Equilibrium Income- Keynesian

Approach
Income & Expenditure Approach
Consumption, Savings &
Investment Function
Consumption Function:
Consumption function epresents the functional relationship between total
consumption ( C) and gross national income (Y). Consumption exp. Increases when
income increases.
C= f (Y)
Consumption Function Equation:
C=α+βY
Ex: C= 20 +0.8 Y
(α) = Autonomous Consumption
It is the consumption at zero level of income. When the Income is Nill, people use
to consume from past savings or borrowings. Here α =20. Rs. 20 is consumption at
zero level of income. Autonomous consumption is independent of income.
(β)= Slope of Consumption Function/line ( β = Slope = MPC = )
It is the rate at which consumption increases when income increases. Here β=0.8
means 80% of increased income is consumed. (β) = MPC
 • When Y increases, Both C & S also
increases.
Income Consumption Savings • Here autonomous consumption (α) =
(Y) (C) (Y-C = S) 20
Dissaving : C >Y
0 20(α) -20
At low level of income, C > Y. People use
50 60 -10 to borrow or use the past savings to
100 100 0 consume. This is dissaving (negative)
Savings : C < Y
150 140 10 At higher level of income, C < Y.
200 180 20 People use to save some portion of
250 220 30 income. That is savings.
From this table the consumption function
derived as :
C=α+βY
(α) = 20, β = Slope = = = 0.8
C= 20 + 0.8 Y
Consumption Function/ Line
 Consumption fn with
Income Line
• Y is the Income Line
• It is a 45 Degree line
• 45 degree line represents:
Y= C+S
• The vertical distance of Y is
combination of C+S.
• Up to OY1 level of income, Y line is
below to C line. Here C > Y. there
is dissaving. Negative savings.
• After OY1 level of income, Y line is
above to consumption line. Here
C < Y. There is savings
Here you can see how Y is divided in to C+S
(Y=C+S)
 Marginal Propensity to Y = Consumption (C ) +
Consume (MPC) Savings (S)
Ratio of Change in Consumption Y= C + S
(ΔC) to Change in Income (ΔY) ΔY = ΔC + ΔS
MPC=
= +
0 < MPC < 1 1 = MPC + MPS
MPC = 0 means nothing is consumed out of
increased income, MPC = 1 means 100% of increased MPC= 1- MPS
income is consumed.
MPS= 1-MPC
Marginal Propensity to Save
(MPS) •Both MPC & MPS are
Ratio of Change in Savings (ΔS) to positive but less than 1
Change in Income (ΔY)
MPS=
•If MCP= 0.8
0 < MPS < 1 •MPS = ?
Note:
 MPC is higher is case of poor communities and lower in case of rich
communities. The reason is that in case of rich communities most of
their basic needs have already been fulfilled and all the additional
increments in income are saved (leading to higher MPS), whereas in
poor communities most of their primary needs remain unfulfilled, so
that additional increase in income lead to increase their consumption.
 Under developed countries MPC is higher than developed countries
 As income increase, the MPC as well as the APC both decline, but the
decline in the MPC is more than the decline in APC. 
 Average Propensity to
Consume (APC) Y= C+S
Ratio of Consumption (C) to = +
Income (Y) 1= APC +APS
APC= APS= 1-APC
APC =1-APS
Average Propensity to Save
(APS)
Ratio of Savings (S) to Income
(Y)
APS=
Income Consumption Savings MPC = MPS= APC = APS =
(Y) (C) (S)

0 20 -20 ------- ----- Infinity Infinity

50 60 -10 = 0.8 = 0.2 = 1.2 = -0.2
100 100 0 = 0.8 = 0.2 =1 = 0.00
150 140 10 = 0.8 = 0.2 = 0.93 = 0.07

