Determination of income and Employment

Keynes used aggregate demand and aggregate supply approach to explain his simple theory of
income determination. The equilibrium level of income or output depends on the relationship
between the aggregate demand curve and aggregate supply curve. As Keynes was interested in
the immediate problems of the short run, he ignored the aggregate supply function and focused
on aggregate demand. And he attributed unemployment to deficiency in aggregate demand.
a. Aggregate Demand
AD refers to total value of all final goods and services that are planned to buy by all the sectors of the
economy at a given level of income during a period of time. AD represents the total expenditure on goods
and services in an economy during a period of time.
Components of Aggregate demand are :
(i) Household consumption expenditure (C).
(ii) Investment expenditure (I).
(iii) Govt. consumption expenditure (G).
(iv) Net export (X M).
Thus, AD = C + I + G + (X M)
In two sector economy AD = C + I.
b. Aggregate Supply
AS refers to total value of all final goods and services, that are planned to be produced by all the
producing units in the economy during a given period of time. It is also the value of total output available
is an economy during a given period of time. It is also the value of total output available is an economy
during a given period of time.
AS = C + S
Aggregate supply represents the national income of the country.
AS = Y (National Income)

This purely depends on available technology, resources (material and human), efficiency of
labour, etc. Most of these factors change only in the long run and remain constant in the short
run.

1. Consumption Function
A consumption function is a functional statement of relationship between consumption expenditure and
its determinants. Although, consumption expenditure of households depends on a number of factors such
as income, wealth, rate of interest, expected future income, life style, age, sex etc; income is the primary
determinant of consumption.
A linear consumption function can be expressed as
C=a+bY
Where C is the aggregate consumption expenditure and Y is the total disposable income
The term a is the positive intercept coefficient that denotes the level of consumption when income is
zero. The amount of consumption at zero income level is called autonomous consumption. The term b
is the positive constant that represents the slope of consumption function

Keynes psychological theory of consumption

Keynes stated his fundamental psychological law as follows ..men are disposed, as a rule and on the
average, to increase their consumption as their income increases, but not as much as the increase in
income. In other words, as income increases, people will spend part but not all of the increase, choosing
instead to save some part of it.