UNIT 8 - DETERMINATION OF INCOME AND EMPLOYMENT

Definition: -
Involuntary unemployment: - It occurs when those who are able
and willing to work at the going wage rate do not get work.

Definition: -
Equilibrium level of income, employment, and output in the
economy refers to situation when the aggregate demand in the
economy equals the aggregate supply

AGGREGATE DEMAND
Definition: -
Aggregate Demand (AD) refers to the total demand for
final(finished) goods and services in the economy.
Since demand in economics refers to effective demand, we can
say that AD also equals the aggregate expenditure on final goods
and services.
AD = C + I + G + (X – M)

Components of Aggregate Demand: -

1. Private final consumption expenditure (C) - It is also called

Consumption expenditure by households on final goods and
services. It refers to the expenditure that private households incur
on purchase of commodities like food, clothing and shelter which
are for satisfying their consumption requirements.

2. Investment expenditure by private firms (I) - It refers to the

expenditure of the private business firms for investment in
business for e.g. machines, technology, plant, etc.
3. Govt. expenditure (G) – It refers to the expenditures done by
the govt. They are divided as consumption and investment
expenditure -
a. Govt. final consumption expenditure - It refers to the
expenditure of the govt. for consumption goods like purchase of
food grains for distribution through ration shops and armed forces.
b. Govt. investment expenditure – It refers to expenditure on
capital goods like machinery for public sector undertakings.

4. Net exports (X – M) - It refers to the net aggregate demand

from external sector. Here X stands for export and M for imports.
Since exports leads to creation of demand within the economy,
they are added to aggregate demand. Similarly imports refer to
demand for commodities outside the economy and are
subtracted.

1. Private final consumption expenditure (C) – This refers to

the expenditure by the private households on consumer goods. It
must be kept in mind that consumption expenditure discussed
here is ex–ante i.e. planned consumption expenditure. Ex–post
means actual consumption expenditure. In our syllabus we will be
studying consumption expenditure through the theory formulated
by Keynes called Keyne’s Psychological law of consumption.
Statement of law – Men are disposed as a rule and on the
average to increase their consumption as their income increases,
but not by as much as the increase in the income.
Definition: -
Consumption function – The functional relation between
consumption and income is called the consumption function.
C = C + bY where
C = autonomous consumption
b = Marginal propensity to consume (MPC)
Y = level of income.

Y Y C C
 MPC =
C
Y
0 - 100 - -
50/100 =
100 100 150 50
0.5
50/100 =
200 100 200 50
0.5
50/100 =
300 100 250 50
0.5
50/100 =
400 100 300 50
0.5
50/100 =
500 100 350 50
0.5

Relation between consumption and savings: -

Here Y = income, C = consumption, S = savings

Y=C+S
(Since out of whatever is earned one either spends on
consumption or saves for the future)
S=Y–C
= Y – (C + bY)
= Y – C – bY
= - C + 1Y – bY
S = - C + (1 – b) Y.
This is the saving function which express the functional relation
between savings and income.
Here S = level of savings in the economy.
-C = Savings at Zero level of income
(1 – b) = Marginal Propensity to Save (Slope of the saving
curve) and
Y = level of income.
With the help of the consumption schedule we can derive the
saving schedule:
Y Y C C MPC S S MPS
(Y-C
)
0 - 100 - - -100 - -
50/100 = -50 50 50/100
100 100 150 50
0.5 = 0.5
50/100 = 0 50 50/100
200 100 200 50
0.5 = 0.5
50/100 = 50 50 50/100
300 100 250 50
0.5 = 0.5
50/100 = 100 50 50/100
400 100 300 50
0.5 = 0.5
50/100 = 150 50 50/100
500 100 350 50
0.5 = 0.5

Diagram: - Consumption & saving curves, BEP

.
We notice that consumption expenditure at 0 level of income is
100. This is also known as autonomous consumption (C) because
it is not dependent on the level of income. It refers to expenditures
on necessities of life which have to be done at zero level of
income. Such expenditures will either be financed through
borrowing or dis-savings.
(Dis–savings refers to selling / liquidation of stock of assets to
finance current consumption expenditure.)
Hence at zero level of income where consumption is a positive
value C, savings are a negative value = - C

