Determination of Income and Employment

8/13/2019 Determination of Income and Employment

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DETERMINATION OF INCOME AND EMPLOYMENT

Aggregate demand, aggregate supply and their !mp!nents

A""RE"ATE DEMAND AND IT#$ COMPONENT$ %

Aggregate demand in an e!n!my is measured in terms !& t!tal e'penditure !n all

the g!!ds and ser(ies in the e!n!my as a )h!le(It is different from market demand.

Market demand refers to the demand for one commodity in the market)

Note: While measuring AD we always refer to planned ependiture (also called e! anteependiture) "y the people.

C!mp!nents !& aggregate demand %

#he components of aggregate demand are $

*+ Pri(ate !nsumpti!n demand C+ % It re&ers t! the t!tal am!unt !& e'penditure

inurred -y the h!useh!lds !n the purhase !& g!!ds and ser(ies &!r !nsumpti!n

purp!ses.

It is also called as the household consumption ependiture. %enerally it depends on the

le&el of disposa"le income in the economy. 'igher the le&el of disposa"le income higher

is the pri&ate consumption ependiture and &ice &ersa.

/+ Pri(ate In(estment demand I+ 0 It re&ers t! the t!tal am!unt !& e'penditureinurred -y the pri(ate in(est!rs !n urrently pr!dued apital assets1 real assets

li2e -uildings, mahines, ra) materials et. )hih help in pr!duti!n.

In&estment implies increase in the stock of capital goods or capital formation (In&estment apital formation) *ate of interest is the principal determinant of in&estment. 'igher

rate of interest generally implies lower in&estment ependiture.

3+ "!(ernment e'penditure "+ % "!(ernment demand &!r g!!ds and ser(ies

re&ers t! the t!tal am!unt !& e'penditure inurred -y the g!(ernment !n the

purhase !& !nsumer and apital g!!ds t! ater t! the !mm!n needs !& the s!iety.

%o&ernment ependiture thus includes "oth go&ernment consumption ependiture and

go&ernment in&estment ependiture. %o&ernment consumption ependiture is likeependiture o n purchase of consumption goods for military use. %o&ernment in&estment

ependiture is like ependiture on construction of roads+ dams+ "ridges etc. In&estment

ependiture "y the go&ernment is generally not profit oriented. ,ocial welfare is the


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prime consideration. ,uch an in&estment is called aut!n!m!us in(estment !rindependent in(estment.

4+ Net E'p!rts ' % m+ % It is the di&&erene -et)een e'p!rts and imp!rts.

-ports refer to the demand for domestically produced goods "y the rest of the world.

Imports refer to the demand "y our residents for the goods produced a"road.

Accordingly+ ependiture "y foreigners on our goods is added to AD (or total

ependiture) in the economy+ while ependiture on imports is su"tracted. #hus+ it is $ m

(net eports) which is added to AD.

-penditure on imports is determined "y the income le&el of our residents+ while

ependiture on our eports is determined "y the income le&el of the rest of the world.

*elati&e prices (i.e. price of eports in relation to imports) are also another determinant of

net eports.

#hus AD can "e estimated as follows $

AD 5 C 6 I 6 " 6 ' % m+

Imp!rtant N!te7 eynes considers /ust 0 principal components of AD. According to

eynes AD is the sum total of and I. eynes focused on closed economy with no

eports1imports. According to eynes AD 2 I)

8eha(i!r !& AD !r aggregate demand &unti!n %

Aggregate demand depends upon the le&el of income. %reater the le&el of income+

greater the purchasing power and therefore+ greater the demand. ,o+ as the income

increases+ aggregate demand tends to rise. 3ut two things need to "e noted here $

4) #here is always some minimum le&el of demand e&en when income is 5ero.

3ecause for sur&i&al+ we must eat something+ and so demand something e&en

when we ha&e to "orrow from others or draw on our past sa&ings. #his is called asautonomous consumption

0) As income rises demand also rises+ "ut after a particular le&el of income is

reached people start sa&ing a part of their income. ,o the ependiture tends to lag"ehind the rising income. In other words the rate at which the income increases

eceeds the rate at which ependiture increases.


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A""RE"ATE $9PPLY AND IT#$ COMPONENT$ %

According to eynes+ aggregate supply (A,) refers to aggregate production as planned"y the producers during an accounting year. It is the money &alue of final goods and

ser&ices or national product produced in an economy during an accounting year.

We know+ production of goods and ser&ices implies 6&alue addition7+ and &alue addition

implies 6income generation7. According to National Income Accounting 6&alue added and

6income generated7 are identical to each other. #herefore+ A, also implies flow of incomein the economy during an accounting year.

