Keynesian Economics - Core Topics
Includes:
• Principle of Effective Demand
• Income Determination in a Simple 2-Sector Model
• Simple Investment Multiplier
Principle of Effective Demand
Meaning:
Effective demand is the total demand for goods and services in the economy at a given level of
employment. It is the point where Aggregate Demand (AD) equals Aggregate Supply (AS).
Components:
• Aggregate Demand (AD) = Consumption (C) + Investment (I)
• Aggregate Supply (AS) = Expected receipts/sales proceeds from output
Equilibrium:
The level of employment is determined at the point where AD = AS.
- Left of equilibrium → AD > AS → Firms expand output and jobs.
- Right of equilibrium → AD < AS → Firms cut output and jobs.
Importance:
• Shows that unemployment equilibrium is possible (contradicts classical full employment theory).
• Emphasises the role of aggregate demand in determining output and employment.
• Provides theoretical basis for public spending policies.
Income Determination in a Simple 2-Sector Model
Framework:
Two sectors: Households (consumption) and Firms (production). Government and foreign trade are
absent.
Aggregate Demand:
AD = C + I
Consumption function: C = a + bY
Aggregate Supply:
AS = Y (national income)
Equilibrium:
Y = AD
Y = a + bY + I
Y(1 - b) = a + I
⇒ Y = (a + I) / (1 - b)
Interpretation:
• Income depends on autonomous consumption (a) and investment (I).
• Higher MPC (b) → larger multiplier → higher income.
• Equilibrium may be below full employment, causing unemployment equilibrium.
Simple Investment Multiplier
Derivation:
At equilibrium: Y = (a + I) / (1 - b)
If investment rises by ∆I:
∆Y = ∆I / (1 - b)
Multiplier (k):
k = ∆Y / ∆I = 1 / (1 - b)
Intuition:
A rise in investment increases income, part of which is spent (MPC = b). This spending becomes
income for others, generating a chain effect:
1 + b + b² + b³ + ... = 1 / (1 - b)
Factors affecting k:
• Higher MPC (b) ⇒ Larger multiplier
• Lower leakages ⇒ Larger multiplier
