INCOME

DETERMINATION
AND
MULTIPLIER
OR
SHORT RUN
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1. EXPLAIN WHEN THE ECONOMY IS IN EQUILIBRIUM?

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ANS. According to Keynesian theory equilibrium condition is based on 2 terms (i)(AD) Aggregate demand
(ii) (AS) Aggregate Supply. So an economy is in equilibrium when Aggregate demand for goods and services is
equal to Aggregate Supply of goods and services during a specific period of time

So, Basically there are two approaches for the determination of equilibrium level.

(a) AD = AS approach
(b) S = I approach.

Because as we all know

AD = AS – (i)
AD = C+I – (ii)
AS = C+ S – ( iii)

So, by substituting equation (ii) and (iii) in

(i)
We get
C+S=C+I

So , we can say that there are 2 approaches to find equilibrium level.

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2. WHAT ARE THE ASSUMPTIONS OF DETERMINATION OF EQUILIBRIUM OUTPUT?

ANS.

• It is study on the basis of 2 sectors of economy which means that only household
and firm are involved. No government of foreign sectors are involved.

• It is assumed that the investment expenditure is autonomous which means that the
investment are not depend by the level of income.

• It is based on Short run.

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3. EXPLAIN AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH.
ANS. So, according to Keynesian theory the equilibrium level of income in an economy is determined when
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aggregate demand represented by (C + I) is equal to aggregate supply represented by (C + S).

EQUILIBRIUM CONDITION BY AD AND AS APPROAH.

EMPL INCO CONS SAVIN INVES AD AS ( C+ REMA

ME (Y) UMPTI G TMEN ( C+ I) S) RKS
OYME
ON (C) ( S) T (I)
NT
0 0 40 -40 40 80 0 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
50 500 440 60 40 480 500 AD <
AS

60 600 520 80 40 560 600 AD <

AS
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• In the given figure y axis represents AD and AS .

• X axis represents Income/ Output / Employment.

• OY is the income curve at 45° which is represented by AS.

• AD is starting from point M on Y axis where ( AD = C+ I).

• The point where Income Curve intersect AD curve that point is known as equilibrium level
which is denoted by E. Because at this point only the desired level of spending on
Consumption and investment is exactly equals to the level of output i.e. ( AS).

• OY is the equilibrium level of Income, Output and Employment.

• This creates the situation of effective demand curve ( AD= AS).

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3. EXPLAIN THE SITUATION WHEN (AD) IS MORE THAN (AS) AND HOW IT WILL BE SORTED
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OUT?

ANS. When planned sending (AD) is more than planned output (AS) which means that all the
consumer as well as the firms are buying more and more goods than firms are willing to
produce. Due to this reason the planned inventory would fall below the desired level.
So, in order to bring the inventory back to the desired level the firms will increase the
employment and output till then , when (AD) becomes equal to ( AS) at OY.

4. EXPLAIN THE SITUATION WHEN (AD) IS LESS THAN (AS) AND HOW IT WILL
BE SORTED OUT?

ANS. When planned spending (AD) is less than planned output (AS). It means that the
consumers and firms together are buying less goods than firm are willing to produce, as a
result planned inventory will rise. So in order to clear the unwanted inventory or to bring
the inventory back to the desired level. The firm would plan to decrease the employment
and output till then when (AD) becomes equals to (AS) at OY.
 6. EXPLAIN SAVING AND INVESTMENT APPROACH.
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ANS. When planned saving is equal to planned investment then equilibrium level of income is
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determined.

INCOME CONSUM SAVING INVESTM REMARK

(Y) PTION (C) (S) ENT (I) S

0 40 -40 40 S<1

100 120 -20 40 S<1

200 200 0 40 S<1

300 280 20 40 S<1

400 360 40 40 S=1

500 440 60 40 S>1

600 520 80 40 S>1

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• In the given figure, a straight line parallel to X- axis is Investment Curve

representing autonomous investment because it is independent level of income.
ADD YOUR TEXT
• SS is the saving curve starting from point on Y axis.

• Slope of shaving curve is upward because when income increases saving also
increases.

• The point where saving curve intersect the investment curve that point is known
as equilibrium point which is denoted by E where ( S = 1) at OY level of income,
output, employment.

• AtTEXT
ADD YOUR this point exante saving = exante investment.
ADD YOUR TEXT

• Which means that at same level of income AD curve will intersect AS curve that
point is known as equilibrium point which is denoted by E where ( AD = AS ) at OY
level of income, output and employment.
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8. EXPLAIN THE SITUATION WHEN SAVING IS LESS THAN INVESTMENT AND HOW IT WILL
BE SORTED OUT?

ANS. When saving is less than investment which means that household are
consuming more and more goods that firms are expecting. So due to this the
planned inventory would fall below the desired level and in order to bring the
inventory back to the desired level the firms will plan to increase the employment
and output till then when saving and investment becomes equal to each other i.e.
(S = 1 ).
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INVESTMENT FUNCTION
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Investment refers to the expenditure incurred or creation of new capital assets. It includes the
expenditure incurred on assets like machinery, building, equipment, raw material, etc. The investment
expenditure is classified in two heads:-
(a) Included Investment. (b) Autonomous Investment

(A) INCLUDED INVESTMENT

Included investment refers to the investment which depends on the profit expectations and is directly
influenced by income level.
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(B) AUTONOMOUS INVESTMENT

Autonomous Investment refers to investment which is not affected by the changes in the level of income and is
not included solely by profit motive.
 BASIS INCLUDED INVESTMENT AUTONOMOUS
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INVESTMENT
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MOTIVE It is driven by profit It is done for social

motive i.e. it depends on welfare and not for profit.
profit expectations.

INCOME ELASTICITY It is income elastic i.e. It is unaffected by

increase in income level changes in income level.
raises it’s level.

INVESTMENT CURVE It’s curve slope upwards It’s curve is parallel X

as it is income elastic. axis as it’s income
inelastic.

SECTOR It is generally done by It is generally done by

private sector. government sector.