Keynesian Model of Income Determination

Keynesian Model of Income Distribution

J. M. Keynes, a famous economist of the 20th century, is popularly known for his theory of employment and output which is known as the Keynesian theory of employment and output. During the great depression of the 1930s in U.K. and U.S.A, the classical economic model failed to explain and solve the problem which led to higher unemployment. Keynes bitterly criticized the classical theory and developed a systematic theory of employment in his book ‘The General theory of employment, interest and money’ in 1936. While classical economist emphasized the role of supply, Keynes, on the other hand, emphasized on the role of demand in the determination of output and employment.

According to Keynes, the level of employment can be determined by effective demand due to which the Keynesian model is also called the effective demand theory of employment. Keynes argued that the unemployment arises due to deficiency of effective demand. Hence, effective demand should be increased to remove unemployment. Effective demand refers to that situation of equilibrium at which total income is equal to total expenditure. Effective demand is determined by the concept of aggregate demand (AD) and aggregate supply (AS).

In briefly, Keynesian model states that the equilibrium level of national income is determined at the level where the aggregate demand of goods and supply equals their aggregate supply.

Aggregate Demand

Aggregate demand price is the amount of money or proceeds which the entrepreneurs expect to get by selling the output produced by the number of labor employed. The relationship between employment and process is positive i.e. when more labors are employed in the economy the expected proceeds also increase.

The table below shows the aggregate demand schedule. In the table, it is shown that the expected proceeds rise with the increase in the level of employment and it declines at the low level of employment. The aggregate demand function is an increasing demand function of employment which is expressed as AD = f (N), where AD is income expected from the employment of N number of people.

The aggregate demand curve is drawn on the basis of above table. AD curve is the schedule of income expected from the different level of employment. The AD curve is upward sloped because the level of employment and AD are directly proportional.

Aggregate Supply

Aggregate supply represents the different amount of money which the entrepreneurs must get from the sale of output at varying levels of employment. In brief, aggregate supply price refers to the proceeds necessary from the sale of output at a particular level of employment.

­The table below shows the aggregate supply schedule. The table shows the aggregate supply schedule which reveals that the aggregate supply rises with the increase in the level of employment. The aggregate supply function is and increasing function of the level of employment expressed as AS = f (N).

The aggregate supply curve is drawn on the basis of above table. As curve is the schedule of the minimum amount of proceeds required to induce varying quantities of employment. The As curve is upward sloped from left to right because the level of employment and necessarily expected proceeds are directly proportional.

Determination of effective demand

The principle of effective demand is the core principle of Keynesian economics. Effective demand is the point at which aggregate demand (AD) curve and aggregate supply (AS) curve intersect.

The table below explains about the determination of effective demand.

As per the table above, as long as the aggregate demand is greater than aggregate supply, it is economic for the business firms to employ more labors. When the necessary proceeds equal the expected proceeds (26 crores), the AD and AS curve intersects were affected demand in determined. It is the equilibrium employment level but this is not the full employment. To obtain full employment a new AD schedule is necessary which is shown in 3^rd column in the table above.

In the figure, AD₁ and AS curve intersect at point E. This is the effective demand where ON labors are employed. To the right of E expected proceed is less than required proceed which leads to reducing in the level of employment. To the left of E, expected proceed is greater than required proceed which leads to increase in the level of employment,

To get full employment, E should shift rightward and it is possible by increasing aggregate demand. The new aggregate demand curve AD₂ is drawn where ON_f id the level of full employment at new effective demand E’. Hence E’ is the point of equilibrium which provides an optimal level of employment CN_f.

Income determination in a two-sector economy

Two sector economic model consists of only two sectors: household and business firms where there are no government interventions. Apart from this the assumption of two sector economy are summarized below:

• Comprises only two sectors. Households own the factors of production and provide factor services to the business sector while the business firm hires factor services from households, produce goods and services and sells those goods and services to the households.
• There is no any role of government in economic activities.
• It is a closed economy where there is no involvement of foreign sectors.
• There are no corporate savings i.e. total corporate saving is distributed as dividends to shareholders,
• Prices of goods and services, supply of labor and capital and production technology remain constant.

According to income determination theory of Keynesian economics, the equilibrium level of national income is determined at the point where aggregate demand is equal to the aggregate supply. Thus the national income is determined as:

AD = AS ----------------- (i)

C + I = C + S --------------- (ii)

At the equilibrium level of national income, Y = C + I. Similarly, it is assumed that C = a + by and I is constant. So, the equation (ii) will be

Y = a + by + I

Y – by = a + I

Y (1 - b) = a + I

Y= 1/(1 - b) * (a + I) -----------------(iii)

On the basis of equation (iii), we can conclude that the equilibrium level income in two sector economy is the sum of (a + I) times the value of multiplier .

Graphical representation of national income determination in the two-sector economy

In the figure, above C + I schedule represents the AD. AD schedule intersects AS schedule at point E, which is called equilibrium point. At this point, the income is determined.

As per the figure, at point E the income is RS 200 which is the national income of the country. In the schedule, before point E, AS is greater than AD i.e. the goods and services are costing more than RS 200. In such situation, the households are not willing to buy. As a result, the supply of goods and services exceeds the demand.

On the other hand, after point E, the aggregate demand is more than aggregate supply. In such situation, the business firms are producing less goods as compared to consumer’s demand. Finally, the firms increase the production to meet consumer’s need.

Change in aggregate demand and investment multiplier

Aggregate demand, in two sector economy, is composed of consumption expenditure and business investment. Hence a change in aggregate demand is induced due to the change in consumption expenditure of business investment or both. Consumption expenditure changes with a change in income only. But when the economy is in equilibrium, income if kept constant and hence there is no change in consumption expenditure. It is therefore assumed that the change in business investment causes a change in aggregate demand. Change in investment can either be increasing or decreasing. For our purpose, we assume the increasing effect of the investment on aggregate demand.

The figure below illustrates the upward shift in investment schedule from I to I + ΔI, causing an upward shift in aggregate demand function from C + I to C + I + ΔI. The upward shift in aggregate demand results in an increase in national income. The initial aggregate demand schedule is shown by C + I. It intersects aggregate supply schedule C + S at point E1 where the national income is determined at Y1. When the investment increases and aggregate demand also rises , the equilibrium point of national income shifts from E1 to E2. As a result of national income shifts from Y1 to Y2.

The increase in national income is, ΔY = Y2 – Y1

Investment multiplier

In order to find the investment multiplier, let’s look at the relationship between ΔI and ΔY.

From the figure above, at equilibrium point E1, Y1 = C + I

Since, C = a +by, by substitution, we get

Y1 = a + bY1 + I

Y1 = 1 / (1-b) * (a + I) ---------------------- (i)

Similarly, at equilibrium E2, Y2 = C + I + ΔI

Y2 = a + bY2 + I + ΔI

Y2 = 1 / (1-b) * (a + I + ΔI) ------------------------- (ii)

Subtracting equation (i) from (ii), we get

ΔY = 1 / (1-b) * ΔI ----------------------- (iii)

The equation (iii) gives the relationship between ΔY and ΔI. ΔY is 1 / (1-b) times ΔI. Therefore, 1 / (1-b) is the Investment multiplier.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.