200 180 20 = 0.8 = 0.2 = 0.90 = 0.10

 Savings Function: S= f (Y)
• Savings is a function of Income
• When Income(Y) increases, Savings (S) also increases.
Savings function Equation
S = -α + (1-β)Y
Ex: S = -20 + (1 - 0.8)Y
S= -20 + 0.2 Y
(α)= Autonomous Consumption
(-α )=Dissaving's at zero level of income (-20)
At zero income households borrow (α) amount to afford basic necessities
(β)= MPC = 0.8 (1-β) = MPS = = 0.2
MPS is the slope of the savings function/ line. It tells us the rate at which
savings increases as income increases ().
MPS 0.2 means, 20% of increased income saved.
 Savings Function/Line
Savings line is starting from negative (-α) due to house holds borrow
the α amount for basic necessities at zero level of income
If consumption function is: C = 500+ 0.75 Y
Autonomous Consumption (α) = 500
MPC (β) = 0.75
MPS (1-β) = 0.25
Savings Function = -500+0.25Y
If MPS = 0.3
Autonomous Consumption (α)= 1000
& Income (Y) =5000
C = 4500
S = 500
 Savings (S) line along with
Consumption (C) & Income (Y) Line

Sa
vin
gs
= 0
Determinants of Consumption Function
1. Changes in Wage: wage rate rises the consumption
function shifts upward.
2. Changes in tax: when tax rises, the consumption
function shifts to downward.
3. Interest rate: When interest rate falls, people will
borrow more and spend more. C function shifts upward.
4. Future Expectations: People use to spend more if they
are expecting price in future will rise. C function shifts
upward.
5. Redistribution of Income: In case of less inequalities,
consumption function shifts upward. If the govt policies
are focused more on poor & middle income group then
the consumption function will shift up. Poor and middle
income group propensity to consume is higher than rich
people. when the income of poor and middle income
group rises, they spent more.
7. Corporate policies: if companies are giving more
dividend payments & keeping less excess reserves. The
consumption will increase & consumption function shifts
upward.
8.Real Income
A change in the price level will change the value of money
and the purchasing power. Fluctuation in prices will affect
real income and also the propensity to consume.
Phenomenal rise in the price level will reduce the real
income and so there will be a fall in the propensity to
consume.
Keynes Psychological Law of Consumption
Consumption function is based on human psychology towards
consumption.
• When income increases, consumption expenditure also increases but
by smaller amount. For an example Consumption is increased by 40
when income increases by 50. MPC < 1
• The increased income is divided in between Consumption & Savings.
One portion of increased income is consumed remaining is saved. ΔY =
ΔC + ΔS
• Consumption function is non-proportional. Means the ratio of C to Y
(APC= ) is not constant at all level of income. (APC= ) is falling as
income increases.
Investment
 Investment Function
I = f (Y, r)
I= Investment, Y=Income, (r) = Rate of interest
Investment (I) & Income (Y) Relationship
• Investment is directly related to Income (Y)
• When Income (Y) increases, Aggregate Demand increases, Price rises,
As a result investment increases due to higher profit expectation.
Investment (I) & Rate of interest (r) Relationship
• Investment is inversely related with rate of interest (r )
• When (r ) increases, cost of borrowing increases, it discourages to
invest more.
 Types of investment
Autonomous Vs Induced
Autonomous Investment
• It is not profit/income motivated
investment.
• Public/Govt. investments on Dams,
Schools, Colleges, Roads etc are
autonomous investment.
• It is income-inelastic.
• It is not influenced by changes in
demand. But it influences demand in
the economy.
• Autonomous investment curve is
horizontal straight line. remains
constant across the level of income.
• It is independent from income
Induced Investments:
• It is profit/Income motivated investment.
• When Income (Y) increases, Consumption
Demand & price rises which raises the
expected profitability. As a result
investment increases.
• Keeping the rate of interest remain same,
induced investment depends on the
income/GDP
I= f (Y)
• Private investments are induced
investment.
• It is income-elastic
• Induced investment curve is upward
sloping as income increases.
 Investment Demand Curve
Investment Demand curve slopes downward due to inverse
relationship between Rate of Interest (r ) & Investment (I)
 Determinants of Investment Demand/Factors other than
rate of interest (r)
Level of Income/GDP: When the level of income or GDP rises,
demand & price rises. As a result Investment Demand increases with
given rate of interest. Investment Demand curve shifts to right.
State Policy: If govt cut the corporate tax, the inducement to invest is
high. Investment Demand curve shifts to right.
Growth of population: Demand rises due to rapid population growth.
As a result Investment demand at given rate of interest rises &
investment Demand curve shifts to right.
Changes in Technology: Due to advanced technoligy the productivity
increases. As a result cost decreases. Investment demand at given
rate of interest rises & investment Demand curve shifts to right.
Stock of Capital Goods on Hand: If the existing stock of capital
goods is large, it would discourage to invest more in new capital.
For instance, a company that has excess office space or idle plants
is not as likely to invest in additional capital. Investment demand
for new capital will decreases with given rate of interest.
Investment demand curve shifts to left.
Political Stability: If there is political instability in the country it
will adversely affect domestic as well as foreign investment.
Investment demand at given rate of interest decreases &
investment Demand curve shifts to left.
Wages: Rise in wage rate discourages to invest more. Investment
demand decreases with given interest rate. Investment Demand
curve shifts to left.
Gross Investment:
Gross Capital Formation (Addition of new fixed assets:
machineries, Factories, buildings etc & replacement of old
capital) + Inventories (changes in stocks) + Valuables ( Gold's
etc for investment purpose).
Net Investment:
Gross investment- Replacement of old capital (Depreciation)
Gross Private Investment Includes 4 types of
investment:
1. Business Fixed investment: Expenditures by firms
on capital such as tools, machinery, and factories.
2. Residential Investment: The expenditure which people make on
constructing or buying new houses.
3. Change in inventories : The change of firm inventories in a
given period. the firm is buying inventories from itself. This is
an investment.
4. Valuables ( Golds etc for investment purpose)
Determination of Equilibrium
Income-Keynesian Approach
Income & Expenditure Approach

