Keynesian Macroeconomics
Keynesian macroeconomics, born from the Great Depression, argues that aggregate demand determines output and employment. This unit — the largest in the course (30 LH) — covers the principle of effective demand, the consumption function and its determinants, the saving function and the paradox of thrift, the investment function and marginal efficiency of capital, income determination in a two-sector economy, and the investment multiplier.
In this chapter
Principle of Effective Demand
Keynes's central insight was the principle of effective demand: the level of output and employment is determined by the level of aggregate demand (AD), not by supply. Effective demand is the level of AD at which the economy actually settles. If AD is too low, firms produce less, hire fewer workers, and the economy settles at an underemployment equilibrium — a situation the classical theory said was impossible. Keynes argued that the Great Depression was caused by a collapse in AD: consumption and investment spending both fell sharply, and the classical self-correcting mechanism failed because wages and interest rates were sticky.
Consumption Function
The consumption function expresses the relationship between total consumption (C) and disposable income (Yd). Keynes proposed a linear consumption function: C = a + bYd, where a is autonomous consumption (consumption when income is zero — financed by dissaving/borrowing) and b is the marginal propensity to consume (MPC) — the fraction of an additional rupee of income that is spent on consumption. Keynes's Fundamental Psychological Law of Consumption states that "men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income" — meaning 0 < MPC < 1.
Keynesian consumption function
Consumption Schedule (MPC = 0.75)
| Income (Y) | Consumption (C) | Saving (S) | MPC (ΔC/ΔY) |
|---|---|---|---|
| 0 | 50 (autonomous) | −50 | — |
| 100 | 125 | −25 | 0.75 |
| 200 | 200 | 0 | 0.75 |
| 300 | 275 | 25 | 0.75 |
| 400 | 350 | 50 | 0.75 |
Key Relationships
Average Propensity to Consume (APC) = C ÷ Y. Marginal Propensity to Consume (MPC) = ΔC ÷ ΔY. Since C = a + bY, APC = (a ÷ Y) + b, which falls as Y rises (because a ÷ Y shrinks). The break-even point is where C = Y (all income is consumed), so S = 0. Below this point, the household dissaves (borrows); above it, the household saves.
Determinants of Consumption
Subjective and Objective Determinants
- Income (Y) — the most important determinant; higher income means higher consumption.
- Interest rate — higher rates encourage saving and discourage consumption (especially of durable goods bought on credit).
- Wealth — the "wealth effect": higher asset values (houses, stocks) make people feel richer and spend more.
- Income distribution — poorer households have higher MPC, so redistributing income from rich to poor raises total consumption.
- Expectations — if people expect future income to rise or prices to rise, they spend more now.
- Tastes and habits — cultural factors, social norms, and advertising.
Saving Function and the Paradox of Thrift
Since income is either consumed or saved (Y = C + S), the saving function is derived from the consumption function: S = −a + (1−b)Y, where (1−b) is the marginal propensity to save (MPS). The paradox of thrift is a Keynesian insight: if everyone tries to save more simultaneously (MPS rises), aggregate consumption falls, which reduces total income — and total saving may actually fall or stay the same, not rise. What is rational for one person (saving more) is irrational for society as a whole in a depressed economy.
Saving function derived from consumption function
The Paradox of Thrift Explained
Suppose everyone decides to save Rs 100 more per month. Consumption falls by Rs 100. Firms sell less, so they cut production and lay off workers. Incomes fall. With lower incomes, people can no longer save the extra Rs 100 — their saving returns to the original level. Society has the same saving as before, but lower income and higher unemployment. This is the paradox: the attempt to save more leads to the same saving but lower output. The lesson: in a recession, increased saving can be harmful.
Investment Function and Marginal Efficiency of Capital
Investment is the addition to the capital stock — spending on new plants, equipment, and inventory. It is the most volatile component of GDP. Keynes introduced the Marginal Efficiency of Capital (MEC) — the expected rate of return from an additional unit of capital. A firm invests if MEC > interest rate (the cost of borrowing). The investment demand curve plots MEC against the quantity of investment, and it slopes downward (the best projects are undertaken first, with the highest returns). Determinants of investment: interest rate, expected future demand, business confidence, technological change, and the cost of capital goods.
