Unit 3

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 Say’s Law of Market/
Classical Theory of Employment
• Say’s Law of markets is the core of classical theory of employment.

• A famous French Economist Jeane Baptiste Say enunciated the formal statement that
“Supply creates its own demand.”

• This means that the production of goods and services will generate enough income
and expenditures to demand whatever is produced.

• It implies that the supply of goods generates sufficient income to create demand for
goods equal to its supply.

• Therefore, there is no possibility of overproduction and unemployment in the economy.

• Even if there is some unemployment in the short-run, the economy automatically tends
towards full employment in the long-run.

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• Assumptions of Say’s Law of Markets
◆ There is free market economy.
◆ No government interventions.
◆ Automatic adjustment of economic system due to flexibility of wages,
interest and prices.

◆ Extent of market is limitless.

◆ Closed economy, no trade links with any other country.
◆ Money is only a medium of exchange.
◆ Validity of long-run.
◆ Optimum allocation of resources.

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Say’s Law in the barter system

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 Say’s law in Money Economy:

→ In money economy, people receive money in exchange of the goods that they
have produced.

→ This implies that the supply of product, through the process of production,
generates necessary income- occurring to the factors of production in the form of
rent, wages, interest, profit, etc. to demand the goods produced so that an
equivalent demand is created in accordance with the supply. So, we can say that
the main source of demand is the flow of incomes generated from the process of
production itself.

→ However, in money economy, people may not spend all the money income that
they have received. They may have decided to save a part of their income.

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→ If there is any divergence between saving and investment, the equality is
maintained through the flexibility of money interest.

→ According to classical economists, interest is a reward for saving.

→ The higher the rate of interest higher will be the savings and vice versa.

→ On the contrary, the lower the rate of interest the higher the demand for
investment and vice versa.

→ If the investment is greater than saving, rate of interest will rise.

→ Then saving will rise and investment will fall till the two become equal.

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 Criticism of Say’s Law of Markets.

 Supply does not create its demand

• Say’s law states that supply creates its demand, but Keynes disagrees with this view.
According to Keynes in modern times, demand does not increase as much as
production increases. It is also not possible to consume the goods produced in
domestic economy.

 Self – adjustment is not possible

• Say’s Law assumes that self -adjustment mechanism maintains full employment in the
long – run. But according to Keynes employment can be increased by increasing in
the rate of investment not by self-adjustment mechanism in the long-run. Neither he
was in favor of long-run nor he believed that we all are alive in the long-run.

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 Money is not neutral

• Say’s law assumes that the role of money is neutral, and it does not affect the
economic activities. Keynes gives due importance to money.

• According to Keynes, money is held for income and business motives, industrialists
hold money for unforeseen contingencies, businessmen hold cash in reserve for future
purpose. So money is not neutral, it affects economic activities.

 Overproduction is possible

• Say’s law denies the possibility of overproduction, but Keynes is against it. He
believes that whole factor-income is not spent. A portion of income is saved but it is
not automatically invested. Therefore, saving and investment are always not in
equality. Hence, the problem of overproduction remains in the economy.

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 Need of state intervention
• Say’s Law is based on free market policy, but Keynes has focused on the need of the
intervention of state at times of overproduction and mass unemployment through
fiscal and monetary policies.

 Saving and Investment equality through income

• Keynes opposes Say’s view that savings and investment equality is restored through
rate of interest. He advocates, it is change in income rather than rate of interest which
brings about equality in them.

 Unemployment Situation
• According to Keynes full employment is a special case because in capitalist
economies, unemployment is found existing. Capitalist economies are not found
functioning according to say’s law and supply is always higher than its demand.
Therefore, many workers are willing to work at current wage rate but remain
unemployed.
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 Keynesian Theory of Employment/
Principle of Effective Demand
• The principle of effective demand is the starting point of Keynes theory of
employment.

• According to Keynes, unemployment is due to lack of effective demand.

• Thus, employment can be raised by increasing the level of effective demand.

• Effective demand is identified with the total demand for goods and services.

• The level of employment depends upon effective demand, greater the level of
effective demand, the greater the amount of employment in the economy.

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• It is the level of effective demand which determines the
level of employment since it represents total demand for
goods and services.

• Therefore it is necessary to maintain high level of

effective demand through expenditure on consumption
(C) and investment (I) to maintain a high level of
income and employment.
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• Keynes used the term ‘effective demand’ to designate
the point where aggregate demand curve intersects
the aggregate supply curve.
• Thus, according to Keynes, effective demand is
determined by two factors:
• Aggregate Demand Price
• Aggregate Supply Price

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 Aggregate Demand Price

• It is the amount of money which the entrepreneurs

expect to receive from the sale of output produced at
a particular level of employment.
• It is the schedule of the proceeds expected from the
sale of output resulting from varying amount of
employment.

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• The AD curve slopes upwards from left to right.
• This is because as the level of employment and
income increases, the aggregate demand price tends
to rise.
• However, when income increases, people tend to
spend a smaller proportion of their income on
consumption goods.
• Thus, as output and employment increase, aggregate
demand price rises at a diminishing rate.
• Hence, the slope of aggregate demand curve
diminishes as the employment increases.
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 Aggregate Demand
• It shows the sum of money which all the firms actually expect to receive from the sale of output
produced by the workers.

• The amount of expenditure actually expected by the firms when a given number of workers are
employed is known as aggregate demand price.

• Aggregate demand function has four components: -

a. Consumption Demand [C]

b. Investment Demand [I]

c. Government Expenditure [G]

d. Net Exports [X-M]

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 Aggregate Supply Function

• When firms employ some people, they employ incur some cost of production.

• Thus, each level of employment involves a certain money costs of production

including normal profits which the entrepreneurs must earn.

• At any given level of employment, the aggregate supply price is the total amount
of money which all the firms must expect to receive from the sale of output by the
given level of labors.