Economy is equilibrium when Income =

Expenditure
2 Sector Economy Equilibrium Income- 2 Sector
Household & Business Economy
• Equilibrium level of income when
AD = AS
• Total Expenditure (C+I) = Total
Income (Y)
• C is the consumption line
• “I” amount of investment added
with consumption line
• C+I represents consumption +
Investment line in the economy.
• Y is the income Line that represents
(Y=C+S)
• Equilibrium point E
• Equilibrium Income /GDP = Y
Determination of Income- 3 sector Economy
(H.H, Firm & Govt)
Here Y line represents AS (Y=C+S+T)
C+I+GE line represent AD
Equilibrium Income - 4 Sector Economy

E
 Multiplier
• When Aggregate Demand (Consumption , Investment,
Govt. Exp or Net export: X-M) in the economy
increases, The National Income or GDP increases
multiple times of increment in AD.
• This is called as multiplier effect in the economy.
 Investment Multiplier
• Employment, Output & Income increases when
investment in the economy increases.
• Income rises multiple times of investment due to
multiplier effect.
• Multiplier tells us how much income rises (ΔY) due
to an increment in investment (ΔI)
 Investment Multiplier (K) =
Ratio of increment in income (ΔY) to increment in Investment (ΔI)

= k ΔI
National Income increases K times of
increment of investment.
Example: If multiplier (K) = 2 & Investment increased (ΔI) =100
= k ΔI = 2*100= 200
Our National Income increases by 200 for an investment of 100 due to
multiplier effect.
 Derivation of Multiplier
Y=C+I
Income (Y) = Consumption Exp. (C) + Investment Exp. (I)
ΔY= ΔC+ΔI
= +
1= MPC+
= 1-MPC
= 1-MPC (K=)
Multiplier (K) = =
 Multiplier (K) = =

