Assignment on

Keynesian Model of Income

Course Code: AES 123

Course Title: Macro Economics

Submitted to:
Anup Kumar Mandal
Assistant Professor
Department of Economics and Sociology
Faculty of Business Administration and Management
Patuakhali Science and Technology University

Submitted by:
Md. Mamun Sarder
ID: 1703039
Reg : 07680
Faculty of Business Administration and Management
Patuakhali Science and Technology University

Date of Submission: October 31, 2018

 Keynesian Model of Income

Introduction
John Maynard Keynes (1883-1946) was a British economist whose ideas fundamentally
changed the theory and practice of macroeconomics and the economic policies of governments.
He develops the model of income known as Keynesian model of income determination. In
1936, Keynes had published The General Theory of Employment, Interest and Money, a book
that revolutionised economic theory in the same way that Charles Darwin’s The Origin of
Species revolutionised biology. This so-called Keynesian revolution was grounded in a new
theory of income determination; a theory based on the concept of:
• The 'consumption function',
• The 'liquidity preference theory of interest', and
• The ‘inflexibility of money wages’.

The consumption function referred to a relationship between total consumer spending and
national income, such that consumer spending always rises less than proportionately with
income, leaving a savings gap that only private or public investment can fill. The liquidity
preference theory of interest emphasised the role of interest rates as the reward for doing
without the advantages of money as the only perfectly liquid asset. The inflexibility of money
wages, the most controversial of Keynes' leading principles, was grounded on a realistic
appreciation of labour markets in a modern industrial economy.
With the General Theory, as it became known, Keynes sought to develop a theory that could
explain the determination of aggregate output - and therefore, employment. Among the
revolutionary concepts initiated by Keynes was the concept of a demand-determined
equilibrium wherein unemployment is possible, the ineffectiveness of price flexibility to cure
 Keynesian Model of Income | 2

unemployment, a unique theory of money based on "liquidity preference", the introduction of

radical uncertainty and expectations, the marginal efficiency of investment schedule breaking
Say's Law (and thus reversing the savings-investment causation), the possibility of using
government fiscal and monetary policy to help eliminate recessions and control economic
booms. Indeed, with this book, he almost single-handedly constructed the fundamental
relationships and ideas behind what became known as "macroeconomics".
Before the General Theory, economists could not explain how economic depressions happen,
or what to do about them. After 1936, they could. Full employment, Keynes concluded, could
be maintained in a capitalist economy but only if governments are willing to incur
countercyclical budgetary deficits to offset the inbuilt tendency towards private over-saving.
For a stretch of about 25 years, many economists turned their backs on Keynes. They claimed,
with some justice, that he made assumptions that could not be rigorously justified. Moreover,
the problems facing the world in the 70s and 80s were non-Keynesian in nature; inflation rather
than deflation, inadequate saving rather than deficient demand. For a while various anti-
Keynesian ideas - ranging from mathematically impeccable academic demonstrations that
recessions cannot happen, to popular doctrines like supply-side economics - seemed to have
crowded Keynes off the stage.

Basic Analysis
According to the Keynesian model, Aggregate Demand and Aggregate Supply is used to
determine the equilibrium level of income and output in the economy.
Aggregate Demand - the money value of all the goods and services that all the different sectors
of the economy are PLANNING to BUY during the given time period at the given level of
income. (total planned expenditure by the economy)
AD = C + I +G + (X-M)
C = Private consumption expenditure
I = Investment Expenditure by firms
G - Govt expenditure
X-M = Net exports
Aggregate Supply - is the money value of all the goods and services that all the firms are
PLANNING to PRODUCE during the given time period. (total planned production by the
economy)
AS = National Income (by product method)
so, AS - Y
Income generated is either consumed (C) or saved (S)
so, Y - AS - C+S
 Keynesian Model of Income | 3

Equilibrium - the economy is at equilibrium when:

1. AD = AS : planned expenditure = planned output

Proof:
If AD > AS (to the left of E): the consumers are willing to buy more than what firms are
willing to produce -+ planned output is insouciant due to high demand firms will increase the
level of output -+ till AS rises and becomes equal to AD.
If AD < AS (to the right of E) : the consumers are willing to buy less than what firms are
planning to produce —+ excess stock -+ to clear this unwanted high level of output due to lack
of demand, firms reduce output -4 AS falls and becomes equal to AD.
2. S = I : Planned saving = planned investment
Because at equilibrium, AD = AS

• —i C + I = C + S ( from above definition of AD and AS)

• —+1 = S (C is same)

(I-X) Y
 Keynesian Model of Income | 4

Determinants of Income
The determinants of effective demand and so of equilibrium level of national income and
employment are the aggregate demand and aggregate supply
➢ What is Effective Demand?
Effective demand represents that aggregate demand or total spending (consumption
expenditure and investment expenditure) which matches with aggregate supply (national
income at factor cost)
In other words, effective demand is the signification of the equilibrium between aggregate
demand (C+l) and aggregate supply (C+S). This equilibrium position (effective demand)
indicates that the entrepreneurs neither have a tendency to increase production nor a tendency
to decrease production. It implies that the national income and employment which correspond
to the effective demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income and
employment emphasizes that the equilibrium level of employment would not necessarily be
full employment. It can be below or above the level of full employment.

➢ Aggregate Demand (C+I)

Aggregate demand refers to the sum of expenditure, households, firms and the government is
undertaking on consumption and investment in an economy. The aggregate demand price is
the amount of money which the entrepreneurs expect to receive as a result of the sale of output
produced by the employment of certain number of workers. An increase in the level of
employment raises the expected proceeds and a decrease in the level of employment lowers it.
The aggregate demand curve AD (C+l) would be positively sloping signifying that as the level
of employment increases, the level of output also increases, thereby increasing of aggregate
demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the level of
real national income and indirectly on the level of employment.
 Keynesian Model of Income | 5

➢ Aggregate Supply (C+S)

The aggregate supply refers to the flow of output produced by the employment of workers in
an economy during a short period. In other words, the aggregate supply is the value of final
output valued at factor cost. The aggregate supply price is the minimum amount of money
which the entrepreneurs must receive to cover the costs of output produced by the employment
of certain number of workers
The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other
part is saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S)
is positively sloped indicating that as the level of employment increases, the level of output
also increases, thereby, increasing the aggregate, supply. Thus, the aggregate supply (C+S)
depends upon the level of employment through4he economy's aggregate production function

➢ Determination of Level of Employment and Income

According to Keynes, the equilibrium levels of national income and employment are
determined by the interaction of aggregate demand curve (AD) and aggregate supply curve
(AS). The equilibrium level of income determined by the equality of AD and AS does not
necessarily indicate the full employment level the equilibrium position between aggregate
demand and aggregate supply can be below or above the level of full employment as is shown
in the curve below.
Diagram/Figure:
Effective

Real National Income

In this figure, the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at
point El which is an effective demand point. At point El the equilibrium of national income is
OYI Let us assume that in the generation Of OYI level of income, some of the workers Willing
to work have not been absorbed It means that El (effective demand point) is an under-
employment equilibrium and OYI is under employment level of income.
The unemployed workers can be absorbed if the level of output can be increased from OYI to
OY2 which we assume is the full employment level. We further assume that due to spending
by the government, the aggregate demand curve (C+I+G) rises. As a result of this, the economy
 Keynesian Model of Income | 6

moves from lower equilibrium point El to higher equilibrium point E2 The OY is now the new
equilibrium level of income along with full employment. Thus, E2 denotes full employment
equilibrium position of the economy.
Thus, government spending can help to achieve full employment. In case the equilibrium level
of national income is above the level of full employment, this means that the output has
increased in money terms only. The value of the output is just the same to the national income
at full employment level.

