Determination of National Income:

Keynes’s Two sector(Households &

business firm) basic model
• With help of Keynesian theory we shall explain how
the equilibrium level of national income is determined
through the intersection of aggregate demand and
aggregate supply.
• Let us first understand what is aggregate demand and
aggregate supply.
• Assumptions:
• Relevant only in short run
• Stock of capital, techniques of production, efficiency of
labour, size of population remain constant.
• Price level in economy remain unchanged.
 Cont.
• Aggregate demand(Aggregate expenditure):
Defined as sum of Consumption demand
and Investment demand.
• Or AD = C + I
• Here consumption demand(Consumption
expenditure) (C), depends on the propensity
to consume and level of national income.
Given the propensity to consume, C is a
function of income.
 Cont.
• Investment Demand(Investment expenditure)
(I): I, depends upon two factors, marginal
efficiency of capital and interest rate
• In short run if interest rate assumed to be
constant then it only depends on marginal
efficiency of capital. Which in turn depends
upon profit expectations of entrepreneurs.
• Thus in the Keynesian theory of income
determination, investment demand is
independent of the national income.
 Cont.
• Aggregate Supply: It is equal to the total money
value of goods and services produced in an
economy in a year.
• It is same thing as national income or national
product.
• According to Keynes, up to the level of full-
employment of resources more output will be
produced and supplied at the given price level in
response to increase in demand.
 Equilibrium level of National
Income
Aggregate supply or
• Fig. National product, Z C+I = Aggregate
Y=C+S demand
E
Savin C=a
gs +bY
G At equilibrium point
E, Y = C+S = C+I
i.e., (S = I)
Consumpti
on
yl ppus et ager gg A
& dna med et ager gg A

45
˚
O National Income Y
’
 Cont.
• In above figure, income is measured along X-axis and
consumption demand (C) and investment demand(I) on
Y-axis.
• OZ, a straight line with 45˚ angle with the X-axis
represents the aggregate supply curve of the economy.
This is also known as income line. This line shows two
things
• First, it shows changing levels of production(Supply) will
be offered for sale at the given price level.
• Secondly, it represents national income in money terms.
 Cont.
• GE, represents saving.
• Thus Y(income) can also be represented as,
consumption + Saving or Y = C+S(i.e., Total income,
partly consumed and partly saved)
• At any point, distance of OZ line from x-axis and y-
axis is equal, shows that Aggregate supply = NI.
• The distance between C curve and C+I curve is
constant, which indicates level of investment does
not change with the change in income.
 Cont.
• Now in figure, E is the equilibrium point where both
aggregate demand and aggregate supply intersect each
other and OY’ represents the equilibrium level of NI.
• Income cannot be in equilibrium at level smaller than OY’
because, then aggregate demand exceeds aggregate
supply of output.
• This excess demand will lead to the decline in inventories
below the desired levels.
• This will induce the firm to expand output and the
process will continue till national income cannot be
greater than OY’
 Determination of equilibrium
level of national income:
Algebraic Analysis
• We know, at equilibrium, National income(Y)
= Consumption(C) + Investment(I)
• Suppose consumption function C = a +bY
• Where, a, refers intercept, an autonomous
consumption which does not change with
income. a>0 means even if Y=0, there is
some consumption, this is possible in short
run by liquidating accumulated assets.
• b, refers marginal propensity to
consume(MPC = dc/dy)
 Cont.
• Now suppose I = Ia ( an autonomous
investment demand which does not
depend on income)
• Thus we get three equations
Y = C + I.........i
C = a + bY……ii
I = Ia……………… iii
• Substituting the value of C and I in first
equation then
 Cont.
• Y = a + by +Ia………..iv
• Or Y-bY = a + Ia
• Y(1-b) = a +Ia
• Or Y = 1/1-b(a+Ia) ……..v
• The equation v Shows that the
equilibrium level of national income
when aggregate demand equals
aggregate supply.
 Cont.
• It also reveals that autonomous consumption
and autonomous investment(a+Ia) generates so
much expenditure or aggregate demand which is
equal to the income generated by the production of
goods and services.
• It also reveals that equilibrium level of national
income can be known by multiplying elements of
autonomous expenditure(a+Ia) with 1/1-b which is
equal to the value of multiplier.