Q. Can there be positive consumption at 0 level of income?

In the table as income increases each time by 100 the

consumption expenditure goes on increasing at a constant rate of
50 which is less than the change in income. Income that is not
consumed is saved.
At income level 200 Consumption expenditure = Income (C = Y),
this is called the breakeven point in the economy. Represented
by the intersection of income line ‘OY’ and consumption curve
‘CC’ at point ‘B’ in the diagram.
At the BEP savings in the economy are Zero and the saving curve
intersects the x-axis.
At all levels of income below 200, the consumption is greater
than income.
The consumption curve lies above the income line while the
savings being negative the savings curve lies below the x-axis.
For all levels above breakeven points consumption is lesser than
income.
Hence at these levels there will be positive savings in the
economy.
The consumption curve lies below the income line while the
savings curve lies above the x-axis.
The vertical distance between consumption and income at any
income level equals the vertical distance between the saving
curve and the x-axis.

Relation between MPC and MPS

Definition: - Marginal propensity to consume is the rate of
change in consumption per unit change in income. Eg. If the per
unit increase in income is Re. 1/- the per rupee increase in
consumption is 0.8

Formula MPC = C/ Y

It is assumed to be constant in the table. MPC is 0.5

By assumption the value of MPC ranges between 0 and 1 i.e .0 <
MPC <1
This means that the consumption increases with the increase in
income but the increase in consumption is always less than the
increase in income.
Q. Explain why 0 < MPC < 1.
A. It is assumed that an increase in income leads to an increase
in consumption which is less than the increase in income. Hence
if income increases by 100 consumption cannot increase by more
than 100. In the formula C / Y the value of C will be less
than Y i.e. numerator will be less than the denominator and the
resultant value of MPC would be less than 1.
Since consumptions cannot be negative or consumption do not
decrease with the increase in income, C can never be less than 0.
Hence MPC will be a positive value greater than 0.
Definition: - Marginal propensity to save is the rate of change
in savings per unit change in income. Eg. If the per unit increase
in income is Re. 1/- the per rupee increase in consumption is 0.8
then, MPS is 0.2.

Formula MPS = S / Y. It is assumed to be constant. The

value of MPC ranges between 0 and 1 i.e 0 < MPC <1. Since Y =
C + S, MPC + MPS = 1.

Relation between APC and APS: -

Definition: - Average propensity to consume is the ratio of
consumption to income at a particular level of income. APC = C/Y
Definition: - Average propensity to save is the ratio of savings to
income at a particular level of income. APS = S/Y
Q. APC + APS = 1

A. Since Y = C + S.
Dividing both sides by income Y = C + S
i.e. 1 = APC + APS. Y Y Y

Y C APC = S APS = APC + APS

C/Y (Y-C S/Y =1
)
0 100 - -100 - -
 -50 1.5 + (-0.5) =
100 150 1.5 -0.5
1
200 200 1 0 0 1+0=1
50 0.83 + 0.17 =
300 250 0.83 0.17
1
100 0.75 + 0.25 =
400 300 0.75 0.25
1
500 350 0.7 150 0.3 0.7 + 0.3 = 1

At all income levels where C > Y, APC is > 1 and APS is negative.
When C = Y, APC = 1 and APS = 0.
At all income levels where C < Y, APC is < 1 and APS is positive.
As income increases, APC decreases and APS increases. Hence
as income increases the propensity to spend goes on decreasing
and the propensity to save goes on increasing.
Q. Distinguish between MPC and MPS, APC and APS, MPC and
APC, MPS and APS

2. Investment Expenditure (I) – It refers to the expenditure of the

private business firms for investment in business for e.g.
machines, technology, plant, etc. Investment Expenditure in the
economy is assumed to be Autonomous. It is not influenced by
the level of income in the economy. Hence it is assumed to
remain constant at all income levels. The investment curve is thus
a horizontal straight line parallel to the x-axis. It is denoted by (I).
Diagram: - Investment curve
Note: -Although there are 4 sectors in an economy, our syllabus
assumes a 2-sector economy for simplicity in understanding.
Thus, the Aggregate demand (AD) in a two-sector economy = C +
I

Diagram: - C, I, AD curves
 AGGREGATE SUPPLY

Definition: - Aggregate supply in an economy refers to the

money value of goods and services produces in the economy. In
a two-sector economy where there is no government or external
trade; whatever income (Y) is earned can either be consumed or
saved. Hence AS = C + S. Hence the aggregate supply curve
coincides with the 45-degree Income line (Y).

