keynsain thory

7/28/2019 Keynsain thory

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According to Keynes the full employment stateis just one of the possible states the economycan be in and there is no reason why the

economy should be automatically at this state.The model introduced here is the SimpleKeynesian Model of Income Determination.The principal tool of analysis in this model is

the 'aggregate demand'. The focus of thismodel is only the goods market and theinfluence of the money market on the goodsmarket is abstracted away. There are certain

assumptions on which this model is built. It isassumed that prices do not change at all andthat firms are willing to sell any amount ofoutput at the given level of prices (the

aggregate supply curve is perfectly elastic).


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It was in the backdrop of great depression of 1930s, Keynestried to explain the causes of depression through the concepts ofaggregate demand, aggregate supply and effective demand. Theconcept of aggregate supply helps understand the functioningof the economy. The given figure helps us to understand the

supply function. The supply function is represented by abackward L shaped curve. Points BA, the horizontal section ofsupply function shows that the prices are stable where anychange in the aggregate demand changes the output level. Thishappens because the economy has not attained full employmentlevel. The vertical section, 'AC', represents full employment and

an increase in the aggregate demand will lead to an increase inthe price. Point A is the full employment level, whereas point Brepresents a situation where an economy functions below thefull employment level. At this point, any increase in the demandfor goods and services can be met by increasing the factors ofproduction without increasing the price till it reaches point A.


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Aggregate demand (AD) is the total or aggregatequantity of output bought willingly at a givenprice level, while other things remain constant. Inother words, aggregate demand is the amount that

firms and households spend on goods and servicesat each level of income.

The following components play an important rolein analyzing the Keynesian aggregate demand:

Consumption Investment

Government purchases

Net exports


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There are various factors that help indetermining the consumption. But the mostimportant factor that determines theconsumption is disposable income. A Prussianstatistician, Ernest Engel, observed thatpercentage of income spent on food and othernecessities falls with rise in the income. This

relationship is known as Engels law. Acountrys consumption expenditure rise asincome rises. This relationship can beexplained with the help of a graph


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Consumption expenditure (C) is one of the importantcomponents of aggregate demand. Although many factorsinfluence the consumption expenditure, income (Y) isconsidered to be the most important influencing factor.

The relationship between consumption and income can be

described using consumption function, C = f(Y). Theconsumption and income are positively related that is,greater the income, greater is the consumption. Let usassume that consumption demand increases linearly withthe increase in income level.

C = a + bY; a > 0, 0 < b < 1 Where a is the consumption when the income level is zero

and b is the slope of the consumption function. brepresents the marginal propensity to consumer (MPC) thatis, rate at which consumption changes for a unit change inincome. The consumption function is shown in the figuregiven below


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Hitherto we assumed that the chief determinant ofprivate consumption and saving is the level ofprivate disposable income. But, consumption andsaving is determined by many factors in addition

to the level of disposable income. Following aresome of the important factors that influence theconsumption and savings function.

Wealth Expectations Taxation policy Distribution of income Age composition


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DISPOSABLE INCOME CONSUMPTION SAVINGS

A 12000 12055 -55

B 12500 12500 0

C 13000 12925 75

D 13500 13300 200

E 14000 13620 380

F 14500 13915 585

G 15000 14180 820


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The 450 line tells us the relationship betweenconsumption and disposable income. The

break even point on the consumption scheduleintersects at 450 line, that shows the disposableincome at which households break even. PointB represents the break even point. At an

income of Rs 14,000, the level of consumptionis Rs 13,620. The fact that 450 line is above theconsumption function shows that consumptionis less than income. The distance between E

and E1

represents consumption and thedistance between E and E11 represents savings.The region on the left of point B shows thedissavings.


