DETERMINATION OF INCOME AND EMPLOYMENT

• The basic objective of macroeconomics is to develop theoretical tools called models capable of describing the processes which determine the values of these variables.
• The models attempt to provide a theoretical explanation to questions that cause periods of slow growth or recessions in the economy increments in the price level or a rise in unemployment.
• It is difficult to account for all the variables at the same time. In the determination of a particular variable the values of all other variables constant
• This is a stylisation typical of almost any theoretical exercise is called the assumption of ceteris paribus means other things remain equal.
• To solve for the values of two variables X and Y from two equations, we solve the X variable, in terms of Y from one equation first and then substitute this value into the other equation to obtain the complete solution.
• The same method is used in the analysis of the macroeconomic system.
• The determination of National Income under the assumption of fixed price of final goods and constant rate of interest in the economy, the theoretical model used in this chapter is based on the theory given by John Maynard Keynes.

1. Aggregate demand and its components

• The National Income Accounting is the terms like consumption, investment or the total output of final goods and services in an economy (GDP).
• These terms have dual connotations used in the accounting sense denoting the actual values of these items as measured by the activities within the economy in a certain year.
• This is called actual or accounting values ex-post measures of these items. These can be used with different connotations.
• Consumption may denote that not all people have consumed in a given year, but they planned to consume during the same period.
• Similarly, investment can mean the amount a producer plans to add to her inventory.
• Suppose the producer plans to add 100 rupees worth of goods to stock by the end of the year.
• Due to an unforeseen upsurge of demand for her groin, the market volume of her sales exceeds and she needs extra demand.
• She has to sell goods worth 30 from her stock; her inventory goes up by 70 rupees only.
• The planned values of the variables consumption, investment or output of final goods their ex-ante measures
• Ex-ante depictions have been planned and ex-post depictions have happened.
• To understand the determination of income, we need to know the planned values of different components of aggregate demand.

Consumption

• The most important determinant of consumer demand is household income.
• A consumption function describes the relationship between consumption and income.
• The simplest consumption function assumes that consumption changes at a constant rate as income changes.
• Of course, even if income is zero, some consumption still takes place.
• Since this level of consumption is independent of income is called autonomous consumption.

C =͞c + cY

• The above equation is called the consumption function. C is the consumption expenditure by households.
• This consists of two components autonomous consumption and induced consumption (c Y).
• Autonomous consumption is denoted by C and shows the consumption which is independent of income.
• If the consumption takes place even when income is zero, it is because of autonomous consumption.
• The induced component of consumption, cY shows the dependence of consumption on income.
• When income rises by 1 rupee induce consumption rises by MPC i.e. c or the marginal propensity to consume. It may be explained as a rate of change of consumption as income changes.
• Income changes, the change in consumption ΔC can never exceed the change in income (Y) Δ.
• The maximum value that C can take is 1. On the other hand, the consumer may choose not to change consumption even when income has changed.
• In this case MPC= 0. Generally, MPC lies between 0 and 1 (inclusive of both values). This means that as income increases either.
• The consumers do not increase consumption at all (MPC=0) use the entire change in income in consumption (MPC=1) or use part of the change in income for changing consumption (0<MPC<1).

Some Definitions

Marginal propensity to consume (MPC): It is the Change in consumption per unit change in income. It is denoted by C and is equal to  

Marginal propensity to save (MPS): It is the change in savings per unit change in income. It is denoted by S and is equal to 1-c.

It implies that S C + =1.

The average propensity to consume (APC); It is the consumption per unit of income i.e. C/Y 

The average propensity to save (APS); It is the saving per unit of income i.e. S/Y

 Investment

• Investment is defined as an addition to the stock of physical capital (Such as machines, buildings, roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer.
• Note that investment goods (Such as machines) are also part of the final goods. They are not intermediate goods like raw materials.
• Machines produced in an economy in a given year are not used up to produce other goods but yield their services over several years.
• Investment decisions by producers, such as whether to buy a new machine, depend, to a large extent, on the market rate of interest.
• Firms plan to invest the same amount every year, we can write the ex-ante investment demand as

I =͞i

• I am a positive constant which represents the autonomous (given or exogenous) investment in the economy in a given year.

2. Determination of income in the Two-sector model

• In an economy without a government, the Ex ante aggregate demand for final goods is the total of the EX ante consumption expenditure and ex-ante investment expenditure on such goods, AD=C+I. Substituting the values of C and I from Equations aggregate demand for final goods.
• The expression on the right-hand side denotes ex-ante or planned aggregate demand for final goods in the economy.
• Ex-ante supply is equal to ex-ante demand only when the final goods market.
• If ex-ante demand for final goods falls short of the output of final goods that the producers have planned to produce in a given year.
• Stocks will be pilling up in the warehouses which we may consider the unintended accumulation of inventories.
• It should be noted that inventories or stocks refer to that part of output produced which is not sold and therefore remains with the firm.
• Change in inventory is called inventory investment. It can be negative as well as positive.
• If there is a rise in inventory, it is a positive inventory investment, while depletion of inventory is a negative inventory investment.
• The inventory investment can take place due to two reasons

1. The firm decides to keep some stocks for various reasons this is called planned inventory investment.
2. The sales differ from the planned level of sales, in which case the firm has to add to/ run down existing inventories is called unplanned inventory investment.

