Ie Keynesian Theory of Income Determination: A Simple Economy Model INTRODUCTION Keynes had devlped his or of icome deena in A endevor to emulate tow tect oes coat te Sasa ee of euployzest Wace tcoonina ha enpbaized te mk ot pp Rees a ‘Sized, in contrast, the role of demand in the determination of cup an enlomnen. Bry psig ie ene of income determin sts at equine he tadeul Ions ts detuned athe Sole denund Tor B00 aid servis eau sk agg oy In tS aad the two suece ain the Keynesian theory of income is pool deebpet Heed trptcly and agtrcal, ase deen modes &) dane en ea The (wo-sector model includes only households and firms sectors; threesector model consists Siareetetelis, Gms end the government sectors: and the foursector medsl is contracted byPeoria to note here that throughout the Keynesian theory of income determiniio, py rT to rena 1 even if aggregie demand and ageregate supply change Thm sa applies to all the Cree models of income determination inthe rubsequent ch Sais, definitions and functions used in his theory of income determination. The concepts and pment dep rsh Bie srces supply function, (i) the aggregate demand function, (ii) the aggregate consumption 31 THE CONCEPTS AND FUNCTIONS 1.18" The Aggregate Supply! Function sopoly refers tothe. total supply of goods and servess in an economy. The derivation sia aggiegate supply function is illustrated in panel (8) of Fig. 61. Keynes wood ie ‘ derive his agercgatc supply function. It may be recalled that the Y= ft) logy. the Hevel real income (1) depends o9 the sures vie, capital (E) )aud abou (2). In tie short ran, the capil Ks facd Therelot, thorny oatpat depends on the level at ¢L) eapial. Ks z wo py aft Ue oF the Fad ee a ay be wettn 28 ag 1) e- as ee ae ey ky % it ob) it ao Enpyjrent aarguie Demand Aggregnte Exgentire) ® ” Fit. G1 Deviation of che Aggregate Supply Curve Pi cmc of aerate sy and pepe demand ver in sed by deel propose thatthe canao be arerpedction or egret, ‘eagh nt goroeny tht grep ders Keynes developed enfant sdf 7 R. Maths to contatit the lng at, Malas adatom Mal show fe aggregate upp keadag vi ocrpenn dcvelop hic then of income andemoy nent Sonat,54 Mocoecnanics Theory and ‘The production function (6.1) is presented ea matted Y= (RDAs de cn stow, al tape (nec cae ee clymet ong Phy ATA pss een eee wt ee carly nd he ona We nent een eb Soe forms the basis ofthe Keynesian aggregate supply curve. Let us sre tie hind the increase in rel otput and employment is given a fellows, The vale of veal ouput (1), measured on Y-axis, equals the aggregate upply price, tat isthe pce which producers expect w realize when total eupat i sold at a given pice As sows, fan! (a) of 58-6 1. if producers expect a demand equi o OY, they wll employ OL, labour to prods ouput OF I they expecta demand O¥;, they will emplay latour Ola. and supply goodh and services TORh O's and $0 on. It means thatthe aggregate supply (AS) is always oqal 1 the axgresare demand (AD) for output ic. AD = AS at all the levels of output. This tlationship between the AD and AS forms the basis of Keynesian aggregate supply function. In pane (b) of ig 6.1, Y-axis Imeasures the aggregate supply (AS) and X-axis measecs the aggregate demand (AD) in crs of gate expenditure (£). The relationship between aggregate demand and aggregate supply shown by a 48" lin, AE. The 45° aggregate supply line implies that aggregate demand eqs Aggregate supply at all the levels of ouput, The aggregate supply line AE represents the Keynesian aggregate supply function. 6.1.2 The Aggregate Demand Function: Two-sector Model Ina simple two-sector economy in which there is no goverment and no fercign trade, ageregate ‘demand (AD) consists of only (wo components: () aggregate demand for consumer goo (C), and i) agpregate demand for investment goods () OF the two, consumption expeaditute accounts for the highest proportion? of the GDP. Thus, in a simple economy” ADEC+I (62) Jn Bq, (62), the variable 1 is assumed 10 be determined exogenously and to remain constant in the short mn. The short-run aggregate demand function can thus be writen as AD=C+T 63) oshore 7 Equation (63) implies that. in the short-run, AD depends lavgely on the aggregate consermpion ‘expenditure. 1 means that the short-run AD function isthe function of cannenpion function plas constant (J). This implies that if conswnption function is known, the two-seeoe segregate demand function can he easly derived, given the investment (D. Therefore, belere any futher sscusion on the aggregate demand function, we need t explain the derivation of cantumpticn fanction 6.1.3 The Consumption Function The consunptionfuaction is one of the rest important factions wied in macoesenor ‘mot importa cs and the nstion used in the Keyoesian theory of income determination. A consumption function is lunctional statement ef teationship hetwcen the consumption expenditure and itt “hs clas is sed een Ba Oe man Scot een if ost of patito inne nina, fo se eon expen ana oer 5%res, the Se oomy as a tencton © temieans.Altho ar Contam Hructing Keyte's theory of jn Spee Te if one Deere 8 Set toy age here C= consumption exp + The consumption expeaditer isa postive fun Secease in income. According to Keynes, sd ona “fundamental psycholy ~ ACIAY goes on decreasing A question arises here: Does cons JF bore dun proporionately? Keynes an © Fr tis issue are explained by wsing sonomy 38 a whale er at XSesian economists have, Peirincally the con whole tion fonction. The Keynesins have used ome determination. Let ws the me The and sex. te. came is the primary determinant of consumption’, C= fh. aay > 0 tue, fi which take’ the form of Ao Novus, WD. Economic, 1h rated sumption function for the isposable income ome, {consumption inereases with ip between income and consumption is ical iw” that “men are disposed, as a rule and on average. to ‘oasumption as their income increases, but nots mn ‘in case of individual howsshotds. nnpton increase proportionately, less than proportionately or M4 Keynesians have diffeeat views on this issue. Their views the concept of marginal propensity to consume. | Marginal Propensity t0 Consume | §e8 0 the elaionship between margin tion of in Consunsten Expense 1 Edn, 1995. pad Cenc Theory of Employment eres ond ie, 64) their (MPC) The marginal propensity 1 consume (MPC) nl income and marginal consumption. The matginal pro. IC/SY. In the opinion of Reyncs, ACA © cx icar consumption function in recom *loe look atthe linear consumption =e postulated a non-linear interpretation and analysis of Keynesion (@s)96 _Mocroeconoms Theory end Ply In consumption function, as give ‘i Mas given in Eq (6.5), C= agercgate consumption expenditure: ¥= total en paiN income: Tatercep ais a postive eoaant It denotes the level of consumption at 2210 rel of income. The consumption at zero Ive! of income is called autonomous consumption, supposed to be financed out of past savings. In Eq. (65), b isa postive consiant. Mathematically it represents the slope ofa linear consumption function, It denotes a constant MPC = AC/AY. The MPC is less than unity bat greater than zero, that is, 0 A. This Boe tne 2 rene a follows, Now that AY = EA! sn since points aad Ea bth on te ine, E, M= E_M. That is, AY = £5, Note ako that A/ = E, K and that FM > JK. It proves | | as! Fig. 68 Increase in hnvestment Demand and National Income Determination that AF > Af It means that when AY takes place, the resulting AY is some multiple of AL. The multiple (m) ean be obtained as av °a In Ea, (627), ‘m”is the investment malipier Since AY > AL, mokiplice(n) is greater than 1 1 implies that whea investment increases in an economy. national inccme increase: by more than the increase ia investment. How greater is AY than A depends on the MPC ™ 27, How Multi business investment increases by Re 100 millon. As 1 Process Works Suppose an economy is in equilibrium and autonomous lt, an additional income of RS 160 millionsnot: A Semple Economy Mode! epesion Thery of Income Det searac n te forme of age, nest ant FS is ese read of incon ty the ain investmen, e and eve te additional income spend 9 pan of toe dead services depending om this MPC. re seuming their MPC to be OS, they sr lion on censamer goods a services. This expen- pce woth Rs 40 lion i he see eam for tose who supply goods end yes who cae Rs 80 millon sPeD4 «eae Rs 64 milion on consumption. Ths eI an atonal incor Rs 64 mila 0 yi di id ound. Nowe that adiond Hee Hemel in cc succes round SO seeming The proces of income BENE ned und unl addon come generated (ends 09 ‘tthe end of this race equals Rs 500 milion The process of income generation by 2 Te0 min is shown in Table 6.1 ptiaues peovess, a 2 Ea invesment of Rs . Truble 61 Weng of Halper Prose Mpc OF Asin million “Fach none Consoner Tice generation ea aod Fre mond 1000 Sicon und oe ——- 0, “Wid round = ——ee