:e an thus de&ine A$ as &l!) !& g!!ds and ser(ies as planned -y the pr!duers

during an a!unting year. It is idential )ith the &l!) !& in!me during an

a!unting year.

A, refers only toplanned production. It is also called e' % ante pr!duti!n.

According to eynes A, is determined "y (i) le&el of employment of resources and

(ii) 8e&el of technology. 3ut in short run technology remains constant. #herefore le(el !&

empl!yment is ta2en as the s!le determinant !& the le(el !& pr!duti!n. In &at le(el

!& empl!yment and le(el !& pr!duti!n are ta2en as idential t! eah !ther.

;eynes assumes A$ t! -e per&etly elasti. It means that production in the economy

always adapts itself to the le&el of AD. If the le&el of AD is high+ production tends to "e

high9 if the le&el of AD is low+ production tends to "e low. This is p!ssi-le -eause

;eynes assumes that in the e!n!my res!ures are !&ten n!t &ully empl!yed. ,o longas resources are a&aila"le+ they can "e employed to cope with the le&el of AD in the

economy.

"e!metrially, A$ is sh!)n as a 4< degree line &r!m the !rigin. #his is "ecause+ each

point on A, shows the same &ertical distance as hori5ontal distance on ais+ showing

the le&el of income

4< degree line is als! the line !& re&erene sh!)ing the e=uality -et)een AD !n the

Y a'is+ and A$ !n the > a'is+

Diagram


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We can thus sum up A, as follows $

4) A$ is the &l!) !& g!!ds and ser(ies as planned -y the pr!duers during an

a!unting year. It is idential )ith the &l!) !& in!me during an a!unting year.

0) A, refers only toplanned production. It is also called e $ ante production.

;) Le(el !& empl!ymentis taken as the s!le determinant !& the le(el !& pr!duti!n. In

fact le&el of employment and le&el of production are taken as identical to each other.


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;) Income distri"ution


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#he relationship "etween consumption and income is called as the consumption function.

onsumption function can "e represented "y following eCuation $ B

C 5 C 6 -y

3ased on these o"ser&ations we can eplain the consumption function through the

following schedule and diagram.

C!nsumpti!n Funti!n $hedule

In!meRs Cr!res+ C!nsumpti!n Rs Cr!res+

0

4 0>

0 ;

; ;>

#he a"o&e ta"le shows that $

4) onsumption ependiture is *s 0 rores e&en when income is 5ero. #his correspondsto the minimum le&el of demand.

0) onsumption ependiture rises with e&ery rise in the le&el of income.

;) After a certain le&el of income is reached (*s rores. 8ikewise+ onsumption ependiture rises only to *s >rores while income shoots up tot *s ? rores.

Diagram

In the a"o&e diagram income is represented on E ais and onsumption ependiture

on E ais

If was to increase at the same rate as or if was always eCual to then cur&e

would ha&e merged with the cur&e. 3oth cur&es would ha&e "een the same. 3ut it is


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ne&er like that. starts from 0 on the ais indicating minimum le&el of consumption

e&en when income is 5ero (autonomous consumption)

With reference to the a"o&e diagram+ we may note the following o"ser&ations $

4) E is the minimum le&el of consumption. It must "e incurred e&en whenincome() "ecause sur&i&al needs consumption

0) line or consumption function line constantly mo&es up showing a rise in

consumption as income rises;) at point -+ which therefore is the "reak e&en point.


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*+ A(erage Pr!pensity t! C!nsume %

It is the rati! -et)een t!tal !nsumpti!n C+ and t!tal in!me Y+ at a gi(en le(el

!& in!me in an e!n!my. It is the pr!p!rti!n !& in!me that is !nsumed.

APC 5 C1Y

Hor eample+ if income () is 4 and consumption () is + then A= will "e!

A= 1 14 . or pre cent

#his indicates that at any gi&en le&el of employment in an economy+ J of income

is spent "y way of consumption ependiture.

APC an -e greater than * in a situati!n )hen CBY.+

/+ Marginal Pr!pensity t! C!nsume %

It is the rati! -et)een hanges in C!nsumpti!n C+ t! a hange in In!me Y+.

It is denoted as follows $

MPC 5C1Y

Hor eample+ if income of a country increases from *s 4 rores to *s 4+0 rores

and the consumption ependiture increases from *s rores to *s K rores then it

means the change in income "y *s 0 rores has caused change in consumptionependiture "y *s 4 rores. M= will therefore "e $

M= L1L 410 .> or >J

PROPEN$ITY TO CON$9ME

A&erage

=ropensity toonsume

A= 1

!

