Determination of Income and Employment Class 12 Notes

Aggregate demand is the total demand for the final goods and services of the economy in a year, the sum of private consumption, investment, government spending and net exports. Aggregate supply is the total output, which for the whole economy equals the national income, and in the short run it is given, so the equilibrium of the model is fixed on the demand side.The two-sector model, households and firms, reduces aggregate demand to consumption plus investment, and the equilibrium to where the planned saving of the households equals the planned investment of the firms.

• Aggregate demand AD = C + I + G + (X − M).
• In the two-sector model, AD = C + I, consumption plus investment.
• Aggregate supply AS = the national income Y, the output of final goods of the whole economy.
• Equilibrium: AD = AS, the level of income where the planned spending exactly buys the planned output.
• Short-run assumption: the price and the aggregate supply are given, so the equilibrium income is determined by the demand side.

The consumption function states the consumption of the economy as a function of its income. It has two parts: an autonomous component, the consumption that occurs even at zero income, and a dependent component, the part of income that is consumed. The marginal propensity to consume is the slope of the function, the change in consumption per unit change in income, and the saving function is its mirror image.

• Consumption function: C = a + bY, where a is autonomous consumption and b is the MPC.
• Saving function: S = −a + (1 − b)Y, the complement of the consumption function in the same income.
• APC, average propensity to consume C ÷ Y, falls as income rises.
• APS, average propensity to save S ÷ Y, rises as income rises.
• MPC, marginal propensity to consume ΔC ÷ ΔY, and MPS, marginal propensity to save ΔS ÷ ΔY.
• The two identities: APC + APS = 1 and MPC + MPS = 1.
• Keynes's behavioural law: as income rises, consumption rises but by less than the rise in income, so the MPC is positive but less than one.

The equilibrium of the model is the output at which the planned expenditure exactly equals the planned output, and by the circular flow that same equality appears as planned saving equal to planned investment. At any income above the equilibrium, saving exceeds investment and stocks build up, forcing production down; below it, investment exceeds saving and stocks run down, pulling production up. The economy therefore rests where the two plans meet.

• Above the equilibrium: S > I — the unsold output piles up as unplanned stock, so the firms cut production.
• Below the equilibrium: I > S — the stocks are run down faster than they are replaced, so the firms raise production.
• At the equilibrium: the planned plans come to pass, no stock builds or runs down, and income stays stable.
• The actual and planned distinction: the equilibrium concerns planned saving and planned investment, not the accounting identity of the two actuals.

A change in investment changes income by a multiple of itself, because the income earned in one round becomes spending in the next. The multiplier is the reciprocal of the marginal propensity to save, k = 1 ÷ (1 − MPC), and the change in income is the multiplier times the change in investment. The larger the MPC, the larger the multiplier and the farther the chain runs before the saving leakages stop it.

• The chain: investment of Rs. 100, MPC of 0.8 — income Rs. 100, then consumption of Rs. 80, then income of Rs. 80, then consumption of Rs. 64, and so on.
• The total: the geometric series 100 + 80 + 64 + … = 100 × (1 ÷ (1 − 0.8)) = Rs. 500.
• k = 5 means a unit increase in investment raises income fivefold.
• The multiplier works in both directions: a fall in investment contracts income by the same multiple.
• The multiplier exceeds one because the secondary consumption of each round adds to the primary investment.

When the aggregate demand falls short of the aggregate supply at the full-employment level, the economy produces below its capacity, workers willing to work at the going wage find no jobs, and involuntary unemployment appears. The equilibrium income settles below the full-employment level. The remedy is to raise the aggregate demand until the equilibrium reaches the full-employment level.

• Deficient demand: AD falls short of what the full-employment output needs, leaving a demand gap.
• Involuntary unemployment: workers willing at the prevailing wage cannot find jobs, the direct product of the demand gap.
• Fiscal remedy: raise the public expenditure or cut the taxes to lift the demand curve up to the full-employment equilibrium.
• Monetary remedy: lower the bank rate and the reserve ratios, and buy securities, to lower the interest rate, raise investment and lift demand.
• The goal is a full-employment equilibrium: income at the level that matches the economy's capacity to produce.

When the aggregate demand exceeds the aggregate supply at the full-employment level, the economy cannot produce more, and the competition for the fixed output pushes the price level up. This is demand-pull inflation. The remedy is the contraction of aggregate demand, the mirror image of the deficient-demand cure.

• Excess demand: AD exceeds the full-employment output, so the extra spending chases the same output and inflation follows.
• Output cannot rise beyond the full-employment level in the short run, so the gap spills into the price level.
• Fiscal remedy: reduce the government spending, raise the taxes, and lower the net inflow of demand through the budget.
• Monetary remedy: raise the bank rate, the CRR and the SLR, and sell securities, to contract credit and lower the purchasing power.
• The anti-inflationary policy is exactly the reverse of the anti-unemployment policy, and the examiner tests that reciprocity.

The unit is examined through the definitions of the propensities and the multiplier, the numerical computation of the multiplier and the equilibrium, the diagrams of the equilibrium, and the pairing of the two problems with their two remedies. Each question type has a fixed shape, and the numerical questions give away their answer as soon as the formula is named.

• Define aggregate demand, aggregate supply, APC, APS, MPC, MPS, the multiplier, voluntary and involuntary unemployment, excess and deficient demand.
• Compute the multiplier from the MPC or the MPS, and the change in income from the change in investment.
• Find the equilibrium income from a consumption function and an investment figure.
• Draw the 45-degree diagram and the saving-investment diagram and read the equilibrium.
• Explain the mechanism of the multiplier as a chain of rounds.
• State the causes and the remedies of deficient and excess demand, fiscal and monetary, for each.
• Derive the saving function from the consumption function and verify the identities.