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Keynesian theory of income determinationEquilibrium Level of National Income is determined at the level where Aggregate Demand (AD) = Aggregate Supply (AS)
Aggregate Demand: 2-Sector ModelTwo sectors: Household and BusinessAD = C + II= Constant In short run AD depends largely on Consumption expenditure
Consumption FunctionConsumption function: relationship between consumption and its determinants.There are many determinants- income, wealth, interest rate, future expectations etc.Mostly C= f(Y) where Y= Income.Keynes: fundamental psychological law.
Consumption Function C= Total real consumption of households a = Autonomous real consumption of householdsYd= Real personal disposable incomeb= Marginal propensity to consume (MPC)Marginal propensity to consume ‘b’ or MPC represents the proportion of income that goes to consumption and it is always less than one ( why)1b00,a;dbYaC
Derivation of Saving function Y= C+S And S = IYbaSbYYaSbYaYSSbYaYbYaCButSCY)1(
Demand for goods & servicesComponents of aggregate demand:C= consumer demand for g & sI= demand for investment goodsG= No government and (closed economy: no NX )CHAPTER 3National Income
Relationship between Consumption and Saving functionYcaS)1(cYaCSaving (S)- aaIncome (Y)Income (Y)Consumption
exampleFind GDP using following informationC= 100+0.8Y ; and I=1000There is no government and no foreign trade.What will be GDP if investment is increased to 2000?What will be saving function?
Government sector Two changes due to this sectorGovernment expenditure in includedTax is also includedGovernment expenditure directly entersTax enters via consumption function( indirectly).Y= C+I+G …….. Govt sector includedY=[a + b(Y-T)]+I+G …….. Tax included
Budget balanceBudget balance = net tax revenue – ExpenditureIf revenue exceeds expenditure then it is called Budget surplusIf expenditure exceeds revenue then it is called budget deficit.
Impact of govt expenditureY=ADC+I+GC+I∆GY1Y2BA∆YImpact of Government expenditure on Aggregate DemandMPCGY11/
Impact of tax450C +I+GTABC+I+GY2Y1MPC Ct+I+GTbbYbbdTdY101
The Balance Budget MultiplierImpact of Govt exp:Impact of tax:Combined impact:If GbY11TbbY1TbbGbY111GYGbbGbbbY11111TG