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# NCERT Textbook - Income Determination Commerce Notes | EduRev

## NCERT Textbooks (Class 6 to Class 12)

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## Commerce : NCERT Textbook - Income Determination Commerce Notes | EduRev

``` Page 1

Chapter 4
Income Determination Income Determination Income Determination Income Determination Income Determination
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.
4.1 EX ANTE AND EX POST
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 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
not to be republished
Page 2

Chapter 4
Income Determination Income Determination Income Determination Income Determination Income Determination
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.
4.1 EX ANTE AND EX POST
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 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
not to be republished
50 50 50 50 50
Introductory Macroeconomics
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 a theoretical model of the economy the ex ante values of these variables
should be our primary concern. ‘If anybody wants to predict what the equilibrium
value of the final goods output or GDP will be, it is important for her to know
what quantities of the final goods people plan to demand or supply’. We must,
therefore, learn about the determinants of the ex ante values of consumption,
investment or aggregate output of the economy.
Ex Ante Consumption: What does planned consumption depend on? People
spend a part of their income on consumption and save the rest. Suppose your
income increases by Rs 100. You will not use up this entire extra income but
save a certain fraction, say 20 per cent, of it to build up a cushion of savings for
the period when you cease to earn income, or for meeting large expenses in
future. Different people plan to save different fractions of their additional incomes
(with the rich typically saving a greater proportion of their income than the poor),
and if we average these we may arrive at a fraction which will give us an idea of
what proportion of the total additional income of the economy people wish to
save as a whole. We call this fraction the marginal propensity to save (mps). It
gives us the ratio of total additional planned savings in an economy to the total
additional income of the economy. Since consumption is the complement of
savings (additional income of the economy is either put into additional savings
or used for extra consumption by the people), if we subtract the mps from 1, we
get the marginal propensity to consume (mpc), which, in a similar way, is the
fraction of total additional income that people use for consumption. Suppose,
mpc of an economy is c, where 0 < c < 1. If the total income of the economy
increases from 0 to Y , then total consumption of the economy should be
C = c (Y – 0) = c.Y
However, it is not precisely so. We have forgotten something here. If the income
of the economy in a certain year is zero, the above equation tells us that the
economy has to starve for an entire year, which is, obviously, an outrageous
idea. If your income is zero in a certain period you use your past savings to buy
certain minimum consumption items in order to survive. Hence we must add
the minimum or subsistence level of consumption of the economy in the above
equation, which, therefore, becomes
C = C + c.Y (4.1)
where C > 0 is the minimum consumption level and is a given or exogenous
item to our model, which, therefore, is treated as a constant. The equation tells
us that as the income of the economy increases above zero, the economy uses c
proportion of this extra income to increase its consumption above the minimum
level.
Ex Ante Investment: Investment is defined as addition to the stock of physical
capital (such as machines, buildings, roads etc., i.e. anything that adds to the
future productive capacity of the economy) and changes in the inventory (or the
stock of finished goods) of a producer. Note that ‘investment goods’ (such as
machines) are also part of the final goods – they are not intermediate goods like
not to be republished
Page 3

Chapter 4
Income Determination Income Determination Income Determination Income Determination Income Determination
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.
4.1 EX ANTE AND EX POST
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 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
not to be republished
50 50 50 50 50
Introductory Macroeconomics
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 a theoretical model of the economy the ex ante values of these variables
should be our primary concern. ‘If anybody wants to predict what the equilibrium
value of the final goods output or GDP will be, it is important for her to know
what quantities of the final goods people plan to demand or supply’. We must,
therefore, learn about the determinants of the ex ante values of consumption,
investment or aggregate output of the economy.
