UNIT 7

DETERMINATION OF
INCOME AND EMPLOYMENT

AGGREGATE DEMAND AND

RELATED CONCEPTS
 MEANING AND COMPONENTS OF AGGREGATE DEMAND

AD refers to the total value of final goods and services that all the sectors of the
economy are planning to buy during a given period of time.
In other words, it is total expenditure incurred by all the sectors of the economy
on buying final goods and services.
AD = C + I + G + (X - M)

Private Private Government Net exports

Consumption Investment Expenditure
Expenditure (C) (X-M)
Expenditure (G)
It is the planned (I)
expenditure on It is the planned It is the
final goods and It is the planned consumption difference
services by expenditure on expenditure of between the value
households new capital government on of exports and the
during a given goods by the providing free value of imports.
period of time. producers during services to the
a period of time people.
 AGGREGATE DEMAND IN A TWO SECTOR MODEL

In a two sector economy consisting of households and private firms,

the aggregate demand for goods and services consists of planned
consumption expenditure by households (C) and planned investment
expenditure by firms (I).
AD = C + I

AGGREGATE SUPPLY

It refers to the value of final goods and services that all the production
units in the economy are planning to produce in a given period of time.
Aggregate Supply = Total Output = National Income
National Income = Consumption (C) + Saving (S)
Hence AS = C + S
 PROPENSITY TO CONSUME

It is the proportion of income spent on consumption.

There are two aspects of propensity to consume

Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC)

AVERAGE PROPENSITY TO CONSUME (APC)

It is the ratio of total consumption to total income.

APC = C / Y

For example, if consumption in the economy is ₹ 600 at an income level of ₹ 1000,

APC = 0.6. It implies that 60% of the total income is consumed.
 IMPORTANT POINTS ABOUT APC

❑ APC can be more than 1 as long as consumption

is more than income. This happens before the
Income Consumption APC break-even point.
(Y) (C) (C/Y)
❑ APC is equal to 1 when consumption equals
0 40 -
income. This happens at the break-even point.
100 120 1.2
❑ APC can be less than 1 when consumption is less
200 200 1
than income. This happens beyond the
300 280 0.93 break-even point.
400 360 0.9
❑ APC falls with increase in income because the
proportion of income spent on consumption keeps
on decreasing.

❑ APC cannot be zero since consumption can never

be zero. Even at zero level of national income,
there is autonomous consumption.
 MARGINAL PROPENSITY TO CONSUME (MPC)

It is the ratio of change in consumption to change in income.

MPC = ∆C / ∆Y

For eg. If income rises from ₹ 1000 to ₹ 2000 and consumption increases from ₹ 700 to ₹ 1200,
∆Y = ₹ 1000, and ∆C = ₹ 500. Hence MPC = 0.5
It implies that economy consumes 50% of its increased income.
 IMPORTANT POINTS ABOUT MPC

❑ The value of MPC varies between 0 and 1. The increased income is either spent on consumption
or saved.
• If the entire increased income is consumed i.e. ΔC = ΔY, MPC = 1.
• If the entire increased income is saved, i.e. ΔC = 0, MPC = 0.

❑ The value of MPC cannot be greater than 1 because change in consumption cannot be more than
the change in income.

❑ MPC of poor people is more than that of rich. This is because poor people tend to spend a greater
percentage of their increased income on consumption as most of their basic needs remain
unsatisfied. On the other hand, rich people already enjoy a high standard of living and hence they
spend a smaller proportion of their increased income on consumption. Similarly, MPC of
developing countries like India is more than MPC of developed countries like the US.
❑ MPC falls with increase in Income Consumption MPC
income. This is because as an (Y) (C) (∆C / ∆Y)
economy becomes richer, people 0 40 - - -
tend to consume a smaller
proportion of their increased
incomes. 100 120 80 100 0.8
200 200 80 100 0.8
300 280 80 100 0.8
400 360 80 100 0.8
 PROPENSITY TO SAVE

It is the proportion of income saved.

There are two aspects of propensity to save:
Average Propensity to Save (APS) and Marginal Propensity to Save (MPS)

AVERAGE PROPENSITY TO SAVE (APS)

It is the ratio of total savings to total income. APS = S / Y

For example, if saving in the economy is ₹ 800 at an income level of ₹ 2000,
APS = 0.4. It implies that 40% of the total income is saved.
 IMPORTANT POINTS ABOUT APS

❑ The value of APS can never be 1 or more than 1. This is because saving can never be equal to or
more than the national income.

❑ The value of APS can be zero. This happens when savings are zero i.e. when consumption is equal
to income (at the break-even point).

