5.

2 Principle of Effective Dem and

Keynes’ theory of employment is based on the principle of effective demand. The level of
employment in a capitalist economy depends on the level of effective demand. By ‘effective’
demand, Keynes meant the total demand for goods and services in an economy at various
levels of employment. Total demand for goods and services by the people is the sum total of
all demand meant for consumption and investment. In other words, in a two-sector economy
the sum of consumption expenditures and investment expenditures constitute effective
demand

According to Keynes, the level of employment is determined by the effective demand which,
in turn, is determined by aggregate demand function or aggregate demand price and aggregate
supply function or aggregate supply price.

5.2.1Aggregate Dem and and its Com ponents

According to Keynes the speed of economic activity is determined by what he called

“aggregate demand.” Whenever there is recession or overproduction, the capitalists stop
investment and increase savings which further cut jobs and reduce wages. Workers, in a
suddenly bad state, just like in the Great Depression, also reduce their spending and try to
save whatever they can because they have the constant threat of losing their jobs. The ultimate
result of all of this is that consumption of goods throughout society continues to slow down,
which adds to the existing crisis of overproduction. That, in turn, can lead to even more
hoarding by capitalists in a depressing cycle, which cannot be broken unless demand is
pushed up.

The Great Depression of the 1930s has proved the without government intervention economy
cannot overcome economic slowdown. Keynes argued that “The government should pay
people to dig holes in the ground and then fill them up, it doesn’t matter what they do as long
as the government is creating jobs.” MGNREGA can be taken to be a similar attempt like the
interventionist policy as prescribed during the Great Depression in US by Keynes. It is based
on the Keynesian aggregate demand strategy of direct job creation by the government for a
full employment economy that increases purchasing power among workers. What happens in
this case is that it results in direct cash transfers to the group of people whose marginal
propensity to consume (MPC) is the highest.
Unemployment for Keynes, in all cases (regardless of the phase in the business cycle), was a
result of deficient effective demand. When there is guaranteed employment for the poorest
households of the society expectations about the economy would be more stable.
Furthermore, business enterprises would have more stable expectations of effective demand.

Aggregate demand refers to the total demand for final goods and services in the economy. It
is the total expenditure of the community on goods and services. It is also defined as ‘total
amount of money which all sectors (households, firms, government) of the economy are ready
to spend on purchase of goods and services.

5.2.1.1 Com ponents of A ggregate Dem and

The, the main components of aggregate demand (aggregate expenditure) in a four sector
economy are:
1. Household (or private) consumption demand. (C): It is defined as ‘Value of goods and
services that households are able and willing to buy.’
2. Private investment demand. (I): This refers to planned (ex-ante) expenditure on creation of
new capital assets like machines, buildings and raw materials by private entrepreneurs.
3. Government demand for goods and services. (G): It refers to government planned (ex-ante)
expenditure on purchase of consumer and capital goods to fulfil common needs of the society.
4. Net export demand. (X-M): Net export is the difference between export of goods and
services and import of goods and services during a given period.
Thus,
AD = C + I + G+(X-M)

5.3 Consum ption

Consumption makes a major part of aggregate demand for most of the economies.
Consumption includes using your income to buy food items, luxury goods and also for
services like electricity and water supply. We know that as income increases logically, people
tend to consume more. If Ramesh was earning 25,000 per month and suddenly his salary
increases to Rs 50,000, he can now spend more of his income to buy consumer goods like
TV, refrigerator, jewellery, clothes and food items.

5.3.1 Consumption Function and Saving Function

Consumption function explains the functional relationship that exists between income and the
level of consumption. Symbolically, C = f(Y), where C is consumption and Y is income It
shows how consumption varies as income changes. There is a direct relationship between the
two. Consumption function can be expressed in linear form
C = a+bY
C = consumption, a = autonomous consumption ( consumption which is independent of the
level of income) , b induced consumption or MPC and Y is level of income. For example, A
linear consumption function of the form C = 100 + 0.5Y.

The next counter part of this is saving function which is also related to income. Whenever you
get your salary, you do not spend it fully. Instead you save some amount every month.Saving
is that part of income which is not spent on current consumption. The functional relationship
between saving and income is called saving function.
S= f(Y)

Saving is residual income or leftover money of households after consumption.

