Determination of Income and Employment

Aggregate Demand (AD): • Aggregate demand is the total expenditure on goods and services in an economy during a given period, at a given price level. • AD = C + I + G + (X − M) where: C = Private consumption expenditure, I = Investment expenditure, G = Government expenditure, X − M = Net exports (exports minus imports) In the Keynesian two-sector model (closed economy without government): AD = C + I Consumption Function (Propensity to Consume): • The consumption function shows the relationship between aggregate consumption (C) and national income (Y). • Keynes's fundamental psychological law: As income increases, consumption also increases, but by less than the increase in income. Linear consumption function: C = a + bY • 'a' = autonomous consumption — the amount consumed even when income is zero (funded by borrowing or dissaving). • 'b' = Marginal Propensity to Consume (MPC) = ΔC/ΔY — the fraction of each additional rupee of income that is spent on consumption. 0 < MPC < 1. • Example: If MPC = 0.8, then out of every ₹100 increase in income, ₹80 is consumed and ₹20 is saved. Average Propensity to Consume (APC) = C/Y = a/Y + b • APC falls as income rises (since 'a/Y' falls as Y rises). • At low income levels, APC > 1 (people borrow or dissave to consume). Saving Function: • Saving (S) = Y − C = Y − (a + bY) = −a + (1−b)Y • Marginal Propensity to Save (MPS) = 1 − MPC • MPC + MPS = 1

The Investment Multiplier (Keynesian Multiplier): • The multiplier (k) shows the ratio of the change in national income (ΔY) to the change in investment (ΔI) that caused it. • Multiplier k = ΔY / ΔI Formula: k = 1 / (1 − MPC) = 1 / MPS Intuition — the multiplier process: • When firms invest ₹100 crore extra (building a factory), they pay wages to workers. • Workers spend a fraction (MPC) of their income on goods and services — say ₹80 crore (MPC = 0.8). • Those who receive the ₹80 crore in turn spend 80% of it — ₹64 crore. • The spending ripples through the economy in successive rounds. With MPC = 0.8: k = 1 / (1 − 0.8) = 1 / 0.2 = 5 So a ₹100 crore injection of investment leads to a ₹500 crore increase in national income. Example calculation: Round 1: Investment = ₹100 crore → Income ↑ ₹100 crore Round 2: Consumption ↑ ₹80 crore → Income ↑ ₹80 crore Round 3: Consumption ↑ ₹64 crore → Income ↑ ₹64 crore ... and so on. Total income increase = ₹100 / (1−0.8) = ₹500 crore. Significance in economic policy: 1. Justifies fiscal stimulus: During a recession, a government can increase spending by a relatively small amount and generate a much larger increase in national income and employment — this is the basis of Keynesian fiscal policy. 2. Policy effectiveness depends on MPC/MPS: A higher MPC → higher multiplier → more powerful fiscal policy. A lower MPC (people save more) → lower multiplier → less powerful fiscal stimulus. 3. Tax multiplier: Tax cuts also work through the multiplier, but the tax multiplier = −MPC × k, which is smaller in magnitude than the government spending multiplier. 4. Limitations: The multiplier assumes prices are fixed (Keynesian assumption), there is spare capacity, and there are no leakages through imports or taxes. In practice, the multiplier is smaller than the theoretical value.

Equilibrium Income in a Two-Sector Economy: • In a Keynesian two-sector economy (only households and firms, no government, no trade), equilibrium national income is determined where: Aggregate Demand (AD) = Aggregate Supply (AS = Y) i.e., C + I = Y • Equivalently, at equilibrium: Planned Saving (S) = Planned Investment (I) (since Y − C = S, and Y = C + I implies S = I) Adjustment to equilibrium: • If AD > Y (planned spending > output): Firms' inventories fall below desired levels → firms increase production → income rises until AD = Y. • If AD < Y (planned spending < output): Firms' inventories accumulate → firms reduce production → income falls until AD = Y. Full Employment Output (Yf): • The level of output at which all resources (especially labour) are fully employed — no cyclical unemployment. • Keynesian insight: The economy may reach equilibrium below full employment (as in the Great Depression). Deflationary Gap (Recessionary Gap): • A deflationary gap exists when the equilibrium level of income (Ye) is LESS than the full employment level (Yf). • i.e., Ye < Yf — the economy is in recession; there is unemployment. • AD is insufficient to generate full employment output. • Deflationary Gap = Full employment AD − Actual AD at full employment income. • Policy remedy: Expansionary fiscal policy — increase government spending or reduce taxes to raise AD and close the gap. Inflationary Gap: • An inflationary gap exists when the equilibrium level of income (Ye) would be GREATER than full employment output — i.e., AD exceeds what the economy can supply at full employment. • Since output cannot increase beyond full employment, excess demand causes prices to rise (inflation). • Inflationary Gap = Actual AD at full employment income − Full employment AD. • Policy remedy: Contractionary fiscal policy — reduce government spending or raise taxes to reduce excess AD.