Ex Ante Consumption: What does planned consumption depend on? People
spend a part of their income on consumption and save the rest. Suppose your
income increases by Rs 100. You will not use up this entire extra income but
save a certain fraction, say 20 per cent, of it to build up a cushion of savings for
the period when you cease to earn income, or for meeting large expenses in
future. Different people plan to save different fractions of their additional incomes
(with the rich typically saving a greater proportion of their income than the poor),
and if we average these we may arrive at a fraction which will give us an idea of
what proportion of the total additional income of the economy people wish to
save as a whole. We call this fraction the marginal propensity to save (mps). It
gives us the ratio of total additional planned savings in an economy to the total
additional income of the economy. Since consumption is the complement of
savings (additional income of the economy is either put into additional savings
or used for extra consumption by the people), if we subtract the mps from 1, we
get the marginal propensity to consume (mpc), which, in a similar way, is the
fraction of total additional income that people use for consumption. Suppose,
mpc of an economy is c, where 0 < c < 1. If the total income of the economy
increases from 0 to Y , then total consumption of the economy should be
C = c (Y – 0) = c.Y
However, it is not precisely so. We have forgotten something here. If the income
of the economy in a certain year is zero, the above equation tells us that the
economy has to starve for an entire year, which is, obviously, an outrageous
idea. If your income is zero in a certain period you use your past savings to buy
certain minimum consumption items in order to survive. Hence we must add
the minimum or subsistence level of consumption of the economy in the above
equation, which, therefore, becomes
C = C + c.Y (4.1)
where C > 0 is the minimum consumption level and is a given or exogenous
item to our model, which, therefore, is treated as a constant. The equation tells
us that as the income of the economy increases above zero, the economy uses c
proportion of this extra income to increase its consumption above the minimum
level.
Ex Ante Investment: Investment is defined as addition to the stock of physical
capital (such as machines, buildings, roads etc., i.e. anything that adds to the
future productive capacity of the economy) and changes in the inventory (or the
stock of finished goods) of a producer. Note that ‘investment goods’ (such as
machines) are also part of the final goods – they are not intermediate goods like
not to be republished
51 51 51 51 51
Income Determination
raw materials. Machines produced in an economy in a given year are not ‘used
up’ to produce other goods but yield their services over a number of years.
Investment decisions by producers, such as whether to buy a new machine,
depend, to a large extent, on the market rate of interest. However, for simplicity,
we assume here that firms plan to invest the same amount every year. We can
write the ex ante investment demand as
I = I (4.2)
where I is a positive constant which represents the autonomous (given or
exogenous) investment in the economy in a given year.
Ex Ante Aggregate Demand for Final Goods: In an economy without a
government, the ex ante aggregate demand for final goods is the sum total of the
ex ante consumption expenditure and ex ante investment expenditure on such
goods, viz. AD = C + I. Substituting the values of C and I from equations (4.1)
and (4.2), aggregate demand for final goods can be written as
C + I + c.Y
If the final goods market is in equilibrium this can be written as
Y = C + I + c.Y
where Y is the ex ante, or planned, ouput of final goods. This equation can be
further simplified by adding up the two autonomous terms, C and I , making it
Y = A + c.Y (4.3)
where A = C + I is the total autonomous expenditure in the economy. In
reality, these two components of autonomous expenditure behave in different ways.
C , representing subsistence consumption level of an economy, remains more or
less stable over time. However, I has been observed to undergo periodic fluctuations.
A word of caution is in order. The term Y on the left hand side of equation (4.3)
represents the ex ante output or the planned supply of final goods. On the other
hand, the expression on the right hand side denotes ex ante or planned aggregate
demand for final goods in the economy. Ex ante supply is equal to ex ante
demand only when the final goods market, and hence the economy, is in
equilibrium. Equation (4.3) should not, therefore, be confused with the
accounting identity of Chapter 2, which states that the ex post value of total
output must always be equal to the sum total of ex post consumption and ex
post investment in the economy. If ex ante demand for final goods falls short of
the output of final goods that the producers have planned to produce in a
given year, equation (4.3) will not hold. Stocks will be piling up in the warehouses
which we may consider as unintended accumulation of inventories. It is not a
part of planned or ex ante investment. However, it is definitely a part of the
actual addition to inventories at the end of the year or, in other words, an ex
post investment. Thus even though planned Y is greater than planned C +
I, actual Y will be equal to actual C + I, with the extra output showing up
as unintended accumulation of inventories in the ex post I on the right
hand side of the accounting identity.
At this point, we can introduce a government in this economy. The major
economic activities of the government that affect the aggregate demand for final
goods and services can be summarized by the fiscal variables Tax (T) and
Government Expenditure (G), both autonomous to our analysis. Government,
through its expenditure G on final goods and services, adds to the aggregate
not to be republished
Page 4

Chapter 4
Income Determination Income Determination Income Determination Income Determination Income Determination
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.
4.1 EX ANTE AND EX POST
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 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
not to be republished
50 50 50 50 50
Introductory Macroeconomics
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 a theoretical model of the economy the ex ante values of these variables
should be our primary concern. ‘If anybody wants to predict what the equilibrium
value of the final goods output or GDP will be, it is important for her to know
what quantities of the final goods people plan to demand or supply’. We must,
therefore, learn about the determinants of the ex ante values of consumption,
investment or aggregate output of the economy.
