Chapter # 3

Keynesian Theory of Income and Employment

Chapter`s outlines• Introduction to Keynes` Theory• Determination of NI in two sector

economy.• Two methods for determination of

National Income.1. AD & AS method.

2. Saving & Investment Method.• Determination of NI in three sector

economy. numerical examples.

Introduction to Keynes theory

• In the year 1936 Lord John Maynard Keynes’ General Theory of Employment, Income and Rate of Interest was first published..

• His followers Harrod, Domar, Kaldor, Solow etc. have ever since widened the scope of macroeconomic analysis.

Introduction…….. Cont`d

• Keynes has introduced a variety of new tools of analysis.

• His equations of income and expenditure, consumption function, law of marginal propensity to consume (MPC), Multiplier operations, Investment Function and Marginal Efficiency Of Capital (MEC), identity between Savings and Investment, and monetary Liquidity Preference Theory of interest accompanied by speculative motive for demand for money are some of his important contributions.

Introduction…….. Cont`d

• Keynes denied the classical belief that the free enterprise system is a self regulating one and asserted that such a system requires periodic intervention of the public authority to avoid fluctuations and instability in economic activities.

• Besides, Keynes was building an entirely new structure of economic analysis to study and redress the problem of unemployment..

Determination of Equilibrium Determination of Equilibrium level of NI in TWO Sector level of NI in TWO Sector

EconomyEconomy

Determination of Equilibrium Determination of Equilibrium level of NI in TWO Sector level of NI in TWO Sector

EconomyEconomy

Assumptions1 Two sector economy i.e. consumer and

producers Y= C+I2 The consumption expenditures (C) has

the following equation C= Co + cY3 The investment expenditure (I) consist

of autonomous investment4 The saving equation is as S= -So + sY5 The output side of NI will be as Y= C + S

Two methods

1 AD and AS Method

2 Saving and Investment Method

1 AD and AS MethodAggregate Demand (AD) Y = C + I

• Total demand for goods and services produced in a year

» OR

• Total National expenditure incurred on the final goods and services produced in a country.

Aggregate Supply (AS) Y = C+S

• In a two sector economy, “AS” consist of total output produced in the economy .

» OR

• “AS” is a national income which has been produced by the factor of production.

Determination of equilibrium Level of NI

C+I

C+S

0 x

Y

National income

C+ I= C+S

E.

B

A

Y3Y2Y1

C+ I > C+S

C+ I < C+S

Explanation of Graph• In this figure the equilibrium level of NI is determined at E

where C+I=C+S, and OY2 is the equilibrium level of NI.

• The equilibrium can not take place at point OY1 because here C+I > C+S. This would lead to increase in income. Similarly at OY3, C+I < C+S which would have the effect of reducing the income of the country.

• Thus we find that it is OY2 level of income where aggregate demand is equal to aggregate supply.

Numerical explanation of NI determination in two sector Economy --- AD/AS Method• If C= 40+0.6Y and I=I0 =80

• Then NI Y= C+I

• Putting the value of C & I in equation

• Y = 40 + 0.6Y + 80

• Y- 0.6Y = 120

• 0.4Y =120 dividing both sides by 0.4

• 0.4Y/0.4 = 120/0.4

• Thus Y = 300

Cont`d• And we know that C= 40+0.6(Y)

• Put the value of Y in equation, we get C = 40 + 0.6 (300)

• C = 40 + 180

• C = 220

• Now Y = 300, C= 220, so S ?• As Y=C+S so S= 80= I0

• Hence at Y=300 , S=I so income is determined at level Y=300

2 Saving & Investment Method

• SavingThe part of income which is not consumed is called saving.

• Saving depends upon income S= f(Y)while S = -S0 + sY

• -S0 shows –ve Y and sY shows induced saving.

Cont`d• The part of the income which is

spent on the purpose other than consumption is called investment.

• According to Keynes investment is autonomous i,e. I=I0

Cont`d

I=I0

S=f(Y)

0 x

Y

National income

Y3

I=S.I > S

I < S

BEA

Y2Y1

Sav

ing

& in

vest

men

t

Explanation of graph

• In this figure, the equilibrium level of NI is determined where I=S. Accordingly OY2 is the equilibrium level of NI. Equilibrium does not take place at OY1 because here I>S, this would result in increase in income.

• Similarly at OY3, I<S which would result in decrease in NI.

• So we find that OY2 is the equilibrium level of NI.

Numerical explanation of NI determination in two sector Economy --- AD/AS Method• If S= -40+0.4Y and I=I0 =80• Then NI S = I• Putting the value of C & I in equation• -40 + 0.4Y = 80• 0.4Y = 120• 0.4Y =120 dividing both sides by 0.4• 0.4Y/0.4 = 120/0.4• Thus Y = 300 so S = -40 + 0.4 (300)

S = -40 + 120• S = 80 =I

Example to be solved???

• Suppose the consumption function is given by C= 100+ 0.8Y, while I0 =50

1. What is the equilibrium level of income?

2. What is the level of saving at equilibrium level?

3. If I0 (Autonomous Investment) increases to 100 what will be the new equilibrium level of NI.

Inflationary and Deflationary Gaps

• Inflationary Gaps

The equilibrium level of NI may be at above full employment. This situation occurs when at the level of full employment AD is greater than AS.

Inflationary Gap cont`d• When level of investment in an economy

exceeds the investment level required to full employment, the equilibrium level of NI will be above the full employment level. This gap between current investment and required investment level shows a inflationary gap.

Deflationary Gaps

The equilibrium level of NI may be at below full employment. This situation occurs when at the level of full employment AD is less than AS.

CONT`D• When level of investment in an economy is

below the investment level required to full employment, the equilibrium level of NI will also be below the full employment level. This gap between current investment and required investment level shows a deflationary gap.

Determination of Equilibrium Determination of Equilibrium level of NI in THREE Sector level of NI in THREE Sector

EconomyEconomy

Determination of Equilibrium Determination of Equilibrium level of NI in THREE Sector level of NI in THREE Sector

EconomyEconomy

Determination of equilibrium level of NI in three sector economy

1 Three sector economy means- consumer, producers and Government, Y= C+S+T & Y=C+I+G

2 The consumption expenditures (C) has the following equation C= Co + cYd whereas Yd= Y-T

3 The investment expenditure (I) consist of autonomous investment, I=I0

Determination of equilibrium level of NI in three sector economy cont`d

4 The saving equation is as S= -So + sYd

5 G =G0 , is autonomous government expenditure.

6 AD = Y = C+I+G & AS = Y = C+S+T

Cont`d

C+I

C+S

0 x

Y

National income

E.

B

A

Y3Y2Y1

C+I+G

Con

sum

ptio

n, in

vest

, Gov

t.

Numerical example

• If C= 40+0.6Yd , I=80, G=20, T=10

• Then Y=C+I+G

• Y= 40+0.6[Y-T] + 80+20

• Y= 40+0.6[Y -10] +80+20

• Y= 40+0.6Y - 6 +80+ 20

• Y -0.6 = 134

• 0.4Y =134

• Y = 134/0.4

• Y = 335

Cont`d

• Now Putting the value of Y in C• Yd = Y-T • Yd= 335-10= 325• C= 40+0.6Yd • C= 40+0.6(325)• C= 40 +195• C= 235 Hence Y= C + I + G

335=235+80+20

335=335

Example to be solved

• If C = 100+0.75Y, G0= 20, & I0= 50

1 Find the equilibrium level of National income?

2 Prove that S=I0+G0

Another Example…???• If C = 100+0.75Yd, (Yd =Y-T) T=20

G0= 20, & I0= 50

1 Find the equilibrium level of National income?

2 Prove that S+T=I0+G0

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