CLASS 12 MACROECONOMICS UNIT-3: DETERMINATION OF INCOME & EMPLOYMENT- BEST IMPORTANT NOTES

UNIT-3: DETERMINATION OF INCOME & EMPLOYMENT

Introduction:

In any Macroeconomic model the equilibrium level of income, employment and output for any economy is determined by the interaction of Aggregate Demand and Aggregate Supply. Hence it is important to discuss the behavior of aggregate demand and aggregate supply before discussing how equilibrium level of income, employment and output is determined in any economy.

Aggregate demand

Meaning:

Aggregate demand refers to the total demand for final goods and services in the economy.

Alternatively, it is the total expenditure which the community intends to incur on purchase of goods and services. Thus, aggregate demand is synonymous with aggregate expenditure in the economy.

Components of Aggregate Demand:

The main components of aggregate demand (aggregate expenditure) in a four sector economy are:

1. Household (or private) consumption Expenditure (C)

2. Private investment Expenditure (I)

3. Government demand for goods and services/ Government Expenditure (G)

4. Net Export demand. (X-M)

Thus,

AD = C + I + G+(X-M)

Note: all the variables represent planned (ex-ante) and not actual (ex-post).

Consumption Function:

The functional relationship between consumption and income is called consumption function

C = f (y)

A typical linear consumption function is depicted by: ̅

Where

ü C is the consumption

ü ̅ is the autonomous consumption which is the vertical intercept of the consumption curve i.e. amount of consumption at zero level of income

ü b is the slope of the consumption curve which measures the rate of change in consumption per unit change in income and known as Marginal Propensity to Consume (MPC)

ü Y is the level of income.

This can be explained through the following table and diagram:

INCOME (Y)	CONSUMPTION (C)
0	40
100	120
200	200
300	280
400	360
500	440
600	520
700	600

Ø Consumption curve starts at a positive intercept with Y axis (from C) implying there is positive consumption at zero level of income.

Ø It is positively sloped implying direct relationship between income and consumption

To understand the consumption curve it is helpful to look at the 45° line drawn from the origin.

ü Since the vertical and horizontal axes have the same scale the 45° line has the property that at any point on it the distance up from the horizontal axis (which is consumption expenditure) exactly equals the distance across from the vertical axis (which is income)

ü Any point on the 45° line consumption expenditure exactly equals income. The 45° line therefore immediately tells us whether consumption spending is equal to , greater than or less than income

ü The consumption curve crosses the 45° line at point E , this point is known as breakeven point. Here household are just breaking even , because the consumption is exactly equal to the income

ü Any point to the left of E on the consumption curve implies consumption is greater than income , it means the household are making consumption from past saving , so it is called Dissaving

ü Any point to the right of E on the consumption curve implies consumption is less than income , it means the part of the income which is not consumed is saved , so it is called saving gap

ü Saving is measured as the vertical distance between the consumption curve and the 45° line .

Propensity to consume:   

 

Propensity to consume, in economics is the proportion of total income or of an increase in income that consumers tend to spend on goods and services rather than to save. It is of two types:

Ø Average Propensity to Consume (APC)

Ø Marginal Propensity to Consume (MPC)

Average Propensity to Consume (APC):

Meaning: It is the ratio of absolute level of consumption to absolute level of income.

Symbolically: C/Y

This can be understood from the following table and diagram

                    

Income (Y)		Consumption ( C )		APC = C/Y
0		40		-
100		120		120/100 = 1.2
200		200		200/200 = 1
300		280		280/300 = 0.933
400		360		360/400 = 0.90
500		440		440/500 = 0.88
600		520		520/600 = 0.866
700		600		600/700 = 0.85

Ø In this diagram APC at point B is APC= BY2/OY2  at point A it is APC = AY1/OY1

Ø If it is a linear consumption function then

Properties :

ü Value of APC is always positive (APC>0) – as C and Y are always positive

ü Before breakeven point APC>1

ü After breakeven point APC<1

ü At breakeven point APC = 1

ü APC Falls with increase in income: In case of linear consumption function , APC = tan θ when income increases the value of θ decreases and the value of tan θ also decreases.

