The Keynesian model of income and expenditure, developed by British economist John Maynard Keynes during the Great Depression of the 1930s, explains how national income is determined by aggregate demand in an economy. This revolutionary model provides a framework for understanding economic output, employment levels, business cycles, and the potential role of government intervention in stabilizing the economy. At its core, the model demonstrates a circular flow between spending and income, where household consumption and other expenditures drive production decisions by firms, which in turn affects employment and income levels.
Aggregate demand, often abbreviated as AD, represents the total spending in an economy. It consists of four main components. First, consumption spending by households, which typically accounts for about 60% of total demand in developed economies. Second, investment spending by businesses on capital goods, which might represent around 17%. Third, government spending on goods and services, accounting for approximately 14%. And finally, net exports—the difference between exports and imports—which can be around 9% depending on the economy. The Keynesian model emphasizes that changes in any of these components can significantly impact total output and employment levels.
The consumption function is a cornerstone of Keynesian economics. It describes how household consumption spending relates to disposable income. The basic form is C equals a plus b times Y-d, where C is consumption, a is autonomous consumption—spending that occurs even at zero income, b is the marginal propensity to consume or MPC, and Y-d is disposable income. The MPC represents the fraction of each additional dollar of income that households spend rather than save. It's always between zero and one. On our graph, the consumption function is represented by the blue line. The slope of this line is the MPC, which in this example is 0.6, meaning households spend 60 cents of each additional dollar earned. The vertical intercept is autonomous consumption, which continues even when income is zero, through borrowing or using savings.
In the Keynesian model, equilibrium occurs when aggregate output equals aggregate demand. This is represented by the equation Y equals AD, which equals C plus I plus G plus net exports. On our graph, equilibrium is found at the intersection of the aggregate demand line and the 45-degree line, where output equals expenditure. A key insight of Keynesian economics is the multiplier effect. This shows how an initial change in spending creates a larger change in total income. The multiplier is calculated as one divided by one minus the marginal propensity to consume. For example, if the MPC is 0.8, the multiplier is 5, meaning a $100 increase in government spending would increase total income by $500. This is because the initial spending becomes someone's income, who then spends a portion of it, creating additional income for others, and so on in a chain reaction.
To summarize the Keynesian model of income and expenditure: First, aggregate demand, which consists of consumption, investment, government spending, and net exports, determines the level of output and employment in the short run. Second, consumption is linked to income through the consumption function, where spending increases with income but at a decreasing rate due to the marginal propensity to consume. Third, economic equilibrium occurs where income equals aggregate demand, represented graphically at the intersection of the AD curve and the 45-degree line. Fourth, the multiplier effect explains how initial changes in spending create larger changes in total income, with the multiplier calculated as one divided by one minus the MPC. Finally, this model provides the theoretical foundation for government intervention through fiscal policy to influence aggregate demand and stabilize the economy during recessions or periods of high inflation.