NCERT Class 12 Economics Part 2 Chapter 4: Determination of Income and Employment

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  • Aim of macroeconomics is to develop theoretical tools, called models, capable of describing the processes which determine the values of these variables
  • Model provide theoretical explanation to the question like reason for slow growth or recession
  • When we focus on one variable, we hold other variables as constant - assumption of ceteris paribus, which literally means โ€˜other things remaining equalโ€™ .
  • Hard to understand if we manipulate all variables together
  • We solve x in terms of y and then substitute the equation.
  • determination of National Income under the assumption of fixed price of final goods and constant rate of interest in the economy โ€“ by Keynes

Aggregate Demand and Components

  • Ex-post
  • Ex-ante
  • National Income Accounting โ€“ Consumption, Investment and GDP (total output of goods and services)
  • Actual value measured by activities within economy in a year โ€“ or accounting values ex-post measures
  • Consumption โ€“ not only actual consumption, but what they plan to consume
  • Investment โ€“ what adds to the inventory or what one ends up doing (planned investment is โ‚น 100 but actual is โ‚น 70 due to selling because of extra demand)
  • Planned values of the variables โ€“ consumption, investment or output of final goods โ€“ their ex-ante measures. In simple words, ex-ante depicts what has been planned, and ex-post depicts what has actually happened
  • Aggregate demand for final goods consists of ex ante consumption, ex ante investment, government spending etc. The rate of increase in ex ante consumption due to a unit increment in income is called marginal propensity to consume.

Consumption and Savings

  • Function of household income
  • C = autonomous () + induced ()
  • A consumption function describes the relation between consumption and income. The simplest consumption function assumes that consumption changes at a constant rate as income changes.
  • If I = 0, consumption still happens; this level of consumption is independent of income, it is called autonomous consumption (induced component)
  • cY shows the dependence of consumption on income. When income rises by Re 1. induced consumption rises by MPC i.e.. c or the marginal propensity to consume. It may be explained as a rate of change of consumption as income changes.
  • ~#i# ~M ~#/i# ~ ~#i# ~P ~#/i# ~ ~#i# ~C ~#/i# ~= โˆ† ~#i# ~C ~#/i# ~/ โˆ† ~#i# ~Y ~#/i# ~= ~#i# ~c ~#/i# ~ (marginal propensity to consume) Y is income amount
  • MPC can be between 0 (does not increase consumption even if income increase) to 1 (use entire income on consumption) .
  • (implies if income increases by 100, consumption increases by )
  • Savings is that part of income that is not consumed.
  • Where
  • So,
  • Marginal propensity to save (MPS) : it is the change in savings per unit change in income (s + c) = 1
  • Marginal propensity to consume (MPC) : it is the change in consumption per unit change in income
  • Average propensity to consume (APC) : it is the consumption per unit of income i.e.. , C/Y
  • Average propensity to save (APS) : it is the savings per unit of income i.e.. , S/Y


  • Investment decision depends on market rate of interest
  • Investment is defined as addition to the stock of physical capital (such as machines, buildings, roads etc. , i.e.. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer. Note that โ€˜investment goodsโ€™ (such as machines) are also part of the final goods โ€“ they are not intermediate goods like raw materials. Machines are not used in one year.
  • Investment decision depends on market rate of interest
  • We assume here that firms plan to invest the same amount every year, where is positive constant which represents the autonomous (given or exogenous) investment in the economy in a given year.

