Chapter 12- Full notes.

Chapter 12 - Theory of Income and Employment In this chapter, we will study the determinants of Income, output and employment and use the concepts of Keynesian Theory. He developed his concepts based on “Short Run” basis and stated that level of income output and employment depends upon the Aggregate Demand. Aggregate demand and its components Meaning : Aggregate demand is the total amount of goods and services demanded in the economy. It refers to the desired, intended or planned demand or spending of people. It is also known as EX-Ente Demand – That is desired or planned demand. Components of Aggregate Demand A)- Ex- Ante Aggregate Demand (Planned or desired demand) AD is the sum total of desired expenditure of all the sectors in the economy viz Households, producers, Government and foreign buyers. Therefore we can expressed AD as follows • AD = C + I + G + (X-M) Where 1. C= Desired Consumption Expenditure of Households: 2. I= Desired Investment Expenditure by business. 3. G= Desired Government Expenditure on goods and services. 4. X- M= Net Exports (Export – Imports) That's demand from other countries. B) Effective or Ex-post demand Ex post demand is the total amount of goods and services that people actually buy in an economy.

It is actual Aggregate Demand. An economy will be in a state of equilibrium when desired AD and actual AD are equal. Desired AD will happen at the level of full employment. What is level of Aggregate Demand in an Open Economy AD demand in an Open economy : an open economy is that economy which allows exports and imports (International Trade) AD = C + I + G + (X-M) AD in a closed economy AD = C + I Propensity to Consume It shows functional relationship between the desired consumption expenditure and Income. This relationship is also called consumption function. To explain the consumption function, we will discuss two concepts: a) Average Propensity to consume b) Marginal Propensity to consume Average Propensity to consume APC refers to the proportion of income devoted to consumption Average propensity to consume (APC) is the ratio of consumption expenditure (C) and income (Y), which indicates the average percentage of income that is spent on consumption. It can be algebraically expressed as:

APC= If consumption expenditure is Rs 70 crores at national income of Rs 100 crores, Then: APC C/Y = 70/100 = 0.70, i.e. 70% of the income is spent on consumption. In Table we see that at the income level of Rs 100 crores, APC = 1.20. APC falls to 1 when income rises to Rs 200 crores. The value of APC further falls to 0.933 and then to 0.90. In Fig 7.4, income is measured on the X-axis and consumption is measured on the Y-axis. CC is the consumption curve. APC represents any one point on the consumption. At point A on the consumption curve CC, APC = ON/OY1 Important Points about APC: (i) APC can be more than 1: As long as consumption is more than national income, APC > 1. (ii) APC = 1:

When consumption is equal to national income, APC = 1. That is at the income level of Rs 200 crores. (iii) APC can be less than 1: Beyond the equalibirum point (where C=Y), consumption is less than national income. As a result, APC <1. (iv) APC falls with increase in income: APC falls continuously with increase in income because the proportion of income spent on consumption keeps on decreasing and people save a part of their income. (v) APC can never be zero: APC can be zero only when consumption becomes zero. However, consumption is never zero at any level of income. Even at zero level of national income, there is autonomous consumption (c). 2. Marginal Propensity to Consume (MPC): Marginal propensity to consume refers to the ratio of change in consumption expenditure to change in total income. MPC explains what proportion of change in income is spent on consumption. MPC = Change in Consumption (∆C) / Change in Income (∆Y) If consumption expenditure increases from Rs 70 crores to Rs 110 crores with an increase in income from Rs 100 crores to Rs 200 crores, then: MPC = ∆C/∆Y = 110 – 70/200-100 = 40/100= 0.40 i.e., 40% of the incremental income is spent on consumption. Let us understand MPC with the help of following schedule and diagram: Income (Y) Consumption Change in Change in MPC = ∆C/∆Y (Rs Crores) (C) (Rs Crores) Consumption Income (∆Y) 0 (∆C) (Rs (Rs Crores) 40 Crores) -

