DETERMINATION OF INCOME AND EMPLOYMENT
Aggregate demand is defined as the total willingness of all the sectors of an economy who demand goods and services in an economy in a given period.
It is the total amount of money which the buyers are ready to spend on the purchases of goods and services produced in an economy produced in a given period.
It includes all the expenses made by household, firms, govt, and rest of the world on an economy’s output.
The main Components of AD are :
- Consumption Demand
It is the total expenses that all the households in an economy are willing to incur on the purchase of goods and services for their personal consumption in a given time period. The determinant of private consumption demand is the disposable income of the primary household.
- Investment Demand
This refers to the desired demand for capital goods by private investors during a given period of time. Investment means the addition to the capital stock or the expenditure incurred for the creation of new capital asset of the country such as building, plant and machinery. Investment helps the economy to grow.
- Government Demand
It refers to the government’s willingness to the purchase of goods and services in a given time period. Government purchases are of two kinds:
(a) Consumption spending
(b) Investment spending
The primary determinant of the extant of govt, demand for goods and services is the objective of social welfare.
- Net Export Demand (X-M)
Net Export demand is the demand by the rest of the world for the goods and services of the consumer in a given period of time. It is the difference between country’s export and import. Exports reflect the willingness of the foreigners to purchase country’s goods and services in a given period of time. Imports are the demand of foreign good by a country.
AD = C + I + G + (X-M)
(1) AD is different at different levels of income. Income and AD is positively related to each other.
(2) AD curve does not originate from the point of origin which shows even at zero level of income, some consumption will take place.
It implies the money value of goods and services that all the producers are willing to supply in the economy in the given period of time.
AS is also known as national income of the country because total output of an economy in money terms is equal to the factor income generated in the economy.
The factor income of wage, rent, interest and profit are paid to the owners ofthe factors of production or households. When all the factor incomes are added, we getdomestic income of the economy. Aggregate supply is nothing else but the national income of the country.
AS = TO=Y
TO = Total Output
Y= National Income
Factor Income earned bv the households will either be consumed or saved.
AS = C + S
When the relationship between income and aggregate supply is represented graphically, we get AS curve. It is also known as income line. (45° line)
CONSUMPTION FUCTION / PROPENSITY TO CONSUME
Consumption function determines the relationship between the income of theconsumer and the level of consumption made by household. Income here means the disposable income.
whereC = Consumption, f= function of and y = Income
Consumption has 2 parts :
(a) First part relates to consumption when income is zero i.e. when minimum level of consumption has to be maintained. This is called AUTONOMOUS CONSUMPTION (Co or C).
(b) Second part of the consumption i.e when the income increases, the consumption also increases but by lesser amount, i.eDC <DY .
BASIS OF CONSUMPTION FUNCTION OR PSYCOLOGICAL LAW OF CONSUMPTION
The law states that as income increases, consumption also increases, but less proportionately than the rise in the income. For e.g. , if the income increases by Rs 20 crores, than consumption may increases by Rs. 10 crores. It implies that with the increases in income, the household tends to save. In other words MPC < 1.
LINEAR CONSUMPTION FUNCTION / CURVE
Under linear consumption function the rate of change of consumption is held constant. It is written as
C = Co+by
where C = Total consumption
Co = Autonomous consumption
b = Marginal propensity to consume
y = Level of income
Y C Linear consumption curve is a straight line.
0 60 starting from the point on Y-axis because even at
100 120 0 level of income, Rs. 60 of consumption takes place.
200 180 The slope of consumption curve (MPC) is constant
300 240 i.e 0.6.
BREAK-EVEN LEVELS OF INCOME
It is the level of income, where it is equal to the consumption. Saving are zero at this point. In the Fig., E is the break-even point where Y = C and S = O.
TWO PROPENSITIES OF CONSUME
MARGINAL PROPENSITY TO CONSUME (MPC)
MPC is the ratio of the change in consumption due to change in income. It measures the extant to which the household consumes additional income in the economy.
MPC is the slope of the consumption curve and its value varies from 0 to 1. If all the additional income is consumed, MPC will be 1. If all the additional income is saved, MPC will be 0.
AVERAGE PROPENSITY TO CONSUME (APC)
APC is defined as the ratio of total consumption to total income.
It is percentage of income which is spend on consumption.
(1) As income increases, APC falls. But, it can never be equal to zero because consumption is never zero,
(2) At break-even point, value of APC is always equals to 1.
(3) At income level lower than the break-even levels, the value of APC is greater than 1.
Difference between APC and MPC
(a) Total consumption divided by total income is APC and change in consumption by change in income is MPC.
(b) When income increases both APC and MPC falls but MPC falls more rapidly.
(c) The value of APC can be greater than 1 but MPC can never be greater than one.
Saving is the residual income that is left after consumption by the households. Saving function is also known as propensity to save which shows the relationship between income and savings in a given time period.
S = f (Y) where S = Saving , f = Function of and Y = Income
(1) As income level increases, savings also increases. It becomes zero before becoming positive.
