ICAI Notes- Unit 2: The Keynesian Theory of Determination of National Income | Business Economics for CA Foundation PDF Download

 Page 1


  
 
BUSINESS ECONOMICS 
a
 
 
6.34 
LEARNING OUTCOMES 
UNIT - 2: THE KEYNESIAN THEORY 
OF DETERMINATION OF NATIONAL 
INCOME 
 
 
 
After studying this Unit, you will be able to understand: 
? 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. 
 
  
© The Institute of Chartered Accountants of India
Page 2


  
 
BUSINESS ECONOMICS 
a
 
 
6.34 
LEARNING OUTCOMES 
UNIT - 2: THE KEYNESIAN THEORY 
OF DETERMINATION OF NATIONAL 
INCOME 
 
 
 
After studying this Unit, you will be able to understand: 
? 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. 
 
  
© The Institute of Chartered Accountants of India
 
 
a
 
 6.35 
DETERMINATION OF NATIONAL INCOME 
 
 
 
2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have discussed the importance of 
(GDP) to estimate the macro fundamentals of the country. 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.  
The Great Depression of the 1930's, was the greatest economic crisis the western world had 
experienced. The classical economist of the time had no well developed theory that would 
explain persistent unemployment nor any policy prescriptions to solve the problem. Many 
economists then recommended government spending as a way of reducing unemployment, 
but they had no macroeconomic theory by which to justify their recommendations. The history 
of modern macroeconomics was revolutionised in 1936, with the publication of John Maynard 
Keynes’s General Theory of Employment, Interest, and Money.  
The General Theory of Employment, Interest, and Money was more than a treatise for 
economists. It offered clear policy implications, and they were in tune with the times of the 
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 
 
© The Institute of Chartered Accountants of India
Page 3


  
 
BUSINESS ECONOMICS 
a
 
 
6.34 
LEARNING OUTCOMES 
UNIT - 2: THE KEYNESIAN THEORY 
OF DETERMINATION OF NATIONAL 
INCOME 
 
 
 
After studying this Unit, you will be able to understand: 
? 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. 
 
  
© The Institute of Chartered Accountants of India
 
 
a
 
 6.35 
DETERMINATION OF NATIONAL INCOME 
 
 
 
2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have discussed the importance of 
(GDP) to estimate the macro fundamentals of the country. 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.  
The Great Depression of the 1930's, was the greatest economic crisis the western world had 
experienced. The classical economist of the time had no well developed theory that would 
explain persistent unemployment nor any policy prescriptions to solve the problem. Many 
economists then recommended government spending as a way of reducing unemployment, 
but they had no macroeconomic theory by which to justify their recommendations. The history 
of modern macroeconomics was revolutionised in 1936, with the publication of John Maynard 
Keynes’s General Theory of Employment, Interest, and Money.  
The General Theory of Employment, Interest, and Money was more than a treatise for 
economists. It offered clear policy implications, and they were in tune with the times of the 
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 
 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
6.36 
Great Depression. Keynes introduced many of the building blocks of modern 
macroeconomics: 
1. The relation of consumption to income, and the multiplier, which explains how shocks 
to aggregate demand can be amplified and lead to larger shifts in output.  
2. Liquidity Preference ( the term Keynes gave to the demand for money), which explains 
how monetary policy can affect interest rates and aggregate demand. 
3. The importance of expectations in affecting consumption and investment; and the idea 
that shifts in expectations are a major factor behind shifts to demand and output.  
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 model demonstrates how money moves through society. Money flows from 
producers to workers as wages and flows back to producers as payment for products. In short, 
an economy is an endless circular flow of money. That is the basic form of the model, but 
actual money flows are more complicated. Economists have added in more factors to better 
depict complex modern economies. These factors are the components of a nation's GDP or 
national income. For that reason, the model is also referred to as the circular flow of income 
model. 
The basic purpose of the circular flow model is to understand how money moves within an 
economy. It breaks the economy down into two primary players: households and corporations. 
It separates the markets that these participants operate in as markets for goods and services 
and the markets for the factors of production.  
Households own all factors of production and they sell their factor 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 
© The Institute of Chartered Accountants of India
Page 4


  
 
BUSINESS ECONOMICS 
a
 
 
6.34 
LEARNING OUTCOMES 
UNIT - 2: THE KEYNESIAN THEORY 
OF DETERMINATION OF NATIONAL 
INCOME 
 
 
 
After studying this Unit, you will be able to understand: 
? 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. 
 
