Determination of Income and Employment
What the domain tests
Determination of Income and Employment tests the Keynesian aggregate demand–aggregate supply model, consumption and saving functions, the multiplier, and output gaps. You must calculate equilibrium income and explain how autonomous spending changes it.
Core rules
- Consumption function: C = a + bY, where a is autonomous consumption and b is MPC, with 0 < b < 1. APC = C/Y; APS = S/Y; MPC + MPS = 1.
- Equilibrium: in a simple two-sector model, Y = C + I, or saving = investment.
- Multiplier: k = 1/(1 − MPC) = 1/MPS. It amplifies changes in autonomous spending.
- Gaps: excess demand causes inflationary pressure; deficient demand causes a deflationary gap and unemployment.
Worked example
C = 100 + 0.8Y and I = ₹100 crore. Equilibrium Y = (100 + 100)/(1 − 0.8) = ₹1,000 crore. At Y = 1,000, C = 100 + 800 = ₹900 crore, so C + I = ₹1,000 crore. If investment rises by ₹50 crore, income rises by 50 × 5 = ₹250 crore, because k = 1/0.2 = 5.
Traps that cost marks
Do not use APC in place of MPC in the multiplier. Do not say the multiplier works only upward; it also magnifies falls. Do not confuse saving with hoarding. Do not treat an increase in autonomous consumption as a movement along the consumption function; it shifts the function. Equilibrium output need not be full-employment output.