0< MPC < 1

When MPC = 0, K=1
When MPC= 1, K= Infinity
1 < K < Infinity
Multiplier (K) is always in between 1 & infinity.
MPC, MPS & Multiplier (K) Relationship
Higher is the MPC, Higher is the Multiplier, Higher is the increment in
income
Higher is the MPS, Lower is the Multiplier & Lower is the increment in
income.
Example.1 :
Increment in Investment (ΔI)=100, MPC=0.5
Multiplier (K) = = = 2
Increment in National Income (ΔY) = k ΔI =2x100=200
Example.2 :
Increment in Investment (ΔI)=100, MPC=0.75
Multiplier (K) = = = 4

ΔY = k ΔI =4x100=400
 Derivation of the Multiplier
MPS Multiplier
MPC
(1-MPC) K=
0 1 1
0.25 0.75 1.3
0.5 0.5 2
0.75 0.25 4
0.9 0.1 10
1 0 Infinity
 Process of Multiplier
How the initial investment amount increases
National income Multiple times (K times)
Increment in
Initial Increment Increment in
Consumption
investment in income Savings (ΔS)
(ΔC)
(ΔI) (ΔY) MPS=0.5
MPC=0.5
 Process of Multiplier
Suppose MPC=0.5 & Investment (ΔI) =100 & K=2
How investment of 100 is generating 200 income
Round-1: When initially 100 invested, This will immediately lead to a rise in
production & income by 100. Out of 100 income, 50 is consumed & 50 is saved
as MPC=0.5.
Round-2: When 50 is spent on consumption of goods and services in round 1 ,
it will create additional 50 income in round 2. in round 2 out of 50 income, 25
consumed & 25 saved due to MPC=0.5.
Round-3: When 25 is spent on consumption of goods and services in round 2 ,
it will create additional 25 income in round 3. in round 3 out of 25 income, 12.5
consumed & 12.5 saved due to MPC=0.5.
This process will continue further & total income will rise by 200.
Increment in Income ΔY = 100+50+25+12.5+6.25+3.125+………= 200
Importance of MPC & MPS
• Countries having higher MPC (or Lower MPS) increases the
Investment multiplier (K). Effect of new investment on national
income is more.
• Countries having Lower MPC (or Higher MPS) decreases the
Investment multiplier (K). Effect of new investment on national
income is less.
• Equal amount of investment creates more employment, output &
income for the countries having higher MPC(Lower MPS) than the
countries having lower MPC(Higher MPS).
• India’s MPC= 0.7 & MPS=0.3 & K=3.333 (Economic Survey 19-20)
• In India new investment amount creates GDP, 3.333 times of
investment amount.
 Multiplier Effect on Income
Investment Multiplier
(Graphical Presentation)
Effect on Income
• Suppose MPC=0.5 & K=2
• Original equilibrium is E &
Equilibrium income =100
• Now investment increased by ΔI=50.
AD curve shifts upward to AD1
• New equilibrium is at E1
• Income increased from 100 to 200.
ΔY=100
• Here multiplier effect is ΔY=100
ΔY= k ΔI = 2x50=100
 Complex Multipliers
Govt. Exp. Multiplier
Tax-Multiplier
(Balanced Budget Multiplier)
3-Sector Model
Balanced Budget
Multiplier
The balanced budget multiplier implies that if the
government increases spending and taxation by the
same amount (100), then GDP will be increase by that
amount (100).
If (ΔT) = (ΔG) = 100
Then our Income or GDP will increase by 1 time of the
Tax amount due to multiplier effect.
Increase in Income or GDP (ΔY)=100
Balanced Budget Multiplier (K) = 1
(ΔT) = (ΔG)=(ΔY)=100
Balanced Budget Multiplier = Tax Multiplier +
Govt. Exp. Multiplier =1
Tax Multiplier: Due to tax cut, Consumption exp. & AD also
decreases. As a result National Income or GDP also decreases by
multiplier times. It has negative impact on National income or GDP.
Govt. Exp. Multiplier: AD increases due to additional govt exp.
from the increased tax. As a result National Income or GDP also
increases by multiplier times. It has positive impact on National
Income or GDP.
Balanced budget multiplier is the combined effect on National income or
GDP.
Net increase in National Income or GDP depends on both Tax multiplier +
Tax Multiplier: Due to Tax cut, consumption expenditure &
aggregate demand decreases, as a result GDP or Income also
decreases multiplier times.
It tells us how many times the GDP or Income will decrease due
to Additional tax.
Tax Multiplier: =
Decreases in GDP or Income (ΔY)
If additional tax ΔT =100 & MPC= 0.5
Tax multiplier = =(-0.5)/(1-0.5)= -1
Tax multiplier (-1) means, GDP will decrease by 1 time of Tax amount
Decreases in GDP or Income due to tax
Decreases in GDP (ΔY) -1*100= -100
Govt. Exp. Multiplier:
Change in GDP or Income due to change in govt. expenditure.
Due to Govt. Exp., Aggregate Demand increases & Income or
GDP also increases.
Govt. exp multiplier measures how much GDP increases due to
increase in govt. expenditure
Govt. exp multiplier : =
Increase in GDP (ΔY) ΔGE
IF ΔT = ΔGE =100 & MPC= 0.5
Govt. exp multiplier = = = 2
Increase in GDP(ΔY) Multiplier *ΔGE =2*100=200
Balanced Budget Multiplier =
Tax Multiplier ( ) + Govt. Exp. Multiplier( )

