Keynes Model of Income Determination : two sector

economy
 Understanding that aggregate demand is the total amount of goods demanded in an economy.
 Learning that the consumption function is a relationship between income and consumption.
 Learning that saving is income that is not spent on consumption.
 Arriving at the aggregate demand function by a vertical summation of the investment function and
consumption function.
 Explaining the two approaches to the determination of income and output in the Keynesian theory—
aggregate demand-aggregate supply approach and saving-investment approach.

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 Introduction

 We focus on the determination of the equilibrium level of income in the simple Keynesian model in a
two-sector economy.
 Model assumes that AS curve is perfectly elastic up to the full employment level of output, after which
it becomes perfectly inelastic. Hence price level ,until the full employment level will be determined by
the height of the supply curve.
 Hence the price variable gets less attention while the entire focus is on the determination of the
equilibrium level of income, which is solely determined by the AD. Thus the basic question relates to
determination of AD.

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 Aggregate Demand in a Two-Sector Economy
 Aggregate demand is the total amount of goods demanded in an economy.
 The aggregate demand function can be expressed as
 AD = C + I
 Basic assumptions:
 1. prices don’t change.they are constant
 2.Given the price level ,firms are willing to sell any amount of the output at that price level
 3.Short run ss as curve is perfectly elastic or flat
 4. Investment is assumed to be autonomous, thus independent of the level of income
 5.there are only two sectors in the economy: households and firms
 6.Technology and supply of capital are given

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 Consumption
 We focus on the determination of the equilibrium level of income in the simple Keynesian model in a
two-sector economy.
 Consumption spending in any time period will depend upon the real income of the households.
 The consumption function is a relationship between income and consumption expenditure.
 Consumption expenditure varies directly with disposable income.
 The most general non linear form of the consumption function can be expressed as C = C(Y) as in
Figure 5.1.

Figure 5.1: The Non Linear Consumption Function

 Income that is not spent on consumption is saved.

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 Consumption
 The consumption function equation in a linear form can be expressed as C = Ca + bY as depicted in
Figure 5.2.
 Ca is autonomous consumption.Ca>0
 It is the intercept of the consumption function on the y axis.
 The constant b is the MPC.,0 < b < 1
 It denotes the slope of the consumption function.
 APC is defined as the ratio of consumption to income,
 MPC is defined as the increase in the consumption per unit of increase in the income, ΔC/ΔY

Figure 5.2: The Linear Consumption Function

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 Saving as a Counterpart of the Consumption
Function
 The saving function is the counterpart of the consumption function depicted in Figure 5.2.
 It can be written as S= Y - C,
 S=Y - Ca – bY ;
 S = -Ca + (1-b) Y
 S= – Ca + sY, where S=1-b, s>0
 The APS is the saving counterpart to the APC and is defined as the ratio of saving to income,
 The constant s is the MPS and denotes the slope of the saving function, ΔS/ΔY
 MPS is defined as the increase in the saving per unit of increase in the income.               
 Since MPS or s is always positive, savings will be an increasing function of income.
 The sum of APC and APS is always equal to one. Y=C+S, (Divide both sides by Y) :1=C/Y +S/Y,
1=APC+APS. The sum of MPC and MPS is always equal to one. (Divide both sides by ΔY.)

Figure 5.3: The Saving Function

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 The Aggregate Demand Function
 We can now determine the aggregate demand function in a two-sector economy.
 We are assuming that investment is constant or I = I.
 Also C = Ca + bY.
 The aggregate demand function can be written as
AD = Ca + bY +I
 Figure 5.4 depicts the derivation of the aggregate demand curve.

Figure 5.4: The Aggregate Demand Function

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 Determination of Equilibrium Income or Output in
a Two-Sector Economy
 An economy can be said to be in equilibrium when the production plans of the firms and the expenditure plans of the
households are realized.
 According to the Keynesian theory, there are two approaches to the determination of income and output as depicted in
Figure 5.5(a) and 5.5(b). 
 Aggregate demand-aggregate supply approach and saving-investment approach.

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Determination of Equilibrium Income or Output in
a Two-Sector Economy

Figure 5.5: Determination of Equilibrium Income or Output in a Two-Sector Economy

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 Determination of Equilibrium Income or Output in
a Two-Sector Economy
 Figure 5.5: Determination of Equilibrium Income or Output in a Two-Sector Economy
Equilibrium Income and Output :Aggregate Demand-Aggregate Supply Approach
 The equilibrium national income is determined at that level where the aggregate demand = aggregate
supply.
 Keynes had argued that it is not necessary that aggregate demand will be always equal to aggregate
supply.
 Disequilibrium occurs if aggregate demand is not equal to aggregate supply.
 Consider a situation where aggregate demand is greater than aggregate supply. AD>AS
 There is a run down on inventories to meet the excess demand.
 The firms revise their production plans upwards till aggregate demand becomes equal to aggregate
supply.
 Consider a situation where aggregate demand is less than aggregate supply.
 There is an involuntary accumulation of inventories.
 The firms revise their production plans downwards till aggregate demand becomes equal to aggregate
supply.
 If any disequilibrium occurs then the forces inbuilt in the system would operate in such a manner that
equilibrium is restored.

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 Saving-Investment Approach

While ex-ante (planned or desired) saving and investment may differ, ex-post
(actual or realized) saving and investment are always equal.
The equilibrium national income is determined where the aggregate demand and
the aggregate supply are equal.
Also at that level, planned saving is equal to planned investment.
Disequilibrium occurs when planned saving is not equal to the planned
investment.
Firms expand production or cut back on production till planned investment is
equal to planned saving.
The two approaches to the determination of the equilibrium income, the
aggregate demand-aggregate supply approach and the saving-investment
approach, both yield the same result.  

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