Page 1
Chapter 4
Chapter 4
Determination of Income and Determination of Income and Determination of Income and Determination of Income and Determination of Income and
Employment Employment Employment Employment 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
Page 2
Chapter 4
Chapter 4
Determination of Income and Determination of Income and Determination of Income and Determination of Income and Determination of Income and
Employment Employment Employment Employment 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
54 54 54 54 54
Introductory Macroeconomics
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
the consumption expenditure by households. This consists of two
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
Page 3
Chapter 4
Chapter 4
Determination of Income and Determination of Income and Determination of Income and Determination of Income and Determination of Income and
Employment Employment Employment Employment 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
54 54 54 54 54
Introductory Macroeconomics
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
the consumption expenditure by households. This consists of two
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
55 55 55 55 55
Income Determination
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<1).
Imagine a country Imagenia which has a consumption function
described by C=100+0.8Y .
This indicates that even when Imagenia does not have any income,
its citizens still consume Rs. 100 worth of goods. Imagenia’s autonomous
consumption is 100. Its marginal propensity to consume is 0.8. This
means that if income goes up by Rs. 100 in Imagenia, consumption will
go up by Rs. 80.
Let us also look at another dimension of this, savings. Savings is
that part of income that is not consumed. In other words,
S Y C = -
We define the marginal propensity to save (MPS) as the rate of change
in savings as income increases.
S
MPS s
Y
?
= =
?
Since, S Y C = - ,
( )
1
Y C
s
Y
Y C
Y Y
c
? -
=
?
? ?
= -
? ?
= -
Some Definitions
Marginal propensity to consume (MPC): it is the change in
consumption per unit change in income. It is denoted by c and is
equal to
C
Y
?
?
.
Marginal propensity to save (MPS): it is the change in savings per
unit change in income. It is denoted by s and is equal to 1 c - . It
implies that 1 s c + = .
Average propensity to consume (APC): it is the consumption per
unit of income i.e.,
C
Y
.
Average propensity to save (APS): it is the savings per unit of income
i.e.,
S
Y
.
Reprint 2024-25
Page 4
Chapter 4
Chapter 4
Determination of Income and Determination of Income and Determination of Income and Determination of Income and Determination of Income and
Employment Employment Employment Employment 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
54 54 54 54 54
Introductory Macroeconomics
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
the consumption expenditure by households. This consists of two
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
55 55 55 55 55
Income Determination
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<1).
Imagine a country Imagenia which has a consumption function
described by C=100+0.8Y .
This indicates that even when Imagenia does not have any income,
its citizens still consume Rs. 100 worth of goods. Imagenia’s autonomous
consumption is 100. Its marginal propensity to consume is 0.8. This
means that if income goes up by Rs. 100 in Imagenia, consumption will
go up by Rs. 80.
Let us also look at another dimension of this, savings. Savings is
that part of income that is not consumed. In other words,
S Y C = -
We define the marginal propensity to save (MPS) as the rate of change
in savings as income increases.
S
MPS s
Y
?
= =
?
Since, S Y C = - ,
( )
1
Y C
s
Y
Y C
Y Y
c
? -
=
?
? ?
= -
? ?
= -
Some Definitions
Marginal propensity to consume (MPC): it is the change in
consumption per unit change in income. It is denoted by c and is
equal to
C
Y
?
?
.
Marginal propensity to save (MPS): it is the change in savings per
unit change in income. It is denoted by s and is equal to 1 c - . It
implies that 1 s c + = .
Average propensity to consume (APC): it is the consumption per
unit of income i.e.,
C
Y
.
Average propensity to save (APS): it is the savings per unit of income
i.e.,
S
Y
.
Reprint 2024-25
56 56 56 56 56
Introductory Macroeconomics
4.1.2. 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 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.
4.2 DETERMINATION OF INCOME IN TWO-SECTOR MODEL
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
AD = 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 should
be noted that inventories or stocks refers to that part of output produced which
is not sold and therefore remains with the firm. Change in inventory is called
Reprint 2024-25
Page 5
Chapter 4
Chapter 4
Determination of Income and Determination of Income and Determination of Income and Determination of Income and Determination of Income and
Employment Employment Employment Employment 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
54 54 54 54 54
Introductory Macroeconomics
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
the consumption expenditure by households. This consists of two
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
55 55 55 55 55
Income Determination
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<1).
Imagine a country Imagenia which has a consumption function
described by C=100+0.8Y .
This indicates that even when Imagenia does not have any income,
its citizens still consume Rs. 100 worth of goods. Imagenia’s autonomous
consumption is 100. Its marginal propensity to consume is 0.8. This
means that if income goes up by Rs. 100 in Imagenia, consumption will
go up by Rs. 80.
Let us also look at another dimension of this, savings. Savings is
that part of income that is not consumed. In other words,
S Y C = -
We define the marginal propensity to save (MPS) as the rate of change
in savings as income increases.
S
MPS s
Y
?
= =
?
Since, S Y C = - ,
( )
1
Y C
s
Y
Y C
Y Y
c
? -
=
?
? ?
= -
? ?
= -
Some Definitions
Marginal propensity to consume (MPC): it is the change in
consumption per unit change in income. It is denoted by c and is
equal to
C
Y
?
?
.
Marginal propensity to save (MPS): it is the change in savings per
unit change in income. It is denoted by s and is equal to 1 c - . It
implies that 1 s c + = .
Average propensity to consume (APC): it is the consumption per
unit of income i.e.,
C
Y
.
Average propensity to save (APS): it is the savings per unit of income
i.e.,
S
Y
.
Reprint 2024-25
56 56 56 56 56
Introductory Macroeconomics
4.1.2. 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 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.
4.2 DETERMINATION OF INCOME IN TWO-SECTOR MODEL
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
AD = 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 should
be noted that inventories or stocks refers to that part of output produced which
is not sold and therefore remains with the firm. Change in inventory is called
Reprint 2024-25
57 57 57 57 57
Income Determination
inventory investment. It can be negative as well as positive: if there is a rise in
inventory, it is positive inventory investment, while a depletion of inventory is
negative inventory investment. The inventory investment can take place due to
two reasons: (i) the firm decides to keep some stocks for various reasons (this is
called planned inventory investment) (ii) the sales differ from the planned level of
sales, in which case the firm has to add to/run down existing inventories (this is
called unplanned inventory 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
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.
4.3 DETERMINATION OF EQUILIBRIUM INCOME IN THE SHORT RUN
You would recall that in microeconomic theory when we analyse the equilibrium
of demand and supply in a single market, the demand and supply curves
simultaneously determine the equilibrium price and the equilibrium quantity.
In macroeconomic theory we proceed in two steps: at the first stage, we work out
a macroeconomic equilibrium taking the price level as fixed. At the second stage,
we allow the price level to vary and again, analyse macroeconomic equilibrium.
What is the justification for taking the price level as fixed? Two reasons can
be put forward: (i) at the first stage, we are assuming an economy with unused
resources: machineries, buildings and labours. In such a situation, the law of
diminishing returns will not apply; hence additional output can be produced
without increasing marginal cost. Accordingly, price level does not vary even if
the quantity produced changes (ii) this is just a simplifying assumption which
will be changed later.
4.3.1 Macroeconomic Equilibrium with Price Level Fixed
(A) Graphical Method
As already explained, the consumers demand can be expressed by the equation
C C cY = +
Reprint 2024-25
Read More