BBM = + = = 1
 Balanced budget multiplier is always equals 1
 Multiplier equals to 1 means, GDP will increase by the same amount of tax & govt. exp.
If ΔT = ΔG =100 & MPC =0.5
Tax Multiplier = = = (-1)
Govt. Exp. Multiplier = = = 2
Decrease in GDP due to tax = Tax multiplier x ΔT = (-1) x 100 = (-100)
Increase in GDP due to govt exp. = Govt. Exp. Multiplier x ΔG = 2 x 100 = 200
Net increase in GDP = ΔY = 200-100=100
ΔT = ΔG =ΔY =100
Initial AD= 1000
Tax=100
MPC=0.5
Consumption decrease by = 50
AD decreases by= 50
AD after tax=950

Govt. Exp= 100

AD after govt exp = 1050
Net increase in AD = 50
Multiplier = 1/1-mpc=2
Delta Y= 50*2=100
Foreign Trade Multiplier
 When export (X) increases, the aggregate demand in the economy increases
and the national income also increases
 But how much the national income increases that depends on foreign trade
multiplier like investment multiplier.
Trade Multiplier: Change in National income (ΔY) to change in export (ΔX)
Trade Multiplier (Kf) = (ΔY) /(ΔX)
An economy is equilibrium when:
Investment (I) = Savings (S)
Total investment is divided in to Domestic Investment & foreign investment
Investment (I) = Domestic Investment (Id) + Foreign Investment (If)
I=S
Id+If = S
Id + If (Export-Import)= S
Id + (X-M) = S
Id + X = S + M
Assumption: No change in domestic Investment (Id)
ΔX = ΔS +ΔM
 ΔX = ΔS +ΔM
Now divide ΔY in both the side
= +
= Marginal Propensity to Save (MPS)
= Marginal Propensity to Import (MPM)
=MPS +MPM
=
= Foreign Trade Multiplier (Kf)
Foreign Trade Multiplier =
Foreign Trade multiplier is inversely related with Marginal Propensity to Save
(MPS) and Marginal Propensity to Import (MPM).
Higher is the MPS & MPM lower is the multiplier and lower will be the impact
to export on the economy.

IF MPS = 0.25 & MPM = 0.15 & Net increase in Export (ΔX)= 100 crore
Trade Multiplier = ?
Change in National income due to rise in export = (ΔY)= ?