DETERMINATION OF INCOME AND EMPLOYMENT

TOPIC - 1 AGGREGATE DEMAND AND SAVING

Aggregate Demand means total expenditure planned to be incurred on final goods and services in the economy during an accounting year. 

Component of Aggregate Demand

AD = C+ I + G +(NX)

Where 

(i) Private  Final Consumption Expenditure (C)  - Demand for goods and services for private consumption or value of goods and services that households are able and willing to buy. 

(ii) Private Final Investment Expenditure (I)  - It refers to creation of new capital assets like machineries, building, raw material etc. by private entrepreneurs. 

(iii) Government expenditure (G) - It refers to intended expenditure on purchase of consumer and capital goods to fulfil common needs of society. 

Net export    (NX) - It refers to the difference between exports and imports of an economy.

Aggregate Supply 

Aggregate Supply is the money value of goods and services that all the producers in the economy are planning to supply in a given period of time. 

AS = C+ S

Effective Demand

It signifies the point where aggregate demand equals to aggregate supply. 

 Propensity to Consume or    Consumption Function.                       

 Keynesian Psychological Law of Consumption.

                                                       

Consumption Function (Propensity to Consume) is the functional relationship between consumption and level of income. 

                                            C = f (Y)

C= Private consumption Expenditure

(i) As income increases consumption expenditure also increases. 

(ii) Consumption increases at a lower proportion when compared to increase in income. 

(iii) Even at zero level of income, there is autonomous consumption.   

		MPC

Average Propensity to Consume

                   Average Propensity to Consume (APC) is the ratio of consumption expenditure to corresponding level of Income

APC = 

(i) APC is greater than 1 (APC > 1), when consumption is more than Income. 

(ii) APC is equal to 1 (APC = 1), when consumption is equal to income. It is at the break-even point.

(iii) APC is less than 1 (APC < 1), when consumption is less than income. It is after the break – even point.  There is saving.

(iv) APC can never be zero, because there is autonomous consumption.

 Marginal Propensity to Consume

                      

Marginal Propensity to Consume is the ratio of change in consumption to change in income. 

                   

MPC = Change in Consumption/Change in Income 

      (i) MPC is 1, when entire increased income is spent on consumption. 

       (ii) MPC is zero, when entire increased income is saved. So, MPC can be between zero and 1.

      (iii) MPC of poor is more than the MPC of rich. Poor spent major part of their increased income on consumption. It is because most of their basic needs are not fulfilled. Rich spent small part of increased income because most of their wants are already satisfied. 

     (iv) MPC of poor countries is greater than MPC of rich countries. Poor spent major part of their increased income on consumption. It is because most of their basic needs are not fulfilled. Rich spent small part of increased income because most of their wants are already satisfied. 

     (iv) MPC falls as income increases because when people become richer, they spent smaller parts of increased income on consumption.

* Consumption consists of autonomous consumption(c) and induced consumption.

Consumption at zero level of income is called autonomous consumption. Increase in consumption

caused by increase in income is called induced consumption. It can be found out by multiplying

MPC (b) with Income(Y). So, equation of consumption function can be written as,

C = c + b (Y)*

Saving Function/ Propensity to Save 

Saving Function refers to the functional relationship between saving and Income. 

S= F(Y) 

Types of  Propensity to Save 

(i) Average Propensity to Save (APS) - It is the ratio of savings to the corresponding level of Income. 

APS 

(ii) Marginal Propensity to Save (MPS) - It is ratio of change in saving to change in Income. 

MPS 

Relationship between APC and APS

Relationship between MPC and MPS

Investment 

Increase in the value of capital stock is called investment. It is the amount spent by producers to buy capital gooda. 

Investment is of two types

(i) Autonomous Investment - It refers to the investment which is independent of the lwvel of Income as is generally done by change in Income level. 

(ii) Induced Investment - It refers to the investment which is made with motive of earning profit as is done by the private Sector. 

Ex-ante Measures 

The planned value of the variables are called their ex-ante measures. For example – ex-ante consumption, ex-ante savings and ex-ante-investment.