Equilibrium level of Income, Output and Employment in the

Economy

An economy is said to be in equilibrium when AD = AS / Y

Or C + I = C + S or when I = S i.e. when Investments = Savings

APPROACHES TO EQUILIBRIUM

1. AD – AS Approach and
2. S – I Approach

1. AD – AS Approach: - Under this approach equilibrium is when

AD = AS in the economy.
Diagram: -
In the above diagram the economy is in equilibrium at income
level q* where AD and AS curves intersect at point ‘e’.
Adjustment Mechanism: - is the phenomenon where at any
other income level in the economy the market forces will
automatically clear the market to arrive at equilibrium level. It can
be explained as under.

Let as assume that any income level says q1 where income is

less than q* is the equilibrium income.
At this level the AD curve lies above the AS line of the economy
by a distance = ‘ab’. This indicates that the demand being more
than supply, wants of some consumers will remain unsatisfied.
This will lead to unplanned de-accumulation of inventory.
To satisfy their wants these consumers will be willing to pay a
higher price. Hence price levels in the economy will increase.
Increasing prices reflect increase in the profits of the sellers who
will be willing to produce more output and sell it.
Increase in output will lead to increase in employment and income
in the economy. As income increases, AD increases.
This chain of reactions continues till finally AD = AS at q* level of
income and the economy is in a state of rest.
Hence any income level before q* (where AD = AS) cannot be the
equilibrium level of income in the economy.

Let as assume that any income level says q2 where income is

more than q* is the equilibrium income. At this level the AD curve
lies below the AS line of the economy by a distance = ‘cd’. This
indicates that the demand being less than supply, goods of some
sellers will remain unsold. This will lead to unplanned
accumulation of inventory.
To reduce their unsold stock the sellers will be willing to sell at a
lower price. Hence price levels in the economy will decrease.
Decreasing prices reflect decrease in the profits of the sellers who
will be willing to produce less output.
Decrease in output will lead to decrease in employment and
income in the economy. As income decreases, AD decreases.
This chain of reactions continues till finally AD = AS at q* level of
income and the economy is in a state of rest.
Hence any income level after q* (where AD = AS) cannot be the
equilibrium level of income in the economy.

2. S – I Approach: - Under this approach equilibrium is when S =

I in the economy.
Diagram: -

In the above diagram the economy is in equilibrium at income

level q* where S and I curve intersect at point ‘e’.
Adjustment Mechanism: - is the phenomenon where at any
other income level in the economy the market forces will
automatically clear the market to arrive at equilibrium level. It can
be explained as under.

Let as assume that any income level says q1 where income is

less than q* is the equilibrium income.
At this level the I curve lies above the S curve of the economy by
a distance = ‘ab’.
If savings in the economy are less it means that the unplanned
consumption expenditure / demand in the economy is more than
anticipated by the investors. This indicates that the demand being
more than supply, wants of some consumers will remain
unsatisfied. It will lead to unplanned de-accumulation of inventory.
To satisfy their wants these consumers will be willing to pay a
higher price. Hence price levels in the economy will increase.
Increasing prices reflect increase in the profits of the sellers who
will be willing to produce more output and sell it.
Increase in output will lead to increase in employment and
income in the economy.
As income increases, Savings increase.
This chain of reactions continues till finally S = I at q* level of
income and the economy is at a state of rest.
Hence any income level before q* (where S = I) cannot be the
equilibrium level of income in the economy.

Let as assume that any income level says q2 where income is

more than q* is the equilibrium income.
At this level the S curve lies above the I curve of the economy by
a distance = ‘cd’. More savings indicates that the unplanned
consumption expenditure / demand in the economy is less than
anticipated by the investors.
This indicates that the demand being less than supply, goods of
some sellers will remain unsold. This will lead to unplanned
accumulation of inventory.
To reduce their unsold stock the sellers will be willing to sell at a
lower price. Hence price levels in the economy will decrease.
Decreasing prices reflect decrease in the profits of the sellers who
will be willing to produce less output.
Decrease in output will lead to decrease in employment and
income in the economy.
As income decreases, savings decrease. This chain of reactions
continues till finally S = I at q* level of income and the economy is
in a state of rest.
Hence any income level after q* (where S = I) cannot be the
equilibrium level of income in the economy.