Ex Ante Consumption: What does planned consumption depend on? People
spend a part of their income on consumption and save the rest. Suppose your
income increases by Rs 100. You will not use up this entire extra income but
save a certain fraction, say 20 per cent, of it to build up a cushion of savings for
the period when you cease to earn income, or for meeting large expenses in
future. Different people plan to save different fractions of their additional incomes
(with the rich typically saving a greater proportion of their income than the poor),
and if we average these we may arrive at a fraction which will give us an idea of
what proportion of the total additional income of the economy people wish to
save as a whole. We call this fraction the marginal propensity to save (mps). It
gives us the ratio of total additional planned savings in an economy to the total
additional income of the economy. Since consumption is the complement of
savings (additional income of the economy is either put into additional savings
or used for extra consumption by the people), if we subtract the mps from 1, we
get the marginal propensity to consume (mpc), which, in a similar way, is the
fraction of total additional income that people use for consumption. Suppose,
mpc of an economy is c, where 0 < c < 1. If the total income of the economy
increases from 0 to Y , then total consumption of the economy should be
C = c (Y – 0) = c.Y
However, it is not precisely so. We have forgotten something here. If the income
of the economy in a certain year is zero, the above equation tells us that the
economy has to starve for an entire year, which is, obviously, an outrageous
idea. If your income is zero in a certain period you use your past savings to buy
certain minimum consumption items in order to survive. Hence we must add
the minimum or subsistence level of consumption of the economy in the above
equation, which, therefore, becomes
C = C + c.Y (4.1)
where C > 0 is the minimum consumption level and is a given or exogenous
item to our model, which, therefore, is treated as a constant. The equation tells
us that as the income of the economy increases above zero, the economy uses c
proportion of this extra income to increase its consumption above the minimum
level.
Ex Ante Investment: Investment is defined as addition to the stock of physical
capital (such as machines, buildings, roads etc., i.e. anything that adds to the
future productive capacity of the economy) and changes in the inventory (or the
stock of finished goods) of a producer. Note that ‘investment goods’ (such as
machines) are also part of the final goods – they are not intermediate goods like
not to be republished
51 51 51 51 51
Income Determination
raw materials. Machines produced in an economy in a given year are not ‘used
up’ to produce other goods but yield their services over a number of years.
Investment decisions by producers, such as whether to buy a new machine,
depend, to a large extent, on the market rate of interest. However, for simplicity,
we assume here that firms plan to invest the same amount every year. We can
write the ex ante investment demand as
I = I (4.2)
where I is a positive constant which represents the autonomous (given or
exogenous) investment in the economy in a given year.
Ex Ante Aggregate Demand for Final Goods: In an economy without a
government, the ex ante aggregate demand for final goods is the sum total of the
ex ante consumption expenditure and ex ante investment expenditure on such
goods, viz. AD = C + I. Substituting the values of C and I from equations (4.1)
and (4.2), aggregate demand for final goods can be written as
C + I + c.Y
If the final goods market is in equilibrium this can be written as
Y = C + I + c.Y
where Y is the ex ante, or planned, ouput of final goods. This equation can be
further simplified by adding up the two autonomous terms, C and I , making it
Y = A + c.Y (4.3)
where A = C + I is the total autonomous expenditure in the economy. In
reality, these two components of autonomous expenditure behave in different ways.
C , representing subsistence consumption level of an economy, remains more or
less stable over time. However, I has been observed to undergo periodic fluctuations.
A word of caution is in order. The term Y on the left hand side of equation (4.3)
represents the ex ante output or the planned supply of final goods. On the other
hand, the expression on the right hand side denotes ex ante or planned aggregate
demand for final goods in the economy. Ex ante supply is equal to ex ante
demand only when the final goods market, and hence the economy, is in
equilibrium. Equation (4.3) should not, therefore, be confused with the
accounting identity of Chapter 2, which states that the ex post value of total
output must always be equal to the sum total of ex post consumption and ex
post investment in the economy. If ex ante demand for final goods falls short of
the output of final goods that the producers have planned to produce in a
given year, equation (4.3) will not hold. Stocks will be piling up in the warehouses
which we may consider as unintended accumulation of inventories. It is not a
part of planned or ex ante investment. However, it is definitely a part of the
actual addition to inventories at the end of the year or, in other words, an ex
post investment. Thus even though planned Y is greater than planned C +
I, actual Y will be equal to actual C + I, with the extra output showing up
as unintended accumulation of inventories in the ex post I on the right
hand side of the accounting identity.
