Determination of Income and Employment - Notes & Video Link - by Ecopoint
Determination of Income and Employment - Notes & Video Link - by Ecopoint
Determination of Income and Employment - Notes & Video Link - by Ecopoint
(Macroeconomics)
Notes-By Mrs Sanchi Arora
Note: AD in Keynesian framework, in case of two sector economy (households and firms) is the sum of
consumption demand and investment demand i.e. AD is a function of only consumption expenditure and
Investment expenditure. Hence,
AD = C+I
Y=C+S
or
Note: The consumption expenditure we are discussing here is ex-ante i.e. planned consumption expenditure
which households are planning to consume during a given period of time.
C = C + bY
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Autonomous consumption vs Induced consumption
Table: Consumption schedule showing Consumption, Income and Marginal Propensity to Consume
100
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In the above table:
When income is zero consumption expenditure is 100 depicting autonomous consumption = 100.
As income increases the consumption expenditure also increases but increase in consumption is less
than the increase in income. A rupee increase in income causes less than a rupee increase in
consumption (Keynes psychological law of consumption). In the above table each time income
increases by 100 and consumption expenditure increases by 80.
The rate of change in consumption per unit change in income, also known as the Marginal
Propensity to Consume (MPC). It remains same at all levels of income. In the above table the value of
MPC is 80/100 = 0.8. It depicts the slope of the given consumption function which is constant throughout.
This may result in a straight-line consumption function curve as shown in the diagram below:
Fig: The Consumption Curve
Consumption curve
The above figure shows the graph of the consumption function C = 100 + 0.8Y.
To understand the figure, we draw a 45 o line from the origin. Since the vertical and horizontal axes have the
same scale, the 45o line has the property that at any point on it, the distance up from the horizontal axis (which
is a consumption expenditure) exactly equals the distance across from the vertical axis (which is income). Thus,
at any point on the 45o line, consumption expenditure exactly equals income. The 45o line therefore tells us
whether consumption spending (as per the consumption function) is equal to, greater than, or less than the
level of income.
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The point where the consumption function crosses the 45o line, the level of consumption is exactly equal to the
level of income and savings are zero. This is called break-even point (At point B in the diagram
corresponding to 500 income level).
When the consumption curve lies below the 45o line, the level of consumption is less than the level of income.
This means that there is positive saving. (At any point to the right of B in the diagram)
The amount of dissaving or saving is always measured by the vertical distance between the consumption
curve and the 45o line.
1. Average Propensity to consume (APC): It refers to the ratio of consumption expenditure (C) to the
corresponding level of income (Y). It is a measure of total consumption expenditure as a proportion of
total income.
APC = C
2. Marginal Propensity to consume (MPC): It refers to the ratio of change in consumption expenditure
(∆C) to change in income (∆Y). In other words, it is the change in consumption per unit change in
income.
MPC = ∆𝐶
∆Y
MPC (b) refers to the slope of consumption curve which measures the rate of change in
consumption on per unit change in income. In the above schedule MPC is constant (0.80) and due to
constant MPC the consumption curve is a straight line, i.e. consumption function is linear.
Savings
Savings is that part of income that is not consumed. Thus.
S=Y–C (i)
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Saving function
It refers to the functional relationship between savings and income. That is,
S = f (Y)
S = – C + (1 – b)Y or S = – C + MPSY
In the above saving function, intercept ‘– C’ represents negative savings (dissavings) at zero level of income.
(1 – b) represents MPS, the slope of saving curve which represents the rate of change in savings on per unit
change in income.
Saving Schedule
For the given consumption function C = 100 + 0.8 Y the saving function is derived as:
S = -100 + 0.2Y
It is represented by the following schedule:
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
- 100 - -100 - -
The above table shows the levels of consumption and savings for various levels of income.
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It shows that as income increases savings also increases, for e.g. as income increases from Rs. 600 to Rs. 700 (an
increase of 100), the savings rise from 20 to 40 (an increase of 20) but increase in saving on is less than the
increase in income. In the above table each time income increases by 100 but savings increase by 20.
The rate of change in saving per unit change in income, also known as the Marginal Propensity to Save
(MPS), remains same at all levels of income. In the above table the value of MPS is 20/100 = 0.2. It depicts
the slope of the given saving function which is constant throughout. This may result in a straight-line saving
function curve as shown in the diagram below.