Marginal Efficiency of Capital and investment decision
Income Determination in a Two-Sector Economy
In a two-sector economy (households + firms, no government, no foreign trade), equilibrium income is where aggregate demand equals aggregate supply: Y = C + I. Since C = a + bY, we substitute: Y = a + bY + I. Solving for Y: *Y = (a + I) ÷ (1 − b) = (a + I) ÷ MPS. This is the Keynesian cross** model — the equilibrium is where the aggregate expenditure line (C + I) crosses the 45° line (where expenditure = income).
Equilibrium income in a two-sector economy (Keynesian cross)
The Investment Multiplier
The investment multiplier (k) is the ratio of the change in equilibrium income to the initial change in investment that caused it: k = ΔY ÷ ΔI. When investment increases by ΔI, income rises by ΔI in the first round. The recipients spend a fraction b (MPC) of this new income, creating more income in the second round. This continues in an infinite geometric series: ΔY = ΔI × (1 + b + b² + b³ + …) = ΔI ÷ (1 − b). So k = 1 ÷ (1 − b) = 1 ÷ MPS. The larger the MPC, the larger the multiplier.
Investment multiplier
Multiplier Process (ΔI = 100, MPC = 0.8)
| Round | Additional Spending (Rs) | Cumulative ΔY (Rs) |
|---|---|---|
| 1 (Initial investment) | 100 | 100 |
| 2 | 80 (= 100 × 0.8) | 180 |
| 3 | 64 (= 80 × 0.8) | 244 |
| 4 | 51.2 | 295.2 |
| … | … | … |
| Total (infinite) | — | 500 (= 100 ÷ 0.2) |
Real-Life Example: Nepal's Remittance Economy
Nepal receives about Rs 1,000 billion per year in remittances — money sent home by Nepalis working abroad. This is like an injection of income (ΔI or ΔX in the multiplier model). If the MPC is about 0.75, the multiplier k = 1 ÷ (1 − 0.75) = 4. So the total impact on GDP could be up to Rs 4,000 billion. However, leakages — imports (a big part of Nepali consumption), taxes, and saving — reduce the actual multiplier. Nepal's high import dependence (petroleum, consumer goods) means a large fraction of spending leaks out as imports, reducing the multiplier effect.
Leakages and Criticism of the Multiplier
- Leakages reduce the multiplier: saving, taxes, imports, and debt repayment all remove spending from the circular flow.
- The multiplier works in both directions — if investment falls, income falls by k × ΔI, amplifying recessions.
- Criticism: assumes constant MPC, no capacity constraints, no price changes, and instant spending — unrealistic in practice.
- The multiplier is larger in economies with high domestic content (more spending stays home) and smaller in open economies with high imports.
Practice Problem
In a two-sector economy: C = 200 + 0.75Y and I = 100. (a) Find the equilibrium level of income. (b) Calculate the investment multiplier. (c) If investment increases by 50 (ΔI = 50), what is the new equilibrium income? Verify using the multiplier. (d) What is the saving at the new equilibrium?
Keynes vs Classical: Comparison
Classical vs Keynesian Macroeconomics
| Issue | Classical View | Keynesian View |
|---|---|---|
| Equilibrium | Supply creates demand (Say's Law) | Demand creates supply |
| Employment | Full employment is automatic | Underemployment equilibrium possible |
| Wages & prices | Perfectly flexible | Sticky downward |
| Interest rate | Balances saving & investment | Determined by liquidity preference |
| Saving | Always becomes investment | May not become investment (hoarding) |
| Role of money | Neutral (medium of exchange) | Active (store of value) |
| Government | Laissez-faire (no intervention) | Active fiscal & monetary policy needed |
APC vs MPC: Detailed Comparison
APC (Average Propensity to Consume) = C ÷ Y — the ratio of total consumption to total income. MPC (Marginal Propensity to Consume) = ΔC ÷ ΔY — the ratio of change in consumption to change in income. Keynes's law says MPC is constant and between 0 and 1. But APC falls as income rises (because C = a + bY, so APC = a/Y + b, and a/Y shrinks as Y grows). In the short run, MPC < APC. In the long run, APC tends to be constant (Kuznets found this empirically), which led to the permanent income hypothesis (Friedman) and the life-cycle hypothesis (Modigliani).
