Determination of Output

Keynesian Theory
 KEYNESIAN THEORY
 Aggregate demand
 Simple Model
 The Multiplier
 Assumptions
 A simple economy
 No government
 No foreign trade
 Aggregate demand
 Aggregate demand is the total amount of
goods and services demanded in the
economy.
 Components:
 Consumption (C)

 Investment (I)
 Consumption Function
 Relation between consumption spending
and current disposable income
 GFCF at 2004-05 prices
37
36
35
34
as % of GDP

33
32
31
30
29
28
2004-05 2005-06 2006-07 2007-08 2008-09
year
 Investment Function
 Investment is spending devoted to
increasing or maintaining the stock of
capital.
 Gross investment represents total
additions to capital stock.
 Net Investment = Gross investment -
Depreciation
Components of Investment
 Business fixed investment
 Residential investment
 Inventory investment
 Business Fixed Investment
 Factors affecting business fixed
investment
 Expected level of output
 Cost and return of using capital
 Residential Investment
 Building of houses
 Factors affecting residential investment
 Price of housing
 Wealth of an individual
 Real return available on other assets
 Net Real return obtained by owning house
 Inventory Investment
 Raw materials, goods in the process of
production and finished goods
 Inventories are held
 To meet fluctuating demand
 To minimise cost of transporting goods
very frequently
 Equilibrium Output
 Output (Y) is at its equilibrium level when
the quantity of output produced in the
economy is equal to the quantity
demanded.
 Y=C+I
 Autonomous aggregate demand
 Planned aggregate spending

GDP(Rs) YD C I planned AE planned

0 0 300 500 800
500 500 600 500 1100
1000 1000 900 500 1400
1500 1500 1200 500 1700
2000 2000 1500 500 2000
2500 2500 1800 500 2300
3000 3000 2100 500 2600
3500 3500 2400 500 2900
 Inventory adjustment

GDP(Rs) AE planned AE unplanned

0 800 -800
500 1100 -600
1000 1400 -400
1500 1700 -200
2000 2000 0
2500 2300 200
3000 2600 400
3500 2900 600
 Equilibrium Output
 Actual output = Planned spending +
unintended inventory adjustment
 The Multiplier
 What the multiplier tells us is that a
change in autonomous consumption
results in a multiple change in equilibrium.
 Increase in Total
Round spending spending
1 100 100
2 80 180
3 64 244
4 51.2 295.2
5 40.96 336.2
6 32.77 368.9
7 26.21 395.1
8 20.97 416.1
9 16.78 432.9
10 13.42 446.3
 The Multiplier
 The MPC here is taken as 0.8
 The value of the multiplier is

1
1  MPC