Keynesian Income Expenditure Model
Introduction
We will look at a simplified version of Keynes’s theory where there are initially just two
sectors within the economy.
• Households – consumers and providers of labour
• Firms – producers and users of raw materials (including labour)
Key assumptions
• Prices, wages and interest rates are fixed
• The level of output depends upon only the total level of demand (aggregate
expenditure) in the economy
The Consumption Function (1)
𝐶 = 𝑐0 + 𝑐1 𝑌
c0 is autonomous/independent consumption; this can be thought of as the minimum level of
consumption needed for survival.
𝑐1 𝑌 is affected by the level of income. 𝑐1 is known as the marginal propensity to consume
(MPC).
The Marginal Propensity to Consume
The MPC is the fraction of extra income that households wish to consume. Since the MPC is
defined as a fraction, its value will run from 0 to 1.
• If the MPC = 0, no part of extra income will be consumed
• If the MPC = 1, all extra income will be used for consumption purposes
Thus, for an increase in income by one unit, consumers will use MPC share of it to spend on
consumption.
, The Consumption Function (2)
Investment Expenditure
• Investment expenditure will include the planned additions to physical capital and
inventories by firms
• The main determinant of investment expenditure here will be firms’ expectations of
how the demand for their output will change
• There is no close connection between the current level of output and expectations
about changes in the level of demand
• The level of investment expenditure is determined by animal spirits (the term "animal
spirits" is used by Keynes to describe human emotion that drives consumer
confidence)
• Investment is assumed to be exogenous (caused or produced by factors external to a
model, organism, organization, or system. Opposite of endogenous): 𝐼 = 𝑖0
Aggregate Expenditure/Demand
Introduction
We will look at a simplified version of Keynes’s theory where there are initially just two
sectors within the economy.
• Households – consumers and providers of labour
• Firms – producers and users of raw materials (including labour)
Key assumptions
• Prices, wages and interest rates are fixed
• The level of output depends upon only the total level of demand (aggregate
expenditure) in the economy
The Consumption Function (1)
𝐶 = 𝑐0 + 𝑐1 𝑌
c0 is autonomous/independent consumption; this can be thought of as the minimum level of
consumption needed for survival.
𝑐1 𝑌 is affected by the level of income. 𝑐1 is known as the marginal propensity to consume
(MPC).
The Marginal Propensity to Consume
The MPC is the fraction of extra income that households wish to consume. Since the MPC is
defined as a fraction, its value will run from 0 to 1.
• If the MPC = 0, no part of extra income will be consumed
• If the MPC = 1, all extra income will be used for consumption purposes
Thus, for an increase in income by one unit, consumers will use MPC share of it to spend on
consumption.
, The Consumption Function (2)
Investment Expenditure
• Investment expenditure will include the planned additions to physical capital and
inventories by firms
• The main determinant of investment expenditure here will be firms’ expectations of
how the demand for their output will change
• There is no close connection between the current level of output and expectations
about changes in the level of demand
• The level of investment expenditure is determined by animal spirits (the term "animal
spirits" is used by Keynes to describe human emotion that drives consumer
confidence)
• Investment is assumed to be exogenous (caused or produced by factors external to a
model, organism, organization, or system. Opposite of endogenous): 𝐼 = 𝑖0
Aggregate Expenditure/Demand
