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# Keynesian Theory of National Income
Chapter 6 · Determination of National Income · Unit 2 · Exam-focused Revision Notes
### Crux First
- Keynes said equilibrium income is determined by aggregate demand .
- Equilibrium need not be at full employment.
- In two-sector model: Y = C + I and equilibrium condition is S = I .
- Consumption function: C = a + bY where a = autonomous consumption and b = MPC .
- 0 < MPC < 1 ; also MPS = 1 - MPC .
- APC = C/Y and APS = S/Y .
- Multiplier: k = 1 / (1 - MPC) = 1 / MPS .
- Three-sector model: Y = C + I + G .
- Four-sector model: Y = C + I + G + (X - M) .
- Exports are injection ; imports are leakage .
- Higher MPC → higher multiplier; higher MPS or higher imports → lower multiplier.
- Deficient demand causes deflationary gap ; excess demand causes inflationary gap .
### 1. Introduction to Keynesian Theory
- Keynes developed his theory during the Great Depression to explain persistent unemployment and inadequate demand.
- His key focus was on determination of equilibrium aggregate income and output .
- He rejected the classical belief that economy automatically reaches full employment.
- According to Keynes, output and income depend mainly on aggregate effective demand .
### 2. Keynesian Models Covered in the Unit
- Model | Sectors Included | Equilibrium Formula
- Two-sector model | Households + Firms | Y = C + I
- Three-sector model | Households + Firms + Government | Y = C + I + G
- Four-sector model | Households + Firms + Government + Foreign Sector | Y = C + I + G + (X - M)
#### MCQ Trap
- Closed economy with government = three-sector model .
- Open economy = four-sector model .
### 3. Circular Flow in Simple Two-Sector Model
- The two main players are households and firms .
- Households supply factor services and receive factor income.
- Firms hire factors, produce goods and services, and sell them to households.
- In the simple model, entire household income is spent on consumption.
- There are no injections and no leakages in the simplest version.
### 4. Meaning of Equilibrium
- Equilibrium means a position where there is no tendency to change .
- Output is at equilibrium when quantity produced = quantity demanded .
- In Keynesian terms, equilibrium is where firms’ production plans match households’ expenditure plans.
### 5. Aggregate Demand Function
- Aggregate Demand means total planned expenditure.
- In the simple two-sector model, it has only two parts: Consumption demand (C) Investment demand (I)
- Consumption demand (C)
- Investment demand (I)
- In the short run, investment is usually treated as autonomous and exogenous.
### 6. Consumption Function
- Consumption function shows the relationship between consumption expenditure and disposable income.
- Keynes gave the linear form of consumption function.
- a = autonomous consumption, i.e. consumption even when income is zero.
- b = marginal propensity to consume (MPC).
#### Must Remember
- a is the intercept.
- b is the slope.
- Keynes assumed 0 < b < 1 .
- Consumption rises with income, but by less than the rise in income.
### 7. MPC and APC
#### Marginal Propensity to Consume (MPC)
- MPC shows how much consumption rises when income rises by one unit.
#### Average Propensity to Consume (APC)
- APC is the ratio of total consumption to total income.
### 8. Saving Function, MPS and APS
- Whatever part of income is not consumed is saved.
- Therefore saving is also a function of income.
#### Marginal Propensity to Save (MPS)
#### Average Propensity to Save (APS)
#### Golden Relations
- MPC + MPS = 1
- APC + APS = 1
- If income is zero and consumption is positive, saving will be negative i.e. dissaving.
### 9. Aggregate Supply in Keynesian Model
- Planned aggregate supply equals national income, which is either consumed or saved.
### 10. Two-Sector Model of Income Determination
- In the two-sector model, equilibrium occurs where aggregate demand equals aggregate supply.
- That means: AD = C + I AS = C + S
- AD = C + I
- AS = C + S
- In Keynesian model, equilibrium is where planned expenditure = output .
- The 45-degree line shows points where aggregate expenditure = aggregate output .
### 11. Keynesian Cross Logic
- If aggregate demand line lies above the 45-degree line, planned expenditure exceeds output and income tends to rise.
- If aggregate demand line lies below the 45-degree line, planned expenditure is less than output and income tends to fall.
- At the intersection point, equilibrium income is reached.
### 12. Equilibrium Need Not Be Full Employment
- Keynes strongly argued that equilibrium may occur below full employment.
- So, equality of AD and AS does not guarantee full employment.
#### Deflationary Gap
- When aggregate demand is less than the level required for full employment, there is deficient demand .
- This creates a deflationary gap or recessionary gap .
#### Inflationary Gap
- When aggregate demand exceeds the full employment output level, there is excess demand .
- This creates an inflationary gap .
#### Exam Trap
- Deflationary gap = deficient demand
- Inflationary gap = excess demand
- Keynesian equilibrium may be at under-employment level.
### 13. Numerical Shortcuts for Two-Sector Model
#### Case 1: Given C = a + bY and I is autonomous
#### Case 2: If saving function is given
#### Case 3: Once Y is found
### 14. Investment Multiplier
- Multiplier shows by how much equilibrium income changes when autonomous investment changes.
- A rise in investment causes multiple rises in income because one person’s spending becomes another person’s income.
#### Must Memorise
- Multiplier is directly related to MPC.
- Multiplier is inversely related to MPS.
- If MPC = 0.75, multiplier = 4 .
- If MPC = 0.8, multiplier = 5 .
### 15. Leakages that Reduce Multiplier
- High taxes
- Idle savings / high liquidity preference
- Imports
- Purchase of old securities / existing wealth
- Undistributed profits
- Repayment of debts
- Full employment situation leading only to inflation
- Scarcity of goods and services
- The more powerful the leakages, the smaller the multiplier.
