Chapter # 3
Keynesian Theory of Income and
Employment
Chapter`s outlines
• Introduction to Keynes` Theory
• Determination of NI in two sector
economy.
• Two methods for determination of
National Income.
1. AD & AS method.
2. Saving & Investment Method.
• Determination of NI in three sector economy.
numerical examples.
Introduction to Keynes theory
• In the year 1936 Lord John Maynard Keynes’
General Theory of Employment, Income and Rate
of Interest was first published..
• His followers Harrod, Domar, Kaldor, Solow etc.
have ever since widened the scope of
macroeconomic analysis.
Introduction…….. Cont`d
• Keynes has introduced a variety of new tools of
analysis.
• His equations of income and expenditure,
consumption function, law of marginal propensity
to consume (MPC), Multiplier operations,
Investment Function and Marginal Efficiency Of
Capital (MEC), identity between Savings and
Investment, and monetary Liquidity Preference
Theory of interest accompanied by speculative
motive for demand for money are some of his
important contributions.
Introduction…….. Cont`d
• Keynes denied the classical belief that the free
enterprise system is a self regulating one and
asserted that such a system requires periodic
intervention of the public authority to avoid
fluctuations and instability in economic activities.
• Besides, Keynes was building an entirely new
structure of economic analysis to study and
redress the problem of unemployment..
Determination of Equilibrium
level of NI in TWO Sector
Economy
Assumptions
1
2
3
4
5
Two sector economy i.e. consumer and
producers Y= C+I
The consumption expenditures (C) has the
following equation C= Co + cY
The investment expenditure (I) consist of
autonomous investment
The saving equation is as S= -So + sY
The output side of NI will be as Y= C + S
Two methods
1 AD and AS Method
2 Saving and Investment Method
1
AD and AS Method
Aggregate Demand (AD) Y = C + I
• Total demand for goods and services
produced in a year
» OR
• Total National expenditure incurred
on the final goods and services
produced in a country.
Aggregate Supply (AS)
Y = C+S
• In a two sector economy, “AS”
consist of total output produced in
the economy .
» OR
• “AS” is a national income which has
been produced by the factor of
production.
Determination of equilibrium
Level of NI
C+ I < C+S
Y
C+S
B
C+I
C+ I= C+S
.
E
C+ I > C+S
A
0
Y1
Y2
Y3
National income
x
Explanation of Graph
• In this figure the equilibrium level of NI is determined at E
where C+I=C+S, and OY2 is the equilibrium level of NI.
• The equilibrium can not take place at point OY1 because
here C+I > C+S. This would lead to increase in income.
Similarly at OY3, C+I < C+S which would have the effect
of reducing the income of the country.
• Thus we find that it is OY2 level of income where
aggregate demand is equal to aggregate supply.
Numerical explanation of NI determination
in two sector Economy --- AD/AS Method
•
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•
If C= 40+0.6Y and I=I0 =80
Then NI Y= C+I
Putting the value of C & I in equation
Y = 40 + 0.6Y + 80
Y- 0.6Y = 120
0.4Y =120 dividing both sides by 0.4
0.4Y/0.4 = 120/0.4
Thus Y = 300
Cont`d
•
•
•
•
•
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And we know that C= 40+0.6(Y)
Put the value of Y in equation, we get C = 40 + 0.6 (300)
C = 40 + 180
C = 220
Now Y = 300, C= 220, so S ?
As Y=C+S
so S= 80= I0
• Hence at Y=300 , S=I so income is determined at level
Y=300
2
Saving & Investment Method
• Saving
The part of income which is not consumed
is called saving.
• Saving depends upon income S= f(Y)
while S = -S0 + sY
• -S0 shows –ve Y and sY shows induced
saving.
Cont`d
• The part of the income which is
spent on the purpose other than
consumption is called investment.
• According to Keynes investment is
autonomous i,e. I=I0
Cont`d
Y
S=f(Y)
Saving & investment
I<S
0
I>S
I=S
A
E
B
Y2
Y3
Y1
.
National income
I=I0
x
Explanation of graph
• In this figure, the equilibrium level of NI is determined
where I=S. Accordingly OY2 is the equilibrium level of NI.
Equilibrium does not take place at OY1 because here I>S,
this would result in increase in income.
• Similarly at OY3, I<S which would result in decrease in NI.
• So we find that OY2 is the equilibrium level of NI.
Numerical explanation of NI
determination in two sector Economy --AD/AS Method
•
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If S= -40+0.4Y and I=I0 =80
Then NI S = I
Putting the value of C & I in equation
-40 + 0.4Y = 80
0.4Y = 120
0.4Y =120 dividing both sides by 0.4
0.4Y/0.4 = 120/0.4
Thus Y = 300 so
S = -40 + 0.4 (300)
S = -40 + 120
•
S = 80 =I
Example to be solved???
• Suppose the consumption function is given by
C= 100+ 0.8Y, while I0 =50
1. What is the equilibrium level of income?
2. What is the level of saving at equilibrium level?
3. If I0 (Autonomous Investment) increases to 100
what will be the new equilibrium level of NI.
Inflationary and Deflationary Gaps
• Inflationary Gaps
The equilibrium level of NI may be at
above full employment. This situation
occurs when at the level of full employment
AD is greater than AS.
Inflationary Gap cont`d
• When level of investment in an economy
exceeds the investment level required to
full employment, the equilibrium level of
NI will be above the full employment level.
This gap between current investment and
required investment level shows a
inflationary gap.
Deflationary Gaps
The equilibrium level of NI may be at
below full employment. This situation
occurs when at the level of full employment
AD is less than AS.
CONT`D
• When level of investment in an economy is
below the investment level required to full
employment, the equilibrium level of NI
will also be below the full employment
level. This gap between current investment
and required investment level shows a
deflationary gap.
Determination of Equilibrium
level of NI in THREE Sector
Economy
Determination of equilibrium level
of NI in three sector economy
1 Three sector economy means- consumer, producers
and Government,
Y= C+S+T & Y=C+I+G
2 The consumption expenditures (C) has the
following equation C= Co + cYd
whereas Yd= Y-T
3 The investment expenditure (I) consist of
autonomous investment, I=I0
Determination of equilibrium level of NI
in three sector economy cont`d
4 The saving equation is as S= -So + sYd
5 G =G0 , is autonomous government
expenditure.
6 AD = Y = C+I+G
AS = Y = C+S+T
&
Cont`d
C+S
Y
Consumption, invest, Govt.
B
C+I+G
C+I
.
E
A
0
Y1
Y2
Y3
National income
x
Numerical example
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If C= 40+0.6Yd , I=80, G=20, T=10
Then Y=C+I+G
Y= 40+0.6[Y-T] + 80+20
Y= 40+0.6[Y -10] +80+20
Y= 40+0.6Y - 6 +80+ 20
Y -0.6 = 134
0.4Y =134
Y = 134/0.4
Y = 335
Cont`d
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Now Putting the value of Y in C
Yd = Y-T
Yd= 335-10= 325
C= 40+0.6Yd
C= 40+0.6(325)
C= 40 +195
C= 235 Hence Y= C + I + G
335=235+80+20
335=335
Example to be solved
• If C = 100+0.75Y, G0= 20, & I0= 50
1 Find the equilibrium level of National
income?
2 Prove that S=I0+G0
Another Example…???
• If C = 100+0.75Yd, (Yd =Y-T) T=20
G0= 20, & I0= 50
1 Find the equilibrium level of National
income?
2 Prove that S+T=I0+G0
THANK YOU