Keynesian Theory of I income determination & Theory of Multiplier

Unit - 2

Income Determination 

Keynesian Model is for short run 

Short run prices fixed output determined by aggregate demand unemployment is negatively related to output

Differences between the Classical and Keynes  Labour supply depends on the real wage rate. The economy is at full employment equilibrium  Supply of labour depends on the money wage rate. There is no money illusion.      Market Economy  Mixed Economy . There is money illusion. The economy is at underemployment equilibrium.

Concept of AD  Aggregate demand is measured in terms of expenditure. Aggregate demand means aggregate expenditure on the purchase of domestically produced goods & services during an accounting year. This expenditure is to be estimated as desired expenditure or planned expenditure.   .

Components of AD     C I G X private consumption expenditure private investment expenditure government expenditure M net exports  AD = C+I +G + X .M .

 AD = C+ I .AD schedule  In order to simplify we initially assume we have closed economy with no government . so desired expenditure of the people consists of only two components C & I.

O Income X .Y AD AD = C+ I m Even at 0 level of income om is the aggregate demand as some minimum expenditure is always essential even when income does not permit it.

Concept of AS  AS refers flow of good & services as planned by the producers during an accounting year. Since Y = C+S AS = C+S    . It implies flow of goods & services in the economy during an accounting year.

Y AS Factors of production AS line happens to be a 45 line . This is because of the obvious identify between Y on the X-axis & C +S O OUTPUT X .

MPC = change in consumption/ change in income Consumption function is written as C = C + bY ( b is the marginal propensity to consume)    .Marginal Propensity To Consume  Marginal propensity to consume is the ratio of change in consumption to a change in income.

4 300 100 150 30 30/100 = 0.Marginal Propensity to Consume Income ( Y) ( Rs Crore) 100 Change in Consumption income ( Rs Crore) (Y) 80 Change in consumption - MPC 200 100 120 40 40/100 = 0.3 .

Concept of equilibrium level of Income & output y Expenditure Y E =Y Q E<Y AD = C + I Q is the point of equilibrium where AD = AS E>Y o INCOME L OUTPUT x .

Y = C+ S Y = C+I I : Autonomous Investment C : Autonomous consumption Y = C+ I = C +bY + I Y bY = C +I Y = C + I (where b is marginal propensity to consume) 1 b .

It is measured investment.Concept of multiplier  Multiplier refers to the factor by which output / income increases . as ratio of increase in income / output & increase in investment. investment. because of increase in investment.  K = Change in income / change in investment .

y Diagrammatic representation of multiplier Y = 1( I) 1-b AS J F H I AD = C + I + I AD = C + I Change in investment leads to multiple times increase in income o x L M .

MPC .Derivation of multiplier K = Y / I Y = C+ I Y = I = C+ Y I C Putting value of K= Y/ Y - I in equation 1 C y Dividing right hand side of equation by K = 1 / 1.

There are no time gaps between multiplier process. There are no changes in prices There is closed economy. The MPC is constant Consumption is a function of current income only.Assumptions of Multiplier       There is change in autonomous investment & induced investment is absent. ..

resources.    . The multiplier works both the sides ( rise in income & fall in income) Multiplier working is dependent upon an assumption of underutilized resources. Multiplier will work if any autonomous component of AD changes. changes. multiplier.Implications of Multiplier  A higher MPC raises the value of the multiplier.

Leakages in Multiplier  Savings Strong liquidity preference Purchase of old stocks & securities Debt cancellation Net imports Undistributed profits Taxation       .

1 YT = a + bYT. function.1 + IT   . In case of dynamic multiplier we are considering a time lag in consumption function.Dynamic Multiplier  A dynamic model of multiplier can be formulated by using period or sequence analysis which considers time path of changes in relevant variables and also in which value of one variable in period depends on its value in previous period. YT = C T + I T CT = a + bYT. period.