Determination of Income, Employment and Government Budget
This domain links the consumption function to equilibrium income, the multiplier, and the vocabulary of government budgeting. Expect a numerical equilibrium-income question plus deficit definitions.
Core rules
- Equilibrium: AD = AS, or Y = C + I in a two-sector model (add G and net exports for open economy).
- Consumption function C = a + bY, where a is autonomous consumption and b = MPC, with 0 < b < 1. APC = C/Y, APS = S/Y; MPC + MPS = 1 and APC + APS = 1, but APC generally exceeds MPC.
- Investment multiplier k = 1/(1 − MPC) = 1/MPS; ΔY = k × ΔI.
- Excess demand creates an inflationary gap; deficient demand creates a deflationary gap. Full employment means no involuntary unemployment; frictional, structural and cyclical unemployment can still exist.
- Budget receipts: revenue (tax and non-tax) and capital (borrowings, disinvestment, loan recovery). Expenditure: revenue and capital.
- Revenue deficit = revenue expenditure − revenue receipts. Fiscal deficit = total expenditure − total receipts excluding borrowings. Primary deficit = fiscal deficit − interest payments.
Worked example
C = 50 + 0.8Y and I = 100. Equilibrium: Y = 50 + 0.8Y + 100, so 0.2Y = 150 and Y = 750. The multiplier is 1/(1 − 0.8) = 5, so if investment rises by 50, income rises by 5 × 50 = 250 to 1,000.
Traps that cost marks
- Writing the multiplier as 1/MPC instead of 1/MPS.
- Confusing fiscal deficit with revenue deficit, or forgetting to subtract interest payments for the primary deficit.
- Treating disinvestment receipts as revenue receipts.
- Assuming zero deficit means a healthy budget; the composition of expenditure matters.