Fur end sak Fit rot ae Last own 00 S000 Taal howe G4 A SIMPLE MODEL OF INVESTMENT MULTIPLIER ce model preseied below answers the questions: Bs there definite relation- ys ht etnies tn hit The ‘wodel given below provides ‘out the investment multiplier ‘Tre investment mi ship between AY andi ‘an algsbraie method of workin ‘Lotus recall thatthe equilibrium level of income is given by crt (628) ow: kt aesen sce by a Wen A ks ‘hey siemens et eae lowe Ca ace i+ ar (629) yes Subircting Eq. (628) fem Eq, (6.29). we Bet ay=4c4 al 4 Al (630)a+ b+ bay, C= Far BY subsitting Ba. (631) fp 4¢ in By 30) (630) we pot 632 (a3) TOMS the team. l- soee te vite of te investment multiplier te eal ht, in Bg (639), b= SPC and | — nrc w MES. Thetefoce, mabiplice dn) can also be expressed at = 4Y detec i a4) ar Pe ~ ars sa The Inst term in Bq, (6:34) indicates tht ox = recipes of MP: E-4:1 An Alternative Method of Working Out the Multiplier The makilie can be akern ely worked out by using the expanded form of the PATS 2 the points of nacional income equilibria Beers cat eer Fe 68, pre-alnatonal incor equlioum takes place a i A Nece7 4 + BY, the pre-A/ equilibsium I cregate demand A takes place. At shown in where Since C’ vel of income (¥) may be rewriten as: Yeasoer 635) 1 een Similarly, ot post cquilibsium point £; in Fig. 68, HeCssas 636) a4 41 sat asian ra By subtracting Eq. (6.35) from Eq, (636), we get (637)Keyneson Theory ef Income Deteminaon: A Simple Eeonomy Made {= _gavation (637) yields the relationship between AY and AV, that i, AY equals (I~ 6) times i Seqeefor. 1 (L~ 6) is the investment multiplier (m. Thus, mote maiper = hs (ox ~ ANumerical Exomple of the Multiplier Model The multiplice mode! preseated above pry te istatd with a ami example, Let us eeall ou twoseioe model of income deter fmiation (sce Eq. 6.21). In the model, C= 100 + 0757 (639) a 1= 200 Given this model, the pre-A7 equilibrium level of income (J) may be expressed as cal = 1004 075 ¥; + 200 (6.40) t x = oars (100 + 200) = gh Gm ‘Now iet us soppase that exogenous investment increases by 100 Thus, the total investment may Bb ewmesed as 14 Al = 2004 100 The postaA/ equilibsium level of income can now be expressed as Yz= 100 + 0.75 ¥ + 200 + 100 (61) 1 si Tebzy (100 + 200 + 100) Since Y= 400 and al = 100, 4) AY _ 400 na GT Mas B= 29 Row be consiaded that if MPC = 0.5, the ivesine ; a multiplier (m) oqals 4.1 imp m= 4, then any additional investment will generate ani fay ital vest wil pene an teal cn i unrterial value ofthe multiplier is deter ‘Tis is evident from the mulpticr fara siven in Eq (634), 1 ”* pe 158 obviow fm this fomay m this formula that the Pumerical value of the multiplier is determi by | value o al a oman °F MPC ote ting benno am "lenin used nthe fom | Te —— TLE a re oo 22/6 ——$—< on m= V-01y un 059 m=1d-0%) 20 . 075 m= 1/1098) so om m= 1/d-0%) in om mets -09 00 me t/d— 109 os a 65° STATIC AND DYNAMIC MULTIPLIER Depending onthe purpose of enayss, sometimes a Aistinction is made Tamale uae mR. The sade matuptiey fe ake “eon malig tt MMi “pial maple’ mele renga moultipie” aseath f Sate multiplier implies ttt change in invesmen Causes change in income in eames Means that there is no time lag betwren the ee in income. It impli thatthe moment + nypecie increases by a multiple of Re 1. The of Static mailer. Let us explain th ‘sequence’ multiplier so ee aman muller rcoprises the fact thet be overall cb Changes ap CHEE i investment sno instaancous Theres ercacy Process by sich Changes as a result of change in investment or ether ae change tag: The multiplier process works semeration and consumption expendtare. To dynamic mip: Yrosess ofthe change in income and the change in consump at income teioe gemini maliplicr is esetaly 3 stage bystage cocyeaseet re © n investment tl the fell between the static mutiphicr rparative static maltiplic, “lagless muir” and ‘instast ange in income as a i the same. When an ‘capital equipment snd Rs 100, in the frst instance 10 X 0.80). As s result, income ‘They spend a pat Let us eall i AY; 0F those who sKeyrson Thay of Iu Detention A Sinple Ecnony Mey t-Ks 80 x O80 = Rs GE. This creates AY, This process continss until additions income ang expenditure ate reduced to zero, The witle process of the computation oF the total increase fy Sgcome (4Y) as a result of A/ = Rs 109 can be summarised as follows, AY= AY, + Oh + Am+... AY {In numerical terms, AY = 100 + 100 (0.8) + 100 (08)? + 100 (08) +... + 100 (08y" 100 + 804 64+ 51.20+...490 499.999 = 500 * After having caleulated the total incorae effect (AY), the multiplise can be ealeulated as: AY _ 500 ‘at ~ 100 of dynamic mukipler can be generalised as follows, AY AI + A106) + a1) + A164... 