Determination of Income and Employment PDF

Chapter 4 Chapter 4 Determination of Income and Employment We have so far talked about the national income, price level, rate of interest etc. in an ad hoc manner – without investigating the forces that govern their values....

Chapter 4 Chapter 4 Determination of Income and Employment We have so far talked about the national income, price level, rate of interest etc. in an ad hoc manner – without investigating the forces that govern their values. The basic objective of macroeconomics is to develop theoretical tools, called models, capable of describing the processes which determine the values of these variables. Specifically, the models attempt to provide theoretical explanation to questions such as what causes periods of slow growth or recessions in the economy, or increment in the price level, or a rise in unemployment. It is difficult to account for all the variables at the same time. Thus, when we concentrate on the determination of a particular variable, we must hold the values of all other variables constant. This is a stylisation typical of almost any theoretical exercise and is called the assumption of ceteris paribus, which literally means ‘other things remaining equal’. You can think of the procedure as follows – in order to solve for the values of two variables x and y from two equations, we solve for one variable, say x, in terms of y from one equation first, and then substitute this value into the other equation to obtain the complete solution. We apply the same method in the analysis of the macroeconomic system. In this chapter we deal with the determination of National Income under the assumption of fixed price of final goods and constant rate of interest in the economy. The theoretical model used in this chapter is based on the theory given by John Maynard Keynes. 4.1 AGGREGATE DEMAND AND ITS COMPONENTS In the chapter on National Income Accounting, we have come across terms like consumption, investment, or the total output of final goods and services in an economy (GDP). These terms have dual connotations. In Chapter 2 they were used in the accounting sense – denoting actual values of these items as measured by the activities within the economy in a certain year. We call these actual or accounting values ex post measures of these items. These terms, however, can be used with a different connotation. Consumption may denote not what people have actually consumed in a given year, but what they Reprint 2024-25  had planned to consume during the same period. Similarly, investment can mean the amount a producer plans to add to her inventory. It may be different from what she ends up doing. Suppose the producer plans to add Rs 100 worth goods to her stock by the end of the year. Her planned investment is, therefore, Rs 100 in that year. However, due to an unforeseen upsurge of demand for her goods in the market the volume of her sales exceeds what she had planned to sell and, to meet this extra demand, she has to sell goods worth Rs 30 from her stock. Therefore, at the end of the year, her inventory goes up by Rs (100 – 30) = Rs 70 only. Her planned investment is Rs 100 whereas her actual, or ex post, investment is Rs 70 only. We call the planned values of the variables – consumption, investment or output of final goods – their ex ante measures. In simple words, ex-ante depicts what has been planned, and ex-post depicts what has actually happened. In order to understand the determination of income, we need to know the planned values of different components of aggregate demand. Let us look at these components now. 4.1.1. Consumption The most important determinant of consumption demand is household income. A consumption function describes the relation between consumption and income. The simplest consumption function assumes that consumption changes at a constant rate as income changes. Of course, even if income is zero, some consumption still takes place. Since this level of consumption is independent of income, it is called autonomous consumption. We can describe this function as: C = C + cY (4.1) The above equation is called the consumption function. Here C is 54 the consumption expenditure by households. This consists of two Introductory Macroeconomics components autonomous consumption and induced consumption ( cY ). Autonomous consumption is denoted by C and shows the consumption which is independent of income. If consumption takes place even when income is zero, it is because of autonomous consumption. The induced component of consumption, cY shows the dependence of consumption on income. When income rises by Re 1. induced consumption rises by MPC i.e. c or the marginal propensity to consume. It may be explained as a rate of change of consumption as income changes. ∆C MPC = =c ∆Y Now, let us look at the value that MPC can take. When income changes, change in consumption ( ∆C ) can never exceed the change in income ( ∆ Y). The maximum value which c can take is 1. On the other hand consumer may choose not to change consumption even when income has changed. In this case MPC = 0. Generally, MPC lies between 0 and 1 (inclusive of both values). This means that as income increases either Reprint 2024-25 the consumers does not increase consumption at all (MPC = 0) or use entire change in income on consumption (MPC = 1) or use part of the change in income for changing consumption (0< MPC