100 120 80 100 0.80 200 200 80 100 0.80 300 280 80 100 0.80 400 360 80 100 0.80 As seen in Table above, MPC is 0.80, Value of MPC remains same at 0.80 throughout the consumption function. This is because of the simple reason that rise in income and consumption is at a constant rate, the MPC will be constant. As we see income when rises with 100 crores each time and consumption rises with Rs 80, MPC will be 0.80 That is people spent 80% of their rise in income and 20 % is saved. Since MPC {AC/AY} measures the slope of ∆Y /∆Y Consumption curve, constant value of MPC indicates that the consumption curve is a straight line. Important Points about MPC: 1. Value of MPC varies between 0 and 1:

We know, incremental income is either spent on consumption or saved for future use. i. If the entire additional income is consumed, i.e. Savings = 0, then MPC = 1. ii. However, if entire additional income is saved, i.e. Consumption (C) = 0, then MPC = 0 In normal situations, value of MPC varies between 0 and 1. 2. MPC of poor is more than that of rich: It happens because poor people spend a greater percentage of their increased income on consumption as most of their basic needs remain unsatisfied. On the other hand, rich people spend a smaller proportion as they already enjoy a high standard of living. Similarly, MPC of developing countries like India, Bangladesh, etc. is more than MPC of developed countries like America or England. 3. MPC falls with successive increase in income: It happens because as an economy becomes richer, it has the tendency to consume smaller percentage of each increment to its income. However if the rate of spendings (Consumption) remains unchanged, then MPC will be constant. Comparison between APC and MPC: Basis APC MPC Meaning It is the ratio of It is the ratio of change in consumption expenditure consumption expenditure Formula (C) to the corresponding (∆C) to change in income Value more than one level of income (Y) at a (∆Y) over a period of point of time. time. Response to change in APC = C/Y MPC= ∆C/∆Y income APC can be more than MPC cannot be more one as long as than one as change in consumption is more consumption cannot be than national income, i.e. more than change in till the break-even point. income. When income increases, When income increases, APC falls MPC also falls or remains

constant if income and consumption rise at the same rate. Propensity to Save Saving is that part of income which is not spent. Hence S= Y – C where S =Savings, Y= Income , C= Consumption. Propensity to save shows functional relationship between the desired savings and Income. This relationship is also called saving function. Just like consumption function, to explain the saving function, we will discuss two concepts: a) Average Propensity to save b) Marginal Propensity to save 1. Average Propensity to Save (APS): Average propensity to save refers to the ratio of saving to the corresponding level of saving income. APS= If saving is Rs 30 crores at national income of f 100 crores, then: S APS = S/Y =30/ 100 = 0.30, i.e. 30% of the income is saved

In Table 7.7, APS = (-) 0.20 at the income of Rs 100 crores as there is negative saving of Rs 20 crores. APS = 0 at income of Rs 200 crores as saving is zero. In Fig 7.7, income is measured on the X-axis and saving is measured on the Y-axis. SS is the saving curve. APS at point A on the saving curve SS: APS = OR/OY1 Important Points about APS: 1. APS can never be 1 or more than 1: As saving can never be equal to or more than national income. 2. APS can be 0: In Table 7.7, APS = 0 as saving are zero at the income level of Rs 200 crores. This point is known as Break-even point. This happens when Income and Consumption are equal. 3. APS can be negative or less than 1: At income levels which are lower than the break-even point, APS can be negative as there will be disserving in the economy (shown by the shaded area in Fig. 7.7). 4. APS rises with increase in income: APS rises with increase in income because the proportion of income saved keeps on increasing.