(2) At break-even level of income, savings are zero, before this level, savings are negative and after this level, it becomes positive.
C = Co + by
Y-S = Co + by
-S = Co + (b-l)y (y = C + S)
S = -Co + (l-b)Y (y-S = C)
SAVING CURVE AND ITS DERIVATION
Graphically savings represents the vertical distance between AS and consumption function curve. In the diagram, savings at zero income level is OA. At OY income level, its BC. By plotting there savings on different diagram, we can derive saving curve.
The lower diagram shows the saving curve which is derived from the upper diagram that shows consumption curve.
In the diagram, before the income level OY1, consumption curve is above the AS curve which means that there is negative or dis-savings. After this level of income, consumption curve is below the AS (45° line) which means positive savings. The point where consumption and AS (45º line) intersects represents zero savings (i.e. savings curve will intersect X-axis).When plotted in the lower diagram, upward sloping saving. Curve is derived. The portion of the curve below X-axis represents dis-savings. The portion above the X-axis represents positive savings and the point on the x-axis represents zero savings.
Types of Propensity to Save
- Marginal Propensity to Save (MPS) :It is defined as the ratio of change in savings due to change in income level. It measures the extent to which households save the income in the economy.
Its value lies between 0 and 1. This is because if additional income is entirely consumed then there is no savings i.e. MPS = 0. If entire additional income is saved MPS = 1.
- Average Propensity to Save (APS) :APS is defined as the ratio of total saving to total income. The value of APS can be negative when consumption exceeds income.
Relationship between APC and APS
Y = C + S
Divide both sides by Y.
1 = APC + APS
1 – APC = APS
1 – APS = APC
Relationship between MPC and MPS
Divided both sides by DY
1 = MPS + MPC
1 – MPC = MPS
1 – MPS = MPC
Investment is that part of income which is used for further production. It does not mean the financial investment i.e. purchase of old machine, shares, bonds, etc.
Induced and Autonomous Investment
Induced Investment : This type of investment is made with the objective of earning profits. It changes with the change in national income because increases in National Income leads to increase in demand for goods and services which in turn induce investors to invest more to meet the rising demand.
The induced investment is determined by :
(a) MEI – It is the expected rate of return from the investment.
(6) Rate of interest at which the funds are borrowed.
Autonomous Investment : Autonomous investment is independent of national income. It is income inelastic. Autonomous investment remains the same for all the levels of income. This investment is influenced by following reasons,
(1) Increase in population
(2) Discovery of new technology
(3) Public utility works such as construction of roads.
Ex-Ante Saving and Ex-Ante Investment
Ex-Port Saving and Ex-Port Investment
Ex-ante saving : Plan to save in a particular period is called ex-ante saving.
Ex-ante investment : Plan to invest in a particular period is called ex-anteinvestment.
If Planned saving > Planned investment
Planned expenditure < Planned output.
Because of less exp., some output will remain unsold. To tackle this problem, lesser output would be planned next year which means less investment, less output and less income. This process will continue till saving and investment are equal.
Ex-post savingsrefers to actual saving. It is called realized savings.
Ex-post investment refers to actual investment made in an economy during a particular time period. It is also called realized investment.
Ex-post saving and Ex-post investment are equal at all levels of income.
Multiplier (Investment Multiplier)
The change in income is the multiple of change in investment. This multiple is known as multiplier. It shows a relationship between initial increase in investment and resultant increase in income. For e.g. If an increase in investment of Rs.lOO Crores causes an increase in income by Rs. 300 Crores. The value of multiplier is 3.
Working of Multiplier:
The working of multiplier is based on the assumption that one man’s expenditure is another man’s income.
Suppose, the govt, of the country, spends Rs.lOO crores on the construction of road (i.e. DI = Rs.100. The first impact is that it increases the income of the workers engaged in the work by
Rs. 100 Crores. Assuming MPC = 0.75. The workers will spend 75 Crores i.e. (0.75 x 100) on consumer goods. The producers of these goods will have an additional income of 75 Crores. This additional income will be spend on goods i.e. 0.75 x 75 = 56.25 crores:
This process will go on till the change in income becomes equal to k times change in investment.
|I II III||100||100
|75 56.25 42.18|
Additional income = 400
The working of multiplier can be shown with the help of the following diagram:
In the graph, AD ÞC + I is Aggregate demand curve, intersecting with AS curve at the point e. Due to the additional investment (DI) AD curve shifts to AD2ÞC + I + DI giving new equilibrium level of income OY1 showing the effect of multiplier.
Relation between Multiplier, MPC and MPS
The value of multiplier (k) depends on the value of MPC and MPS .k and MPC are directly related to each other. There is inverse relationship between k and MPS.
Minimum and Maximum Value of Multiplier
(a) Minimum value of k can be 1 because minimum MPC can be 0.
(b) Maximum value of k can be ¥ (infinity) because maximum MPC can be 1.