- In underdeveloped countries, even with high MPC, multiplier may remain low due to structural bottlenecks.
### 16. Three-Sector Model: Government Included
- Now government is added to the model.
- Aggregate demand now includes government purchases also.
- In this model: Injections = I + G Leakages = S + T
- Injections = I + G
- Leakages = S + T
### 17. Role of Government Sector
- Government imposes taxes on households and firms.
- Government gives transfer payments to households and subsidies to firms.
- Government purchases goods and services.
- Government may borrow from financial markets if expenditure exceeds tax revenue.
- Taxes are leakages .
- Government expenditure is injection .
- Transfer payments affect disposable income , not direct current production.
### 18. Three-Sector Income Determination with Lump Sum Tax
- When government imposes lump sum tax and there are no transfer payments:
### 19. Three-Sector Income Determination with Lump Sum Tax and Transfer Payments
- Transfer payments increase disposable income .
- Taxes reduce disposable income.
### 20. Three-Sector Model with Tax as Function of Income
- When taxes depend on income, tax function is:
- T̄ = autonomous tax
- t = tax rate
### 21. Three-Sector Model with Tax Function and Transfer Payments
#### Numerical Shortcut
- Check denominator carefully.
- With proportional tax, denominator becomes 1 - b(1 - t) .
- Do not use simple 1 - b multiplier here.
### 22. Four-Sector Model: Open Economy
- The foreign sector is added in the four-sector model.
- Aggregate demand now includes net exports.
- X = exports
- M = imports
### 23. Exports, Imports and Import Function
- Exports are treated as autonomous and exogenous.
- Imports depend partly on income and partly on autonomous imports.
- M̄ = autonomous imports
- m = marginal propensity to import
- Exports = injection
- Imports = leakage
- If X > M , net exports positive and income rises.
- If X < M , net exports negative and income falls.
### 24. Four-Sector Equilibrium Income Formula
- With lump sum tax and income-dependent imports:
#### With proportional tax and transfer payments also included
### 25. Foreign Trade Multiplier
- Foreign trade multiplier shows how much income changes due to change in exports in an open economy.
- Open economy multiplier is smaller than closed economy multiplier.
- Higher m means lower multiplier.
- More open the economy, more leakage through imports, smaller the multiplier.
### 26. Closed Economy vs Open Economy Multiplier
- Case | Multiplier | Why?
- Closed economy | 1 / (1 - b) | No import leakage
- Open economy | 1 / (1 - b + m) | Imports create extra leakage
- With proportional tax | 1 / [1 - b(1 - t)] | Tax reduces induced consumption
- Open economy with proportional tax | 1 / [1 - b(1 - t) + m] | Both tax and imports reduce multiplier
### 27. Ranker Numerical Strategy
- First identify the model: 2-sector → no G, no X-M 3-sector → G and T included 4-sector → X and M included
- 2-sector → no G, no X-M
- 3-sector → G and T included
- 4-sector → X and M included
- Then identify whether tax is: Lump sum, or Income-dependent
- Lump sum, or
- Income-dependent
- Then form Y = AD equation and collect Y terms on left side.
- Finally solve for Y and then calculate C, S, NX or whatever is asked.
### 28. Top MCQ Traps from This Unit
- In Keynesian model, equilibrium income is determined by aggregate demand .
- Equilibrium may exist below full employment .
- In C = a + bY , a is autonomous consumption, b is MPC.
- MPC means change in consumption due to change in income .
- MPS = 1 - MPC .
- APC = C/Y ; APS = S/Y .
- In two-sector model, equilibrium condition is S = I .
- Three-sector closed economy AD = C + I + G .
- Four-sector model AD = C + I + G + (X - M) .
- Taxes and imports are leakages .
- Government spending and exports are injections .
- Multiplier is greater when MPC is higher.
- Multiplier is lower when MPS, tax rate or import propensity is higher.
- At 45-degree line, planned expenditure = output .
- Deflationary gap = deficient demand ; inflationary gap = excess demand .
### 29. Formula Sheet – Must Memorise
### Final Quick Revision
- Keynes: national income depends on aggregate effective demand .
- Equilibrium can be below full employment .
- Two-sector: Y = C + I , and S = I .
- Consumption function: C = a + bY .
- a = autonomous consumption; b = MPC.
- 0 < MPC < 1 .
- Multiplier: 1 / (1 - MPC) .
- Three-sector: Y = C + I + G .
- Leakages in three-sector: S + T ; injections: I + G .
- Four-sector: Y = C + I + G + (X - M) .
- Exports increase income; imports reduce income.
- Foreign trade multiplier: 1 / (1 - b + m) .
- Deflationary gap = deficient demand; inflationary gap = excess demand.
### The Keynesian Theory of Determination of National Income notes built for concept clarity and exam recall.
This chapter page is written for CA Foundation Business Economics students who want quick understanding first and revision support later. Use it to revise definitions, logic, distinctions, traps, and answer-writing points before moving to objective practice.
- Meaning, definitions and core concepts in simple language
- Important distinctions and exam-oriented traps
- Quick revision support before classroom tests or self-study
- Direct bridge from theory revision to chapter-wise MCQ practice
### What students should be able to answer after revising this topic.
- Explain the meaning and importance of The Keynesian Theory of Determination of National Income.
- Identify the most common conceptual differences linked to this unit.
- Write short exam answers using the right terminology and logic.
- Solve chapter-wise objective questions without confusion on keywords.
#### Related chapters for stronger internal revision
- National Income Accounting
- Fiscal Functions, Centre and State Finance
- Business Cycles