Macroeconomic Theory and

Policy

PGDM - BFS : 2015 17

Term 2 (September December, 2015)
(Lecture 07)

Keynesian Theory of Equilibrium Income

Determination in a Country/Economy
Prices are sticky
In the short run, quantity adjustments are more important than
price adjustments.
Quantities demanded can change more rapidly than prices, which
is why you can have temporary shortages of goods.
Output determined by aggregate demand. So aggregate expenditure
(demand) determines the volume of goods that firms sell.
unemployment is negatively related to output
Producers, government, and consumers all make plans that may or
may not be achieved.
In the short run, all plans are fixed, except for planned consumption
expenditure because it alone varies with income.

The Keynesian Cross/Simple Keynesian Model

A simple closed economy model in which income is
determined by expenditure.
(due to John Maynard Keynes)

Notation:
I = planned investment
E = planned expenditure = C + I + G
Y = real GDP = actual expenditure = C + Ir + G
T = Tax (Lump-sum)
Difference between actual/realized (Ir) & planned
expenditure: unplanned inventory investment

Equivalent Equilibrium Conditions in Simple

Keynesian System
We know that , Output = Aggregate Expenditure = National Product
Y = E = C+I+G..(1)
C + Ir + G =C + I + G
Ir = I(2)
But Y is also income, and from income we purchase consumer goods (C), save (S),
or pay taxes (T), so
Y=C+S+T
So that
C+I+G=C+S+T
S + T = I + G.(3)
Which means that saving and taxes paid by the public must finance investment and
government spending.
(1), (2), and (3) represent three equivalent equilibrium conditions of the economy.
Our task is to find out the value of Output (Y*) for which any of these conditions
is met.
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Components of Aggregate Demand

Recall that, Aggregate Demand (AD) = C+I+G
The components of AD are
1. Consumption (C)
2. Investment (I)
3. Government Expenditure (G)
Following the Keyness assumptions, Investment (I) and Government
Purchases (G) are part of autonomous expenditure of the economy
since these do not depend on disposable income (YD).

Consumption
Consumer Expenditure is the largest component of aggregate demand (around 60% of GDP in India in 2012-13).
Consumption plays an important role in the Keynesian theory of equilibrium income determination.
Keynes believed that the level of consumption expenditure was a stable function of disposable income. Keynes did
not deny that variables other than income affect consumption but believed that income was the dominant factor
determining consumption. As a first approximation other influence can be neglected.
The specific form of the consumption-income relationship, termed the Consumption Function, proposed by Keynes
was as follows:
C = a + c (Y-T) = a+ cYD; a > 0 and 0 < c <1 (Graph in the next slide depicts this relationship. )
Where, T is lump-sum tax.
The intercept term a, which is assumed to be positive, is the value of consumption when disposable income equals
zero. This a can be considered as a measure of the effect of other variable not explicitly included in this simplified
consumption function.
The slope parameter c gives the increment to consumer expenditure per unit increase in disposable income. This value
of increment in consumption expenditure per unit increment in disposable income is termed as Marginal Propensity to
Consume (MPC). Keynesian assumption is that consumption will increase with the increase in income but that
increase in consumption will be less than the increase in disposable income.
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Consumption Function
c = MPC = marginal propensity to consume = C/ YD
C

C = a + cYD
C
Yd
a
Yd
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Is Consumption related to Income?: Empirical

Evidence

U.S. Annual Data, 1929 - 2001

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Regression Results
Over 99% of the variation in consumption expenditures
is explained by GDP. (R2 = 99%)
Slope is 0.67.
Roughly 67 out of every dollar of new income (GDP) is
spent on consumption goods.

This gives us good reason to believe that Consumptions

follows a relationship like:
C = a + c (Y-T) = a+ cYD
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Saving Function

Since Y = C + S + T and YD = Y T
YD = C + S
S = YD C
= YD a c YD
S = - a+ (1 c)YD

If consumption is a units with YD equal to zero, then at that point S = a.

If a one unit increase in disposable income leads to an increase of b units of

consumption, the remainder of the one unit increase (1-c) is the increase in Saving,
i.e., S/ Yd = (1 c).
The increment to saving per unit increase in disposable income (1-c) is termed as
Marginal Propensity to Save (MPS). The graph of the saving function is shown in the
next slide.
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Saving Function
1 c= MPS = Marginal Propensity to Save = S/ YD
S

S = a + (1 c)YD
S
YD
YD
a

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Saving and Dissaving

Planned C

YD (if C = YD)
Dissaving
C > YD

C
Saving
YD > C

YD1

Y*D1

YD2
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YD1

Note

In the classical model:

S = S(r)

In the Keynesian model:

S = S(YD)

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Investment

Investment is also a key variable in the Keynesian system. Changes in desired

investment expenditure are one of the major factors that is responsible for changes
in income.

As noted previously that consumption is a stable function of disposable income.

This does not imply that the level of consumption expenditure would not vary over
time. it implies that in the absence of other factors that caused income to change,
consumption factor will not be an important independent source of variability in
income. Consumption is primarily an induced expenditure, by which it means an
expenditure that depends directly on the level of income.

