Module 2 - Basic Concepts of Keynesian Economics

• The Principle of Effective Demand: Aggregate

Demand and Aggregate Supply
• Consumption Function: Properties, Assumptions and
Implications
• Investment function and Marginal Efficiency of
capital
• Investment Multiplier effect on Income and Output:
Assumptions, Working, Leakages, Criticism and
Importance - paradox of thrift
 The Principle of Effective Demand
• Principle of effective demand is basic to Keynes
analysis of income, output and employment.
• It is outlined in Keynes' path breaking book, "General
theory on Employment, Interest and Money",
published in 1936.
• A fundamental principal is that as the real income
increases, consumption will also increase but by an
amount which is less than the increase in income.
Therefore in order to have enough demand to sustain
an increase in employment there must be an increase
in real investment equal to the gap between income
and consumption.
 Income

Employment

Effective
Demand

Aggregate Demand Aggregate Supply

Function Function

Consumption Investment Government

Expenditure Expenditure Expenditure

Income Propensity Rate of Marginal

to consume Interest Efficiency of
Capital
Subjective Objective
Factors Factors
 Effective Demand
The aggregate demand in a two sector economy
consists of consumption demand and investment
demand.
At various level of employment and income, there are
corresponding levels of demand, but all levels of
demand are not effective only that level of demand is
effective which is fully met by the aggregate supply so
that the firms do not have tendency to increase or
decrease the level of employment and output.
Thus effective demand represents ' equilibrium level of
employment.'
 Determinants of Effective Demand
According to Keynes, effective demand is determined
by two factors
1. Aggregate Demand Function (ADF)
2. Aggregate Supply Function (ASF)
1. Aggregate Demand Function: It refers to the
schedule of maximum sales proceeds which the firms
expect to receive from the sale of output resulting
from different levels of employment.
Aggregate demand price is the amount of money
which the firms expect to receive from the sale of
output produced at a particular level of employment.
 ADF

ADF ADF

O O
Employment Employment
The vertical intercept of ADF shows autonomous consumption (i.e. the level
of expenditure at zero level of employment and output).
Non-linear ADF shows that the propensity to consume diminishes along with
the increase in employment and output. Linear curve shows constant
marginal propensity to consume (MPC).
 Determinants of Effective Demand
2. Aggregate Supply Function
ASF refers to the schedule of minimum amount of sales
proceeds or revenue, which the firms must get from
the sale of output resulting from various levels of
employment.
In other words these are the minimum amounts which
are considered just necessary to induce the firms to
provide a certain level of employment. The ASF is also
an increasing function of the level of employment. It is
clear that the aggregate supply price depends on the
cost of production.
 ASF ASF

ASF

O O
Employment N F Employment N F
The ASF curve becomes vertical at the full level of 'NF'. Linear ASF represent
homogenous cost function with constant returns. Non - linear ASF is more
realistic as it represents diminishing returns in production function. Unlike
the ADF curve which has positive Y - intercept. The ASF curve starts from the
point of origin because for zero employment cost is also zero.
 ASF
ADF
ASF

ADF
E

O N1 N F Employment
N N2
ED is obtained at point E where ADF = ASF. The equil level of emp is given as
'ON'. To the left of the point 'E' or 'ON', ADF > ASF and emp will increase to
'ON'. At ON1 emp, ADF is higher than ASF and the firms are getting more than
the required min. to continue in the production. the firms will increase the
level of emp upto 'ON'. At 'ON2' level of emp, the ADF < ASP and the firms are
getting less than the min price. They will reduce the level of emp and output..
 ‘Under-employment Equilibrium'
In the diagram given above full employment is given as
ONF , where as employment equilibrium is ON hence
unemployment exist in the economy. There are two
ways to attain full employment level
(1) shifting the ADF upwards,
(2) shifting the ASF downwards.
 ASF
ADF
E2
ASF ADF2

E1
ADF1

O
N 1 N F Employment

The initial equilibrium level (effective demand) is at E1, but it

shows under employment equilibrium. If ADF1 can be shifted to
ADF2 in such a way that it passes through E2 so that full
employment is obtained.
 Consumption Function
The consumption demand is a major component of
aggregate demand. The level of consumption
expenditure in an economy depends on the current
level of income, current and expected price level, taste
and preference, expected future income, etc. Keynes
stated that in the short period consumption is a
function of current real income.
Symbolically,
C  f Y 

