The simple keynesian theory of income determination

The Determination of National Income: It is worth noting here that the Keynesian theory is relevant in the context of the short run only since the stock of capital, techniques of production, efficiency of labour, the size of population, forms of business organisation have been assumed to remain constant in this theory.

The simple keynesian theory of income determination

In the Keynesian theory, employment depends upon effective demand. Effective demand results in output. Since Keynes assumes all these four quantities, viz. Effective demand is determined by two factors, the aggregate supply function and the aggregate demand function.

The aggregate supply function depends on physical or technical conditions of production which do not change in the short-run. Since Keynes assumes the aggregate supply function to be stable, he concentrates his entire attention upon the aggregate demand function to fight depression and unemployment.

Thus employment depends on aggregate demand which in turn is determined by consumption demand and investment demand. Consumption depends on income C Y and when income rises, consumption also rises but not as much as income. In other words, as income rises, saving rises.

Consumption can be increased by raising the propensity to consume in order to increase income and employment.

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But the propensity to consume depends upon the psychology of the people, their tastes, habits, wants and the social structure which determine the distribution of income.

All these elements remain constant during the short-run. Therefore, the propensity to consume is stable. Employment thus depends on investment and it varies in the same direction as the volume of investment. Investment, in turn, depends on the rate of interest and the marginal efficiency of capital MEC.

The MEC depends on the supply price of capital assets and their prospective yield. It can be raised when the supply price of capital assets falls or their prospective yield increases.

The simple keynesian theory of income determination

Since the supply price of capital assets is stable in the short- run, it is difficult to lower it. The second determinant of MEC is the prospective yield of capital assets which depends on the expectations of yields on the part of businessmen.

The simple keynesian theory of income determination

It is again a psychological factor which cannot be depended upon to increase the MEC to raise investment. Thus there is little scope for increasing investment by raising the MEC.

The other determinant of investment is the rate of interest. Investment and employment can be increased by lowering the rate of interest.

The rate of interest is determined by the demand for money and the supply of money. On the demand side is the liquidity preference LP schedule. The higher the liquidity preference, the higher is the rate of interest that will have to be paid to cash holders to induce them to part with their liquid assets, and vice versa.

People hold money M in cash for three motives: The transactions and precautionary motives M are income elastic.

Thus the amount held under these two motives M1 is a function L1 of the level of income Yi. But the money held for speculative motive M2 is a function of the rate of interest ri.

The higher the rate of interest, the lower the demand for money, and vice versa. Since LP depends on the psychological attitude to liquidity on the part of speculators with regard to future interest rates, it is not possible to lower the liquidity preference in order to bring down the rate of interest.

The other determinant of interest rate is the supply of money which is assumed to be fixed by the monetary authority during the short-run. The relation between interest rate, MEC and investment is shown in Figure 1, where in Panels A and B the total demand for money is measured along the horizontal axis from M onward.

In Panel Bthe L2 curve represents the speculative demand for money as a function of the rate of interest. When the rate of interest is R2, the speculative demand for money is MM2.

With the fall in the rate of interest to R1, the speculative demand for money increases to MM1.

The Keynesian Theory

Panel C shows investment as a function of the rate of interest and the MEC. But when the rate of interest falls to R1, investment increases to OI2. Saving is a function of income, i.

This is shown in Panel D of Figure 1 where the horizontal axis from O toward the right represents investment and saving, and OY axis represents income.According to Keynes theory of national income determination in short-run investment (I) remains constant throughout the AD schedule, while consumption (C) keeps on changing.

Therefore, consumption (C) acts as the major determinant or function of income (Y). 1 1 The Simple Keynesian Theory of Income Determination 2 The Simple Keynesian Theory • Some Basic Definitions – Endogenous variables • Output • Consumer Spending.

The Determination of National Income: Keynes's Basic Two Sector Model

Keynes used 'aggregate demand and aggregate supply approach' to explain his simple theory of income determination. The term 'aggregate' is used to describe any quantity that is a grand total for the whole economy. Aggregate demand is the total demand for all commodities (goods and services) in .

Determination of Equilibrium for National Income in a Two Sector Economy: Methods For the Determination of National Income/Keynes Model of Income Determination.

Keynesian model 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: are constant,at given price level firms are willing to sell any amount of the output at that price level.

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