• The aggregate supply function (ASF) shows the relationship between the number
of workers employed and the receipts which all firms in the economy must get,
prices remaining constant.
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Aggregate supply schedule

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• The ASF curve starts from the origin and slopes upward to the right.

• In the beginning, it rises slowly and afterwards it rises rapidly.

• This is because the cost of production rises as more people are employed and further due to
the operations of law of diminishing returns.

• The ASF curve becomes vertical after full employment is reached.

• In the following diagram ONF is the full employment level.

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 Effective demand
• The level of employment is determined at the point where the aggregate demand price equals the
aggregate supply price.

• This point is called the Effective Demand.

• If the aggregate demand price exceeds aggregate supply price, the firms will go on employing extra
laborers.

• When the aggregate demand price equal aggregate supply price then after this point it will not be
profitable to employ more workers.

• The employment of labor will be in equilibrium at the level at which aggregate demand price equals
aggregate supply price.

• Here, ON2 is the equilibrium level of employment at which AD = AS.

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 Schedule
Level of Employment (N) Aggregate Demand Price (Rs Aggregate Supply Price
in Lakhs Crores) (Rs Crores)
20 230 215
25 240 230
30 250 245
35 260 260
40 270 275
45 280 290
50 290 305

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Effective demand

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 Under employment equilibrium –
the problem of demand deficiency
• It Is not necessary that the equilibrium level of employment is always at full employment.
Equality between aggregate demand and aggregate supply does not necessarily indicate a full
employment level.

• In the following diagram the equilibrium level of employment is ON and NNF persons remain
unemployed.

• They are involuntarily unemployed which means people are willing to work but are unable to
find jobs.

• Thus, according to Keynes, this unemployment is due to deficiency of aggregate demand.

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• This unemployment can be removed a and a full employment
equilibrium is achieved through increase in investment or increase in
consumption or increase in both.
• This will shift the aggregate demand curve upward so that it
intersects the aggregate supply curve at point E1.
• The intersection of aggregate demand and aggregate supply curve at
point E1, the equilibrium is established at full employment level of
ONF.

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Consumption Function

Meaning
Diagram
Concepts
Saving function
assumptions
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 Consumption Function
• The Consumption Function relates the amount of consumption to the level of income.

• The consumption function schedule describes the amount of consumption at various levels of income.

• Thus, according to Keynes, consumption depends upon level of income i.e.

• C = f(Y)

• The linear form of Consumption function is given as

• C = a + bY
• ‘a’ is the autonomous consumption i.e. consumption at zero level of income

• ‘b’ is the slope of consumption function i.e. MPC (Marginal Propensity to consume)

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Linear Consumption Function

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Non-Linear Consumption Function

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• C1 is the consumption function.

• If the consumption curve coincides with 45 line OZ it would simply mean that
the amount of consumption is equal to income.

• When the Consumption function changes, the consumption function curve will
shift.

• When the propensity to consume increases the consumption function curve shifts
upward from C1 TO C3

• When the propensity to consume decreases, the consumption function curve shifts
downwards i.e. from C1 TO C2.

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1/28/2023 12:32
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• C= a+bY
• C=200+0.5Y
• Y= 1000 C= 300 0.3
• Y= 2000 C= 700 0.35

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• Average Propensity to Consume (APC)

• It is the ratio of amount of consumption to total income.

• It is calculated by dividing consumption by income

𝐶
• 𝐴𝑃𝐶 =
𝑌

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• Marginal Propensity to Consume (MPC)
• It is the ratio of change in consumption to change in income.

𝐶
• 𝑀𝑃𝐶 = 𝑌

• The slope of consumption curve is MPC.

• Y=4000 C=2500
• Y=5000 C=3200

• MPC=700/1000=0.7

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• MPC varies between 0 & 1.
• If MPC is 0, then the whole of the increment in income would have
been saved and the consumption function curve will be horizontal.

• If MPC = 1, then the whole of the increase in income would be

consumed and in that case the consumption function curve would be
parallel with 45 line.

0<MPC<1

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1. Y=4000 C=2500

• Y=5000 C=3200

• MPC=700/1000=0.7

2. Y=4000 C=2500

• Y=5000 C=2500

• MPC= 0

3. Y=4000 C=2500

• Y=5000 C=3500

• MPC= 1

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• In the Keynesian (linear) consumption function, the MPC
remains constant and APC is falling with increase in
income.
• Thus, in a linear consumption function MPC remains
constant.
• While MPC is constant, APC falls with increase in income.
• The fall in APC with an increase in income has an
important implication that increase in consumption is not
proportional to increase in income.
• Thus MPC < APC at various levels of income.

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Example

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 Psychological Law of Consumption

• Keynes has put forward psychological law of consumption, according to which as income
increases, consumption also increases but not in the same proportion as increase in income
as MPC is less that 1 but greater than 0 i.e.

• 0 < MPC < 1

• Keynes points out that consumption expenditure does not have a proportional relationship
with income.

• The decline in APC as the income increases implies that proportion of income that saved
increases with an increase in income.

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Relationship between APC and MPC

1. APC is the position of the consumption curve.

• MPC is the slope of the consumption curve.
2. According to Keynes, as income increases the MPC
and APC fall, but the decline in MPC is greater than the
decline in APC.
3. If the consumption function is linear, the
consumption function is a straight line, the MPC is
constant but the APC falls as income increases.
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 Example

Income Consumption APC MPC

(Y) (C)
1000 950 0.95 --
1100 1040 0.945 0.9
1200 1120 0.933 0.8
1300 1190 0.915 0.7
1400 1250 0.893 0.6
1500 1300 0.867 0.5
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 Saving Function

• Saving is defined as the part of income which is not consumed. Thus,

• Y=C+S

• S=Y–C

• Saving function is a counter part of consumption function. Saving is also a function of

income, i.e.

