The Keynesian Theory

Theory of Income Determination

The Keynesian
Theory
Macroeconomics in the Short Run
Macroeconomics in the Short Run
US Real GDP Growth Rate

1929

1933
Macroeconomics in the Short Run
US Real GDP Percapita
 Classical vs Keynesian Economics
Classical Economics
• Role of Agg Supply in determination
of Output and Employment
• Assumes perfect competition in both
output and labour markets
• Says’ law i.e. supply creates it’s own
demand, No fluctuations is output .
AS=AD.
• Problem of AS
• Labor is the only factor of production
• Prices , Wages and Interest Rate are
flexible.
• Long run Analysis.
• LRAS is Vertical
• No Role of Govt.
• No Role of Money
Keynesian Economics:
• Role of Aggregate Demand in
determination of Output and Employment
• Assumption of perfect competition in both
labor and output markets is unrealistic.
• Says’ law failed during great depression.
AS≠AD always. In fact fall in AD lead to
Business cycle ( fluctuation in Output)
• Problem of AD
• Apart from Labor other factor of
productions are also important.
• Prices, Wages & Interest Rates are Sticky.
• Everything is in short run.
• SRAS is Upward sloping
• Active Role of Govt.
• Active Role of Money.
 Keynesian Premises
J.M Keynes assumes that some Prices, Wages and Interest rates are fixed in the
short-run. It implies that some markets need not clear.

1. Product (Goods & Service) Market: AD=AS determines Output

and Price

2. Factor(Labor) Market: DL= SL determines Wage rate

3. Capital (Money) Market: Md=Ms determines interest rates

 A.
The Product Market Equilibrium
A. The Product Market Equilibrium: AD=AS

• Question: How national income and output is determined?

• Keynesian Theory of Income Determination says, “the equilibrium

level of national income and Prices is determined at the level where
aggregate demand (AD) for goods and services equals their aggregate
supply (AS)”.

Equilibrium: AD=AS

Model can be explained through

• Aggregate Supply(AS) Function
• Aggregate Demand (AD) Function
a. Aggregate Supply Functions/Curve

Real GDP and Price Level 1934-1940

• According to
Keynesian theory, in a
depressed economy
an increase in
aggregate spending
can increase output
without raising prices.
a. Aggregate Supply Functions/Curve
Aggregate Supply : The total supply of goods and services in an
economy which the economy produces by utilizing all its resources.
It depends on productivity.
Production Function: Y = f (K , N )
Where K is capital, fixed in short run
N is labor, variable in short run

Price Level
LRASC

SRASC

Output ( GDP)
b. Aggregate Demand of Income Curve
Aggregate Demand: Aggregate Demand Curve is the total demand curve (
aggregate expenditure) of all economic agent. It is negatively related with the price
level and hence slope down ward from left to right.

Aggregate demand is the total spending on

goods and services in the economy.

AD=C+I+G+(X-M)

Thus Keynes tried to explain the

P1 economic equilibrium with
Two, Three & Four sector model

P2

Y1 Y2
A. The Product Market Equilibrium: AD=AS
with Fixed vs.Flexible Prices

SRAS

Fixed Prices Flexible Prices

According to Keynes, any change in AD will change Real GDP, thus output is demand determined.
Price level doesn’t change
 B.
The Factor (Labour) Market Equilibrium
 B. Labor Market Equilibrium
Labor Market in the Keynesian Sticky Wage Model
Nd= f( Money Wage rate ,W). They are
Involuntary negatively related. Nd is MRPL=W
Unemployment
Ns= f(Money Wage rate, W).They are
positively related. But due to rigid wage rate,
labour supply curve is perfectly elastic.
E F
Money wages are rigid or inflexible in the
downward direction, but they are flexible, in
G the upward direction due to (a) money illusion,
(b)trade union

wmc= market clearing wage rate

w* = sticky wage rate So unemployment.

