Analyse the case of ‘simultaneous equation bias’ in the Keynesian Model of Income Distribution.

Simultaneous Equation Bias in the Keynesian Model of Income Distribution

The Keynesian Model of Income Distribution, a key component of Keynesian economics, analyzes the distribution of income in an economy based on the relationship between aggregate demand and national income. However, the model is susceptible to simultaneous equation bias, which arises when the variables in the model are endogenous and mutually determined.

1. Keynesian Model of Income Distribution:

• The Keynesian Model posits that aggregate demand determines national income, which in turn influences the distribution of income among factors of production (e.g., labor and capital).
• The model assumes a relationship between aggregate demand, consumption, saving, investment, and national income, with feedback effects between these variables.

2. Simultaneous Equation Bias:

• In the Keynesian Model, variables such as consumption, saving, and investment are endogenous, meaning they are determined within the model rather than being exogenously given.
• When these endogenous variables are included in a system of simultaneous equations, their estimates may be biased due to the mutual determination of the variables.
• This bias occurs because the model assumes that the independent variables are predetermined when, in reality, they are influenced by the same factors that determine the dependent variable.

3. Example:

• In the Keynesian Model, the relationship between consumption and national income is crucial. Higher national income leads to higher consumption, which in turn affects national income through the multiplier effect.
• However, if consumption and national income are estimated simultaneously in a system of equations, the estimated effect of national income on consumption may be biased, as national income itself is influenced by consumption.

4. Implications:

• Simultaneous equation bias in the Keynesian Model can lead to incorrect estimates of the parameters of the model, affecting the reliability of policy recommendations based on the model's predictions.
• Policymakers relying on the Keynesian Model for income distribution policies must be aware of the potential bias and take steps to mitigate it, such as using instrumental variables or structural equation modeling techniques.

5. Conclusion:

• Simultaneous equation bias in the Keynesian Model highlights the importance of carefully considering the endogeneity of variables in economic models.
• By recognizing and addressing this bias, economists can improve the accuracy and reliability of their models, leading to better-informed policy decisions regarding income distribution and economic stabilization.