Everything you need to know about the Keynesian Theory of Income and Employment!

Total Spending and Economic Activity:

Basically, expansions and contractions in economic activity, or changes in real output, are caused by changes in total, or aggregate, spending.

Total, or aggregate, spending refers to the total spending for all new goods and services by households, businesses, govern­ment units, and foreign buyers combined.

Why do changes in spending cause the level of economic activity to change? In a market economy, buyers, through their spending decisions, choose goods and services that are produced by sellers. If buyers do not spend their money on products, sellers will not produce those products for the market. Thus, if total spending were to decrease, output would decrease; if total spending were to increase, output would increase; and if total spending remained unchanged, output would not change.

ADVERTISEMENTS:

When the level of spending goes up and sellers increase production, more land, labour, capital, and entrepreneurship are required. This means that there will be an increase in the employment of resources, which will, in turn, enlarge incomes. Thus, increased spending leads to economic expansion, or recovery, because it stimulates a growth in output, employment, and income.

When spending falls and sellers reduce their outputs, a cutback occurs in the employment of resources. This cutback in turn leads to a decrease in resource owners’ incomes. Thus, a reduction in spending leads to a recession, or contraction in economic activity, because of its dampening effect on output, employment, and income. The relationship between spending and output, employment, and income is summarised in Table 18.1.

Because aggregate spending is composed of expenditures by households, businesses, the government, and foreign buyers, it is necessary examine the spending behaviour of each of these sectors, along with how that behaviour affects the level of economic activity.

Aggregate Effective Demand:

Keynes’ analysis of general unemployment is based on the concept of aggregate (or total) demand in the economy. To simplify his analysis, Keynes initially left aside the government sector (and, therefore, the element of government expenditure in aggregate demand). He also ignored foreign trade (or exports). (However, for the sake of completeness, we shall incorporate these elements in our analysis at the later stage.)

ADVERTISEMENTS:

In a closed economy (i.e., one having no trading relation with the rest of the world) with no government sector.

The two components of aggregate demand are:

(1) private consumption expenditure and

(2) private investment ex­penditure.

ADVERTISEMENTS:

Table 18.1: Total Spending and the Level of Eco­nomic Activity

Total Spending and Level of Economic Activity

The Household Sector:

In the aggregate, the largest spending group in the economy is households. Households buy far more goods and services than do businesses, government units, and foreign purchasers combined. Also, over time, household spending increases at a relatively stable pace. Because individuals do not usually alter their expenditure patterns from year to year, aggregate house­hold spending on new goods and services, which is technically termed personal con­sumption expenditures, tends to fluctuate very little as it grows over time.

The Consumption Function:

To construct Keynesian macroeconomic models, it is necessary to have a clear under­standing of the consumption function. The concept of propensity to consume or the so- called consumption function is based on the— “fundamental psychological law” which states that — “as a rule and on the average” — as income increases, consumption increases but the rate of the increase in consumption is less than the rate of increase in income.

Thus, in Keynes’ consumption function, a relation­ship between functions has the following characteristics:

(i) Consumption is a function of (dispos­able) income, i.e., C = f (Y).

(ii) The relationship between consumption and income is a direct one.

(iii) The rate of increase in consumption is less than the rate of increase in income. In Keynes’ terminology, the value of the marginal propensity to consume (MPC) is less than one.

The Saving Function:

The portion of income which is not consumed is automatically saved. Thus, saving is the difference between income and consumption. That is,

ADVERTISEMENTS:

S = Y- C

Like consumption function, saving also directly depends or income. To have a clear understanding of the saving function, we must define Keynes’ concepts like average and marginal propensities to save.

Four Definitions:

Before we proceed further we have to note four important definitions. These will come up again and again in our discussion of macro­economics.

1. The average propensity to consume (APC):

ADVERTISEMENTS:

It is the proportion of income which is spent on consumption. It is worked out by dividing total consumption expenditure (C) by total income (Y) – APC = C/Y. Thus, if India’s national income is Rs. 10,000 crore and con­sumption expenditure is Rs. 7,000 crore, APC = 7/10 or 0.7.

2. The marginal propensity to consume (MPC):

It is the proportion of an addition to income that is spent on consumption. It is worked out by dividing the (absolute) change in consumption by the (absolute) change in income that brings it about.

It is expressed as:

ADVERTISEMENTS:

MPC = ΔC/ΔY, where C denotes the change in consumption and Y is the change in income.

[It may be noted that C = f(Y), i.e., consump­tion is a function of income or, consumption depends on income. Income changes brings about consumption change. The converse is not true.]

If for example, income rises by Rs. 10,000 crore and out of this Rs. 9,000 crore is spent on consumer goods and services, MPC = 9/10 or 0.9.

3. The average propensity to save (APS):

It is the proportion of income that is saved. It is found out by dividing total savings (S) by total income (Y) or APS = S/Y. Thus, if income is Rs. 10,000 crore and saving is Rs. 3,000 crore, APS = 3/10 or 0.3.

4. The marginal propensity to save (MPS):

ADVERTISEMENTS:

It is the proportion of an addition to income that is saved – MPS = ΔS /ΔY, where S is the change in saving.