Therefore, S= Y-C
Saving equation can be derived from consumption equation. As we know C= a+ bY
Since S = Y-C
S =(Y- a-bY) so, S = -a + (1-b)Y

Graph given below examine a linear saving function S = -a + (1-b)Y

Where a = Autonomous consumption (- a represents dissaving which is needed to finance
autonomous consumption. Clearly, at zero level of income, amount of autonomous
consumption = Amount of dissaving.), b = MPC (so that 1 – b represents MPS, i.e.. Marginal
propensity to save), Y = Income.

Let us plot a consumption function with the help of a numerical example

 Y = C +S
Consumption

C = 100 + 0.5Y

300
250
200 ΔC
ΔY S = -100 + 0.5Y
150
100

o 100 200 300 400

Income
-100

The total output or aggregate supply in the economy is shown by Y=C+S. The consumption
function shown by c=100+0.5Y, shows us that 100 is autonomous consumption that is
independent of the level of income. 0.5 is the slope of the consumption function, that is its
MPC. When there is zero income, the houehold has to consume something so consumption is
 100 and saving is -100.,i.e, there is dissaving in the economy. Now, suppose the income rises
to 100, then the consumption is 150,and still the saving is -50. The lower part of the graph is
depicted by the saving function i.e, S=-100+0.5Y.When income becomes 200, consumption is
200 and savings become zero. The MPC is constant at 0.5. The additonal consumption as a
result of additional income remains constant at 0.5. When income increases to 500
,consumption also increases to 350,savings become 150. We observe that APC declines with
increase in income,. Keynesian observsation about the pattern of consumption was that as
income increases consumption also increases but not at the same rate as the increase in
income.

Student Activity:Now examine what happened to the consumption function as the equation
become C = 100 + 0.8Y. Prepare a table and Plot the graph.

BOX 1
Concepts related to Consumption and Saving

Average Propensity to Consume

Average propensity to consume is the ratio of the amount of consumption to total income. Therefore,
average propensity to consume is calculated by dividing the amount of consumption by the total income.
Thus,
APC = C/Y, where
APC stands for average propensity to consume,
C for amount of consumption, and
Y for the level of income.

Marginal Propensity to Consume

MPC = ΔC/ΔY or dC/dY

As for the consumption equation C = a+bY,
MPC =slope dC/dY = b
The value of MPC is always positive but less than one. This means that when income increases, the
whole income is not spent on consumption
Average propensity to save APS

Average propensity to save is the proportion of disposable income that is saved. It is the ratio of total
saving to total income. Mathematically
APS = S/Y or -a/Y +(1-b)
We know Y = C+S, dividing through by Y we have Y/Y = C/Y+S/Y. That is APC + APS =1.
5.3.2 Keynes Fundam ental
Marginal Propensity to Save (MPS)
Psychological Law of
The marginal propensity to save is the ratio of change in Consum
saving ption
to the change in income.
MPS = ΔS/ΔY or dS/dY
where, MPS stands for marginal propensity to consume,
ΔS for change in consumption, and
ΔY for change in income.
As for the saving equation S = -a+ (1-b) Y, MPs = ds/dY = 1-b, that is the slope
Relatio nship between MPC and MPS
From C + S = Y, it follows that any change in income (ΔY) must induce either change in consumption
“The amount of aggregate consumption depends mainly on the amount of aggregate income.
The fundamental psychological law, upon which we are entitled to depend with great
confidence both a priori from our knowledge of human nature and from (the detailed facts of
experience is that men (and women, too) are disposed, as a rule and on an average to increase
their consumption as their income increases, but not by as much as the increase in their
income.”

Keynes major inference regarding income consumption relation is summarized as

• Consumption expenditure depends mainly on absolute income of the current period,

that is, consumption is a positive function of the absolute level of current income. That
is Ct = f(Yt)
• Consumption income relationship is non proportional. That is when income increases;
consumption also increases but not as much as the increase in income. Therefore, APC
eventually declines.
• The consumption income relationship is reversible. That is people will reduce
consumption when their income falls

5.4 Investm ent Function

What is investment? Why is it important in an economy?Investment or capital formation

refers to addition to the capital stock of an economy. Suppose you are buying a new house, it
adds to residential investment. When Samsung factory producing phones buy new machinery
it adds to investment in the present year.In Keynesian economics investment leads to increase
in the levels of income and production. Investment thus includes new plant and equipment,
construction of public works like dams, roads, buildings, etc., net foreign investment,
inventories and stocks and shares of new companies.