Investment Multiplier

It refers to the resultant change in income (Y) in the economy due

to change in Investment Expenditure (I).
Definition: -Investment multiplier (k) is the number by which
change in investment is multiplied to get the resultant change in
income. k = Y / I.
Effect of Multiplier: - A change in investment brings about a
change in income of an amplified magnitude.
The working of the multiplier is dependent on: -
i) Initial autonomous investment (I) and ii) MPC in the
economy.
(Higher the I and MPC greater is the multiplier effect – Direct
relation)
(k = 1/(1-MPC) OR k = 1/MPS)

The working of the multiplier can be understood with the help of

the numerical example: -
Let us assume I = 1,000 and MPC = 0.8
Let us assume that a business made an Initial autonomous
investment of Rs.1,000 by getting a factory building constructed
from a construction house.
This investment of the business house becomes the income of
the construction company, architect, laborer’s, etc. in the first
round.
If the MPC in the economy is 0.8 it meant that these income
earners will spend (1000 x 0.8) Rs. 800 on their consumption
needs.
Their consumption expenditure becomes income for the sellers of
these consumer goods in the second round.
 The sellers will in turn spend (800 x 0.8) Rs. 640 which become
income for others in the third round. This endless chain would
continue as follows: -

Rounds Y C S
Round 1 1000 800 200
Round 2 800 640 160
Round 3 640 512 120
Round 4 512 409.6 102.4
. . .
. . .
∞ ∞ ∞
Totals 5000 4000 1000

The multiplier effect continues in the above manner for infinite

rounds where each time the income and consumption expenditure
increase by a lesser amount.
The multiplier effect comes to an end when the total savings
become equal to the initial autonomous investment.
At the end of the multiplier effect:

K = 1/(1-MPC) = 1/1-0.8 = 1/0.2 =5

Y= Ixk = 1000 x 5 = 5000

C= Y x MPC = 5000 x 0.8 = 4000

S= Y x MPS= 5000 x 0.2 = 1000 OR S= Y- C

Diagram: - Investment Multiplier

 Concepts of Full Employment Equilibrium, Excess and
Deficient Demand

Definition: - Full Employment level in the economy refers to a

state where all resources labor, land, capital, who are willing to
work are efficiently employed.

Full employment equilibrium in the economy is when AD = AS at

full employment level of income, employment and output.

Problem of Deficient Demand / Underemployment

equilibrium: -

When the actual AD in the economy is less than the AD desired to

achieve full employment equilibrium, it is called as a situation of
Deficient demand. Definition: - Deficient demand is the excess of
desired aggregate demand over actual aggregate demand in the
economy at full employment level of income. It can be explained
as under.
Diagram: -
Let AD0 (C + I0) be the actual AD in the economy. AD0 lies below
AD1 (C = I1) which is the AD desired to attain full employment
equilibrium.
At income level qf the vertical distance ‘fg’ between AD0 and AD1
indicates the deficient demand to achieve full employment
equilibrium.
It is also called as the Deflationary Gap as it sets the economy
into a deflationary trend.
At qf the AD is less than AS.
This indicates that the actual demand being less than supply,
goods of some sellers will remain unsold. This will lead to
unplanned accumulation of inventory.
To reduce their unsold stock the sellers will be willing produce
less output. Decrease in output will lead to decrease in
employment and income in the economy.
As income decreases, AD decreases.
This chain of reactions continues till finally actual AD = AS at q0
level of income pushing the economy in underemployment
equilibrium where all resources are not fully employed.

Remedies of Deficient demand: -

A) Monetary policy measures: -
i) Bank rate: - Decreasing the bank rate will increase investment
by producers. Investment demand increases leading to a parallel
upward shift in the AD curve thus bridging the deficient demand
and putting the economy in full employment equilibrium.

ii) Open market Operations: - The RBI can buy back securities
from the market. This will increase the availability of money in the
economy and increase the AD

iii) Varying Reserve Ratios: - Decreasing the VRR will increase

the credit creating capacity of commercial banks and increase
money supply in the economy. AD increases.