Relationship between APC and APS and MPC and MPS:

We know that, out of total income, a part is consumed and another part is saved, i.e., Y = C + S.

Thus, if we know APC or MPC, then we can determine APS and MPS in the following way:

APC = C/Y

APS = S/Y = Y – C/Y [As S = Y – C]

Or, APS = 1 – C/Y

ADVERTISEMENTS:

Or, APS = 1 – APC.

Thus, APC and APS are complementary concepts. The sum of APC and APS is always equal to one. We know that, Y = C + S.

Dividing both sides of the equation by Y we get,

Y/Y = C/Y + S/Y

Or, 1 = APC + APS

Let us now determine MPS from MPC. Here we will show that MPC + MPS = 1.

ADVERTISEMENTS:

We know that, Y=C + S.

Let us suppose that both consumption and saving change as income changes. Thus Y = C + S.

Dividing both sides of the equation by Y we get,

∆Y/∆Y = ∆C/∆Y + ∆S/∆Y

Or, 1 = MPC + MPS

Or, MPS = 1 – MPC

Factors Affecting Consumption:

ADVERTISEMENTS:

Various factors affect consumers’ expenditure. Since consumption and saving are the two sides of the same coin, the determinants of consumption are also the determinants of saving. These determinants are not separate from each other. For example, how much people save is determined largely, if not entirely, by income. People with low income cannot afford to save or cannot save much.

On the other hand, people with very high incomes cannot spend all their income on goods and services. So they cannot avoid saving a portion of their income. If we look at different income groups, we observe that as income rises, the average propensity to consume (APC) falls, or, what comes to the same thing, the average propensity to save (APS) rises. It is because, as income rises, people can afford to save more.

Alternatively, Keynes said that, as income rises, the MPS falls. This brings us on to the consumption function, which lies at the heart of the Keynesian analysis. The consumption function shows the level of consumer’s ex­penditure at each level of income. Fig. 18.1 represents the consumption function diagrammatically.

A Linear Consumption Function

We know that even when income is zero, consumption expenditure is positive. This is known as ‘autonomous consumption’ and can take place because people draw on past savings to pay for it. Or, some people may depend on others for survival.

This is also known as ‘subsistence consumption’. It has no relation to individual’s (or society’s) income. As income increases above this zero level, consumption expenditure also increases. In Fig. 18.1, when income rises from OY1 or OYv2 consumption expenditure increases from OC1 to OC2.

However, the increase in consumption is less than the increase in income — because part of the increase in income is likely to the saved.

Thus, when income rises from OY1 to OY2 the resulting change in consumption (MN) is less than the change in income (LM).

The slope of the consumption schedule— denoted by b in the diagram — is given by MN/LM. Here, LM is the change in income and MN the change in consumption. Therefore, the slope is given by which is indeed the marginal propensity to consume (MPC). Thus, the slope of the consumption schedule gives us the MPC. From the Fig. 18.1, one can establish the relationship between APC and MPC.

At the zero level of income, APC is infinite. However, as income increases, APC declines. Its value may be greater than, equal to, or less than one. On the other hand, the value of MPC is always greater than zero but less than one; i.e., 0 < MPC < 1. On a straight line consumption function, the value of MPC remains constant. Thus, APC should exceed MPC.

A Linear Consumption Function:

The Keynesian consumption function can also be shown in the form of an equation:

C = a + bY, where a is autonomous (income- independent) consumption and b the marginal propensity to consume (which depends on income).

The equation merely states what is shown in Fig. 18.1. Given the values of a and b, we could work out the level of consumption expenditure at any level of income.

If, for example, autonomous consumption is Rs. 4 crore and the MPC is 0.7, then the consumption function will be:

C = Rs. 4 crore + 0.7 (Y); and for any given value of Y, we can calculate the value of C.

A More Realistic Consumption Function:

In Fig. 18.2, the marginal propensity to con­sume is constant. Yet we stated earlier that as income increases, MPC tends to fall. There­fore, a more realistic consumption function would be of the type shown in Fig. 18.2. This shows that as income increases, the slope of the consumption schedule decreases, i.e., as income increases, MPC gradually falls.

However, for the sake of simplicity, we prefer to work with a linear consumption function (where MPC is a constant) in the rest of our analysis.

A Consumption Schedule with Declining MPC

Saving Function in a Diagrammatic Form:

Like consumption function, saving function can also be represented with the help of Fig. 18.3. Here SS’ is the saving curve. It starts somewhere from the vertical axis below the origin (i.e., negative quadrant). This is because, at a very low level of income, saving may be negative, since consumption is always positive.

Consumption expenditure takes place during this time by drawing down past savings. That is why the saving live starts from the negative axis. But, as income increases, saving increases, so saving curve must be a rising one.

Further, the slope of the saving function is nothing but the MPS. Let us pick up points/and d on the SS’ curve. As we move from point f to d income increases (ΔY) by ft and consequently, saving increases (ΔS) by dt.

Thus MPS = ΔS/ΔY = d’t’/f’t’ = slope of the SS’ curve.

Its coefficient is also less than one.