Nd= Ns determines real wage rate,w

Point E Underemployment Equilibrium. At this wage rate N** people are willing to work, but N*
people got employed. So EF is involuntary unemployment. Point G is full employment
equilibrium.
Why not full employmnet equilirbium —(i) liquidity trap, and (ii) interest inelasticity of investment
 C.
The Financial (Money) Market Equilibrium

Money Or Cash

Keynesian Financial Market

Bond
 C. Financial(Money) Market
Equilibrium: Md=Ms

• Demand for Money: Md= L(P,Y,i) or Md= P L(Y,i)

• Supply of Money : Ms is fixed ( by RBI)
Md positively related with income
i Md negatively related with interest rate
Ms
Liquidity trap means a minnium rate of
interest beyond which interest rate can not
fall and people wish to hold entire money in
idle cash balance.

i2 Liquidity trap

i1
Md (Y1, i)

M Ms, Md
Determination of Equilibrium
Level of Income and Output

• Two Sector Model

• Three Sector Model
• Four Sector Model
 Equilibrium level of Income and Output:
The Circular Flow
Let AD=AD=AS Always
Y = AY= Aggregate (National) Income Y=Z=Q
Z = AD = Aggregate Expenditures
Q = AS= Aggregate Output (Money Value) For Keynes P is fixed

AD(=AD) Y=E

E2

E1

450

Y1 Y2 AS(=AY)

(c) Aggregate demand ( or Expenditure)

= Aggregate supply ( Income)

Through circular flow

Two Sector Model
 Income and Output Determination:
Two Sector Model
Assumption:
1. Only 2 sector in the economy: Households and Firms/Industry
1. Households: owner of factors of production, L, L, K, E
2. Firms/Industry: Hire factor of production and sale output to
households
2. Absence of Government: No Tax, No Govt. Exp.

3. Business Sector:
a. No corporate saving
b. No retain earning

4. All Prices are Fixed in Short-run: Sticky Price, Wage, and interest
rate.

5. Supply of Capital and Technology given (constant).

 Aggregate Demand Functions
Aggregate Demand : AD(Z)=C + I
1. Consumption Function: C = C0 + c * Y
C = Consumption
I = Private Domestic Investment Co = Autonomous consumption
c = Marginal propensity to consume
out of income (MPC)
Y = Income
Keynesian Psychological law of consumption,' men or
AD=C+I women are disposed , as a rule and on average , to
C+I
increase their consumption as their income increases,
C but not as much as the increase in their income”

I 0<MPC<1
2. Savings Functions: S = Y-C
=Y-C0-c*Y
=-C0+s*Y
Y S = - C0 + s * Y
where s= 1-c
-Co = Autonomous Saving
s = Marginal propensity to save out of income (MPS)
S= Saving
 Equilibrium: Income and Output Determination

Equilibrium: AY=AD AD Keynesian

Cross AY
=>Y= C + I0
C+I
Substituting C,
Y= C0+c*Y+I0
C
Or Y- c*Y= C0+I0
Or (1-c)*Y= C0+I0
Or 1
Y =( ) * (C0 + I 0 )
1− c

How to determine C???

C=C0+c*Y
AS
Or C=C0+(c/1-c)*{C0+I0}

0<c<1 OR 0<MPC<1
 Income and Output Determination :
Savings and Investment Approach

