CA > Foundation > Paper 4 – Skim Notes

Unit 2 : The Keynesian Theory of Determination of National Income

Overview

  • Understanding of Keynes’ equilibrium aggregate income concept.
  • Components of aggregate expenditure in different sector models.
  • National income determination in two, three, and four sector economy models.
  • Illustration of the multiplier mechanism.
  • Equilibrium changes and determinants’ impacts on aggregate income.

Key Topics

Keynesian Equilibrium Income

  • Keynes introduced equilibrium aggregate income as a balance between planned output and planned expenditure.
  • Published in 1936 in ‘The General Theory of Employment, Interest, and Money’, which shifted the framework of macroeconomics.
  • Equilibrium occurs when the quantity produced is equal to the quantity demanded, establishing the foundation of Keynes’ theory.

Deep Dive

  • Examined causes of unemployment during the Great Depression, leading to Keynes’ policy recommendations.
  • Highlighted the importance of demand-side stimuli for economic recovery, contrasting with classical economics.

Circular Flow Model

  • Explains the movement of money and goods through the economy via households and firms.
  • Two-sector model: households supply factors of production to firms, which produce goods for consumption.
  • There are no savings in the simplistic model; all income is spent on goods and services, representing a closed loop.

Deep Dive

  • The model’s utility extends to understanding injections and leakages in economic activity, crucial for further analysis of equilibrium.
  • Real vs. money flow implications on GDP measurement and economic activity.

Aggregate Demand and Consumption Function

  • Aggregate demand signifies total planned expenditure: AD = C + I.
  • Consumption function relates aggregate consumption expenditure to disposable income: C = a + bY.
  • Marginal Propensity to Consume (MPC) indicates the fraction of additional income spent on consumption.

Deep Dive

  • Consumption function analysis used to deduce the relationship between income levels and consumer behavior, facilitating predictions on spending patterns.
  • Graphical representations illustrate shifts in consumption with income variations.

Two-Sector Model of National Income Determination

  • Equilibrium derived when aggregate demand equals aggregate supply; simplified to C + I = C + S for households and firms.
  • Investment (I) equals savings (S) to maintain equilibrium under the assumptions of no government or foreign sector.
  • MPC influences multiplier effects on economy through augmentations in national income.

Deep Dive

  • Illustrates the implications of the relationship between planned and realized values in the economy, addressing potential gaps in demand vs. supply.
  • Empowers analysis of fiscal stimulus impacts on output and employment via the IS-LM model.

The Investment Multiplier

  • Describes the phenomenon where an increase in investment leads to a proportionate rise in national income: k = ΔY/ΔI.
  • Multiplier effects depend on the MPC, with higher values indicating greater economic responsiveness.
  • Example: if I increases by 2000 million, ΔY could be 6000 million, yielding a multiplier of 3.

Deep Dive

  • Explores the ‘ripple effect’ of increased investment; how initial shocks propagate through income generation.
  • Identifies leakages that reduce multiplier efficiency in economies, showing real-world constraints.

Three Sector Model

  • Includes households, businesses, and government in national income determination: Y = C + I + G.
  • Governmental interactions with both households and firms, including taxation, transfer payments, and public spending.
  • National income is influenced by both leakages (savings and taxes) and injections (government investments).

Deep Dive

  • Analyzes how fiscal policies can stabilize or destabilize the economy, influencing employment rates and output capacity.
  • Utilizes graphical equity conditions to demonstrate equilibrium dynamics.

Four Sector Model

  • Incorporates households, businesses, government, and foreign sector, allowing for imports and exports: Y = C + I + G + (X-M).
  • Imports act as leakages, while exports serve as injections, shaping national income flows from abroad.
  • The model outlines conditions for determining income through net exports and incorporates a foreign trade multiplier perspective.

Deep Dive

  • Examines implications of trade balances on national economy health, addressing surplus vs. deficit scenarios.
  • Employs comparative static models to analyze shifts in equilibrium due to trade alterations.

Summary

In summary, the Keynesian theory of national income determination encapsulates the relationship between aggregate demand and supply within different economic models. From the foundational concepts presented by Keynes, including his analysis of the Great Depression, to the intricate functions of circular flow, consumption, and income multipliers, this theory offers a comprehensive framework. Each model builds on the essence of demand management and consumption behavior, illustrating how they influence equilibrium income across different economic sectors. Understanding these dynamics is crucial for applying Keynesian principles in real-world fiscal and monetary policy.