Class 12 Economics - Chapter 4: Determination of Income and Employment

Introduction

This chapter develops a theoretical model to explain:

What determines national income and employment levels
What causes periods of slow growth or recessions
Changes in price levels and unemployment

The model is based on Keynesian theory and assumes:

Fixed price of final goods
Constant interest rate
Ceteris paribus (other things remaining equal)

4.1 Aggregate Demand and its Components

Key concepts:

Ex post: Actual measured values (what happened)
Ex ante: Planned values (what was intended)

4.1.1 Consumption

The consumption function describes the relationship between consumption (C) and income (Y):

C = C + cY

Where:

C = Autonomous consumption (independent of income)
cY = Induced consumption (depends on income)
c = Marginal propensity to consume (MPC)

MPC = ΔC/ΔY = c (0 ≤ c ≤ 1)

Savings (S) is income not consumed:

S = Y - C

Marginal propensity to save (MPS):

MPS = ΔS/ΔY = s = 1 - c

Key Definitions

MPC: Change in consumption per unit change in income (ΔC/ΔY)
MPS: Change in savings per unit change in income (ΔS/ΔY = 1 - c)
APC: Consumption per unit of income (C/Y)
APS: Savings per unit of income (S/Y)

4.1.2 Investment

Investment (I) is assumed to be autonomous (independent of income):

I = I

Investment includes:

Addition to physical capital (machines, buildings)
Changes in inventory (stock of finished goods)

4.2 Determination of Income in Two-sector Model

Aggregate Demand (AD) in a two-sector economy (no government):

AD = C + I = C + I + cY

Equilibrium condition (ex ante AD = ex ante supply):

Y = C + I + cY

Y = A + cY (where A = C + I)

Important Note: When planned AD ≠ planned output, unintended inventory changes occur:

If AD < output → Unintended inventory accumulation
If AD > output → Unintended inventory depletion

4.3 Determination of Equilibrium Income in the Short Run

4.3.1 Macroeconomic Equilibrium with Price Level Fixed

(A) Graphical Method

Consumption Function: C = C + cY

Intercept = C, Slope = c

Investment Function: I = I (horizontal line)

Aggregate Demand: AD = C + I = (C + I) + cY

Parallel to consumption function but shifted up by I

Aggregate Supply: 45° line (Y = AD)

Equilibrium: Intersection of AD curve and 45° line

(B) Algebraic Method

Solving the equilibrium condition:

Y = A + cY

Y - cY = A

Y(1 - c) = A

Y = A/(1 - c)

4.3.2 Effect of an Autonomous Change in Aggregate Demand

Changes in equilibrium income can occur due to:

Change in autonomous consumption (C)
Change in MPC (c)
Change in autonomous investment (I)

Example: Let C = 40 + 0.8Y, I = 10

Initial equilibrium: Y = (40 + 10)/(1 - 0.8) = 250

If I increases to 20:

New equilibrium: Y = (40 + 20)/(1 - 0.8) = 300

ΔY = 50 while ΔI = 10 → Multiplier effect

4.3.3 The Multiplier Mechanism

The multiplier explains how an initial change in autonomous expenditure leads to a larger change in equilibrium income.

Table 4.1: The Multiplier Mechanism
Round	Consumption	Aggregate Demand	Output/Income
1	0	10 (ΔI)	10
2	(0.8)10	(0.8)10	(0.8)10
3	(0.8)²10	(0.8)²10	(0.8)²10
...	...	...	...
Total			10/(1-0.8) = 50

The investment multiplier (k):

k = ΔY/ΔA = 1/(1 - c) = 1/s

Where s = MPS = 1 - c

Paradox of Thrift

When people try to save more (increase MPS), the total savings in the economy may remain unchanged or even decrease because:

Higher savings → Lower consumption → Lower AD → Lower income
Final savings S = Y - C may not increase despite higher saving propensity

Example: Initial equilibrium Y=250, C=40+0.8Y, S=10

If MPC falls to 0.5 (MPS rises to 0.5):

New equilibrium Y=100, C=40+0.5×100=90, S=10 (same as before)

4.4 Some More Concepts

Full employment level of income: The output level where all factors of production are fully employed.

Equilibrium income may differ from full employment income:

Deficient demand: AD < full employment output → Unemployment
Excess demand: AD > full employment output → Inflationary pressures

Key Concepts

Aggregate demand
Aggregate supply
Equilibrium
Ex ante
Ex post
Ex ante consumption
Ex ante investment
Marginal propensity to consume
Unintended changes in inventories
Autonomous change
Parametric shift
Effective demand principle
Paradox of thrift
Autonomous expenditure multiplier

Review Questions

What is marginal propensity to consume? How is it related to marginal propensity to save?
What is the difference between ex ante investment and ex post investment?
What do you understand by 'parametric shift of a line'? How does a line shift when its (i) slope decreases, and (ii) its intercept increases?
What is 'effective demand'? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?
Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is Rs 4000 crores. State whether the economy is in equilibrium or not (cite reasons).
Explain 'Paradox of Thrift'.