W
Ld  f  
 P  

The negative sign (–) in the expression indicates that a higher real wage rate is
associated with a lower demand for labour.

9.3.3 Labour Supply

While maximizing their utility, individuals decide on the amount of work to put
in and the amount of leisure to enjoy. It is assumed that work creates disutility
(discomfort, uneasiness, or burden) in labour and there is a general preference for
leisure to work. Economists use the term ‘leisure’ for all the activities which are
off-the-job such as eating, sleeping, spending time with friends, etc. Because of
its disutility, labour needs to be compensated for work with wage. Individuals
weigh costs and benefits of working before deciding the number of hours to
work.

There is a trade-off between income and leisure as income is earned through

work which in turn reduces the leisure time. An individual has 24 hours in a day
to allocate between work hours and leisure hours. Let us consider an example of
an individual – (s)he has an option of working for 24 hours or spending all the
day in leisure. S(he) chooses the combination of work and leisure which
maximises her/ his utility given the wage rate and price level. Thus it is possible
to substitute between work and leisure.

In Fig. 9.3, real income is measured on the x-axis, and real income/ real wage is
measured on the y-axis. Real income is equal to real wage (W/P) multiplied by
the number of hours the person works. Each vertical intercept represents zero
leisure. In that case the real income will be [W/P × 24]. Indifference curves are
labelled as U1, U2 and U3. Points on these curves give various combinations of
income and leisure which give equal satisfaction to the workers. The slope of the
indifference curve gives the rate at which the person is willing to trade-off leisure
for income. The slope of the indifference curve implies the increase in income
the individual would have to be paid, so that he gives up a unit of leisure. The
cost of foregoing an hour of leisure is the real wage per hour, W/P.

115
The Closed Economy
in the Short-run
c

C
b

Real Income
U3

a B
U2

A U1

0 L3 L2 L1 24 leisure
work hours

Ls
Real Wage

B
A

0 Work hours per day

L1 L2 L3

Fig. 9.3: Supply of Labour

The straight-line rays starting from point 24 on the horizontal axis give the
budget lines facing the individual. The slope of these lines is real wage, W/P.
Higher real wage rate makes the budget line steeper. Three budget lines are
shown in Fig. 9.3 representing three different real wage rates. In the bottom panel
of Fig. 9.3 we plot the labour supply curve, which is upward sloping. We can say
that labour supply is a function of real wage, which is given by

W
LS  f  
 P   

116
The positive sign (+) in the above equation indicates that labour supply increases Classical and Keynesian
as real wage (W/P) increases. You should note that labour supply is determined Systems
by real wage and not money wage. Secondly, there are both ‘substitution effect’
and ‘income effect’ in the decision-making process of an individual on the
number hours (s)he would work. As wage rate increases, a person works for more
number of hours (substitution effect). Similarly, lower wage rate would
discourage the person from work. Income of an individual depends on the
number of hours (s)he works, multiplied by the wage rate. A higher wage rate
implies higher income level for individuals. Suppose, person G is willing to work
for 4 hours when wage rate is Rs. 100 per hour. When wage rate increases to Rs.
150 per hour (s)he is willing to work 6 hours a day. The first 4 hours which (s)he
was willing to work at Rs. 100 per hours now pay him Rs. 150 per hour. Thus
her/ his income increases from Rs. 400 to Rs. 900 per day! When her/ his income
increases to a very high level, (s)he may actually decrease her/ his hours of work,
and enjoy more leisure. This is similar to the ‘income effect’ in consumer
demand theory. It is observed that at a very high an individual might reduce the
work hours and increase leisure. This is a situation where the income effect is
dominant. So, at very high wage rates, the labour supply curve assumes a
negative slope and starts bending backwards towards the vertical axis.

Check Your Progress 1

1) Bring out the salient features of classical theory.

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2) Explain the relationship of labour with output in the short run as per
classical view.

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3) Derive the labour demand and labour supply curves.

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117
The Closed Economy
in the Short-run
9.4 EQUILIBRIUM LEVEL OF OUTPUT AND
EMPLOYMENT
So far, we have established the following relationships.

Y  F L, K  
W
Ld  f  
 P   

W
LS  f  
 P   

𝑊
𝑃 Ls

𝑊 E
𝑃
Real Wage

Ld

Employment
0
L0

E 𝑌 = 𝐹 (𝐾 , 𝐿)
𝑌
Output

Fig.
0 Employment
L0

9.4: Output and Employment Determination

118
Equilibrium condition in the labour market, i.e., Ld  LS along with production Classical and Keynesian
function determines the output, employment and real wage rate in the classical Systems
system. Fig. 9.4 depicts the equilibrium in the labour market, where Y0 is output
W
level, L0 is employment level and   is wage rate.
 P  0 

Output and employment are dependent on certain exogneous variables. You

should note that exogenous variables are determined outside the model while
endogenous variables are decided within the model. It is very simple to identify
the exogenous variables which affect output and employment. We have used
labour demand, labour supply and production function in Fig. 9.4 in order to
determine output and employment. Thus, any variable that affects labour supply,
labour demand and the production function will in turn affect the level of output
and employment.

In the long run if there is a change in the capital stock, there will be a shift in the
production function (because we assumed capital input to be fixed in the
production function that we considered). Simlarly, if there is a change in
technology, the production function will shift. In case of a shift in the production
function, MPL will change, which will shift the labour demand curve.

The labour supply curve however would depend upon a different set of variables
– it will shift if there is change in the size of population and if the individuals’
preferences change due to change in the labour-leisure trade offs. In the classical
system, the levels of output and employment are dependent only on the supply-
side factors.

Let us again consider labour supply and labour demand curves. We look at Ld
and Ls as functions of money wage. We have an upward sloping labour supply
curve, which is a function of money wage (W), assuming a given price level P1.

Let us look at Fig. 9.5. We observe that different price levels give different
labour supply curves. Each price level would mean, for a given money wage, a
different real wage – hence a different labour supply curve.

