According to Keynes the full employment state is just one of the possible states the economy can be in and

there is no reason why the economy should be automatically at this state. The model introduced here is the Simple Keynesian Model of Income Determination. The principal tool of analysis in this model is the 'aggregate demand'. The focus of this model is only the goods market and the influence of the money market on the goods market is abstracted away. There are certain assumptions on which this model is built. It is assumed that prices do not change at all and that firms are willing to sell any amount of output at the given level of prices (the aggregate supply curve is perfectly elastic).

It was in the backdrop of great depression of 1930s, Keynes tried to explain the causes of depression through the concepts of aggregate demand, aggregate supply and effective demand. The concept of aggregate supply helps understand the functioning of the economy. The given figure helps us to understand the supply function. The supply function is represented by a backward L shaped curve. Points BA, the horizontal section of supply function shows that the prices are stable where any change in the aggregate demand changes the output level. This happens because the economy has not attained full employment level. The vertical section, 'AC', represents full employment and an increase in the aggregate demand will lead to an increase in the price. Point A is the full employment level, whereas point B represents a situation where an economy functions below the full employment level. At this point, any increase in the demand for goods and services can be met by increasing the factors of production without increasing the price till it reaches point A.

Aggregate demand (AD) is the total or aggregate quantity of output bought willingly at a given price level, while other things remain constant. In other words, aggregate demand is the amount that firms and households spend on goods and services at each level of income. The following components play an important role in analyzing the Keynesian aggregate demand: Consumption Investment Government purchases Net exports

There are various factors that help in determining the consumption. But the most important factor that determines the consumption is disposable income. A Prussian statistician, Ernest Engel, observed that percentage of income spent on food and other necessities falls with rise in the income. This relationship is known as Engels law. A countrys consumption expenditure rise as income rises. This relationship can be explained with the help of a graph

Consumption expenditure (C) is one of the important components of aggregate demand. Although many factors influence the consumption expenditure, income (Y) is considered to be the most important influencing factor. The relationship between consumption and income can be described using consumption function, C = f(Y). The consumption and income are positively related that is, greater the income, greater is the consumption. Let us assume that consumption demand increases linearly with the 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. b represents the marginal propensity to consumer (MPC) that is, rate at which consumption changes for a unit change in income. The consumption function is shown in the figure given below

Hitherto we assumed that the chief determinant of private consumption and saving is the level of private disposable income. But, consumption and saving is determined by many factors in addition to the level of disposable income. Following are some of the important factors that influence the consumption and savings function. Wealth Expectations Taxation policy Distribution of income Age composition

DISPOSABLE INCOME A B C D E F G 12000 12500 13000 13500 14000 14500 15000

CONSUMPTION SAVINGS 12055 12500 12925 13300 13620 13915 14180 -55 0 75 200 380 585 820

The 450 line tells us the relationship between consumption and disposable income. The break even point on the consumption schedule intersects at 450 line, that shows the disposable income at which households break even. Point B represents the break even point. At an income of Rs 14,000, the level of consumption is Rs 13,620. The fact that 450 line is above the consumption function shows that consumption is less than income. The distance between E and E1 represents consumption and the distance between E and E11 represents savings. The region on the left of point B shows the dissavings.

To study the changes in consumption, Keynes introduced the concept of marginal propensity to consume (MPC). It can be defined as the additional amount consumed as a fraction of additional disposable income. Mathematically, it can be denoted as: MPC = change in consumption / change in disposable Income

If the income rises and the consumer does not consume the additional fraction of the increase in income, then it is saved. The marginal propensity to save (MPS) is given by, MPS = change in savings / change in disposable income

In a simple economy, without any government intervention or international 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 the consumption demand. This can be seen in the given figure. In the given figure, national product and not disposable income is shown on the horizontal axis, as in the simple economy NP = DI. When aggregate demand 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. The point where the 45o line cuts the aggregate demand indicates equilibrium in the economy i.e., whatever is produced is consumed by the economy. Any point to the right of this equilibrium indicates that the economy is over producing. This results in unsold products, which leads to excess inventory in the economy, which ultimately leads to a fall in the production. Any point to the left of the equilibrium point indicates that the market is not able to meet the demand. This forces businesses to produce until the equilibrium point. An economy produces more with the help of investment. An investment can be either actual investment or investment demand. Actual investment can be defined as the investment in new plants and equipment i.e. new plants and equipment acquired during a particular year whether desired or undesired. Investment demand can be defined as the desired investment or planned investment.

Simple model of reaching equilibrium has no government intervention. Keynes tried to solve the problem of free market economy through government intervention. Keynes was of the opinion that government can use fiscal measures to reduce the unemployment. He suggested that government can increase aggregate demand in the recessionary periods by making changes in its spending or by altering the tax rates. Government spending comprises of generation of employment opportunities 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 in government spending. As a result, the equilibrium point shifts from point D to point E. The increase in aggregate demand will have a multiplier effect on the economy. The multiplier effect will work on government spending as it worked on investment expenditures. In other words, government spending for productive purposes will create employment opportunities in the economy. This in turn will increase the disposable income and consumption in the economy.

The fourth sector that is added to the economy is international trade. Net exports can be defined as exports of goods and services minus imports of goods and services. Net exports play a significant role in an open economy. If the exports exceed imports, the domestic income would rise. On the contrary, if imports are more than the exports, it would have a negative effect on domestic economy. Thus, in four sector model of economy, equilibrium is reached when: Y = C+ I +G + (X-M)

Of all the major components of aggregate demand (and hence output), investment is the most volatile because of operation of the multiplier mechanism. Whenever a businessman intends to make capital investments in the form of new buildings, new machineries, inventory etc, his source of finance is either out of his own resources or borrowings from other sources (financial institutions). If he selects the later method for financing, he has to pay interest on the amount borrowed. This is also called `Debt financing. That does not however mean that in the case of selffinancing, the businessman enjoys resources, free of cost. With `self financing the businessman sacrifices the interest that he could otherwise have earned. Investments are done with an objective to earn profit. While Interest is the price, profit is the reward for investment. The expected rate of profit from investment is called as marginal efficiency of capital or marginal productivity of investment. It is rational for the investor to compare the profits earned with the rate of interest that is to be paid on the funds borrowed. An investor would decide to invest only if the expected profit from investment (or, the marginal efficiency of capital) is higher than the rate of interest that has to be paid.

Thus, we may arrive at the conclusion that the volume of investment in an economy mainly depends 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 significant influence 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

CONSUMPTION AND SAVIN APC

Consumption / Income

APS
Saving / Income

MPC
Change in Consumption Change in Income

MPS
Change in Saving Change in Income

CONSUMPTION AND SAVIN

Consumption
SAVING

Consumption schedule

MPC = Slope of C
o

DISSAVING

o
Saving

45

MPC + MPS = 1
Disposable Income
Saving schedule

MPS = Slope of S

S
SAVING

o S
Disposable Income

DISSAVING