To understand the underlying causes of movements in aggregate demand and,

hence, income, we need to look at the autonomous component of aggregate
demand. These were the components that are determined independently of
disposable income. However, when these components vary income changes.

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Investment and its Volatility

According to Keynes, Investment (I) is the most highly variable of the autonomous
components of aggregate demand . Also, unlike Classical economists, Keynesian
theory believes it is the variability of such investment spending that is primarily
responsible for the instability of Income.

Investment means spending on capital goods. Capital goods have a long life.
Capital goods take time to build. So it requires large expenditure.

Value of investment is related to the income stream it can generate over a very long
time horizon.
This requires business people to form expectations about future business
conditions and profitability.
Investment is inherently risky.

As a result of these things, the investment expenditure tends to be erratic or

volatile.
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Investment

Keynesian theory does not differ much from Classical Theory while suggesting the
determinants of Investment expenditure in the short run. The determinants are interest rate
(r) and future profitability of business.

So, I = I(r) and I(r) < 0

Real rate of
interest*

I(r)
Investment

*Real Rate of Interest = Nominal Interest rate Inflation Rate

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Government Purchases (G) and Tax (T)

The level of Government Spending (G) is the second element of autonomous

expenditures. Government spending is assumed to be controlled by the policy
makers and therefore does not depend directly on the level of income.

We assume that the level of tax receipts (T) is also controlled by policy maker and
a policy variable. A more realistic assumption is that the policymakers set the tax
rate and tax receipts vary with the income. This would complicate our present
analysis but would not change the important conclusions (you can check it yourself
by incorporating a tax component which is dependent on income).

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Aggregate Demand/Planned expenditure: Graphical

Exposition
AD/ Planned Expenditure ( E )

AD = E =C +I(r) +G
= a + c (Y-T) +I(r) +G
= a + cYD +I(r) +G

MPC

Autonomous Expenditure
= I(r) +G

Income, Output, (Y )

Determining Equilibrium Income: Graphical Exposition

AD/ Planned Expenditure ( E )

E =Y

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Income, Output, (Y )

slide 19

Determining Equilibrium Income: Graphical Exposition

AD/Planned Expenditure ( E )

E =Y
AD = E =C +I(r) +G
= a + c (Y-T) +I(r) +G
= a + cYD +I(r) +G

Y* = AD

S + T = a + (1 c) YD + T
I+G

Y*

Equilibrium
Income

S(Y*)+T = I(r)+G
Income, Output, (Y )

Disequilibrium: AD AS Gap
AD/Planned Expenditure ( E )

E =Y
AD < Y

AD > Y

Y1

Y*

Equilibrium
Income

Y2

Income, Output, (Y )

Disequilibrium: Saving Investment Gap

AD/Planned Expenditure ( E )

S + T = a + (1 c) YD + T

S(Y*)+T = I(r)+G

S+T>I+G
I+G

S+T<I+G

Y1

Y*

Equilibrium
Income

Y2

Income, Output, (Y )

Determining Equilibrium Income : Mathematical Exposition

Equilibrium Condition : Aggregate Supply = Aggregate Demand

Realized Expenditure (Output, Y) = Planned Expenditure (E)

Y = a + cYD +I(r) +G
= a + c(Y T) + I(r) +G
(1-c)Y = a cT +I(r) +G

Y* = [1/(1 c)] [(a cT) +I(r) +G]

Autonomous
Autonomous
Expenditure (AE)
Expenditure
Multiplier
where, Y* is the Equilibrium output/income of the economy
and d(Y*)/d(AE) = [1/(1-c)]
This AE multiplier measures the change in equilibrium income of an economy due to one
unit change in Autonomous Expenditure.
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Determining Equilibrium Income : Mathematical Exposition

Equilibrium Condition : Saving Investment Approach

When the economy is in Equilibrium,

S + T = I(r) + G
a + (1 c) YD + T = I(r) + G
a + (1 c) (Y T) + T = I(r) + G

Y* = I(r) + G a c(1 T)
where, Y* is the Equilibrium output/income of the economy.

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Determining Equilibrium Income : Numerical Problem

Problem 01
In a three sector (Household, Firms, and Government) economy, the basis equations are as
follows: the consumption function is C = 100 + 0.80 YD and investment is I(r) = 150.
Government spending is 50.
a.The country is so rich the Government does not impose any tax. What is the equilibrium level
of income of the country?
b. Now suppose because of natural disaster a lump-sum tax imposed on the people of the
economy to finance the government spending and the amount is 15.What is the equilibrium level
of income of the economy now? At this point assume that nothing else is changed in the
economy.
Problem 02
Suppose the consumption function is C = 50 + 0.80 YD and investment is I(r) = 100, Government
Expenditure is 90 and the income tax function is T = 0.10Y.
c.What is the equilibrium level of Income in this economy.
d.Find the revenue from taxes at the equilibrium level. Is the budget balanced?
e.Suppose there is an increase in the level of investment from 100 to 120. What is the
equilibrium level of income now?
f.How does this extra investment affect consumption of the country?
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