• S = f(Y)

• The Keynesian consumption function is C = a + bY, and S = Y - C

• Therefore, S = Y(1 - b) – a

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 Equation

• C=a+bY ------(1)
• S= Y-C
• S= Y-(a+bY)
• S= Y-a-bY
• S= -a+Y-bY
• S= -a+(1-b)Y -------(2)

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 Example

1. C=100+0.6Y
S= -100+(1-0.6)Y
S= -100+0.4Y

2. S= -200+0.3Y
C=200+0.7Y

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1. C=200+0.4Y
• S=-200+0.6Y

• 2. S= -100+0.3Y
• C= 100+0.7Y

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Diagram

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• Average Propensity to Save (APS):
• It is the counterpart of APC.
• It is the ratio of amount of saving to total income.

• It is calculated by dividing saving by income

𝑆
• 𝐴𝑃𝑆 = 𝑌

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• Marginal Propensity to Save:
• It is the counter part of MPC.
• It is the ratio of change in saving to change in income.

𝑆
• 𝑀𝑃𝑆 = 𝑌

• The slope of saving curve is MPS.

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 Derivation

• Y=C+S
• Divide both side by Y
• Y/Y= C/Y+S/Y
• 1= APC+APS
• APC=1-APS
APS=1-APC

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• Y=C+S
• ∆Y= ∆C+ ∆S
• Divide both sides by ∆Y
• ∆Y/ ∆Y= ∆C/ ∆Y+ ∆S/ ∆Y
• 1= MPC+MPS
• MPC=1-MPS
• MPS=1-MPC
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 EXAMPLE
Y C S APC MPC APS MPS

0 50 -50 -- --- ---- ---

100 125 -25 1.25 0.75 -0.25 0.25

200 200 0 1 0.75 0 0.25

300 275 25 0.91 0.75 0.09 0.25

400 350 50 0.88 0.75 0.12 0.25

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• C=a+bY
• C=50+0.75Y
• Y=100,200, 300, 400
• C= 125, 200, 275, 350

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 Determinants of Consumption Function/
Determinants of Propensity to Consume/
Factors affecting consumption Function

• Keynes has decided the factors determining the propensity to consume into two groups

a. Objective Factors (change in consumption)

b. Subjective Factors (change in savings)

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 Objective Factors

1. Changes in general price level.

• When the general price level increases i.e. inflation occurs, the consumption function shifts
downwards, this is because when the rise in general price level, the purchasing power of
money declines. This causes downward shift in consumption function. This is known as real
balance effect.

• Similarly, as the general price level falls i.e. deflation occurs and consumption function
shifts upwards, this is because when the general price level decreases, the purchasing power
of money increases. This causes an upward shift in consumption function.

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2. Fiscal Policy.

• Fiscal Policy of the government, especially taxation policy affects the propensity to
consume.

• By levying excise duties, sales tax the government can cut down the consumption and
thereby increases savings.

• When the government reduces taxes, consumption of the people increases and this
raises the propensity to consume.

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3. Rate of Interest.

• Rate of Interest affects the propensity to consume and save.

• The higher the rate of interest induces people to save more and this results in reducing their
propensity to consume.

4. Income Distribution.

• If national income is distributed unequally, the lower will be the propensity to consume.

• This is because propensity to consume of the rich is relatively less to that of poor.

• Thus, if inequalities in income distribution increases, this reduces the consumption.

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5. Wind fall gains and losses.

• When the prices of shares go up, the shareholders begin to think better off and this raises their consumption.

• When the prices of shares go down, the shareholders suffer losses and will result in reduction of their
consumption.

6. Monetary Policy.

• The availability of easy credit causes an increase in consumption and shifts the consumption function
upward.
• For example :- In India, in recent years, lowering of lending interest rate by Indian banks on loan for houses,
cars, computers and other durable consumer goods has greatly increased the consumption of people.
• Tightening of the credit produces an opposite effect i.e. it causes downward shift in the consumption function

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7. Change in Expectations.

• When people expect the prices to go up then they will to spend more on goods so as to
meet the needs of immediate wants.

• This raises consumption function in the current period.

• On the other hand, when people expect prices to fall, they reduce their consumption so
that they can spend more when the price actually falls.

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 Subjective Factors (Psychological Factors)

• It consists of those motives which induce

individuals and business firms to refrain from
spending out their income.
• The motives which make the individuals to save
more are as follows :-

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1. Motive of Precaution
• People save as they want to provide for unforeseen
emergencies/contingencies such as illness, unemployment, accident etc.

1. Motive of Foresight
• People are induced to save as they want to provide for the expected future
needs such as old age, education of children, etc.

1. Motive of Calculation
• Several people wish to save from their current income so that they may be
able to use accumulated savings for investment which increases their future
income. Investments will bring them more income in the form of profit and
interest.
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1. Motive of Improvement
• People are motivated to save so that they can accumulate large wealth
which will increase their expenditure to improve standard of living.

1. Motive of Enterprise
• Many individuals save more so that they can use the accumulated
amount for speculative purposes and other business projects.

1. Motive of Avarice
• Many people save because they desire to satisfy pure miserliness.
1. Motive of Pride
• Many people save for the sake of leaving a good fortune for their
successors.
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Investment Multiplier
Meaning
Derivation
Diagram
Limitations
Leakages
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 Introduction
• Y=C+I+G change in I =other factors constant= change in Y

• Investment multiplier is a ratio of final change in income to the initial change in

investment.

𝑌
• 𝐾 = 𝐼

• The essence of multiplier is that the total increase in income is manifold the original
increase in investment.

• For example, if an investment increases by Rs 100 crore, the national income increases by
Rs 300 crore, then the multiplier is equal to 3.