Ex-ante consumption – Planned expenditure on final goods in the economy.

Ex-ante investment -  Planned investment on final goods in the economy.

Ex-ante savings -  Planned savings at different levels of income in an economy.

Voluntary & Involuntary unemployment.

• Voluntary unemployment refers to the situation when people are willing to remain unemployed at the current wage rate.

• Involuntary unemployment refers to the situation when the willing and able bodied people remain unemployed in the economy due to lack of employment opportunities.

Topic - 2 Short Run Equilibrium 

Short Run

According to J M Keynes, "A period of time during which level of output is determined by exclusively by the level of employment in the economy , is termed as short run.

DETERMINATION OF NATIONAL INCOME AND 

EMPLOYMENT USING AGGREGATE DEMAND AND 

AGGREGATE SUPPLY APPROACH 

AD = AS APPROACH

According to Keynes, equilibrium level of income 

and employment is determined at that point where 

Aggregate demand is equal to Aggregate Supply.

AD = AS

 At point E aggregate demand is equal to aggregate

supply. OM is the equilibrium level of income.

• (i) If Aggregate demand is greater than Aggregate

Supply (AD>AS), the inventories fall below the

desired level. This will encourage the producers to increase production. Aggregate Supply will

increases and become equal to Aggregate Demand.

(ii) If Aggregate demand is less than Aggregate

Supply (AD<AS), the inventories increase. There will

be unsold stocks. The producers will reduce

production. Aggregate Supply will fall and become equal to Aggregate Demand.

DETERMINATION OF NATIONAL

INCOME USING SAVING AND

INVESTMENT APPROACH

Saving and Investment approach is derived from

Aggregate Demand and Aggregate Supply

approach.

AD = AS

C+I = C + S

So, S = I

(i) Suppose, Saving is greater than Investment(S>I).

High saving means lower consumption. Lower

consumption leads to fall in Aggregate Demand.

Inventories increase. This will make the producers

to reduce production. Aggregate Supply falls and

becomes equal to Aggregate Demand. When AD

and AS are equal S and I will also be equal.

(ii) Suppose, Saving is less than Investment (S < I). Low

saving means higher consumption. Higher consumption

leads to rise in Aggregate Demand. Inventories fall. This

will encourage the producers to increase production.

Aggregate Supply increases and becomes equal to

Aggregate Demand. When AD and As are equal S and I

also will be equal.

• At point Q the economy is in equilibrium

because at that point Saving and Investment are equal.

Topic - 3 Investment Multiplier and Its Working

Investment Multiplier 

Multiplier establishes relation between income and investment. Investment multiplier is the rate of change in income due to change in investment.

K = ΔY / ΔI

Where,

ΔY = Change National Income

ΔI = Change in Investment

Also,

k = 1/ 1- MPC

Where k = Investment Multiplier

MPC = Marginal Propensity to Consume

And, k = 1/ MPS

Where k = Investment Multiplier

MPS = Marginal Propensity to Save

Therefore, it can be concluded that

K = 1/ 1- MPC = 1/ MPS

Note - 

Increase in Investment leads to increase in income.

Increase in income leads to increase in consumption expenditure.

One man’s consumption is another man’s income. So, increase in consumption leads to increase in income.

This process continues till change in consumption expenditure becomes zero.

The resultant increase in income depends upon the existing MPC

Working of Multiplier 

• Consider that a ₹200 crore (ΔI) additional investment is made to build a road. This additional investment will result in an additional ₹200 crores in revenue in the first round. 
• If MPC is taken to be 0.80, then those receiving this increased income will spend ₹160 crores, or 80% of ₹200 crores, on consumption, and the remaining amount will be saved. The second round will increase the revenue by ₹160 crores.
• In the next round, 80% of the extra income of ₹160 crores, or ₹128 crores, will be spent on consumption, with the remaining amount saved.
• The multiplier process will continue, and every round’s consumer expenditure will be equal to 0.80 times the extra income earned in the previous round. 

