Chapter 4. Determination of Income and Employment

• 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.

• 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 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.

• 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.

Paradox of Thrift
• If all people of economy increase proportion of income that they save total value of savings in economy will not increase – it will either decline or remain unchanged. This result is called Paradox of Thrift – which states that as people become thriftier, they end up saving less or same as before.

Some More Concepts
• equilibrium output in economy determines level of employment, given quantities of other factors of production.
• A Full employment level of income is that level of income where all factors of production are fully employed in production process.
• equilibrium level of output may be more or less than full employment level of output.
• If equilibrium is less than full employment of output, it is due to fact that demand is not enough to employ all factors of production. This situation is known as situation of deficient demand. It leads to a decline in prices in long run.
• If equilibrium level of output is more than full employment level, it is due to fact that demand is greater than level of output produced at full employment level. This situation is known as situation of excess demand. It leads to a rise in prices in long run.

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