4 ary! a2) TAD R EB EL gh he rte low. As (6-2 shows, esr income genre by Ais Aba BA By [Now lt the terms in the parntdeses of a, i) be an Sale be PaO egg Ginebra o ating gamete propesin, when oo Bebe go By subtrction Bq. (ii) from Eg, (i), we get ° Sete sab otoe ow ” 90 Ba, for the tein the Pucnheses, wo get ayaa ce ‘The mpc (m) ean thes be writen as12 Morecomis: Tery an Py LIMITATIONS OF MULTIPLIER Itiplior 66 THE USES AND 6.6.1 The Uses of Mul ‘Bes concept of mt reroeconomic planning and projection tad ala’ SssesSment of possible effects ofthe changes msde ete policy ofthe governn de an? of its foreign trade policy. These wie wil be lenny ae subsequent chapters. In | the two-tector model, iis role is limited to: (2) the assessment of the overall possible increase in the increase in investment ©) w pi national income due to “one-shot” © duc to a ‘single injection’ of investment, and economic growth of the county maf he mskiter concep in dteminig the investment reuiemnt for a cerain planned Fence ihe national income over tne canbe istated with an example, Suppose sceutuy hog Wi be 8 Ss 100 Dillon nd its APPC is 08 (or 80%), The value of muliplier fr the couaey Taube 5 Suppose also thatthe county plans to double its national income over u pared ofan, Mugeh 2 Yene-bor investment. Tht i, it wants to increase is atonal income By Y= Re lee million. The investment requirement of the two-sector county can be easly warked et as fetlone Planned growth (AY) = RS 100 billion Malipier¢m) Requirement (A?) = Vin = 100s = Rs 20 billion In means that increasing national income by Rs 100 million eyuites an additional investment of Re 20 million, all ether things given, 6.6.2 Limitations of the Multiplier ‘The foregoing illusvation ofthe usefulness of the multiplier sion that an exoct assessment of investment requiement tbe made if is APC is Known, However, docs in theory, The reasons are given planning gives an impres. targeted growth of a country can the theory of multiplier does not work in practice ow (A) Leakages from the Income Stream ‘The suuhiplice tieory assumes that those who eaen inc investment woald sowtinus to spend a cnn (constat) proportion of addtional incemc, depcaing ite sesregte MPC: In practice, however, this assumption docs not Mold in ealybecaie, pone feod to spend deir addtional income on many other noa-ccrsumption and nen investonont ane Such expenses are known as leakages from the income siteam in the worling posee at ie ‘multiplier. The leakages redice the value of multiplier Some important kinds of a effect on the multiple are given below. me a8 a result of ceniain autonomous ages and their (Payment ofthe pas debis| When income eames usa prt of the addtional income to epuy their past debts, and those who recover their loans, use # 10 repay thcit own debte nseent oy onsaming it, When this process coninues, the marginal prea 10 nseKeynden Tey of heome Deters: A Simple Economy Model 1 3 i rocess of the multiplier As a resu ns > geen of won income over the working proves ofthe mils , Sie us of makiplic is reduced depending onthe leakage from AY on this account i) Purchase of existing wealth Arciber kind of leakage in the muliliey process arises when BEF ia ne wc pat of votycaned tone on resi cxbng Wea en opty or slr, Tand, building, second-hand consumer durables, and purchase of shares and ponds fiom the share and bond holders, end so on, If money spent on such items keeps circulating © on ss and purchase of od asets an never rtuns to the consumption seam, then the value of allie is reduced i) tapor of goods end services’ The par of nevlyc:med income spert on imported goods and * sehiees is one ofthe mos important leakages from the inceme steam created by the ational Tavestment Tis quite Hkaly that income wsed to repay old dbis and money spent on purchase of _olfssets and consumer durables returns to the consumption seam sooner or later, bt the income | sprit imported gowds and services flows out-of the county anal has litle chance to return to © the income steam ofthe country. The imporis which make incomes flow cut ofthe county reduce the valve of mali. (6) Non-avcilabitity