# Chapter 4. Determination of Income and Employment

Overview
• theoretical model is based on theory given by John Maynard Keynes.

Aggregate Demand and its Components
• Aggregate demand is a measurement of total amount of demand for all finished goods and services produced in an economy.
• Aggregate demand is expressed as total amount of money exchanged for those goods and services at a specific price level and period of time.
• Aggregate Demand is total demand for all goods and services in entire economy, whereas market demand is total demand for one commodity in market. AD = C + I + G + [X-M]

Components of Aggregate Demands Consumption:
• most important determinant of consumption demand is household income.
• A consumption function describes relation between consumption and income.
• Autonomous consumption expenditure is not influenced by income, whereas induced consumption is consumption expenditure that change with change in income. C = C– + cY
• If consumption takes place even when income is zero, it is because of autonomous consumption. induced component of consumption, cY, shows dependence of consumption on income. When income rises by ` 1, induced consumption rises by MPC i.e., c or marginal propensity to consume.

Investment:
• This is defined as an addition to stock of physical capital [such as machines, buildings, roads ., i.e., anything that adds to future productive capacity of economy] and changes in inventory [or stock of finished goods] of a producer.
• ‘Investment goods’ [such as machines] are part of final goods – they are not intermediate goods like raw materials.

Savings:
• Savings is that part of income which is not consumed.
• Saving function refers to functional relationship between saving and national income. S = f [Y]

Some Definitions
• Marginal propensity to consume [MPC]: This is change in consumption per unit change in income. This is denoted by c and is equal to DC DY .
Marginal propensity to save [MPS]: This is change in savings per unit change in income. This is denoted by s and is equal to 1- c. It implies that s + c =1.
• MPC + MPS = 1, because total increment in income is either used for consumption or for saving.
Average propensity to consume [APC]: This is consumption per unit of income i.e., C/Y
Average propensity to save [APS]: This is savings per unit of income i.e., S/Y
• APC + APS = 1 because income is either used for consumption or for saving.
• In an economy without a government, ex-ante aggregate demand for final goods is sum total of ex-ante consumption expenditure and ex-ante investment expenditure on such goods.
• Ex-ante supply is equal to ex-ante demand only when final goods market, and hence economy, is in equilibrium.
• Ex-ante depicts what has been planned, and Ex-post depicts what has actually happened.

Inventory Investment
• Change in inventory is known as inventory investment. It can be negative as well as positive:
(1) If there is a rise in inventory, it is positive inventory investment, while a depletion of inventory is negative inventory investment.

Reason for Inventory Investment
• inventory investment can take place due to two reasons:
(1) firm decides to keep some stocks for various reasons [this is known as planned inventory investment].
(2) sales differ from planned level of sales; in which case firm has to add to/run down
existing inventories [this is known as unplanned inventory investment].

Investment Function – Graphical Representation:
• In a two-sector model, there are two sources of final demand, first is consumption and second is investment.
• In this model, I is autonomous which means it is same no matter what level of income.

Aggregate Demand: Graphical Representation
• It means aggregate demand function can be obtained by vertically adding consumption and investment function.
• aggregate demand function is parallel to consumption function i.e., they have same slope c. It may be noted that this function shows ex-ante demand.

Equilibrium
• point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be equilibrium.

Effect of an Autonomous Change in Aggregate Demand on Income and Output
• equilibrium level of income depends on aggregate demand. Thus, if aggregate demand changes, equilibrium level of income changes.
• This can happen in any one or combination of following situations:
• Change in consumption: This can happen due to: [i] change in C, and [ii] change in c.
• Change in investment: There are a number of variables other than income which can affect investment.
(1) Availability of credit: Easy availability of credit encourages investment.
(2) Interest rate: Interest rate is cost of investible funds, and at higher interest rates, firms tend to lower investment.

Multiplier Mechanism
• production of final goods employs factors such as labour, capital, land & entrepreneurship. In absence of indirect taxes or subsidies, total value of final goods output is distributed among different factors of production – wages to labour, interest to capital, rent to land . Whatever is left over is appropriated by entrepreneur and is known as profit.
• National Income is equal to aggregate value of output of final goods, GDP.
• ratio of total increment in equilibrium value of final goods output to initial increment in autonomous expenditure is known as investment multiplier of economy.