It can be concluded that an initial investment of ₹200 crores has resulted in a total increase of ₹1,000 crores in income.

Thus, the multiplier will be,

k = 5

In the above graph, the X-axis represents income and the Y-axis represents Aggregate Demand. Assume that the initial equilibrium is established at point E, where the AD curve and AS curve intersects. OY is the equilibrium level of income. Assume that investment rises by ΔI, causing the new Aggregate Demand curve (AD1) to cross the Aggregate Supply curve (AS) at point E’. As a result, OY1 is the new equilibrium level of income. Due to an initial increase in investment, the income increases from OY to OY1. The graph clearly shows that the income growth (YY1 or ΔY) is more than the investment growth (ΔI). Thus the value of the multiplier is provided by:

Topic - 4 Problems and Measurement of Excess Demand and Deficient Demand

DEFICIENT DEMAND ( DEFLATIONARY GAP)

Deficient demand is a situation in which Aggregate Demand is less than Aggregate

Supply at full employment level of income. It is also called deflationary gap.

AD < AS

Reasons for Deficient Demand

(i) Decrease in investment expenditure

(ii) Decrease in propensity to consume 

(iii) Increase in taxes

(iv) Reduction public expenditure

(v) Increase in propensity to save

(vi) Decline in export 

Effects of Deficient Demand

(i) There will be unsold stock due to low aggregate

demand. The firms will reduce output.

(ii) Employment opportunities decrease as production falls.

(iii) Deflationary Gap leads to fall in prices

EXCESS DEMAND OR INFLATIONARY GAP

Excess demand is a situation in which Aggregate Demand is more than Aggregate Supply at full employment level of income. It is also called Inflationary gap.

AD > AS

CAUSES OF INFLATIONARY GAP

(i) Increase in consumption expenditure by households

(ii) Rise in Investment by Firms.

(iii) Increase in Government Expenditure. 

(iv) Decrease in Taxes.

EFFECTS OF INFLATIONARY GAP:

(i) Output will not change as the economy is

already at full employment level.

(ii) Employment opportunities will not change because economy is already at full employment level.

(iii) Inflationary Gap leads to increase in prices.

Measures to Correct Deficient Demand

Fiscal Policy

(i) Increase in Government Borrowing - It is a part of fiscal policy. During deficient demand, the government should increase expenditure on public works like construction of roads, building etc. with view to provide additional income, people are  able to provide additional income to people. This will increase the aggregate demand and will help to correct the situation of deficient demand.

(ii) Decrease in tax - During deficient demand, government reduces the rates of taxes. It raises the purchasing power of people. Due to increase in disposable income, people are able to spend more on consumption and investment. It raises the level of aggregate demand and helps to control the situation of deficient demand.

Increase in Money Supply

The central bank aims to raise the availability of credit through its monetary policy. For this purpose two major instruments are used:

of two parts:

• Cash Reserve Ratio (CRR): It is the minimum amount of net demand and time liabilities that commercial banks are required to maintain with the central bank.
• Statutory Liquidity Ratio (SLR): This term refers to the minimum proportion of net demand and time liabilities that commercial banks must keep on hand. 

The central bank reduces CRR or/and SLR to correct deficient demand. It increases commercial banks’ effective cash resources and enhances their ability to create loans. In the end, it helps in raising the amount of credit available to the economy and decreases the deficiency in demand.

(II) Qualitative Instruments

These tools are designed to control the flow of credit. The following are important qualitative tools or measures:

1. Decrease in Margin Requirements: The term Margin Requirement describes the difference between the market value of the offered security and the value of the amount lent. When there is deficient demand in the economy, the central bank reduces the margin, which increases the ability of banks to create credit in exchange for the same level of security. As a result, borrowing becomes more attractive to borrowers, which increases aggregate demand.

2. Moral Suasion (Advice to Encourage Lending): The Central Bank uses a combination of persuasion and pressure to convince other banks to act in a way that is consistent with its policy. Discussions, letters, lectures, and tips to banks are used to exercise moral persuasion. The central bank advises, requests, or persuades commercial banks to provide credit. It increases credit availability and aggregate demand.

