Keynesian Theory of Income Determination

Keynesian Theory of Income Determination

Keynes is considered to be the greatest economist of the 20th century. He wrote several books. However, his 'The General Theory of Employment, Interest and Money' (1936) won him everlasting fame in economics. The book revolutionized macro economic thought. Keynesian economics is called the Keynesian revolution.

The central problem in macro economics is the determination of income and employment of a nation as a whole. That is why modern economists also call macro economics as the theory of income determination. Keynes brings out all the important aspects of income and employment determination and Keynesian economics itself can be called macro economics.He attacked the classical economics and effectively rejected the Say's Law, the very foundation of the classical theory. He believed that in the short run, the level of income of an economy depends on the level of employment. The higher the level of employment, higher will be the level of income.

A perusal of the basic ideas of Keynes can be clearly understood from the brief summary in the flow chart. Total income depends on total employment which depends on effective demand which in turn depends on consumption expenditure and investment expenditure. Consumption depends on income and propensity to consume. Investment depends upon the marginal efficiency of capital and the rate of interest.

The Principle of Effective Demand

The principle of effective demand occupies a key position in the Keynesian theory of employment. Effective demand is the ability and willingness to spend by individuals, firms and government. The level of output produced and hence the level of employment depends on the level of total spending in the economy.

Keynes used 'aggregate demand and aggregate supply approach' to explain his simple theory of income determination. The term 'aggregate' is used to describe any quantity that is a grand total for the whole economy.

Aggregate demand is the total demand for all commodities (goods and services) in the economy. Aggregate supply is the total of commodities supplied in the economy. These two factors are called by Keynes as aggregate demand function (ADF) and the aggregate supply function (ASF).

Keynes made it clear that the level of employment depends on aggregate demand and aggregate supply. The equilibrium level of income or output depends on the relationship between the aggregate demand curve and aggregate supply curve. As Keynes was interested in the immediate problems of the short run, he ignored the aggregate supply function and focused on aggregate demand. And he attributed unemployment to deficiency in aggregate demand.

It is important to note that all demand is not effective. According to Keynes, effective demand is that point where the ADF and ASF are equal. ASF represents cost and ADF represents receipts. Cost must not exceed receipt. When the entrepreneurs find that their receipts are less than their costs, they will stop offering employment to new workers. So long as their receipts are higher than the costs, they will increase employment as they can increase their profits by offering more and more employment.

As already mentioned, the point of intersection between the two curves shows the maximum possible employment. According to Keynes, the level of employment depends on total demand and unemployment results as a consequence of a fall in total demand. If unemployment is to be averted, the remedy lies in increasing the effective demand.

Aggregate Demand

The total expenditure of an economy can be divided in to four categories of spending. They are consumption expenditure (C), investment expenditure (I), government expenditure (G) and net expenditure on trade or net exports that is, exports minus imports, (X-M). The aggregate demand is the sum total of all such spending. Hence the aggregate demand function is represented as

AD = C+ I + G + (X-M)             ...........              (1)

This function shows that the aggregate demand is equal to the sum of expenditure respectively on consumption (C), Investment (I), Government spending (G) and net exports (X-M). Thus aaggregate demand is the total value of all planned expenditure of all buyers in the economy. It is the total demand for goods and services in the economy

(Y) in a specific time period. Moreover, the aggregate demand is known as the amount of commodities people want to buy.

In the economy, as one man's expenditure is another man's income, the total expenditure of the economy must be equivalent to the total income. That is Total income(Y) = Total expenditure (AD). Since Y = AD, equation ( 1) can be written as

Y = AD = C+ I + G + (X-M)

or Y = C+ I + G + (X-M)

Keynes gives all attention to the ADF. This aspect was neglected by economists for over 100 years. Assuming that ASF is constant, the main basis of Keynesian theory is that employment depends on aggregate demand which itself depends on two factors :

1. Propensity to consume (Consumption function)

2. Inducement to invest (Investment function).