Determination of Income and Employment
What this domain tests
Determination of Income and Employment tests equilibrium output, consumption and saving functions, the multiplier, and the policy response to excess or deficient demand.
Core rules
- Aggregate demand = C + I + G + (X − M); aggregate supply = output. Equilibrium occurs where planned AD equals AS (Y).
- Consumption function: C = a + bY, where a is autonomous consumption and b = MPC (0 < b < 1). APC = C/Y; MPC = ΔC/ΔY. Saving function: S = −a + (1 − b)Y; MPS = 1 − MPC.
- Investment multiplier k = 1/(1 − MPC) = 1/MPS. A change in autonomous spending changes equilibrium income by k times the change.
- Excess demand is AD beyond full-employment output, causing an inflationary gap; deficient demand is AD short of full-employment output, causing a deflationary gap. Government spending and tax cuts raise AD; spending cuts and tax rises lower it.
Worked example
C = 100 + 0.8Y, I = 200 (no government or trade). Equilibrium: Y = C + I = 100 + 0.8Y + 200, so 0.2Y = 300, Y = 1,500. MPC = 0.8, multiplier = 5. If investment rises by 50, income rises by 50 × 5 = 250 to 1,750. Reasoning: only induced consumption re-circulates; the multiplier is finite because each round leaks into saving.
Traps
Using APC instead of MPC for the multiplier; forgetting that saving is a leakage; assuming equilibrium is automatically full employment; reversing excess and deficient demand; and treating an unplanned inventory change as planned investment.