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This theory was provided by John Maynard Keynes in his book The Theory of Employment ,Interest and Money. This Theory is also called as Keynesian theory of income determination. This theory is relevant in the short run only , since the stock of capital , techniques of production , efficiency of labour size of population, forms of business organization have been assumed to remain constant in this theory.
The entire economy is divided into four sectors: a) Household sector, b) Firms or business sector c) Government sector d) Foreign sector On the basis of these sectors the following models are discussed: a) Two sector model b) Three sector model c) Four sector model
Two Sector model: According to the Keynesian theory, the equilibrium level of national income is determined where Aggregate Demand( AD) equals Aggregate Supply (AS). Aggregate Demand Aggregate demand is the total expenditure which all households and business firms want to make on goods & services in a period at various levels of national income. It consist of two components: a) Consumption demand b) Investment demand (demand for capital goods) Therefore AD = C + I a) Consumption demand : Consumption demand depends upon the propensity to consume of the community and the level of national income. The consumption function in short run is: C= a+ b Y
AD= a + b Y + I Now can be expressed as C+ I = a + b Y + I The C+ I schedule can be calculated on the basis of the following assumptions: a) C = 50 + 0.5 Y AND b) I = 50 billion The AD function can now be written as C + I = 50 + 0.5 Y + 50 ( Prepare Aggregate Demand Schedule)
Aggregate Supply: The Aggregate supply (AS) refers to the total value of goods and services produced and supplied in an economy per unit of time. Aggregate supply includes both Consumer goods and producer goods. The goods and service produced per time Unit multiplied by their respective prices give the total value of the national output. Aggregate Supply Schedule: If all that is produced is sold ,then aggregate supply grows at a constant rate of increase in output . This is shown by a 45 degree line . This line is also called Aggregate supply schedule. In this theory , aggregate income equals consumption ( C) plus savings (S). Therefore AS schedule is generally named as C+ S Schedule. AS= C+S
From the data provided the two lines AD & AS can be drawn on and where these two are going to intersect ,this point of intersection is called the equilibrium level Of national Income. So as stated above the equilibrium level of national income or national output is determined at a level where aggregate demand for the output(C+I) is equal to aggregate supply of Income (C+S). Therefore Equilibrium Level = AD= AS C+I = C+S, as C is common ,the equilibrium condition may be expressed as I = S
Gm = Y / G = 1/1-b
b) The effect of change in Lump sum Tax : The Tax Multiplier The impact of change in tax (T) on the national income is negative and smaller than the change in G. A change in Tax (T) by T will result in a change in Y by Y.
By incorporating T and y the equilibrium level of national income may be expressed as : Y + Y = 1/1-b ( a - b ( T+ T) + I + G) = 1/1-b ( a - b T - T + I + G ) --- (5) Now subtracting equation 2 by equation 5 we get: Y = 1/ 1- b ( - b T ) Y = -b / 1 b (T ) . The tax multiplier (Tm ) can be obtained by dividing both the sides by T. Tm = - b / 1 b
c) The balanced budget Multiplier: When G =T ,the government budget is said to be balanced. The balanced budget multiplier is obtained by adding G multiplier and T multiplier. Gm + Tm = (1/ 1 b ) + (- b /1 b) Bm = 1-b /1- b = 1 ,Thus Bm is equal to unity. It implies that if G = T national income increases exactly by the amount of increase in government expenditure.
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Investment (I)
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Investment (I)
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Investment (I)
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Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD
Factor payments
Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD
Factor payments
WITHDRAWALS
Factor payments
WITHDRAWALS