Marginal

=ropensity toonsume

M= L1L


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"enerally MPC is greater than and less than *. MPC an n!t -e greater than *

-eause hange in !nsumpti!n an n!t -e m!re than hange in in!me. The part !&

inrease in in!me )hih is n!t !nsumed is e=ual t! sa(ing.

$a(ings &unti!n %

$a(ing &unti!n e'presses the relati!nship -et)een the le(el !& sa(ing and the le(el

!& in!me. Income is eitherspent on consumption or it is sa&ed i.e. 2,

$a(ing is de&ined as the e'ess !& in!me !(er !nsumpti!n e'penditure.

#herefore $ 5 Y % C

,a&ings function is the counterpart of consumption function. It relates to the le&el of

sa&ings to the le&el of income.

$ 5fY+

As income increases so does sa&ings. ,a&ings how e&er can "e "oth positi&e and

negati&e.

,a&ings function can "e epressed with the help of the eCuation gi&en "elow $

B B

$ 5 0C 6 MP$+ Y OR $ 5 0 C 6 *0-+ Y

Where Where+ (4!") M=,

, ,a&ings

B! Dissa&ings at 5ero le&el of income

Income

,a&ings function can "e eplained with the help of the following schedule and diagram!

$a(ings Funti!n

In!meRs+ C!nsumpti!n

E'penditureRs+

$a(ings Rs+

> (!) >

4 4

0 4> >

; 0 4

4>

> ; 0


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Diagram

4) In the a"o&e diagram+ sa&ings function is a straight line "eginning on ais "elow the

origin. At le&el of income sa&ing is negati&e. #his is "ecause consumption at le&el of

income is positi&e (autonomous consumption)

0) #he sa&ings function intersects the ais at point -. At this point sa&ings is eCual to

5ero "ecause consumption is eactly eCual to income. #his is the "reak e&en point.

;) At any point to the left of -+ there is dissa&ing "ecause consumption is greater than

income


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*+ A(erage Pr!pensity t! $a(e AP$+ 0

It is the rati! -et)een t!tal sa(ing $+ and t!tal in!me Y+ at a gi(en le(el !& in!me

and empl!yment in the e!n!my.

It can "e epressed as follows $

AP$ 5 $1Y

Hor eample if Income () is *s 4 and sa&ing is *s


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Hor eample if income rises from *s 4 rores to *s 0 rores and conseCuently

sa&ing , rises from *s 0 rores to *s rores then change in income *s 4 rores(0 $ 4 4) and change in sa&ing *s ? rores( $ 0 ?). M=, will

therefore "e $

M=, L, 1 L ?14 .? or ?J

It indicates that ?J of additional income is sa&ed.

RELATION$IP 8ET:EEN APC AND AP$ 0

A(erage Pr!pensity t! C!nsume APC+ %

It is the ratio "etween total consumption () and total income () at a gi&en le&el of

income in an economy. It is the proportion of income that is consumed.

A= 1

A(erage Pr!pensity t! $a(e AP$+ %

It is the ratio "etween total sa&ing (,) and total income () at a gi&en le&el of income and

employment in the economy.


A=, ,1

We know that $

A= 1

A=, ,1

We also know that $

2 ,

,o+A= 2 A=, 1 2 ,1

2 , 1

1 4

Er

A= 2 A=, 4

Er


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A= 4 $ A=,

And

A=, 4 ! A=

RELATION$IP 8ET:EEN MPC AND MP$ %

Marginal Pr!pensity t! C!nsume MPC+ %

It is the ratio "etween changes in onsumption (L) to a change in Income (L). It is

denoted as follows $

M= L1L

Marginal Pr!pensity t! $a(e MP$+ %

It is the ratio "etween change in sa&ing (L,) caused "y change in income (L).


M=, L, 1 L

We know that

M= L1L

And

M=, or (4!") L, 1 L

We also know that

L L 2 L,

,o+

M= 2M=, L1L 2 L, 1 L

L 2 L, 1 L

L1L 4

ErM= 2M=, 4

M= 4 $ M=, And

M=, 4 $ M=

%enerally M= is greater than and less than 4. M= can not "e greater than 4 "ecause

change in consumption can not "e more than change in income. #he part of increase in

income which is not consumed is eCual to sa&ing. #hus+ the aggregate of Marginal


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=ropensity to onsume and Marginal =ropensity to ,a&e is eCual to unity. If half of the

increase in income is spent on consumption+ then !

M= O#herefore

M=, 4 $ M= i.e. 4 $ O .>

Question) Draw a diagram showing straight line Saving curve for an economy. From it

derive Consumption curve. Show a point on the Consumption curve at which Average

Propensity to consume is equal to .

