Unit II: The Keynesian Theory of Determination of National Income | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


1.51 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
LEARNING OUTCOMES 
UNIT II: THE KEYNESIAN THEORY OF 
DETERMINATION OF NATIONAL INCOME 
 
At the end of this unit, you will be able to: 
? Define Keynes’ concept of equilibrium aggregate income  
? Describe the components of aggregate expenditure in two, three and four 
sector economy models 
? Explain national income determination in two, three and four sector economy 
models 
? Illustrate the functioning of multiplier, and  
? Outline the changes in equilibrium aggregate income on account of changes in 
its determinants 
 
 
 
Determination of National 
Income
The Keynesian Theory of 
Determination of National 
Income
The Two-Sector Model 
for National Income 
Determination
The 
Investment 
Multiplier
Determination of 
Equilibrium Income : 
Three Sector Model
Determination of 
Equilibrium 
Income : Four 
Sector Model
UNIT OVERVIEW 
Page 2


1.51 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
LEARNING OUTCOMES 
UNIT II: THE KEYNESIAN THEORY OF 
DETERMINATION OF NATIONAL INCOME 
 
At the end of this unit, you will be able to: 
? Define Keynes’ concept of equilibrium aggregate income  
? Describe the components of aggregate expenditure in two, three and four 
sector economy models 
? Explain national income determination in two, three and four sector economy 
models 
? Illustrate the functioning of multiplier, and  
? Outline the changes in equilibrium aggregate income on account of changes in 
its determinants 
 
 
 
Determination of National 
Income
The Keynesian Theory of 
Determination of National 
Income
The Two-Sector Model 
for National Income 
Determination
The 
Investment 
Multiplier
Determination of 
Equilibrium Income : 
Three Sector Model
Determination of 
Equilibrium 
Income : Four 
Sector Model
UNIT OVERVIEW 
1.52 ECONOMICS FOR FINANCE 
 2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have come across terms 
such as consumption, investment and total output of final goods and services 
(GDP). These macroeconomic variables were used in the accounting sense, 
representing actual values of these items in a certain year. These actual or 
accounting values are ‘ex post’ (realized) measures of these items. Thus, 
aggregate consumption (C) denotes what people have actually consumed and 
GDP is what is actually produced. These variables can also be defined in ‘ex-ante’ 
(anticipated) terms or in terms of what is intended or planned.  In the theoretical 
model of the economy which we plan to discuss in this unit, the ‘ex ante’ values of 
these variables are our primary concern. Therefore, the term ‘consumption’ would 
indicate what people in an economy plan to consume and ‘investment‘would 
denote planned investment. If we want to predict what the equilibrium value of 
output or GDP is, we need to know what quantities of final goods people plan to 
demand and supply. 
In this unit, we shall focus on two issues namely, the factors that determine the 
level of national income and the determination of equilibrium aggregate income 
and output in an economy. A comprehensive theory to explain these phenomena 
was first put forward by the British economist John Maynard Keynes in his 
masterpiece ‘The General Theory of Employment Interest and Money’ published in 
1936. Before the ‘General Theory’ by Keynes, economists could not explain how 
economic depressions happen, or what to do about them. The classical 
economists maintained that the economy is self-regulating and is always capable 
of automatically achieving equilibrium at the ‘natural level’ of real GDP or output, 
which is the level of real GDP that is obtained when the economy's resources are 
fully employed. While circumstances arise from time to time that cause the 
economy to fall below or to exceed the natural level of real GDP, wage and price 
flexibility will bring the economy back to the natural level of real GDP. If an excess 
in the labour force (unemployment) or products exist, the wage or price of these 
will adjust to absorb the excess.  According to them, there will be no involuntary 
unemployment. 
Keynes’ theory of determination of equilibrium real GDP, employment and prices 
focuses on the relationship between aggregate income and aggregate 
expenditure. There is a difference between equilibrium income (the level toward 
which the economy gravitates in the short run) and potential income (the level of 
income that the economy is technically capable of producing, without generating 
Page 3


1.51 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
LEARNING OUTCOMES 
UNIT II: THE KEYNESIAN THEORY OF 
DETERMINATION OF NATIONAL INCOME 
 
At the end of this unit, you will be able to: 
? Define Keynes’ concept of equilibrium aggregate income  
? Describe the components of aggregate expenditure in two, three and four 
sector economy models 
? Explain national income determination in two, three and four sector economy 
models 
? Illustrate the functioning of multiplier, and  
? Outline the changes in equilibrium aggregate income on account of changes in 
its determinants 
 