Consumption and income has a direct functional

relationship.
 Consumption Function
According to Keynes, consumption function is governed
by the Psychological Law of Consumption. It is stated as
follows - "............. men are disposed, as a rule, and on
the average, to increase their consumption as their
income increases, but not by as much as the increase in
their income.''
This means that the change in consumption (ΔC) is less
than the change in income (ΔY).
Consumption function equation:
C  C  cY C  0 and 0  c  1
 Attributes of Consumption Function
• Average propensity to consume (APC): The APC is
the ratio of consumption expenditure to the
corresponding level of income. . APC diminishes as
C
income increases. APC  Y
• Marginal propensity to consume: It is the ratio of
change in consumption to change in income. .
Following the psychological law of consumption,
MPC lies between zero and one (0 < MPC < 1).
C
MPC 
Y
Consumption and Saving Function Table
MPC
APC S MPS APS
Y C (ΔC/
(C/Y) (Y - C) (ΔS/ΔY) (S/Y)
ΔY)
0 40 - - - 40 - -
100 120 0.8 1.2 - 20 0.2 0.2
200 200 0.8 1.0 0 0.2 0
300 280 0.8 0.93 20 0.2 0.7
400 360 0.8 0.9 40 0.2 0.1
500 440 0.8 0.88 60 0.2 0.12
 Income Line
Consumptio n
& Saving C  C  cY
Saving

S
dissaving
C
45 
O
Y Income
 Explanation of the diagram
The vertical intercept of the consumption function
represents C̅ or the autonomous consumption. The
slope of the consumption function is given by the value
of MPC. The 45° line is the income line. Every point on
the income line shows C = Y.
The consumption function intersects the income line at
point T. Corresponding level of income is known as
break - even level, because, C = Y and S = 0.
Before the break - even level, saving is negative and
afterwards saving is positive.
The saving function is the counter part of the given
consumption function. It passes through the x - axis at
the income where C = Y.
 Factors Affecting Consumption Function
1. Subjective factors:
a) The motive of precaution
b) Motive of foresight
c) Motive of calculation
d) The motive of improvement
e) Motive of independence
f) Motive of enterprises
g) Motive of pride
h) Motive of avarice
 Factors Affecting Consumption Function
2. Objective Factors
a) Windfall income
b) Fiscal policy
c) Changes in the rate of interest
d) Distribution of income
e) The level of holding of financial assets
f) The level of wealth
g) Expectation of price
h) Level of income
 Importance/Implications of the
Consumption Function
1. It invalidates the Say's Law of market
2. It emphasises the necessity of investment
3. Need for state intervention
4. Turning point of trade cycles
5. Underemployment equilibrium
Investment function and Marginal Efficiency of
capital
Investment implies the addition to the capital stock i.e.
plant and equipment. Therefore in employment theory
investment refers to real investment and not the
investment in second hand securities.
Investment demand depends on two factors namely,
1. Marginal Efficiency of Capital (MEC or e)
2. Rate of Interest (i)
 1. Marginal Efficiency of capital

The MEC refers to the profitability of the capital asset.

It is the expected rate of return over cost or the
expected profitability. MEC depends on two factors.
i. Prospective yield (Q)
ii. Supply price (P)
As K. Kurihara states, MEC is the ratio between the
prospective yield of additional asset and its supply
price. Q
e 
P
 Marginal Efficiency of capital
i. Prospective yield (Q):
It is the expected annual net returns from production
and sale of the output. Supply price is the cost of
acquiring a new capital asset. The capital asset is
durable and it gives net returns for a number of years,
so we have to consider the sum of the annual net
returns as the prospective yield.
MEC refers to the rate at which the prospective yield
from an additional capital asset is to be discounted, it is
to be equal to its supply price.
Q1 Q1 Q1 Qn
SP     ...... 
1  e  1  e  1  e 
2 3
1  e n
 Marginal Efficiency of capital
ii. Supply price of the capital asset: 'e' is the rate of
discount of MEC. From the above equation it follows
that
• MEC varies with the changes in the prospective yield
and the supply price.
• Given the supply price, MEC will be higher, if the
prospective yield (Q1, Q2, etc) is higher and vice-versa.
• Given the value of Q1, Q2, etc. MEC will be higher if
supply price is lower.
 Investment Demand Schedule
Investment demand depends on the rate of interest
and the MEC. Investment and rate of interest are
inversely related, which means that at higher interest
rate, investment demand will be lower and vice versa.
Rate of Interest Vol. of Investment MEC
% p.a) (Rs. Crores) (% p.a.)
10 10 10
9 20 9
8 30 8
7 40 7
6 50 6
 Supply Price and Demand Price
The comparison between 'e' and 'i' is infact a
comparison between the supply price of a capital asset
and its demand price.
Supply price is the cost of acquiring new asset. MEC is
the rate which discounts the future net returns so that
it is equal to the supply price.
Demand price is the "sum of the expected future
returns discounted at the rate of interest.
Q1 Q1 Qn
DP    ...... 
1  i  1  i 2
1  i n
e>i DP > SP Investment will increase
e=i DP = SP Investment will be in equilibrium
e<i DP < SP Investment will fall
 2. Interest Elasticity of Investment Demand
The slope of the investment demand curve depends on
the ‘interest elasticity of demand’ which again is related
to how slowly or fast MEC falls to a given increase in
investment.
Investment demand is ‘interest elastic’, if MEC declines
slowly to a increase in investment. This will mean that a
greater increase in investment will be required to
equate MEC with interest.
If investment is ‘interest elastic, the MEC schedule or
investment demand curve is flatter.
If investment is ‘interest inelastic’, investment demand
curve will be steeper.
 Factors Affecting Investment Function
1. Short run factors
a) Nature of demand, prices and cost
b) Propensity to consume
c) Changes in liquid asset
d) Business outlook
2. Long run factors:
a) Population
b) Techniques
c) Development of backward areas
 Investment Multiplier
Investment Multiplier tells us about the changes in
income for changes in the investment. The concept o
Multiplier was developed by R.F. Kahn.
With change in the investment here will be a change in
the income, because the investment expenditure turns
into income. There after the income induce the
consumption to increase depending on the level of
marginal propensity of consumption
 Investment Multiplier
This way an increase in the consumption expenditure
creates incomes in the second round. The induced
income again increases the consumption. This cycle
repeats and an increase in the investment generates
income several times more. This is called as the
multiplier effect.
Multiplier is the ratio of total change in income to the
initial change in investment. Let K denote multiplier,
then
Y
K
I
 Investment Multiplier
The multiplier has a time lag. The multiplier works into
the long run. Each year some income is added and
consumption is generated. This may taper with time
but it shall continue for ever, theoretically. This is called
multiplier effect.
Propensity of Consumption
The intensity of consumption whether aggregate or
additional is called propensity of consumption.
Propensity of consumption can be measured in two
ways.
1. Average propensity of consumption: APC is the ratio
of consumption to Income.
 Investment Multiplier
C
APC 
Y
2. Marginal propensity of consumption: The MPC
measures changes in consumption for changes in
income. It is the measures of propensity of consume
for an increment in
C
MPC 
Y
 Average Propensity to Consume Marginal Propensity to Consume