Agg Demand: Y= C + I
=> Y-C= I
Agg Supply: Y=C+S………………. Savings function
=> Y-C= S
=> S=I
Thus Agg Demand= Agg Supply implies Equilibrium
C+I=C+S
Since I= I0 i.e. Investment is fixed
Substituting S, we get
S=-C0+(1-c)*Y
=> I0 =-C0+(1-c)*Y
=> Y=(1/1-c)*C0+I0
S=I0 exposed or realized Only
S≠I0 exante or planned
 Consumption and Saving Schedules: A
Hypothetical Case
Time Levels of GDP APC= APS= MPC= MPS=
( Year) or Y C=200+cY S=Y-C C/Y S/Y dC/dY 1-MPC
1990 100 275 -175 2.75 -1.75 0.75 0.25
1991 200 350 -150 1.75 -0.75 0.75 0.25
1992 300 425 -125 1.42 -0.42 0.75 0.25
1993 400 500 -100 1.25 -0.25 0.75 0.25
1994 500 575 -75 1.15 -0.15 0.75 0.25
1995 600 650 -50 1.08 -0.08 0.75 0.25
1996 700 725 -25 1.04 -0.04 0.75 0.25
1997 800 800 0 1.00 0.00 0.75 0.25
1998 900 875 25 0.97 0.03 0.75 0.25
1999 1000 950 50 0.95 0.05 0.75 0.25
2000 1100 1025 75 0.93 0.07 0.75 0.25
2001 1200 1100 100 0.92 0.08 0.75 0.25
2002 1300 1175 125 0.90 0.10 0.75 0.25
2003 1400 1250 150 0.89 0.11 0.75 0.25

C= Consumption, APC=Average Propensity to Consume. MPC(c)= Marginal Propensity to consume

S= Savings, APS=Average Propensity to Save. MPS(s)= Marginal Propensity to Save
 S=I
Levels of Planned Planned Planned Level of AD= Planned Resulting
GDP Consumption Saving: Investment GDP (Y) Consumption ( C ) + Tendency of
(i.e. (Y) ( C) Y-C=S (I) Investment (I) Output
(C=200+cY) (Total Exp)

100 275 -175 100 100 < 375 Expansion

200 350 -150 100 200 < 450 Expansion
300 425 -125 100 300 < 525 Expansion
400 500 -100 100 400 < 600 Expansion
500 575 -75 100 500 < 675 Expansion
600 650 -50 100 600 < 750 Expansion
700 725 -25 100 700 < 825 Expansion
800 800 0 100 800 < 900 Expansion
900 875 25 100 900 < 975 Expansion
1000 950 50 100 1000 < 1050 Expansion
1100 1025 75 100 1100 < 1125 Expansion
1200 1100 100 100 1200 = 1200 Equilibrium
1300 1175 125 100 1300 > 1275 Contraction
1400 1250 150 100 1400 > 1350 Contraction

S=I0 exposed or realized Only

S≠I0 exante or planned always. It’s equal only at the equilibrium level Let c=0.75
Change in Aggregate Demand: The Multiplier

• The shift in aggregate spending shift the aggregate demand

curve and so also aggregate national income.

• Multiplier explains the relationship between change in

aggregate spending ( aggregate demand) and change in
national income
1. Investment Multiplier
2. Govt Exp Multiplier
3. Tax Multiplier
4. Balanced Budget Multiplier
5. Export Multiplier
6. Import Multiplier
 Change in Aggregate Demand: The Multiplier
Shift in aggregate demand curve
1. Due to shift in C
Round of Consumptio Income
2. Due to Shift in I
Income n (C ) Generation
Generation

1st 100.00

2nd 80.00 80.00

• Let c=0.80 i.e.
MPC, 3rd 64.00 64.00

4th 51.20 51.20

• the multiplier would
be 5. 5th 40.96… 40.96
…..
……. ….
• Let initial last ….. 0.00
investment is 100.
Total Total 500.00
Income
 Change in Aggregate Demand: The Multiplier
Investment Multiplier:
Model: Y= C + I0

Let Investment Increase by ΔI, then it resulted in increase in Income by ΔY,

which induces to increase Consumption (ΔC). So post ΔI equilibrium level of
income expressed as

Y+ΔY=C + ΔC+ I0+ Δ I

=> ΔY=ΔC+ ΔI

Given C= C0+c*Y
=> C+ΔC= C0+c(Y+Δ Y)
=> ΔC= c ΔY
Substituting ΔC in above model
=> ΔY= cΔ Y + Δ I 1
Y 1 is called as
=>ΔY(1-c)= Δ I = =
I 1− c 1− c investment multiplier
 Uses and Limits of the Multiplier
Limitations

a. Multiplier process works only when there is adequate availability of consumer goods.

b. Full value of multiplier is achieved only when various increments in investments are
repeated at regular intervals.

c. The full value of the multiplier can be achieved only when there is no change in the MPC
during the process of income propagation.

d. Multiplier does not work well in case of leakages from MPC

a. Payments of the past debts
b. Purchase of exiting wealth
c. Import of goods and services

e. Does not work well in case of full employment of resources.