➢ Importance of Effective Demand

The principle of effective demand is the most important contribution of J.M. Keynes. Its
importance in macro economics, in brief, is as under:
(i) Determinant of employment. Effective demand determines the level of employment in the
country. As effective demand increases employment also increases. When effective demand
falls, the level of employment also decreases.
(ii) Say's Law falsified. It is with the help of the principle of effect ve demand that Says Law
of Market has been falsified. According to the concept of effective demand whatever is
produced in the economy is not automatically consumed. It is partly saved. As a result, the
existence of full employment is not possible
(iii) Role of investment. The principle of effective demand explains that for achieving full
enWoyment level, real investment must equal to the gap between income and consumption. In
other words, employment cannot expand, unless investment expands. Therein lies the
importance of the concept of effective demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich
community, the gap between income and expenditure is large. If required investment is not
made to fill this gap, it will lead to deficiency of effective demand resulting in unemployment

Keynes’s arguments against the effectiveness of the market system

Keynes argued that relying on markets to get to full employment was not a good idea. He
believed that the economy could settle at any equilibrium and that there would not be automatic
changes in markets to correct this situation.
The main Keynesian theories used to justify this view were:
• An imperfect labour market
• The existence of a ‘money market’ and not merely a ‘loanable funds market’
• The Multiplier coefficient
• Keynesian inflation theory
 Keynesian Model of Income | 7

➢ The labour market

Keynes did not have the same confidence in the labour market as Classical economists. He
argued that wages would be 'sticky downwards'. In other words, workers would not be happy
about taking wage cuts and would resist this. This would mean that wages would not
necessarily fall enough to clear the market and unemployment would linger. This can be seen
in the diagram below:

Figure: How a freely competitive labour market would reduce unemployment

According to Classical theory, when the demand for labour falls from D1 to D2 (perhaps due
to the onset of a recession), the wage rate should fall in order for the market to clear. However,
Keynes argued that because wages were sticky downwards, this would not happen, and an
unemployment level of ab would persist. This unemployment he termed demand deficient
unemployment.

➢ The money market

Classical economists were of the view that savings would need to be increased in order for
more funds to be available for investment. This would occur when interest rates fall.
Keynes disputed this assumption - once again because he had less faith in markets as the
economic miracle cure. He argued that any increase in savings would mean that people spend
less; and as interest rates declined, excess funds would be held for speculative purposes. Lower
interest rates mean higher bond prices. Hence, more idle money balances or liquidity would
induce speculators to ‘wait’ for higher interest rates and lower bond prices. This is known as a
‘bear’ market, while a market where bond prices are expected to increase is known as a ‘bull’
market.
The point is that, as aggregate demand declines, firms would not be inclined to invest because
they would find the demand for their products decreasing. This occurs in spite of low interest
 Keynesian Model of Income | 8

rates. Keynes believed that while the demand for liquidity is interest elastic, investment
depended much more on business expectations, than on interest rates.
➢ The Multiplier
Any increase in aggregate demand in the economy would result, according to Keynes, in an
even bigger increase in National Income. This process comes about because any increase in
demand would lead to more people being employed. If more people were employed, then they
would spend the extra earnings. This in turn leads to even more spending, which leads to even
more employment, which leads to even more income and which would then lead to even more
spending. The length of time this process went on for would depend on how much of the extra
income was spent each time. If the initial recipients of the extra income saved it all, then the
process would stop very quickly as no-one else would get their hands on the extra income.
However, if they spent it all, the knock-on effects of the extra spending would carry on for
some time.
Therefore, the higher the level of leakages, the lower the multiplier would be. The precise
formula for calculating the multiplier in a two-sector closed economy is:

1
Multiplier =
1 - Marginal propensity to consume

Multiplier = 1
1 - Marginal propensity to consume

➢ Keynesian view of inflation

The key to the Classical view of inflation was the Quantity Theory of Money. This theory
revolved around the Fisher Equation of Exchange:
MV = PT
Where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
Keynes once again rejected this classical theory. He argued that increases in the money supply
would not inevitably lead to increases in inflation. Increasing M may instead lead to a decrease
in V. In other words, the average speed of circulation of money would fall because there was
more of it about.
 Keynesian Model of Income | 9

A MACROECONOMIC IDENTITY

Y=C+S+T

INCOME IS THE SUM OF:

o THE PART YOU SPEND,

o THE PART YOU DON’T SPEND,

o THE PART YOU NEVER SEE!

Alternatively, the increase in M may lead to an increase in T, rather than to an increase in P.