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To study the changes in consumption, Keynesintroduced the concept of marginal propensity toconsume (MPC). It can be defined as the

additional amount consumed as a fraction ofadditional disposable income. Mathematically, itcan be denoted as:

MPC = change in consumption / change in

disposable Income


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If the income rises and the consumer does notconsume the additional fraction of the increasein income, then it is saved. The marginal

propensity to save (MPS) is given by,

MPS = change in savings / change in

disposable income


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In a simple economy, without any government intervention orinternational trade, the aggregate demand of an economy has only two

components, consumption and investment. Let us assume that the investment demand is constant at $ 100 billion. To

arrive at the aggregate demand, we have to add $ 100 billion to theconsumption demand. This can be seen in the given figure. In the givenfigure, national product and not disposable income is shown on thehorizontal axis, as in the simple economy NP = DI. When aggregatedemand equals the national product, equilibrium is reached. Aggregate

demand includes consumption and investment in the economy, i.e., AD =C + I. Here the 45o line is cut by the aggregate demand function. Thepoint where the 45o line cuts the aggregate demand indicates equilibriumin the economy i.e., whatever is produced is consumed by the economy.Any point to the right of this equilibrium indicates that the economy isover producing. This results in unsold products, which leads to excessinventory in the economy, which ultimately leads to a fall in theproduction. Any point to the left of the equilibrium point indicates thatthe market is not able to meet the demand. This forces businesses toproduce until the equilibrium point.

An economy produces more with the help of investment. An investmentcan be either actual investment or investment demand. Actualinvestment can be defined as the investment in new plants andequipment i.e. new plants and equipment acquired during a particularyear whether desired or undesired. Investment demand can be defined asthe desired investment or planned investment.


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Simple model of reaching equilibrium has no government intervention.Keynes tried to solve the problem of free market economy throughgovernment intervention. Keynes was of the opinion that governmentcan use fiscal measures to reduce the unemployment. He suggested thatgovernment can increase aggregate demand in the recessionary periodsby making changes in its spending or by altering the taxrates. Government spending comprises of generation of employmentopportunities by building infrastructure like roads, schools, etc.Mathematically aggregate demand (AD) can be represented as:

AD = Consumption expenditure (C) + Investment demand (I) +Government purchase of goods and services (G).

It can be seen in the given figure that there is an increase of $100 billion ingovernment spending. As a result, the equilibrium point shifts from pointD to point E. The increase in aggregate demand will have a multipliereffect on the economy. The multiplier effect will work on governmentspending as it worked on investment expenditures. In other words,government spending for productive purposes will create employmentopportunities in the economy. This in turn will increase the disposableincome and consumption in the economy.


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The fourth sector that is added to the economyis international trade. Net exports can bedefined as exports of goods and services minusimports of goods and services. Net exportsplay a significant role in an open economy. If

the exports exceed imports, the domesticincome would rise. On the contrary, if importsare more than the exports, it would have anegative effect on domestic economy. Thus, in

four sector model of economy, equilibrium isreached when:

Y = C+ I +G + (X-M)


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Of all the major components of aggregate demand (and hence

output), investment is the most volatile because of operation of themultiplier mechanism. Whenever a businessman intends to makecapital investments in the form of new buildings, newmachineries, inventory etc, his source of finance is either out of hisown resources or borrowings from other sources (financialinstitutions). If he selects the later method for financing, he has topay interest on the amount borrowed. This is also called `Debt

financing. That does not however mean that in the case of self-financing, the businessman enjoys resources, free of cost. With`self financing the businessman sacrifices the interest that hecould otherwise have earned. Investments are done with anobjective to earn profit. While Interest is the price, profit is thereward for investment. The expected rate of profit from

investment is called as marginal efficiency of capital or marginalproductivity of investment. It is rational for the investor tocompare the profits earned with the rate of interest that is to bepaid on the funds borrowed. An investor would decide to investonly if the expected profit from investment (or, the marginalefficiency of capital) is higher than the rate of interest that has tobe paid.


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Thus, we may arrive at the conclusion that thevolume of investment in an economy mainlydepends on two important factors:

(a) Marginal efficiency of capital (b) Interest rates Between interest rate and marginal efficiency of

capital, it is the latter which has a significantinfluence on the volume of investment. Some of the other factors that affect investment

demand are

(a) Acquisition and operating cost (b) Taxes (c) Change in technology (d) Stock of capital goods in hand


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CONSUMPTION AND SAVIN

APC

Consumption / IncomeAPS

Saving / Income

MPSChange in Saving

Change in Income

MPCChange in Consumption

Change in Income


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Consumption

Saving

o

o45

o

C

S

Consumption

schedule

Saving

schedule

C

S

Disposable Income

Disposable Income

SAVING

SAVING

DISSAVING

DISSAVING

MPC = Slope of C

MPS = Slope of S

MPC + MPS = 1

CONSUMPTION AND SAVIN

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