APC and MPC Schedule
| Income (Y) | Consumption (C) | APC = C/Y | MPC = ΔC/ΔY | Saving (S) |
|---|---|---|---|---|
| 0 | 50 | ∞ | — | −50 |
| 100 | 125 | 1.25 | 0.75 | −25 |
| 200 | 200 | 1.00 | 0.75 | 0 |
| 300 | 275 | 0.92 | 0.75 | 25 |
| 400 | 350 | 0.88 | 0.75 | 50 |
| 500 | 425 | 0.85 | 0.75 | 75 |
Real-Life Example: Nepal's Remittance-Driven Consumption
Nepal has one of the world's highest consumption-to-GDP ratios (about 80%). This is driven by remittances — money sent home by workers abroad. When a family receives Rs 30,000/month in remittance, their MPC determines how much they spend vs save. Studies show Nepali remittance-receiving households have MPC ≈ 0.85 — they spend 85% of remittance income, mostly on food, education, and healthcare. Only 15% goes to saving or productive investment. This high MPC creates a large multiplier effect (k ≈ 6.7) but also means most spending leaks out as imports (petroleum, consumer goods), reducing the actual multiplier.
Government and Tax Multipliers
In a three-sector economy (with government), there are additional multipliers. The Government Expenditure Multiplier (kG) shows how much income rises when government spending increases: kG = 1 ÷ (1 − MPC) — same as the investment multiplier. The Tax Multiplier (kT) shows how much income falls when taxes increase: kT = −MPC ÷ (1 − MPC) — it is negative (higher taxes reduce disposable income and thus consumption) and smaller in absolute value than kG (because the first round of tax impact is reduced by MPC). The Balanced Budget Multiplier (kBB) shows the effect of increasing G and T by the same amount: kBB = kG + kT = 1 — meaning a balanced budget increase in spending raises income by exactly the increase in G.
Government, tax, and balanced budget multipliers
Exam Tip: Why Tax Multiplier is Smaller
The tax multiplier is smaller than the government spending multiplier because when the government spends Rs 100, the entire Rs 100 enters the circular flow in round 1. But when the government cuts taxes by Rs 100, households spend only MPC × 100 = Rs 75 (if MPC = 0.75) in round 1 — the other Rs 25 is saved. So the tax cut has a smaller first-round impact, and the total multiplier is smaller.
Key Terms and Definitions
- Effective demand: AD level at which the economy actually settles — प्रभावी माग: अर्थतन्त्र वास्तवमा बस्ने AD स्तर।
- Consumption function: C = a + bY; relationship between consumption and income — उपभोग प्रकार्य: उपभोग र आयबीचको सम्बन्ध।
- MPC: Marginal propensity to consume = ΔC/ΔY (0 < MPC < 1) — सीमान्त उपभोग प्रवृत्ति।
- APC: Average propensity to consume = C/Y — औसत उपभोग प्रवृत्ति।
- Psychological law of consumption: As income rises, consumption rises but less than proportionally — उपभोगको मनोवैज्ञानिक नियम।
- Paradox of thrift: Attempt to save more may lead to same or lower total saving — बचतको विरोधाभास।
- MEC: Marginal Efficiency of Capital — expected rate of return from capital — पुँजीको सीमान्त दक्षता।
- Investment multiplier: k = ΔY/ΔI = 1/(1−MPC) — लगानी गुणक।
- Government multiplier: kG = 1/(1−MPC) — सरकारी खर्च गुणक।
- Tax multiplier: kT = −MPC/(1−MPC) — कर गुणक।
- Balanced budget multiplier: kBB = 1 — सन्तुलित बजेट गुणक।
- Underemployment equilibrium: Equilibrium with less than full employment — अल्परोजगारी सन्तुलन।
Practice Problem
In a three-sector economy: C = 100 + 0.8Yd (where Yd = Y − T), I = 200, G = 300, T = 200. (a) Find the equilibrium income. (b) Calculate the government expenditure multiplier and the tax multiplier. (c) If the government increases spending by 50 (ΔG = 50) with no tax change, what is the new equilibrium income? (d) If instead the government cuts taxes by 50 (ΔT = −50) with no spending change, what is the new equilibrium income? (e) If the government increases both G and T by 50 (balanced budget), what is the new equilibrium income?