• Thus even though planned Y is greater than planned C+I, actual Y will be equal to C+ I, with the extra output showing up as an unintended accumulation of inventories in the ex-post I on the right-hand side of the accounting identity.
• The major economic activities of the government that affect the aggregate demand for final goods and services can be summarized by the fiscal variables Tax (T) and Government Expenditure (G), both autonomous to our analysis.
• The government, through its expenditure G on final goods and services, adds to the aggregate demand like other firms and households.
• On the other hand, taxes imposed by the government take a part of the income away from the household, whose disposable income becomes Yd= Y-T.
• Households spend only a fraction of this disposable income for consumption purposes.

3. Determination of Equilibrium income in the short run

In microeconomic theory, the equilibrium of demand and supply in a single market, the demand and supply curves simultaneously determine the equilibrium price and the equilibrium quantity.

In macroeconomic theory, we proceed in two steps.

1. Macroeconomic equilibrium takes the price level as fixed.
2. The price level to vary and again, analyse the macroeconomic equilibrium

Macroeconomic Equilibrium with Price level Fixed

• Graphical method
• As already explained, the consumer's demand can be expressed by the equation

• C =͞c + Cy

• Consumption function –Graphical representation
• Investment function-Graphical Representation
• Aggregate Demand; Graphical representation
• The aggregate demand function shows the total demand (made up of consumption + investment) at each level of income.
• Supply-side of Macroeconomic equilibrium in microeconomic theory, the supply curve on a diagram with the price on the vertical axis and quantity supplied on the horizontal axis
• In the first stage of macroeconomic theory, the price level is fixed.
• The aggregate supply or the GDP is assumed to smoothly move up or down since they are unused resources of all types available.
• Whatever the level of GDP, that much will be supplied and the price level has no role to play.

Equilibrium

It is ex-ante aggregate demand and supply together in a diagram. The point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be equilibrium.

Effect of an autonomous change in aggregate demand on income and output

The equilibrium level of income depends on aggregate demand.

 Aggregate demand changes the equilibrium level of income changes. This can happen in any one or a combination of the following situations.

1. Change in consumption, this can happen due to
2. Change in C
3. Change in C.

Change in Investment; We assumed that investment is autonomous. It just means that it does not depend on income.  There are several variables other than income which can affect investment.

Availability of credit:  easy availability of credit encourages investment.

Interest rate: it is the cost of investible funds and at higher interest rates, firms tend to lower investment.

The multiplier mechanism

The production of final goods employs factors such as labour, capital, land and entrepreneurship. In the absence of indirect taxes or subsidies, the total value of the final goods output is distributed among different factors of production- wages to labour, capital interest, rent to land etc. Whatever is left over is appropriated by the entrepreneur is called profit. The total aggregate factor payments in the economy, National income, is equal to the aggregate value of the output of final goods, GDP.

Some more concepts

• The equilibrium output in the economy also determines the level of employment, given the quantities of other factors of production.
• The full-employment level of income is that level of income where all the factors of production are fully employed in the production process.
• Equilibrium only means that if left to itself the level of income in the economy will not change even when there is unemployment in the economy.
• The equilibrium level of output may be more or less than the full employment level of output.
• If it is less than the full employment of output, it is because demand is not enough to employ all factors of production.
• This situation is called the situation of deficient demand. It leads to a decline in prices in the long run.
• On the other hand, if the equilibrium level of output is more than the full employment level, it is because the demands are more than the level of output produced at the full employment level. This situation is called the situation of excess demand. It leads to a rise in prices in the long run.
• When, at a particular price level, aggregate demand for final goods equals the aggregate supply of final goods or the product market reaches its equilibrium.
• Aggregate demand for final goods consists of ex-ante consumption, ex-ante investment, government spending etc.
• The rate of increase in ex-ante consumption due to a unit increment in income is called marginal propensity to consume.
• For simplicity, we assume a constant final goods price and constant rate of interest over the short run to determine the level of aggregate demand for final goods in the economy.
• The aggregate supply is perfectly elastic at this price.
• Under such circumstances, aggregate output is determined solely by the level of aggregate demand is known as the effective demand principle.
• An increase (decrease) in autonomous spending causes the aggregate output of final goods to increase (decrease) by a larger amount through the multiplier process.