2. Keynesian theory
General theory of employment, interest and
money
Level of output/income and employment
depends on level of aggregate demand
Increase in aggregate demand – increase in
output – increase in employment – full
employment
Full employment output can be produced if
there is sufficient aggregate demand
Inadequate aggregate demand leads to
unemployment
3. Concept of aggregate demand
Total amount of goods and services demanded in
the economy
AD = C + I + G + NX
Actual and planned aggregate demand
Actual demand in accounting context
Planned or desired demand in economic context
Equilibrium income/output when quantity of output
produced = quantity of output demanded
In equilibrium, AD = C + I + G + NX = Y
Y = AD means actual AD = planned AD at
equilibrium level of income/output
4. Consumption demand
Keynes – psychological law of consumption
– C varies with the level of disposable
income
Franco Modigliani – life cycle theory of
consumption – individuals plan consumption
over long periods to allocate it over entire
lifetime – C as a function of wealth and
labour income
Milton Friedman – permanent income theory
of consumption – consumption related to
longer term estimate of income called
permanent income
5. Consumption function
Demand for consumption goods depends mainly on
level of income in Keynesian analysis
C = a + cY where a > 0 and 0 < c < 1
a – intercept representing minimum level of
consumption when income is zero
c – slope of consumption function known as
marginal propensity to consume
MPC – additional consumption out of additional
income – increase in C per unit increase in Y
MPC = dC / Dy
6. Consumption and savings
S=Y–C
S = Y – (a + cY)
S = - a + (1 - c)Y
(1 – c) – marginal propensity to save
MPS = dS / dY
Savings increase as income increases
Paradox of thrift
7. Investment demand
Investment is the flow of spending that adds to
physical stock of capital
Gross and net investment
Financial and real investment
Planned and unplanned investment
Induced and autonomous investment
Induced investment – depending on profit expectations /
anticipated changes in demand and level of income / rate
of interest
Autonomous investment – not depending on income or
rate of interest – e.g. Government investment in
infrastructure
8. Investment function
Keynesian investment function
Volume of induced investment
depends on
MEC – marginal efficiency of capital –
determined by expected income flow
from capital asset and its purchase price
Market rate of interest
9. Consumption, planned
investment and AD
Assuming planned investment spending
constant and equal to I and also assuming
G and NX equal to zero,
AD = C + I
= (a + I) + bY
= A + bY
where A – part of AD independent of
income or autonomous
10. Contd….
AD
AD = Y
E AD = A + cY
C = a + cY
In equilibrium, without
A G and NX
I Y = AD
Y = A + bY
a
Y = (1 / 1-c) A
Planned I = S
Y
11. Multiplier
An increase in autonomous spending brings about
more than proportionate increase in equilibrium
level of income
Multiplier effect – known as investment or income
multiplier
Ratio of change in income due to change in
autonomous investment
Amount by which equilibrium output changes for
change in autonomous aggregate demand by one
unit
12. Derivation
Y = AD
dY = dAD
dAD = dA + cdY
dA – change in autonomous spending
dY – change in income
dY = dA + cdY
dY = (1/1-c) dA
α = 1 / 1 – c – multiplier
Larger the MPC, greater the multiplier
14. Government spending
Governments affect AD in two ways
G – government spending
Taxes and transfers affecting YD
Consumption now depends on YD and not Y
C = a + cYD = a + c (Y + TR – TA)
TA = t Y
C = a + cTR + c (1-t) Y
Assuming that G and TR are constant,
AD = (a+ cTR+ I+ G) + c(1-t) Y
= A + c(1-t) Y
15. Contd….
In equilibrium, Y = AD
Y = A + c(1-t) Y
Y [1-c(1-t)] = A where A = a+ cTR+ I+ G
Y = A / 1-c(1-t)
Multiplier in presence of taxes = α = 1 / 1–c(1-t)
Government spending can increase A by the
amount of purchases G and by the amount of
induced spending out of transfers bTR
Increased A will increase Y depending on the value
of MPC and tax rate
When tax rates (t) are higher, value of multiplier is
lower
16. Government budget
Plan of the intended expenses and revenues of the
government
Budget surplus = TA – G – TR
BS = tY – G – TR
At low levels of income, budget is in deficit, since
govt spending (G+TR) > tax collection (tY)
At high levels of income, budgets are in surplus
Budget deficits typically persist during recessions
when tax collections are low and transfers like
unemployment allowances increase
17. AD curve
Represents the quantity of goods and services households,
firms and government want to buy at each price level
When prices fall
real wealth of households increases inducing more
consumption
Interest rates fall inducing more investment
Exchange rates depreciate inducing more exports
P
AD
Y
18. Aggregate supply
Total amount of goods and services produced in the
economy over a specific time period
Classical AS – vertical line indicating that same
amount of goods and services will be supplied
irrespective of price level
Assumption – labour market is always in equilibrium with
full employment
Keynesian AS – horizontal line indicating that firms
will supply whatever amount of g & s is demanded
at existing price level
Assumption – unemployment leading to hiring labour at
prevailing wage rate
In practice, AS is positively sloped lying between
Keynesian and classical AS
19. Contd….
Upwards sloping AS in the short run
Misperceptions – changes in price level can mislead the
suppliers about individual markets in which they sell their
output, resulting in changes in supply
Sticky wages – nominal wages are sticky or slow to adjust
in the short run - slow adjustments can be due to long-
term contracts or work/social norms
When P falls, W/P (real wage) rises, increasing the real cost to the
firm, thus making employment and production less profitable
Firms cut down on employment and production and thus on supply
Sticky prices – prices of some goods and services are
slow in adjustment – they lag behind when overall price
level declines thus affecting their demand – this induces
firms to reduce supply in the short run
20. AS curve
Represents the quantity of goods and services firms choose
to produce and sell at each price level
P
AS
Y