Thus if money wage rate is constant, change in price level would result in a shift
in the labour supply curve. As prices rise, the LS curve shifts to the right. So, as
prices go up and the money wage does not increase, the individual is left with a
lower real wage and would like to reduce the amount of working hours. This can
be observed from Fig. 9.5. As price level increases from P1 to 2P1 and 3P1; and
the money wage increases from W1 to 2W1 and 3W1, the real wage remains
unchanged.

 W1 2W1 3W1 
 P  2P  3P 
 1 1 1 

This leads to the fact that employment will remain the same at L1.

119
The Closed Economy
in the Short-run
𝑊

Ls(P1)

s
L (2P1)
Ls(3P1)
3𝑊
Money Wage

2𝑊

Ld(P1) Ld(3P1)
Ld(2P1)
Labour
0
L L1 L2

W
L =f
P
Real Wage

𝑊
𝑃
W
L =f
P

Labour
0
L1

Fig. 9.5: Labour, Money Wage and Real Wage

120
Thus, proportional increases (or decreases) in both money wage and the price Classical and Keynesian
W Systems
level leave the labour supply unchanged. Looking at the demand side,  MPL
P

W = MPL × P
Suppose money wage remains unchanged at W and price level increases from P1
to 2P1 and then to 3P1 there is a decline in real wage more labour is demanded.
Proportional increase in the money wage and the price level however will leave
the labour demand unchanged at L1.

9.5 AGGREGATE SUPPLY FUNCTION

The firm takes money wage as given while deciding its level of output. This, in
turn, indicates the amount of labour to hire. As there are many firms, one firm’s
decision will not have any effect on the money wage level. As money wage is
fixed, the output supply curve for the firm is positively sloped. Higher prices lead
to more output as the real wage declines. At the economy level, however we
cannot assume money wage rate to be fixed. Money wage rate must adjust in
order to maintain the equilibrium between supply of and demand for labour. We
observe from Fig. 9.5 that initial levels are: price level (P1), money wages (W1),
employment (L1), and output (Y1). If P1 increases to 2P1 and wage remains at W1,
the labour demand would increase to L2. Higher prices will lead to lower real
wage, so firms will demand more labour – it will result in expansion of output
and employment. At 2P1, labour supply curve shifts to LS(2P1). Therefore, the
supply of labour at W1 would be only L2ʹ. There is an excess demand for labour
which is equal to (L2 – L2ʹ) and hence the money wage will rise. Firms which do
not increase the money wage experience a decline in availability of losing on
labour. Wages will rise till equilibrium is achieved again. It happens at 2W 1 in
Fig. 9.5. The real wage rate is restored at initial level; employment level also is
back at the initial level. Thus, the output supplied at a higher price, i.e., 2P1 is
equal to Y1.

P YS
Aggregate
Price Level
3P1
2P1
P1

Y
Y1

Fig. 9.6: Classical Aggregate Supply Curve

121
The Closed Economy
in the Short-run Similarly, when price level reaches 3P1, wages rise to 3W1, and output remains at
Y1. Hence, the aggregate supply curve is vertical (Fig. 9.6). Higher prices will be
result in higher output only if they are not accompanied with higher money
wages.

We make an important observation at this point. The shape of the aggregate

demand curve will not make any difference to the equilibrium level of output.
This is because the aggregate supply curve is vertical and is stable at Y1. Factors
like quantity of money, level of government spending and level of demand for
goods and services are demand-side factors. As per classical economists, these
factors do not affect the level of output.

9.6 THE KEYNESIAN SYSTEM

In classical view, supply-side factors are more important than the demand-side
factors. According to Say’s law of market, supply creates its own demand.
Further, as price and wage rate are flexible, equilibrium is attained always. There
is no scope for unemployment and output is always at full employment level. As
supply and demand forces lead to an optimum condition for the economy, there is
no need for government intervention. The Great Depression, however, belied
these beliefs. During the 1930s there was widespread unemployment, poverty,
and insecurity among households. At this point, Keynes provided an altogether
different insight into the problems confronting major economies. Some of the
salient features of Keynesian economics are presented below.

a) Demand Creates its Supply: Just opposite to the classical view, Keynes
proposed that demand for a product encourages producers to come up
with products demanded. If there is idle capacity in the economy, output
will increase if aggregate demand increases.

b) Rigidities in Prices and Wage Rate: Prices and wage rate are not
flexible as suggested by classical economists. Suppliers have monopoly
power; perfectly competitive markets do not exist. As we receive our
wages and salaries in nominal terms, we resist downward movements in
wages and salaries. There are several contracts which do not allow
immediate revision in prices and wages. Moreover, adjustments in prices
and wage rate are staggered over a period of time; adjustments are not
instantaneous.

c) Unemployment in Economy: Classical economists ruled out the

possibility of unemployment in the economy. According to Keynes,
unemployment is normal for an economy. Periodic fluctuations in
unemployment can be neutralized by government intervention.

122
 d) Government Intervention: If aggregate demand is falling short of Classical and Keynesian
aggregate supply, in Keynesian system the government should increase its Systems
spending. Thus in the Keynesian system government has an active and
important role in the economy. If there is large scale unemployment in the
economy, government should create jobs through investments in
productive activities. If inflation is high, government should adhere to
restrictive policies to reduce the level of aggregate demand.

e) Aggregate Supply Curve: According to classical economists, aggregate

supply curve is vertical. The classical economists however were referring
to the long run situations. According to Keynes, short run is also
important. In the short run the aggregate supply curve is horizontal, if the
available resources in the economy are under-utilised. An implication of
the above is that increase in aggregate demand will result in increase in
output, without increasing prices.

We will discuss further on the Keynesian model in subsequent Units of this

course.

Check Your Progress 2

1) Explain the relationship between real wage, money wage and labour
employment.

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2) Why is the classical aggregate supply curve vertical?

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3) Bring out the major differences between Classical and Keynesian models.

