Determination of Income and Employment
Class 12 Economics · Introductory Macroeconomics · Chapter 4
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Summary
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 \(C=\bar{C}+cY\), where \(\bar{C}\) is autonomous consumption and c is the marginal propensity to consume, \(\text{MPC}=c=\dfrac{\Delta C}{\Delta Y}\); the marginal propensity to save is \(\text{MPS}=1-c\). Investment is taken as autonomous. The economy is in equilibrium where planned output equals planned aggregate demand, that is where \(Y=AD\) (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 \(\dfrac{1}{1-c}=\dfrac{1}{\text{MPS}}\). 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.
Key terms
Aggregate demand
Total planned expenditure on final goods: consumption, investment, government spending and net exports.
Consumption function
The relation \(C=\bar{C}+cY\) linking consumption to income.
Marginal propensity to consume
The fraction of extra income spent on consumption, \(\text{MPC}=\dfrac{\Delta C}{\Delta Y}\).
Investment multiplier
The ratio of the change in income to the change in autonomous spending, \(\dfrac{1}{1-c}\).
Paradox of thrift
The result that an attempt by all to save more may leave total saving unchanged and reduce income.
Effective demand
The level of aggregate demand that determines equilibrium output when supply is perfectly elastic.
Extra questions & answers
Try one from this chapter
In the Keynesian model the price level is assumed to be: