Question

1. Present the basic assumptions and structure of the Keynesian income determination model. Cite passages from Keynes' General Theory to support your discussion.

Answer 1

Key assumptions of Keynesian Income determination model

• .Prices are constant,at given price level firms are willing to sell any amount of the output at that price level.
• .Investment is assumed to be autonomous and thus independent of the income level.
• .There exist only two sectors in the economy,the households and the firms.Aggregate demand is the total amount of goods demanded in an economy which can expressed as sum of consumption and investment
• Short run aggregate supply curve is perfectly elastic or flat

As jobs increase, gross real income increases. Community psychology is such that aggregate real income increases aggregate consumption but not by so much as income. Employers would therefore make a loss if the entire rise in employment were to be devoted to meeting the increased demand for immediate consumption.

Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level.

For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment.

The sum of current investment will, in effect, depend on what we will call the investment incentive; and the investment incentive will be found to depend on the relationship between the marginal capital production schedule and the interest rate complex on loans with different maturities and risks.

Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price. This level cannot be greater than full employment, i.e. the real wage cannot be less than the marginal disutility of labour.

The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. Current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.