Simple Keynesian Model of Income

Determination

Of all the economic fluctuations in the world economy, the one that stands
out particularly large, painful and intellectually significant is the great
depression of 1930s. During this time the U S and many other countries
experienced massive unemployment and greatly reduced incomes. In the
worst year 1933, one fourth of labour force was unemployed and the real
GDP was 30 % below its 1929 level.

This devastating episode caused many economists to question the validity of

Classical economic theory, according to which the national income depends
on factor supplies and available technology, neither of which changed
substantially from 1929 – 1933. After the onset of depression, many
economists believed that the new model was needed to explain such a large
and sudden economic downturn and to suggest government policies that
might reduce the economic hardships so many people faced.

In 1936, the British economist John Maynard Keynes revolutionized

economics with his book “The General Theory of Employment, Income
and Money”. Keynes proposed a new way to analyze the economy, which he
presented as an alternative to classical theory. Keynes proposed that low
aggregate demand is responsible for the low income and high
unemployment that characterizes economic downturn

In the General Theory, Keynes proposed that an economy’s total income was
in the short run determined largely by the desire to spend by the household,
firms and the government. The more people want to spend the more goods
and services firms can sell. The more firms can sell the more output they will
choose to produce and the more workers they will choose to hire.

Aggregate Demand: let us try to derive aggregate demand in any

economy. Sources of aggregate demand can be

Household Private Final Consumption Expenditure (C)

Firm Investment (I)
Government Government Expenditure (G)
Rest of the world Export (X) and Import (M)

Therefore aggregate demand can be written as

AD = C + I + G + X - M
Please note that import has been subtracted from the aggregate demand as
aggregate demand gets reduced by the amount of import (as the economic
agents demand shifts to the product from abroad)

In the formulation for AD, G is included as a separate component. It is so

because factors influencing other demand and the demand from government
are quite different in nature. While government can beyond its means the
private sector can not do so.

Consumption Function
C of AD represents consumption which is the function of income. This can be
written as

C = C + cY

where C minimum level of consumption even when income is zero.

Consumption

Income
Fig. 2 Consumption
Function

Differentiating the consumption function

∆C
=c
∆Y
c is termed as marginal propensity to consume. It may be defined
as the incremental change in consumption level as a response to
incremental change in income. (Ref. Fig. 2)

Savings Function

Saving is the difference between income and consumption. (Ref. Fig. 3)

S =Y −C
S =Y −(C +cY )
= −C +(1 −c)Y
= S + sY
where ,
S = −C
s = (1 −c )
Graphically,

Savings

Income

Fig. 3 Savings Function

Using consumption function, Aggregate Demand can be rewritten as

AD =C +cY +I +G +X - M
where C , I , G , X , M are exogenous variables
Exogenous variables can be rewritten as
A =C +I +G +X - M
Then
AD = A +cY
Some key terminology
Endogenous Variables: The variable, the value for which is derived
from the system
Exogenous Variables: The variable for which the values are given.
For any economy to be in equilibrium,
AD = Y

Therefore, in equlibrium
Y = A + cY
⇒ Y − cY = A
⇒ (1 − c ) Y = A
1
⇒ Y* = *A
(1 − c )
1
where, is multiplier
(1 − c )
Re wrting

* (C + I + G + X - M )
1
Y* =
(1 − c )

In differential

*∆ ( C + I + G + X - M)
1
∆Y=
( 1 − c)
Therefore, the same formulation can also be looked differently.
We can say that if any of the Exogenous variables change, income in
any economy can also change via multiplier effect.

Therefore 1/(1 – c) is also called government expenditure multiplier and

investment multiplier.

Let us now look at the same thing graphically,

 AD AD = Y

Incom
e
Y*

Y*
Income Determination in
Keynesian System
Alternative Formulation for equilibrium
Planned Investment = Saving

Stability Analysis
 For any output above Y* there will be involuntary accumulation of
inventories in the economy, whereas for any output below Y* there will
be run down on the stocks.

As a result of disequilibrium, the economy, will equilibriate through

multiplier effect.

AD AD = Y

Incom
Y1 Y* e
Y2

Accumulation and Run down

Multiplier
If the objective of the government is to raise the income of the
economy it can be done by increasing autonomous investment.
Increase in investment would mean that there is increase in income
through multiplier effect.
 AD = Y
AD

Incom
e
Y*

Y*
Figure 6
Change in autonomous investment