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123
The Closed Economy
in the Short-run
9.7 LET US SUM UP

In this Unit we discussed the salient features of classical and Keynesian systems.
The classical economists stressed on the theory of ‘invisible hand’ and advocated
that price level and wage rate should be decided by market forces. Classical
economists suggested that there should be no government intervention in
determination of output, employment, prices and wage rate. According to them,
the economy adjusts to any kind of disturbance through movement of prices and
wage rate, and equilibrium is attained again quickly. The aggregate supply curve
is vertical, reducing the role of aggregate demand to minimum.

Keynesian economics, on other hand, is a contrast to classical economics. Keynes

believed that in case the economy goes through bad times, it is the role of the
government to intervene and help economy to attain equilibrium. According to
Keynes, prices, wage rate and output do not adjust quickly to variation in supply
and demand conditions. If the economy is left to itself (without government
intervention) a very long time period will be required for the economy to attain
equilibrium conditions. Government intervention would neutralize the adverse
effects.

9.8 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) Refer to Section 9.2 and answer.

2) Discuss the concept of MPL and then explain how it applies to the
production function. Refer to Section 9.3 and Table 9.1.
3) Refer to Sub-sections 9.3.1 and 9.3.2. Explain Fig. 9.2 and Fig. 9.3.

Check Your Progress 2

1) Go through Section 9.4 and Fig. 9.5. Discuss the role of change in the price
level in terms of real wage and money wage.
2) Refer to Fig. 9.6. Output supplied at a higher price is the same as that
supplied at a lower price.
3) Refer to Sections 9.2 and 9.6.

124
 UNIT 10 KEYNESIAN MODEL OF INCOME
DETERMINATION*
Structure
10.0 Objectives
10.1 Introduction
10.2 Equilibrium and Aggregate Demand
10.3 Consumption Function
10.3.1 Relationship between Consumption and Aggregate Demand
10.3.2 Formula for Equilibrium Output
10.4 Multiplier
10.4.1 Concept of Multiplier
10.4.2 Investment Multiplier
10.4.3 Limitations of Multiplier
10.5 Let Us Sum Up
10.6 Answers/Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this Unit, you should be in a position to
 define consumption function and saving function;
 explain the concept of multiplier and its operations;
 explain the relationship between marginal propensity to consume and
aggregate demand;
 calculate the value of investment multiplier; and
 explain the concept of Keynesian Cross in a diagram.

10.1 INTRODUCTION

As pointed out in Unit 2, output, income and expenditure are three different ways
of measuring the level of economic activity in an economy. Whatever method we
adopt for measurement, we reach the same level. In this Unit we will discuss
another concept, that is, the equilibrium level of output. At the equilibrium level,
the demand for and supply of output are equal. We assume that prices are fixed
and firms are willing to sell any amount of output at the given level of prices.
To develop the concept of aggregate demand, assuming constant prices is very
important. On supply side, Keynes takes the aggregate supply curve to be
horizontal. We will also discuss the consumption function, factors responsible for
deciding aggregate demand and multiplier.

*
Dr. Nidhi Tewathia, Assistant Professor, Gargi College, University of Delhi
125
The Closed Economy
in the Short-run
10.2 EQUILIBRIUM AND AGGREGATE DEMAND

We already know that the total demand for goods and services is known as
‘aggregate demand’. The factors which together make aggregate demand (AD)
are consumption (C), investment (I), government expenditure (G), and net
exports (NX).
AD = C + I + G + NX

In case we assume the aggregate demand for goods and services to be constant,
we get a horizontal AD curve. It means that AD is independent of income and
output levels. In Fig. 10.1, output level (representing aggregate supply) is
presented on the x-axis while aggregate demand is shown on the y-axis. A 45
line shows equality between the variables shown on x-axis and y-axis, i.e., at any
point on this 45 line, AD = Y. In other words, this line represents the locus of
equilibrium points where aggregate demand is equal to the output level.

AD AD= Y

E
AD

45 Y
O Y1

Fig. 10.1: Horizontal AD Curve

In case the AD curve is horizontal, we can say that the equilibrium exists at point
E where AD = Y. No forces are causing any change at point E. Equilibrium level
of output is Y1. In case firms produce to the left of Y1, aggregate supply is less
than aggregate demand, and there is run down of exiting inventories. On the other
hand, if firms produce to the right of Y1, there is excess supply (aggregate supply
is more than aggregate demand) and inventories will increase. In both the cases,
there will be a movement towards Y1. At E, the firms are selling exactly what
people demand. In case of a deviation from Y1, we have positive or negative
unplanned inventory investment.
UI = Y – AD

where UI is unplanned inventory.

When Y > AD, we find that UI is positive, i.e., there is an addition to the stock of
inventory. When Y < AD, we find that UI is negative, i.e., the existing inventory
is to be used in order to meet the aggregate demand. It is also called unplanned
inventory disinvestment. This leads us to the equilibrium condition Y = AD.

At equilibrium, there is no unplanned inventory investment. Aggregate demand is

also indicated by planned spending. Hence, we can say that at equilibrium,
planned spending equals income.
126
 Keynesian Model of
10.3 CONSUMPTION FUNCTION Income Determination

One of the major determinants of aggregate demand is consumption expenditure

or consumption. We generally observe that consumption expenditure rises as the
income level rises. Hence, we assume that the consumption and income are
positively related. For simplicity, we ignore for the time being that there is no
role of the government. Hence, instead of ‘disposable income’ we consider
‘income’ for finding out consumption. Another issue to consider is that in case
income is zero, the individuals still consume and hence the consumption function
is not entirely dependent on income. In such a situation, the individuals are
expected to sell off their assets such as stocks, bonds, etc. Let us have a look at
the consumption function now.

C = C + cY

C >0 and 0<c<1

You should note that C is the intercept, i.e., the level of consumption when
income is zero. For each rupee increase in income, the level of consumption
increases by c. This is the slope of the consumption function. It is also known as
marginal propensity to consume (mpc). You should note that mpc will lie
between zero and one, which indicates that when mpc = 0, consumption is not
rising due to rise in income and when mpc = 1 the consumption is rising by the
same amount as the rise in income. In other words, it means if c = 0, then C = C .