Marginal Propensity to Save (MPS): Marginal propensity to save refers to the ratio of change in saving to change in total income. APS=

In Table 7.8 MPS = 0.20 when income increases from zero to Rs 100 Corores. Value of MPS remains constant at 0.20 throughout the saving function. Since MPS (∆S/∆Y) measures the slope of saving curve, constant value of MPS means that the saving curve is a straight line. In Fig. 7.8 MPS at point A with respect to Pint B = ∆S/∆Y = PR/ Y1Y2 MPS varies between 0 and 1 1. If the entire additional income is saved, i.e. ∆C=0, then MPS =1 2. However , if entire additional income of MPS varies between and 1. Relationship between APC and APS: The sum of APC and APS is equal to one. It can be proved as under: We know: Y = C + S Dividing both sides by Y, we get Y/Y = C/Y + S/Y Hence APC + APS = 1 (because income is either used for consumption or for saving. ) Relationship between MPC and MPS: The sum of MPC and MPS is equal to one. It can be proved as under: We know: ∆Y = ∆C + ∆S Dividing both sides by ∆Y, we get ∆Y/∆Y = ∆C/∆Y+∆S/∆Y 1 = MPC + MPS

MPC + MPS = 1 because total increment in income is either used for consumption of for saving. The inter-relationships between APC, APS, MPC and MPS can be verified through the following schedule. Table : APC, APS, MPC, MPS Income Consumption Saving C S APC APS MPC MPS (C) Rs) (Y) (S) (Rs) (Rs) 0 20 -20 - - - - - - 100 110 -10 90 10 1.10 0.10 0.90 0.10 200 200 0 90 10 1 0 0.90 0.10 300 290 10 90 10 0.97 0.03 0.90 0.10 400 380 20 90 10 0.95 0.05 0.90 0.10 500 470 30 90 10 0.94 0.06 0.90 0.10 600 560 40 90 10 0.97 0.07 0.90 0.10 Formulae used: (I) S= Y-C (ii) APC = C/Y = 1- APS (iii) APS = S/Y = 1 – APC (iv) MPC = ∆C/∆Y =1- MPS (v) MPS= ∆S/∆Y = 1- MPC

Linear Consumption Equation C = C + bY Where C = Autonomous consumption or minimum consumption b = MPC and Y = National income and This equation is used to find either C= Consumption, or any other variable. Linear Saving Function Equation S = -- C + (1-b) Y Concept of Induced and Autonomous investment: A ) Induced Investment When investment changes as a result of change in income, it is known as induced investment. A ) Autonomous Investment When the level of investment is not affected by a change in the level of income or output, it is known as autonomous investment (Constant at all levels of income)

Determination of Equilibrium Income and Output (Two sector Model) There are two approached to determining equilibrium Income and Output 1. Aggregate Demand and Aggregate Supply Approach ( AD=AS) 2. Savings and Investment Approach 1 ) Aggregate Demand and Aggregate Supply Approach: According to this approach, equilibrium level of income and output in the economy is reached where the desired Aggregate demand for goods and services is equal to aggregate supply. (AD=AS) Now let us understand how the equilibrium is achieved: Aggregate Demand: In a two sector model AD = C + I that is total desired expenditure of the community.

C stands for household consumption expenditure of households on goods and services. I stands for Investment expenditure of producers on capital goods The following Example shows the behavior of Consumption expenditure and Aggregate demand. Let Autonomous consumption be = 20 (crores)and MPC = 0.5 ( that is half of the rise in income is spent ) and autonomous investment (I) = 10 (crores) National Consumption Investment Aggregate Remarks Tendency of Income Demand Income (Y) = AS (C) (I) (AD) /Ouptut (Crores) (Crores) (Crores) (Crores) 0 20 10 30 AD > AS Expansion 20 30 10 40 AD > AS Expansion 40 40 10 50 AD > AS Expansion 60 50 10 60 AD = AS Equilibrium 80 60 10 70 AD < AS Contraction 100 70 10 80 AD < AS Contraction We see from the above table that consumption rises with rise in income. Income rises by 20 crores but rise in consumption is only 10 crores (MPC being 0.5) Higher the MPC, higher will be rate of rise in consumption. Investment is constant at 10 crores in the short run. It does not change with change in Income. AD= C +I. Aggregate demand rises with rise in income because of rise in consumption. Aggregate supply refers to the value of total output of goods and services produced in an economy in a year. It is equal to value of national product i.e. National Income (Y). It is shown by 450 line starting from the point of origin. In a two sector model,