The sum of consumption expenditure and saving equals income everywhere which means income is either
consumed or saved. Also, the sum of MPC and MPS is equal to one This means that part of increase in
income, which is not consumed, is saved.
The above figure shows the consumption function in Part A and the savings function in Part B. In part A, the
amount of saving at any level of income is the vertical distance betweenthe consumption function and the 45o line.
The saving function shown in part B can therefore be directly derived from part A.
Saving curve starts from negative range of y-axis indicating that there is negative savings when
income is zero, it is equal to the amount of autonomous consumption expenditure (= 100) in part A.
The direct relation between income and saving is reflected by the positive slope of saving curve.
Saving curve cuts x-axis at point B, depicting savings = zero (at 500 income level). It is called
break-even point (since here Y = C).
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To the left of point B in part A, the consumption function lies above the 45o line (consumption is more than
income). Hence to the left of point B in part B, savings is negative and the savings function lies below
the horizontal axis (at lower levels of income).
To the right of point B in partA, theconsumption functionlies belowthe 45o line (consumption is less than
income). Hence to the right of point B in part B, savings is positive and the savings function lies
above the horizontal axis.
Propensity to save
It is the proportion of income saved.
It has two aspects: APS and MPS
1. Average Propensity to consume (APS): It refers to the ratio of savings (S) to the corresponding level of
income (Y).
APS = S
2. Marginal Propensity to consume (MPS): It refers to the ratio of change in saving (∆S) to change in income
(∆Y). In other words, it is the change in savings per unit change in income.
MPS = ∆S
∆Y
Relation between APC and APS: The sum of APC and APS is equal to one. That is,
APC + APS = 1
or APC = 1 – APS
or APS = 1- APC
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Relation between MPC and M0PS: The sum of MPC and MPS is equal to one. That is,
MPC + MPS = 1
or MPC = 1 – MPS
or MPS = 1- MPC
Steps of derivation:
1. Draw a 45o line from the origin. This will intersect the consumption curve CC at point B where
consumption = income.
2. Take OS = OC on the Y-axis depicting OC, autonomous consumption = OS, dissavings at zero level
of income. This givea the starting point S for the saving curve.
3. Draw a perpendicular from point B to intersect the x- axis at point B’. At point B’ savings are zero,
(since consumption = income at point B).
4. By joining points S and B’ and extending upward, we get the straight line upward sloping saving curve
SS.
Investment: Investment is defined as addition to the stock of physical capital (such as machines, buildings,
roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the
inventory (or the stock of finished goods) of a producer.
In Keynes theory of income and employment it is assumed that firms plan to invest the same amount
every year.ie. ex ante investment demand as I = I (where I is a positive constant which means that the
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level of investment remains the same (i.e. autonomous/ given/ exogenous) in the economy in a given
year whatever be the level of income.
Types of investment
1. Induced investment
It refers to the investment which depends upon profit expectations and is directly influenced by
income level.
It is income elastic i.e. as income increases it also increases.
It is done by private sector.
Induced investment curve slopes upward.
2. Autonomous investment
It refers to the investment which is not affected by change in the level of income and is not
induced by profit motive i.e. it is independent of the level of income.
It is income inelastic i.e. It remains same irrespective of any change in income.
It is generally done in the government sector.
Autonomous investment curve is a straight line parallel to x-axis.
0 40 20 60
100 120 20 140
200 200 20 220
300 280 20 300
400 360 20 380
500 440 20 460
600 520 20 540
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Determination of equilibrium level of income and output by AD-AS approach
Assumptions: The various assumptions made in determination of the equilibrium level of income/ output
are –
1. It is studied in the context of two sector model (households and firms). It means that there is no
government and foreign sector. Hence, aggregate demand comprises of two components
consumption demand and investment demand.
2. Investment expenditure is autonomous i.e. investment is not influenced by level of income.
3. Under short run fixed price model overall price level in the economy is fixed.
4. Equilibrium output is to be determined in the context of short run.
AD = AS -(1)
Since we have assumed that there is neither government nor foreign trade sector, so AD is sum of private
consumption expenditure (C) and investment expenditure (I).
