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# THEORY OF NATIONAL INCOME DETERMINATION

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.

## THEORY OF NATIONAL INCOME DETERMINATION

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

## THEORY OF NATIONAL INCOME DETERMINATION

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

## THEORY OF NATIONAL INCOME DETERMINATION

The consumption function in short run is: C= a+ b Y It states the relationship between income & consumption. According to Keynes ,the consumption function stems from a fundamental psychological law .The law states that propensity to consume decreases with increase in real income. In simple words , when real income of a society increases in the short run, its total consumption increases , but not by an equal amount of increase in income. C= a + b Y Y = Total disposable income , a= constant term , b = consumption co-efficient ( i.e. The proportion of income spent on income) Aggregate demand schedule AD = C+ I Schedule AD= a + b Y + I

## THEORY OF NATIONAL INCOME DETERMINATION

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)

## THEORY OF NATIONAL INCOME DETERMINATION

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

## THEORY OF NATIONAL INCOME DETERMINATION

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

## THEORY OF NATIONAL INCOME DETERMINATION

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

## THREE SECTOR MODEL CONTD

In this we need to incorporate the government sector into two sector model , assuming that government follows the balanced budget policy , such that government expenditure (G) equals the Amount of Taxes(T) . (G = T) Aggregate demand (AD) in three sector model= C+I+G , and Aggregate Supply (AS) in three sector model= C+I+T Equilibrium level of national income = C+S+T = C+I+G At equilibrium level ,therefore ,Y = C+I+G,---- (1) Where C= a+b Yd , : Yd = Y-T, Where T=Tax

## THREE SECTOR MODEL CONTD

By substituting values in equation 1 , the above equation can be Written as : Y = a+ b ( Y-T) +I+ G Y = 1/1-b (a-b T + I+ G) (2)

## THREE SECTOR MODEL CONTD

Effect of change in governments fiscal policy on the equilibrium level of national income. Fiscal policy refers to the deliberate Changes made by the government in the expenditure (G) and Tax Revenue ( T). The impact of change in fiscal policy is analysed in Three stages. a) The effect of Government Expenditure : G multiplier In this we assume that the government made expenditures Only on the purchase of goods & services & there is no transfer payment. Now let the government expenditure increase by delta G .This will increase the income by Delta Y, through the process of multiplier. The equilibrium level of national income can be expressed as as: Y + Y = 1/1-b( a-b T + I + G + G) (3) By subtracting equation 2 from Equation 3

## THREE SECTOR MODEL CONTD

By subtracting equation 2 from Equation 3 Y = 1/1-b G (4) dividing both the sides of equation 4 by G, we get government expenditure multiplier (Gm ) as :

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.

## THREE SECTOR MODEL CONTD

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

## THREE SECTOR MODEL CONTD

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.

## FOUR SECTOR MODEL

The inclusion of foreign trade make the four sector model of Income determination . In case of foreign trade , exports (X) are injections and Imports ( M) are outflows from the economy. In the national income analysis however only the net exports ( X- M) are considered. That is only ( X- M) is incorporated in the four sector model. Injections increase the level of income and withdrawals decrease it. Therefore if X>M ,there is net injection and national income increase and vice-a -versa. Export Function: It is assumed that exports( X) are determined exogeneously , i.e. by the Factors operating outside the model economy . X is assumed to be given.

## FOUR SECTOR MODEL

Import Function: Import (M) depends on the level of domestic income (Y) and the marginal propensity to consume (mpm). Therefore import function Is : M= M + g Y , Where M = Autonomous imports, g = M/Y = mpm, assumed to be constant. Equilibrium equation for the four sector model : Y = C + I + G + ( X M)

Factor payments

Factor payments

BANKS, etc

Investment (I)

Factor payments

BANKS, etc

Investment (I)

Factor payments

BANKS, etc

GOV.

Investment (I)

Factor payments

Investment (I)

Factor payments

## The circular flow of income

Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

## The circular flow of income

Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

WITHDRAWALS

## The circular flow of income

INJECTIONS
Export expenditure (X) Investment (I) Government expenditure (G) BANKS, etc GOV. ABROAD

Factor payments

WITHDRAWALS