of Consumer Goods and Services Axcaber mation of multiplier arises due tho lock of adcquate and instant supply of consumer fuols and services The mulipier theory assumes an instant and matching supply of consumer arods and services. But, in general, the supply of gocds docs not follow inctnly the rhe in errand. There is alvays time log. During the lag period, nowy earned income eles adcitenal demand fo goods and services which builds, in tun, demand presste, As a res, kee of anaes odds go up leading o inflaion. Ination eas away aan of consumption exerts This eluces the real consumer expenditure which consains the nuhipl eft (C)-Full Employment Situation Pi ities princi doesnot work in ae of fll employment, When oats of the coon {Gtisl dnd Labour) ae fully oF aearfuly employed err jreducton wil on be porsb TRG Adtiona investment will only ead t0 inflation, not 10 the generation of adeitnnal ony (67° APPLICABILITY OF MULTIPLIER THEORY TO LDCs ‘According tothe mili the higher the MPC, the higher the rate of mutipliee Iti equally Aesop counties (OC). And, therfore, «given amour of asbrtnons Ineo ina tavehhighor employment and oxtput in LDCs thin in DCs. It follows that the ste of econeac Berna fsuling fem addtional investment must be much higher in the LDCs than ie Den, fealty however hs is not tue: the multiplier and the rate of growth art both ones i Tee [Dik tess st leva in wo-ccor mol However fe these of omplateen of hls of the ‘uke teary we take noe ofthis sipec sh114 Maceo: They en Petey compared to thote in DCs, the multiplier paradox.? ‘ot apply to the LDCs, ‘The reason for non. conditions under which developed his theories inthe back ground a Depression had affected mostly the d beyond the stage of, witst Rostow al ‘This creates» parsdoic al situation wisi Tis, there his called “Keynes's MPC ang fore, generally agreed that she lo ie Of Keynesian multiplier doe, applicability ofthe ma wii theory he LDCs ta the sumptions ng ht Keynes had formal: ret ated his theories do not apply for the LDC. Keynes tag * the Great Depression during the eatly 1930s. The Gre veloped countries, that i, dhe counties which had grown lied, “ake-ofl” Besides, Keynesian theory of mlplicr w croens pa tith Ive of industial development, (i) iavolntay unemploymnen Gi) eens cramps and Gv) elastic supply curves. I is widely known foc ttc neon of ihe ‘assumptions do ‘not hold in the L EARLY. Roo! had examined te issue of applicability of the Keynesian malipierin the eas {naka then a pial LDC, nthe eal 1950. He found ta the asipions under which multe theory was' developed do not hold forthe underdeveloped counties. Instead, as he pointed ut on underdeveloped county is characterised by © «predominant ultra sector, Gi) a vast disguised unemployment, Gi) low level of capital equipment (Gv) low level of technology and techsical know how, (9) 2 small proportion of wage employment to the toa, (oi) & vast non-monetised sector, and (i) 2 vest sector producing for sel ‘by Keynes primarily for the industrialised economics."? , . ‘it has been found co be 1.4". Furthermore, the multiplier theory has been found to work in tment with ince th faster than real ier thoory doesnot apply 80 LDCs in reat ters * Rap, WACK, “invesmen, come ant Motil nan Unddeetpe Boo” ian Feo Rei AOL, Nes, 982 Ran A Lejogs coves mre BOON Bee ay than ducing the Det Hone “ie PARADOX OF THRIFT Al JER the “paradox of thrift” cry of multiplier, let ws Took at Te Ps . yf ek ed nat saving is «Vr and ND THE MULTIPL! jiscussion on the th 1358) I is wide! The Generel TAO eee ot oe ye words, those who save and invest become prosper- jowever, Keynes oe Pe hs opinion, these belies may be usin of individual ay a a whee. Keynes argued thal when 2 oF most households at onus less and save more, the level of income ‘and savings ‘This is what he calls the edox of Spirited tis widely held sholds, but not for the so vit, ie. they decide ‘garadox of thrift’. The par ye i ros 4 a Lae Fig. 6.9. ‘The Paradox of That. Sra paves ieee SS 6 sda med eee Genome S77 yr tesa eon ft ome rane wn acne savas yb AE As wt, vig ce aun rao FS iereing estat heal a po Consent poi of tic dows named sing co fils fom AY wo Ey Note hat 2 iy, Tee cere hte aubioum evel vig shows he ard tin eu iale cee Some eee eae sa Fo ei ano fi wats sw splice ees aan este fives du to igh te of enone ea Pi aes lives du ih rte of ik This had inven eee sumer goods and services