DETERMINATION OF INCOME AND EMPLOYMENT

Aggregate Demand.

Aggregate demand refers to the money value of goods and services that all sectors of the economy are planning to buy at a given level of income, in a given period of time.

It is equal to Aggregate Expenditure.

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COMPONENTS OF AGGREGATE DEMAND

Private consumption expenditure, Investment expenditure, Government consumption expenditure and Net Exports are the components of aggregate demand.

In a two sector economy aggregate demand consists of Private consumption Expenditure and Investment Expenditure.

AD = C + I

SCHEDULE

�����������������INCOME

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c + I

c

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CONSUMPTION

INVESTNMENT

AD

I

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INCOME

Important features of Aggregate Demand.

(i) In a two sector economy Aggregate demand is the sum of Consumption Expenditure and Investment Expenditure.

AD = C + I

(ii) Even at zero level of income, there is consumption of some basic goods and services. It is called autonomous consumption (C). So, there is Aggregate demand even at zero level of income. Aggregate demand curve and Consumption curve start from a point on Y axis.

(iii) Aggregate Demand and the Consumption curves slopes upward from left to right because consumption increases as income increases.

(iv) It is assumed that Investment is autonomous. So, Investment curve is a horizontal line parallel to X axis.

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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.

The value of total output in the economy is divided in to the rewards for factors of production, such as Rent, Wages, Interest and Profit. So, Aggregate Supply is always equal to National Income of the country(Y).

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A part of National Income is used for meeting consumption expenditure and another part is saved. So, Consumption and Saving are the components of Aggregate Supply.

AS = Y = C + S

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AS

C + S

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INCOME

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Aggregate Supply Curve (Income curve) is a 45’ line starting from the origin. It shows at all levels Income (Y) is equal to Consumption plus Saving (C+S)

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)

(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.

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SCHEDULE

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Y

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Consumption C

E

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Income

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. It is before the break – even point. There is dissaving.
• (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.

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Marginal Propensity to Consume

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

MPC =

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(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.

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PROPENSITY TO SAVE

OR

SAVING FUNCTION.

Saving function refers to the functional relationship between saving and income.

S = f (Y)

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Y

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s

Saving

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0 E

Income X

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AVERAGE PROPENSITY TO SAVE

Average Propensity to Save (APS) is the ratio of saving to corresponding level of Income

APS =

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(i) APS is negative when consumption is more than income.

(ii) APS is zero when consumption is equal to income. It is called break – even point.

(iii) APS can never be 1 or greater than 1 because saving cannot be equal or more than income.

(iv) APS rises as income increases.

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MARGINAL PROPENSITY TO SAVE

Marginal Propensity to Save is the ratio of change in saving to change in income.

MPS =

MPS is in between zero and 1. If the entire increased income is saved, MPS is equal to 1. If the entire increased income is consumed, MPS = 0.

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RELATIONSHIP BETWEEN AVERAGE PROPENSITY TO CONSUME AND AVERAGE PROPENSITY TO SAVE

The sum of APC and APS is always 1. Let us prove it.

APC + APS = 1

Y = C + S

= +

1 = APC + APS

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RELATIONSHIP BETWEEN MARGINAL PROPENSITY TO CONSUME AND MARGINAL PROPENSITY TO SAVE

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The sum of MPC and MPS is always 1. Let us prove it.

MPC + MPS = 1

∆Y = ∆C + ∆S

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= +

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1 = MPC + MPS

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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)

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SAVING FUNCTION

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S = - c + (1 – b) Y

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Ex-ante savings and Ex -ante Investment

• Ex-ante savings refers to the savings planned by the household for the given year. It is also called planned savings.
• Ex-ante investment refers to the amount of investment planned by the producers in the given year. It is also called planned investment.
• Ex-post savings refers to the actual savings made by the households in a year.
• Ex-post investment refers to the actual amount of investment made by the producers in a year.

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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.

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INVESTMENT

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• Increase in the value of capital stock is called investment. It is the amount spent by producers to buy capital goods.
• Investment is of two types:
• (i) Autonomous Investment: Investment which is not influenced by income is called autonomous investment. It is constant at all levels of Income. It is done by the Government.

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Y

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INVESTMENT I

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0 INCOME X

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(ii) Induced Investment: It is the investment caused by increase in income and increase in profitability. It increases as income increases. It is done by the private firms.

