The Determination of Income in an open Economy Video Lecture | Business Economics for CA Foundation

hello friends and welcome back to Eddie
Padilla WorldCom in the last session we
have discussed the basic concepts and
measures of national income in this
session we will discuss a problem of
theoretical nature that is the problem
of national income determination the two
major questions with which we shall be
concerned here are that what factors
determine the level of national income
and how is the equilibrium level of
national income determined now these two
questions were first answered by JM
Keynes in the year 1936 so we are going
to outline here the Keynesian theory of
income determination now according to
Keynes the entire economy is divided
into four sectors that is household
sector firms or the business sector
government sector and foreign sector and
relationship between all these four
sectors will give us different models
which Keynesian theory has given so
according to Keynes
there are three models to determine the
national income that is two sector model
three sector model and four sector model
in this session we will be discussing
about two sector model in the next
session we'll be continuing with three
sector and four sector model so let's
start with two sector model let's look
at the assumptions of the two sector
model the first assumption is that there
are just two sectors that is household
and firms now the household here owned
the factors of production and they sell
the factor services to the firm's and
for which they get the factor payments
in the form of wages interest rent and
profits whereas for the firms on the
other hand they hire factor services
from the households and produce goods
and services which they sell to the
households
so this was a first assumption the
second assumption is that there is no
government or even if the government is
there it is not interfering in the
economic activities of the country the
third assumption is that the economy is
a closed one which means that there are
no foreign trades happening there is not
economic transactions between countries
happening
the fourth assumption is that there are
no corporate savings it means that
whatever profits the firms are earning
they are distributing it to the
shareholders as dividend the fifth and
last assumption is that the prices of
all goods and services the supply of
labour and capital and the state of
production technology all of this
remains constant so these are the
assumptions of the two sector model
let's proceed to the description of the
model so according to Keynes national
income of a country is determined by two
factors that is the aggregate demand and
aggregate supply and that point is a
point of the level of national income
where the aggregate demand is equal to
the aggregate supply that is the
equilibrium point so now in order to
know that how do we determine the
equilibrium point we are going to see
that what is aggregate supply and what
is aggregate demand aggregate supply it
refers to the total value of goods and
services produced and supplied in an
economy per unit of time and the
aggregate sample supply consists of two
components status producer Goods and
consumer goods that is when we talk
about aggregate supply it means supply
of producer goods and consumer goods so
how do we get the value of aggregate
supply the goods and services
which are produced per unit of time is
multiplied by their respective prices
which gives the total value of national
output and this is the value of
aggregate supply in terms of money so if
we calculate the national output or
aggregate supply we can also say a
national output in terms of money which
is equal to the aggregate supply it is
equal to the quantity multiplied by
price per unit so this is how we
calculate the aggregate supply now let's
see that what is the aggregate supply
schedule the Keynesian aggregate supply
schedule or aggregate supply curve is
drawn on the assumption that total
income is always spent that is there are
no savings and total income or we can
say aggregate income is equal to the
aggregate expenditure means whatever I
am earning I am spending on various
goods and services so this is the
assumption made and according to this
assumption the curve that is the
aggregate supply curve which we get is a
45 degree line I will show you how
let's draw a graph to show this on
x-axis I take the aggregate income which
we denote by y and on the y-axis we take
the aggregate expenditure which we
denote by AE so as I told you that
aggregate income is equal to aggregate
expenditure now listen to this very
carefully aggregate income is equal to X
aggregate expenditure now this means
that as in on my income increases my
expenditure will also increase so income
and expenditure are directly
proportional to each other which means
that I will get a line the aggregate
supply line will be like this which is
constantly increasing so this is the
aggregate supply line and this line is
equal to 45 degree because my aggregate
expenditure is always equal to the
aggregate income fine so we can also say
that our s is equal to the AE that is
aggregate supply is equal to aggregate
expenditure now the second point to be
noted here this is the first point that
is my aggregate expenditure will always
be equal to aggregate income and the
aggregate supply line which I am getting
is a 45 degree line the second point
which I need to note here is that
according to Keynes aggregate income is
always equal to consumption plus savings