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• If Y stands for increase in income, I stands for increase in investment and MPC stands for Marginal
Propensity to Consume, we have

1
• 𝑘=
1−𝑀𝑃𝐶

1
• 𝑌 = 𝐼
1−𝑀𝑃𝐶

𝑌 1
• 𝐼 = 1−𝑀𝑃𝐶

1
•𝐾= 1−𝑀𝑃𝐶

• Where ‘K’ is the Multiplier

• Also, since 1 − 𝑀𝑃𝐶 = 𝑀𝑃𝑆
1
• 𝐾=
𝑀𝑃𝑆

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• The formula for multiplier is given as
1
• 𝑘 = 1−𝑀𝑃𝐶

•Where ‘K’ is the Multiplier

•Also, since 1 − 𝑀𝑃𝐶 = 𝑀𝑃𝑆
1
• 𝐾= 𝑀𝑃𝑆

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 Algebraic Derivation
• Y=C+I

• Y = C + I --------- (1)

• The linear form of consumption function is given by

• C = a + bY

• If C = bY ------ (2)

• Y = bY + I

• Y (1 – b) = I

𝐼
• 𝑌 = (1−𝑏)

𝑌 1
• 𝐼 = 1−𝑏

𝑌 1
• =
𝐼 1−𝑀𝑃𝐶
𝑌 1
• 𝐼 = 𝑀𝑃𝑆

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 Value of Multiplier
Value of MPC Value of MPS Value of Multiplier
0 1 1
0.1 0.9 1.11
0.2 0.8 1.2
0.3 0.7 1.42
0.4 0.6 1.6
0.5 0.5 2
0.6 0.4 2.5
0.7 0.3 3.33
0.8 0.2 5
0.9 0.1 10
1 0 ∞
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→ Derivation of Investment Multiplier

• Given the marginal Propensity to consume as 0.8 and initial increase in investment is Rs 100 crore
then,

• 𝑌 = 100 + 100 0.8 + 100(0.8)2 + 100 (0.8)3 … .

• = 100 [1 + 0.8 + (0.8)2 + (0.8)3 + ⋯

• But the above series is of Geometric Progression, therefore increase in income

1
• 𝑌 = 100
(1−0.8)

• 𝑌 = 500

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 Two limiting cases of the value of the multiplier

• One limiting case occurs when the MPC is equal to 1, that is, when whole of
the increment in income is consumed and nothing is saved.

• In this case, the size of the multiplier will be equal to infinity, that is, a small
increase in investment will bring about a very large increase in income and
employment.

• However, this is unlikely to occur since MPC in the real world is less than 1.

• i.e. MPC = 1, then the multiplier (K) = .

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• The other limiting case occurs when MPC is equal to 0, that is, when nothing out
of the increment in income is consumed, and the whole increment in income is
saved.
• In this case, the value of the multiplier is equal to 1.
• That is, in this case, the increment in income will be equal to the original increase
in investment and not a multiplier of it.

• i.e. MPC = O, then the multiplier (K) = 1

• Therefore, in real life MPC is greater than 0 but less than 1.

• 0 𝑀𝑃𝐶 1
• The value of multiplier is greater than 1 but less than infinity.
• 1 𝐾 

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 Example

• If MPC = 0.8
• Initial increase in investment = Rs 1000
• What is the value of multiplier?
• What is the final change in income?

Ans: k= 5
Change in income= Rs 5000
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 Working of the Multiplier
• Let us assume that MPC =0.8 and an increase in Investment of Rs 1000 will
increase the total income by Rs. 5000.
• This is explained as follows:
Rounds Original Increase Induced increase Additional Saving out of
in Investment (𝑰) in Income (𝑌) consumption from income (𝑺)
increased income (0.8
of 𝑌)
1 1000 1000 800 200
2 800 640 160
3 640 512 128
4 512 409.60 102.40
5 409.60 327.68 81.92
etc. etc. etc
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Total Rs 1000 Rs 5000 RS 4000 PM
Rs 781000
 Working of the Multiplier

• Let us assume that MPC =0.6 and an increase in Investment of Rs 5000. The value
of multiplier will be 2.5. This will increase the total income by Rs. 12500.
• This is explained as follows:
• K= 1/1-mpc
• K= 2.5
• 𝑌 = 𝐼 ∗ 𝐾
• = 5000*2.5
• = Rs 12500

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Multiplier with Income and
Expenditure

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Multiplier through Saving-
Investment

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 Example

• Suppose autonomous Investment= Rs 200 crore

• C= 80+0.75Y
• What is the equilibrium level of income?
• What is the value of multiplier?
• What will be the increase in national income if
investment increases by Rs 25 crore?

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• For equilibrium level of income,
• Y=C+I
• Y= 80+0.75Y+200
• Y= 1120 crore
• K= 4
• National income will increase by Rs 100 crore.

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• Suppose in a country, investment increases by Rs 100
crore and consumption is given by C= 10+0.6Y.
• How much increase will take place in income?

• What increase in investment is needed to raise

income by Rs 4000 crore, if MPC is 0.75? How much
increase will there be in consumption and saving due
to this increase in income?

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Reverse Operation of Multiplier/
Paradox of Thrift

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Can we avert the paradox of Thrift?

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Keynesian explanation of the great
Depression: The impact of
multiplier

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 USA Great Depression:
Case Study
1929 1933 (in Billion US$)
Change

Investment 56 8.5 47.5

National Income 315 222 93

Unemployment 3.2 25 21.8

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• As explained by Keynes, the decrease in national income
was not merely equal to $47.5 billion, but by a multiple
amount due to the operation of the multiplier in the
reverse.
• The value of multiplier was around 2 during this period.
𝑌
• 𝐾 = 𝐼
• = 93/47.5= 1.96
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 Assumptions
• The MPC remains constant throughout the time period.
• There is no time-lag between increase in investment and resultant increase
in income.
• There exist excess capacity in the consumer goods industry.
• The economy is closed.
• The price of goods remain constant.
• Multiplier works in both real and monetary terms.
• The multiplier period is absent.
• There exists unemployment in the economy.
• Resources required for production are available.