Fig. 10.2 shows the consumption function. The mpc is positive and hence the
curve is upward sloping.

Consumption C = C + cY

C
Y
O Income level

Fig. 10.2: Consumption Function

We can find out the level of saving in the economy from the consumption
function. If the fraction c is consumed then the remaining portion i.e., (1 – c)
should be saved because, by assumption, income is either consumed or saved.

SY–C

S  Y– C – cY
127
The Closed Economy S = – C + (1– c)Y
in the Short-run
Saving is also an increasing function of income with the slope (1 – c). The
marginal propensity to save (mps) in the case of saving function is given by

mps = (1 – c) = s

The negative intercept (– C ) can be written as S . Thus the saving function is

given by

S = S + sY

We know that income is the sum of consumption and saving.

Y=C+S

Dividing both sides by income (Y), we get

Y C S
 
Y Y Y
In the above equation, the ratio of consumption to income (C/Y) is called
average propensity to consume (APC). Similarly the ratio of saving to income
(S/Y) is called average propensity to save (APS). Thus, we can re-write the
above equation as

APC + APS = 1

10.3.1 Relationship between Consumption and Aggregate Demand

Assuming that the government sector and the foreign sector are absent, we are
left with consumption and investment as the two components of aggregate
demand.

AD = C + I

C + cY + I = AD

 
AD = C  I + cY

AD = 𝐴̅ + cY
where I is planned investment, which is taken as fixed. You should note that
 
C  I is mentioned as 𝐴̅ in the above equation, where 𝐴̅ is the autonomous
expenditure (i.e., independent of income level). The aggregate demand (AD)

curve is obtained by vertically adding I investment to the consumption curve.
As investment is autonomous, it does not affect the slope of the consumption
function. Looking at Fig. 10.3, we get an idea of the AD curve. Equilibrium takes
place at point E with equilibrium level of output at Y0 and equilibrium aggregate
demand at AD0. Slope of AD curve is c because of which AD curve is a parallel
version of the consumption curve.

128
 Keynesian Model of
AD AD= Y Income Determination

AD = A + cY
E
AD0 C = C + cY

𝐴̅
C
45 Y
O Y0
Income and Output

Fig. 10.3: Aggregate Demand and Consumption Function

On the left of Y0 and on the right of Y0, AD is not equal to Y, i.e., economy
experiences disequilibrium. In such cases, as discussed earlier, either the
inventory is built up or it is run down. Equilibrium is maintained at the output
level where AD = Y. As the 45 line crosses AD curve, we call it ‘Keynesian
Cross’.

10.3.2 Formula for Equilibrium Output

The equilibrium condition Y = AD can also be written as

Y = A + cY

Y – cY = A

Y (1 – c) = A

 1 
Equilibrium level of output and income Y0, will be equal to Y0 =  A
1- c 

AD AD= Y

AD2

E
AD1

A
Y
O Y0 Y 1
Income and Output

Fig. 10.4: Equilibrium Output and mpc

129
The Closed Economy We observe that the mpc is in the denominator, with a negative sign. This means
in the Short-run that Y and c are positively related. And clearly, Y and A are also positively
related. Given the intercept, a steeper aggregate demand i.e. higher mpc will lead
to a higher income and output level (Fig. 10.4).

Similarly, higher intercept (implying higher autonomous expenditure), while the

mpc is constant, will lead to higher equilibrium output and income level (Fig.
10.5).

AD AD= Y

AD2
E AD1

A2

A1
Y
O Y0 Y1
Income and Output

Fig. 10.5: Equilibrium Output and Autonomous Spending

In simple words, in case individuals spend a higher fraction of their additional

income, it will influence the income level positively and the output level will rise.
The higher consumption expenditure sends the signal to the producers that more
goods and services are spent at and hence the production is required to be
increased. That is why a higher value of mpc leads to higher levels of output and
income.

Check Your Progress 1

1) Explain the consumption function with the help of a diagram.

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2) What does a horizontal AD curve represent?

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130
3) What is the relationship between mpc and the AD curve? Keynesian Model of
Income Determination
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4) Derive saving function through the consumption function.

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5) Explain the concept of ‘Keynesian Cross’ through a diagram.

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10.4 MULTIPLIER

Investment leads to increase in production capacity and therefore the level of

output increases. As you know from Unit 2, aggregate output and aggregate
income of an economy are the same. Thus a question arises – How much the
equilibrium level of income rises if autonomous spending rises by Re.1? Seems
that if, autonomous demand or spending rises by Re.1, then at equilibrium, the
level of income shall also rise by Re.1. But this is not the case, as we discuss
below.

10.4.1 Concept of Multiplier

Suppose output increases by Re.1 to match the rise in autonomous spending. This
rise in output and income in turn gives rise to induced spending as consumption
rises as a result of rise in income. This induced expenditure would be (c .  A ).
Production increases further to meet this induced expenditure. By now the output
and income have increased by ( A + c. A ), that is., by (1 + c)  A . This will
further give rise to induced expenditure and so on.

131
The Closed Economy
in the Short-run
Round Increase in Increase in Total increase in income
demand this production this
round round
1 A A A
2. c A c A  A + c A = (1+c)  A
3. c.c A c. c A = c2 A  A + c A + c2 A = (1+c
+c2)  A
- - - -
- - - -
- - -  1 
  A
1- c 

As 0 < c < 1, c2 < c and c3 < c2, the induced expenditure keeps becoming smaller
as the number of rounds progress.

 AD =  A + c A + c2 A .............

=  A (1 + c + c2 + ....) =  A ( )

We are dealing with a geometric series here so the equation simplifies to

 1 
AD     A  Y0
1- c 

Cumulative change in aggregate spending is, thus, equal to a multiple of the

increase in autonomous spending and the multiple is = . This multiple is
called the multiplier. The multiplier is the amount by which equilibrium output
changes when autonomous AD increases by one unit. If we denote the multiplier
as , it is equal to .