In Fig. 18.3, we have drawn a linear saving function whose equation is:

S = Y- C

Or, S = Y – (a + bY) [Since C = a + b Y]

Or, S = – a + (1-b) Y

In this equation -a indicates negative saving and (1 – b) indicates MPS.

Investment:

Meaning:

Investment expenditure is the second com­ponent of aggregate effective demand. Business investment refers to expenditure on capital goods such as plant, equipment and machinery (fixed capital) as also stocks (working capital), i.e., physical or real investment. In economics, the term investment relates specifically to physical investment. It creates new assets, thereby adding to society’s productive capacity.

To a layman the term ‘investment’ refers to expenditure on the purchase of financial securities such as stocks and shares. Such investment goes by the name ‘financial investment’. But, in economics, the term investment is used in a different way. It refers to physical or real investment.

To be more specific, investment refers to expenditure on the purchase of physical assets such as plant, machinery and equipment (fixed capital) and stocks (working capital). Such physical or real investment creates new assets — thereby adding to the country’s productive capacity, whereas financial invest­ment only transfers the ownership of existing assets from one person or institution to another.

Investment requires that an amount of current consumption is sacrificed (i.e., a portion of income is saved) so as to release the resources to finance it. It is an injection into the circular flow of national income. Investment expenditure is normally defined as consisting only of private sector investment spending.

Importance of Investment:

Investment expenditure is of much impor­tance to a modern economy. Employment depends on aggregate demand. Investment expenditure is a component of aggregate demand and an addition to the circular flow of income.

If investment increases, aggregate demand also increases and, at the end, we observe an increase in employment and income. In fact, the level of employment in a country largely depends on the volume of investment. If more investment is made more employment can be created.

As Willson H. Talf has put it:

“We are all dependent upon the investment of capital.” In fact, if all sources of capital invest­ment are the dried up, flow of all income may ultimately cease.

Moreover, the growth and prosperity of a nation largely depends on the rate of investment (or capital formation). In short, the significance of investment lies in the contribution it makes to economic prosperity. Building new factories, adding new machinery and equipment, and investing in new products and processes (methods of production) enables industry to supply a large volume of more sophisticated products and services to the consumers at large. Finally, investment in the provision of social capital (such as roads, schools, hospitals, etc.) contributes much to the improvement of a country’s living standards.

Gross v. Net Investment:

Investment may be gross or net. Gross investment is the total amount of investment that is undertaken in an economy in an accounting year. Net investment is gross invest­ment less depreciation. Depreciation or replace­ment investment is necessary to replace that part of society’s existing capital stock which is used up in producing this year’s output.

Determinants:

When considering whether to undertake expenditure an entrepreneur will compare the cost of the venture (such as setting up of a textile mill) and the revenue he expects to get from it. The cost refers to the amount to be paid for the machine, or any other form of capital, and the rate of interest to be paid on the money borrowed to finance the expenditure. If the rate of interest falls, one would expect more investment to be undertaken.

The reason is very simple it is now cheaper to borrow the necessary funds, while, if the rate of interest rises, the amount of investment expenditure may be cut back. If interest rates have been high for some time, entrepreneurs may be less inclined (willing) to undertake investment expenditure.

As Keynes put it:

“The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of marginal efficiency of capital and the interest rates on comes of various maturities and risks.”

Thus investment decisions are governed by whether the expected rate of return on the machine is greater than the cost of borrowing the necessary funds, or, if the funds are already available, the cost of the earnings lost by purchasing the machine rather than by lending out of funds. In short, the inducement to invest depends on the marginal efficiency of capital and the rate of interest r. For an investment to be worthwhile, MEC must never fall below r.

(a) Rate of Interest:

Investment is inversely related to the rate of interest. If the expected return on investment remains constant at, say, 10%, and the rate of interest increases from 5% to 7%, the net return on investment goes down from 5% to 2%. So an increase in the rate of interest makes new investment less attractive than before. Similarly, a fall in the rate of interest, ceterus paribus, will stimu­late investment.

(b) Marginal Efficiency of capital:

The other factor affecting investment decisions is the expected rate of return on investment expenditure—or, what Keynes calls, ‘the marginal efficiency of capital’. This return (or revenue) will not fully materialise until some years have passed.

Moreover, many things may happen in that time to nullify the original expectations of the entrepreneur, e.g., consumers may reduce their demand for the commodity being produced (as in the case of black and white T.V. sets due to the added attraction of colour T.V. sets or simple pocket calculators due to the emer­gence of more useful calculating devices such as mini-computers). Investment is, therefore, a risky matter.

So the desire of on entrepreneur to undertake such risks will depend on their expectations regarding the future. If their view of future prospects is pessimistic they will be less willing to spend more on investment. On the other hand, optimism among entrepre­neurs can make them more ready to undertake new investment projects.

The MEC decreases as the amount of invest­ment increases. This is because initial invest­ments are made on the most productive or profitable projects later investments are made on less productive projects, which yield returns.

We have just mentioned that the demand curve for investment goods depends largely on entrepreneurs’ expectations of the future earnings of these goods. And since expec­tations are largely uncertain, the demand for investment goods is likely to fluctuate overtime. It is not too much to expect that every-thing will continue in future as at present.