Marginal propensity to Consume (MPC):

Meaning:The marginal propensity to consume (MPC) is the ratio of the change in the level of aggregate consumption to a change in the level of aggregate income. Symbolically MPC Δ=C/ΔY

· The MPC, thus, refers to the effect of additional income on consumption.

 It measures the slope of the consumption function

It can be understood from the following table and diagram

	Income	Consumption (
	(Y)	C )		MPC=C/Y
0		40		-
100		120		80/100 = 0.8
200		200		80/100 = 0.8
300		280		80/100 = 0.8
400		360		80/100 = 0.8
500		440		80/100 = 0.8
600		520		80/100 = 0.8
700		600		80/100 = 0.8

Properties of MPC:

Ø , it implies the value of MPC lies between 0 and 1

ü It is equal to 1 when total increased income is consumed

ü It is equal to 0 when total increased income is saved

ü It can never be negative as ΔC and ΔY both are always positive

Ø MPC in case of the poor is higher in comparison to the rich

ü In case of poor most of the basic needs of the people remain unsatisfied

ü So that additional increments of income go to increase consumption, resulting in a higher marginal propensity to consume

Ø MPC falls with increase in income:

ü It happens because when the level of income increases the economy have a tendency to save more as its basic needs get fulfilled

Relation between APC and MPC

APC and MPC are closely related to each other.

Ø APC refers to the ratio of absolute consumption absolute income at a particular point of time. On the other hand MP represents the ratio of change in consumption to change in income; MPC is the rate of change in APC

Ø As income rises both APC and MPC declines, but decline in MPC is more than the decline in APC, as income falls both APC and MPC rises but APC rises at a slower, rate than MPC

Ø MPC is useful in short-period where as APC is useful in long period. In the short period there is no change in MPC and MPC<APC. In the long period APC=MPC.

Investment function:

The functional relationship between investment and income is called investment function.

l = ∫(Y )

There are two types of investment

(a) Autonomous Investment: I = Ī

 If investment does not depend either on income/output or the rate of interest, then such investment is called autonomous investment.

 Thus, autonomous investment is independent of the level of income.

(b) Induced investment

 Investment that is dependent on the level of income or on the rate of interest is called induced investment.

Difference between Autonomous and Induced Investment

: Basis	Autonomous investment	Induced investment
Meaning	If investment does not depend either on income/output or the rate of interest, then such investment is called autonomous investment	Investment that is dependent on the level of income or on the rate of interest is called induced investment
Determinant	Social welfare	Profit , rate of interest etc
Relation with income	Income inelastic	Income elastic
Investment curve	Parallel to income axis	Positively sloped curve
Sectors	Generally done by the govt.	Generally done by the private sector

AGGREGATE SUPPLY (AS) :

Meaning:

It is the value of total quantity of final goods and services produced in the economic territory of a country. It refers to the planned aggregate output in the economy

Components of AS:

Aggregate Supply has two components

(a) Consumption

(b) Savings

So, AS = C+S

The behavior of AS curve depends on the behavior of C and S

Saving Function:

Ø Saving is that part of income which is not spent on current consumption.

Ø The relationship between saving and income is called saving function

Ø Simply put, saving function (or propensity to save) relates the level of saving to the level of income.

Ø It is the desire or tendency of the households to save at a given level of income.

Ø Thus, saving (S) is a function (f) of income (Y).

Ø Remember, saving is residual income of households that is left after consumption.

Algebraically

S= Y-C

Saving function equation:

As saving function is corollary of consumption function, ̅ we can derive the corresponding saving function from consumption function equation by substituting it in the equation S = Y – C as shown below.

