NATIONAL INCOME

DETERMINATION
CLASSICAL VIEW

 Assuming long run, no government

intervention and perfect competition;
Equilibrium level of income is possible only at
full employment level.
 Full employment can be automatically
achieved
KEYNSIAN VIEW
Income Determination in a two-sector
model

 No government; closed economy

 Households and firms are the two categories
of spenders
 Total Expenditure = C + I
 Total Income = Y = C +S = C+I
 For equilibrium; therefore, S should be equal
to I ( withdrawal = injection)
Two-sector Model- Paradox of Thrift

 Recall that household income is partly spent

and the rest saved; Y = C + S
 An attempt by the households to increase
saving (S) means a decrease in consumption
(C)
 If investment remains constant, an increase
in S will mean that withdrawal exceeds
injection, which means, TE falls.
 A fall in TE means total income Y falls
 If Y falls; S falls
 We started with an increase in S and ended
with a decrease in S
 This is called the ‘paradox of thrift’- an
attempt by the nation to save more
boomerangs on it
Consumption Function and Saving
Function

 Simplistic assumptions
 C = f (Y) current consumption expenditure
depends on current income; direct
relationship
 S = f (Y); ditto
 Both functions are complementary; anything
that increases C automatically decreases S
Propensity to Consume/ Save

 Propensity is an amalgamation of capacity

and desire;
 Average and marginal propensity to
consume
 aps = C/Y (total consumption expenditure
divided by total income)
 mps = dC/dY ( change in C divided by
change in Y)
Factors affecting consumption
function- propensity to consume

 Current income
 Future foreseen liabilities
 Unforeseen liabilities
 Social security system of the government
 Socio-cultural background
 Permanent income hypothesis
 Life time spending hypothesis
Empirical studies on consumption
function

 Most empirical studies on consumption

function have found consumption functions to
be stable- that is in short run- people do not
change their propensity to consume in spite
of change in income.
Consumption function

 The implication of this behaviour is that

households cannot be expected to add to the
total expenditure (aggregate demand) in
short run
How can there be equilibrium at
underemployment level of income?

 Suppose the full employment level of income

( or the desired level, Yf,) is Rs.120.
 But the actual level of income, Ya, is 100 of
which C = 70 and I = 30.
 If total expenditure (aggregate demand)
remains at 100, income will also remain at
100. Yf cannot be automatically achieved
 House holds do not increase spending as
consumption function is stable
 Firms do not invest more as there is no
additional spending (aggregate demand) by
households.
 Economy remains at underemployed level of
income.
WHAT IS THE WAYOUT?

 The STATE is seen as a catalyst- fanning

additional spending- pump-priming the
economy
 The era of guided capitalism starts