Y

I

INVESTMENT

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0 X

INCOME

DETERMINATION OF NATIONAL INCOME AND EMPLOYMENT USING AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH

AD = AS APPROACH

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According to Keynes, equilibrium level of income and employment is determined at that point where Aggregate demand is equal to Aggregate Supply.

AD = AS

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SCHEDULE

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Y

AS

AD & AS E C + I

C

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0 M X

INCOME

• 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.

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(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.

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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

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SCHEDULE

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Y AS

AD

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AD& AS

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S

SAVING &

INVESTMENT Q I

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INCOME

0 M X

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• (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.

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• (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.

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Investment Multiplier put forward by J M Keynes.

According to Keynes, a small change in Investment will lead to a big change in Income.

Investment Multiplier is the rate of change in Income due to change in Investment.

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k =

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k =

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k =

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• 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.

Let us assume that chnage in Investment is 100 and MPC is 0.5

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• An investment of Rs. 100 crores leads to an increase in income of Rs. 100 crores. MPC is 0.5. So, 50% of income (Rs. 50 crores) is consumed and another 50% (Rs. 50 crores) is saved.
• One man’s expenditure is another man’s income. So, consumption of Rs. 50 crores creates an income of Rs. 50 crores. 50% of Rs.50 crores (Rs.25 crores) is consumed and remaining 50% is saved.
• This will go on until consumption becomes zero. As MPC is 0.5 and investment is 100, the income generated will be 200.

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Y

AS

AD & AS AD1

AD

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0 M M 1 X

INCOME

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• An increase in investment leads to the shifting of AD curve to AD1. As a result of it, the income increases from OM to OM1. Increase in income is greater than increase in investment.

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EXCESS DEMAND OR INFLATIONARY GAP

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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

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Y AS

INFLATIONAY GAP AD

AD1

AD & AS

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0 X

M

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AD1 is the desired Aggregate Demand for reaching equilibrium. AD is the actual Aggregate Demand. The gap between them is called Excess demand or inflationary gap.

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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.

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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.

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STEPS TO CORRECT �INFLATIONARY GAP

• MONETARY POLICY

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• QUANTITATIVE QUALITATIVE

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a. Quantitative measures :-

Bank Rate

Repo Rate

Reverse Repo Rate

Open Market operations

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

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(i) Bank Rate: Commercial Banks may take loans to meet their long term credit needs from the Central Bank. The interest for these loans is called Bank Rate.

During Inflationary Gap, the Central Bank will increase the Bank Rate. This will discourage Commercial Banks from taking loans from Central Bank. Their lending power will decrease. They will lend less and charge high rate of interest Money supply will fall. Consumption and aggregate demand will fall.

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2. Repo Rate: Commercial Banks may take loans to meet their short term credit needs from the Central Bank. The interest charged on these loans is called Repo Rate.

During Inflation Repo Rate will be increased. The lending capacity of commercial banks will fall. They will advance less loans with high interest rate . Money supply will fall. Aggregate Demand will fall. Excess demand will be corrected.

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3. Reverse Repo Rate

Reverse Repo Rate: Sometimes, the Central Bank may borrow money from Commercial Banks. This interest paid for these loans is called Reverse Repo Rate. During Inflation, the Reverse Repo rate will be increased. The Commercial Banks will lend more money to Central bank. They will lend less to public. Money supply and Aggregate Demand will fall.

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4. Open Market Operations:

During Inflation, the Central Bank will sell securities to the public and get money. Money supply will decrease and . Aggregate Demand will fall and Inflationary Gap will be reduced.

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5. Legal Reserve Ratio

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Cash Reserve Ratio Statutory Liquidity Ratio

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LRR will be increased during inflation

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• QUALITATIVE MEASURES
• (i) Margin Requirement: This can be explained with an example. A person gives a collateral security worth Rs 100 to a commercial bank and the bank may give him loan of Rs 80. This means the margin is 20%. During Inflation bank will increase margin requirement.

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• (ii) Rationing credit: Sometimes the central bank will instruct the commercial bank to give some percent of loan to some sectors. This is called fixing the quota. During Inflation rationing will be introduced.

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(iii) Warning and direct action: The central bank may warn or take direct action against the commercial banks, which do not follow its guide lines. A few months ago RBI slapped Rs 5 lakhs on IDBI.

(iv) Moral suasion: Sometimes central bank may persuade the commercial banks to follow its guidelines.