At this point, we can introduce a government in this economy. The major
economic activities of the government that affect the aggregate demand for final
goods and services can be summarized by the fiscal variables Tax (T) and
Government Expenditure (G), both autonomous to our analysis. Government,
through its expenditure G on final goods and services, adds to the aggregate
not to be republished
52 52 52 52 52
Introductory Macroeconomics
demand like other firms and households. On the other hand, taxes imposed by
the government take a part of the income away from the household, whose
disposable income, therefore, becomes Y
d
= Y – T. Households spend only a fraction
of this disposable income for consumption purpose. Hence, equation (4.3) has to
be modified in the following way to incorporate the government
Y =
C + I + G + c (Y – T )
Note that G – c.T , like
C or I , just adds to the autonomous term A . It does
not significantly change the analysis in any qualitative way. We shall, for the
sake of simplicity, ignore the government sector for the rest of this chapter.
Observe also, that without the government imposing indirect taxes and subsidies,
the total value of final goods and services produced in the economy, GDP, becomes
identically equal to the National Income. Henceforth, throughout the rest of the
chapter, we shall refer to Y as GDP or National Income interchangeably.
4.2 MOVEMENT ALONG A CURVE VERSUS SHIFT OF A CURVE
We shall be using graphical techniques to analyse the model of the economy. It
is, therefore, important for us to learn how to read a graph. Let us now plot two
variables a and b on the horizontal
and vertical axes on a graph
depicting the equation of a
straight line of the form
b = ma + e, where m > 0 is called
the slope of the straight line and
e > 0 is the intercept on the vertical
(i.e. b) axis (Fig. 4.1). When a
increases by 1 unit the value of b
increases by m units. These are
called movements of the variables
along the graph.
Consider a fixed value for
e equal to 2. Let m take two values
m = 0.5 and m = 1, respectively.
Corresponding to these values of
m we have two straight lines, one steeper than the other. The entities e and m are
called the parameters of the graph. They do not appear as variables on the axes,
but act in the background to
regulate the position of the graph.
As m increases in the above
example the straight line swings
upwards. This is called a
parametric shift of a graph.
Since a straight line of the
above form has another
parameter e, we can observe
another type of parametric shift of
this line. To see this hold m
constant at 0.5 and increase the
intercept term e from 2 to 3. The
straight line now shifts in parallel
upwards as shown in Fig. 4.2.
Fig. 4.1
25
20
15
14
10
8
5
2
0
5101215 20 25 30 35
a
b
ba =+ 2
ba = 0.5 + 2
A Positively Sloping Straight Line Swings Upwards
as its Slope is Doubled
Fig. 4.2
25
20
15
10
9
8
5
3
2
0
5101215 20 25 30 35
a
b
ba = 0.5 + 3
ba = 0.5 + 2
A Positively Sloping Straight Line Shifts Upwards in
Parallel as its Intercept is Increased
not to be republished
Page 5

Chapter 4
Income Determination Income Determination Income Determination Income Determination Income Determination
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.
4.1 EX ANTE AND EX POST
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 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
not to be republished
50 50 50 50 50
Introductory Macroeconomics
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 a theoretical model of the economy the ex ante values of these variables
should be our primary concern. ‘If anybody wants to predict what the equilibrium
value of the final goods output or GDP will be, it is important for her to know
what quantities of the final goods people plan to demand or supply’. We must,
therefore, learn about the determinants of the ex ante values of consumption,
investment or aggregate output of the economy.
