Income determination and multiplier

Determination of equilibrium Rajeshwari Rock

• Equilibrium level of income and employment are determined

where AD= AS and planned saving = planned investment.
• There are two ways or approaches of determining the
equilibrium level of income, output and employment in the
economy
 AD – AS approach
 Saving – investment approach
AD = AS approach Rajeshwari Rock

 According to Keynes equilibrium level of income and employment is

determined where AD = AS

Assumptions
The various assumptions used to determine equilibrium
output are:
1.The determination of the equilibrium level will be
examined using a two-sector model (households and firms).
Simply put, it is assumed that there is no foreign industry or
government in the economy.
2.It is also assumed that investment expenditure is
autonomous, i.e., that income level does not have any
impact on investments.
3.It is assumed that the pricing level is constant.
4.Also, to determine equilibrium output, short-run will be
considered.
 Aggregate Demand-Aggregate Supply Approach (AD-AS Approach) Rajeshwari Rock
 The Keynesian theory states that when aggregate demand, as shown by the
C+I curve is equal to the total output (Aggregate Supply or AS), the
equilibrium level of income in an economy is established.
 There are two parts to the aggregate demand:
 Consumption Expenditure (C): This expenditure changes directly with
income; i.e., consumption rises as income rises.
 Investment Expenditure (I): This expenditure is considered to be autonomous
and independent of one’s income level.
 So, in the income determination analysis, the AD curve is represented by the
C+I curve.
 The overall output of goods and services from the national income is known as
the aggregate supply. A 45° line is used to represent it. The AS curve is
represented by the (C+S) curve because the money received is either spent or
saved.
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 The AD or (C+ I) curve in the above graph shows the desired expenditure level by
consumers and businesses at each level of income. At point E where the (C+ Rajeshwari
I) curve Rock
intersects the 45° line, the economy is in equilibrium.
 Observations:
 The equilibrium point, denoted by the letter E, occurs when desired expenditure on
consumption and investment is equal to the total output.
 OY is the output at the equilibrium level that corresponds to point E.
 In the above table, the Aggregate Demand is equal to the Aggregate Supply; i.e., ₹200
Crores, when the equilibrium level of income is ₹200 Crores.
 It is a case of Effective Demand. Effective demand refers to that level of AD that
becomes ‘effective’ since it is equal to AS.
 Readjustment Process
 When there is any deviation from the equilibrium level of output; i.e., if the planned
spending or AD is not equal to planned output or AS, then to bring them equal to each
other, the process of readjustment is started in the economy.
1. When AD is more than AS
Rajeshwari Rock
 If planned expenditure (AD) exceed planned output (AS), the (C+ I) curve will be
over the 45° line. In this situation, consumers and businesses together would be
purchasing more items than they are willing to produce, because of which the
planned inventory would ultimately fall below the desired level. Therefore, until
the economy reaches output level OY, where AD equals AS and there is no longer
a tendency to fluctuate, firms would increase employment and output to bring
the inventory back to the desired level.
2. When AD is less than AS
 If planned expenditure (AD) is less than planned output (AS), (C+ I) curve will lie
below the 45° line. In this situation, consumers and businesses together would
be purchasing fewer items than they are willing to produce, because of which
the planned inventory would rise. Therefore, until the economy reaches output
level OY, where AD equals AS and there is no longer a tendency to fluctuate,
firms would decrease employment and output to bring unwanted inventory back
to the desired level.
Saving = Investment Approach Rajeshwari Rock
 Saving means storing money safely for the future so that when one needs
money, it is available for them. However, Investment means putting one’s
money to work in financial instruments like bonds, shares, etc., to grow
money over time. Saving-Investment Approach (S-I Approach) is used to
determine the equilibrium level of income, output, and employment in an
economy.
 The Investment curve in the above graph shows the autonomous investment made; Rajeshwari Rock
therefore, it is parallel to the X-axis. The Saving Curve S slopes upward, which means
that saving increases with an increase in income. At point E where the investment curve
intersects the saving curve, the economy is in equilibrium.
 Observations:
 The equilibrium point, denoted by the letter E, occurs where saving and investment
curves intersect each other.
 Also, at point E, ex-ante saving is equal to ex-ante investment.
 The equilibrium level of output corresponding to the equilibrium point E is OY.
 In the above table, planned saving is equal to planned investment; i.e., ₹30 Crores, when
the equilibrium level of income is ₹200 Crores.
 Readjustment Process
 When there is any deviation from the equilibrium level of income; i.e., if the planned
saving or S is not equal to planned investment or I, then to bring them equal to each
other, the process of readjustment is started in the economy.
1. When Saving is more than the Investment
Rajeshwari Rock
 In the above graph (example), if planned saving (S) exceeds planned investment (I)
(after point E), it implies that households are not consuming as much as the
businesses expected, which results in an increase in the inventory level above the
desired level. Therefore, to get rid of the unwanted increase in inventory, until
saving and investment become equal to each other, companies would plan to reduce
output.
2. When Saving is less than the Investment
 In the above graph (example), if planned saving (S) is less than planned investment
(I) (before point E), it implies that consumers are likely consuming more and saving
less than what businesses expect, which results in a reduction in the inventory level
below the desired level. Therefore, in order to bring the inventory back to the
desired level, until saving and investment become equal to each other, firms would
plan to increase output.
Full employment equilibrium Rajeshwari Rock
 A situation when the aggregate
demand is equal to the aggregate
supply at full employment level is
Full Employment Equilibrium.
 In the graph below, the full
employment equilibrium is point E
because at this point, the
aggregate demand (EQ) is equal to
OQ; i.e., full employment output
level.
 In simple terms, at OQ output
level, people who are willing and
able to work at a prevailing wage
rate are getting the job. At this
point, there is no involuntary
unemployment.
Under employment equilibrium Rajeshwari Rock
 A situation when the resources
are not fully employed at the
point where the aggregate
demand and aggregate supply
are equal to each other is
Underemployment Equilibrium.
 This point of equilibrium occurs
before the full employment
equilibrium. In the below
graph, at point F, AD1 = AS, and
this point is lower than the full
employment level.
 Therefore, as OQ1 is less than
OQ, point F indicates
underemployment equilibrium.
 Over employment equilibrium
Rajeshwari Rock
 A situation when beyond the full employment level, the
aggregate demand is equal to the aggregate supply is
Over Full Employment Equilibrium.
 This point of equilibrium occurs after the full
employment equilibrium.
 In the below graph, at point G, AD1 = AS, and this point is
higher than the full employment level. Therefore, point
G indicates over full employment equilibrium.
 However, in reality, the situation of over full employment
equilibrium creates Inflationary Pressure. It is because
over full employment equilibrium means that the planned
expenditure is equal to the planned output at level which
is higher than the full employment level, and in real life,
the actual output can never increase beyond the full
employment level as the economy is already at full
employment and has no idle capacity.
 Therefore, if there is any increase in aggregate demand
beyond the full employment output, then it will result in
an increase in general price level or inflation, resulting in
no real increase in the output.
 Investment Multiplier Rajeshwari Rock
 Meaning
• The ratio of change in national income to the change in investment.
• Symbolically, K= ΔY/ ΔI
• Where, K = Multiplier
• Δ Y = Change in income
• Δ I = Change in investment
• For example= suppose investment increases by Rs 50 crore and as a result, national
income increases by Rs 200 crore. The value of multiplier in this case will be K= ΔY/
ΔI , K= 200/50 = 4.
• Multiplier explains how many times the national income increases as a result of
increase in investment
• Multiplier is the number by which the change in investment must be multiplied in
order to determine the resulting change in income
ΔY = K x ΔI
 Relationship of K with MPC and MPS
• Value of MPC depends on the value of MPC and MPS. Rajeshwari Rock

