Determination of

Income, Output and

Employment
Mod II
  The Classical theory of Employment
 The Keynesian theory - The Principle of Effective demand;
 How is Unemployment measured
 Okun's Law
 The Consumption Function -
Module II
 Concepts of MPC & MPS;
 The Psychological Law of Consumption - A brief analysis;
 The Permanent Income hypothesis
 The Life - Cycle hypothesis.
 The Savings Function: Determinants of savings; The Paradox of
thrift;

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  Classical theory
 Adam Smith, David Ricardo, J S Mill, Pigou, Alfred Marshall

 Assumptions
 Laissez faire
 Full employment
The Classical  Perfect competition ---- factor and product
 Closed economy
Theory of  Homogenous labour
Employment  Total output divided between C and I (Y = C+I)
 Money wages and real wages are directly related and proportional
 Savings = Investment
 Technology and Capital is given
 Law of diminishing returns
 Long run analysis

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 Main Postulates/Propositions of Classical Economics
1. Full Employment
Main  Automatic self adjustment free market restores Full empt

Postulates/ 2. Say’s Law of Market

 Supply Creates its own Demand
Propositions of  Implications of Say’s Law
Classical  No general overproduction in the economy
Overproduction leads to Market Glut
Economics Under production leads to Shortages
Long run market economy is always at equilibrium
 No unemployment

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  Saving – Investment Equality
 S = D (capital)
Main Total Income = Total Output
Postulates/ C+S =C+I
S
Propositions of S = f (r) I = f(r)

Classical If, S > I ---- unemployment

Interest Rate
r1
If, I > S ---- Inflation
Economics r E
S = D , full employment r2

0 S=I
Capital
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 Money Market Equilibrium
 MV = PT
Main
 MV ( money supply); PT (value of output)
Postulates/  V & T constant
Propositions of  P = f (M)
Classical

Output
Economics Q
M M1

MV MV1

0 P P1
Price level
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 Production Function
Classical  Aggregate production function
Model of  Labour supply and labour demand functions

 Q = f (K, T, N)
Income, Q = f(N)
 Employment rises ---- output rises
Output and  Q = f(N)

Output
Employment  MP L = ∆Q/∆L

0
Employment
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 Labour Market
 Labour Supply  Labour Demand Curve
 Ls = f (RW)  LD = f (RW, MRP)
 RW = NW/Price  MRP = MPP x P
 RW rises, LS rises
Classical
Model of
Income, LS = f(RW)
Output and
Real Wages

Real Wages
Employment

LD = f(MRP)

0 0
Labour Labour
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 LS = f(RW)

Real Wages
r Determination of
E
Employment and Output
Classical
Model of DL = f(MRP)
 Labour market
equilibrium
0
Income, N
Employment
 Determination of real
Output and Q = f(N)
output

Employment
Real Output

Y
R

0 N
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 Criticisms
 Great Depression
Classical  Full employment myth
Model of  Keynes’ objected Say’s law of market
Income,  Pigou wage cut policy

Output and  Saving and Investment ---- Equality, interest rate

 Money ---- transaction purpose
Employment
 Unrealeastic assumption
 Government interevention

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  New Economics --- JM Keynes
 General Theory of Employment, Interest and Money
 Demand oriented
 Determination of Employment in the economy
 Effective Demand
 Unemployment exist ---- lack of effective demand
 Unemployment reduce ----- increasing effective demand
Keynesian  Effective Demand
Economics  Total demand for goods and services in an economy at various levels
of employment
 Sum total of demand for consumption goods and investment goods
(capital)
 Sum of money expenditure on consumption and investment goods
 ED = National expenditure = National Output = National Income
 Determinants of Effective Demand
 ED = f(AD, AS)

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 Output
Output
AE
Y = f (K, L)

Y2 Y2

Y1 Y1

Aggregate
Supply 0 L1 L2
Employment (L)
0 E1 E2
AD = Agg Expnd
Function
 Aggregate Supply Function
 Y = f (K, L)
 Y = f (L)