In truth the main factor—which will influence entrepreneurs in making investment decisions—is the level of consumption. For the demand for investment goods is a derived demand which depends ultimately on current expenditure on consumption. If current consumption is high, investment will be high too, in as much as entrepreneurs will be optimistic. If consumption is low, then invest­ment will also be low.

MEC represents the demand for new invest­ment goods. MEC is the yield expected from a new unit of capital. An entrepreneur, who decides to purchase a new factory or buy a new machine, first of all considers the pros­pective yield of the asset in question. He will also have to pay for the asset if it is to be produced. This price is known as the supply price of the asset or its replacement cost.

And the MEC of a particular type of asset shows what the entrepreneur expects to earn from one more asset of that kind compared with what he has to pay to buy it. Keynes defines MEC as being equal to that rate of discount which would make the present value of the series of annuities, given by the returns expected from the capital asset during its life, just equal to its supply price.

In other words, the MEC of a particular type of capital asset is the rate at which the prospective yield expected from one additional unit of that particular asset must be discounted if it is just to equal the (replacement) cost of the asset. It shows what the rate of discount must be if some entrepreneur is to be just induced to purchase one more (marginal) unit of that type of asset.

The rate of return over cost, r, is called the MEC. It can be calculated as follows:

Let R1, R2…, Rn the expected earnings of a new capital asset in years 1, 2, …., n, respectively. Let K be the scrap value of the machine at the time of replacement, C0 the initial cost of the machine, and e the rate return over cost. Then

C0 = R1/(1 + e) + R2/(1 + e)2 + … + Rn/(1 + e)n + K/(1 + e)n.

Therefore, if Q, K and R’s are known, e can be calculated.

Illustration:

Let us consider a simple case of a machine with an indefinite return R each year. In this case C0 = R/e, so that, if the machine costs Rs. 1,000 and R is Rs. 100, the expected rate of return over cost of the machine is 10%. If the market rate of interest is 5%, the Rs. 1,000 would bring a return of Rs. 50, if lent in the market.

But if the same Rs. 1,000 is invested in the new machine, the annual return is Rs. 100. Consequently, it pays to invest in the machine rather than in the bond. Similarly, if the Rs. 1,000 is not available, it would pay to borrow at 5% in order to purchase the machine on which 10% can be earned.

Clearly then, if MEC remains constant, the number of new machines that will be bought in any period depends on the market rate of interest.

So the investment demand function can be written as:

I = f (r).

On the basis of the two factors affecting investment (i.e., MEC and the rate of interest) we can draw the MEC schedules in Fig. 18.4.

The Marginal Efficiency of Capital Schedule

It is clear that investment will be profitable up to the point where MEC is equal to the rate of interest (which measures the cost of capital). In Fig. 18.4, at an interest rate of r0 (which is, say, 20%) only OI0 amount of investment is worthwhile. A fall in the rate of interest to r1, (say, 15%), increases the amount of profit investment to OI1.

Investment also depends on expectation of entrepreneurs. If expectations change and investors expect to receive more return from each investment because of, say, technological progress, then the MEC schedule will shift from MEC to MEC1. Consequently, at any given rate of interest (such as 20%) more investment will be undertaken then before.

This is indicated by point C in Fig. 18.4. A more pessimistic outlook would cause the MEC curve to shift to the left, e.g., to MEC2 indicating that less investment will be undertaken at any given rate of interest. The curve is, therefore, likely to shift frequently as and when there is a change in the mood among entrepreneurs.

Equilibrium Level of Income:

In Keynes’ model the equilibrium level of national income is the level at which aggregate demand is equal to output (aggregate supply).

This is known as the income-expenditure approach. Alternatively, we can say (following Keynes) that the equilibrium level of income is reached when planned saving is equal to planned investment. This is known as the saving- investment (or leakage-injection) approach. We may well start with the income-expenditure approach.

(a) Income-Expenditure Approach:

In a closed economy with no government the two components of aggregate demand are consumption and investment. In Fig. 18.5, we have drawn the consumption schedule. For the sake of simplicity, Keynes assumed that all investment is autonomous and, hence, independent of income. Thus in Keynes’ model investment is given. It does not change as output (or national income) changes. Such an investment schedule is drawn in Fig. 18.5.

The Equlibrium Level of Income Where Y = C+I

Now, by combining the two schedules — the upward sloping consumption schedule and the horizontal investment schedule — we get the combined C + I schedule in Fig. 18.5. This is called the aggregate demand schedule. This schedule (in Fig. 18.5) shows what aggregate demand will be at different levels of income.

Following Keynes we use the 45°-line as a guideline. Any point on the line is equidistant from both axes. Thus, for example, the distance OYe represents is equal to EYe. Here OYe represents national output (or income) and EYe also represents the level of output.Therefore, it is true if we take any point on the 45° line, that the distance between that point and the horizontal axis will be a measure of national output.

The aggregate demand C + I cuts the 45° line at only one point corresponding to the level of income OY. The distance EY represents output because E lies on the 45° line. But the distance EYe also represents aggregate demand because E lies on the C + I schedule.