Applications

• Less application in case of Less developed countries due to high MPC.

– Vast agricultural sector
– Disguised unemployment
– Low level of capital equipment, technology
– Vast non-monetised sector
– Producing for self consumption
 Paradox of Thrift and Multiplier

“Savings is a virtue”

‘A Penny saved is a penny earned’.

Those who save become reach and

prosperous.

Keynes criticized, the above

sentence may be true for an
Individual but not for the society

When all or most households

become thrifty, they consume less
and save more, the level of Income
and savings declines.
Three Sector Model
 Income and Out Determination:
Three Sector Model
Three Sector Economy:
1. Households
2. Firms/Industry
3. Govt.
Government can affect aggregate economic activities
through
– Fiscal Policy
– Monetary policy and credit Policy
– Industrial Policy
– Labor Policy, Employment Policy, Wage Policy
– Control and Regulation of Monopoly
– Export and Import Policy
– Environment Policy
 Income and Out Determination:
Three Sector Model
Govt Activities:
1. Imposes only Direct Taxes (T) on Households

2. Spend money to buy goods and services from

firms and factor services from households (G)

3. Make transfer payment (Tr) to households.

eg. Pensions, subsidies etc.
 Aggregate Demand Functions/Curve
A. Government Expenditure
Given:
Step 4. Solve for National Income (Y)
AD = C + I + G
C = C0 + c * Y
I = I0
Y = (C0 + I0 + G0) + c * Y
G = G0
Y - c * Y = C0 + I 0 + G 0
Step 1. Substitute into equation for aggregate
expenditures:
(1 - c) * Y = C0 + I0 + G0
AD = C0 + c * Y + I0 + G0
Step 2. State the Equilibrium Condition:
Y = 1 * (C0 + I0 + G0)
Y = AD
1–c
Step 3. Substitute AD from Step 1 into Step 2:
Y = C0 + c * Y + I0 + G0
Or Y = (C0 + I0 + G0) + c * Y The Govt Expenditure Multiplier:
ΔY/ ΔG= 1/1-c
 Aggregate Demand Functions/Curve
B. Imposing Tax (T)
• Given: AD = C + I + G
C = C0 + c * Y
I = I0
G = G0
If Govt Imposes Income Tax, Then Yd=Y-T,
Y= National Income; Yd = Disposable Income
T=tax
Now, C = C0 + c * Yd
C= C0 + c * (Y-T)

Step 1. Substitute into equation for aggregate expenditures:

AD = C0 + c * (Y-T) + I0 + G0
Or Y = C0 + c * (Y-T) + I0 + G0
Y = 1 * (C0 + I0 + G0-c * T )
1–c

The Tax Multiplier: ΔY/ ΔT= -c/1-c

 Aggregate Demand Functions/Curve
C. Including Transfer Payment(GTr)
• Given: AD = C + I + G
C = C0 + c * Y
I = I0
G = G0
a. If Govt Imposes Income Tax, Then Yd=Y-T,
Y= National Income; Yd = disposable Income
T=tax

b. If Govt Including Transfer Payment, Then

C = C0 + c * (Yd +GTr)
or C= C0 + c * (Y-T+ GTr)

Step 1. Substitute into equation for aggregate expenditures:

