Keynesian Model of Income determination:
The simple model of income determination is the short run Keynesian model of income determination which enable us to understand the basic essentials of determination of income and employment in an economy. The Keynesian theory of income and employment was developed by the British economist, J M Keynes.
The simple and basic model of income determination is a building block for the more complex and realistic model income determination.
Simple Keynesian model of income determination states that “an economy’s total income in the short run depends on the desired aggregate demand or aggregate spending of the people”.
- The more the desired demand , the more will be the amount of goods and services that can be sold.
- The more the goods and services that can be sold in the economy, the more output will be produced and more workers will be employed resulting in higher level of national income.
Aggregate Demand:
- It refers to the total amount of goods and services demanded in the economy.
- It refers to the ‘ex ante demand’ (means before hand or desired) , the desired or intended demand by the people i.e., the total amount of goods and services they would like to purchase.
Ex ante Demand :
- Ex ante means before hand or desired demand. It is the total amount of goods and services that the people would like or desired to purchase.
- Ex ante demand or desired demand in the economy is the sum total of desired private consumption expenditure (C) , desired investment expenditure (I), desired government spending (G) and desired net exports (difference between export and import i.e. X- M)
AE = C + I + G + (X – M) ……equation 1
Where
AE = aggregate expenditure or aggregate demand
C = Desired consumption expenditure by household
I = desired investment expenditure
G = desired government expenditure
(X- M) = desired net export (export – import)
Components of Aggregate demand:
There are four main components:
1. Household consumption expenditure (C)
2. Investment expenditure (I)
3. Government expenditure (G)
4. Net export (X – M)
Ex post demand:
- Ex post means afterward or after the event.
- It is the effective or actual demand made by the people in an economy.
- Ex post or effective demand is the total amount of goods and services that people actually buy in an economy.
- It refers to something that actually or ultimately happens.
Question : What is aggregate demand ? State its main components.
Answer: Aggregate demand:
- Aggregate demand is the total amount of goods and services demanded in an economy.
- It refers to the desired or planned (ex ante) demand or spending by the people, means total amount of goods and services they would like to purchase.
- If we consider four main groups of buyers in an economy:
Households, firms, government and foreign purchasers of domestic output, therefore there are four main components of aggregate demand –
1. Household consumption expenditure (C)
2. Investment expenditure (I)
3. Govt. consumption spending (G)
4. Net export (X – M) , (i.e. difference between export (x) and import (M) .
Question : What is aggregate supply ?
Answer: Aggregate Supply:
- Aggregate supply refers to the value of total output of goods and services produced in an economy during a year.
- Aggregate supply is equal to the value of national product i.e. national income.
- We also know that national product is distributed among people ad factor income. Therefore, aggregate supply can also be taken as total factor income.
- Thus,
Aggregate supply = National product
= Total factor incomes
Question : Two assumption of Keynesian theory of income determination.
Answer: Two assumptions of Keynesian theory are:
1. Economy is assumed to be closed economy i.e. , an economy with no exports and imports
(X – M) = 0
2. Government expenditure and activities are not taken into consideration.
( G = 0 )
Thus, in a simple two sector closed economy aggregate demand is made up of two components :
AE = (C + I)
Propensity to Consume – Consumption Function:
Question : Explain the Keynesian theory of propensity to consume.
Question: What is meant by propensity to consume.
Question : With appropriate diagram explain the concept of consumption function.
Consumption Function:
- The consumption function defines the functional relationship between the consumption expenditure and income.
- Keynesian theory of consumption function shows the functional relation between the desired consumption expenditure and income.
- Consumption expenditure is the function of income C = f (Y) where C = total consumption expenditure and Y = total income.
- There are two technical concepts to explain the consumption function (propensity to consume) – Average Propensity to Consume (APC) and Marginal Propensity to consume (MPC).
1. Average Propensity to Consume (APC) :
- It refers to the proportion of income spent on consumption.
- It is the ratio of consumption expenditure (C) to the income (Y) .
APC = C / Y
- It defines the relationship between total consumption and total income.
2. Marginal Propensity to Consume (MPC) :
- It is the proportion of additional unit of income spent on consumption expenditure.
- It is the ratio of the change in consumption expenditure to the change in income.
- MPC = ∆C / ∆ Y. Where MPC = marginal Propensity to Consume, ∆C = change in consumption expenditure, ∆Y = Change in income.
Properties of Consumption Function:
Consumption Function
1. There is a direct relationship between income and desired or planned consumption expenditure i.e., consumption expenditure increases with the increase in income. But the increase in consumption expenditure is less than the increase in income. The slope of consumption line is positive but less than the slope of 45° sloping Y – line or income line.
2. Consumption expenditure exist even at zero income level i.e., there is a minimum consumption expenditure even at zero level of income. This is called the autonomous consumption expenditure, which is independent of income.
3. This the consumption curve starts from the positive Y on which the consumption expenditure is measured.
4. The slope of C – curve is defined by MPC, which is assumed to be constant in a given period of time. The value of MPC falls between 0 to 1.
5. The linear consumption function is expressed as
C = a + c Y
Where C = aggregate consumption expenditure
a = intercept, autonomous consumption expenditure
c = marginal propensity to consume
Y = income
cY = induced consumption
6. When C > Y , it causes dissaving in the economy equal to the amount by which the consumption expenditure exceeds income.
7. At E, C = Y, where the consumption is equal to the income, this is break even level of income.
8. Beyond OYE , C < Y means consumption is less than income, thus there are savings generated in the economy.
Question : Give the main properties of Keynesian consumption Function.
Question : define marginal and average propensity to consume.
Question: Explain the shape of Keynesian Consumption Function.
Answer: Shape of Consumption Curve :
Consumption Function
1. The consumption curve (C) slopes upward, indicating the direct relation between income and consumption expenditure. The increase in income leads to an increase in consumption expenditure.
2. Line ‘C’ originates from the point ‘a’ intersecting the Y – axis which means that consumption expenditure exists even at zero income level. This level of consumption at zero income is called autonomous consumption.
3. At lower level of income, consumption curve CC lies above income line Y, indicates that consumption is greater than income i.e., dissaving.
4. As the income increases, at OYE the consumption (C) is equal to income (Y ), which is called break even level of income.
5. Beyond OYE point CC – curve lies below income curve indicating the higher level of income is associated with positive savings.
6. The slope of ‘CC’ curve is the marginal propensity to consume. The slope is positive but less than 45° line slope means 0 < c < 1 for all level of income.
7. The general equation for linear consumption function is expressed as:
C = a + c Y
Where, C = aggregate consumption expenditure
a = intercept, autonomous consumption
c = slope of CC curve – marginal propensity to consume
Y = income
cY = induced consumption
Therefore C = (autonomous consumption) + ( induced consumption)
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