J.M. Keynes in his famous book,
'General theory', has used two methods for
the determination of national income at a particular time:
(1) Saving Investment Method.
(2) Aggregate Demand and Aggregate
Both these approaches lead us to the
determination of the same level of national income.
It may here be mentioned that Keynes model of income determination is
relevant in the context of short run only.
Keynes assumes that in the short run:
(i) The stock of capital, technique of production, forms of business organizations,
do not change.
(ii) He also assumes a fair degree of competition in the market.
(iii) There is also absence of government role either as a taxer or as a spender.
(iv) Keynes further assumes that the
economy under analysis is a closed one. There is no influence of exports and
imports on the economy.
(1) Determination of National Income
By the Equality of Saving and Investment Method:
This approach is based on the Keynesian definitions of saving and investment.
According to Keynes, the level of national income, in the short run, is
determined at a point where planned or intended saving is equal to planned or
intended investment. Saving as defined by Keynes is that part of income which is
not spent on consumption (S = Y - C). On the other hand, investment is the
expenditure on goods and services not meant for consumption. (I = Y - C).
According to Keynes, if at any time,
the intended saving is less than intended investment, it implies that people are spending more on consumption.
The rise in consumption will reduce the stock of goods in the market. This will
give incentive to entrepreneurs to increase output. Likewise, if at anytime
intended saving is greater than intended investment, this would mean that people
are spending lesser volume of money on consumption. As a result of this, the
inventories of goods will pile up. This will induce entrepreneurs to reduce
output. The result of this will be that national income would decrease. The
national income will be in equilibrium only when intended saving is equal to
The determination of national income
is now explained with the help of saving and investment curve below:
In figure (31.2), income is measured on OX axis and saving and investment on OY axis. SS is the saving
curve which shows intended saying at different levels of income. The investment
curve ll/ is drawn parallel to the X axis which shows that investment does not
The entrepreneurs intend to invest $50 crore
only irrespective of the amount of income. Saving (SS) and investment curves (ll/)
each other at point M. If the conditions stated above remain the same, the size
of equilibrium level of income is 250 crore.
Under the assumed conditions if there is inequality between
saving and investment or disequilibrium, the forces will operate in the economy
and restore the equilibrium position.
Let us suppose, that the income has
increased from the equilibrium level OL to ON ($300 crore). At this level of
income, desired saving is greater than the desired investment. When intended
saving exceeds planned or intended investment, the businessmen will not be able
to dispose off all their current output. They will slow down their productive
activities. This will result in reducing the number of workers employed in
factories and a decrease in the income. This process will go on until due to a
decrease in income, people's saving is reduced to the level of investment ($50 crore). The equilibrium income is
In the same way, income cannot remain below this equilibrium level of
$250 crore. If at any time, income falls below the equilibrium level, then it means
that people are investing more than they are willing to save I > S. They will
increase productive activities as they are making high profits. The number of
workers employed in the factories will increase. This will result in an increase
in income and higher saving. This rise in national income will go on up to a
point where saving and investment are just in balance and that will be the
equilibrium level. At this point, income will have the tendency of neither to
rise nor to fall. It will be in a state of rest. It is, thus, clear that
national income is determined at a point where the intended investment is equal
to intended saving.
(2) Determination of
Equilibrium Level of National Income According to Aggregate Demand and Aggregate
While determining the level of national income in a two sector economy, it is
assumed that it is an economy where there is no role of the government and of
foreign trade. In other words, it is a closed economy with no government
intervention. The two sector economy comprises of households and firms.
According to J. M. Keynes, the equilibrium level of national income is that
situation in which aggregate demand (C+ I) is equal to aggregate supply (C + S).
The aggregate demand (C+ I) refers to the total spending in the economy. In a two
sector economy, The aggregate demand is the sum of demands for the consumer
goods (c) and investment goods by households and firms respectively. The
aggregate demand curve is positively sloped. It indicates that as the level of
national income rises, the aggregate demand (or aggregate spending) in the
economy also rises.
Aggregate supply (C + S):
It is the flow of goods and services in the economy.
In other words, the value of aggregate supply is equal to the value of net
national product (national income). The aggregate supply curve (C + S) is a
positively sloped 45° helping line. It signifies that as the level of national
income rises, the aggregate supply also rises by the same proportion.
Equilibrium Level of
According to Keynesian model, the equilibrium level of national income is
determined at a point where the aggregate demand curve intersects the aggregate
supply curve. The 45° helping line represents aggregate supply. By definition,
output equals income on each point of aggregate supply curve. The determination
of the level of aggregate income is explained below.
In the figure 31.3, income is measured along OX axis and expenditure on OY
axis. The aggregate demand curve (C + I) intersects the aggregate supply curve
(45° line) at point K point. K, here is the only point where the economy is
willing to spend exactly the amount which is necessary to dispose off the entire
output. The equilibrium level of income is $250 billion. It may, however, be
noted that this equilibrium output does not mean in any way the full employment
Departure From Equilibrium Level of Income:
Now a question arises that if at
any time there is a departure from the equilibrium income of $250 billion,
how will the economy move towards an equilibrium level? To answer this question,
we examine two possible levels of income other than the equilibrium level.
us suppose first that the actual income is $300 billion rather than $250
billion. According to aggregate demand, schedule (C + l), (the actual consumption +
investment expenditure) at an income of $300 billion falls short by $30 billion (shown by bracket). This means that the goods worth
are not sold. When the inventories pile up with the business, they would curtail
this production and provide fewer jobs. There will thus be a decline in total
income which will continue till the income falls to the equilibrium level of $250 billion.
Now let us suppose that the level of income fails to
According to aggregate demand schedule represented by (C + l) curve, the expenditure
at this level exceeds income by $50 billion (shown by bracket). The increase
in demand of consumer and investment goods will induce the businesses to
increase their output. The higher rate of production will provide more jobs to
The level of income would rise and the upward drive continues till
the income reaches the equilibrium level of $250 billion. We, thus, conclude
by saying that an economy sustains only that level of income where the total
quantity supplied and the aggregate quantity demanded are equal. At this
equilibrium national income of $250 billion, the firms have neither the
tendency to increase output nor the tendency to decrease output. Hence, $250
billion is the equilibrium level of national income. The equilibrium output, in
this simple Keynesian analysis, does not mean full employment.