Income Determination Theory

Income Determination Theory

Income Determination, Theory of, the Keynesian theory that in a closed economy with no Government activity, employment, output and income will tend towards the level at which the flow of desired savings of the community is just equal to the flow of desired investment expenditure on new capital assets.

In Keynes's analytical scheme the level of employment offered and the income arising from it is determined by the level of total demand in the community. In a modem society that uses capital, total demand can be broken down into (a) demand for consumer goods and services and (b) demand for investment or capital goods. An essential feature of the theory is that these two demands are determined by entirely different factors. The demand for consumption goods is assumed to depend in the main upon the incomes of consumers; the demand for investment goods is assumed to depend upon the present value put on their earning power, or the direct benefit they are expected to yield over their estimated future life compared with their cost.

Consumption demand is related to income in a systematic way by the propensity to consume: except at low levels some part of income will be saved, and whenever income is increased consumption spending rises too but by a smaller amount; in other words, the marginal propensity to consume is a fraction less than one or less than '00 per cent. It follows that as the level of output and income in the economy rises, a gap will appear between the total spending necessary to support the level of employment, output and income and the total spending on consumption associated with that level of income. The extent to which the community can maintain a given level of output and income therefore depends on the volume of investment expenditure being planned and undertaken. The original feature of Keynes's theory was that, since the community's desire to save and its desire to carry out investment expenditures are put into effect by completely separate decisions by different people, there can be no guarantee that the level of investment expenditure will always be such as to fill the 'gap' between income and consumption spending at the level of income repaired for full employment. The most that can be said is that, given the level of investment as determined by business men's propensity to invest, income will tend to the level which, given the propensity to consume, would yield desired saving just equal to desired investment. This would represent equilibrium in the sense that only at that level would there be no tendency for income to change even though men and productive capacity were involuntarily unemployed. At any other level investment would either fall short of or would exceed the 'savings gap', total demand would either fall short of or exceed the level necessary to support current output levels, and the level of output and income would be forced downwards or upwards.

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