Therefore AD = C + I (2)
Since Aggregate supply is same as national income and income is either consumed or saved. Therefore, it can
be expressed as AS = C + S (3)
Putting equations (1), (2) and (3) together we get:
AD = AS
or C + I = C + S
or I=S
or S=I
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Graphically
o
the equilibrium is determined where AD (C + I) curve intersects the 45o line (Income line/ AS
curve). In the diagram given below equilibrium is attained by the economy at point E, where the C +I curve
intersects the 45o line. Because here, the level of desired spending on consumption and investment exactly equals
the level of total income i.e. AD = AS
The level of income corresponding to point E, is OY which is the equilibrium level ofincome.
In the schedule given below equilibrium is attained by the economy at 400 crores, where planned spending =
planned output (AD = AS).
Case 1: When AD > AS (i.e. planned spending is more than planned output), it refers to the levels of
income lower than equilibrium level of income OY (i.e. at income levels less than 400 crores in the schedule).
It means that buyers (firms and households) are planning to buy more goods and services than what
the producers are planning to produce/ sell.
This would lead to an unplanned/ undesired decrease in inventories.
To bring back the inventories to the desired level, producers would expand production and increase
employment. As a result, income, output and employment will increase.
This process of increase in output will continue until the economy is back at income level OY, where
aggregate demand becomes equal to aggregate supply again and there is no further tendency to change.
Case 2: When AD < AS (i.e. planned spending is less than planned output), it refers to the levels of income
greater than equilibrium level of income OY (i.e. at income levels higher than 400 crores in the schedule).
It means that buyers (firms and households) are planning to buy less goods and services than what the
producers are planning to produce/ sell.
This would lead to an unplanned/ undesired increase in inventories of unsold goods (representing goods
neither sold to households for consumption nor bought by firms for investment).
To bring back the inventories to the desired level, producers cut back on their production and lay off
workers which may result in decrease in income, output and employment level.
This downward trend will continue until the economy is back at income level OY, where again planned
spending becomes equal to planned output (i.e. AD = AS) and there is no further tendency to change.
Note: In Keynesian economics, effective demand is the point of equilibrium where aggregate demand equals
aggregate supply.
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Amount in crores
Employment Income Consumption Saving Investment AD AS Remarks
(Lakhs) (Y) (C) (s) (I) C+I C+S
0 0 40 -40 40 80 AD>AS
10 100 120 -20 40 160 100 AD>AS
20 200 200 0 40 240 200 AD>AS
30 300 280 20 40 320 300 AD>AS
40 400 360 40 40 400 400 AD=AS
(Equilibrium)
50 500 440 60 40 480 500 AD<AS
60 600 520 80 40 560 600 AD<AS
or
S=I
We know that equilibrium is obtained at the point where:
AD = AS
i.e. Planned spending = Planned output
or C + I = C + S
or I=S
In the diagram below, II is the investment curve parallel to x-axis showing autonomous investment.
SS is the saving curve with a positive slope showing a direct relation between income and savings.
In the above diagram equilibrium is determined at point E corresponding to OY income level, where saving
curve intersects the investment curve. Here, planned savings = planned investment (S = I). Hence, OY is the
equilibrium level of income/ output.
In the schedule given below equilibrium level of income is 400 crores where planned savings = planned
investment (= 40 crores). There is no tendency to change at 400 crores income level as change in inventory
is zero.
There is a tendency for the income to increase if income level is below 400 crores and decrease if the income
level is above 400 crores.
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Case 1: When S > I (i.e. planned saving is greater than planned investment)
This situation occurs at OY1 income level i.e. beyond point E (at income levels higher than 400 crores).
It means that buyers (households) are planning to buy less goods and services than what the producers
are planning to produce. (Since savings and consumption are complementary to each other as Y =
C+S).
In this situation planned output exceeds planned spending i.e. AS > AD.
As a result, there will be unplanned addition to inventories.
To clear the unwanted increase in inventory (or to bring back the inventories to the desired level), the
producers plan to cut back production leading to decrease in income, output and employment level.
Since saving is an increasing function of income, as income decreases, saving also decreases. This
adjustment mechanism will continue till the economy reaches equilibrium level of output OY where
S = I.