AD = C0 + c * (Y-T + GTr ) + I0 + G0
Or, Y = C0 + c * (Y-T + GTr ) + I0 + G0
Or Y = 1 * (C0 + I0 + G0)-c * T + c * GTr
1-c
The Govt. Transfer Multiplier: ΔY/ ΔGTr= c/1-c
 Aggregate Demand Functions/Curve:
D. Taxation As a Function of Income
Given: AD = C + I + G
C = C0 + c * Y
I = I0
G = G0
a. If Govt Imposes Income Tax, then Yd=Y-T,
Y= National Income
Yd = disposable Income
T=tax
C = C0 + c * Yd Or C = C0 + c * (Y-T)
b. If Govt Including Transfer payment, then
C = C0 + c * (Y-T +GTr)
c. If Govt Including Taxation as a function of Income, then
T= T0+t*Y
and C = C0 + c * (Y-T0-tY)
( No Transfer payment)
Step 1. .Substitute into equation for aggregate expenditures:
AD = C0 + c * (Y-T0 –t*Y ) + I0 + G0
Or Y =C0 + c * (Y-T0 –t*Y ) + I0 + G0
Or Y = 1 * (C0 + I0+ G0-c * T )
1 – c+ct
−c
Govt Income Tax Multiplier: ΔY/ ΔT=
1 − c + ct
 Aggregate Demand Functions/Curve
With Govt. Fiscal Policy : Tax Function, Govt Exp and Transfer Payment
Given Equations: AD = C + I + G
where, C = C0 + c * Y; I = I0, G = G0,
Now C = C0 + c * Yd with disposable income (Yd= Y-T)

where, Yd = Y - t * Y - T0 + GTr T= T0+t*Y

So, C = C0 + c * (Y-T0-t*Y+GTr)
Yd = disposable income; t * Y = income tax revenues
T0 = lump sum tax; GTR = gov’t transfer payments

Step 1: Restate aggregate expenditures

AD = C + I + G
Or AD = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr
Or Y = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr
=> Y = 1 * [C0 + I0 + G0 + c * (GTr - T0)]
[1 - c * (1 - t )]
 The Multiplier: Summary
Change in Y = Multiplier * Change in C0, I0,or G0 or GTr

Equilibrium model solution:

Y = 1 * (C0 + I0 + G0)
1-c
1
1. Autonomous Spending Multiplier: ΔY/ ΔI = 1− c
1
2. Govt Expenditure Multiplier: ΔY/ ΔG= 1− c
−c
3. Govt Tax Multiplier : ΔY/ ΔT= 1− c
c
4. Govt Transfer Payment Multiplier: ΔY/ ΔGTr=
1− c
5. Govt Income Tax Multiplier: ΔY/ ΔT= −c
1 − c + ct
1
6. The Complete Fiscal policy Multiplier: ΔY/ ΔG=
1 − c + ct

If ΔY/ ΔG- ΔY/ ΔGTr=1, then So ΔY/ ΔG> ΔY/ ΔGTr

Government Fiscal Policy: Balanced Budget Multiplier

Let the Model is Ex. Rs.1 increase in government spending

Y = 1 * [C0 + I0 + G0 + c * (GTr - T0)]
exactly matched by Rs.1 increase in lump sum
1-c taxes
• Spending multiplier (assume no income tax)
Multiplier (assume ΔC0 = ΔI0= ΔGTr= 0): 1
1–c

ΔY = 1 * (Δ G0 - c * Δ T0) • Lump Sum tax multiplier

1-c - c
1-c
Balanced Budget (Δ G0 = Δ T0):
Balanced budget multiplier: ΔG= ΔT
Δ Y = 1 * (Δ G0 - c * Δ G0)
1-c • Spending multiplier + lump sum tax
= 1 * ( 1 – c) * Δ G0 multiplier
1-c
= 1 * Δ G0
1 + -c =1–c =1
1–c 1–c 1-c
Multiplier = 1
Four Sector Model
 Income and Out Determination:
Four Sector Model

Four Sector Economy:

