Determination of Income and Employment
Determination of Income and Employment tests the equilibrium level of income, the consumption and saving functions, the multiplier, and the gaps that appear at full employment.
Core rules
- Equilibrium: AD = AS, equivalently S = I, with planned injections equal to planned leakages.
- Consumption function: C = a + bY, where a is autonomous consumption and b = MPC = change in C divided by change in Y. Saving function: S = −a + (1 − b)Y; MPS = 1 − MPC.
- APC + APS = 1 and MPC + MPS = 1.
- Multiplier: k = 1/(1 − MPC) = 1/MPS; change in Y = k × change in I.
- Excess demand beyond full-employment demand creates an inflationary gap; deficient demand creates a deflationary gap and unemployment.
- Policy: excess demand means cut government spending and raise taxes; deficient demand means the reverse.
Worked example
MPC = 0.8 and autonomous investment rises by ₹100 crore. k = 1/(1 − 0.8) = 5, so income rises by 5 × 100 = ₹500 crore, of which ₹400 crore is induced consumption and ₹100 crore is the initial investment. If MPC were 0.5, the same ₹100 crore would raise income by only ₹200 crore.
Traps that cost marks
- Using APC instead of MPC in the multiplier formula.
- Forgetting that the multiplier works in both directions; a fall in investment contracts income by k times.
- Treating full employment as zero unemployment; frictional and structural unemployment can coexist with it.