Determination of Income and Employment
What this domain tests
This domain covers aggregate demand and supply, the consumption function, MPC and MPS, saving and investment, equilibrium income, the multiplier, full employment, and inflationary and deflationary gaps.
Core rules
- AD = C + I + G + (X - M); AS = Y in a simple two-sector model.
- Consumption function: C = a + bY, where a is autonomous consumption and b is MPC.
- MPC = change in C / change in Y; MPS = change in S / change in Y; MPC + MPS = 1.
- Equilibrium: Y = AD, or saving = investment.
- Multiplier k = 1/(1 - MPC) = 1/MPS.
- Equilibrium income need not be full-employment income.
- Deficient demand causes a deflationary gap; excess demand causes an inflationary gap.
Worked example
C = 100 + 0.8Y and I = 50. Equilibrium: Y = 100 + 0.8Y + 50, so 0.2Y = 150 and Y = 750. MPC = 0.8, so k = 1/0.2 = 5. If investment rises to 70, change in I = 20 and change in Y = 20 x 5 = 100; new income = 850.
Traps that cost marks
MPC + MPS = 1, not MPC = MPS. The multiplier is 1/MPS, not 1/MPC. Saving equals investment at equilibrium, but this does not mean full employment. Do not treat an increase in saving as always good; the paradox of thrift can lower income.