consumption
consumption

Income Income

C C
APC  MPC 
Y Y
 Derivation of Multiplier
Y
K
I
Y  CS
Y
K By substituting ∆I with ∆Y - ∆C Y  CI
Y - C
Y  C  I
Y
K  Y
I   Y  C
Y - C
Dividing numerator and
Y denominator with ∆Y
Y
K Y By simplification
Y C

Y Y

1 By factorization
K
C
1-
Y
1
K Since, ∆C / ∆Y = MPC
1 - MPC
1
K Since, 1 – MPC = MPS
1 - MPS
 Working Process of the Multiplier
∆I ∆Y ∆C ∆S ∆I ∆Y ∆C ∆S
100 100 80 20 0.59 0.47 0.12
80 64 16 0.47 0.38 0.09
64 51.20 12.80 0.38 0.30 0.08
51.20 40.96 10.24 0.30 0.24 0.06
0.24 0.19 0.05
40.96 32.77 8.19 0.19 0.15 0.04
32.77 26.22 6.55 0.15 0.12 0.03
26.22 20.98 5.24 0.12 0.096 0.02
20.98 16.78 4.20 0.10 0.077 0.02
16.78 13.42 3.36 0.08 0.062 0.02
13.42 10.74 2.68 0.06 0.050 0.01
10.74 8.59 2.15 0.05 0.040 0.01
0.04 0.032 0.01
8.59 6.87 1.72 0.03 0.024 0.01
6.87 5.50 1.37 0.02 0.016 0.00
5.50 4.40 1.10 0.02 0.013 0.00
4.40 3.52 0.88 0.01 0.010 0.00
3.52 2.82 0.70 0.01 0.008 0.00
2.82 2.26 0.56 0.01 0.006 0.00
2.26 1.81 0.45 0.01 0.005 0.00
1.81 1.45 0.36 0.01 0.004 0.00
0.00 0.003 0.00
1.45 1.16 0.29 0.00 0.002 0.00
1.16 0.93 0.23 0.00 0.002 0.00
0.93 0.74 0.19 0.00 0.002 0.00
0.74 0.59 0.15 Total 500 400 100
 Y  AD

E2 C  I  I
Aggregate 
Demand CI
E1

I C
I

45
0 Y1 Y2
National Income

Y Y1Y2
I I
 Leakages in the Multiplier Process
1. Increase in saving or hoarding: When hoarding take place some
amount of income disappears from the income flow this will
reduce the value of multiplier (K).
2. Purchase of old assets: The income recipients may buy old assets
such as shares and securities from other people who may not
increase their consumption or expenditure; this will reduce the
value of K.
3. Repayment of old debt: The income recipients may use the
income to repay old debt instead of spending it on goods and
services.
4. Excess of import over exports: In this case there will be a net
outflow of income which will reduce the value of K.
5. Inflation: The rise in prices would require additional money
expenditure even to buy the same quantity of goods and services.
Hence the actual consumption demand will not increase.
6. High taxes and corporate savings: High taxes and an increase in
corporate savings will lead to a decline in consumption
expenditure and the value of K.