4) In the a"o&e diagram+ sa&ings function is a straight line "eginning on ais "elow the

origin. At le(el !& in!me sa(ing is negati(e. #his is "ecause !nsumpti!n at le(el

!&in!me is p!siti(e aut!n!m!us !nsumpti!n+E is the minimum le&el of

consumption. It must "e incurred e&en when income() "ecause sur&i&al needs

consumption


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0) #he sa&ings function intersects the ais at point -. At this point sa(ings is e=ual t!

er!"ecause !nsumpti!n is e'atly e=ual t! in!me. onsumption cur&e passesthrough the income cur&e . At point -+ . #his is the -rea2 e(en p!int.

;) =rior to point -+ CBY: a situation of -!rr!)ing !r negati(e sa(ing


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undertaken on the "asis of epected demand or epected returns to the producers.

In&estment is undertaken in anticipation of future demand.

/+ C!st !& in(estment$ It has three components !

i) ost of purchase of eCuipment+ also called the supply prieof eCuipment

ii) ost of maintenance of eCuipment+ also called depreiati!niii) ost of funds "orrowed for in&estment+ also called the interest rate.

3+ 8usiness e'petati!ns$ In&estment is present ependiture for future gains. 3ut futureis uncertain. #herefore "usiness epectations "ecome significant for in&estment

3usinessmen may ha&e $

i) 8earish e'petati!ns+ implying that they epect the prices to go down in the nearfuture

ii) 8ullish e'petati!ns+ implying that they epect the prices to go up in the near future

3ullish epectations attract more in&estment

Numerials

4) Hind out the marginal propensity to consume from the following data

In!me Rs+ C!nsumpti!n Rs+4+ 4+>

0+ 0+

,olution $

In!me

Rs+

Change in

In!meRs+

Y+

C!nsumpti!n

Rs+

Change in

C!nsumpti!nRs+

C+

4 ! 4> !

0 0! 4 4 0 0!4> >

M= L1L >14 .>

M= .>


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0) Hind the M= from the following

In!me Rs+ $a(ing Rs+

4 ?

0 4

,olution

In!me

Rs+

Change in

In!meRs+

Y+

$a(ing

Rs+

C!nsumpti!n

Rs+

Change in

C!nsumpti!nRs+

C

Answer $ .?

;) Hind M= and A= from the following

4) Initial consumption $ *s

;) Income at the "eginning of the year $ *s 4+

+(Ans $ M= .0 A= .< on

initial income)


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>) alculate M= and M=, from the following

In!me Rs+ 4> 0

C!nsumpti!n Rs+ 4; 4@

(Ans $ M= . M=, .0)

?) omplete the following ta"le

Le(el !& in!me

Rs+

C!nsumpti!n

E'penditure Rs+

MPC MP$

* %MPC+

@

(Ans! M= !+ .+ .@>+ .@

M=, !+ .0+ .0>+ .;)

@) (i) 'ow much is the M= in an economy in which the M=, is .; (ii) 'ow much is the M=, in an economy where the M= is .

Ans) (i) M= 4 $ M=,

4 $ .; .@

(ii) M=, 4 $ M=

4 $ . .0

) If the disposa"le income is *s 4 rore and consumption ependiture is *s @>rore+ find the A=,.

Ans) , $

*s 4 rore $ *s @> rore *s 0> rore

A=, ,1 0>14 .0>

K) What is the &alue of M= when M=, is 5eroPAns) M= 4

4) Eut of A= and M=+ the &alue of which can "e greater than 4 and whenPAns) A= can "e greater than 4 in a situation when F

44) What can "e the maimum &alue of M=,P

Ans) #he maimum &alue of M=, can "e 4(one)

40) Why can M= not "e greater than 4P

Ans) It is "ecause the change in consumption can not "e greater than change in income.


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4;) ,uppose consumption eCuals + In&estment eCuals I *s ? and

2 I. Hind $ (i) the eCuili"rium le&el of income (ii) 8e&el of consumption

(iii) 8e&el of sa&ing at eCuili"rium

Ans) (i) y 2 ?

B 2 "y 2 I

$ .@> 4 .0> 4

441 0>


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4>) ,uppose consumption function 0 2 .>+ in&estment eCuals I > and 2I

Hind $ (a) #he eCuili"rium le&el of income (") 8e&el of consumption at eCuili"rium

(c) 8e&el of sa&ings at eCuili"rium

(Ans! (a) 4)

4@) If planned consumption eCuals + find the

eCuili"rium le&el of income (Ans $ *s K)

4) If sa&ing function is , ! 4> 2 .4>y and planned in&estment is *s @>+ find the

eCuili"rium le&el of income and sa&ings(Ans $ *s?+ , *s @>)

(N!te0*emem"er eCuili"rium condition is , I)


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Determination of Income and Employment

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Transcript of Determination of Income and Employment