 
 
Determination of National 
Income
The Keynesian Theory of 
Determination of National 
Income
The Two-Sector Model 
for National Income 
Determination
The 
Investment 
Multiplier
Determination of 
Equilibrium Income : 
Three Sector Model
Determination of 
Equilibrium 
Income : Four 
Sector Model
UNIT OVERVIEW 
1.52 ECONOMICS FOR FINANCE 
 2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have come across terms 
such as consumption, investment and total output of final goods and services 
(GDP). These macroeconomic variables were used in the accounting sense, 
representing actual values of these items in a certain year. These actual or 
accounting values are ‘ex post’ (realized) measures of these items. Thus, 
aggregate consumption (C) denotes what people have actually consumed and 
GDP is what is actually produced. These variables can also be defined in ‘ex-ante’ 
(anticipated) terms or in terms of what is intended or planned.  In the theoretical 
model of the economy which we plan to discuss in this unit, the ‘ex ante’ values of 
these variables are our primary concern. Therefore, the term ‘consumption’ would 
indicate what people in an economy plan to consume and ‘investment‘would 
denote planned investment. If we want to predict what the equilibrium value of 
output or GDP is, we need to know what quantities of final goods people plan to 
demand and supply. 
In this unit, we shall focus on two issues namely, the factors that determine the 
level of national income and the determination of equilibrium aggregate income 
and output in an economy. A comprehensive theory to explain these phenomena 
was first put forward by the British economist John Maynard Keynes in his 
masterpiece ‘The General Theory of Employment Interest and Money’ published in 
1936. Before the ‘General Theory’ by Keynes, economists could not explain how 
economic depressions happen, or what to do about them. The classical 
economists maintained that the economy is self-regulating and is always capable 
of automatically achieving equilibrium at the ‘natural level’ of real GDP or output, 
which is the level of real GDP that is obtained when the economy's resources are 
fully employed. While circumstances arise from time to time that cause the 
economy to fall below or to exceed the natural level of real GDP, wage and price 
flexibility will bring the economy back to the natural level of real GDP. If an excess 
in the labour force (unemployment) or products exist, the wage or price of these 
will adjust to absorb the excess.  According to them, there will be no involuntary 
unemployment. 
Keynes’ theory of determination of equilibrium real GDP, employment and prices 
focuses on the relationship between aggregate income and aggregate 
expenditure. There is a difference between equilibrium income (the level toward 
which the economy gravitates in the short run) and potential income (the level of 
income that the economy is technically capable of producing, without generating 
1.53 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
accelerating inflation).Keynes argued that markets would not automatically lead 
to full-employment equilibrium and the resulting natural level of real GDP.  The 
economy could settle in equilibrium at any level of unemployment. Keynesians 
believe that prices and wages are not so flexible; they are sticky, especially 
downward. The stickiness of prices and wages in the downward direction prevents 
the economy's resources from being fully employed and thereby prevents the 
economy from returning to the natural level of real GDP. Therefore, output will 
remain at less than the full employment level as long as there is insufficient 
spending in the economy.  This was precisely what was happening during the 
great depression. 
The Keynesian theory of income determination is presented in three models:  
(i) The two-sector model consisting of the household and the business sectors, 
(ii) The three-sector model consisting of household, business and government 
sectors, and  
(iii) The four-sector model consisting of household, business, government and 
foreign sectors 
Before we attempt to explain the determination of income in each of the above 
models, it is pertinent that we understand the concept of circular flow in an 
economy which explains the functioning of an economy.  
 2.2 CIRCULAR FLOW IN A SIMPLE TWO-SECTOR 
MODEL 
Concept of circular flow  
The circular flow of income is a process where the national income and expenditure 
of an economy flow in a circular manner continuously through time. Savings, 
expenditures, exports and imports are various components of circular flow of income 
which are shown in the figure in the form of currents and cross currents in such a 
manner that national income equals national expenditure.  
Initially, we consider a hypothetical simple two-sector economy. Even though an 
economy of this kind does not exist in reality, it provides a simple and convenient 
basis for understanding the Keynesian theory of income determination.  The 
simple two sector economy model assumes that there are only two sectors in the 
economy viz., households and firms, with only consumption and investment 
outlays. Households own all factors of production and they sell their factor 
Page 4


1.51 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
LEARNING OUTCOMES 
UNIT II: THE KEYNESIAN THEORY OF 
DETERMINATION OF NATIONAL INCOME 
 