There­fore, at the level of income OYe, aggregate demand is equal to output. It is only at this level of income that the equality is reached. What is the logic of this equilibrium? To prove that E is the only point of equilibrium, we have to disprove that no other point can be a point of equilibrium.

Thus, at any level of income below OYe, aggregate income is greater than output. The consequent pressure of excess demand will cause prices to rise, production to expand, and the demand for factors of production to increase. Since production is profitable, output will increase to meet the extra demand. Some unemployed resources will now be used. The owners of these resources will get income and so the economy will move towards the equilibrium point.

Conversely, at any level of income above OYe, aggregate demand is less than output. There is excess supply. Producers find it difficult to sell their entire output at current prices. So they will be forced to accumulate inventories (i.e., stocks of finished goods and raw materials). So they reduce production. Consequently, some resources will be un­employed. Their incomes will fall.

The process will continue until and unless the inventories are totally exhausted. Ultimately, the economy will reach the point E and equilibrium will be restored. Thus, it is clear that, at the level of income OYe, aggregate demand is equal to output and so there is no need for output to change, i.e., there is equilibrium. OYe is, there­fore, the equilibrium level of output (income).

(b) The saving-investment (the leakage- injection) approach:

The alternative approach to income deter­mination is illustrated in Fig. 18.6. Here the equilibrium condition of national income is found by using the alternative equilibrium condition—planned saving being equal to planned investment.

The saving schedule is derived from the consumption schedule in Figs. 18.1 and 18.4. When national income is zero, saving is negative. Such negative saving (dis-saving) occurs because past savings are being used to pay for autonomous consumption, as is indi­cated by the distance Oa in Fig. 18.6. With increases in income the amount of dis-saving is reduced and a point is reached when saving is zero, i.e., neither positive nor negative. This point (shown as 5 in Fig. 18.6) is also called the break-even point in the theory of consumption because at this point income = consumption and the nation, as a whole, neither saves nor dis-saves. Beyond this point, saving becomes positive and rises as income rises.

The Equilibrium Level of Income Where S = I

The investment schedule is horizontal (as in Fig. 18.6), because all investment is autono­mous. The equilibrium level of income is given by the point of intersection of the saving and investment schedules. Since at the level of income OYe, planned saving = planned invest­ment, there is equilibrium.

Saving and Investment:

Incomes are generated by production and the economic system is said to be in equilibrium when all the incomes earned are returned to the income flow through spending. This simple model system is affected by the existence of two complicating factors — saving and invest­ment. Saving is that part of income which is not consumed and, therefore, not passed on in the income flow. Investment is the process of capital formation plus addition to stocks and, therefore, is an addition to the income flow.

We know that saving is undertaken by con­sumers and investment by entrepreneurs. But, in spite of the fact that saving and investment are undertaken by different groups, the amount saved and the amount invested will always be equal in an accounting sense.

The amount spent on consumer goods must equal the sale of consumer goods. Therefore, that part of national income which is not spent on con­sumption, i.e., saving, must be equal to that part of national income (or national output) which is not made up of marketed consumer goods, i.e., investment.

The Circular Flow with Saving and Investment:

Income is earned by selling goods and services and the amount received depends upon the amount spent on them. The circular flow is in complete if there is no mention of saving. In economics, saving is treated as residue. It is that part of society’s current income which is not spent on consumption goods. As savings are not passed on through the purchase of goods and services they act as leakages from the circular flow.

Saving is treated as leakage (or withdrawal) from the circular flow of income because it is that portion of income received by house­holds which has not been spent on consumption goods. To the extent people do not pass a portion of their income in the form of consumption expenditure, the income of others will fall. Thus, saving causes the flow of income to become smaller.

On the other hand, there is an injection (addition) into the flow in the form of invest­ment. When firms undertake investment, capital goods are being produced. Thus, the producers of those capital goods (such as, textile producing machines) must be paid, i.e., they receive income. Hence, investment provides additional income into the flow and this causes the flow to get larger.

From a country’s national income accounting system we know that the actual amount spent on investment, i.e., adding to the stock of capital will equal actual savings (Fig. 18.7). Investment is an injection into the circular flow of income and if it equals savings, the leakage caused by the latter will be offset and can be ignored.

The Circular Flow of Income

The circular flow of income viewed from the expenditure (spending) point of view can be expressed in the following equation form:

National income = Consumption + Savings = Consumer Goods + Investment = National Product.

The amount spent on consumption must be the same as the value of consumer goods produced assuming that savings (the supply of capital goods) equal investment (the demand for capital goods).

If saving and investment are equal, the flow will remain unchanged because the amount withdrawn from it is equal to the amount of injected into it. Thus, if saving and invest­ment are equal, the level of income will not change, i.e., national income is equilibrium.

A few numerical examples will help to show why saving and investment must be equal.

Example 1:

We assume that firms plan an output of Rs. 1,000 crore for a particular period. Of this output, Rs. 800 crore worth will be in the form of consumer goods and Rs. 200 crore investments.

Thus the firms’ plans are:

Planned Y = Rs. 1,000 crore

Planned C = Rs. 800 crore

Planned I = Rs. 200 crore

Households, however, plan to spend only Rs. 700 crore and save Rs. 300 crore. Here the total income of households must be Rs. 1,000 crore because total output is, by definition, equal to total income.