Once again, Keynes disputed the assumption that the economy will find its own equilibrium
through changes in the price level. Hence, if the economy is in a position where there is
insufficient demand, increasing the money supply may fund extra demand and move the
economy closer to full employment.

The Simple Keynesian Model

Suppose a factory with a wages payroll of BDT 50,000 locates in Dumki, Patuakhali, a small,
isolated, suburban community. Suppose further that the BDT 50,000 is the only money that the
factory spends in the community, that all employees live in Dumki, and that each person who
lives there spends exactly one half of his income locally. By how much will the income of
Dumki rise as a result of the new factory?
The BDT 50,000 will be an addition to Dumki income. But the story does not end here because,
by assumption, the people who earn the payroll will spend one half of it, or BDT 25,000, in the
community. This BDT 25,000 will become income for the shopkeepers, plumbers, lawyers,
teachers, etc. Thus, Dumki income will rise by at least BDT 75,000. But the story does not end
here either. The shopkeepers, plumbers, etc. who received the BDT 25,000 will in turn spend
one half of their new income locally, and this BDT 12,500 will become income for other people
in the community. Total Dumki income is now BDT 87,500. The process will, by geometric
progression, continue on and on, and on, and as it does, total income will approach BDT
100,000.
Note that the initial BDT 50,000 in income expands to BDT 100,000 once it is injected into the
system. There is a multiplier effect; the size of which depends on the percentage of income
people spend within the community. The smaller the percentage, the more quickly the extra
income leaks out of the economy and the smaller the multiplier.
 Keynesian Model of Income | 10

Central in the income-expenditure model is an assumption about how people spend; the
consumption function. The consumption function positively relates the amount people spend
with their income. As income increases, so does consumption.
The table below illustrates a consumption function. It says that if people expect incomes of
BDT 10,000, they will spend BDT 12,500. This amount of spending is possible if people plan
to dissave, which means that they use past savings or sell other assets. The table says that when
expected income is BDT 30,000, people will spend BDT 27,500 which means that they plan to
save BDT 2,500.

Table 1: A Consumption Function

Expected Income Consumption Expected Savings

BDT 10,000 BDT 12,500 -BDT 2,500

BDT 12,000 BDT 14,000 -BDT 2,000

BDT 20,000 BDT 20,000 0

BDT 30,000 BDT 27,500 BDT 2,500

The table shows that if expected income rises by BDT 2,000, from BDT 10,000 to BDT 12,000,
people will increase their spending by BDT 1,500, or that they will only spend three-fourths of
additional income that they expect to receive. This fraction of additional income that people
spend has a special name; the marginal propensity to consume (or mpc for short). In the table
above the mpc is always three-fourths or 0.75. Thus, if income increases by BDT 8000, from
BDT 12,000 to BDT 20,000, people increase spending by BDT 6,000, from BDT 14,000 to
BDT 20,000.
The marginal propensity to consume can be computed with the formula:
MPC = (change in consumption) ÷ (change in income)
In addition, economists often talk of the marginal propensity to save, which is the fraction of
additional income that people save. Since people either save or consume additional income,
the sum of the marginal propensity to save and the marginal propensity to consume should
equal one.
The value of the marginal propensity to consume should be greater than zero and less than one.
A value of zero would indicate that none of additional income would be spent; all would be
saved. A value greater than one would mean that if income increased by BDT 1.00,
consumption would go up by more than a euro, which would be unusual behaviour.
The consumption function can also be illustrated with an equation or a graph. The equation that
gives the consumption function in the table above is:
 Keynesian Model of Income | 11

Consumption = BDT 5,000 + (3/4) × (expected Income)

Where BDT 5000 is autonomous consumption and (3/4) * (expected Income) is induced
consumption

Proof:
S = Y – C, where C = a + bY
C = a + bY
S = Y – (a + bY)
S = – a + (1 – b) Y
S = Y – a – bY
C + S = 0 + bY + (1 – b) Y
S = – a + Y – bY
C + S = (b + 1 – b) Y
S = – a + (1 – b) Y
C + S = Y and
S=–a+sY
b+s=1
where: b = MPC and s = MPS