At the end of this unit, you will be able to: 
? Define Keynes’ concept of equilibrium aggregate income  
? Describe the components of aggregate expenditure in two, three and four 
sector economy models 
? Explain national income determination in two, three and four sector economy 
models 
? Illustrate the functioning of multiplier, and  
? Outline the changes in equilibrium aggregate income on account of changes in 
its determinants 
 
 
 
Determination of National 
Income
The Keynesian Theory of 
Determination of National 
Income
The Two-Sector Model 
for National Income 
Determination
The 
Investment 
Multiplier
Determination of 
Equilibrium Income : 
Three Sector Model
Determination of 
Equilibrium 
Income : Four 
Sector Model
UNIT OVERVIEW 
1.52 ECONOMICS FOR FINANCE 
 2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have come across terms 
such as consumption, investment and total output of final goods and services 
(GDP). These macroeconomic variables were used in the accounting sense, 
representing actual values of these items in a certain year. These actual or 
accounting values are ‘ex post’ (realized) measures of these items. Thus, 
aggregate consumption (C) denotes what people have actually consumed and 
GDP is what is actually produced. These variables can also be defined in ‘ex-ante’ 
(anticipated) terms or in terms of what is intended or planned.  In the theoretical 
model of the economy which we plan to discuss in this unit, the ‘ex ante’ values of 
these variables are our primary concern. Therefore, the term ‘consumption’ would 
indicate what people in an economy plan to consume and ‘investment‘would 
denote planned investment. If we want to predict what the equilibrium value of 
output or GDP is, we need to know what quantities of final goods people plan to 
demand and supply. 
In this unit, we shall focus on two issues namely, the factors that determine the 
level of national income and the determination of equilibrium aggregate income 
and output in an economy. A comprehensive theory to explain these phenomena 
was first put forward by the British economist John Maynard Keynes in his 
masterpiece ‘The General Theory of Employment Interest and Money’ published in 
1936. Before the ‘General Theory’ by Keynes, economists could not explain how 
economic depressions happen, or what to do about them. The classical 
economists maintained that the economy is self-regulating and is always capable 
of automatically achieving equilibrium at the ‘natural level’ of real GDP or output, 
which is the level of real GDP that is obtained when the economy's resources are 
fully employed. While circumstances arise from time to time that cause the 
economy to fall below or to exceed the natural level of real GDP, wage and price 
flexibility will bring the economy back to the natural level of real GDP. If an excess 
in the labour force (unemployment) or products exist, the wage or price of these 
will adjust to absorb the excess.  According to them, there will be no involuntary 
unemployment. 
Keynes’ theory of determination of equilibrium real GDP, employment and prices 
focuses on the relationship between aggregate income and aggregate 
expenditure. There is a difference between equilibrium income (the level toward 
which the economy gravitates in the short run) and potential income (the level of 
income that the economy is technically capable of producing, without generating 
1.53 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
accelerating inflation).Keynes argued that markets would not automatically lead 
to full-employment equilibrium and the resulting natural level of real GDP.  The 
economy could settle in equilibrium at any level of unemployment. Keynesians 
believe that prices and wages are not so flexible; they are sticky, especially 
downward. The stickiness of prices and wages in the downward direction prevents 
the economy's resources from being fully employed and thereby prevents the 
economy from returning to the natural level of real GDP. Therefore, output will 
remain at less than the full employment level as long as there is insufficient 
spending in the economy.  This was precisely what was happening during the 
great depression. 
The Keynesian theory of income determination is presented in three models:  
(i) The two-sector model consisting of the household and the business sectors, 
(ii) The three-sector model consisting of household, business and government 
sectors, and  
(iii) The four-sector model consisting of household, business, government and 
foreign sectors 
Before we attempt to explain the determination of income in each of the above 
models, it is pertinent that we understand the concept of circular flow in an 
economy which explains the functioning of an economy.  
 2.2 CIRCULAR FLOW IN A SIMPLE TWO-SECTOR 
MODEL 
Concept of circular flow  
The circular flow of income is a process where the national income and expenditure 
of an economy flow in a circular manner continuously through time. Savings, 
expenditures, exports and imports are various components of circular flow of income 
which are shown in the figure in the form of currents and cross currents in such a 
manner that national income equals national expenditure.  
Initially, we consider a hypothetical simple two-sector economy. Even though an 
economy of this kind does not exist in reality, it provides a simple and convenient 
basis for understanding the Keynesian theory of income determination.  The 
simple two sector economy model assumes that there are only two sectors in the 
economy viz., households and firms, with only consumption and investment 
outlays. Households own all factors of production and they sell their factor 
1.54 ECONOMICS FOR FINANCE 
services to earn factor incomes which are entirely spent to consume all final 
goods and services produced by business firms. The business firms are assumed 
to hire factors of production from the households; they produce and sell goods 
and services to the households and they do not save. There are no corporations, 
corporate savings or retained earnings. The total income produced, Y, accrues to 
the households and equals their disposable personal income Y
d 
i.e., Y = Yd.                                                  
All prices (including factor prices), supply of capital and technology remain 
constant. The government sector does not exist and therefore, there are no taxes, 
government expenditure or transfer payments. The economy is a closed economy, 
i.e., foreign trade does not exist; there are no exports and imports and external 
inflows and outflows. All investment outlay is autonomous (not determined either 
by the level of income or the rate of interest); all investment is net and, therefore, 
national income equals the net national product.   
In the figure 1.2.1, the circular flow of income and expenditure which presents the 
working of the two- sector economy is illustrated in a simple manner. 
Figure 1.2.1  
Circular Flow in a Two Sector Economy 
 
The circular broken lines with arrows show factor and product flows and present 
‘real flows’ and the continuous line with arrows show ‘money flows’ which are 
generated by real flows. These two circular flows-real flows and money flows-are 
Page 5


1.51 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
LEARNING OUTCOMES 
UNIT II: THE KEYNESIAN THEORY OF 
DETERMINATION OF NATIONAL INCOME 
 
At the end of this unit, you will be able to: 
? Define Keynes’ concept of equilibrium aggregate income  
? Describe the components of aggregate expenditure in two, three and four 
sector economy models 
? Explain national income determination in two, three and four sector economy 
models 
? Illustrate the functioning of multiplier, and  
? Outline the changes in equilibrium aggregate income on account of changes in 
its determinants 
 
 
 
Determination of National 
Income
The Keynesian Theory of 
Determination of National 
Income
The Two-Sector Model 
for National Income 
Determination
The 
Investment 
Multiplier
Determination of 
Equilibrium Income : 
Three Sector Model
Determination of 
Equilibrium 
Income : Four 
Sector Model
UNIT OVERVIEW 
1.52 ECONOMICS FOR FINANCE 
 2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have come across terms 
such as consumption, investment and total output of final goods and services 
(GDP). These macroeconomic variables were used in the accounting sense, 
representing actual values of these items in a certain year. These actual or 
accounting values are ‘ex post’ (realized) measures of these items. Thus, 
aggregate consumption (C) denotes what people have actually consumed and 
GDP is what is actually produced. These variables can also be defined in ‘ex-ante’ 
(anticipated) terms or in terms of what is intended or planned.  In the theoretical 
model of the economy which we plan to discuss in this unit, the ‘ex ante’ values of 
these variables are our primary concern. Therefore, the term ‘consumption’ would 
indicate what people in an economy plan to consume and ‘investment‘would 
denote planned investment. If we want to predict what the equilibrium value of 
output or GDP is, we need to know what quantities of final goods people plan to 
demand and supply. 
In this unit, we shall focus on two issues namely, the factors that determine the 
level of national income and the determination of equilibrium aggregate income 
and output in an economy. A comprehensive theory to explain these phenomena 
was first put forward by the British economist John Maynard Keynes in his 
masterpiece ‘The General Theory of Employment Interest and Money’ published in 
1936. Before the ‘General Theory’ by Keynes, economists could not explain how 
economic depressions happen, or what to do about them. The classical 
economists maintained that the economy is self-regulating and is always capable 
of automatically achieving equilibrium at the ‘natural level’ of real GDP or output, 
which is the level of real GDP that is obtained when the economy's resources are 
fully employed. While circumstances arise from time to time that cause the 
economy to fall below or to exceed the natural level of real GDP, wage and price 
flexibility will bring the economy back to the natural level of real GDP. If an excess 
in the labour force (unemployment) or products exist, the wage or price of these 
will adjust to absorb the excess.  According to them, there will be no involuntary 
unemployment. 
Keynes’ theory of determination of equilibrium real GDP, employment and prices 
focuses on the relationship between aggregate income and aggregate 
expenditure. There is a difference between equilibrium income (the level toward 
which the economy gravitates in the short run) and potential income (the level of 
income that the economy is technically capable of producing, without generating 
1.53 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
accelerating inflation).Keynes argued that markets would not automatically lead 
to full-employment equilibrium and the resulting natural level of real GDP.  The 
economy could settle in equilibrium at any level of unemployment. Keynesians 
believe that prices and wages are not so flexible; they are sticky, especially 
downward. The stickiness of prices and wages in the downward direction prevents 
the economy's resources from being fully employed and thereby prevents the 
economy from returning to the natural level of real GDP. Therefore, output will 
remain at less than the full employment level as long as there is insufficient 
spending in the economy.  This was precisely what was happening during the 
great depression. 
The Keynesian theory of income determination is presented in three models:  
(i) The two-sector model consisting of the household and the business sectors, 
(ii) The three-sector model consisting of household, business and government 
sectors, and  
(iii) The four-sector model consisting of household, business, government and 
foreign sectors 
Before we attempt to explain the determination of income in each of the above 
models, it is pertinent that we understand the concept of circular flow in an 
economy which explains the functioning of an economy.  
 2.2 CIRCULAR FLOW IN A SIMPLE TWO-SECTOR 
MODEL 
Concept of circular flow  
The circular flow of income is a process where the national income and expenditure 
of an economy flow in a circular manner continuously through time. Savings, 
expenditures, exports and imports are various components of circular flow of income 
which are shown in the figure in the form of currents and cross currents in such a 
manner that national income equals national expenditure.  
Initially, we consider a hypothetical simple two-sector economy. Even though an 
economy of this kind does not exist in reality, it provides a simple and convenient 
basis for understanding the Keynesian theory of income determination.  The 
simple two sector economy model assumes that there are only two sectors in the 
economy viz., households and firms, with only consumption and investment 
outlays. Households own all factors of production and they sell their factor 
1.54 ECONOMICS FOR FINANCE 
services to earn factor incomes which are entirely spent to consume all final 
goods and services produced by business firms. The business firms are assumed 
to hire factors of production from the households; they produce and sell goods 
and services to the households and they do not save. There are no corporations, 
corporate savings or retained earnings. The total income produced, Y, accrues to 
the households and equals their disposable personal income Y
d 
i.e., Y = Yd.                                                  
All prices (including factor prices), supply of capital and technology remain 
constant. The government sector does not exist and therefore, there are no taxes, 
government expenditure or transfer payments. The economy is a closed economy, 
i.e., foreign trade does not exist; there are no exports and imports and external 
inflows and outflows. All investment outlay is autonomous (not determined either 
by the level of income or the rate of interest); all investment is net and, therefore, 
national income equals the net national product.   
In the figure 1.2.1, the circular flow of income and expenditure which presents the 
working of the two- sector economy is illustrated in a simple manner. 
Figure 1.2.1  
Circular Flow in a Two Sector Economy 
 