Where C = Autonomous consumption (- C represents dissaving which is needed to finance autonomous consumption. Clearly, at zero level of income, amount of autonomous consumption = Amount of dissaving.), b = MPC (so that 1 – b represents MPS, i.e.. Marginal propensity to save), Y = Income.

This can be shown through the table and diagram

Income	Consumpti	Saving
(Y)	on ( C )	(S)
0	40	-40
100	120	-20
200	200	0
300	280	20
400	360	40
500	440	60
600	520	80
700	600	100

ü Saving curve starts at a negative intercept with Y-axis

ü It slopes upward indicating direct relationship between saving and income

Propensity to save;

Propensity to Save, in economics is the proportion of total incomeor of an increase in income that consumers tend to save rather than to consume. It is of two types:

Ø Average Propensity to Save (APS)

Ø Marginal Propensity to Save (MPS)

Average Propensity to Save (APS):

Meaning: It is the ratio of absolute level of saving to absolute level of income.

Symbolically:

APC=S/Y

This can be understood from the following table and diagram.

Income	Consumpti	Saving	APS (S/Y)
(Y)	on ( C )	(S)
0	40	-40	-40/0 = Infinite
100	120	-20	-20/100=-0.2
200	200	0	0/200=0
300	280	20	20/300=0.06
400	360	40	40/400=0.1
500	440	60	60/500=0.12
600	520	80	80/600=0.13
700	600	100	100/700=0.14

Ø In this diagram APC at point A is APS

Properties :

ü Value of APS may be negative , may be zero and positive

ü Before breakeven point APS<0

ü After breakeven point APS>0

ü At breakeven point APS =0

ü APS rises with increase in income

Marginal propensity to Save (MPS):

Meaning:The marginal propensity to Save(MPS) is the ratio of the change in the level of aggregate Saving to a change in the level of aggregate income. Symbolically MPS = ΔS/ ΔY

· The MPS, thus, refers to the effect of additional income on Saving

 It measures the slope of the Saving function .

It can be understood from the following table and diagram.

Income (Y)		Consumption ( C )	Saving (S)	MPS (ΔS/ΔY)
0		40	-40	-
100		120	-20	20/100 = 0.2
200		200	0	20/100 = 0.2
300		280	20	20/100 = 0.2
400		360	40	20/100 = 0.2
500		440	60	20/100 = 0.2
600		520	80	20/100 = 0.2
700		600	100	20/100 = 0.2

· The value of MPS lies between 0 and 1

Derivation of saving curve from consumption curve:

Ø We know that consumption + saving is always equal to Income because income is either consumed or saved

Ø It implies that consumption and saving curves representing consumption and saving functions are complementary curves

Ø Therefore, we can derive saving function or curve directly from consumption function or curve.

Ø This has been depicted in the adjoining Fig. 8.7 comprising Part-A showing consumption function and Part-B showing saving function.

Ø In Part-A of this Figure, CC curve shows consumption function corresponding to each level of income whereas 45° line represents income.

Step-1: At zero level of income consumption is OC , mark a point S1 on Part-B exactly

equal to the negative of OC Page | 22

Step-2: At point B on consumption curve C=Y, implying Zero Saving, so mark a point B1 on X-axis

of Part-B

Step-3: Join the point S1 and B1 and extend it, this will be the Saving Curve as shown S1S

Derivation of Consumption curve from saving curve:

Ø We know that consumption + saving is always equal to Income because income is either consumed or saved

Ø It implies that consumption and saving curves representing consumption and saving functions are complementary curves

Ø Therefore, we can derive consumption function or curve directly from saving function or curve.

Ø This has been depicted in the adjoining Fig. 8.7 comprising Part-A showing consumption function and Part-B showing saving function.

Ø In Part-B of this Figure, S1S curve shows saving function corresponding to each level of income whereas 45° line in part-A represents income.