• Direct relationship between MPC and Multiplier[K] i.e. Higher the MPC, higher the
multiplier.
• K = 1/ 1-MPC
• There is an inverse relationship between MPS and the value of Multiplier. Higher the value
of MPS, lower is the Multiplier.
• K = 1/ 1 – MPC , MPC + MPS = 1
• Therefore MPS = 1 – MPC, K = 1/MPS
• Derivation of the relationship
• K= ΔY/ ΔI………….[i]
• We know that, Y = C+I………..[ii]
• ΔY = ΔC + ΔI
• Δ I = ΔY – ΔC
• Putting the value of ΔI in [i] K = ΔY/ ΔY – ΔC
• Dividing the right side of the equation by ΔY,
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 Working of the multiplier [Multiplier mechanism]

• The operation of the multiplier is based on the assumption that the expense of one is the income of the
other.
• Let MPC be at 0.5 or ½ [showing 50% of additional income will be spent].
• There is an increase in investment of Rs.100 crore [ΔI = 100 crores]

 Multiplier process
• The working of multiplier assumes the following process:
• Change in investment causes change in income. As a result , there is change in consumption.
Consumption expenditure of one person is the income of the other. Hence, the change in consumption
leads to change in income. This process continues till change in consumption [ΔC]
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Maximum and minimum value of multiplier Rajeshwari Rock
• The maximum value of multiplier is infinity
when the value of MPC [MPC =1] is one or
MPS is zero [MPS = 0]
• The minimum value of multiplier is 1 when
MPC = 0 and MPS = 1