Income Determination Class 12 Notes Economics Part B Chapter 4

Lesson at a Glance

• Aggregate Demand: Aggregate demand means the total demand for final goods and services in the economy. Since aggregate demand is measured by total expenditure of community on goods & services, therefore, it also means the total amount of money which all sections are willing / planning to spend on purchase of goods and services produced in an economy during a given period. Aggregate demand is synonymous with aggregate expenditure.

• Components of AD: AD = C + I + G + (X-M)

Private consumption expenditure (C) : It is defined as the value of all goods and services that households are willing or planning to buy. Alternatively, it refers to ex-ante (planned) consumption expenditure to be incurred by all households on purchase of goods and services.

• Private Investment Expenditure (I): It refers to planned (ex-ante) expenditure on creation of new capital assets like machines, buildings, raw material by private entrepreneurs. It comprises of expenditure on (a) fixed assets of business like machinery, building etc.; (b) inventory and (c) residential construction.

• Government Demand for goods and services (G): It refers to government planned (ex-ante) expenditure on purchase of consumer and capital goods to fulfill common needs of the society. It includes schools, transports, hospitals, roads,power, health etc.

Net Exports: (X – M): Net export demand is defined as aggregate of all demand for our goods and services by foreign countries over our country’s demand for foreign countries’ goods and services.Net exports = Exports (X) – Imports (M)

Note: For the purpose of our study, it is assumed that there is neither foreign trade nor government; therefore AD has only two components i.e. private consumption and private investment.
AD = C + I

In the figure, AD curve has been shown as the sum of consumption & investment.
(a) AD curve has a positive slope which means when income rises AD also rises.
(b) AD curve does not originate at point O which shows that even at zero level of income, some minimum level of consumption is essential.
(c) Investment curve is a straight line parallel of x-axis because according to Keynes, level of investment in an economy remains constant at all levels of income during short period.

Aggregate Supply: Aggregate Supply is the money value of final goods and services planned to be produced by an economy during a given period. In other words, AS is the aggregate value of total output which is planned to be produced in an economy. It is the aggregate cost of total output. It is Net National Product at Factor Cost i.e. National Income.

• Components of AS : Main components of aggregate supply are consumption (C) and saving (S). A major portion of income is spent on consumption of goods and services and the balance is saved. Thus
AS = C + S
Or Y = C + S
AS = National Income

Aggregate Supply or National Income has been shown on x-axis and total spending i.e. consumption + saving on y-axis.AS curve is artificially represented by a 45° line from the origin. Because every point on this line is equidistant from x-axis and y-axis. In other words, each point on this line indicates Expenditure (AD) = Income (AS).

Consumption Function (Propensity to Consume) :The functional relationship between consumption and income is called consumption function or propensity to consume. It refers to the schedule which shows the level of consumption at different levels of income. In other words, it means the proportion of income spent on consumption. Since consumption directly depends upon income. Thus consumption (C) is a function (f) of income (Y). symbolically:
C = f (Y)

There are two main features of consumption function:

1. At zero level or very low level of income, consumption expenditure is higher than income as minimum consumption is necessary for survival. This is called autonomous consumption.
2.As income increases, consumption expenditure also increase but in less proportion. It means additional consumption (DC) is less than additional income (DY) or DC / DY (Marginal propensity to consume i.e. MPC) is less than 1. Consumption function equation: Consumption function is represented by the following equation:
C = C + bY

Where C represents total consumption, C represents autonomous consumption, b shows MPC, Y represents income. Thus, total consumption comprises of two components i.e. autonomous consumption and induced consumption (bY).The figure shows the consumption function curve. It slopes upward.

The propensity to consume is of two types:
(a) Average Propensity to Consume: APC is defined as the ratio of aggregate consumption expenditure to aggregate income

(b) Marginal Propensity to Consume: MPC is defined as the rate of change in aggregate consumption expenditure as aggregate income changes. Symbolically,

If income rises from 100 crores to120 crores and consumption rises from 40 crores to 50 crores then MPC = 10/20 = 0.5 or 50%.

• Saving Function / Propensity to Save: It shows the relationship between income and saving. It is the proportion of income saved. Saving is a function of income. Symbolically: S = f(Y)

There are two main features of saving function:
1. Saving can be negative at zero or low level of income.
2. As income increases, saving also increases but not more than the increase in income. S = Y – C
Saving Function Equation: It shows the relationship between income and saving. Saving is that part of income which is not spent.
S = Y – C

Saving function can be derived from consumption function.
S = Y – C
– –
S = Y – (c + bY) (C = c + bY)
S = Y – c – bY

S = – c + (1 – b) Y
The saving function curve has been shown in the figure. It is a straight line because slope of saving is constant. The curve slopes upwards which depicts direct relationship between income and saving. The point where savings are zero is called Break-even point. At this point consumption is equal to income. Savings are negative to the left of BEP and positive towards its right.
Saving function is of two types:

(a) Average Propensity to Save: APS is defined as the ratio of aggregate saving expenditure to aggregate income. Value of APS can be negative.