Thus, for households we have:

C = Rs. 700 crore

S = Rs. 300 crore

Therefore, firms will not sell Rs. 800 crore worth of goods. The result is that the Rs. 100 crore worth of unsold goods will be added to stocks.

But stocks of finished goods are counted as investment and so we must amend the investment figures as follows:

I = Rs. 200 crore + Rs. 100 crore

= Rs. 300 crore

We see now that the amount of actual investment is equal to the amount of actual saving.

Example 2:

The firms’ plans are the same as they were in Example 1. However, in this example, households intend to spend Rs. 900 crore and save Rs. 100 crore. This means that, in order to meet the demands of the households, firms have to take Rs. 100 crore worth of goods from their stocks. The investment figure is, therefore, lowered by Rs. 100 crore, thereby bringing investment down to Rs. 100 crore, i.e., equal to saving.

Example 3:

Again the firms’ plans are the same as previously, but this time households plan to spend Rs. 800 crore and save Rs. 200 crore. This time no goods are added to stocks and none are taken from stocks. But again we have investment and saving equal (at Rs. 200 crore).

Saving Investment Equality vs. Saving-Investment Equili­brium:

In each of these examples actual saving has been equal to actual investment. But it was only in the third example that planned saving and planned investment were equal. In Examples 1 and 2, planned investment differed from planned saving and, as a result, changes had to take place. In Example 3, because planned invest­ment was equal to planned saving, there was no need for any changes, i.e., there was equili­brium.

When Keynes stated that saving was always equal to investment he was referring to actual or realised saving and actual or realised investment. The income obtained from the production of the national output is distri­buted to the various factors of production employed in the production process and, so, national income and national output are always and necessarily equal.

They are merely the same thing looked at in two different ways. The output produced will be either for current use or will be added to the country’s stock of investment goods. The income earned will either be used for consumption purposes or saved. As aggregate output and income equal and consumption is identical in both places, the rest of the equation must also be equal, or Y = C +1 and, Q = GNP = C + S and if Y = Q, C + S = C + I or S = I.

When we talk of saving and investment being equal, we are referring to the observed behaviour of an economy; a study of what has actually happened or what has been realised. But the Keynesian analysis of income deter­mination revolves around the intended nature of such variables as saving and investment. These plans to save and invest lead to changes in the income flow, with different equilibrium levels being reached.

Decisions to save and invest are constantly being made by different groups of people at different times and for different reasons. There is very little chance of these plans being equal to each other within the same time period.

When any discrepancy between the plans to save and invest occurs a change in the level of income brings about a state of disequilibrium, and as income continues to change so do these plans get readjusted until a level of income is reached where planned saving and investment are once more equal to each other.

It is only then that equilibrium has been attained where there is no tendency for the level of income and employment to alter. This process is facilitated by a multiplied change in income— which operates both in an upward and down­ward direction.

A simple numerical example may clarify the above. (Rs. crores)

Saving Investment Equality vs.Saving-Investment Equilibrium

The table gives a consumption function from which saving plans can be obtained. Assuming that planned investment is autonomous and that all household plans are realised, an equili­brium level of income can be calculated.

When income is 500 the consumption schedule indicates that 450 will be consumed, leaving the remainder (50) to be saved. At this level of income autonomous planned investment is 50, thereby bringing total expenditure (con­sumption + investment) equal to the level of output (or income). With planned saving and investment being equal, the economy is in a state of equilibrium—there are no forces at work changing the level of output or income.

However, at the higher level of income (600), planned saving exceeds planned invest­ment resulting in planned expenditure falling below planned income. As the rate of production exceeds the rate of sales by 20 the level of stock will rise, thereby resulting in a rise in unplanned investment.

Any stock changes are regarded as changes in investment. At this stage realised investment — made up of planned and unplanned investment—will still be equal to realised saving, but the discre­pancy between the intentions of savers and investors will result in the level of income falling back until it reaches the equilibrium level of 500.

If income were 400 the consumption schedule would indicate that 370 would be consumed and 30 saved. With planned invest­ment exceeding planned saving, planned ex­penditure would exceed planned income resulting in a fall in the value of stocks (inventories). The fall in stocks can be regarded as un­planned disinvestment, giving a realised invest­ment figure of 50 – 20 = 30 (which is the same as realised savings).

Equilibrium and Full Employ­ment:

The classical economists believed that the equilibrium level of income correspond to the full employment level. The implication is simple if there was equilibrium there would be full employment, too. The economists all believed that the operation of the Say’s Law of Markets (which states that supply creates its own demand) would push the economy toward the full employment level.

Keynes, however, points out that there was no reason why the equili­brium level of income should be the same as the full employment level. It could be that the full employment level is higher than the equili­brium level or it could be that it is below the equilibrium level.

To see the implications of this we refer to Fig. 18.8. We see that the equilibrium level of income is OYe. If the full employment level is OX, what happens? The level of income in the economy will move towards the equilibrium level. If, say, income has been below this, it will rise until it reaches equilibrium, but then it will rise no further.