Thus, if people expect an income of BDT 10,000, this equation says that consumption will be:
Consumption = BDT 5,000 + (3/4) × (BDT 10,000) = BDT 5,000 + BDT 7,500 = BDT
12,500 and

Savings (Dissaving) = - BDT 5,000 + (1/4) × (BDT 10,000) = - BDT 5,000 + BDT 2,500 = (-
BDT 2,500) Graphing the consumption function presented above yields a straight line with a
slope of 3/4 shown below. If the slope of the consumption function, which is the mpc, never
changes, the consumption function is linear. If the mpc changes as income changes, then the
consumption function will be a curved line, or a nonlinear consumption function. The BDT
5,000 autonomous consumption is shown on the graph as the intercept, which indicates the
amount of consumption if expected income is zero. The logical equilibrium condition in this
model is that expected income should equal actual income.
In the table we see that BDT 20,000 will be the equilibrium income. When people expect
income to be BDT 20,000, they behave in a way that makes their expectations come true. We
can show the solution on a graph by adding a line that shows all the points for which actual
income equals expected income. These points will form a straight line that will bisect the graph,
shown below, as a 45° line. Equilibrium income occurs in the model when the spending line
intersects the 45° line.
 Keynesian Model of Income | 12

Figure: The Consumption function at equilibrium, denominated in thousands of euros

The significance of taxes in the Keynesian model

Introducing taxes into an income-expenditure model means that people base consumption
decisions not on total income, but on disposable income. Furthermore, total income never gets
to households because it stays in the business sector as depreciation or as retained earnings,
and there are a number of adjustments involving both taxes and transfer payments such as
subsidies and social benefits.
But for the sake of simplicity, the only adjustment to be made in this model is direct taxation.
Disposable income will be total income less taxes. Note that increases or decreases in taxes
will change the relationship between expected income and consumption. This is illustrated in
the table below.

Table 2: Taxes in the Income-Expenditure Model

Expected
Expected Government Actual
Taxes Disposable Consumption Investment
Income Spending Income
Income

BDT 12,500 BDT BDT 10,000 BDT 12,500 BDT 500 BDT 2,000 BDT
2,500 15,000
BDT 14,500 BDT BDT 12,000 BDT 14,000 BDT 500 BDT 2,000 BDT
2,500 16,000
BDT 22,500 BDT BDT 20,000 BDT 20,000 BDT 500 BDT 2,000 BDT
2,500 22,500
BDT 32,500 BDT BDT 30,000 BDT 27,500 BDT 500 BDT 2,000 BDT
2,500 30,000
 Keynesian Model of Income | 13

From expected income in column one, taxes are subtracted to give an expected disposable
income. The consumption decisions in column four are based on this expected disposable
income. The next two columns showing investment and government spending are similar to
the fourth column in Table Two.
Actual income at each level of expected income is attained by adding together consumption,
investment, and government spending. Since spending by some is income for others, this
summation gives us total income, which is shown in the last column. Equilibrium in this table
should exist when expected income equals actual income, which happens when actual income
is BDT 22,500.
The addition of government spending and taxes gives government a role in determining the
level of national income. In this model, when government increases spending by BDT 1.00,
income rises by more than a euro because of the multiplier effect. When government increases
taxes, expected disposable income decreases and people reduce consumption. Through the
multiplier process, national income falls by a multiple of the change in taxes. The use of
discretionary or automatic changes in government spending or taxation, with the goal of
changing national income, is called fiscal policy.
Changes in government spending and taxes both have the same effects on consumption in this
table. A one euro increase in government spending increases consumption spending by three,
as does a one BDT decrease in taxes. The reason that they have different multiplier effects is
that the change in government spending not only induces a change in consumption but also
gets counted in spending, whereas the change in taxes does not get counted.

