1. It is a closed economy in which there are no exports and imports.
  2. There are no business taxes and government expenditure and transfer payments 
  3. There is autonomous investment.
  4. The economy is at less than full employment level of output
  5. The price level remains constant up to the level of full employment
  6. The rate of interest is fixed.
  7. The money wage rate is constant.
  8. There is a stable consumption function.

Given these assumptions, the equilibrium level of national income can be determined by the equality of aggregate demand and aggregate supply or by the equality of saving and investment. It is shown by the following two approaches:




Determination of equilibrium national income in a two sector economy

J.M. Keynes in his famous book, “General theory”, has used two methods for the determination of national income at a particular time, (1) Saving investment Method and (2) Aggregate Demand and Aggregate Supply Method. Both these approaches lead us to the determination of the same level of national income.

It may here be mentioned that Keynes model of income determination is relevant in the context of short run only. Keynes assumes that in the short run, the stock of capital, technique of production, forms of business organizations, do not change. (2) He also assumes a fair degree of competition in the market (3) there is also absence of government role either as a taxer or as a spender (4) Keynes further assumes that the economy under analysis is a closed one. There is no influence of exports and imports on the economy.

I – Determination of National Income by the Equality of Saying and Investment

This approach is based on the Keynesian definitions of saving and investment. According to Keynes, the .level of national income, in the short run, is determined at a point where planned or intended saving is equal to planned or intended investment. Saving as defined by Keynes is that part of income which is not spent on consumption (S=Y-C). On the other hand, investment is the expenditure on goods and services not meant for consumption. (1=Y-C). .

According to Keynes, if at any time, the intended saving is less than intended investment, it implies that people are spending more on consumption. The rise, in consumption will reduce the stock of goods in the market. This will give incentive to entrepreneurs to increase output. Likewise, if at any time intended saving is greater than intended investment, this would mean that people are spending lesser volume of money on consumption. As a result of this, the inventories of goods will pile up. This will induce entrepreneurs to reduce output. The result of this will be that national income would decrease. The national income will be in equilibrium only when intended saving is equal to intended investment.

Illustration The determination of national income is now explained with the help of saving and investment curve below.

In figure (31.2), income is measured on OX axis and saving and investment on OY axis, SS is the saving curve which shows intended saying at different levels of income.

The investment curve is drawn parallel to the X axis which shows that investment does not change. The entrepreneurs intend to invest Rs. 50 crores only irrespective of the amount of income. Saving (SS) and investment curves (II’) intersect each other at point M. If the conditions stated above remain the same, the size of equilibrium level of income is Rs.250 crores.


II. Determination of Equilibrium level of National Income according to Aggregate Demand and Aggregate Supply Approach.

While determining the level of national income in a two sector economy, it is assumed that it is an economy where there is no role of the government and of foreign trade. In other words, it is a closed economy with no government intervention. The two sector economy comprises of households and firms.

According to J. M. Keynes, the equilibrium level of national income is that situation in which aggregate demand (0+1) is equal to aggregate supply (C+S). The aggregate demand (0+1) refers to the total spending in the economy. In a two sector economy, The aggregate demand is the sum of demands for the consumer goods (c) and investment goods by households and firms respectively. The aggregate demand curve is positively sloped. It indicates that as the level of national income rises, the aggregate demand (or aggregate spending) in the economy also rises.

Aggregate supply (C+S) is the flow of goods and services in the economy. In other words, the value of aggregate supply is equal to the value of net national product (national income). The aggregate supply curve (C+S) is a positively sloped 450 helping line. It signifies that as the level of national income rises, the aggregate supply also rises by the same proportion.

Equilibrium level of income

According to Keynesian model, the equilibrium level of national income is determined at a point where the aggregate demand curve intersects the aggregate supply curve. The 450 helping line represents aggregate supply. By definition, output equals income on each point of aggregate supply curve. The determination of the level of aggregate income is explained below.


Determination of Equilibrium Income or Output in a Three Sector Economy

Though the government is involved in a variety of activates three of them are of greater relevance to us in the present context. Hence we will focus on these activities of the government, which are discussed below:

Government Expenditure

This includes goods purchased by the central, state and the local government and also the payments made to the government employees.


These are those government payments which do not involve any direct services by the recipient for instance welfare payments, unemployment insurance and others.


These include taxes on property, income and goods. Taxes can be classified into two categories, direct taxes and indirect taxes. Direct taxes are levied directly and include personal income and corporate income tax. They are paid as a part of the price of the goods.

We simplify our analysis by making a few postulations, which are as follows.

The government purchases factor services from the household sector and goods and services from the firms.

Transfer payment includes subsidies to the firms and pensions to the household sector.

The government levels only direct taxes on the household sector. We here introduce the notion of an income leakage and an injection. In a two sector model, a part of the current income stream leaked out as saving whereas injections in the form of investment were injected into the system. In a three sector model taxes, like saving, are income leakages whereas government expenditures like investment are injections.

Determination of Equilibrium income or output in a Four Sector

The inclusion of the foreign sector in the analysis influences the level of aggregate demand through the export and import of goods and services. Hence it is necessary to understand the factors that influence the exports and imports.

The volume of exports in any economy depends on the following factors:

  • The prices of the exports in any domestic economy relative to the price in the other countries.
  • The income level in the other economics.
  • Tastes, Preferences, customs and traditions in the other economics.
  • The tariff and trade policies between the domestic economy and the other economics.
  • The domestic economy’s level of imports.