Income expenditure model proposed by British economist John Maynard Keynes analyses the relationship between GDP, Income and expenditure by individual and government as well. During 1930's, almost all the countries around world has faced severe recession, historically called as great depression. It was started in US in 1929 by huge decline in stock prices and spread to remaining part of the world. It was attributed to several reasons, main being indebtedness, deflation and high unemployment rates. Unemployment rates were all time high for almost a decade. Keynes has done extensive research on this depression and proposed that government spending at that point of time should increase to create new employment opportunities. But, government was not willing to follow these steps as spending during recession could worsen economy to much higher extent and government was more interested in decreasing interest rates, which almost reached record lowest levels. Further, most of the economists were in belief that markets recover itself without government interference. Hayek, famous economist of those days has also proposed in 1920's that markets should be left freely and government interference should be negligible. US and Britain government were least interested in following Keynes proposal as spending and tax cuts would push economy into more trouble. (Nelson, 2006)
Keynes' views on economy of country have been in and out of implementations several times, from the time he postulated them (Ovans, 2009). Though they proved effective, they were unable to bring economy into stable position due to slow implementation by than government. Keynes postulates came into full existence only after world war, when US government started following Keynes suggestions in improving US economy and was succeeded to some extent (Ovans, 2009). 1946 employment act by federal government is mainly because if Keynes income expenditure model. This act was passed mainly to increase employment, thereby increasing production and purchasing power of the country.
This model proposes following facts that are accepted by almost all the economists. They include (Nelson 2006)
Individual expenditure is affected by government spending and taxation. This in turn affects countries GDP. An increase in government spending increases the income of individuals directly or indirectly, hence, the expenditure of individuals also increases, thereby increasing the GDP.
Decrease in taxation (tax cuts) also increases disposable income of individual's and shows positive effect on GDP.
Due to above two facts, equilibrium level of GDP is consistent with aggregate expenditure.
We can come to conclusion that at equilibrium level of national income, GDP is equal to total aggregate expenditure (AE) of the country. It can be put down as,
GDP at equilibrium = AE at equilibrium
AE= C+ G+ I + X
Substituting, C= A + mpc (Y)
AE = A + mpc(Y) + G +I + X
Here, AE = aggregate expenditure, A=autonomous expenditure, X = net exports, I = investments, G = Government spending, mpc = Marginal propensity to consume and Y= Real GDP
Though the model looks quite simple it is associated with different components. They include marginal propensity to consume, autonomous expenditure, aggregate expenditure, GDP, government spending and multipliers. These are main concepts to be considered, as part of income expenditure model. A change in one component can show immediate effect on other.
Autonomous expenditure (A): It is the consumption expenditure of the country independent of current income. This expenditure is constant and doesn't change with change in real GDP. But change in autonomous expenditure can show effect on GDP. Autonomous expenditure is part of consumption function (C). This is mainly based on consumer's needs. When the income is equal to zero, then also, country needs some basic needs that are to be fulfilled. These needs form autonomous expenditure.
Marginal propensity to consume (mpc): It is the extra expenditure on extra unit of income received. Technically, it is the proportion of increase in national income spent for expenditure. This is an important changing factor in deciding the real national income. It is usually represented by mpc. Slope in the graph represents marginal propensity to consume. If marginal propensity to consume increases GDP also increases.
Change in expenditure
mpc = -------------------------------
Change in disposable income
Consumption function C, can be calculated from autonomous income and marginal propensity to consume.
C = A + mpc (Y)
Where, Y stands for real income at that point of time.
Aggregate expenditure (A): It is the total consumption expenditure. It usually considered sum of autonomous expenditure and induced expenditure. Induced expenditure is consumption expenditure that keeps on changing with real national income. In fact, this change in GDP is mainly due to induced expenditure.
Figure Keynes income expenditure model
Government spending (G): It is the expenditure that government incurs in providing extra works and releases money in to public. It involves subsidiaries given to increase demand, projects approved to increase employment, etc. According to Keynes, increase in government spending increases the money to be circulated. This money reaches public pockets and they increase their expenditure and investments. Thus, increasing the real national income of the country and improving the economy. For example, an increase in government spending by .8 trillion, increases government spending to G*. Then, aggregate expenditure increases and graph can be shown as
Figure Change in government expenditure
Taxation: Taxation plays key role in changing the economy of country. Disposable income of individual's increases with tax cuts. This increases expenditures of individual and thus the GDP as well. An increase in the tax can reduce disposable income of individual's and shows negative impact on GDP (Franco and Richard, 1954).
National income at equilibrium (Ye): At Y1, expenditure is higher than national income. Government increases its spending by injection and improves real GDP to Ye. Ye represent equilibrium level of GDP. At this point, aggregate expenditure equals national income. This is the situation where withdrawals would be equal to injections in Keynes withdrawal-injection approach (Sloman and Garrat, 2010). When national income in higher than expenditure (Y2), government starts withdrawing money through net savings, net taxes and through expenditure on imports. Governments always try to maintain national income at equilibrium level, as higher income would make money stagnant in the country, higher supply can also lead to depletion of resources of the country and higher expenditure means high demand and lower supply. This can lead to exploitation of customer.
Keynesian multiplier: When government spending is increased by 10 million dollars, than national income increases by more than $10 million. This is due to snow balling effect. Keynes has used multiplier effect to give solution to this problem. He proposed two multipliers to nullify snow balling effect.
Government spending multiplier = 1/ 1-mpc
Tax cut multiplier = (1/ 1-mpc) - 1