By: Mr.

Vipul Budhiraja m: 98151-67577 Page 1

Macroeconomics
Chapter - 8
(Theory of Income and Employment)

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1. When is equilibrium attained in an economy?

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According to the Keynesian Theory, equilibrium condition is generally stated in terms of aggregate

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demand (AD) and aggregate supply (AS). An economy is in equilibrium when aggregate demand

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for goods and services is equal to aggregate supply during a period of time.
So, equilibrium is achieved when:
AD = AS

t o ….(1)

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We know, AD is the sum total of Consumption (C) and Investment (I):

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AD = C + I .... (2)

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Also, AS is the sum h;>tal of consumption (C) and saving (S):

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AS=C+S …(3)

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Substituting (2) and (3) in (1), we get:

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C+S=C+I

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Or, S = I

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It means, according to Keynes, there are Two Approaches for determining the equilibrium level of
income and employment in the economy.

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2. What assumptions are taken while determining equilibrium in an economy?
The various assumptions made in determination of equilibrium output:

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(i) The determination of equilibrium output is to be studied in the context of two-sector model

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(households and firms). It means, it is assumed that there is no government and foreign sector .

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(ii) It is assumed that investment expenditure is autonomous, i.e. investments are not influenced
by level of income.

(iii) Price level is assumed to remain constant.

(iv)Equilibrium output is to be determined in context of short-run.

3. How equilibrium is determined under AD-AS approach?

According to the Keynesian theory,the equilibrium level of income in an economy is determined

when aggregate demand, represented by C + I curve is equal to the total output (Aggregate
Supply or AS or C + S curve).

Aggregate demand comprises of two components:

• Consumption expenditure (C): It varies directly with the level of income, i.e.
consumption rises with increase in income.

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So, AD curve is represented by (C + I) curve in the income determination analysis. Aggregate
supply is the total output of goods and services of the national income. It is depicted by a 45°
line. Since the income received is either consumed or saved, the AS curve is represented by the
(C + S) curve.

The determination of equilibrium level of income can be better understood with the help of the
following schedule and diagram:

Equilibrium by AD and AS Approach:

Employment Income Consumption Investment Savings AD C+I

ls AS C+S Remarks

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(Lakhs) (Y) (C) (I) (S)

0 0 40 20 -40
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60 i 0 AD>AS
10
20
100
200
120
200
20
20
-20
0
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140
220
100
200
AD>AS
AD>AS

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30 300 280 20 20 300 300 Equilibrium

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40 400 360 20 40 380 400 AD<AS
50 500 440 20 60 460 500 AD<AS
60 600 520 20 80 540 600 AD<AS

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In Fig., the AD or (C + I) curve shows the desired level of expenditure by consumers and firms
corresponding to each level of income. The economy is in equilibrium at point 'E' where (C + I)
curve intersects the 45° line.

• 'E' is the equilibrium point because at this point, the level of desired spending on consumption
and investment exactly equals the level of total output.

• OY is the equilibrium level of output corresponding to point E.

• In Table, the equilibrium level of income is Rs 400 crores, when AD (or C +1) = AS = Rs 400
crores.,
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If there is any deviation from the equilibrium level of output, i.e, when planned spending (AD) is not
equal to planned ou.tput (AS), then a process of readjustment will start in the economy and the
output will tend to adjust up or down until AD and AS are equal again

When AD is more than AS .

When planned spending (AD) is more than planned output (AS), then (C + I) curve lies above the
45° line. It means that consumers and firms together would be buying more goods than firms are
willing to produce. As a result, the planned inventory would fall below the desired level.

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To bring the inventory back to the desired level, firms would resort to increase in employment

there is no further tendency to change.

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and output until the economy is back at output level OY, where AD becomes equal to AS and

When AD is less than AS

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When AD < AS, then (C + I) curve lies below the 45° line. It means that consumers and firms

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together would be buying less goods than firms are willing to produce. As a result, the planned

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inventory would rise.

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To clear the unwanted increase in inventory, firms plan to decrease the employment and output

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until the economy is back at output level OY, where AD becomes equal to AS and there is no

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further tendency to change.

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It must be noted that equilibrium level mayor may not be at the level of full employment, i.e.
equilibrium is possible even at a level lower than the full employment level. For instance, in

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Table, employment level is 40 lakhs corresponding to equilibrium income of ~ 400 crores. It is

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not the full employment level since employment increases even after the equilibrium level.

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4. How equilibrium is determined under I-S approach?

According to this approach, the equilibrium level of income is determined at a level, when

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planned saving (5) is equal to planned investment (1).

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Let us understand this with the help of following schedule and diagram:

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Equilibrium by Saving and Investment Approach:

Income (Y) Consumption ( C) Saving (S) Investment (I) Remarks

0 40 -40 20 S<I
100 120 -20 20 S<I
200 200 0 20 S<I
300 280 20 20 S=I (Equilibrium)
400 360 40 20 S>I
500 440 60 20 S>I
600 520 80 20 S>I

In Fig, Investment curve (I) is parallel to the X-axis because of the autonomous character
investments. The Saving curve (S) slopes upwards showing that as income rises, saving also
rises.