Equilibrium and Full Employment

Therefore, the level of income will not reach OX. If the economy stays at OF, then full employment will not be achieved, i.e., there is unemployment. The unemployment is caused by a deficiency of demand. At OX, output (XA) is greater than aggregate demand (XB). There is a deficiency of demand of the amount AB. This is the amount demand will have to increase for full employment to be achieved. (AB is sometimes referred to as the ‘deflationary gap’ because it shows deficiency of demand or purchasing power.)

If, however, the full employment level of income is OZ, i.e., below the equilibrium level, the economy is not going to reach the equili­brium level. The economy may expand up to the income level OZ, but it cannot go beyond that because there is then full employment and the resources are not available for further expansion. It is as if the economy has come up against the wall which prevents it from going any further.

The economy, therefore, remains at the full employment level, but, at this level, aggregate demand (ZL) is greater than output (ZM). There is excess demand of the amount LM. This excess demand cannot be satisfied by an increase in output because there is frill employment. Therefore, there is upward pressure on prices and the result is inflation. (LM is sometimes referred to as the ‘ inflationary gap’.)

Thus, if the full employment level of income is above equilibrium level, the result is un­employment, while, if the full employment level is below the equilibrium level, the result is inflation. This is what would happen if there were no government activity. However, if the government intervened to regulate demand, it could, in the one case, increase demand in order to reduce unemployment or, in the other, reduce demand in order to reduce inflation.

Keynes, therefore, argued that the only way to avoid high level of unemployment was for the government to increase aggregate demand.

Changes in Equilibrium In­come:

The simple Keynesian analysis of income determination tells us something about the causes and direction of changes in the circular flow of income but nothing about the size of those changes. This latter depends upon the relative proportions of income withdrawn from the circular flow or passed on through expenditure on consumption. Thus, if, taken together, the members of a community have, after withdrawals, four- fifths of their income left for consumption this latter expenditure will become the income of the suppliers of consumer goods and services.

However, Keynes considered it important to analyse the effect on the equilibrium level of income of a change in planned investment.

Keynes realised that an increase in invest­ment will increase the level of income and employment, and the converse is also true. Modern income analysis shows that an increase in investment will increase national income by a multiplied amount — by an amount greater than itself.

This amplified effect of investment on income is called the ‘multiplier’ doctrine. The word stands for the numerical coefficient showing how much above unity is the increase in income resulting from each increase in investment.

An increase in investment will create income for those who produce the capital goods. Part of this income will be saved, but the rest will be spent, thereby providing income for someone else. That ‘someone else’ will, in turn, save part of the new income and spend the remainder, so that another person (or persons) will receive additional income. In this way there is a much larger increase in income than the original increase in investment.

The relationship between an autonomous change in expenditure (in this case, invest­ment) and the resulting change in income is known as the ‘investment multiplier’ (or simply multiplier).

When an increase in investment creates a larger increase in income, the value of the multiplier is given by the following formula:

Multiplier = ΔY/ΔI.

Thus, the multiplier is the ratio of an induced change in the equilibrium level of national income to an initial change in the level of autonomous spending. The ‘multiplier effect’ denotes the phenomenon whereby a small change (increase or decrease) in autonomous spending (such as investment) brings about a more than proportionate change in national income (output).

In Fig. 18.9, we see that a rise in investment from I1, to I2, has caused this equilibrium level of income to rise from OY1 to OY2. The size of the multiplier is given by FH/JH.

The Multiplier Effect

On what does the value of the multiplier depend? A consideration of our previous example will give us the answer. The extent to which income increases depends upon the proportion of income which is passed on at each stage of the process, i.e., the marginal propensity to consumer (MPC). If, for example, investment increases by Rs. 1,000 and the MPC is 4/5, the final increase in income will be Rs. 5,000.

This must be so because when the increase in income reaches Rs. 5,000, the increase in saving will be Rs. 1,000 (since MPS is 1/5. And when the increase in saving reaches Rs. 1,000 it will be equal to the increase in investment and the economy will again be in equilibrium. Thus, in this example, the multiplier (∆Y/∆I) is 5.

An alternative way of finding the multiplier is to use the following formula:

Multiplier = 1/1 – b

where b is the MPC. In our example this would be 1/(1 – 4/5) = 5.

Moreover, since MPC + MPS = 1, the multiplier can be found by using following formula:

Multiplier = 1/s

where s is the MPS. In other words, the reciprocal of MPS gives us the numerical value of the multiplier. This can easily be proved. National income reaches equilibrium when S = 1. So when / increases by ΔI, S must also increase by ΔS to maintain equilibrium (at a higher level of national income). In Keynes’ model ΔY = m (ΔI). In Keynes’ theory, the multiplier (m) investment is the number by which the change in interest has to be multiplied to find out the resulting change in national income (GNP).

or, m = ∆Y/∆I = ∆Y/∆S

= I/(∆S/∆Y) = 1/MPS

= 1/1 – MPC

Thus the multiplier is the reciprocal of the MPS (which is 1 – MPC).

Keynes’ multiplier is known as the invest­ment multiplier, because investment is the key variable in his theory. A change in invest­ment leads to a change in national income through the multiplier process. According to Keynes any change in autonomous spending will have a multiplier effect. In Keynes’ two- sector demand-determined model, investment is the only type of autonomous spending.