To be more precise, investment is the production or acquisition of real capital assets during
any period of time.
Symbolically, let I be investment and К be capital in year t, then It = Kt– Kt- 1.
Kt- 1.is capital in the previous year
We are now interested to examine two major types of investments related to Keynesian
concept of aggregate demand.
a) Induced investment: is another name for private investment. Investment, which varies
with the changes in the level of national income, is called induced investment. When
national income increases, the aggregate demand and level of consumption of the
community also increases. In order to meet this increased demand, investment has to
be stepped up in capital goods sector which finally leads to increase in the production
of consumption goods.
b) Autonomous Investment: is another name for public investment. The investment,
which is independent of the level of income, is called as autonomous investment. Such
investments do not vary with the level of income. Autonomous investment depends
upon population growth, technological progress, discovery of new resources etc for
example expenditure on public buildings, transport and communications, defense,
public utilities, water supply, generation of electricity etc are considered as
autonomous investment.

RECAP
• During the Great Depression of the 1930s, existing economic theory was unable either
to explain the causes of the severe worldwide economic collapse or suggest any policy
measures to correct it.Keynesian macroeconomics, rejected Classical theory and
suggested that by boosting aggregate Demand the economy could improve output and
employment
• Keynes wanted governemnt intervention through fiscal and monetary policy to correct
business cycles.
• The AD- AS model is used by Keynes to explain short run economic fluctuations.
• Keynesian theory of employment is based on the principle of effective demand.By
‘effective’ demand, Keynes meant the total demand for goods and services in an
economy at various levels of employment.
• Aggregate Demand is the total demand for goods and services in the economy.In a
four sector model
• AD= C+I+G+(X-M)
• Consumption Function shows the relationship between income and consumption
• Consumption function can be expressed in linear form
• C = a+bY,
• Where C = consumption, a = autonomous consumption ( consumption which is
independent of the level of income) , b induced consumption or MPC and Y is level of
income.
• MPC aand APC are two components of consumption
 • Keynesian Psychological law of Consumption states that as income increases
consumption increases but not at the same extent of increase in income
• The two components of saving function are MPS and APS.
• Investment is addition to capital stock. Both Induced investment and autonomous
investment are important in the economy.

5.5 Keynesian Theory of National Incom e Determ ination

In the national income chapter you have already studied the circular flow of income in a two
sector model, where there is only household and firms. We also looked at a three sector model
in which government was also included. The four sector model included transactions with the
rest of the world, thus including both exports and imports. There are three different models of
income determination under Keynesian macroeconomics. They are two sector model, three
sector model and four sector model.The two-sector model of economy involves households
and businesses only, while three-sector model represents households businesses, and
government. On the other hand, the four-sector model contains households, businesses,
government, and foreign sector.

5.5.1 The Sim ple Keynesian Model (Incom e Determ ination in a two
sector Model) Condition for Equilibrium Output or Income Determination
Using Cross Diagram

Two sector Closed M odel

Even though the there are extended versions of Keynesian income determination model, we
first start with the discussion of a Simple keynesian Model.The determination of level of
national income in the two-sector economy is based on an assumption that two-sector
economy is an economy where there is no intervention of the government and foreign trade.
The following are the assumptions of the model

Assumptions

1. It is a two-sector economy where only consumption and investment expenditures take

place. Thus the total output of the economy is the sum of consumption and investment
expenditure.
2. Investment relates to net investment after deducting depreciation.
3. It is a closed economy in which there are no exports or imports.
4. There are no transfer payments.
5. There is no government.
 6. There is autonomous investment.
7. The economy is at less than full employment level of output.
8. The price level remains constant up to the level of full employment.
9. The money wage rate is constant.
10. There is stable consumption function.
11. The rate of interest is fixed.
12. The analysis relates to the short period.