some part of income is not spent on consumption and is saved. Hence national income (Y) or supply is consumption plus savings. Thus AS= Y = C + S As seen in the table above AD becomes equal to AS at income level of 60 crores (equilibrium level of income) C+I= AD We can see in the diagram above, the AD or (C +1) curve shows the desired level of expenditure by consumers and firms corresponding to each level of output. The economy is in equilibrium at point ‘E’ where (C + I) curve intersects the 45° line (AS= C+S). So, E is the point of equilibrium where desired aggregate demand AD = desired aggregate supply. (AS) At this point of equilibrium, desired aggregate spending is equal to national output. Buyers can fulfill their spending plans, and the firms are able to sell whatever they desire to produce. There are no incentives for the firms to change their output. Therefore, output and income are the same at equilibrium. If there is any deviation from the equilibrium level of output, i.e. when planned spending (AD) is not equal to planned output (AS), then a process of readjustment

will start in the economy and the output will tend to adjust up or down until AD and AS are equal again. What happens when AD <AS (state of disequilibrium) When aggregate demand is greater than aggregate supply, AD < AS, then (C +1) curve lies below the 45° line. It means that consumers and firms together would be buying fewer goods than firms are willing to produce. As a result, the planned inventory would rise (Shown with the gap AB above, when aggregate supply is 80 and demand is 70 ) To clear the unwanted increase in inventory, firms plan to decrease the employment and output until the economy is back at output level 60, where AD becomes equal to AS and there is no further tendency to change. What happens when AD> AS (state of disequilibrium) When planned spending (AD) is more than planned output (AS), then (C + I) curve lies above the 45° line. It means that consumers and firms together would be buying more goods than firms are willing to produce. As a result, the planned inventory would fall below the desired level. (Shown with the gap GH above, when aggregate Demand is 50 and demand is 40 ) To bring the inventory back to the desired level, firms would resort to increase in employment and output until the economy is back at output level 60, where AD becomes equal to AS and there is no further tendency to change. 2) Saving-Investment Approach (S-l Approach): According to this approach, the equilibrium level of income is determined at a level, when planned saving (S) is equal to planned investment (I). Let us understand this with the help of following schedule and diagram:

National Consumption Savings (S) Investment Remarks Income (C) (Crores) (I) (Y) = AS (Crores) (Crores) (Crores) 20 -20 10 S<I 0 30 -10 10 S<I 20 40 0 10 S<I 40 50 10 10 S=I 60 60 20 10 S>I 70 30 10 S>I 80 100 Investment curve (I) is constant and parallel to the X-axis because of the autonomous character of investments.

The Saving curve (S) is negative initially because of lower income and higher consummation. Ti rises and slopes upwards showing that as income rises, saving also rises. . The economy is in equilibrium at point ‘E’ where saving and investment curves intersect each other. At point ‘E’, where ex-ante saving is equal to ex-ante investment. Hence E is the equilibrium point, where level of income is Rs 60 crores, and planned saving – planned investment = RS 10 crores. If there is any deviation from the equilibrium level of income, i.e., if planned saving is not equal to the planned investment, then a process of readjustment will start which will bring the economy back to the equilibrium level. When saving is more than Investment: S > I If planned saving is more than planned investment, i.e. after point ‘E’ it means that households are not consuming as much as the firms expected them to. This is shown with the gap AB (S>I) .As a result, the inventory rises above the desired level. To clear the unwanted increase in inventory, firms would plan to reduce the production till saving and investment become equal to each other. When saving is less than Investment: S < I If planned saving is less than planned investment, i.e. before point ‘E’ it means that households are consuming more and saving less than what the firms expected them to. This is shown with the gap GH (S<I) .As a result, planned inventory would fall below the desired level. To bring the inventory back to the desired level, firms would plan to increase the production till saving and investment become equal to each other. Note : the remaining topics are not in the syllabus: Also practice the following Problem Questions Page 214 ( Problems 1 to 7) Page 227 ( Q 1 to 5)