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 Limitations

• Availability of consumer goods

• Continuous net investment
• Multiplier period
• Full employment ceiling
• Availability of resources

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 Leakages of Working of Multiplier

• Paying off debts

• Holding of idle cash balances
• Taxation
• Increase in prices
• Imports

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• Without trade:
• MPC= 0.75 MPI= 0
• K= 1/1-(MPC-MPI)
• K= 4
• With trade:
• MPC= 0.75 MPI= 0.25
• K= 1/1-(MPC-MPI)
• K= 2
 National Income Determination in
Two Sector Model
• Y=C+I
• C=f(Y)
• C=a+bY
• I=I+cY

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• Y=C+I

• Y = (a + bY) + Ia

• Y – bY = a + Ia

• Y (1 – b) = a + Ia

(𝑎+𝐼𝑎 )
• 𝑌= (1−𝑏)

𝑌 1
• =
𝐼 (1−𝑏)

𝐼
• 𝑌 = (1−𝑏)

• (1 – b) is Marginal Propensity to Save (MPS)

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 Examples

• 1. Suppose the C= 200+0.8Y

• Autonomous investment (I)= Rs 600
• Find out the equilibrium level of income. (4000)
• 2. C=0.8Y and autonomous investment is Rs 500
crore, find out the equilibrium level of income. (2500
crore)

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• 3. C= 20+0.6Y
• I= 10+0.2Y
• What will be the equilibrium level of income? (150)
• 4. C= 40+0.8Y
• Planned investment= Rs 75 crore
• What will be the equilibrium level of income and
consumption? (575, 500)

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• 5. C=60+0.75Y
• If investment in a year is Rs 35 crore, What will be
the equilibrium level of income and consumption?
(380, 345)
• If full employment level of income is Rs 460 crore,
what investment is required to be undertaken to
ensure equilibrium at full employment?

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• Given S= -10+0.2Y and autonomous investment I =
Rs 50 crore.
• Find the equilibrium level of income? (300)
• Find the level of consumption. (250)
• If investment increases permanently by Rs 5 crores,
what will be the new levels of income and
consumption. (325, 270)

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• S=-15+0.25Y
• I= 20 crores
• Eqm income and consumption? (140, 120)
• Find out the value of multiplier. (4)
• If investment increases by Rs 10 crore, what will be
the new level of income? (180)

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National Income in Three Sector

• Y=C+I+G
• Y = (a + bY) + I + G

• Y – bY = a + I + G

• Y (1 – b) = a + I + G

𝑎+𝐼+𝐺
• 𝑌= (1−𝑏)

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→Introducing taxes in the three-sector model
• Y = C + I + G and C = a + bY
• Y = a + b (Y – T) + I + G
• Y – bY = a – bT + I + G
• Y(1-b)=a+I+G-bT

(𝑎+𝐼+𝐺−𝑏𝑇)
• 𝑌= (1−𝑏)

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• Government Expenditure Multiplier

(𝑎+𝐼+𝐺−𝑏𝑇)
• 𝑌= (1−𝑏)

• From the above equation, we state that if government expenditures increase by one-unit, other
determinants such as ‘I’ and ‘T’ remaining constant, the equilibrium national income ‘Y’ will
1
increase by
(1−𝑏)

• Similarly, if government expenditure is increased by G, the equilibrium national income ‘Y’
1
will increase by G x
(1−𝑏)

• Thus,

G
• Y = (1−𝑏)

• Rearranging,

Y 1
• =
G (1−𝑏)

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 1
• The size of the government expenditure multiplier is equal to (1−𝑏) .
• Increase in government expenditure has multiplier effect on
equilibrium level of income and the size of government expenditure
multiplier depends upon MPC.
• Since 1-MPC=MPS, the value of government expenditure is also
equal to 1/MPS.

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• Lump-sum tax multiplier
• Three-sector model with government expenditure and lump-sum tax
is given as

• Y = C + I + G and C = a + b(Yd).

• In a three-sector model with lump-sum tax and no transfer payments,

consumption function is given as

• C = a + b (Y – T)

• C = a + bY – bT

1
• 𝑌 = (1−𝑏) 𝑋 (𝑎 + 𝐼 + 𝐺 − 𝑏𝑇)

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• From the above equation

• Increase in lump-sum tax ‘T’ by 1unit, other determinants of income such as ‘a’, ‘I’, ‘G’
−𝑏
remaining constant, will lead to decrees in national income by
(1−𝑏)

• Similarly, increase in lump-sum tax by T will cause decrease in national income Y by

−𝑏
𝑋T. Thus,
(1−𝑏)

−𝑏
• 𝑌 =
(1−𝑏)
𝑋𝑇

• Rearranging,

𝑌 −𝑏
• =
𝑇 (1−𝑏)

𝑌
• Where ;
𝑇
is lump-sum tax multiplier.

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• Three Sector economy with lump sum taxes and Transfer
payments
• C= a+bYd
• Yd= Y-T+TR
• C= a+b(Y-T+TR)
• Y=C+I+G
• Y=a+b(Y-T+TR)+I+G
• Y= a+bY-bT+bTR+I+G
• Y-bY= a-bT+bTR+I+G
• Y(1-b)=a-bT+bTR+I+G
• Y=1 (a-bT+bTR+I+G)
(1-b)

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• Suppose govt expenditure increases by ∆G. Then
increased income is
• Y+ ∆Y= 1(a-bT+bTR+I+G +∆G)
1-b
∆Y= 1 (∆G)
(1-b)
∆Y/ ∆G= 1/1-b
Thus the Govt expenditure multiplier, ∆Y/ ∆G= 1/1-b

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• Suppose govt increases transfer payments by ∆TR.
Then increased income is
• Y+ ∆Y= 1(a-bT+bTR +b ∆TR +I+G +∆G)
1-b
∆Y= 1 (∆TR)
(1-b)
∆Y/ ∆TR= b/1-b
Thus the transfer payments multiplier, ∆Y/ ∆TR= b/1-
b

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• Balanced Budget Multiplier

• In case of a Balanced Budget, the government expenditure is equal

to tax revenue.

• When the government increase its expenditure by G, then it also

raises tax to get more tax revenue T so that, G = T.

