THE KEYNESIAN THEORY

INTRODUCTION

In the last unit on measurement of national income, we have developed theoretical insights into the different concepts of national income and methods of measurement. In this unit, we shall focus on two issues namely, the factors that determine the level of national income and the determination of equilibrium aggregate income and output in an economy. A comprehensive theory to explain these phenomena was first put forward by the British economist John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936. The Keynesian theory of income determination is presented in three models:

i.  The two-sector model consisting of the household and the business sectors,

ii.  The three-sector model consisting of household, business and government sectors, and

iii.  The four-sector model consisting of  household,  business, government and foreign sectors

Before we attempt to explain the determination of income in each of the above models, it is pertinent that we understand the concept of circular flow in an  economy which explains the functioning of an economy.

CIRCULAR FLOW IN A SIMPLE TWO-SECTOR MODEL

Initially we consider a hypothetical simple two-sector economy. Even though an economy of this kind does not exist in reality, it provides a simple and convenient basis for understanding the Keynesian theory of income determination. The simple two sector economy model assumes that there are only two sectors in the economy viz., households and firms, with only consumption and investment outlays. Households own all factors of production and they sell their factor services to earn factor incomes which are entirely spent to consume all final goods and services produced by business firms. The business firms are assumed to hire factors of production from the households; they produce and sell goods and services to the households and they do not save. There are no corporations, corporate savings or retained earnings. The total income produced, Y, accrues to the households and equals their disposable personal income Yd i.e., Y = Y d.

All prices (including factor prices), supply of capital and technology remain  constant. The government sector does not exist and therefore, there are no taxes, government expenditure or transfer payments. The economy is a closed economy, i.e., foreign trade does not exist; there are no exports and imports and external inflows and outflows. All investment outlay is autonomous (not determined either by the level of income or the rate of interest); all investment is net and, therefore, national income equals the net national product.

Factor Payments = Household Income= Household Expenditure = Total Receipts of Firms = Value of Output.

Before we go into the discussion on the equilibrium aggregate income and changes in it, we shall first try to understand the meaning of the term ‘equilibrium’ (defined as a state in which there is no tendency to change; or a position of rest). Equilibrium output occur when the desired amount of output demanded by  all the agents in  the economy exactly equals the amount produced in a given time period. Logically, an economy can be said to be in equilibrium when the production plans of the firms and the expenditure plans of the households match.

Having understood the working of the two sector model and the meaning of equilibrium output, we shall now have the formal presentation of the theory of income determination in a two-sector model  which is the simplest representation  of the key principles of Keynesian economics. To see the factors that determine the level of income, first we consider the factors that affect the components of aggregate demand namely, consumption and investment.

THE AGGREGATE  DEMAND FUNCTION:   TWO-SECTOR MODEL

In a simple two-sector economy aggregate demand (AD) or aggregate expenditure consists of only two components:

i.   aggregate demand for consumer goods (C), and

ii.  aggregate demand for investment goods (I)

                                     AD = C + I      (2. 1)

Of the two components, consumption expenditure accounts for the highest proportion of the GDP. In a simple economy, the variable I is assumed to be determined exogenously and constant in the short run. Therefore, the short-run aggregate demand function can be written as:

                                    AD = C + I̅         (2.2)

                    

From the equation (2.2), we can infer that, in the short run, AD depends largely on the aggregate consumption expenditure.