You should note that here we are dealing with a two sector closed economy
comprising households and firms; there is neither government nor foreign trade.
When we include the government and foreign trade, the above formula will
change.

Examples:

Let us now find out the value of the multiplier for various value of marginal
propensity to consume, given by c.

1
c = 0.5 = =2
1  0.5

1
c = 0.4 = = 1.66
1  0.4
132
 1 Keynesian Model of
c = 0.25 = = 1.33 Income Determination
1  0.25

1
c = 0.6 = = 2.5
1  0.6

From the above examples, we find that a higher c leads to a higher .

Diagrammatically, higher c means (see Fig. 10.4) steeper AD and we already

have discussed that steeper AD means higher Y. We conclude by saying that a
change in the output will be larger than the change in autonomous spending due
to multiplier effect. In other words, if an economy for some reason experiences a
shock that reduces income, then people whose incomes have gone down will
spend less and this will reduce equilibrium income further.

In Fig. 10.6, we show the impact of an increase in aggregate demand on

equilibrium output. We assume that aggregate demand increases from AD to 𝐴𝐷′
due to an increase in the autonomous component from 𝐴̅ to 𝐴′ (say, there is an
increase in autonomous investment due to which the autonomous component
increases). As a result, the equilibrium point shifts from E to 𝐸′. You should note
that AD = 𝐴̅ + cY and 𝐴𝐷′ = 𝐴′ + cY where 𝐴′ > 𝐴̅ . In Fig. 10.6 note that 𝐸′𝑃 is
the change in autonomous spending ( A ) while 𝐸′𝑃 is the change in aggregate
demand (AD). Change in the output level, i.e.,  Y is the difference between Y1
and Y0.

AD AD = Y

AD’

E’ ∆𝐴 AD

𝐴̅
E
𝐴̅
Y
O Y0 Y1 Income and Output

Fig. 10.6: Multiplier

Change in the equilibrium output is equal to the change in aggregate demand

(Y0 = AD). Looking at the change in aggregate demand, we can say that

AD =  A + cY0

Since AD = Y0

we can say, Y0 – cY0 =  A

133
The Closed Economy Or, (1 – c) Y0 =  A
in the Short-run
1
Or, Y0 = A .
1 c

10.4.2 Investment Multiplier

Autonomous investment ( I ) is a part of autonomous spending/expenditure A ,  

hence any change in I will lead to a multiplier effect on the equilibrium level of
income and output. The whole analysis remains the same as mentioned in the
previous sub-section. But, to specifically calculate the change in income due to
change in investment, we use the following:

Y0 = 𝐼 ̅

For example, if c = 0.2 and  I = Rs. 50 crore, let us find out the change in the
equilibrium level of income and output.

 1 
Y0 =   × 50 crore
 1  0.2 

 50 
=  crore
 0.8 

= Rs. 62.5 crore

The equilibrium level of income (Y0) was initially Rs. 120 crore. Now after an
increase in autonomous investment of Rs 50 crore, the equilibrium level of
income reaches to Rs. 182.5 crore (Rs 120 crore+ Rs. 62.5 crore). An increase of
Rs. 50 crore in investment leads to an increase of Rs. 62.5 crore in the output. If
Y0  1 
we calculate the investment multiplier, it will be   = 1.25.
I 1- c 

10.4.3 Limitations of Multiplier

In the discussion above, we saw that income increases much more than the initial
investment because of the ‘multiplier’. There are certain limitations to the
multiplier however.

(a) As you know, aggregate output of an economy cannot be more than the
full employment output level. Thus output, income and employment can
expand till the economy has unutilized resources.

(b) It is implicitly assumed that income received is spent on consumption or

saved in financial institutions (so that banks use the money in extending
loans). If income received is not spent at any of the subsequent stages,
rather kept as idle cash at hand, then the value of the multiplier will
decrease.
134
 Keynesian Model of
(c) It is assumed that there is no shortage of consumption goods in the Income Determination
economy. If there is a shortage of consumption goods, the households or
individuals who are the income recipients will not be able to spend on
consumption. It will result in a decline in the MPC and hence the
multiplier.

(d) It is assumed that there is no time lag between income received, and
expenditure incurred. Sometimes there is a time lag (interval) between the
receipt of income and the spending of it, and similarly between the
spending and its re-appearance as income. If the time lag is long, there is
a decrease in the level of expenditure on consumption in subsequent
periods. This will lead to a smaller value of multiplier.

(e) It is assumed that there is idle production capacity in the economy and
there is no increase in prices due to increase in aggregate demand. If the
price level rises, consumption may be lower, and value of the multiplier
will be affected.

Despite these limitations, the investment multiplier is an important tool of policy

analysis.

Check Your Progress 2

1) Explain the concept of investment multiplier.

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2) Find out the investment multiplier if mpc = 0.8.

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10.5 LET US SUM UP

Consumption function is an upward sloping curve, having a positive relationship
with the income level. Marginal propensity to consume (mpc) takes values
between 0 and 1. The remaining fraction i.e., (1 – c) is known as marginal
propensity to save (mps). With the help of consumption function, we derived
135
The Closed Economy aggregate demand curve. Assuming government and foreign sector to be absent,
in the Short-run the aggregate demand is made up of consumption and autonomous investment.
Hence, the slope of AD curve is same as the slope of consumption function.
Intersection of the 45 line with the AD curve is known as ‘Keynesian Cross’ and
gives us the equilibrium level of income and output. This level of income and
 
output are dependent upon the autonomous investment A and the slope of AD
curve (that is, c). The multiplier tells us by how much income and output will
change if autonomous spending changes. As A changes, the output and income
changes by manifold. The investment multiplier, often denoted by , is given by
1
.
1 c

10.6 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Explain Figure 10.2.
2) Horizontal AD curve means that the aggregate demand is independent of
income and output level.
3) Explain Figure 10.3. The slope of consumption function is also the slope
of AD curve.
4) C = C + cY
C+S=Y
(1 – c) = s as c + s = 1
So, S = C + (1 –c)Y
S = S + sY
5) Figure 10.3.