3. Selective Credit Controls (Withdraw Credit Rationing): This technique involves the central bank instructing other banks to provide or refuse credit to specific sectors for a given set of purposes. In times of deficient demand, the central bank withdraws credit rationing and makes efforts to promote credit.

Quantitative Instruments

1) Decrease in Bank Rate

 During deficient demand, the central bank decreases the bank rate, which reduces the cost of borrowing from the central bank. Forces commercial banks to decrease their lending rates encourages borrowers from taking loans & ultimately helps them to correct deficient demand.

2) Open Market Operations

During deficient demand, the central bank offers securities for buy which raises the reserves of commercial banks & positively affects the bank’s ability to create credit & increases the level of AD in the economy.

3) Decrease in Legal Reserve Requirements

Commercial banks are obliged to maintain a legal reserve. An decrease in such reserve is a direct method to raise the availability of credit. It includes:

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To correct deficient demand, the central bank decreases CRR and SLR. It raises the amount of effective cash resources of commercial banks & expand their credit-creating power which ultimately helps in increasing the availability of .

Measures to Correct Excess Demand

During excess demand current AD in the economy is more than the full employment level of output. It happens because of a rise in money supply & availability of credit at easy terms.

To correct excess demand the following measures may be adopted:

Govt. Expenditure

It is a part of fiscal policy. The government spends a huge amount on infrastructural & administrative activities. To control the situation of excess demand govt. should reduce its expenditure to the maximum possible extent.

Decrease in govt. spending will reduce the level of AD in the economy & help to correct inflationary pressure in the economy.

Increase in Taxes

During excess demand govt. increases the rate of taxes & even imposes some new taxes. It leads to a decrease in the level of aggregate expenditure in the economy & helps to control the situation of excess demand.

Decrease in Money Supply

The central bank aims to reduce the availability of credit through its monetary policy. For this purpose two major instruments are used:

Quantitative Instruments

1) Increase in Bank Rate

The bank rate is the rate at which the central bank lends money to commercial banks to meet their long-term needs. During excess demand, the central bank increases the bank rate, which raises the cost of borrowing from the central bank.

forces commercial banks to increase their lending rates discourages borrowers from taking loans & ultimately helps them to correct excess demand.

2) Open Market Operations

During excess demand, the central bank offers securities for sale which reduces the reserves of commercial banks & adversely affects the bank’s ability to create credit & decreases the level of AD in the economy.

3) Increase in Legal Reserve Requirements

Commercial banks are obliged to maintain a legal reserve. An increase in such reserve is a direct method to reduce the availability of credit. It includes:

• CRR (Cash Credit Ratio): It is the minimum percentage of net demand & time liabilities to be kept by commercial banks with the central bank.
• SLR (Statutory Liquidity Ratio): Statutory liquidity ratio is the minimum percentage of net demand & time commercial banks with themselves.

To correct excess demand, the central bank increases CRR and SLR. It reduces the amount of effective cash resources of commercial banks & limits their credit-creating power which ultimately helps in reducing the availability of credit in the economy.

Qualitative Instruments

1) Margin Requirements

It refers to the difference between the market value of securities offered & the value of the amount lent.

When the economy is suffering from excess demand, the central bank increases the margins that restrict the credit-creating powers of banks & decreases the level of aggregate demand.

2) Moral Suasion

It is a combination of persuasion as well as pressure that the central bank applies on other banks in order to get the act in a manner or line with its policy.

During excess demand, the central bank advises, requests, or persuades commercial banks not to advance credit for speculative or non-essential activities. It helps to reduce the availability of credit or aggregate demand.

3) Selective Credit Control

It refers to a method in which the central bank gives direction to other banks to give or not give credit for certain purposes to a particular sector.

During excess demand, the central bank introduces rationing of credit to prevent excess flow of credit particularly for speculative activities. It helps to wipe off excess demand.