Determination of Income and Employment — Class 12 Economics

This chapter develops the Keynesian theory of income determination, assuming a fixed price level and a given rate of interest so that output is determined by aggregate demand. Aggregate demand is the total planned (ex-ante) spending on final goods, made up of consumption, investment, government spending and net exports. Consumption depends on income through the consumption function , where is autonomous consumption and c is the marginal propensity to consume, ; the marginal propensity to save is . Investment is taken as autonomous. The economy is in equilibrium where planned output equals planned aggregate demand, that is where (the 45-degree line meets the AD line), or equivalently where planned saving equals planned investment. A key result is the multiplier: an autonomous change in spending changes equilibrium income by a larger amount, since the investment multiplier is . The chapter also explains the paradox of thrift — when everyone tries to save more, total saving may not rise and income falls — and distinguishes full-employment equilibrium from situations of deficient demand (which causes unemployment and tends to lower prices) and excess demand (which tends to raise prices), introducing the idea of effective demand.