~ The Balanced Budget Multiplier is equal to 1

~ Govt Exp Multiplier Gm= 1/1-b

~ Lump sum Tax multiplier (Tm) = -b/1-b

~ Balanced Budget Multiplier= Gm+Tm=1

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• Proof :- Balanced Budget Multiplier is the sum of government
expenditure multiplier and lump-sum tax multiplier.

• Government Expenditure Multiplier (GM)

1
• 𝐺𝑀 = (1−𝑏)

• Lump-sum tax Multiplier (TM)

−𝑏
• 𝑇𝑀 = (1−𝑏)

• Balanced Budget Multiplier = GM + TM

• Therefore, Balanced Budget Multiplier is always equal to 1.
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 Example
• C=250+0.75Yd
• G=150
• I=80
• T=200
• Find the equilibrium level of income, consumption and
private sector savings. (1320, 1090, 230)
• Tax multiplier (-3)
• Using the value of tax multiplier, how much will income
increase if taxes are reduced by 30? (90 crore)
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• C= 50+0.8Yd
• I=100
• G=75
• T=75
• Eqm income, consumption. (825, 650)
• What is the value of tax multiplier. (-4)
• Investment multiplier (5)
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• C= 20+0.8Yd
• I=50
• G=20
• T=10
• Find equilibrium level of income.(410)
• If lump sum taxes increase by 10, what is the new
equilibrium level of income and lump sum tax
multiplier. (370, -4)
• If govt expenditure decreases by 10, what is new
equilibrium level of income and govt expenditure
multiplier. (360, 5)
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 Example
• C= 100+0.75Yd
• I=200
• G= 100
• T=100
• TR=50
• Find the equilibrium level of income. (1450)
• Calculate govt expenditure multiplier (4) and transfer payments
multiplier (3). What is the difference between the two? (1)
• If full employment level of income is Rs 1600 crores, how much
govt expenditure be increased to attain full employment. (37.5)

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 Determination of National Income
in Four Sector Model
• Y = C + I + G + (X-M)
• where
• C = a + bY
• C = a + b (Y – T + TR)
• Y = a + bY – bT + bTR + I + G + (X – M)

1
• 𝑌= 1−𝑏
(𝑎 − 𝑏𝑇 + 𝑏𝑇𝑅 + 𝐼 + 𝐺 + 𝑁𝑋)

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→ Foreign Trade Multplier
• In the Keynesian model of National Income determination, exports are assumed to be
constant and imports are treated as a function of

• (i) autonomous imports

• (ii) level of income

• The import function is given as

• 𝑀= 𝑀
ഥ + 𝑚𝑌

• where
• 𝑀 is autonomous imports
• mY represents imports depending on the level of income (Y)
• m is the Marginal Propensity to Import

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• Given the Marginal Propensity to Import (m) as income increases, mY will also increase.

• Given the import function, we can derive the complete four sector model of national income determination as
follows: -

• Y = C + I + G + (X-M)

• C = a + bY

• ഥ + 𝑚𝑌
𝑀= 𝑀

• ഥ − 𝑚𝑌)
𝑌 = 𝑎 + 𝑏 𝑌 − 𝑇 + 𝐼 + 𝐺 + (𝑋 − 𝑀

• ഥ
𝑌 + 𝑚𝑌 − 𝑏𝑌 = 𝑎 − 𝑏𝑇 + 𝐼 + 𝐺 + 𝑋 − 𝑀

1
• 𝑌= 1−𝑏+𝑚
ഥ
(𝑎 − 𝑏𝑇 + 𝐼 + 𝐺 + 𝑋 − 𝑀)

• where

1
• (1−𝑏+𝑚)
is the foreign trade multiplier

• The value of foreign trade multiplier is determined by MPC (b) and MPI (m)

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• Thus, if exports increase by X, the national income
will increase by

1
• Y = (1−𝑏+𝑚)
X

• ∆Y/ ∆X= 1/(1-b+m)

• (1-b)= mps

• ∆Y/ ∆X= 1/mps+mpi

• mps=0.3 and mpi=0.2

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 Example
• C=60+0.8Yd
• I=100
• G=76
• T=15
• TR=60
• X= 70
• M=12+0.2Y
• What the equilibrium level of income, consumption and imports. (825, 756, 177)
• What is the value of foreign trade multiplier. (2.5)
• What is trade balance. (-107)
• What is tax multiplier? (-2)
• What is investment multiplier?

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• C=50+0.9Yd
• T=100
• TR=70
• I=150
• G=100
• X= 20
• M= 10+0.1Y
• What the equilibrium level of income, consumption and
imports.(1415, 1296.5, 151.5)
• What is the value of foreign trade multiplier. (5)
• What is trade balance. (-131.5) 1/28/2023 12:32
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• C=50+0.9Yd
• T=100
• TR=70
• I=150
• G=100
• X= 200
• M= 10+0.01Y
• Y=
• (X-M)=
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Demand for Money
Keynesian approach of demand for money
Liquidity preference theory of Interest
[Link] APPROACH OF DEMAND FOR
MONEY

• According to Keynes, peoples desire to hold money in the form of cash or there preference
for liquidity is due to fear and uncertainty regarding their future.

• The liquidity preference approach to demand for money is based on money as a medium of
exchange and store of value.

• According to Keynes there are three motives for holding money

1. Transactions Motive

2. Precautionary Motive

3. Speculative Motive

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• Transactions Motive

• People require money to carry out day to day transactions but they do not receive their income daily.

• There is a time gap between successive income receipts and expenditure increased on various
transactions. It is further divided into

• a. income motive and

• b. business motive.

• According to Keynes the transaction demand for money depends on level of income.

• LT = f(Y)

• where LT is the transaction demand for money.

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• Precautionary Motive

• Individuals hold money to meet unexpected increase in expenditure due to illness, accidents and
any other unforeseen emergencies and also due to temporary unemployment.

• The precautionary demand for money also depends on level of income.

• LP = f(Y)

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• Demand for money held for transaction and precautionary motives is known as Demand for
“active cash balance” and it depends on level of income.