The circular broken lines with arrows show factor and product flows and present 
‘real flows’ and the continuous line with arrows show ‘money flows’ which are 
generated by real flows. These two circular flows-real flows and money flows-are 
1.55 
 
THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME 
in opposite directions and the value of real flows equal the money flows because 
the factor payments are equal to household incomes. There are no injections into 
or leakages from the system. Since the whole of household income is spent on 
goods and services produced by firms, household expenditures equal the total 
receipts of firms which equal the value of output.  
Factor Payments = Household Income = Household Expenditure = Total Receipts 
of Firms = Value of Output. 
Before we go into the discussion on the equilibrium aggregate income and 
changes in it, we shall first try to understand the meaning of the term 
‘equilibrium’ (defined as a state in which there is no tendency to change; or a 
position of rest).  Equilibrium output occurs when the desired amount of output 
demanded by all the agents in the economy exactly equals the amount produced 
in a given time period. Logically, an economy can be said to be in equilibrium 
when the production plans of the firms and the expenditure plans of the 
households match. 
Having understood the working of the two-sector model and the meaning of 
equilibrium output, we shall now have the formal presentation of the theory of 
income determination in a two-sector model which is the simplest representation of 
the key principles of Keynesian economics.In the theoretical model of the economy, 
the ex ante values of different variables should be our primary concern.Before we 
discuss the Keynesian theory of income determination, let us look at the basic 
concepts, definitions and functions used in his theory of income determination. 
 2.3 BASIC CONCEPTS AND FUNCTIONS  
2.3.1  Aggregate Demand Function 
Aggregate demand (AD) is what economists call total planned expenditure. In a 
simple two-sector economy, the ex ante aggregate demand (AD) for final goods 
or aggregate expenditure consists of only two components: 
(i) Ex ante aggregate demand for consumer goods (C), and 
(ii) Ex ante aggregate demand for investment goods (I) 
AD = C + I                            (2. 1) 
Of the two components, consumption expenditure accounts for the highest 
proportion of the GDP. In a simple economy, the variable I is assumed to be