NATIONAL INCOME DETERMINATION

CLASSICAL VIEW

Assuming long run, no government intervention and perfect competition; Equilibrium level of income is possible only at full employment level.

Full employment can be automatically achieved

KEYNSIAN VIEW

Income Determination in a two-sector model

No government; closed economy Households and firms are the two categories

of spenders Total Expenditure = C + I Total Income = Y = C +S = C+I For equilibrium; therefore, S should be equal

to I ( withdrawal = injection)

Two-sector Model- Paradox of Thrift

Recall that household income is partly spent and the rest saved; Y = C + S

An attempt by the households to increase saving (S) means a decrease in consumption (C)

If investment remains constant, an increase in S will mean that withdrawal exceeds injection, which means, TE falls.

A fall in TE means total income Y falls If Y falls; S falls We started with an increase in S and ended

with a decrease in S This is called the ‘paradox of thrift’- an

attempt by the nation to save more boomerangs on it

Consumption Function and Saving Function

Simplistic assumptions C = f (Y) current consumption expenditure

depends on current income; direct relationship

S = f (Y); ditto Both functions are complementary; anything

that increases C automatically decreases S

Propensity to Consume/ Save

Propensity is an amalgamation of capacity and desire;

Average and marginal propensity to consume

aps = C/Y (total consumption expenditure divided by total income)

mps = dC/dY ( change in C divided by change in Y)

Factors affecting consumption function- propensity to consume

Current income Future foreseen liabilities Unforeseen liabilities Social security system of the government Socio-cultural background Permanent income hypothesis Life time spending hypothesis

Empirical studies on consumption function

Most empirical studies on consumption function have found consumption functions to be stable- that is in short run- people do not change their propensity to consume in spite of change in income.

Consumption function

The implication of this behaviour is that households cannot be expected to add to the total expenditure (aggregate demand) in short run

How can there be equilibrium at underemployment level of income?

Suppose the full employment level of income ( or the desired level, Yf,) is Rs.120.

But the actual level of income, Ya, is 100 of which C = 70 and I = 30.

If total expenditure (aggregate demand) remains at 100, income will also remain at 100. Yf cannot be automatically achieved

House holds do not increase spending as consumption function is stable

Firms do not invest more as there is no additional spending (aggregate demand) by households.

Economy remains at underemployed level of income.

WHAT IS THE WAYOUT?

The STATE is seen as a catalyst- fanning additional spending- pump-priming the economy

The era of guided capitalism starts