Determination of Income and Employment

Aggregate Demand (AD) in Economics refers to the total value of all final goods and services that are planned to be purchased by all sectors of the economy at a particular level of income over some time. Aggregate demand is critical to the economy since it influences the entire state of affairs. Aggregate demand and its components are discussed below.

Aggregate demand and its components

Aggregate Demand refers to the total value of all final goods and services that all sectors of the economy intend to purchase at a certain level of income during a specific period. AD is the total expenditure on goods and services in a given economy over a given period.

Aggregate demand is made up of the following elements:

1. Consumption expenditure by households (C).
2. Capital expenditures (I).
3. Consumption expenditures by the government (G).
4. Export net (X – M).

As a result, AD equals C + I + G + (X – M).

AD = C + I in a two-sector economy

The money worth of all final goods and services available for purchase by an economy over a certain period is known as the aggregate supply. It is the economy’s movement of goods and services.

C = AS

Because the monetary worth of final goods and services equals the net value-added, AS equals national income.

The country’s national revenue is represented by aggregate supply.

Y = AS (National Income)

The consumption function depicts the link between consumption and earnings.

f = C (Y)

where C stands for consumption

Y = Earnings

f refers to a functional relationship.

Consumption Function Equation

C = C = C = C = C = C = C = C = C = C = C = C = C = C = C = C = C

= Consumption that is self-contained.

MPC(b) = Marginal Consumption Propensity

Changes in income do not affect the Marginal Consumption Propensity. Even when income is zero, it is the bare minimum of consumption. Autonomous consumption is defined as consumer expenditure at a zero level of income. Income is inelastic.

Induced consumption refers to spending that is influenced by changes in income. MPC Y is the indicator. The portion of consumption that fluctuates with disposable income is known as induced consumption.

The propensity to consume is a graph that depicts consumer expenditure at various levels of income in a given economy.

There are two types of consumption functions (propensity to consume):

(a) Consumption proclivity on average (APC)

(a) Consumption proclivity in the fringes (MPC)

The ratio between total consumption (C) and total income (Y) at a particular level of income in the economy is known as the average propensity to consume (APC).

APC= Consumption C/ Income Y =C/Y

APC’s Most Important Points

(i) APC is greater than 1: APC is greater than 1 as long as consumption exceeds national income before the break-even point.

(ii) At the break-even point, APC = 1, consumption equals national income.

(iii) APC less than 1: APC is below the break-even mark. The national income is less than the consumption.

(iv) As income rises, the APC decreases.

(v) APC can never be zero: autonomous consumption exists even at a zero level of national income.

Marginal Propensity to Consume (MPC)

The ratio of change in consumer spending to change in income is known as marginal propensity to consume.

MPC=Change in consumption/ Change in income

MPC’s Most Important Points

(1) MPC has a range of values between O and 1: if all new revenue is used, C = Y, and MPC = 1. If the full additional income is saved, however, C = 0 and MPC = 0.

(2) In the short run, MPC is the slope of the consumption curve and remains constant.

(3) APC Value > MPC

Determination of income in two-sector model

For the sake of simplification of National Income Determination is classified into:

• Two-sector model
• Three-sector model
• Four-sector model

The first two sectors concern a closed economy with no foreign commerce, whereas the third sector is concerned with an open economy.

Determination of income in a two-sector model:
In a two-sector model, an economy’s income is determined solely by the domestic and business sectors.

Assumptions: In a closed economy, the determination of income in a two-sector model is calculated using the following assumptions:

1. It is a two-sector economy, with solely consumption and investment spending. As a result, the economy’s total production is equal to the sum of consumption and investment expenditure.
2. Investment refers to the amount invested after depreciation.
3. It is a closed economy in which no exports or imports are permitted.
4. There are no corporate enterprises in the economy, hence there are no corporate earnings that have not been divided.
5. Because there are no corporate taxes, income taxes, or social security taxes, disposable personal income equals NNP.
6. No transfer payments are made.
7. There is no such thing as a government.
8. There is self-directed investment.
9. The economy’s output is below that of full employment.
10. The price level remains constant until full employment is reached.
11. The monetary wage rate is fixed.
12. The consumption function is stable.
13. The interest rate is set.
14. The analysis is limited to a short time frame.

Explanation: The equilibrium level of national income can be calculated by the equality of aggregate demand and aggregate supply, or by the equality of saving and investment, given these assumptions.

The sum of household consumption spending on newly created consumer goods and services (C) and businessmen’s investment expenditure on newly produced capital goods and inventories (I) is aggregate demand (I).

The following IDs demonstrate this:

C+I = Y… (1)

Yd = C+S = Yd = C+S = Yd = C+S = Yd = C (2)

However, Y=Yd

I = S or C + I = C + S

Where Y represents national income, Yd represents disposable income, C represents consumption, S represents a saving, and I represents an investment.

Determination of equilibrium income

Aggregate demand and supply define the level of income and employment at which the economy is in balance. 

Determination of equilibrium income, according to Keynesian theory, is established when aggregate demand, represented by the C + I curve, equals total output (Aggregate Supply or AS).

The equilibrium condition is often described in terms of aggregate demand (AD) and aggregate supply (AS) according to Keynesian Theory (AS). When aggregate demand for goods and services equals aggregate supply over a period of time, and economy is in equilibrium.

As a result, balance is reached when:

AS Equals AS.. (1)

We now know that AD equals the sum of Consumption (C) and Investment (I):

C + I = AD.. (2)

AS is also equal to the sum of consumption (C) and saving (S):

C + S = AS.. (3)

When (2) and (3) are substituted for (1), we get:

S = I or C + S = C + I

It indicates that there are two approaches to determine the equilibrium level of income and employment in the economy, according to Keynes:

It should be emphasised that the ‘Classical Theory’ can also be used to determine the equilibrium level of income and employment.

Two Methods for Calculating Equilibrium Levels:

The following are two techniques of determining the economy’s equilibrium level of income, output, and employment:

1. The Demand-Supply Aggregate Approach (AD-AS Approach)

2. The Savings-Investment Strategy (S-I Approach)

It’s important to remember that AD, AS, Savings, and Investment are all ex-ante factors.

Assumptions:

Before we go any further, let’s go over the various assumptions used to calculate equilibrium output:

•  In the framework of a two-sector model, the determination of equilibrium output will be investigated (households and firms). It implies that there is no government or international sector.
•  It is believed that investment expenditure is self-contained, i.e., investments are unaffected by income levels.

Conclusion

The article covers the important points in the determination of income vis-a-vis aggregate demand and its components, determination of equilibrium income, and determination of income in a two-sector model. Some things to remember are:

1. Aggregate demands and its components:

• Consumption expenditure by households (C).
• Capital expenditures (I).
• Consumption expenditures by the government (G).
• Export net (X – M).

1. Determination of equilibrium income is done through a two-sector model using Kayesian theory.
2. National income is determined through the two-sector model.
3. Two types of consumption functions are APC and MPC.