Hi Simple_keynesian_model_of income determinationQUTLINE e Aggregate expenditure: > Consumption function > Investment function e Aggregate output > Short run supply curve © Equilibrium income. + Introduction my * Keynesian economics was developed during the Great Depression (1930s). * Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s. * Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment. * National income means the total money value of goods and services produced in an economy in a yearViews: i Keynesian View of spending and output: * Keynes argued that spending induced business firms to supply goods & services. * Hence, if total spending fell, then firms would respond by cutting back production. Less spending would lead to less output. J.M.keynes in his book general thoery has used two methods for the determination of national income at a particular time Saving investment method Aggregate demand & aggregate supply method.Keynesian model Ci In the keynesian theory , there are two approaches to the determination of income and output: aggregate demand-Aggregate supply Approach and saving-investment Approach. " Key Assumption: 1.Prices are constant,at given price level firms are willing to sell any amount of the output at that price level.+ 2.Investment is assumed to be autonomous and ti Ni independent of the income level. 3.There exist only two sectors in the economy,the households and the firms.Aggregate demand is the total amount of goods demanded in an economy.the aggregatedemand function can be expressed as: AD=C+I where,C=Aggregate demand for consumer goods =aggregate demand for investment goods. 4.Short run aggregate supply curve is perfectly elastic or flatAggregate demand Hi * Aggregate demand is the total amount of goods demanded in an economy. So, aggregate demand =consumption demand+investment AD=C+I * CONSUMPTION DEMAND: Consumption function is a relationship between income and consumption expenditure. The most common form of short run consumption function is | C=a+by, Were, ais the intercept term of the function and represents autonomous consumption whereas b represents the slope of consumption function.In keynes theory current consumption expenditure depends primarily on current income and it varies directly with disposable income.keynes had stated in his ‘fundamental psychological law’ that, in general an individual increase his consumption expenditure when his income increases.So, the increase in consumption is less than the increase in income* Consumption function ceatby consumption expenditure consumption function ceatby national income* Explaination 7 In above figure 1. ]national income is measured along the a-axis and consumption demand [C] is shown on the Y-axis.in ths fig,a straight line OZ with 45degree angle with the X-axis represents the references income line to measure the difference between consumption and level of the income.This is also often called income line.this 45 degree line represents national income in money terms.In fact,national product and income are the same thing.In this fig a curve C has also been drawn which represents consumption function,C=a+by of the community which slopes upward from left to right,which shows that as income increase the amount of consumption demand also increases.as income line oz makes 45 degree angle with x-axis, the gap between the consumption function curve c and the income line oz represents the saving of the community .So y=C+S.+ Investment demand Ly investment incomeexplaination: ct * The other component of the aggregate demand is inves. which is crucial factor in the determination of equilibrium level of national income .investment demand depends upon two factors;1.marginal efficiency of capital and 2.rate of interest. The marginal efficiency of capital means the expeted rate of profit which the business community hopes to get from the investment in capital assets. In keynes theory investment being determined by marginal efficiency of capital and rate of interest does not depend on the level of income. As it is shown in fig.2.In actual practice, when the level of -f income rises,the demand for goods win also rises and this will favourably affect the expectations of the entrepreneurs regarding making of profits.Rise in profit ecpectations will raise the marginal eeficiency of capital which in turn will increase the level of investment .But investment demand does not directly depend upon income;it is only affected indirectly by changes in income.In fig.3 we have taken a given amount of investn Ci demand independent of the level of income and a it to upward sloping consumption function curve to get aggregate expenditure curve C+ AE=Y aggregate N\ expenditure, y aggregate demand national income(Y)The distance between the c curve ¢ Ci the C+I curve is parallel to the c curve throughout which indicates that the level of investment is constant and does not change with the change in income it may however be noted that with either change in the rate of interest or marginal efficiency of capital investment will change .Aggregate output Ci In the short run the level of national income and employment in a free market economy depends upon the equilibrium between aggregate expenditure and aggregate output. keynes assumed : prices and wages remain constant in the short run. National income means the total money value of goods and services produced in an economy ina year. Constituents of aqqreqate output 1.the supply or output of final consumer goods and services in a year; and 2.the output of capital goods which are also called producer goods because they help in producing further goods, Aggregate output which is also referred to as aggregate supply of goods of an economy depends upon the stock of capital, the amount of labour used and the state of technology. Production function in the short run. Y=(N,K,T) where, y is national income ,K is the constant amount of capital stock, T is the constant state of technological and n is labour employed which is variable factorw 45 degree line as aggregate output with (fixed prices) we need to compare GDP or N.Y with aggregate expenditure or aggregate demand which is represented on vertical axis. For this purpose we draw 45 degree line from the origin which helps to transfer GDP or N.Y from the horizontal axis to vertical axis aggregate output YeC4S aggregate output curve x national income or GDPeye . ° + Equilibrium _income ty aggregate exp. aggregate BEER or AD expenditure Ceasby yl x+ Explaination Qh Through the the intersection of aggregate demand ana aggregate supply curves the equilibrium level of national income is determined in keynes’s two sector model.C+I curve represents the aggregate expenditure and 45 degree oz line represents aggregate supply of output.the goods and services are provided by firms when they think they can sell them in themarket.there will be equilibrium in the goods market when total output of goods and serviceproduced will be equal to the total demand for them is represented by aggregate expenditure.in equilibrium aggregate expenditure must equal aggregate output.since aggregate output or GDP equals national income we have the following condition for equilibrium. AE=GDP=Y.In the fig 5 that aggregate expenditure curve or Ci curve intersects 45degree line at point E whic satisfies the equilibrium condition.that is a,point E which corresponds to the income level OY1,aggregate expenditure is equal to aggregate output.therefore,E is the equilibrium point and OY1 represents the equilibrium level of national income.now,income cannot be in equilibrim at levies smaller than OY1,since aggregate expenditure exceeds aggregate supply of demand will be met by the firms selling goods from their stocks or inventories of goods kept by them.this leads to the decline in inventories of goods below the desired levels.On the country,the equilibrium level of nation Ci income cannot be greater than OY | because at any level greater than OY1 aggregate expenditure or demand[C+I] falls short of aggregate output.This will cause the increase in inventories of goods with the firms beyond the desired levels. Thus deficiency in aggregate demand relative the aggregate supply of output will lead to the fall in national income and output until the level OY 1 is reached where aggregate expenditure[C+I]is equal to the value of aggregate output.Thus,OY 1 is the equilibrium level of national income.