Step-1: At zero level of income saving is negative OS1, mark a point C on part-A exactly

equal to the positive of OS1

Step-2: At point B1 on consumption curve saving is equal to zero, implying breakeven point, so

mark a point B on income curve corresponding to this level of income in Part-A

Step-3: Join the point C and B and extend it, this will be the Consumption Curve as shown CC1

Determination Of Equilibrium Income, Employment & Output In A Two Sector Economy

Equilibrium level of income employment and output can be determined by two approaches

(a) AD = AS or Y= C+S approach

(b) Investment = Savings (I = S) approach

(a) AD = AS or Y = C+S approach

Meaning:

Equilibrium level of income , employment and output in a two sector model economy is determined by the interaction of AD and AS (Effective demand principle).

Condition:

Planned expenditure should be equal to planned output

AD = AS ----------------------------- (1)

Explanation:

This can be explained from the following table and diagram

Ø In this table the condition of equilibrium S = I = 40satisfied for income level of 400

Ø Hence the equilibrium level of income , employment and output is 400

ü In the diagram S curve intersect I curve at point E , so E is the point of equilibrium

ü Corresponding to this the equilibrium level of income , employment and output is OY

If conditions of equilibrium are not satisfied then there are two possibilities:

(i) I > S

 In equilibrium I = S

 If I > S , it implies planned savings are less than planned investment means planned spending is more than planned output , this is at ON1 level of output

 Due to this there is unplanned decumulation of inventory

 Firms would then respond to this unplanned inventory decrease by increasing employment and hence output

 This process will continue until the economy is back at income level ON, where again I = S and there is no further tendency to change (Equilibrium is restored).

(ii) I < S

 In equilibrium I = S

 If I < S , it implies planned savings are more than planned investment means planned spending is less than planned output , this is at ON2 level of output

 Due to this there is unplanned accumulation of inventory

 Firms would then respond to this unplanned inventory increase by cutting back production and employment

 This process will continue until the economy is back at income level ON, where again I = Sand there is no further tendency to change (Equilibrium is restored).

SHORT-RUN FIXED PRICE MODEL OF DETERMINATION OF INCOME

Ø Under fixed price model in short run equilibrium level of income is determined solely by aggregate demand (AD) , it is called effective demand principle

Ø In this case AD = C+I

Ø In short run I assumes to be autonomous type

Ø The equilibrium condition will be

ü In this diagram C+I curve intersect the 45° line at point E , so E is the point of equilibrium

ü The corresponding level of income is OY

 If investment increases then the new AD curve is C+I +I1 and it intersect the 45° line at point E1

 Now E1 is the new equilibrium and E is no more the point of equilibrium

 Corresponding to this the new equilibrium level of output is OY1

EXCESS DEMAND AND DEFICIENT DEMAND

Excess Demand

It refers to a situation where current aggregate demand is excess of the aggregate demand required for full employment equilibrium. (ADc>ADf)

Inflationary Gap: The gap by which actual aggregate demand exceeds the aggregate demand required to establish full employment equilibrium. (ADc – ADf)

Reasons for Excess Demand:

 Rise in propensity to consume

 Reduction in tax

 Increase in govt. expenditure

 Rise in exports

 Fall in imports

Effects:

 No effect on output

 No effect on employment

 General Price level increases

Measures to correct:

 Increase in tax

 Reduction in govt. expenditure

 Reducing availability of credit

Deficient Demand

It refers to a situation where current aggregate demand fall short of the aggregate demand required for full employment equilibrium. (ADc<ADf)

Deflationary Gap: The gap by which actual aggregate demand fall short of the aggregate demand required to establish full employment equilibrium. (ADf -ADc)

Reasons for Deficient Demand:

 Fall in propensity to consume

 Increase in tax

 Reduction in govt. expenditure

 Fall in exports

 Rise in imports

 decrease in availability of credit

Effects:

 Output falls

 Employment falls

 General Price level falls

Measures to correct:

 decrease in tax

 Increase in govt. expenditure

 Increasing availability of credit