UNIT 3- DETERMINATION OF INCOME AND EMPLOYMENT

By:

Premjeet Kumar Bhati

PGT Economics JNV Ferozepur (Punjab)

- Meaning of Aggregate Demand

*AD refers to total value of all final goods and services that are

planned to buy by all the sectors of the economy at a given level of

income during a period of time.

*AD represents the total expenditure on goods and services in an

economy during a period of time.

Components of Aggregate demand are :

(i) Household consumption expenditure (C).

(ii) Investment expenditure (I)

(iii) Govt. consumption expenditure (G).

(iv) Ne export (X – M).

Thus, AD = C + I + G + (X – M)

In two sector economy AD = C + I.

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• Aggregate supply:

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*Aggregate supply (AS):It refers to total value of all final goods and

services that are planned to be produced by all the producing units

in the economy during a given period of time.

• It is also the value of total output available in an economy during a

given period of time.

AS = C + S

* Aggregate supply represents the national income of the country. AS = Y (National Income).

• Consumption function:

• Consumption function: It shows functional relationship between

income and consumption.

* C = f(Y), where C = Consumption, Y = National Income, f =

Functional relationship

* Equation of Consumption Function- C = C + MPC. Y C =

Autonomous consumption. C does not change affect by change in

income.

• Consumption expenditure at zero level of income is called

autonomous consumption.

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• Propensity to consume :

• Consumption function (propensity to consume) is of two types :

(a) Average propensity to consume (APC)

(b) Marginal propensity to consume (MPC)

• Average propensity to consume (APC): It refers to the ratio of

consumption expenditure to the corresponding level of income.

• Break even point C = Y.
• Important Points about APC:
• APC is more than 1 : as long as consumption is more than national

income. It means before the break-even point, APC > 1,

(ii) APC = 1, at the break-even point, consumption is equal to national

income.

(iii) APC is less than 1 : beyond the break-even point.Consumption is less

than national income.

(iv) APC falls with increase in income.

(v) APC can never be zero : because even at zero level of national income,

there is autonomous consumption.

• Marginal Propensity to Consume (MPC) :

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* Marginal Propensity to Consume (MPC) : Marginal propensity to

consume refers to the ratio of change in consumption expenditure to

change in income.

• MPC = Change in Consumption / Change in Income Y.
• Important Points about MPC:
• Value of MPC varies between 0 and 1 : But if the entire additional income

is consumed, then ΔC = ΔY, making MPC = 1.

*However, if entire additional income is saved then ΔC = 0, making MPC = 0.

• Saving function :

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• Saving function: It refers to the functional relationship between saving

and national income.

• S = f(Y) Equation of Saving function S = - C +MPS.Y where S = saving Y

= National Income f = Functional relationship.

* Saving function (Propensity to Save) is of two types:

(i) Average Propensity to Save (APS)

(ii) Marginal Propensity to Save (MPS)

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• Average Propensity to Save (APS) :

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*Average Propensity to Save (APS) : Average propensity to save refers to

the ratio of savings to the corresponding level of income. APS =Savings S

/ Income Y

* Important Point about APS :

* APS can never be 1 or more than 1 : As saving can never be equal to more than income.

* APS can be zero : At break even point C = Y, hence S = 0.

* APS can be negative : At income levels which are lower

than the break-even point, APS can be negative when

consumption exceeds income.

• APS rises with increases in income.

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• Marginal Propensity to Save (MPS) :

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* Marginal Propensity to Save (MPS) : Marginal propensity to save refers

to the ratio of change in saving to change in total income.

* MPS Change in Savings S / Change in Income Y.

• MPS varies between 0 and 1, but (i) if the entire additional income is

saved. In such a case, ΔS = ΔY, then MPS = 1.

• If the entire additional income is consumed. In such a

case, ΔS = 0, then MPS = 0.

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• Relationships:

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* Relationship between APC and APS :

* The sum of APC and APS is equal to one.

*APC + APS = 1. because income is either used for consumption or for

saving.

* Relationship between MPC and MPS:

• The sum of MPC and MPS is equal to one. 1 = MPC + MPS.

* MPC + MPS = 1 because total increment in income is either used for

consumption or for saving.�

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• Capital Formation / Investment :

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* Capital Formation / Investment: It refers to increase the stock of capital

goods during a financial year.

* The investment expenditure is classified under two heads :

(i) Induced investment (ii) Autonomous investment.

• Induced Investment : Induced investment refers to the investment which

depends on the profit expectations and is directly influenced by income

level (only for reference).

• Autonomous Investment :Autonomous investment refers to the investment

which is not affected by changes in the level of income and is not induced

solely by profit motive.

*It is income inelastic. �

• Equilibrium level of income :

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* Equilibrium level of income is determined only at the point where AD =

AS or S = I.

* But it cannot always be at full employment level also. It can be at less

than full employment level or over full employment level.

• Full employment is a situation when all those who are able and willing to

work at prevailing wage rate, get the opportunity to work.

• Voluntary unemployment is a situation where person is able to work but

not willing to work at prevailing wage rate.

• Involuntary unemployment is a situation where worker is able and willing

to work at prevailing wage rate but does not get work.

• Investment multiplier (K) :

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* Investment multiplier (K): It is the ratio of change in income (ΔY) due to

change in investment ΔI.

• Value of Investment multiplier lies between 1 to infinity.
• Working of Multiplier: Multiplier works through consumption. How?
• The concept of multiplier is based on the assumption that expenditure of one person is another person’s income, e.g., expenditure of A is income of B; B’s expenditure is income of C; C’s expenditure is income of D and so on until spending becomes zero.