In the Keynesian model equilibrium level of output requires that output be equal to aggregate
demand, That is Y = E, where Y is the total output and E consists of Household consumption
C and desired level of investment I. Y which represent national income is partly consumed
and partly saved. Therefore, we have the identity
Y = C+S Aggregate Supply
E = C+I Aggregate Demand
Now in equilibrium Y = E or C+ S = C+ I leads to S=I
Since saving is a leakage from the income stream and investment is an injection to the income
stream, the condition may be written as Leakages = Injections

Now the equilibrium condition may be represented in any one form

Aggregate Demand = Value of output ( Income)
Y = C+I
S =I
Leakage = Injection

Now let us look at the algebraic condition for equilibrium

(a) Income – Expenditure Approach or AD=AS Approach

Given the equilibrium condition Y = C+I and C = a + bY and I = Ī

Y = a+bY+ Ī
Yeq = 1/1-b (a + Ī)
(b) Saving- investment approach
S=I
S=Y–C
S = -a + (1-b)Y
-a + (1-b)Y = Ī therefore
So Yeq = 1/1-b (a + Ī)

Numerical Example
For the determination of national income let us assume that the consumption function is
C = 100 + 0.5Y and I = 50 which is exogenously determined ( therefore, constant)

Y=C+I S=I
Y = 100 + 0.50Y+ 50 -100 +(1-0.5)Y = 50
Y = 1/1-0.5(100 + 50) Y = 1/1-0.5(100 + 50)
Y = 1/0.5(150) Y = 1/0.5(150)
Y = 300 Y = 300

Using the above example a trial and error table can be prepared to understand the equilibrium
condition. Table given below examine the equilibrium conditions

Y or AS C S I AD = C+I Remark
0 100 -100 50 150
100 150 -50 50 200
200 200 0 50 250
300 250 50 50 300 Equilibrium
400 300 100 50 350
500 350 150 50 400

From the above table it is clear that when the level of income is 300 AD is equal to AS,
Saving is equal to investment. Hence equilibrium is established at level of income 300.
Now,let us draw a graph from this table to understand the relationship.

Graphical Solution
 Consumption
Y = C +S
AD = AS

Y= C+I
C = 100 + 0.5Y
350
300
250
200 ΔC

150 ΔY

100
S = -100 + 0.5Y
300 400
o 100 200 500 Income
Saving
I = 50
Δs S=I

100 200 ΔY 300 400 500

-100 Income

Explain graph

The Equality of AD and AS ( Panel A)

The equilibrium level of national income is determined at a point where the aggregate demand
function (C+I) intersects the aggregate supply function (C+S). The aggregate demand
function drawn by adding to the consumption function C and the investment demand I. The
45° line represents the aggregate supply function, Y = C+S. The aggregate demand function
C+I intersects the aggregate supply function Y= C+S at an income level of 300 and the
equilibrium level of income is determined.
Suppose there is disequilibrium in aggregate supply and aggregate demand of the economy.
First, take the case when aggregate supply exceeds aggregate demand. This is shown by the
level of income,400. At this level of income aggregate supply is 400 and AD is 350 Therefore
AS is more than AD by 50 The surplus output of goods worth 50 is accumulated by
businessmen in the form of unintended inventories. The second situation of disequilibrium
when aggregate demand exceeds aggregate supply is shown by the income level of 200 At
this level AD is 250 which is greater than the aggregate supply of goods by 50. To meet this
excess demand worth 50 businessmen will have to reduce inventories by this amount.

Equality of Saving and Investment: ( Panel B)

The equilibrium level of income can also be shown by the equality of the saving and
investment functions. The saving and investment functions intersect which determines the
equilibrium level of income of 300. If there is disequilibrium in the sense of inequality
between saving and investment, forces will operate in the economy and the equilibrium
position will be restored. At 400 level of income saving exceeds investment by 50 It means
that people are consuming less. Thus aggregate demand is less than aggregate supply. This
will lead to the accumulation of unintended inventories with businessmen. To avoid further
accumulation of inventories, businessmen will reduce production. Consequently, output,
income and employment will be reduced till the equilibrium level of income OY is reached at
point where S=I.
On the contrary, if the income level is less than the equilibrium level, investment exceeds
saving. This is shown by OY level of income when investment Y E is greater than saving.
1 1 1

The excess of intended investment over intended saving means that AD is greater than AS by
eE . Since AS is less than AD, businessmen will decrease inventories held by them. To stop
1

further reduction in their inventories, they will increase production. Consequently, output,
income and employment will increase in the economy and the equilibrium level of income
OK will be again reached at point E.