we denote consumption by C and savings
by s so we can see that aggregate income
is always equal to C plus S fine so
these are the two important points which
we need to remember in deriving the
aggregate supply now next we come to
that what is aggregate demand now the
aggregate demand is also known as
effective demand which means that the
aggregate expenditure is made by the
society per unit of time usually one
year and it consists of two component
status aggregate demand for consumer
goods C and aggregate demand for capital
goods I so let's see that how aggregate
demand is derived as I told you that
aggregate demand is equal to C plus I
now see here stands for aggregate demand
for consumer goods that is consumption
and I is aggregate demand for capital
goods that is investment now according
to Keynes it is assumed that I is
constant that is it will not change
now what about consumption C C depends
upon the income of the consumer which is
denoted by Y so Y here is the income of
the consumer so we can also say that C
is a function of Y that is it will
increase as an on the income of the
consumer increases now to express this
in a form of function we write it like
this
that is C is equal to a plus B Y now you
must be wondering that what is a here is
a constant
which will be equal to see when y is
zero got it
let me explain this to you further
suppose Y is equal to zero
fine then C will be equal to a plus B
into zero because Y we have assumed bi
is equal to zero then solving this
further a plus C is equal to a plus zero
therefore C will be equal to a because
consumption can never be zero even if
your income is zero which means that
even if you're unemployed still you will
be consuming in order to live find
source a is a constant that is equal to
C when we assume that income is zero
fine now
what about B B is a constant that
denotes a part of income which is spent
on the consumer goods I again repeat B
is a constant which denotes a percentage
or a part of income which is spent on
the consumer goods for suppose my income
is dollar hundred and I am spending
dollar ten out of this income on
consumer goods that is my expenditure is
dollar ten so B here will be equal to
ten percent of my income fine which is
equals to point one zero so B here will
be equal to 0.1 0 or rather we can say
that B is equal to change in consumption
upon change in income ok now let us move
forward this is how we derive the value
of C and the Val
I I is supposed to be assumed to be
constant
now what about ad that is aggregate
demand aggregate demand is equal to C
plus I okay or we can say because C is
equals to a plus B why so we can say
that aggregate demand is equals to a
plus B 5 plus I so aggregate demand is
equals to a plus B y plus I now in order
to illustrate it and in order to give
you a clear view let's do this with the
help of example
now suppose assume that C is equals to
50 plus 0.5 by and I is equal to dollar
50 billion now with the help of this
data you have to determine the aggregate
demand that is ad now as you know that
ad is always equals to C plus I so what
we need to do now is we are going to
assume the values of y and we are going
to put these value in this function
which will help us to derive the value
of C and 2 the value of C we are going
to add the value of I in order to get
the aggregate demand so let's draw a
shed dual in order to show this this is
the aggregate demand schedule so we take
the income then C which is equals to 50
plus 0.5 y then we take the investment
which is equals to dollar 50 billion and
then we get the value of aggregate
demand
so these are the four columns which will
be showing now suppose the income value
is zero the income level is zero so what
will be the value of C revising upon C
will be equal to a 50 is the value of a
constant and 0.5 is the value of B
constant so when the income is zero the
consumption level will be equal to a
let's show you that so 50 plus zero will
be equal to 50 this is the consumption
level now suppose when the Inc income
increases to 50 then what will be the
value of C 50 plus 50 into 0.5 C we have
assumed the value of y to be 50 so in
order to get the value of consumption we
will multiply the value of y to our
constant B and we will add the constant
a to it and we'll get the consumption
level so 50 into 50 plus 50 it will be
equal to 75 we get this value 25 by
multiplying 50 into 0.5 fine then
suppose a value of income increases 250
plus 100 into 0.5 which will give us 50
equals 200 suppose it increases to 150
then 50 plus 115 to 0.5 equals to 75
equals to 125 then 250 we assume the
value of income to be 250 plus 200 into
0.5 equals 200 which will give us 150
then 250 so 50 plus 250 into
0.5 this will give us
sorry 125 and this is equals to 175
likewise we keep on assuming the values
of income and we get the value of
consumption on the basis of that fine
then as I told you that the investment
level will always be constant so for all
level of income the investment level
will be constant which is assumed to be
dollar fifty billion now in order to get
aggregate demand si plus I is equals to
aggregate demand aggregate demand will
be equal to C plus I that is for the
first case it would be 50 plus 50 equals
to 100 then 125 then 150 then 175 then
200 then 225 and then 275 fine so these
are the values of these are the values
of aggregate demand for various levels
of income now this is how we get the
aggregate demand schedule now as I told
you initially for the aggregate supply
aggregate supply is always equal to the