Check Your Progress 2

1) Refer to Section 10.4 for the answer.
Y 1
2) α 
I 1  0.8
1
 5
0.2

136
UNIT 11 FISCAL POLICY IN KEYNESIAN
MODEL*
Structure
11.0 Objectives
11.1 Introduction
11.2 The Government Sector
11.2.1 Government Spending and the Multiplier
11.2.2 Automatic Stabilizers
11.2.3 Effect of Change in Government Spending and Tax Rate
11.3 Government Budget
11.4 Let Us Sum Up
11.5 Key Words
11.6 Some Useful Books
11.8 Answers/Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through this Unit, you should be in a position to

 identify the changes in the Keynesian model when government sector is

introduced;
 explain the government spending multiplier and how it is different from
investment multiplier;
 explain the change in equilibrium output level due to introduction of
government sector;
 discuss the role of automatic stabilizers;
 explain the change in AD curve when government expenditure or tax rate
change;
 identify the components of government budget; and
 explain how the budget surplus changes as government expenditure or tax
rate change.

11.1 INTRODUCTION

This Unit is an extension of the previous one. In this Unit we introduce the
government sector in the Keynesian model. We extend our two-sector model to a
three sector model; thus there are three economic agents, viz., households, firms
and government. Thus AD = C + I + G.

Once we introduce the government sector, certain changes are needed to be

carried out in the Keynesian model. Government has the power of earning

*
Dr. Nidhi Tewathia, Assistant Professor, Gargi College, University of Delhi
The Closed Economy revenue by imposing taxes. Government also spends money for the welfare of
in the Short-run
people. Sometimes, government needs to borrow when its revenues are less than
expenditure. Such a situation is called budget deficit. When revenue exceeds
government expenditure, it is a situation of budget surplus. Government
exercises fiscal policy by varying the tax rate or changing the level of
government expenditure. The objective of government intervention is to
smoothen the operation of the economy.

11.2 THE GOVERNMENT SECTOR

Government affects the equilibrium level of income and output as it purchases

goods and services. Hence, government purchases (G) is an important component
of the aggregate demand (AD).
AD = C + I + G …(11.1)

where, I is planned or autonomous investment, which is independent of income.

In other words, we assume that investment is fixed or constant.

As government sector collects tax from individuals, there may be certain changes
in the consumption function (C = C + cY). Consumption is dependent upon
disposable income (YD) instead of total income. We know that
YD = Y – TA

where Y is the aggregate income and TA is the tax. Another component which
finds its way in the disposable income is government transfers (TR) such as
subsidies, pensions, scholarships, etc. These are an addition to the individual’s
income (Y) but there is no corresponding output. So,

YD = (Y – TA + TR) …(11.2)

By substituting YD in place of Y in (11.1), we get AD as

AD = C + cYD + I + G
By substituting the value of YD from (11.2) we have
AD = C + c(Y – TA + TR) + I + G …(11.3)

We assume that government expenditure is fixed at 𝐺̅ ; also government makes a

constant amount of transfer 𝑇𝑅. Government collects a fraction of income (tY) as
taxes.

So, G= G
TR = TR
TA = tY
138
Now the consumption function can be written as: Fiscal Policy in
Keynesian Model
C = C + c(Y + TR – tY)
= C + c TR + c(1 – t)Y …(11.4)

It is important to note here is that transfers ( TR ) are increasing the consumption

spending by (c TR ), i.e., marginal propensity to consume times the amount of
transfers. On the other hand, income tax lowers the consumption spending at
each level of income. This is because taxes affect disposable income (YD) and not
the income (Y) as such. So, the marginal propensity to consume (mpc) out of
disposable income remains c but marginal propensity to consume out of income
is c(1 – t) where (1 – t) is a function of income after deduction of taxes. Let us
explain this with the help of an example.
Let us assume that marginal propensity to consume from disposable income is 80
per cent and tax rate is 20 per cent. Thus c = 0.8 and t = 0.2; and mpc out of
income is c(1 – t) = 0.8(1 – 0.2) = 0.8(0.8) = 0.64.

Now, going back to the AD in equation (11.3) we find that

AD = [ C + c TR + I + G ] + c(1 – t)Y

AD = A + c(1 – t)Y …(11.5)

We have taken all the autonomous terms together and denote it by A . As pointed
out earlier, income and output levels get affected with the introduction of the
government sector. We will see the change algebraically as well as with the help
of a diagram. As you know from the previous Unit, equilibrium is attained when
Y = AD.
Thus, by substituting values from equation (13.5), we obtain
𝑌 = 𝐴̅ + 𝑐 (1 − 𝑡)𝑌
Or, Y – [c(1 – t)Y] = A
Or, Y – (c –ct)Y = A
Or, Y (1 – c + ct) = A
A
This gives us Y  … (11.6)
1  c  ct

In Fig. 11.1 we present two AD curves; AD1 shows absence of government sector
and AD2 in the presence of government sector. Thus AD2 includes taxes and
transfers. We observe that AD2 is flatter than AD1 and has a higher y-intercept
than AD1. It is because the slope of AD2 is c(1– t) instead of c. The vertical
intercept includes

 
(c TR  G ) in addition to C  I , the vertical intercept of AD1.
139
The Closed Economy Thus 𝐴 = 𝐶̅ + 𝐼 ,̅ and 𝐴 = 𝐶̅ + 𝐼 ̅ + 𝑐𝑇𝑅 + 𝐺̅
in the Short-run

AD
AD1

AD2
A2

A1

Y
Income and Output

Fig. 11.1: Government Sector and the AD Curve

Fig. 11.2 shows the effect of government sector’s presence on equilibrium levels
of income and output. We consider two cases. In the first case, when the
government sector is not present, equilibrium takes place at point E1 where the
45 line intersects AD1.