Ex Ante Consumption: What does planned consumption depend on? People
spend a part of their income on consumption and save the rest. Suppose your
income increases by Rs 100. You will not use up this entire extra income but
save a certain fraction, say 20 per cent, of it to build up a cushion of savings for
the period when you cease to earn income, or for meeting large expenses in
future. Different people plan to save different fractions of their additional incomes
(with the rich typically saving a greater proportion of their income than the poor),
and if we average these we may arrive at a fraction which will give us an idea of
what proportion of the total additional income of the economy people wish to
save as a whole. We call this fraction the marginal propensity to save (mps). It
gives us the ratio of total additional planned savings in an economy to the total
additional income of the economy. Since consumption is the complement of
savings (additional income of the economy is either put into additional savings
or used for extra consumption by the people), if we subtract the mps from 1, we
get the marginal propensity to consume (mpc), which, in a similar way, is the
fraction of total additional income that people use for consumption. Suppose,
mpc of an economy is c, where 0 < c < 1. If the total income of the economy
increases from 0 to Y , then total consumption of the economy should be
C = c (Y – 0) = c.Y
However, it is not precisely so. We have forgotten something here. If the income
of the economy in a certain year is zero, the above equation tells us that the
economy has to starve for an entire year, which is, obviously, an outrageous
idea. If your income is zero in a certain period you use your past savings to buy
certain minimum consumption items in order to survive. Hence we must add
the minimum or subsistence level of consumption of the economy in the above
equation, which, therefore, becomes
C = C + c.Y (4.1)
where C > 0 is the minimum consumption level and is a given or exogenous
item to our model, which, therefore, is treated as a constant. The equation tells
us that as the income of the economy increases above zero, the economy uses c
proportion of this extra income to increase its consumption above the minimum
level.
Ex Ante Investment: Investment is defined as addition to the stock of physical
capital (such as machines, buildings, roads etc., i.e. anything that adds to the
future productive capacity of the economy) and changes in the inventory (or the
stock of finished goods) of a producer. Note that ‘investment goods’ (such as
machines) are also part of the final goods – they are not intermediate goods like
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Income Determination
raw materials. Machines produced in an economy in a given year are not ‘used
up’ to produce other goods but yield their services over a number of years.
Investment decisions by producers, such as whether to buy a new machine,
depend, to a large extent, on the market rate of interest. However, for simplicity,
we assume here that firms plan to invest the same amount every year. We can
write the ex ante investment demand as
I = I (4.2)
where I is a positive constant which represents the autonomous (given or
exogenous) investment in the economy in a given year.
Ex Ante Aggregate Demand for Final Goods: In an economy without a
government, the ex ante aggregate demand for final goods is the sum total of the
ex ante consumption expenditure and ex ante investment expenditure on such
goods, viz. AD = C + I. Substituting the values of C and I from equations (4.1)
and (4.2), aggregate demand for final goods can be written as
C + I + c.Y
If the final goods market is in equilibrium this can be written as
Y = C + I + c.Y
where Y is the ex ante, or planned, ouput of final goods. This equation can be
further simplified by adding up the two autonomous terms, C and I , making it
Y = A + c.Y (4.3)
where A = C + I is the total autonomous expenditure in the economy. In
reality, these two components of autonomous expenditure behave in different ways.
C , representing subsistence consumption level of an economy, remains more or
less stable over time. However, I has been observed to undergo periodic fluctuations.
A word of caution is in order. The term Y on the left hand side of equation (4.3)
represents the ex ante output or the planned supply of final goods. On the other
hand, the expression on the right hand side denotes ex ante or planned aggregate
demand for final goods in the economy. Ex ante supply is equal to ex ante
demand only when the final goods market, and hence the economy, is in
equilibrium. Equation (4.3) should not, therefore, be confused with the
accounting identity of Chapter 2, which states that the ex post value of total
output must always be equal to the sum total of ex post consumption and ex
post investment in the economy. If ex ante demand for final goods falls short of
the output of final goods that the producers have planned to produce in a
given year, equation (4.3) will not hold. Stocks will be piling up in the warehouses
which we may consider as unintended accumulation of inventories. It is not a
part of planned or ex ante investment. However, it is definitely a part of the
actual addition to inventories at the end of the year or, in other words, an ex
post investment. Thus even though planned Y is greater than planned C +
I, actual Y will be equal to actual C + I, with the extra output showing up
as unintended accumulation of inventories in the ex post I on the right
hand side of the accounting identity.
At this point, we can introduce a government in this economy. The major
economic activities of the government that affect the aggregate demand for final
goods and services can be summarized by the fiscal variables Tax (T) and
Government Expenditure (G), both autonomous to our analysis. Government,
through its expenditure G on final goods and services, adds to the aggregate
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52 52 52 52 52
Introductory Macroeconomics
demand like other firms and households. On the other hand, taxes imposed by
the government take a part of the income away from the household, whose
disposable income, therefore, becomes Y
d
= Y – T. Households spend only a fraction
of this disposable income for consumption purpose. Hence, equation (4.3) has to
be modified in the following way to incorporate the government
Y =
C + I + G + c (Y – T )
Note that G – c.T , like
C or I , just adds to the autonomous term A . It does
not significantly change the analysis in any qualitative way. We shall, for the
sake of simplicity, ignore the government sector for the rest of this chapter.