The Feedback Loop

The diagram below illustrates the cause and effect relationship between variables, sometimes
referred to by economists as the feedback loop. This is central in the income expenditure
model. Consumption, investment, and government spending determine actual income. Actual
income and taxes determine expected disposable income, and finally expected disposable
income determines what consumption will be.
 Keynesian Model of Income | 14

The feedback loop is the reason why investment and government spending have multiplier
effects. A drop-in investment, for example, begins by reducing actual income by the amount
of the drop. Then the lower level of actual income changes expected income, and consumption
also declines. Hence a BDT 1.00 decline in investment will, according to the logic of this
model, cause a decline in income of more than BDT 1.00.
There are holes in the bucket, national income equilibrium can be illustrated with an analogy
to a leaky bucket. In the leaky bucket higher levels of water create more pressure and thus
faster leakage. An equilibrium level of water occurs when the leakage just equals the inflow of
water, and the water line remains stable.

In the income-expenditure model, investment and government spending are inflows and taxes
and expected saving are leakages. As income increases, so does leakage in the form of expected
savings. Just as there will be only one level of water in the bucket for which leakages will equal
inflows, so there will be only one level of income in the model for which leakages will equal
inflows.
In the top part of the illustration below, the difference between the C and the C+I+G lines is
investment plus government spending, which the bottom part graphs separately as the I+G line.
Because the distance between the C line and the C+I+G line is constant in the top part, the I+G
line is flat in the bottom part. In other words, investment and government expenditure are
considered as autonomous variables. The difference between the 45° line and the C line is the
difference between expected income and consumption, or taxes plus planned savings, which is
graphed as the S+T line in the bottom part. Because the C line begins above the 45° line
(autonomous consumption), the S+T line in the bottom part begins with a negative value
 Keynesian Model of Income | 15

(dissaving’s). It rises to zero when the C line crosses the 45° line, and then continues to rise as
the gap between the 45° line and the C line widens.

Figure : National Equilibrium in a closed three sector economy

Equilibrium exists when the C+I+G line crosses the 45° line. At this level of expected income,
the distance between the C and the C+I+G lines (which is investment plus government
spending) just equals the distance between the C line and the 45° line (which is savings plus
taxes). Thus, equilibrium exists when investment plus government spending equals expected
savings plus taxes.

Keynes’s income vs. Gross National Product

The definition of income is a headache for accountants as well as economists. By assuming
perfect competition, Keynes the economist is able to determine the opportunity cost of an
existing capital-good as the highest net present value of its prospective yield placed upon it by
any investor, and this is sufficient for causal analysis. For the accountancy profession, the
policies for the valuation of inventories, work-in-progress and fixed assets are perennial meat
and drink, since market prices are not readily available for most existing capital-goods, and
both shareholders and tax inspectors require an alternative and verifiable measure. The
preference for historic cost (backed up by invoices) is understandable, even if sometimes it
leads to measures of reported income which differ substantially from economic income.
Keynes’s aggregate income Y lies somewhere between GNP (gross national product at factor
cost) and NNP (net national product), and his aggregate net income (Y - V) does not correspond
 Keynesian Model of Income | 16

to NNP. GNP is calculated without deducting the user cost of fixed capital equipment. NNP
deducts all three forms of capital consumption, including windfall losses that Keynes deducts
from capital and not income, since capital consumption is calculated by a comparison of the
estimated values of the opening and closing capital equipment. National income accountants
have become increasingly sophisticated in bringing their valuations of fixed capital and stocks
(inventories) closer to economic values, and to derive better ‘real’ measures (e.g. by chain-
linked indices) but their work remains an art and not an exact science. The above reference to
national rather than domestic income is deliberate, partly because The General Theory does
not, as generally thought, describe only a closed economy (see Chapter 3 of this book).
Keynes’s definition of income as the value of output rather than expenditure avoids the
concentration on the ‘circular flow’ of income and expenditure characteristic of Old Keynesian
economics, into which fits awkwardly the net factor income from foreign sources that is the
difference between GDP and GNP.

Remarks
This assignment is about ‘Keynesian Model of Income’ and it contains the information about
Model of income determination and relevant topics of it. As short of knowledge most of the
information of this assignment I have collected from internet and different books mostly online
copy. Doing this assignment I feel that how long could be a simple income model! I also feel
honour to my course teacher Anup Kumar Mandal from Department of Economics and
Sociology of Patuakhali Science and Technology University who assigned me to do such an
important topic.