Class 12 Income and Employment Determination: Complete Concepts and Practice

Big picture

Why does an economy sometimes produce less than it could, leaving people unemployed, and at other times push prices up? Keynes's answer was aggregate demand: the total planned spending in the economy. Output adjusts to meet demand. If planned spending is too low, firms cut output and jobs; if it is too high at full employment, prices rise.

This chapter builds a simple model of a two-sector economy (households and firms). It finds the equilibrium level of income, shows how a change in investment changes income by a multiple (the multiplier), and explains the problems of excess and deficient demand and their remedies. Numericals with the consumption function and multiplier are certain to appear.

Learning goals

• Explain aggregate demand, aggregate supply and their components.

• Explain the consumption and saving functions, and calculate APC, MPC, APS and MPS.

• Distinguish ex-ante and ex-post, and autonomous and induced investment.

• Find equilibrium income using AD = AS and S = I.

• Explain the investment multiplier and calculate its effect.

• Explain full employment and involuntary unemployment.

• Explain excess and deficient demand, inflationary and deflationary gaps, and measures to correct them.

Core ideas

1. Aggregate demand and aggregate supply

Aggregate demand (AD) is the total planned (ex-ante) expenditure on final goods and services in an economy in a year. In a two-sector economy, AD = C + I, where C is consumption expenditure and I is investment expenditure. (In a four-sector economy, AD = C + I + G + (X − M).)

Aggregate supply (AS) is the total value of final goods and services planned to be produced. It equals national income, because output generates income: AS = Y = C + S (income is either consumed or saved).

2. Consumption function

The consumption function shows the relationship between consumption and income: C = c̄ + bY.

• c̄ (autonomous consumption): the minimum consumption even at zero income, financed by past savings or borrowing.

• b (MPC): the marginal propensity to consume.

Example. Income rises from ₹1,000 crore to ₹1,200 crore and consumption from ₹800 crore to ₹950 crore. APC at the first level = 800 ÷ 1,000 = 0.8. MPC = 150 ÷ 200 = 0.75.

Properties: MPC lies between 0 and 1. APC can be more than 1 at low incomes (consumption exceeds income, the break-even point is where C = Y). APC falls as income rises.

3. Saving function

Saving is income not consumed: S = Y − C = −c̄ + (1 − b)Y.

Relationships: APC + APS = 1, and MPC + MPS = 1. In the example above, MPS = 1 − 0.75 = 0.25. APS can be negative at low incomes (dissaving).

4. Investment

• Investment is addition to the stock of physical capital (machines, buildings) and inventories.

• Autonomous investment does not depend on income (for example, government projects or investment due to new technology). In this model, investment is taken as autonomous: I = Ī.

• Induced investment depends on income and profit expectations.

• Ex-ante (planned) values are what people plan to consume, save or invest at the start of a period. Ex-post (actual or realised) values are what actually happened. Equilibrium uses ex-ante values. Ex-post saving always equals ex-post investment, because unplanned changes in inventories absorb the difference.

5. Equilibrium income

Equilibrium is where planned spending equals planned output: AD = AS, or equivalently, planned saving equals planned investment: S = I.

• If AD > AS, inventories fall unexpectedly; firms raise output, and income rises towards equilibrium.

• If AD < AS, unsold stocks pile up; firms cut output, and income falls towards equilibrium.

Worked example. C = 100 + 0.8Y and I = 200 (₹ crore).

AD = AS approach:
Y = C + I
Y = 100 + 0.8Y + 200
0.2Y = 300
Y = 1,500

Check:
C = 100 + 0.8 x 1,500 = 1,300
AD = 1,300 + 200 = 1,500 = Y

S = I approach:
S = -100 + 0.2Y
At Y = 1,500, S = -100 + 300 = 200 = I

Equilibrium income = ₹1,500 crore.

General formula: Y = (c̄ + I) ÷ (1 − b).

Schedule form. Equilibrium can also be read from a table of income, consumption, saving and investment as the income level where S = I (or C + I = Y).

6. The investment multiplier

When investment increases, income increases by a multiple of that increase. The investment multiplier (k) is:

k = ΔY ÷ ΔI = 1 ÷ (1 − MPC) = 1 ÷ MPS

Why it works. New investment becomes income for workers and suppliers. They spend a part (MPC) of it, which becomes someone else's income, who again spends a part, and so on. Each round is smaller, and the total adds up to k times the original investment.

Example. In the economy above, MPC = 0.8, so k = 1 ÷ 0.2 = 5. If investment rises by ₹50 crore, income rises by 50 × 5 = ₹250 crore, from ₹1,500 crore to ₹1,750 crore.

The higher the MPC, the larger the multiplier. The minimum value of k is 1 (when MPC = 0) and there is no maximum (it tends to infinity as MPC approaches 1).

7. Full employment and unemployment

• Full employment is a situation where everyone willing and able to work at the prevailing wage rate gets work.

• Voluntary unemployment is when people choose not to work at the prevailing wage. It is consistent with full employment.

• Involuntary unemployment is when people are willing to work at the prevailing wage but cannot find work. Keynes said equilibrium may occur below full employment, with involuntary unemployment, if AD is too low.

8. Excess demand and deficient demand

Excess demand occurs when AD is more than AS at the full employment level of output. Output can't rise further, so prices rise. The amount by which AD exceeds AS at full employment is the inflationary gap.

Deficient demand occurs when AD is less than AS at the full employment level. Firms cut output and jobs, creating involuntary unemployment. The shortfall of AD below AS at full employment is the deflationary gap.

Example. Full employment output is ₹2,000 crore. If AD at that level is ₹2,200 crore, the inflationary gap is ₹200 crore. If AD is ₹1,800 crore, the deflationary gap is ₹200 crore.

Measures to correct the gaps

A reliable problem-solving routine

1. Write the consumption function and investment. If the saving function is given, MPC = 1 − MPS and c̄ = the constant with its sign reversed.

2. Find equilibrium with Y = (c̄ + I) ÷ (1 − MPC), and check with S = I.

3. For a change in investment, find k = 1 ÷ (1 − MPC) and ΔY = k × ΔI.

4. If ΔY and ΔI are given, find k and then MPC = 1 − 1/k.

5. For gaps, compare AD with AS at the full employment output, then choose fiscal and monetary measures in the right direction.

Connections that matter

• National income measures the output whose equilibrium level is determined here.

• Money and banking supplies the monetary instruments used to close the gaps.

• Government budget supplies the fiscal instruments.

Common mistakes

• Using ex-post values for equilibrium. Equilibrium uses planned (ex-ante) values.

• Writing the multiplier as 1 ÷ MPC. It is 1 ÷ (1 − MPC) = 1 ÷ MPS.

• Saying MPC can exceed 1. MPC lies between 0 and 1; APC can exceed 1.

• Measuring the gaps at the equilibrium level. They are measured at the full employment level.

• Reversing the measures, such as lowering taxes to fight inflation.

Revision checklist

• I can explain AD, AS and their components.

• I can calculate APC, MPC, APS and MPS and use their relationships.

• I can find equilibrium income by AD = AS and S = I.

• I can calculate the multiplier and the change in income.

• I can explain involuntary unemployment, excess and deficient demand, and the gaps.

• I can suggest fiscal and monetary measures for each gap.