Observe also, that without the government imposing indirect taxes and subsidies,
the total value of final goods and services produced in the economy, GDP, becomes
identically equal to the National Income. Henceforth, throughout the rest of the
chapter, we shall refer to Y as GDP or National Income interchangeably.
4.2 MOVEMENT ALONG A CURVE VERSUS SHIFT OF A CURVE
We shall be using graphical techniques to analyse the model of the economy. It
is, therefore, important for us to learn how to read a graph. Let us now plot two
variables a and b on the horizontal
and vertical axes on a graph
depicting the equation of a
straight line of the form
b = ma + e, where m > 0 is called
the slope of the straight line and
e > 0 is the intercept on the vertical
(i.e. b) axis (Fig. 4.1). When a
increases by 1 unit the value of b
increases by m units. These are
called movements of the variables
along the graph.
Consider a fixed value for
e equal to 2. Let m take two values
m = 0.5 and m = 1, respectively.
Corresponding to these values of
m we have two straight lines, one steeper than the other. The entities e and m are
called the parameters of the graph. They do not appear as variables on the axes,
but act in the background to
regulate the position of the graph.
As m increases in the above
example the straight line swings
upwards. This is called a
parametric shift of a graph.
Since a straight line of the
above form has another
parameter e, we can observe
another type of parametric shift of
this line. To see this hold m
constant at 0.5 and increase the
intercept term e from 2 to 3. The
straight line now shifts in parallel
upwards as shown in Fig. 4.2.
Fig. 4.1
25
20
15
14
10
8
5
2
0
5101215 20 25 30 35
a
b
ba =+ 2
ba = 0.5 + 2
A Positively Sloping Straight Line Swings Upwards
as its Slope is Doubled
Fig. 4.2
25
20
15
10
9
8
5
3
2
0
5101215 20 25 30 35
a
b
ba = 0.5 + 3
ba = 0.5 + 2
A Positively Sloping Straight Line Shifts Upwards in
Parallel as its Intercept is Increased
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Income Determination
How will the producer try to update his
production plans in order to avoid excess supply
or demand? Discuss this in the classroom.
Consider, next, the following
two equations representing a
downward and an upward
sloping straight line, respectively
y = z – x, and, y = 1 + x, z = 0
In the first equation z appears
as an intercept parameter. Hence
for increasing values of z starting
from zero, the first straight line will
undergo parallel upward shifts
as depicted in Fig. 4.3.
Consequently, its points of
intersection with the second
straight line will move up along the
second line as shown in Fig. 4.3.
Suppose we want to find out
the relationship between z and equilibrium values of x. This can be obtained by
plotting the points (x
*
1
, z
1
), (x
*
2
, z
2
), (x
*
3
, z
3
) etc. on a figure depicting the variables
x and z on the horizontal and
vertical axes, respectively, as
shown in Fig. 4.4.
Note that in the (x, y) plane z
was being treated as a parameter.
But in the (x, z) plane z is a variable
in its own right. What we have
essentially done is the following –
we have kept z constant while
dealing with x and y in the second
equation and solved for y in terms
of x. Then we have plugged this
solution in the first equation to
derive the relationship between
x and z. We shall be making use
of this technique throughout
this chapter.
4.3 THE SHORT RUN FIXED PRICE ANALYSIS OF THE PRODUCT MARKET
We now turn to the derivation of aggregate demand under fixed
price of final goods and constant rate of interest in the economy.
In order to hold price constant at any particular
level, however, one must assume that the
suppliers are willing to supply whatever
amount consumers will demand at
that price. If quantity supplied is either
in excess of or falls short of quantity
demanded at this price, price will
change because of excess supply or
demand. To avoid this problem, we
assume that the elasticity of supply is
infinite – i.e., supply schedule is
Fig. 4.3
0
.. .
x
y = z – x
yx = 1 +
z = z
4
z = z
3
z = z
2
z = z
1
y
x
*
1
x
*
2
x
*
3
x
*
4
Parametric Shift of z and Changing Equilibrium
V alues of x
Fig. 4.4
z = 1 + 2x
z
z
3
z
2
z
1
0
x
*
1
x
*
2
x
*
3
x
Relationship between x and z
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