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It planned saving is more than planned investment, i.e. after point 'E' in Fig., it means

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households are not consuming as much as the firms expected them to. As a result, the inventory

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rises above the desired level.

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To clear the unwanted increase in inventory, firms would plan to reduce the production till

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saving and investment become equal to each other.

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When Saving is less than Investment

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If planned saving is less than planned investment, i.e. before 'point 'E' in Fig., it means that

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households are consuming more and saving less than what the firms expected them to. As a
result, Planned inventory would fall below the desired level. To bring the inventory back to the
desired level, firms would plan to increase the production till saving and investment become

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equal to each other.

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5. Explain full employment equilibrium?

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It refers to a situation when the aggregate
demand is equal to the aggregate supply at
full employment level.

• In Fig., E is the full employment equilibrium

because aggregate demand 'EQ' is equal to full
employment level of output ‘OQ'.

• At OQ level of output, all those who are

willing to work at the prevailing wage rate,
are able to nd employment, i.e. there is no
involuntary unemployment.

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 es
the under employment equilibrium.

7. Explain over full employment equilibrium?

It refers to a situation when AD is equal to

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AS beyond the full employment level. It occurs

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after the full employment level.

• In Fig., AD] = AS at point 'G' which is higher than the full

employment level.
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• Point 'G' signi es the over full employment equilibrium.

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Over Full Employment Equilibrium creates In ationary

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Pressure

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• Over Full Employment Equilibrium signi es that
planned-expenditure (AD)-is equal to planned

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output (AS) at a level higher than full employment

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level.

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7. De ne Investment multiplier?
Multiplier (k) is the ratio of increase in national income (ΔY) due to an increase in investment.

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Suppose an additional investment of Rs 4,000 crores in an economy generates an additional

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income of Rs 16,000 crores. The value of multiplier (k), in this case will be:

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It means, income increased 4 times with a single increase in investment.

8. Explain the relation between investment multiplier and MPC?

There exists a direct relationship between MPC and the value of multiplier. Higher the MPC, more
will be the value of multiplier, and vice-versa.
The concept of multiplier is based on the fact that one person's expenditure is another person's
income. When investment is increased, it also increases the income of the people. People spend a
part of this increased income on consumption. However, the amount of increased income spent on
consumption depends on the value of MPC.

• In case of higher MPC, people will spend a large proportion of their increased income on
consumption. In such case, value of multiplier will be more .
• In case of low MPC, people will spend lesser proportion of their increased income on
consumption. In such case, value of multiplier will be comparatively less.

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Algebraic Relationship between Multiplier and MPS

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The algebraic relation between Multiplier and MPC can be derived in the following manner:

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We know, at equilibrium, income (Y) is the sum total of consumption (C) and investment (I).

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Y=C+I

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Similarly, any change in income (ΔY) will also be equal to (ΔC + ΔI) .

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ΔY=ΔC+ΔI

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Dividing both sides by ΔY, we get

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or

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or

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10. What is the maximum value of K?
Maximum Value of Multiplier

The maximum value of multiplier is infinihJ when the value of MPC is 1. MPC = 1 indicates that
the economy decides to consume the whole of its additional income. Here, not even a bit of the
additional income is saved. It will lead to a continuous increase in the consumption expenditure
and value of multiplier will be infinity.

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The minimum value of multiplier is one when the value of MPC is zem. MPC = 0 indicates that
the economy decides to save the whole of its additional income and nothing is spent as
consumption expenditure. So, there will be no further increase in income. As a result, the total
increase in income (Ll Y) will be equal to the increase in investment (LlI), i.e., Ll Y = LlI. Here,
the value of multiplier is equal to 1.

12. Explain the working of investment multiplier?

Working of multiplier is based on the fact that one person’s is expenditure is another person’s
income. When an additional investment is made, than income increases many times more than
the increase in investment. Let us understand with the help of an example:

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• Suppose an additional investment of rupees hundred crore is made to construct a yover. The

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extra investment will generate an extra income of rupees 100 crores in the rst round. But, this
is not the end of the story.

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• If MPC is assumed to be 0.9, recipients of this additional income is spent 90% of rupees

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hundred crores, that is Rs.90 crores as consumption expenditure and the remaining amount

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will be saved. It will increase the income by rupees 90 crores in the second round.

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• In the next round, 90% of the additional income of Rs.90 crores, that is Rs.81 crores will be

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spent on consumption and the remaining amount will be saved.

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• This multiplier process will go on and the consumption expenditure in every round will be 0.90
times of the additional income received from the previous round. The multiplier process is
shown in the table:
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Round
W Increase in Increase in income Increase in Increase in savings

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investment consumption

1 100 100 90 10

pu 90 81 9

Vi 3

4
81

72.90
72.90

65.61
8.10

7.29

— — — —

— — — —

— — — —

Total 100 1000 900 100

Thus, an admission investment of Rs.100 crores leads to a total increase of Rs.1000 crores and
the income. As a result multiplier (k) = 10

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