Determination of Income in 2-Sector Model

  • In an economy without a government, the ex-ante aggregate demand for final goods is the sum total of the ex-ante consumption expenditure and ex ante investment expenditure on such goods, viz.
  • Y is the ex-ante, or planned, output of final goods. Ex ante supply is equal to ex ante demand only when the final goods market, and hence the economy, is in equilibrium. (~#i# ~s ~#/i# ~ ~#i# ~u ~#/i# ~ ~#i# ~b ~#/i# ~ ~#i# ~s ~#/i# ~ ~#i# ~i ~#/i# ~ ~#i# ~s ~#/i# ~ ~#i# ~t ~#/i# ~ ~#i# ~e ~#/i# ~ ~#i# ~n ~#/i# ~ ~#i# ~c ~#/i# ~ ~#i# ~e ~#/i# ~ ~#i# ~c ~#/i# ~ ~#i# ~o ~#/i# ~ ~#i# ~n ~#/i# ~ ~#i# ~s ~#/i# ~ ~#i# ~u ~#/i# ~ ~#i# ~m ~#/i# ~ ~#i# ~p ~#/i# ~ ~#i# ~t ~#/i# ~ ~#i# ~i ~#/i# ~ ~#i# ~o ~#/i# ~ ~#i# ~n ~#/i# ~ ~#i# ~l ~#/i# ~ ~#i# ~e ~#/i# ~ ~#i# ~v ~#/i# ~ ~#i# ~e ~#/i# ~ ~#i# ~l ~#/i# ~ ~#i# ~s ~#/i# ~) (~#i# ~p ~#/i# ~ ~#i# ~e ~#/i# ~ ~#i# ~r ~#/i# ~ ~#i# ~i ~#/i# ~ ~#i# ~o ~#/i# ~ ~#i# ~d ~#/i# ~ ~#i# ~i ~#/i# ~ ~#i# ~c ~#/i# ~ ~#i# ~f ~#/i# ~ ~#i# ~l ~#/i# ~ ~#i# ~u ~#/i# ~ ~#i# ~c ~#/i# ~ ~#i# ~t ~#/i# ~ ~#i# ~u ~#/i# ~ ~#i# ~a ~#/i# ~ ~#i# ~t ~#/i# ~ ~#i# ~i ~#/i# ~ ~#i# ~o ~#/i# ~ ~#i# ~n ~#/i# ~ ~#i# ~s ~#/i# ~)
  • So, (ex-ante supply) (ex-ante demand)
  • Stocks will be piling up in the warehouses (if demand < supply) which we may consider as unintended accumulation of inventories. It should be noted that inventories or stocks refers to that part of output produced which is not sold and therefore remains with the firm
  • Change in inventory is inventory investment - if there is a rise in inventory, it is positive inventory investment, while a depletion of inventory is negative inventory investment. The inventory investment can take place due to two reasons: (i) the firm decides to keep some stocks for various reasons (this is called planned inventory investment) (ii) the sales differ from the planned level of sales, in which case the firm has to add to/run down existing inventories (this is called unplanned inventory investment) .
  • Fiscal variable tax (T) and Government expenditure (G)
  • Government through its expenditure G on final goods and services, adds to the aggregate demand like other firms and households. government take a part of the income away from the household, whose disposable income, therefore, becomes Yd = Y โ€“ T (tax) . Households spend only a fraction of this disposable income for consumption purpose.
  • Without the government imposing indirect taxes and subsidies, the total value of final goods and services produced in the economy, GDP, becomes identically equal to the National Income.

Determination of Equilibrium Income in Short Run

  • Assume โ€“ constant final goods price and constant rate of interest in short run & aggregate supply is perfectly elastic. So aggregate output is determined by aggregate demand โ€“ called as effective demand principle.
  • An increase (decrease) in autonomous spending causes aggregate output of final goods to increase (decrease) by a larger amount through the multiplier process.
  • Equilibrium of demand and supply in a single market, the demand and supply curves simultaneously determine the equilibrium price and the equilibrium quantity. In macroeconomic theory we proceed in two steps: at the first stage, we work out a macroeconomic equilibrium taking the price level as fixed. At the second stage, we allow the price level to vary and again, analyses macroeconomic equilibrium

Why Price Level is Fixed?

At the first stage, we are assuming an economy with unused resources: machineries, buildings and labors. In such a situation, the law of diminishing returns will not apply; hence additional output can be produced without increasing marginal cost. Accordingly, price level does not vary even if the quantity produced changes.

Macroeconomic Equilibrium with Price Level Fixed

  • is autonomous expenditure (intercept)
  • c is marginal propensity to consume (slope of consumption function as )
Macroeconomic Equilibrium
  • tan
  • I is autonomous which means, it is the same no matter whatever is the level of income.

Aggregate Demand, Supply and Equilibrium

Aggregate Demand, Supply & Equilibrium

Demand Side

  • Graphically it means the aggregate demand function can be obtained by vertically adding the consumption and investment function.
  • The aggregate demand function is parallel to the consumption function i.e.. , they have the same slope c. It shows ex-ante demand

Supply Side

Supply curve with price on vertical and quantity on horizontal axis.

