Income and Output Determination (Unit B: AD–AS, Effective Demand; Classical vs Keynesian)

1) What is “income/output determination”?

This unit explains how the level of aggregate output (Y) and employment is determined in the economy, especially in the short run.

Two big approaches:

• Keynesian theory: output and employment can be demand-determined; involuntary unemployment possible.
• Classical theory: economy tends toward full employment via flexible prices and wages.

2) Aggregate Demand (AD): meaning and components

Aggregate Demand (AD) is total planned spending on final goods/services at different income/price levels.

In basic macro:

For simplest Keynesian model (2-sector, closed, no govt):

2.1 Consumption function (Keynes)

Keynes proposed:

where:

• $a$ = autonomous consumption (even at Y=0),
• $b$ = MPC (marginal propensity to consume), $0<b<1$.

Savings:

3) Aggregate Supply (AS): meaning in this unit

In income determination chapter, AS often means:

• the value of output/income firms produce at a given employment level. In Keynes’ simplified short-run analysis:
• prices may be sticky,
• firms respond to demand by changing output (rather than prices) until capacity/full employment limits bind.

In AD–AS diagrams:

• Keynesian SRAS is often shown as relatively flat at low output (prices sticky) and steeper near full employment.
• Classical LRAS is vertical at full-employment output $Y_f$ (output determined by resources/technology).

4) Keynes’ Principle of Effective Demand (core idea)

Effective demand is the level of aggregate demand that becomes “effective” because it is backed by actual spending, determining firms’ output and employment.

Keynes’ point:

• Firms hire labour and produce output based on expected sales.
• If aggregate demand is insufficient, equilibrium can occur at less than full employment.