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. There is no money illusion. The economy is at full employment equilibrium

Supply of labour depends on the money wage rate. There is money illusion. The economy is at underemployment equilibrium.

Market Economy

Mixed Economy

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 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.

AD = C+ I

AD

AD = C+ I

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.

O Income

Concept of AS


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

 

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

OUTPUT

Marginal Propensity To Consume



Marginal propensity to consume is the ratio of change in consumption to a change in income. 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

Income ( Y) ( Rs Crore) 100

Change in Consumption income ( Rs Crore) (Y) 80

Change in consumption -

MPC

200

100

120

40

40/100 = 0.4

300

100

150

30

30/100 = 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

INCOME

OUTPUT

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

Concept of multiplier


Multiplier refers to the factor by which output / income increases , because of increase in investment. It is measured investment. as ratio of increase in income / output & increase in investment. investment.

K = Change in income / change in investment

Diagrammatic representation of multiplier

Y = 1( I) 1-b
AS

J F H I

AD = C + I +

AD = C + I

Change in investment leads to multiple times increase in income

Derivation of multiplier

K =

Y /

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- MPC

Assumptions of Multiplier


    

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

Implications of Multiplier


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

Leakages in Multiplier


Savings Strong liquidity preference Purchase of old stocks & securities Debt cancellation Net imports Undistributed profits Taxation

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. period. In case of dynamic multiplier we are considering a time lag in consumption function. function. YT = C T + I T CT = a + bYT- 1 YT = a + bYT- 1 + IT