We may now examine how this happens. If investment exceeds saving by cd, when income is Y1, the ex­pansionary forces behind the national income will be stronger than the contractionary forces and national income will rise. 50 + 0.80Yd; I= Rs. Recall that real GDP can be decomposed into four component parts: aggregate expenditures on consumption, investment, government, and net exports. 34.5 does not everywhere coincide with the investment line, planned saving of the household sector does not al­ways equal planned investment of firms. Saving and Investment in the Circular Flow Dia­gram: Figure 34.2 presents a circular flow diagram. Firstly there is the possibility that households and business firms will not be able to spend Rs. Summary 6. The equilibrium level of employment and income is not necessarily the full employment income level as believed by classical economists. 100 – 6r and S = -Rs. Unrealistic assumption of perfect competition: In real business world imperfect competition is found … […] They are forced to cut back production. Associated with this level of real GDP is an aggregate expenditure curve, AE 1. The economy is therefore in equilibrium be­cause injections are equal to leakages (withdrawals). We may now consider the second approach, viz., the leakages-injections approach. 100 crores, although firms originally planned to invest Rs. While households save for cer­tain personal reasons business firms invest for mak­ing profits. Keynesian Theory of Income and Employment! Conversely, if planned (desired) investment is greater that desired saving, national income would rise. Assumptions of keynes. (2) There may be unemployment even when national income is in equilibrium. Suppose national income goes above the equi­librium value. As real national income Y rises, so does the level of aggregate expenditure. On the basis of these two functions we may now see how the equilibrium level (size) of national income is determined. and desired investment is Rs. Thus, a 10% rate of interest is consistent with a Rs. 40 + 0.20F and planned investment is Rs. Suppose C = Rs. Suppose I = Rs. The implication is clear: as long as there is sur­plus capacity there is no need for prices to rise so as to stimulate production. Households do al­locate their income between consumption C and sav­ing 5. Just as the behaviour of prices and quantities in individual markets can be explained by the interaction of de­mand and supplies, the behaviour of a country’s total output (or its national income) depends on the econ­omy’s total demand and total supply. 400, found by equat­ing planned saving and planned investment. The potential output of an economy is noth­ing other than its full employment output (national income). The premise of full employment runs throughout the whole structure of this theory. It is in this context that we have to distinguish between planned and actual values. Effective demand results in output. It is quite obvious that in a modern economy using money as a medium of exchange all income is generated by production, i.e., the entire na­tional income is paid out to households, so that the income of the households is exactly equal to the value of output i.e., GNP or GNI. Since national income = national expenditure = national output, we can write: By cancelling out C from both sides we get: This is known as saving-investment equality and is always true because it is a definitional identity rather than an equation. In the Keynesian model, since there are unemployed resources, the aggregate supply curve will be hori­zontal, not vertical. 34.1 is the same as the level of income, Ye where the saving line intersects the investment line in Fig. Put simply, “Supply adjusts to demand.” Contrast this statement with Say’s Law, which said, “Sup­ply creates its own demand.”. It is interesting to note that both give the same result. KEYNESIAN THEORY OF EMPLOYMENT J.M. Since employment depends on production and production responds to spending, the level of em­ployment in a market economy depends on the level of planned spending in the economy. Keynes's income‐expenditure model. They no doubt spend Rs. Therefore, both the terms on the right hand side are constant. It implies that there is a mechanism that ensures that households end up desiring to save exactly what firms desire to invest. 50: b = 0.80 and Ī= Rs. Saving is mainly done by households but in­vestment activities are largely carried out by business firms. So stocks will rise. Since investment spending creates income, investment represents an injection of income into the circular flow. Income is made out of expenditure on con­sumer goods and that on capital goods. Thus, investment and employment go together. In words, the equilibrium level of real GDP, Y*, is equal to the level of autonomous expenditure, A, multiplied by m, the Keynesian multiplier. Since households wish to buy less than this, firms will be forced to hold stocks. They distribute their entire after-tax profits as dividends). Graphically this is shown by the intersection between the aggregate ex­penditure line and the 45° line. Since there is neither excess demand nor ex­cess supply there is no upward or downward pressure on national income either. 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. The same level of income can be found out by solving the following two simul­taneous equations: The first is the equation of the planned expenditure line and the second is the equation of the 45° line. There are two alternative ways of stating the equi­librium conditions for national income: 1. Intended saving equals Yd — C. Thus, the saving function is S = —Rs. Now let us consider a situation where people plan to save more then actual investment. Both of these are disequilibrium situations. 40 4- 0.20F. 1600 crores when planned expenditure is Rs. This, in its turn, would raise the volume of sav­ing. Suppose planned consumption equals Rs. As a result national income falls. Keynesian theory of Income and employment 2. • Therefore if aggregate demand increases, output will increase, prices remaining the same. Suppose, now national income is Rs. The British Economist John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936 put forth a comprehensive theory on the determination of equilibrium aggregate income and output in an economy. If they reduce the volume of production, stocks will gradually get exhausted. 520. Keynes in his eminent work “General Theory of Employment, Interest and Money” not only criticised the classical Say’s law but also propounded a new theory of income and employment. Keynesian Theory of Income Determination . This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. 300 crores less than what they planned. It reduces the flow of income. In fact, income change con­tinues until the two become equal. The core issue of macroeconomics is the determination of level of income, employment and output. In a market economy, planned spending on busi­ness output will determine the level of produc­tion. He in his book 'General Theory of Employment, Interest and Money' out-rightly rejected the Say's Law of Market that supply creates its own demand. (2) The motives for savings and investment are diverse. The same condition will be obtained if we use the second approach, viz., the saving-investment ap­proach. Both saving (S) and investment (I) are defined as the excess of income over consumption (Y-C) so that they are necessarily equal. Income and Employment By ROBERT J. BARRO AND HERSCHEL I. GROSSMAN* As is now well understood, the key to the Keynesian theory of income determination is the assumption that the vector of prices, wages, and interest rates does not move instantaneously from one full employment equilibrium position to another. Note also that each Y is a multiple of the level of autonomous aggregate expenditure, A, as was found in the algebraic determination of the level of equilibrium real GDP. Any stock changes are regarded as changes in investment. In Fig. If, on the other hand, there is enough demand to buy just 80 per cent of the economy’s potential output, then actual output will exactly be 80 per cent of full-employment GNP. So the demand for their products falls. As business firms reduce the volume of production, national income will fall. The explanation of the apparent conflict is the essence of the Keynesian theory of income determi­nation. Since peo­ple, plan to buy exactly what is produced, there is no tendency for national output (GNP) or income to rise or fall. Because the mpc is the fraction of a change in real national income that is consumed, it always takes on values between 0 and 1. They, therefore, find that they end up making investment of Rs. According to this theory, in an economy income and employment are in equilibrium at that level at which Aggregate Demand = Aggregate Supply. We know that s = 1 — b (what is saved out of every rupee of income is the portion of income that is not spent on consumption). But firms will adopt necessary measures to meet the extra demand well in advance. We now explain the reason(s). A portion of such income is spent by households on consumption goods like food, clothing, etc. In this situation, the classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP. Below the equilibrium level of national income and output, planned investment injects more spend­ing into the circular flow of income than planned sav­ing withdraws from it. With planned saving and investment being equal, the economy is in-equilibrium. Having discussed the two theories in the foregoing pages, we can now make the following comparison: Classical Theory Keynesian Theory 1 Equilibrium level of income and employment is established only at the level of full employment.

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