❑ The value of APS can be negative. This happens when there is dissaving or negative savings i.e.
consumption is more than income (at income levels before the break-even point).

❑ APS rises with increase in income. This happens because as income rises, the proportion of the
income saved keeps on increasing.

Income Consumption APS

(Y) (C) (S / Y)

0 40 - 40 -
100 120 - 20 - 0.20
200 200 0 0
300 280 20 0.067
400 360 40 0.10
 MARGINAL PROPENSITY TO SAVE (MPS)

It is the ratio of change in saving to change in income. MPS = ∆S / ∆Y

For eg. If income rises from ₹ 1000 to ₹ 2000 and saving increases from ₹ 300 to ₹ 550,
∆Y = 1000, and ∆S = 250. Hence MPS = 0.25

It implies that economy saves 25% of its increased income.

 IMPORTANT POINTS ABOUT MPS

❑ The value of MPS varies between 0 and 1.

• If the entire increased income is saved i.e. ΔS = ΔY, MPS = 1.
• If the entire increased income is consumed, i.e. ΔS = 0, MPS = 0.
❑ The value of MPS can never be negative. This is because change in saving cannot be
negative.
❑ The value of MPS can never be more than 1. This is because change in saving can never be
more than the change in income.
Income Consumption (C) Saving MPS
(Y) (S) (∆S / ∆Y)

0 40 - 40 - - -
100 120 - 20 20 100 0.2
200 200 0 20 100 0.2
300 280 20 20 100 0.2
400 360 40 20 100 0.2
 RELATIONSHIP BETWEEN APC & APS

Income is the sum of consumption and savings. i.e. Y = C + S

APC + APS = C + S = 1
Y Y

APC + APS = 1

RELATIONSHIP BETWEEN MPC & MPS

A change in income causes change in both consumption and savings of the

economy. i.e. ∆Y = ∆C + ∆S

MPC + MPS = ∆ C + ∆ S = 1
∆Y ∆Y

MPC + MPS = 1
 NUMERICAL 1

Calculate APC, MPC, APS and MPS

Income Saving

50 10
100 40
150 75
200 120

Solution
Income Saving Cons APC MPC APS MPS
(Y – S)

50 10 40 0.8 - 0.2 -
100 40 60 0.6 0.4 0.4 0.6
150 75 75 0.5 0.3 0.5 0.7
200 120 80 0.4 0.1 0.6 0.9
 NUMERICAL 2

Given that National Income is ₹ 80 crores and consumption expenditure is ₹ 64 crores,

calculate Average Propensity to Save. When income rises to ₹ 100 crores and consumption
expenditure to ₹ 78 crores, what will be the Average Propensity to Consume and the Marginal
Propensity to Consume?
SOLUTION

APS = S = 80 – 64 = 16 = 0.20
Y 80 80

When income rises to ₹ 100 crores and consumption expenditure to ₹ 78 crores

APC = 78 / 100 = 0.78

MPC = ΔC / Δ Y = 78 – 64 = 14 = 0.70
100 – 80 20
 NUMERICAL 3

If APC of an economy is 0.8, what should be the saving at an income level of

₹ 2000 crores?

SOLUTION

APC + APS = 1

If APC = 0.8, APS = 0.2

APS = S / Y

At an income level of ₹ 2000 crores, Saving = 2000 x 0.2 = ₹ 400 crores

 CONSUMPTION FUNCTION

The mathematical equation which shows the relationship between consumption and
income is called consumption function.
_
It can be expressed by the following equation: C = c + b Y
_
Where C refers to Consumption, c is autonomous consumption, b represents the
Marginal Propensity to Consume and Y refers to the level of Income.

AUTONOMOUS CONSUMPTION AND INDUCED CONSUMPTION

Autonomous consumption expenditure refers to the minimum consumption expenditure

even when income is zero. It is not influenced by the level of income. Induced consumption
refers to the consumption expenditure which changes with change in income.
_ _
In the consumption function C = c + b Y, c represents autonomous consumption where
as bY represents induced consumption
 DIAGRAMMATIC REPRESENTATION OF CONSUMPTION FUNCTION

Let us assume that the consumption function for an economy is C = 40 + 0.8Y

We can calculate consumption at different levels of income and draw the consumption
curve.

Income Consumption
(Y) (C)

0 40
100 120
200 200
300 280
400 360
500 440
600 520
 MAIN POINTS ABOUT THE CONSUMPTION CURVE

❑ The consumption curve starts from a positive intercept on

the y-axis which implies that there is positive consumption
even at zero level of income known as Autonomous
consumption.