Example:

Let us suppose that industrial investment rises by Rs. 1,000 per month. If the proportion of income withdrawn does not change, people will now increase their consumption ex­penditure by 4/5th of Rs. 1,000 per month, i.e., Rs. 800. So, income will now rise further by this amount and consumption by 4/5th of Rs. 800, i.e., Rs. 640. This process goes on until the addition to incomes becomes so small that it can be ignored for all practical purposes.

If we add Rs. 1,000 + Rs. 800 + Rs. 640 and all the other items in the series we can find out the size of expansion of the circular flow caused by the initial Rs. 1,000 increase in injection or autonomous expenditure.

Let ΔY denote the change (Δ) in the flow of income (Y), I stand for the initial increase in injections and b for the proportion of extra income spent on consumption (the marginal propensity to consume).

The income equation in Keynesian model may now be expressed as:

ΔY = ΔI (1 /1-b)

and substituting our assumed figures we get:

Y =Rs. 10 crore x 1/1- 4/5

= Rs. 10 crore x 5

= Rs. 50 crore per month.

If injections rise by Rs. 1,000 per month and the marginal propensity to consume (MPC) is 4/5 (i.e., a constant ratio was the proportion of the increase in income spent on consumption) total incomes will raised by Rs. 5,000 per month.

In this case, the initial change in income has been multiplied 5 times and, therefore, the multiplier is 5. If we let ‘m’ stand for the multiplier we can write,

m = 1/1- b or, in our example, m = 5.

Another way of reaching the same result is by concentrating attention on the proportion of extra income withdrawn (5). Now 1 – b = s, so we can write,

m = 1/s.

Assumptions of the Multiplier:

The Keynesian concept of multiplier is based on the following assumptions:

(i) Autonomous Investment:

The Keynesian multiplier comes into operation for any auto­nomous (income-independent) change in spen­ding.

(ii) Lump-sum taxes:

The multiplier is derived on the assumption that taxes are lump-sum (once-for-all) only. If part of economy’s extra income is taxed away by the government, total leakages (i.e., the withdrawals from the income flow) would rise and the value of the multiplier would be smaller.

(iii) Closed economy:

It is also assumed that the economy is closed. The multiplier ignores all external economic transactions that could be significant for a country with foreign sector.

Leakages from the Multiplier:

Anything that leads to a fall in national income through the multiplier is to be consi­dered as a leakage.

There are three such leakages:

(1) Savings,

(2) Taxes, and

(3) Im­ports.

These are the three deflationary components of national incomes (if consumption can be regarded as fairly stable in the short run).

Comments on the Multiplier:

Two important features of the multiplier are:

(a) It is a cumulative process rather than instantaneous effect. So it can be seen as series of successive ’rounds’ of additions to income.

(b) The value of the multiplier depends on the proportion of extra income that is spent on consumption (the MPC) at each successive round.

The size of a change in the flow of income initiated by every change in injection or withdrawal, other things remaining the same, will depend upon the community’s MPC or its counterpart, its marginal propensity to withdraw income. (In reality, however, what is important in causing income change is the relationship between I and S.)

The larger an increase in consumption from an income increase, the higher the value of the multiplier. Thus, if MPC = 0.9, and MPS = 0.1, the value of the multiplier is 10; if MPC = 0.75 and MPS = 0.25, the value is only 4.

However, the multiplier process takes time to work itself out. It is not that people receive some extra income and spend a proportion of it the next day. They may take weeks or months to spend the relevant proportion of their additional income at each stage of the process. Thus, it will take some time for the full effects of the multiplier to be felt.

Apparently the above analysis is true at all points of time. Actually there is a time tag between the receipt of income and its spen­ding in equation (i) and between its spending and subsequent re-emergence as income in equation (ii). Therefore, the multiplier only tells us the position which will be reached by an economy after a lapse of time if the rate of injection remains constant.

The multiplier concept brings out the fact that income is related to investment in a definite way. But it is very difficult to measure- its active value in case of a country like India.

Importance of the Multiplier:

The multiplier is one of the most important concepts in the theory of the national income It offers a means of numerically measuring or quantifying the impact of changes in aggre­gate demand and any of its component parts. For example, surveys of business plans may show that next year business firms expect to increase their investment spending above this year’s level by say, Rs. 5 crore.

With a twelve­month multiplier of 2, this change would bring a Rs. 10 crore rise in the value of output in the coming year. Business people and govern­ment policymakers can make use of this information to analyse the effects of the change, forecast its impact on other sectors of the economy, and take necessary steps to adapt to the new conditions that will prevail. Both corporate and national planning will be helped.

There is a second way in which the Keynesian multiplier is important. Since the effect of any change is magnified, it is possible to achieve large results from relatively small beginnings. For example, suppose the economy is currently operating well below its full- employment potential by some Rs. 200 crore and the central government wants to increase aggregate demand so as to move the GNP upward to the amount.

Additional spending will have to be generated by government directly or by stimulating consumer spending or business investment. Whatever the path taken, the amount of new spending required to push the national income upward by Rs. 200 crore is only half that amount when the twelve-month multiplier is 2.