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• Relationship of K with MPC and MPS:

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• (i) There is direct relationship between K and MFC. If MPC is high, K

will also be high but if MPC is low, K will also be small.

• In short, higher the value of MPC, higher will be the value of multiplier.

Lower the value of MPC, lower will be the value of multiplier (K). (ii) There is inverse relationship between K and MPS. If MPS is high, K

will be low but if MPS is low, K will be high .

• Minimum value of multiplier is 1 because minimum value of MPC can be

zero.

• Maximum value of multiplier may be – (infinity) because maximum value

of MPC can be 1.

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• Excess demand & Inflationary gap :

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* Excess demand refers to a situation when aggregate demand exceeds

aggregate supply corresponding to full employment.

• Inflationary gap is the gap by which actual aggregate demand exceeds the

level of aggregate demand required to establish full employment. It

measures the amount of excess of aggregate demand.

* In the following diagram Inflationary gap is AB because at Full

employment Y*, Aggregate demand (BY*) is greater than Aggregate

Supply(AY*).�

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• Reasons or causes for excess demand:

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• The main reasons for excess demand are apparently the increase in the

following components of aggregate demand:� (a) Increase in household consumption demand due to rise in propensity

to consume.� (b) Increase in private investment demand because of rise in credit

facilities.� (c) Increase in public (government) expenditure.� (d) Increase in export demand.� (e) Increase in money supply or increase in disposable income.

• Impacts or effects of excess demand on price, output, employment:

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• (a) Effect on General Price Level: Excess demand gives a rise to general

price level because it arises when aggregate demand is more than

aggregate supply at a full employment level. There is inflation in

economy showing inflationary gap.� (b) Effect on Output: Excess demand has no effect on the level of output.

Economy is at full employment level and there is no idle capacity in the

economy. Hence output can’t increase.� (c) Effect on Employment: There will be no change in the level of

employment also.

* The economy is already operating at full employment equilibrium,

and hence, there is no unemployment.

• Measures to control the excess demand:

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• (a) Monetary Policy: Monetary policy is the policy of the central bank of

a country to control money supply and availability of credit in the

economy. The central bank can take the following steps:�(i) Quantitative Instruments or General Tools of Monetary Policy: These

are the instruments of monetary policy that affect overall supply of

money/credit in the economy. 

• Increase in Bank Rate
• Increase in Repo Rate
• Increase in Reverse Repo Rate
• Open Market Operations (OMO) (Sale of securities)
• Increase in CRR
• (ii) Qualitative Instruments or Selective Tools of Monetary Policy:
• (i) Imposing margin requirement on secured loans (Increase)
• (ii) Moral Suasion:
• (iii) Selective Credit Control (SCC) [Introduce Credit Rationing]

• Measures to control the excess demand:

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• (b) Fiscal Policy: The expenditure and revenue policy taken by the

general government to accomplish the desired goals is known as

fiscal policy. A general government can take the following steps:

• (a) Revenue Policy (Increase Taxes)
• (b) Expenditure Policy (Reduces Expenditure)
• (c) Increase in Public Borrowing/Public Debt

• Deficient Demand or Deflationary Gap:

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• Deficient Demand or Deflationary Gap: When in an economy, aggregate

demand falls short of aggregate supply at full employment level, the

demand is said to be a deficient demand.�� * Deflationary gap is the gap showing Demand deficient of current

aggregate demand over ‘aggregate supply at the level of full

employment’. It is called deflationary because it leads to deflation

(continuous fall in prices).

• In the diagram, equilibrium between AD and AS is at a point less than

level of full employment. Keynes called it an under employment

equilibrium.�

• Reasons or causes for deficient demand:

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• The main reasons for deficient demand are apparently the decrease in four

components of aggregate demand:� (a) Decrease in household consumption demand due to fall in propensity to

consume.�(b) Decrease in private investment demand because of fall in credit

facilities.�(c) Decrease in public (government) expenditure.�(d) Decrease in export demand.�(e) Decrease in money supply or decrease in disposable income.�

• Impacts or effects of deficient demand:

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• (a) Effect on General Price Level: Deficient demand causes the general

price level to fall because it arises when aggregate demand is less than

aggregate supply at full employment level. There is deflation in an

economy showing deflationary gap.�(b) Effect on Employment: Due to deficient demand, investment level is

reduced, which causes involuntary unemployment in the economy due

to fall in the planned output.�(c) Effect on Output: Low level of investment and employment implies low

level of output.�

• Measures to control the deficient demand:

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• (a) Monetary Policy: Monetary policy is the policy of the central bank of a

country to control money supply and availability of credit in the economy.

The central bank can take the following steps:�(i) Quantitative Instruments or General Tools of Monetary Policy: These

are the instruments of monetary policy that affect overall supply of

money/credit in the economy. 

• Decrease in Bank Rate
• Decrease in Repo Rate
• Decrease in Reverse Repo Rate
• Open Market Operations (OMO) (Purchase of securities):
• Decrease in CRR
• (ii) Qualitative Instruments or Selective Tools of Monetary Policy:
• (i) Imposing margin requirement on secured loans (Decrease):
• (ii) Moral Suasion
• (iii) Selective Credit Control (SCC) [Reduce Credit Rationing]:

• Measures to control the excess demand:

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• (b) Fiscal Policy: The expenditure and revenue policy taken by the

general government to accomplish the desired goals is known as fiscal

policy. A general government can take the following steps:

• (a) Revenue Policy (Decrease Taxes):
• (b) Expenditure Policy (Increases Expenditure):
• (c) Decrease in Public Borrowing/Public Debt:

By:

Premjeet Kumar Bhati

PGT Economics JNV Ferozepur (Punjab)