❑ The consumption curve has a positive slope. As income

increases, consumption also increases but the increase in
consumption is less than the increase in income. This is
because a part of the increased income is saved.

❑ The 45 degree line shows equality between income and

consumption. At each point on this line Y = C.

❑ Point B represents the break-even point. At this point

consumption equals income.

❑ At all points left of point B income is less than

consumption. Hence there is dissaving or negative savings.

❑ Beyond point B, consumption is less than income i.e. a part

of income is saved.
 SIGNIFICANCE OF 45 DEGREE LINE

• While plotting the consumption curve, the vertical and the horizontal axis have the
same scale. The 45° line has the property that any point on this line the distance up
from the horizontal axis (which is consumption expenditure) exactly equals the
distance across from the vertical axis (which is income). Thus, at any point on the 45 °
line consumption expenditure exactly equals income. The 45 ° line therefore
immediately tells us weather consumption spending (as per the consumption function)
is equal to, greater than or less than the level of income.

• The consumption function crosses the 45 ° line at point B. This point is known as the
break even point. Here households are just breaking even because the consumption is
exactly equal to income.

• Any point other than B on the consumption function consumption is not equal to
income.

• At points to the left of point B, the consumption function lies above 45 ° line.
Therefore consumption expenditure is greater than income.

• At any point to the right of point B, the consumption curve lies below the 45 ° line,
therefore consumption expenditure is less than the level of income.
 KEYNES’ PSYCHOLOGICAL LAW OF CONSUMPTION

The consumption function is based on Keynes’ Psychological Law of

Consumption.

This law sates:

❖ There is a minimum consumption known as autonomous

consumption at zero level of national income.

❖ As income increases, consumption also increases.

❖ Consumption increases at a smaller proportion than the increase in

income.
 SAVING FUNCTION

It refers to the mathematical function which shows relationship between income and
saving.
_
The saving function can be expressed as: S = – C + (1 – b) Y

For eg. Given that the saving function for an economy is S = - 40 + 0.2Y

We can calculate Saving at different levels of income.

Income Saving
(Y) (S)
0 - 40
100 -20
200 0
300 20
400 40
500 60
600 80
 MAIN POINTS ABOUT THE SAVING CURVE

❑ The savings curve starts from the negative range on the y-axis indicating that there is negative
saving at zero level of income.

❑ The savings curve has a positive slope indicating that there is a positive relationship between
income and savings. As income increases, savings also increase. However, the increase in saving is
less than the increase in income.

❑ Savings are zero at the break-even level of income i.e. when consumption equals income. The
saving curve intersects the x-axis at this point.

❑ Before the break-even level, there are negative savings and after the break-even level there are
positive savings.
DERIVATION OF SAVING CURVE FROM CONSUMPTION CURVE

• At zero income there is autonomous consumption

equal to OC. Therefore, saving at zero level of
income will be OS. Hence the saving curve starts
from point S in the negative range of the y-axis.

• Before point B, consumption is more than income,

i.e. there is negative saving. Hence the saving
curve is in the negative region.

• At pt. B, i.e. the break-even point, consumption =

income; hence savings are zero. The saving curve
intersects the x-axis at point R.

• After pt. B, consumption is less than income

therefore there is positive saving. Hence saving
curve becomes positive.

• By joining points S and R and extending it further,

we get the saving curve SS.
DERIVATION OF CONSUMPTION CURVE FROM SAVING CURVE

• At zero income there is negative saving

equal to OS. Therefore, consumption at zero
level of income will be O. Hence the
consumption curve starts from point C in the
positive range of the y-axis.

• The saving curve intersects the x-axis at

point B indicating zero savings. This is the
break-even point i.e. consumption = income.
The consumption curve will intersect the 45
degree reference line at point A indicating
the breakeven point.

• By joining points C and A and extending it

further, we get the consumption curve CC.
 INVESTMENT

Investment (I) is the expenditure incurred on creation

of new capital assets.

Investment is of two types –

• Induced investment: It refers to the investment which

depends upon profit expectations and is directly
influenced by the level of income.

• Autonomous investment: It refers to the investment

which is not affected by changes in the level of income
and is not induced solely by profit motive.

There are two determinants of investment:

• Marginal Efficiency of Investment: It refers to the
expected rate of return from an additional investment.
• Rate of Interest: It refers to the cost of borrowing
money for financing the investment.
DERIVATION OF AD CURVE

• We know that AD = C + I

• To derive the AD curve we add the

autonomous investment expenditure
to consumption expenditure at each
level of income.

• At every point the (C + I) curve lies

above the consumption curve by an
amount equal to Investment.
 AUTONOMOUS EXPENDITUE

Autonomous Expenditure is the sum of Autonomous Consumption

Expenditure and Autonomous Investment Expenditure.