AD AD= Y

AD1

AD2
AD2
A
AD1
E1
A
Y
Y1 Y2

Income and Output

Fig. 11.2: Government Sector and Equilibrium

This intersection gives us 𝑌 as the equilibrium output. Now as government

spending 𝐺̅ and other components like taxes and transfers come into existence,
AD1 becomes flatter and changes its y-intercept also. The new curve is labeled as
AD2. The second Keynesian cross happens at point E2. This new equilibrium
gives us the equilibrium output as Y2. We notice that Y2 is greater than Y1.
140
Hence, we can say that introduction of the government sector increases the level Fiscal Policy in
Keynesian Model
of income and output in the economy.

Check Your Progress 1

1) Explain the changes in the consumption function when we introduce the
government sector.
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2) Write down the AD equation in the presence of government sector.

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3) Explain the new equilibrium income in the presence of government

sector.

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11.2.1 Government Spending and the Multiplier

Let us re-write the multiplier by introducing the government sector.

ΔY 1 1
 or
Δ A 1  c  ct 1  c(1  t)

141
The Closed Economy As seen in the previous Unit, in the absence of the government sector, the
in the Short-run
1
multiplier is . We see that the government purchases of goods and services
1 c
make a substantial difference in the economy. The value of the multiplier is
reduced. Let us denote the government multiplier as G . So, we can say that G <
. Let us explain with the help of an example.

If c = 0.8 and t = 0.2 then

1 1
α  = 5.
1 c 1 - 0.8
1
Now let us find out α G 
1  c  ct
1

1  0.8  0.8(0.2)
1

0.2  0.16
1
  2.77
0.36

Thus we observe that the value of the multipler gets reduced in the presence of
the government sector.

11.2.2 Automatic Stabilizers

Automatic stabilizers are the revenue and expenditure items in the government
budget which automatically change with the state of the economy in such a way
as to stabilize GDP. We found that imposition of income tax lowers the value of
the multiplier, . Why does income tax reduce the value of the multiplier? It
reduces the value of the multiplier because the increase in consumption out of
changes in income gets reduced due to imposition of taxes. When such stabilizers
are in place, the change in autonomous expenditure (for example, I ) will have
smaller effect on output. Presence of such stabilizers reduces the volatility in the
economy, particularly during various phases of business cycle. When the
economy is passing through the expansion phase of a business cycle and income
is increasing, imposition of progressive taxes on income increases government
revenue automatically and consumption is reduced. On the other hand, when the
economy is passing through the recession phase, tax burden is automatically
reduced because of reduced income. These stabilizers act as shock absorbers to
the economy.

11.2.3 Effect of Change in Government Spending and Tax Rate

Let us now consider the changes in fiscal policy. Fiscal Policy tools are
government spending, transfers and tax rate. Government changes the magnitude
of these tools as per the situation of the economy.
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 Fiscal Policy in
Let us consider the diagrammatic representation of fiscal policy initiative. Initial Keynesian Model
level of equilibrium output is Y0 as shown in Fig. 11.3. Autonomous spending
i.e., G changes, hence A 0 shifts up to A1 and AD0 shifts parallel upwards to
AD1. As per the equilibrium condition, the equilibrium income and output
becomes Y1 from Y0. Is the increase in income same as increase in autonomous
spending? By how much has the income expanded?

AD AD= Y

AD1
E1 } ∆G
A AD0
E0
A

Y
Y0 Y1

Income and Output

Fig. 11.3: Equilibrium Output and Government Spending

Change in autonomous government spending is equal to the change in AD,

Y0 =  G + c(1 – t) Y0

We have assumed that C , TR and I are constant. Thus, the change in

equilibrium income is,

1
ΔY0  G
1  c(1  t)

= G. G

The other tool, i.e., income tax, is generally reduced so that individuals get higher
disposable income. Fig. 11.4 shows the effects of reduction in income tax rate. It
means that there is a decrease in ‘t’, which in turn increases the slope of the AD
curve. Initial equilibrium income is Y0, i.e., intersection between AD0 and the 45
line. As AD0 swivels out to AD1, the new equilibrium occurs at E1 which gives us
the new equilibrium level of output as Y1. As income tax rate decreases, the
equilibrium income and output increases. To find out the change in equilibrium
143
The Closed Economy income, we need to equate the change in income to the change in AD. There are
in the Short-run
two components of change in AD, namely,

1) Change in spending at the initial level of income due to reduction in the

tax rate;
2) Change in spending due to higher income.

AD AD= Y
AD1

E1
AD0

A E0
Y
Y0 Y1

Income and Output

Fig. 11.4: Changes in the Income Tax Rate

By combining the two components, we can write,

Y0 = –cY0t + c (1 – t) Y0

where, t is the new tax rate. As,

 1 
Y0   .A
 1  c  ct 

So,

ΔY0 c
 .A
Δt 1  c  ct 2
and A  Y0 1  c  ct 

Using the value of (Ā), we get

ΔY0 c
 .Y 1  c  ct 
Δt 1  c  ct 2 0

144
ΔY0  cY0 Fiscal Policy in

Δt 1  c  ct  Keynesian Model

 cy 0
or Y0  .t
1  c  ct 
 cy 0
where 1  c  ct is the income tax multiplier, which is normally denoted by t.

Similarly, the effect from transfer payment can be written as:

ΔY0 c
  α TR
ΔTR 1  c  ct

 c 
Y0    . TR
 1  c  ct 

because

cTR  A
Y0 
1  c  ct 

where c TR is separately written as A comprising of other autonomous spending.

A reduction in the transfer would lower the equilibrium output and vice-versa. A
rise in the transfers will shift the AD curve parallel upwards and a fall in the
transfers will shift the AD curve parallel downwards.