1.Households
2.Firms/Industry
3.Govt.
4.Foreign Sector: Export and Import

Foreign Transaction in two things

1. Commodity Flow
2. Financial Flow
 Export, Import and Aggregate Demand
a. Export Function: determinant
• Prices of export in relation to those in
importing countries
• Income of importing countries
• Income elasticity of import
• Tariff and trade policies: both the country
• Exchange rate policies
• Export policy
• Export duties and subsidies
• Availability of export surplus
• Etc.
b. Import Function: determinant
• Prices of foreign goods in relation
to domestic prices.
• Income of domestic countries
• Income elasticity of import
• Tariff and trade policies: both the
country
• Exchange rate policies
• Import duties and subsidies
• Etc.
 Export, Import and Aggregate Demand
a. Aggregate Demand (Expenditures) with Exports:
Given:
AD = C + I + G+X
C = C0 + c * Y
Yd=Y-T
I = I0,, T=T0, GTr=0 ,G = G0 ,, X=X0

Step 1. Substitute into equation for aggregate expenditures:

AD = C0 + c * (Y –T)+ I0 + G0+X0
Or Y = C0 + c * (Y-T) + I0 + G0+X0
Or Y = 1 * (C0 + I0 + G0+X0) - c * T
1–c
Export Multiplier: ΔY/ ΔX0= 1
1–c
 Export, Import and Aggregate Demand

b. Aggregate Demand (Expenditures) with Imports

Given:
AD = C + I + G+X-M
C = C0 + c * Y
Yd=Y-T
I = I0,, T=T0, GTr=0, G = G0 , X=X0, M =M0+ m*Y

Step 1. Substitute into equation for aggregate expenditures:

AD = C0 + c * (Y –T)+ I0 + G0+X0- M0- m*Y
Or Y = C0 + c * (Y-T) + I0 + G0+X0- M0- m*Y
Or Y = 1 * (C0 + I0 + G0+X0-M0) - c * T
1– c+m

Foreign Trade Multiplier: ΔY/ ΔNX= ___1__

1 – c+m
NX=(X-M)
The Complete Four Sector Model:
Aggregate Demand
 Aggregate Demand :
The Complete Four Sector Model

Aggregate Demand (Expenditures) with Import and Exports:

Given:
AD = C + I + G+X-M
C = C0 + c * Yd
Yd=Y-T
T=T0+t*Y
I = I0, G=G0 , GTr=GT0>0 , X=X0,
M =M0+ m*Y
Now C= C0 + c * (Y-T0-t*Y+GT0)

Step 1. Substitute into equation for aggregate expenditures:

AD = C0 + c * (Y –T0-t*Y+GT0)+ I0 + G0+X0- M0- m*Y

Step 2. State the Equilibrium Condition:

Y = AD
 Aggregate Demand :
The Complete Four Sector Model

Step 3. Substitute AD from Step 1 into Step 2:

Y = C0 + c * (Y-T0-t*Y+GT0) + I0 + G0+X0- M0- m*Y

Or Y = C0 + I0 + G0+X0 + c * Y - c * T0 - c *tY+c * GT0- M0- m*Y

Step 4. Solve for National Income (Y)

=> Y = C0 + I0 + G0+X0 + c * Y- c * T0 - c *tY+ c * GT0- M0- m*Y
=> Y - c * Y + m*Y + c *tY = C0 + I0 + G0+X0- c * T0 + c * GT0- M0
=>(1 – c+ct+m) * Y = C0 + I0 + G0+X0-M0- c * T0+ c * GT0
=> Y = 1 * (C0 + I0 + G0+X0-M0 - c * T0+ c * GT0)
1– c+ct+m

Foreign Trade Multiplier: ΔY/ ΔNX= ___1__

1 – c+ct+m
 References

• Ch 12 and 13. Macroeconomics by N

Gregory Mankiw and Mark P Taylor
( your prescribed text book)
-:Thank You All:-