Determination of Income, Employment and Output
Determination of Income, Employment and Output
This domain presents the Keynesian short-run model. The exam tests consumption and saving functions, MPC and MPS, the equilibrium level of income, the investment multiplier, and the meaning of full employment and deflationary or inflationary gaps.
Core rules
- Consumption C = a + bY, where a is autonomous consumption and b is MPC. Saving S = Y − C; at equilibrium, planned saving equals planned investment.
- APC = C ÷ Y; APS = S ÷ Y; MPC = change in C ÷ change in Y; MPS = change in S ÷ change in Y. MPC + MPS = 1; APC + APS = 1.
- Equilibrium income occurs where aggregate demand equals aggregate output (Y = C + I), or where planned saving equals planned investment. In a two-sector model, Y = (a + I) ÷ (1 − b).
- The investment multiplier k = 1 ÷ (1 − MPC) = 1 ÷ MPS. A change in investment changes income by change in investment × k.
- Full employment output is the level at which all willing workers are employed. An inflationary gap is excess demand beyond full-employment output; a deflationary gap is deficient demand.
Worked example
Autonomous consumption is ₹100 crore, MPC = 0.8, and investment is ₹300 crore. Equilibrium Y = (100 + 300) ÷ (1 − 0.8) = 400 ÷ 0.2 = ₹2,000 crore. At this income, C = 100 + 0.8(2,000) = ₹1,700 crore, and S = ₹300 crore, equal to investment. If investment rises by ₹50 crore, income rises by 50 × 5 = ₹250 crore, because k = 1 ÷ 0.2 = 5.
Traps
Do not use MPC as a percentage without converting it to a decimal. The multiplier is not 1 ÷ MPC. Equilibrium is not necessarily full employment. Do not confuse a movement along the consumption function with a shift caused by changes in autonomous consumption or wealth. In numerical answers, state the equilibrium condition before substituting.