  
© The Institute of Chartered Accountants of India
 
 
a
 
 6.35 
DETERMINATION OF NATIONAL INCOME 
 
 
 
2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have discussed the importance of 
(GDP) to estimate the macro fundamentals of the country. 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.  
The Great Depression of the 1930's, was the greatest economic crisis the western world had 
experienced. The classical economist of the time had no well developed theory that would 
explain persistent unemployment nor any policy prescriptions to solve the problem. Many 
economists then recommended government spending as a way of reducing unemployment, 
but they had no macroeconomic theory by which to justify their recommendations. The history 
of modern macroeconomics was revolutionised in 1936, with the publication of John Maynard 
Keynes’s General Theory of Employment, Interest, and Money.  
The General Theory of Employment, Interest, and Money was more than a treatise for 
economists. It offered clear policy implications, and they were in tune with the times of the 
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 
 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
6.36 
Great Depression. Keynes introduced many of the building blocks of modern 
macroeconomics: 
1. The relation of consumption to income, and the multiplier, which explains how shocks 
to aggregate demand can be amplified and lead to larger shifts in output.  
2. Liquidity Preference ( the term Keynes gave to the demand for money), which explains 
how monetary policy can affect interest rates and aggregate demand. 
3. The importance of expectations in affecting consumption and investment; and the idea 
that shifts in expectations are a major factor behind shifts to demand and output.  
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 model demonstrates how money moves through society. Money flows from 
producers to workers as wages and flows back to producers as payment for products. In short, 
an economy is an endless circular flow of money. That is the basic form of the model, but 
actual money flows are more complicated. Economists have added in more factors to better 
depict complex modern economies. These factors are the components of a nation's GDP or 
national income. For that reason, the model is also referred to as the circular flow of income 
model. 
The basic purpose of the circular flow model is to understand how money moves within an 
economy. It breaks the economy down into two primary players: households and corporations. 
It separates the markets that these participants operate in as markets for goods and services 
and the markets for the factors of production.  
Households own all factors of production and they sell their factor 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 
© The Institute of Chartered Accountants of India
 
 
a
 
 6.37 
DETERMINATION OF NATIONAL INCOME 
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.                                                  
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. 
Real flows refer to the flow of the actual goods or services, while money flows refer to the 
payments for the services (wages, for example) or consumption payments.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).  Output is at equilibrium level when the 
quantity of output produced is equal to the quantity demanded. Logically, an economy can 
© The Institute of Chartered Accountants of India
Page 5


  
 
BUSINESS ECONOMICS 
a
 
 
6.34 
LEARNING OUTCOMES 
UNIT - 2: THE KEYNESIAN THEORY 
OF DETERMINATION OF NATIONAL 
INCOME 
 
 
 
After studying this Unit, you will be able to understand: 
? 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. 
 
  
© The Institute of Chartered Accountants of India
 
 
a
 
 6.35 
DETERMINATION OF NATIONAL INCOME 
 
 
 
2.1 INTRODUCTION 
In the previous unit on National Income Accounting, we have discussed the importance of 
(GDP) to estimate the macro fundamentals of the country. 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.  
The Great Depression of the 1930's, was the greatest economic crisis the western world had 
experienced. The classical economist of the time had no well developed theory that would 
explain persistent unemployment nor any policy prescriptions to solve the problem. Many 
economists then recommended government spending as a way of reducing unemployment, 
but they had no macroeconomic theory by which to justify their recommendations. The history 
of modern macroeconomics was revolutionised in 1936, with the publication of John Maynard 
Keynes’s General Theory of Employment, Interest, and Money.  
The General Theory of Employment, Interest, and Money was more than a treatise for 
economists. It offered clear policy implications, and they were in tune with the times of the 
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 
 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
6.36 
Great Depression. Keynes introduced many of the building blocks of modern 
macroeconomics: 
1. The relation of consumption to income, and the multiplier, which explains how shocks 
to aggregate demand can be amplified and lead to larger shifts in output.  
2. Liquidity Preference ( the term Keynes gave to the demand for money), which explains 
how monetary policy can affect interest rates and aggregate demand. 
3. The importance of expectations in affecting consumption and investment; and the idea 
that shifts in expectations are a major factor behind shifts to demand and output.  
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 model demonstrates how money moves through society. Money flows from 
producers to workers as wages and flows back to producers as payment for products. In short, 
an economy is an endless circular flow of money. That is the basic form of the model, but 
actual money flows are more complicated. Economists have added in more factors to better 
depict complex modern economies. These factors are the components of a nation's GDP or 
national income. For that reason, the model is also referred to as the circular flow of income 
model. 
The basic purpose of the circular flow model is to understand how money moves within an 
economy. It breaks the economy down into two primary players: households and corporations. 
It separates the markets that these participants operate in as markets for goods and services 
and the markets for the factors of production.  
Households own all factors of production and they sell their factor 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 
© The Institute of Chartered Accountants of India
 
 
a
 
 6.37 
DETERMINATION OF NATIONAL INCOME 
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.                                                  
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. 
Real flows refer to the flow of the actual goods or services, while money flows refer to the 
payments for the services (wages, for example) or consumption payments.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).  Output is at equilibrium level when the 
quantity of output produced is equal to the quantity demanded. Logically, an economy can 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
6.38 
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 determined exogenously and 
constant in the short run. Therefore, the short-run aggregate demand function can be written 
as: 
AD = C + I                         (2.2) 
Where       = constant investment. 
From the equation (2.2), we can infer that, in the short run, AD depends largely on the 
aggregate consumption expenditure. We shall now go over to the discussion on consumption 
function.   
2.3.2 The Consumption Function 
Consumption function expresses the functional relationship between aggregate consumption 
expenditure and aggregate disposable income, expressed as:  
© The Institute of Chartered Accountants of India