Determination of Income and Employment
Determination of Income and Employment tests the Keynesian cross, the multiplier and fiscal-policy links.
Keynesian equilibrium
Aggregate demand (AD) is planned consumption plus investment (and government spending and net exports in an open economy). Consumption function C=a+bY, where b=MPC; MPS=1−MPC. Equilibrium income occurs where planned AD equals output Y, or saving equals investment. The multiplier k=1/(1−MPC)=1/MPS. An autonomous spending increase raises income by ΔA×k.
Government and budget link
Government spending raises AD; taxes reduce disposable income and the multiplier. A balanced-budget multiplier equals 1 in the simple model. Fiscal policy can close a deflationary gap (increase G or cut T) or an inflationary gap (opposite). The paradox of thrift: higher planned saving can lower equilibrium income.
Worked example
C=100+0.8Y, I=200. Equilibrium: Y=100+0.8Y+200, so 0.2Y=300, Y=1,500. Multiplier=1/0.2=5. If investment rises by ₹50, income rises by ₹250 to ₹1,750. If government imposes a lump-sum tax of ₹50, consumption falls by 0.8×50=₹40; the new equilibrium falls by 40×5=₹200, other things equal.
Traps
The multiplier applies to autonomous spending, not to every rupee of income. MPC plus MPS equals 1, not MPC plus multiplier. Saving equals investment is an equilibrium condition, not a claim that they are always equal. Do not confuse a movement along the consumption function with a shift caused by wealth or expectations.