Let us consider how it is possible to display and study the main elements of the mechanism for determining national income, based on the principle of effective demand, with the help of graphs. Somewhat simplifying, the principle of effective demand refers to the provision according to which, for sufficiently short periods of time at which the level of productive capacity is considered to be specified, national income (the level of output) is determined by factors lying on the demand side. Let’s resort to the help of formulas.
Aggregate effective demand is defined as the sum of consumption and investment. Thus:
D = C + 1 (8-1)
Consumer demand can be represented as
C = cY + A (0 < c < 1), (8-2)
where C is demand, is a linear function of national income (aggregate output), Y; and c, A are constants. The coefficient c expresses the proportion in which consumption increases with an increase in income Y, and is called the propensity to consume. A is called basic consumption. The formula (8-2) is called the linear consumption function. To determine investments, we will use the hypothesis of the independent nature of investments, according to which the level of investment is determined by the long-term expectations of enterprises, to a certain extent independent of the level of income.
Equilibrium national income Ye, meeting the condition of equality of supply and demand,
D = Y (8-3)
is defined as a solution to an equation.
Y = cY + A + I (8-4)
From where
Ye = ( I + A) (8-5)
The expression I/ (I-c) shows how much national income increases with a given growth in investment, and is therefore called a multiplier, which is one of the key concepts of the Keynesian concept.
Equilibrium point E and its corresponding equilibrium national income Ye reflect a level of current economic activity that satisfies households and enterprises to a certain extent, but does not coincide with the desired level, i.e. the level at which full employment is achieved. Graphic illustrations help to clarify the central point of Keynesian theory, according to which the equilibrium national income of Ye is always less than the value of the national income of Yi at which full employment is provided. Therefore, the goal of public policy is to achieve the state of Ye = Yi by increasing investment I.
The process of “changing the volume of investment – the amount of income”, operating through the multiplier
I/ (I – c),
it is also called a multiplicative process. Suppose that an enterprise makes a new investment of ^I in order to expand production. Investment means the formation of fixed capital, including production facilities, machinery and equipment. And therefore generates an increase in income by an amount equal to ^I (primary effect of distribution). If, of this amount (^I), households use the amount of c X ^I to purchase consumer goods, then income is further increased by c X ^I (secondary effect of distribution). This process continues indefinitely and eventually leads to an overall increase in revenue by ^Y:
^Y = ^I + c^I + c2^I +c^I +…+ =
(I + c + c + c + …) ^I =
= ^I
Thus. we get the following formula:
Increase in income = Investment multiplier * Investment growth.
If we consider the reduction in inventories as a negative increase in investment, we come to the same multiplier formula. Even if spending on consumer and capital goods is covered by inventories.