Case 1: When S < I (i.e. planned saving is less than planned investment)
This situation occurs at OY2 income level i.e. before point E (at income levels lower than 400 crores).
It means that buyers (households) are planning to buy more goods and services than what the producers
are planning to produce.
(Since savings and consumption are complementary to each other as Y = C+S). In this situation
planned output is less than planned spending i.e. AS< AD.
As a result, planned inventory would fall below the desired level.
To bring back the inventories to the desired level, firms/ producers would plan to increase production
leading to increase income, output and employment.
As income increases, saving also increases. This adjustment mechanism will continue till the economy
reaches equilibrium level of output OY where S = I.
K = ∆Y
∆I
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this increased income on consumption. However, the amount of increased income spent on consumption
depends on the value of MPC.
In case of higher MPC people will spend a large proportion of increased income on consumption.
Higher the expenditure on consumption, higher the increase in income of producers of goods and
services. As a result, in such a case the value of multiplier will be more.
In case of lower MPC, people will spend less proportion of increased income on consumption. In such
a case the value of multiplier will be comparatively less.
K= 1
1 - MPC
There exists a direct relationship between MPC and the value of multiplier. Higher the value of MPC,
more is the value of multiplier. Hence greater is the increase in income. Similarly, lower the value of MPC,
lesser is the value of multiplier. Hence less is the increase in income.
There exists an inverse relationship between MPS and the value of investment multiplier. Higher the
value of MPS, lower will be the value of multiplier and lower the value of MPS the higher is the value of
multiplier. Hence more will be the increase in income because lower the value of MPS implies lower savings,
higher is the consumption expenditure and consequently, higher the income of producers of consumer goods
and services. As a result, the value of multiplier will be more.
As K = 1
1 - MPC
or K = 1 =∞
1-1
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B. The minimum value of multiplier is 1.
When MPC = 0, the economy decides to save its whole of additional (increased) income i.e. ∆Y = ∆S
(and ∆C = 0)
As K = 1
1 - MPC
K= 1 =1
1-0
In this way, national income goes on increasing in round after round. But the increase in each round is
restricted to 80% of the previous round. The absolute increase becomes smaller and smaller with every round.
The multiplier process goes on till initial increase in investment becomes equal to increase in savings i.e.
∆I = ∆S.
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Rounds Increase in Increase in income Increase in consumption Increase in savings
investment (∆I) (∆Y) (∆C) = ΔY x MPC (∆S)
I 1000 1,000 800 (= 1000 x 0.8) 200
II 800 640 (= 800 x 0.8) 160
III 640 512 (= 640 x 0.8) 128
IV 512 409.6 (= 512 x 0.8) 102.4
: :
: :
: : :
Total 1,000 5,000 4,000 1,000
where multiplier k = 1 = 1 = 1 =5
1 - MPC 1- 0.8 0.2
Thus, an initial increase in investment of 1,000 crores leads to a total increase of 5,000 crores in the income.
This implies that the national income increased by 5 times of the initial increase in investment since the value
of multiplier is 5.
Full Employment: When the entire labour force of the country is in employment, it is called full
employment. Labour force comprises of people who are able to work and willing to work.
Full employment level of income: It is that level of income where all the factors of production are fully
employed in the production process.
In the diagram shown below point E is full employment equilibrium as at this point aggregate demand EQ =
OQ, full employment level of output. At OQ level of output all those who are able and willing to work at the
prevailing wage rate are able to find employment i.e. there is no involuntary unemployment.
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D. Underemployment equilibrium: It refers to a situation when AD =AS occurs at a level of output,
less than full employment level (where all the resources are not fully employed) in the economy.
In the above diagram F is an underemployment equilibrium point because at this point AD= AS occurs
corresponding to an output level OQ1 which is less than full employment output level OQ.
This situation arises due to deficient demand in the economy i.e. when AD is less than AS, at full employment
income level.
Note: Full employment level of income is that level of income where all the factors of production are fully
employed in the production process
The equilibrium level of output may be more or less than the full employment level of output. If it is less than
the full employment of output, it is due to the fact that demand is not enough to employ all factors of
production. This situation is called the situation of deficient demand. It leads to decline in prices in the long
run. On the other hand, if the equilibrium level of output is more than the full employment level, it is due to
the fact that the demand is more than the level of output produced at full employment level. This situation is
called the situation of excess demand. It leads to rise in prices in the long run.