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FISCAL POLICY

• It refers to the policy related with the income and expenditure of the Government.
• (i) Decrease in Government Expenditure: During excess demand, the Government will reduce its expenditure. Income of the people will fall and aggregate demand will fall.
• (ii)Increase in Taxes: During Inflation, the Government will increase taxes. The disposable income of the people will fall. This will lead to fall in aggregate demand.
• (iii) Increase public borrowing: During Inflation, Government will increase borrowing from the public. This will reduce money supply and aggregate demand will fall.

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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

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Y AS

DEFLATIONARY GAP AD1

AD

AD & AS

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0 X

M

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• AD1 is the desired Aggregate Demand for reaching equilibrium. AD is the actual Aggregate Demand. The gap between them is called Deficient demand or deflationary gap.

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Causes of Deflationary Gap

(i) Fall in consumption expenditure by households

(ii) Fall in Investment by Firms.

(iii) Fall in Government Expenditure.

(iv) Increase in Taxes

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Effects of Deflationary Gap:

(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.

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Measures that can be taken to correct deficient demand (Deflationary Gap)

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MONETARY POLICY: It refers to the policy of the Central Bank in relation to money and financial institutions.

MONETARY POLICY

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QUANTITATIVE MEASURES QUALITATIVE MEASURES

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QUANTITATIVE METHODS

• (i) Bank Rate: Commercial Banks may take loans to meet their long term credit needs from the Central Bank. The interest for these loans is called Bank Rate. During deflationary Gap, the Central Bank will reduce the Bank Rate. This will encourage commercial banks to take loans from Central Bank. Their lending power will increase. They will collect less interest. Fall in interest will encourage people to take loan and buy goods and services. Aggregate demand will increase.

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• (ii) Repo Rate: Commercial Banks may take loans to meet their short term credit needs from the Central Bank. The interest for these loans is called Repo Rate.
• During deflationary Gap, the Central Bank will reduce the Repo Rate. This will encourage commercial banks to take loans from Central Bank. Their lending power will increase. They will collect less interest. Fall in interest will encourage people to take loan and buy goods and services. Aggregate demand will increase.

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• (iii) Reverse Repo Rate: Sometimes, the Central Bank may borrow money from Commercial Banks. The interest paid for these loans is called Reverse Repo Rate.
• During Deflation, the Reverse Repo rate will be reduced. The Commercial Banks will not lend to Central bank. Instead, they will advance more loans to people. Money supply and Aggregate Demand will increase.

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• (iv) Open Market Operations: During deflationary Gap, the Central Bank will buy back securities from the public and give them money. Money supply will increase and aggregate demand will increase.

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• (iii) Cash Reserve Ratio (CRR): Commercial Banks have to keep a part of the deposits with the Central Bank. It is called Cash Reserve Ratio. During deflation, the CRR will be reduced. This will allow Commercial Banks to give more amount as loans. Money Supply will increase and aggregate demand will increase.

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• (iv)Statutory Liquidity Ratio (SLR): Commercial Banks have to keep a part of the deposits with them to meet day today withdrawals. It is called SLR. During deflation, the SLR will be reduced. This will allow Commercial Banks to give more amount as loans. Money Supply will increase and aggregate demand will increase.

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Qualitative Measures

• (i) Margin Requirement: This can be explained with an example. A person gives a collateral security worth Rs 100 to a commercial bank and the bank may give him loan of Rs 80 as loan. This means the margin is 20%. During deflation bank will reduce margin requirement.

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• (ii) Rationing credit: Sometimes the central bank will instruct the commercial bank to give some percent of loan to some sectors. This is called fixing the quota. During deflation rationing will be removed.

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• (iii) Warning and direct action: The central bank may warn or take direct action against the commercial banks, which do not follow its guide lines. A few months ago RBI slapped Rs 5 lakhs on IDBI.
• (iv) Moral suasion: Sometimes central bank may persuade the commercial banks to follow its guidelines.

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FISCAL POLICY

It refers to the policy related with the income and expenditure of the Government.

(i) Increase in Government Expenditure: During deficient demand, the Government will increase its expenditure. The Government will construct roads, canals, bridges etc. This will create employment opportunities. Income of the people will increase and aggregate demand will increase.

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• (ii) Reduction in Taxes: During deflation, the Government will reduce taxes. The disposable income of the people will increase. This will lead to increase in aggregate demand.
• (iii) Printing more currency: The Government may ask the central bank to print more currency notes. Money supply in the economy will increase and aggregate demand will increase.
• (iv) Reduce public borrowing: During deflation, Government will reduce borrowing from the public. This will increase money supply and aggregate demand will increase.

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