11.3 GOVERNMENT BUDGET

Budget is a term which is very important for every individual. The households
are interested in knowing how much of income they will receive and what is their
expenditure for a given time period.

Similarly, the government needs to find out its sources of revenues and areas
where it needs to spend. Hence, the government budget is of great importance. In
this context, we will use the term budget to represent government budget. Budget
is a record of revenues and expenditure. If government is experiencing a budget
deficit, it means government is spending more than earning. In case it
experiences a budget surplus, then the government spending is less than the
revenue. Generally, budget deficit is faced by majority of the governments. .
Algebraically,

Budget Surplus (BS) = TA  G  TR

145
The Closed Economy
in the Short-run
= tY – G – TR

where TA = tY

It is common knowledge that when income level is low, the revenue also
becomes low, which lead to budget deficit and vice versa. Fig. 11.5 shows that
the sum of G and TR exceeds tY when income levels are low and vice-versa.

BS

BS = tY – G – TR
Budget Surplus

O Y
Y0

– ( G + TR )

Fig. 11.5: Government Budget

The income level Y0 shows no deficit and no surplus. On the left of Y0,
government runs in deficit and on the right of Y0, surplus exists. This is because,
at high income level, the government tax receipts are large. If the income does
not increase due to fiscal policy tools, government deficit can still decrease. An
increase in the investment (I) will lead to an increase in Y which in turns raises
the tax receipts and that is how the budget deficit decreases. It follows that,
during the time of recession, budget deficits are observed.

Impact of Budget, Taxes and Government Spending

 
It seems logical to think that an increase in the government spending G would
decrease the budget surplus (BS), however it does not hold true always. Because
increase G has a multiplier effect on the equilibrium level of income and output,
this leads to higher tax receipts. There is a possibility that, the negative effect of
 
such rising G is compensated by the positive effect of rising tax receipts, which
does not reduce the budget surplus. Let us see, algebraically, how the increased
government spending reduces the budget surplus.

Y0 = G.G (due to higher government spending)

146
Due to change in income, tax revenues also change, i.e., Fiscal Policy in
Keynesian Model
TA = t.Y0
= t. G.G
Change in the budget surplus (BS), will be
BS = TA –  G
= tG. G –  G  ( t. G  1) ΔG

 t 
=  1 Δ G
1  c  ct 
or
 t 
=  1 ΔG
1  c(1  t) 
 t  1  c(1  t) 
=  ΔG
 1  c(1  t) 
1  t  c(1  t) 
=    ΔG
 1  c(1  t) 
 1  t   c(1  t) 
=     ΔG
 1  c(1  t) 
 1  t (1  c) 
=    ΔG
 1  c(1  t) 

Now, let us consider a numerical example, where c = 0.8, t = 0.25 and G = Re.1

 1  0.8 (1  0.25) 

BS =     Re.1
 1  0.8(1  0.25) 
0.2(0.75)
=  
1  0.8(0.75)
0.15
=
1  0.6
0.15
=
0.4

= Rs. – 0.375.

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The Closed Economy
in the Short-run
So a one rupee increase in government spending reduces the government surplus
by Rs. 0.375. Similarly, the tax hike will lead to a positive effect on the budget
surplus.

If the government raises the tax rate and government purchases by the same
amount, then what will be impact on the budget surplus? The response will
include the explanation of a concept called ‘balanced budget multiplier’. The
equilibrium budget will be unchanged as the multiplier will be equal to 1.

The equilibrium income can be affected by due to change in the autonomous

expenditure which includes the autonomous investment, autonomous government
spending and government transfers and tax policy or tax rates. To evaluate the
impact of change in government sending we need to assume that only one
component of the autonomous spending changes that is the government
expenditure. Hence, like investment multiplier, the government expenditure
multiplier is

1 1
G = and or ΔY0  G
1 c 1 c

Similarly for the change in tax rate, the tax multiplier is

c
T =
1 c

1 -c
or ΔY0  ( c *  T )  T
1 c 1 c

Now change in income due to both the changes in government expenditure and
tax rate is:
Y = G.G + T.T
Y = G.G + T.G (as G = T)
Y = (G+T)G
 1   c 
Y =   ΔG
1  c  1  c 

1 c 
Y = ΔG
1 c 

Y = G

We found that output rises exactly by the amount of increase in government

spending.
148
 Fiscal Policy in
Check Your Progress 2 Keynesian Model

1) What are automatic stabilizers? Explain.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2) Calculate the government spending multiplier given the following:

c = 0.6 t = 0.12
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

3) How does AD curve changes when there is a change in government

spending? Does it also change equilibrium level of income and output?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

4) Explain, in short, the concept of Budget Surplus.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

5) How does the balanced budget multiplier work?

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

149
The Closed Economy
in the Short-run 11.4 LET US SUM UP

In this Unit we introduced the government sector into the Keynesian model and
re-defined the aggregate demand. As the government sector is included, the fiscal
policy tools like taxes, transfers and government spending are exercised by the
government. The government multiplier and the tax multiplier were found to be
smaller than the investment multiplier. Due to automatic stabilizers, the volatility
in the economy is reduced. Subsequently, we understood the concept of
government budget. Government borrows at the time of deficit which makes it
difficult for the private firms to arrange funds. As government spending
increases, the budget will go in deficit. At the same time, however, equilibrium
output increases, which in turn increases the tax receipts. The balanced budget
multiplier shows how the output increases by the same amount as the government
spending increases.

11.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) C = C + c(Y – TR + tY)

= C + c TR + c(1 – t)Y

2) AD = A + c(1 – t)Y, where A  C  c TR  I  G

3) Refer to Fig. 11.2.

Check Your Progress 2
1) Refer to Sub-section 11.2.2.

1 1
2) 
1  c  ct 1  0.6  0.6(0.12)

3) Refer to Sub-section 11.2.3. Yes, it changes equilibrium level of income

and output. It increases.
4) Budget surplus is excess of government revenue over government
spending.
5) Refer to Sub-section 11.3.1.

150