• L1 = f(Y)

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• Speculative Motive

• People have the alternative of holding either cash money or financial assets like equities, shares or
government bonds.

• The speculative demand for money is related to uncertainty.

• The uncertainty is concerned with uncertain capital value of financial assets.

• The speculative demand for money is interest elastic. At a higher rate of interest less money is held for
speculative motive and vice versa. This is because: -

a. Holding cash when rate of interest is high has greater opportunity cost.
b. There is an inverse relationship between the interest rate and security prices.

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• The demand for money for speculative motive is known as “idle cash balances” and it depends
upon rate of interests.

• Thus, L2 is a function of r.

• L2 = f(r)

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→ Liquidity Trap
• Keynes suggested that at a very low rate of interest, the speculative demand for money becomes
perfectly elastic.
• At such low rate of interest, people prefer cash and not the securities because when the
expectation about the future fall in the security prices is high, everyone prefers to hold cash to
gain from the future market situation.
• In the above diagram, at point T, the L2 curve becomes horizontal, the horizontal part of the L2
curve shoes the liquidity trap which explains the perfectly elastic demand for money for
speculative motive.
• This arises because people prefer to hold cash instead of bonds due to fear of decline in their
prices.

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28-01-2023 137
→ The total demand for money.

• The total demand for money is expressed as: -

• Md = L = L1(Y) + L2(r)

• Md = L = f(Y, r)

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 2. Determination of rate of interest/
Liquidity Preference Theory of Interest
• According to J. M. Keynes, the rate of interest is determined by demand for money (liquidity
preference) and supply of money.
• The supply of money is fixed by the monetary authority of the country (central bank) and it is
independent of rate of interest. Thus, MS curve is perfectly inelastic.

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 Impact of changes in demand for
money and supply of money on rate
of interest
• Changes in Demand for Money:
• If the demand for money increases, it will bring an upward shift in the money demand curve
and thus increase the rate of interest i.e. from r to r1.

• If the demand for money decreases, it will bring a downward shift in the money demand
curve and it will reduce the rate of interest i.e. from r to r2.

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• Changes in supply of Money
• Given the demand for money, an increase in the supply of money will bring down the rate of
interest i.e. from r to r1.

• Given the demand for money, a decrease in the supply of money will increase the rate of interest
i.e. from r to r2.

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IS-LM Model
 The IS-LM Model
• It has been asserted that in the Keynesian model whereas the changes in rate of interest in
the money market affect investment and therefore the level of income and output in the
goods market, there is seemingly no inverse influence of changes in goods market i.e.,
(investment and income) on the money market equilibrium. In this way changes in money
market equilibrium influence the determination of national income and output in the goods
market.
• According to J.R. Hicks, the level of income which depends on the investment and
consumption demand determines the transactions demand for money which affects the rate
of interest.
• Hicks, Hansen, Lerner and Johnson have put forward a complete and integrated model
based on the Keynesian framework wherein the variables such as investment, national
income, rate of interest, demand for and supply of money are interrelated and mutually
interdependent and can be represented by the two curves called the IS and LM curves.

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 Derivation of Goods market
equilibrium/
Derivation of IS Curve
• The goods market is in equilibrium when aggregate demand is equal to income.
• The aggregate demand is determined by consumption demand and investment demand.
• In the Keynesian model of goods market equilibrium we also now introduce the rate of interest as an
important determinant of investment.
• With this introduction of interest as a determinant of investment, the latter now becomes an
endogenous variable in the model.
• When the rate of interest falls the level of investment increases and vice versa.
• Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing
changes in the investment demand.
• When the rate of interest falls, it lowers the cost c’ investment projects and thereby raises the
profitability of investment.
• The businessmen will therefore undertake greater investment at a lower rate of interest.
• The increase in investment demand will bring about increase in aggregate demand which in turn will
raise the equilibrium level of income.

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28-01-2023 147
• Why does IS Curve Slope Downward?
• As seen above, the decline in the rate of interest brings about an increase in the planned
investment expenditure. The increase in investment spending causes the aggregate demand curve
to shift upward and therefore leads to the increase in the equilibrium level of national income.
• Thus, a lower rate of interest is associated with a higher level of national income and vice-versa.
This makes the IS curve, which relates the level of income with the rate of interest, to slope
downward.
• Steepness of the IS curve depends on
• (1) the interest elasticity of the investment demand curve, and
• (2) the size of the multiplier

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Derivation of Money Market Equilibrium/
Derivation of LM
• The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium. According to Keynes, demand for money to hold depends upon transactions
motive and speculative motive.
• It is the money held for transactions motive which is a function of income. The greater the
level of income, the greater the amount of money held for transactions motive and therefore
higher the level of money demand curve.
• The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money
also depends on the rate of interest which is the cost of holding money.

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• Transaction demand L=f(Y) =directly related
• Precautionary demand L=f(Y) directly related
• Speculative demand L=f(r) inversely related
• Thus, total demand for money (Md) can be expressed as:
• Md (L) = f (Y, r)
• Where Md stands for demand for money, Y for real income and r for rate
of interest.
• The supply of money is fixed by the RBI and it is interest inelastic.

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• The LM curve relates the level of income with the rate of interest which is determined
by money-market equilibrium corresponding to different levels of demand for money.
• The LM curve tells what the various rates of interest will be (given the quantity of
money and the family of demand curves for money) at different levels of income.
• As income increases, money demand curve shifts outward and therefore the rate of
interest which equates supply of money, with demand for money rises. In Fig. 24.2 (b)
we measure income on the X-axis and plot the income level corresponding to the
various interest rates determined at those income levels through money market
equilibrium by the equality of demand for and the supply of money in Fig. 24.2 (a).