B) Fiscal Policy Measures: -

i) Public Expenditure: - Increasing Govt.’s consumption and
investment will increase the AD.

ii) Taxation: - Decreasing direct and indirect taxes will increase

the disposable income of the consumers. AD will increase.

iii) Public Debt: - The Govt.’s public debt policy is linked to RBI’s
OMO. Decreasing Public debts and repaying them will increase
credit creating capacity of commercial banks and increase money
supply in the economy. AD will increase.

Problem of Excess Demand: -

When the actual AD in the economy is more than the AD desired
to achieve full employment equilibrium, it is called as a situation of
Excess demand.
Definition: - Excess demand is the excess of actual aggregate
demand over desired aggregate demand in the economy at full
employment level of income. It can be explained as under.
Diagram: -
Let AD0 (C + I0) be the actual AD in the economy. AD0 lies
above AD1 which is the AD desired to attain full employment
equilibrium. At income level qf the vertical distance ‘fh’ between
AD0 and AD1 indicates the excess demand at full employment
income level. It is also called as the Inflationary Gap as it sets
the economy into an inflationary trend.
At qf the AD is more than AS. This indicates that the actual
demand being more than supply, the needs of some buyers will
remain unsatisfied. This will lead to unplanned de-accumulation of
inventory.
To satisfy their wants the buyers will be willing pay higher prices.
Since the economy is already at full employment, output and
employment cannot be increased.
Hence same quantity of goods in the economy will be sold at a
higher price setting the economy in an inflationary trend.
Here only nominal income will increase with no increase in real
income in the economy.
This chain of reactions continues till finally actual AD = AS at q1
level of income.

Remedies of Excess demand: -

A) Monetary policy measures: -
i) Bank rate: - Increasing the bank rate will decrease investment
by producers. Investment demand decreases leading to a parallel
downward shift in the AD curve thus decreasing the demand and
putting the economy in full employment equilibrium.

ii) Open market Operations: - The RBI can sell securities in the
market. This will decrease the availability of money in the
economy and decrease the AD

iii) Varying Reserve Ratios: - Increasing the VRR will decrease

the credit creating capacity of commercial banks and decrease
money supply in the economy. AD decreases.

B) Fiscal Policy Measures: -

i) Public Expenditure: - Decreasing Govt.’s consumption and
investment will decrease the AD.

ii) Taxation: - Increasing direct and indirect taxes will decrease the
disposable income of the consumers. AD will decrease.

iii) Public Debt: - The Govt.’s public debt policy is linked to RBI’s
OMO. Increasing Public debts will decrease credit creating
capacity of commercial banks and decrease money supply in the
economy. AD will decrease.

Investment Multiplier Numericals.

Q.1. What increase in investment is needed to raise income by Rs. 1000
crores if MPC is 0.75?
Q.2. Calculate the change in investment required if multiplier is 2.5 and
change in income is 500.
Q.3. If income in the economy increases from Rs. 20,000 to Rs. 70,000,
as a result, the level of consumption increases from Rs. 15,000 to
Rs.45,000. Calculate MPC.
Q.4.If increase in investment is Rs. 10,000and Income is Rs. 40,000,
calculate MPS.
Q.5. In the economy, the level of income is Rs. 2000, MPC is 0.75.
calculate the increase in income if investment increases by Rs. 200.
What is the new income level?
Q.6. In an economy, actual income is Rs. 500 whereas full employment
income is Rs. 800. MPC is 0.75. How much Increase in investment is
required to attain full employment equilibrium?
Q.7.In an economy, investment increases by Rs. 400, MPC is 0.8.
Calculate change in income and change in savings.
Q.8. Calculate AD when autonomous consumption and autonomous
investment is 50 crores, MPS is 0.2 and income is Rs. 4000 crores. Is the
economy in Equilibrium?
Q.9. Autonomous investment is 10 crores, C=40+0.8Y, Y=200 crores. Is
the economy in equilibrium? If not suggest measures.
Q.10. Y=250 crores, Autonomous Expenditure is 10 crores, MPC =0.8.
Is the economy in equilibrium?