_ _ _
A =C + I

AD which is equal to C + I can also be written as:

_
AD = A + bY
 DIAGRAMMATIC REPRESENTATION OF AS

Income Consumption
(Y) (C)

0 40 - 40 0 • Aggregate Supply is equal

100 120 - 20 100 to National Income.
200 200 0 200 • Income is either
300 280 20 300
consumed or saved.
400 360 40 400
• A 45 degree line indicates
the Aggregate Supply.
 EX ANTE AND EX POST SAVING AND INVESTMENT

❑ Ex-ante means planned and ex-post means actual or realized.

❑ Both these terms are generally used in the context of saving and investment.
❑ Ex ante saving refers to the amount of savings which households plan to make at
different levels of income in the economy.
❑ Ex ante investment refers to the amount of investment which firms plan to make at
different levels of income in the economy.
❑ Ex post saving refers to the actual or realized saving in an economy during the year.
It is the sum of planned saving and unplanned saving
❑ Ex post investment refers to the actual or realized investment in an economy during
the year. It is the sum of planned investment and unplanned investment.
 EXAMPLE OF EX ANTE AND EX POST SAVING AND INVESTMENT

❑ A producer plans to add ₹100 worth goods to her stock by the end of the year.

❑ Her planned or ex ante investment therefore is ₹100 in that year.

❑ However, due to an unforeseen increase in demand for her good in the market, the volume
of her sales exceeds what she had planned to sell.

❑ To meet this extra demand, she has to sell goods worth ₹30 from her stock.

❑ Therefore, at the end of the year, her inventory goes up by ₹70 ( 100 – 30) only.

❑ Her planned or ex ante investment is ₹ 100 whereas her actual or ex post investment is
₹ 70 only.
 FULL EMPLOYMENT AND INVOLUNTARY UNEMPLOYMENT

❑ Full Employment: It refers to a situation in which all those people who are able
and willing to work at the prevailing wage rate get work. Full employment does
not imply zero unemployment. Even in a situation of full employment, there can
be some frictional and structural unemployment.

❑ Involuntary Unemployment: It refers to unemployment in which all those people

who are able and willing to work at the existing wage rate do not get work. It
must be noted that only involuntary unemployment is considered while estimating
the unemployment of an economy.

❑ Voluntary Unemployment: It refers to a situation where a person is unemployed

because he is not willing to work at the existing wage rate.
It is not counted while estimating the size of unemployment.
 NUMERICAL 1

The consumption function of an economy is C = 120 + 0.6 Y. Determine:

(i) Saving function
(ii) Break even level of income
(iii) Saving at an income level of ₹ 600 crores

SOLUTION

(i) S = - 120 + 0.4Y

(ii) At break even C = Y

120 + 0.6Y = Y
0.4 Y = 120
Y = ₹ 300 crores
(iii) At Y = ₹ 600 crores
S = -120 + 0.4 x 600
= ₹ 120 crores
 NUMERICAL 2

If MPC is four times the value of MPS and consumption at zero level of income is
₹ 70 crores, derive the consumption function and saving function. Also calculate the level
of income where saving is zero.

SOLUTION

MPC + MPS = 1
4 MPS + MPS = 1
MPS = 0.2
So MPC = 0.8
C = 70 + 0.8 Y
S = - 70 + 0.2 Y
When S = 0
0 = -70 + 0.2 Y
Y = 70 / 0.2 = ₹ 350 crores
 NUMERICAL 3

The breakeven level of income in an economy is ₹ 500 crores. If households save 40% of
their increased income, calculate (i) Autonomous Consumption (ii) Saving Function
(iii) Level of income where consumption is ₹ 1100 crores.

SOLUTION

At the breakeven level C = Y

_
C + (0.6 x 500) = 500
_
C = 500 – 300 = ₹ 200 crores

S = - 200 + 0.4 Y

If C = ₹ 1100 crores

1100 = 200 + 0.6 Y

Y = 900 / 0.6 = ₹ 1500 crores

 NUMERICAL 4

The saving curve makes an intercept of ₹40 crores on the negative y axis. If consumers
spend 60% of their additional income, calculate:
(i) Consumption Function
(ii) Break even level of income
(iii) Saving at an income level of ₹ 800 crores.

SOLUTION

(i) C = 40 + 0.6 Y

(ii) At breakeven C = Y

40 + 0.6 Y = Y

Y = 40 / 0.4 = ₹ 100 crores

(iii) S = - 40 + (0.4 x 800)

= ₹ 280 crores