We Take Price as Fixed

  • Here, aggregate supply or the GDP is assumed to smoothly move up or down since they are unused resources of all types available. Whatever is the level of GDP, that much will be supplied, and price level has no role to play. This kind of supply situation is shown by a 450 line. Now, the 450 line has the feature that every point on it has the same horizontal and vertical coordinates.
  • Equilibrium is shown graphically by putting ex ante aggregate demand and supply together in a diagram

Equilibrium level of income is

Effect of Autonomous Change in Aggregate Demand on Income and Output

Income and Output
  • Equilibrium level of income depends on aggregate demand. Thus, if aggregate demand changes, the equilibrium level of income changes.
  • Change can happen because of change in consumption or investment
  • Investment is affected by income, easy availability of credit and interest rate (higher interest rates, firms tend to lower investment)
  • Let . In this case, the equilibrium income (obtained by equation Y to AD) comes out to be .
  • and
  • Now, let investment rise to 20. It can be seen that the new equilibrium will be 300. Increase in income is due to increase in investment which is component of autonomous expenditure. When autonomous expenditure increases shift to and aggregate demand at output is greater than value at output. New aggregate demand at and it is now new equilibrium point. Here output and aggregate demand increased by an amount which is greater than initial increment in autonomous expenditure
  • Output increases (Since we have increase which is as excess demand due to increase in autonomous expenditure)

  • Initial increment in the autonomous expenditure seems to have a multiplier on the equilibrium values of aggregate demand and output

Multiplier Mechanism

Multiplier Mechanism
  • With change in autonomous expenditure of 10 units; change in equilibrium income is equal to 50 units
  • The production of final goods employs factors such as labour, capital, land and entrepreneurship. In the absence of indirect taxes or subsidies, the total value of the final goods output is distributed among different factors of production โ€“ wages to labour, interest to capital, rent to land etc.
  • Left over by entrepreneur is profit
  • National Income is equal to aggregate value of output of final goods, GDP
  • When income increases by 10, consumption expenditure goes up by (0.8) 10, since people spend 0.8 (= mpc) fraction of their additional income on consumption.
  • This process goes on, round after round, with producers increasing their output to clear the excess demand in each round and consumers spending a part of their additional income from this extra production on consumption items โ€“ thereby creating further excess demand in the next round
  • The ratio of the total increment in equilibrium value of final goods output to the initial increment in autonomous expenditure is called the investment multiplier of the economy.
  • As MPC (c) in investment multiplier gets larger, multiplier increases
  • Equilibrium output in the economy also determines the level of employment, given the quantities of other factors of production.
  • Full employment level of income is that level of income where all the factors of production are fully employed in the production process.
  • Equilibrium only means that if left to itself the level of income in the economy will not change even when there is unemployment in the economy
  • Equilibrium output < full employment (demand is not enough) โ€“ deficient demand โ€“ leads to decline in price in long run
  • Equilibrium output > full employment (demand is enough) โ€“ excess demand โ€“ leads to increase in price in long run

Paradox of Thrift

Paradox of Thrift
  • If all the people of the economy increase the proportion of income they save (i.e.. if the MPS of the economy increases) the total value of savings in the economy will not increase โ€“ it will either decline or remain unchanged. This result is known as the Paradox of Thrift โ€“ which states that as people become more thrifty, they end up saving less or same as before.
  • Stocks pile, payment reduces, income reduces, consumption reduces โ€“ creates more supply
  • The equilibrium output and aggregate demand have declined by 150. As explained above, this, in turn, implies that there is no change in the total value of savings.
  • The Paradox of Thrift states that if consumers follow their natural inclination to reduce their spending and increase their savings during a recession, they are actually causing the recession to be deeper and their own economic situation to be worse. In other words, decreasing consumption and increasing savings during a recession is like pouring gasoline on a fire.
  • Proponents of the Paradox of Thrift would argue that if consumers want to improve their economic situation, they should continue to spend during a recession to help get the economy back on its feet and then start to increase their savings once the economy is up and rolling again. Locking your money up in a bank or other savings account only exacerbates the problem.
  • Of course, opponents of the Paradox of Thrift would argue that individual investors need to look out for themselves during a recession and make sure that they are okay financially, and that it was consumption and overspending that got the economy into trouble in the first place. They would also argue that putting your money into a bank is the best thing for you and for the economy because banks arenีšt designed to just sit on your money. They are designed to lend your money out and put it to work. So eventually the money consumers are saving will end up in the hands of businesses and other consumers in the form of loans - which will stimulate the economy.
  • However, if the majority of consumers decide to tighten their purse strings during the recession, the economy will eventually recover, but it may have to take a longer, bumpier road.

โœ Manishika