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 Expenditure
C
 AD = C + I
Aggregate  C = f(Y)
Demand C  C = a + bY
I
Function
0
Income

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  Aggregate Supply
 Capital
 Labour

 Aggregate Demand
 Consumption
Employment  Income
 Propensity to consumption
Income  High, rise employment

Output  Investment
 Less, uneployment

 Rate of interest
 High, less investment
 Less, more investment
 Marginal efficiency of capital
 Prospective yield

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  Functional Relationship between Consumption and Income
 C = f (Y)
 Keynes Linear Consumption Function
 C = a + by
 a = autonomous consumption (zero income)
Consumption ∆𝐶
 b = ∆𝑌

Function  Properties of Consumption Function

Consumption
∆𝐶
 MPC = C
∆𝑌
𝐶
 APC =
𝑌

200

0
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  Functional Relationship between
Saving and Income
 S = f (Y)
 Y=C+S
 1 = 0.75 + .025

Consumption
 C+S=1
 S =Y – C
Saving ∆𝑆
 MPS =
Function ∆𝑌 S
𝑆
 APS =
𝑌
 APC + APS = 1
 MPC + MPS = 1 0
Income

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 Income Consumption Saving APC APS MPC MPS

120 120 0 = 100% =0 --- ---

180 170 10 = 94% = 6% 0.83 0.17
240 220 20 = 92% = 8% 0.83 0.17
300 270 30 = 90% = 10% 0.83 0.17
360 320 40 = 89% = 11% 0.83 0.17
Concepts of
Consumption Y=C+S
1 = APC + APS
and Saving 1 = .94 + .06

1 = MPC + MPS
Y = 0.83 + 0.17

S=Y–C
𝑆 𝐶
APS = ;APC =
𝑌 𝑌

∆𝐶 50 ∆𝑆 10
MPC = ∆𝑌 = 60 = 83% MPS = ∆𝑌 = 60 = 17%
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  Fundamental Psychological Law of Consumption
 Psychological tendency of the community with respect to
consumption spending

Keynes’ THREE RELATED PROPOSITIONS

1. When Income increases, consumption expenditure also
Psychological increases but less than proportionately
Law of ∆𝐶
∆𝑌
< 1 ; ∆𝐶 < ∆𝑌; MPC<1

Consumption 2. The increased income will be divided in some proportion

between consumption and saving
∆𝑌 = ∆𝐶 + ∆𝑆

3. An increase in income will always lead to an increase in

consumption and saving
Rise ∆𝑌 = Rise ∆𝐶 + 𝑅𝑖𝑠𝑒 ∆𝑆

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 C abd S
E2
Keynes C

E1
Psychological E C1
C2
 Three Propositions
Law of S2 S
S1
Consumption
0 Y Y1 Y2
Income

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  Assumptions of the Law
 Ceteris Paribus ---- tastes, habits, prices, income distribution,
population growth etc
 Normal condition
 Laissez faire economy

Keynes  Implications of the Law

 Possibility of over production and repudiation of Say’s Law
Psychological  Importance of Investment
Law of  Need for State Intervention
 Under employment equilibrium
Consumption  Declining rate of expected profit
 Turning points of trade cycles
 Process of income generation
 Multiplier

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 Subjective Factors:
Psychological influence upon
consumptions
Individual motives Business motives
 Precaution  Enterprise
Objective Factors
External factors that influence
consumption
 Income/Salary
 Income distribution

Determinants  Foresightedness  Improvement  Price level

 Improvement in  Rate of interest
of future standard of
 Liquidity
 Consumer credit
living  Financial Prudence
Consumption  Calculation
 Fiscal policy
 Advertisement and sales
 Independence efforts
 Enterprise  Stock market effect
 Pride  Demographic factors
 Miserliness  Social security

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