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• Slope of LM Curve:
• First, the responsiveness of demand for money (i.e., liquidity preference) to the changes in
income. As the income increases, say from Y0 to Y1 the demand curve for money shifts from
Md0 to Md1 that is, with an increase in income, demand for money would increase for being held
for transactions motive, Md or L1 =f(Y).
• The second factor which determines the slope of the LM curve is the elasticity or responsiveness
of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of
interest. The lower the elasticity of liquidity preference for speculative motive with respect to the
changes in the rate of interest, the steeper will be the LM curve.
• On the other hand, if the elasticity of liquidity preference (money demand-function) to the
changes in the rate of interest is high, the LM curve will be flatter.

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 Simultaneous Equilibrium of the Goods Market and Money
Market:

• The IS and the LM curves relate the two variables:

• (a) Income and
• (b) The rate of interest.
• Income and the rate of interest are therefore determined together at the point of intersection
of these two curves, i.e., E in Fig. 24.3.
• The equilibrium rate of interest thus determined is Or2 and the level of income determined
is OY2.
• At this point income and the rate of interest stand in relation to each other such that
• (1) the goods market is in equilibrium, that is, the aggregate demand equals the level of
aggregate output, and
• (2) the demand for money is in equilibrium with the supply of money (i.e., the desired
amount of money is equal to the actual supply of money).

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• Thus, the IS-LM curve model is based on:
• (1) The investment-demand function,
• (2) The consumption function,
• (3) The money demand function, and
• (4) The quantity of money.
• According to the IS-LM curve model both the real factors, namely, saving and investment,
productivity of capital and propensity to consume and save, and the monetary factors, that is, the
demand for money (liquidity preference) and supply of money play a part in the joint
determination of the rate of interest and the level of income.
• Any change in these factors will cause a shift in IS or LM curve and will therefore change the
equilibrium levels of the rate of interest and income.

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Effects of Monetary Policy

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Effects of Fiscal Policy

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 Examples
• Suppose an economy is described by the following equations

• C = 10 + 0.8 Yd

• I = 140 – 20i
• Find out the equation of the IS curve and represent it graphically.
• Suppose a hypothetical economy is described by the following equation:

• C = 50 + 0.80Yd

• I = 30 – 20i

• G = 40

• T= 40

• Derive the IS equation.

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• Md = 0.5Y – 50i
• Ms = 500
• 1. Derive the equation of the LM curve
• 2. Give an economic interpretation of the LM curve and draw the
curve.
• Md = 0.8 Y + 100 – 160 i
• Ms = 200.
• Derive the LM curve equation.

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• 1. The following equations describe an economy:
• C= 10+0.5Yd (Consumption function)
• I= 190-20i (Investment Function)
• Derive the equations for IS curve and represent it graphically.
• Solution: IS curve is: Y=400-40i
• 2. The following equations describe an economy:
• C=100+0.75Yd
• I= 50-25i
• G=50
T=50
• Derive the IS curve for the economy.
Solution: IS equation is: Y=650-100i
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• 4. The following data is given for the monetary sector of the economy.
• Transaction demand for money (M1)= 0.5Y
• Speculative demand for money (M2)= 105-1500i
• Money supply (MS)= 150
• Derive LM equation from the above data.
• Solution: LM equation is: i= 1/3000Y-3/100
• 5. For an economy the following functions are given:
• C= 100+0.8Y
• I= 120-5i
• Ms= 120
• Md= 0.2Y-5i
• Find out: a) IS equation b) LM equation c) equilibrium level of income and interest rate
• Solution: a) IS equation is: Y= 1100-25i
• b) LM equation is: i= 0.2/5Y-24
• c) The equilibrium rate of interest is 10 and the equilibrium level of income is 850.

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• 6. Consider the following economy:
• C= 100+0.8Yd
• I= 50-25i
• G=T= 50
• Ms/P= 200
• Md= 1Y-25i
• Find out: a) IS equation b) LM equation c) equilibrium level of income and interest rate
• Solution: a) IS equation is: Y= 800-125i
• b) LM equation is: i=0.04Y-8
• c) The equilibrium rate of interest is 4 and the equilibrium level of income is 300
• 7. The following data are given for an economy:
• C= 40+0.75Yd
• I= 140-10i
• G= 100
• T= 80
• Md= 0.2Y-5i
• Ms= 85
• Find out: a) IS equation b) LM equation c) equilibrium level of income and interest rate
• Solution: a) IS equation is: Y= 880-40i
• b) LM equation is: i= 0.04Y-17
• c) The equilibrium rate of interest is 7 and the equilibrium level of income is 600.

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• C= 100+0.9Yd
• T=1/3Y
• I=600-30i
• G=300
• M1=0.4Y
• M2=-50i
• M_=1040
• P= 2
• Find out: a) IS equation b) LM equation c) equilibrium level
of income and interest rate
• IS equation is Y= 2500-75i
• LM equation is i= Y/125-10.4
• Equilibrium r= 6 Y= 2050
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• C=60+0.8Yd
• I=100-5i
• G=76
• T=15
• TR=60
• X=70
• M=12+0.2Y
• Find out: a) IS equation b) equilibrium level of income when
interest rate =6 c) calculate the foreign trade multiplier.
• IS equation Y= 825-12.5i
• Y= 750
• FTM= 2.5
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• C=50+0.75Yd
• I=140-10i
• G=100
• T=80
• Md=0.2Y-5i
• Ms=85
• Find out: a) IS equation b) LM equation equilibrium level of income and interest
rate c) suppose the govt increases its expenditure on education by Rs 65 crores,
what will be the effect on equilibrium income and rate of interest.
• IS equation= Y= 920-40i
• LM equation= i= 0.04Y-17
• Eqm i= 7.62 Y= 615.38
• Y’= 1180-40i
• i’= 0.04Y-17
• Eqm i= 11.62 Y’=715.38

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• C=50+0.9Yd
• I=150-5i
• G=100
• T=100
• Md=0.2Y-10i
• Ms=100
• X=20
• M=10+0.1Y
• Find out: a) IS equation b) LM equation b) equilibrium level of
income and interest rate
• IS equation= Y= 1100-25i
• LM equation i= 0.02Y-10
• Eqm i= 8 Y=900
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