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Excess demand/ Inflationary gap
If aggregate demand is for a level of output/ income more than the full-employment level, then a situation of excess
demand exists.
In other words, excess demand refers to the situation when aggregate demand (AD) is more than
aggregate supply (AS) corresponding to full employment level of output in the economy.
The situation of excess demand give rise to inflationary gap; which causes a rise in the price level or inflation.
The inflationary gap is the amount by which actual aggregate demand exceeds the aggregate demand
required to establish full-employment equilibrium. The inflationary gap is a measure of the amount of the
excess of aggregate demand.
In the diagram given below OQ’ is full employment level of output/ income. Therefore, F is full employment
equilibrium point. Aggregate demand at full employment is FQ’. Actual aggregate demand is GQ’ which is
greater than the full employment level of income OQ’ (= FQ’). The level of aggregate demand corresponds to
point G on the aggregate demand curve (C+I), depicts the situation of excess demand which result in
inflationary gap equal to GF. (GQ’ - FQ’ = GF)
The inflationary gap is so called because it sets in motion forces that will cause inflation or a rise in the price level.
The situation of deficient demand give rise to ‘deflationary gap’, which causes the economy’s income/ output/
employment to decline, thus pushing the economy into an under-employment equilibrium.
Deflationary gap is the gap by which actual aggregate demand falls short of the aggregate demand required to
establish full employment equilibrium.
In the diagram, the Y-axis measures the aggregate demand. The X-axis measures income/ output/ employment.
OQ is the full employment level of income. Hence point F is full employment equilibrium point. For the
economy to be at a full-employment equilibrium, the aggregate demand should be equal to FQ. However, in the
economy the actual aggregate demand is GQ, which is less than FQ i.e. the full-employment level AD by an amount
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equal to FG (= FQ – GQ) which represents deflationary gap. This level of aggregate demand corresponds to
point G on the aggregate demand curve (C+1)o depicts the situation of deficient demand.
E is the point of under employment equilibrium and OM is the equilibrium level of income which is less than
the full employment level thereby creating involuntary unemployment equal to MQ.
A. Fiscal measures
Fiscal policy
It refers to the policy concerning revenue and expenditure of the government in order to achieve economic
objective. During excess demand government takes following measures to reduce aggregate demand:
Reduce government expenditure - During excess demand government should curtail/ reduce its
expenditure on public work programmes (on its administration and welfare activities, like police,
military, courts, education, sanitation etc.). This may reduce the purchasing power in the hands of the
people which may in turn decrease aggregate demand in the economy and be helpful in correcting
excess demand.
Increase in taxes - During excess demand the government may raise the rate of taxes and even impose
new taxes. Increasing taxes may reduce the disposable income of the people which may in turn reduce
their consumption expenditure. This may decrease aggregate demand in the economy and thus help in
correcting excess demand situation.
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B. Monetary measures
Monetary policy
It refers to the policy of the RBI (central bank of India) to influence credit and money supply in the
economy to achieve economic objectives.
To reduce aggregate demand during excess demand the central bank aims to reduce availability of credit
in the economy through its various monetary policy measures:
I. Quantitative measures
1) Increase in Bank rate
Bank rate is the rate of interest at which the central bank lends money to commercial banks for its
long-term needs.
During excess demand the central bank increases bank rate., which raises the cost of borrowings from
the central bank. It forces commercial banks to increase their lending rates thereby making credit
costlier. As a result, demand for loans for investment and other purposes decrease, leading to decrease
in aggregate demand in the economy.
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Qualitative measures
Increase in Margin requirement of loan
It is the difference between the amount of loan and the market value of the security offered by the
borrower against the loan.
During excess demand RBI increases the margin requirement of loans, which means that less amount
of loan will be granted to the borrowers against the same amount of security. This may adversely
affect the demand for loans for consumption as well as investment purposes which in turn decreases
aggregate demand in the economy.
Fiscal Measures
Increase in government
Decrease in taxes
expediture
B. During deficient demand, the central bank aims to ensure easy availability of credit and reducing cost of
borrowing money through its monetary policy.
Monetary measures
government
requirement
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Click on the following links for further explanation of the topics discussed above:
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