(b) Marginal Propensity to Save: MPS is defined as the rate of change in aggregate saving expenditure as aggregate income changes. Value of MPS varies from zero to one.

Relationship between APC & APS and MPC & MPS:
APC + APS = 1
MPC + MPS = 1

It is so because out of the total income, a person can either spend or save or partly do both. If 60% of total income is spent then it means that 40% of it is saved. The same applies in the case of increase in income also.

Derivation of Saving curve from Consumption curve

Savings at different levels of income can be obtained by taking the vertical difference between the consumption curve and income curve. It has been shown in the figure above also. When consumption curve lies above the income curve then there are dis-savings or negative savings and when consumption curve lies below the income curve then there are positive savings. When these curves intersect then there are zero savings.

Investment Function: Investment function is the behaviour of investment corresponding to different levels of income. Investment means expenditure made on purchase of new capital assets like machines, tools, equipments etc. It means an addition to existing stock of assets to increase productive capacity of an economy.

According to Keynes, volume of investment depends upon

  1. marginal efficiency of capital (MEC is the rate of return from marginal unit of capital) or rate of return and
  2. rate of interest. Firms undertake investment as long as return form investment is greater than cost. There are following two types of investment:

(a) Induced Investment: This investment is made with the motive of earning profit as done by private sector. It is a positive function of national income i.e. it changes directly with change in national income. It is income elastic. However, it is an inverse function of rate of interest. It changes inversely with the change in rate of interest. Induced investment curve is like supply curve. It has a positive slope.

(b) Autonomous Investment: It is an investment which is to be done irrespective of level of income and rate of interest. It is income inelastic. It is a straight line parallel to the income axis. In our study we have assumed investment to be autonomous investment. It is generally done by the government.

• Full Employment: It refers to a situation in which every able-bodied person who is willing to work at the existing wage rate is, in fact, employed. Full employment implies an absence of involuntary unemployment. In other words, under full employment situation, the entire labour force in the economy is employed. The labour force is that part of the population of the country which is physically & mentally able and willing to work.

• Voluntary Unemployment: It refers to those people who are not willing to work although; sustainable work is available for them. In other words, they are voluntarily unemployed. They are not included in labour force of the country.
• Involuntary Unemployment: It occurs when those who are willing and able to work at the existing wage rate, do not get suitable work. According to Keynes, involuntary unemployment arises due to insufficiency of effective demand which can be solved by increasing the aggregate demand through government intervention.
• Full Employment income level: It is the potential income level that can be achieved when resources of an economy are fully employed. It is the maximum that an economy can achieve with the available resources in the long run.
• Ex-ante & Ex-post: Ex-ante means planned or desired or intended during a particular period. For example: ex-ante investment means the planned investment during a particular period.
•Ex-post means actual or realized during a particular period. For example: ex-post investment means actual or realized investment.


AD- AS approach / Consumption – Investment Approach:
According to Keynes, equilibrium level of national income is determined at a point where Aggregate Demand equals Aggregate Supply. Symbolically, Equilibrium condition is given as:
C + I = C + S

In the figure, AD is Aggregate Demand Curve.AS is the Aggregate Supply curve.E is the point of equilibrium OY is the equilibrium level of national income Effective Demand is EY at equilibrium level of national

Adjustment mechanism when AD is not equal to AS.

(a) AD < AS: In this situation the economy will face recession. It means planned demand is less than planned production. There will be unsold stock of goods. The producer will reduce the factors of production to cut down the level of output. This will reduce the income level till AD and AS once again becomes equal. Then equilibrium is achieved again. It can be concluded that when AD < AS then National income tends to fall.

(b) AD > AS: In this situation, there will be excess demand and producers will earn abnormal profits. It means planned demand is more than the planned production. In this case there will be a fall in the stock of goods with the producers. Hence, they will expand their output which will raise the income level. The income level will rise till AD once again becomes equal to AS and equilibrium is achieved. Hence, when AD>AS then national income tends to rise.

Saving Investment Approach: According to Keynes, equilibrium level of national income can be alternatively determined by the point where planned investment equals planned savings. Both AD = As and S = I
give same level of national income equilibrium because:
C + I = C + S
S = I
Or planned savings = Planned investment
Or Ex- ante savings = Ex-ante investment
Equilibrium level of national income is shown in the figure given below with the help of Saving – Investment approach.

Investment is assumed to be autonomous investment which is same irrespective of level of national income. Saving curve starts from a negative intercept equal to autonomous consumption which is the level of consumption at zero level of national income. Economy is in equilibrium when S = I at point Q.

Adjustment mechanism when Savings are not equal to Investment.