level of income and so the first column
here in this particular dual shows us
the aggregate supply now what you need
to do is in order to determine the
equilibrium level you have to see that
in this particular schedule what is the
point where we are getting agree
it's supply equals to aggregate demand
so you can see here at this particular
level of income that is 200 when we have
assumed the income to be 200 our
aggregate demand is also 200 so this is
a particular level where we are getting
the equilibrium point where ad is equals
to a s so this is how we determine the
national income through a schedule fine
now this we can also show graphically so
let's draw a graph to show this an
x-axis we take the income which is
dollar in billion and on y-axis we take
the expenditure which is dollar in
billion so in order to get the
equilibrium point we need to know the S
curve and the ad curve revising upon s
curve will be a curve whose slope is
always equal to 1 and why so because we
have assumed that whatever is the income
of the consumer he is spending it all
that is income is equal to the
expenditure and it will the expenditure
will constantly increase according to
the income of the consumer the income is
increasing the expenditure will increase
and both of them will will be equal to
each other so we get a a S curve whose
slope will always be equal to 1 and it
will form a 45-degree angle what about
the ad curve ad curve will be a
summation of consumption and investment
curve and as Keynes has assumed that
investment
we'll always be constant that is it will
be a line which is parallel to x axis in
our example we have taken the investment
to be dollar fifty billion so it is
constant at dollar fifty billion and it
is a line which is parallel to x axis
what about the consumption the
consumption will constantly increase
according to the income of the consumer
and so we get a line like this this is a
consumption line
it starts at dollar fifty billion so
submitting these two that is the
consumption and investment line we get
our ad curve which is like this the ad
curve will be equal to the consumption
and investment curve so you see here
that the ad curve has cut the a s curve
at this particular point this is the
point of equilibrium at this particular
point the ad curve starts at 100 billion
dollar hundred billion at this
particular point the income is equal to
the expenditure which is equal to dollar
two hundred billion so e is a point
where ad is equal to a s and AD here is
dollar two hundred billion and s is also
here is dollar two hundred two hundred
billion so this is how equilibrium is
determined that is the level of national
income is determined under Keynesian two
sector model so the next important
question which bugs us up is why not
equilibrium at any other point now in
order to answer this question let's back
get back to the graph now you can see
here that
the equilibrium point has been
determined at dollar 200 billion now
suppose what if the aggregate supply is
more than aggregate demand that is a s
is greater than a d or rather we can say
that C plus s that is consumption plus
saving is greater than consumption plus
investment so what is happening here
that whatever the firms are producing
now listen to this very carefully
whatever the firms are producing they
are not able to sell the stocks to the
consumers so as a result the firm will
find that they have produced in excess
of the aggregate demand and their unsold
stocks are piling up so what they will
do they will reduce their production and
cut cut down the expenditure on inputs
as a result of this the demand for
factors of production will also get
decreased this will actually reduce the
income of the household because now the
factor services are not being utilized
by the firm so from where they will get
the income this will reduce the income
of the households and they will start
spending less on the goods and services
now this process will continue until
again the equilibrium point of dollars
two hundred billion is reached fine
similarly we can see that what will
happen below the level of dollar two
hundred billion that is below the
equilibrium point that is where ad is
greater than s that is aggregate demand
is greater than aggregate supply so at
this particular level that is this level
the firm's are not able to meet up the
demand of the market that is they are
providing less output to the society
so when they realize that the demand of
their product is more in the market what
they will do they will start producing
more which will create more demand for
the factor services which will again
enhance the income of the households
therefore and if the income of the
households increase they will demand
more for goods and services in the
market which will again and this this
process will therefore continue till
again we reached a point of dollar 200
billion so you see here that if the
economy is not at the equilibrium level
it will itself adjust and reach to the
point of equilibrium so we see that how
do we determine the level the national
income the level of income under
Keynesian to sector model so this was
about the theory of national income
determination that is we have studied
that how national income under two
sector model is derived under Keynesian
theory the next session will be
continuing our discussion by discussing
that how national income is derived
under three sector and four sector model
till then have a nice time and thank you
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