If S < I: When investments are more than savings, it means households are saving less than what firms are willing to invest. In other words, buyers are planning to spend more what the producers are planning to invest. Output would fall short of demand. To cope up, firm will plan to expand its investment and production. It will hire more factors. This will raise the income levels to the equilibrium level of

If S > I: When savings are more than the investment, then the households is saving more than what the firms are wanting to invest. In other words, buyers are not spending to match investment plans of the producers. As a result, some goods would remain unsold. To cope with the situation, lesser output would be planned for the following year, implying lesser investment, lesser production, lesser income and lesser saving. This will reduce national income level to equilibrium level of income where planned saving is equal to planned investment.

Simultaneous Equality between AD & AS approach and S & I approach

The figure shows equality between AS & AD as well as S & I.
Equilibrium is attained at point E where AD = AS & S = I.

Keynesian Theory:
An economy can be in equilibrium even at less than full employment level: Economic system does not ensure automatic equality between AD & AS at full employment as believed by classical. He proved that economy could be in equilibrium at less than full employment level. This is the basic difference between Classical theory and Keynesian theory.

Assumptions of the theory:

1. Demand creates its own supply: Aggregate demand for goods & services directly determines the level of output, income & employment. If AD increases, level of output will go up by increasing employment of resources to meet the increased demand and as a result income will also go up. Thus, demand creates its own supply.

2. Rigid wages and Prices: Government intervenes through minimum wage laws to fix wages when supply of labour is more. It results in involuntary unemployment. Government also intervenes to fix the prices of essential commodities through various policies.

3. Constant MP of labour: If MP of each labour is constant and Wage rates are also same then it means that each additional unit cost the same to the producer.

Investment Multipier

Meaning: It is the measure of change in national income as a result of change in investment. In other words, multiplier is that number which when multiplied by the amount of change in investment gives us the value of consequent change in income. When there is an increase in investment, national income increases not by the amount of investment but by a multiple of it. Measure of it is called multiplier.
ΔY = K x ΔI or
Where K = Multiplier
ΔY = Change in National Income
ΔI = Change in Investment
Excess Demand

When in an economy, aggregate demand is in excess of aggregate supply at full employment, the demand is called excess demand. The gap between AD and AS is then called inflationary gap since it causes inflation in the economy. Inflationary Gap: When there is excess demand at full employment level, it cannot be fulfilled by increasing AS by corresponding amount. It leads to inflation in such a case. In such a case an increase in demand means only increases in money expenditure without any corresponding increase in output and employment because all the resources are fully employed.

The situation of inflationary gap has been shown in the future. Point E is the equilibrium point which is an ideal situation. Here, AD is represented by EM which is equal to full employment level of output i.e. OM. Suppose, the actual aggregate demand is for a level of output BM which is greater than full employment level of output. The difference between the two is BE which is a measure of inflationary gap.In short, inflationary gap is the amount by which the actual AD exceeds the AD required to establish full employment equilibrium.

Deficient Demand
It refers to the situation when AD is less than AS corresponding to full employment level of output in the economy. This situation arises when planned aggregate expenditure falls short of aggregate supply at the full employment level.

Deflationary Gap
In an economy when AD is than AS at full employment, then the deficiency or gap is called deflationary gap. It is a measure of amount of deficiency in AD.
The situation of deflationary gap has been shown in the figure. Point E is the point of equilibrium. Here, AD is represented by EM and AS by OM. Suppose the actual demand is for a level of output OM1 which is less than full employment level of AS i.e. OM. The difference between the two is EB which is a measure of deflationary gap or deficient demand.

Measures to control the situation of excess and deficient demand
There are two policy measures to deal with the problems of deficient and excess demand.

1. Fiscal Policy Measures: Fiscal policy is the expenditure and revenue policy of the government. These measures are also called change in government spending. The main tools of fiscal policy are:

(a) Revenue Policy: The main source of revenue to the government is through taxes.

  • In the case of excess demand or inflation government raises the rates of all taxes, especially on the rich people. This reduces the purchasing power of people and reduces both consumption & investment expenditure. Thus AD gets reduced.
  • In the situation of deficient demand, the government reduces the rates of taxes. It will increase the purchasing power of people and thy will spend more on consumption & investment. Thus AD will rise and producers will increase the production.

(b) Expenditure Policy: Government spends huge amount on public works like construction of roads, flyovers, buildings etc. changes in such expenditure directly affects the level of AD.

  • In the situation of excess demand, government reduces its expenditure. It will result in a fall in demand for goods & services.
  • In the situation of deficient demand, government increases its expenditure. It will result in the rise in demand for goods & services.

(c) Deficit Financing: It means printing of new currency notes to finance the deficits in budget.

  • In the situation of excess demand, government should reduce deficit financing to bring the excess demand down.
  • In the situation of deficient demand, government should encourage deficit financing so that demand can be increased.

2. Monetary Policy Measures: It is the policy concerning money supply and availability of credit in an economy. These measures are also called change in availability of credit. Central bank is officially authorized to design the monetary policy in the country. Therefore, it is also called Central Bank’s Credit Control Policy. Various instruments that help in controlling credit are called instruments of monetary policy. Such instruments can be:

Quantitative credit control instruments: As the name suggests these are the instruments that affect the total volume i.e. total quantity of the credit.

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