Theory of Income and Employment - Economics 12th ISC Refresher course.pptx

Suitable for Class 12 ISC Economics

1. Theory of income and Employment Economics 12 th ISC Refresher course

2. Exante Demand Exante demand refers to the desired demand or planned demand during the period of one year. This is the market demand which is intented to be expected in the economy during the period of one year.

3. Ex post demand (effective) Ex-post aggregate demand refers to the actual demand in the economy during the period of one year. Actual consumer spending and business capital investment are included in ex-post aggregate demand. In other words, the ex-post describes what actually occurred.

4. Aggregated demand means the total demand for final goods and services in an economy. It is the total (final) expenditure of all the units of the economy, i.e., households, firms, government, and the rest of the world. (b) Following are the various components of aggregate demand: Components of aggregate demand AD = C + I + G + (X – M) (a) Private (Household consumption expenditure) (C)) ● It comprises a household’s expenditure on the consumption of goods and services. ● \ Aggregate demand and its components ● Net exports depend upon many things like foreign trade policy, foreign exchange rate, comparative prices, quality, etc. Aggregated demand means the total demand for final goods and services in an economy. It is the total (final) expenditure of all the units of the economy, i.e., households, firms, government, and the rest of the world. Aggregate Demand refers to the desired level of expenditure in the economy during an accounting year. It is what people wish to spend on the purchase of goods and services during an accounting year. Aggregate demand= C+I+G+ (X-M) where C= Consumption expenditure I= Investment expenditure G= Government expenditure (X-M)= Net export, where X= Exports and M= Imports.

5. Marginal propensity to save Marginal Propensity to Save or MPS is a concept propounded in Keynesian macroeconomic theory, which refers to the proportion of any additional income that is saved by a consumer rather than utilizing it for spending on the consumption of goods and services. In other words, it shows how much an individual is willing to save when he receives some additional income. For example, if we say MPS is 2%, then the individual is willing to save 2 rupees for every 100 rupees earned by him. MPS is represented by a savings line which is a sloped line that is created by putting change in savings on the y-axis (vertical) and change in income on the x-axis (horizontal)

6. . Marginal Propensity to save Any change in government expenditure will lead to an increase in disposable income that will lead to increased consumption. The increased consumption will result in an increase in disposable income for other sectors, which leads to further consumption. Calculating MPS MPS is calculated using the following formula MPS = Change in Savings (ΔS) / Change in Disposable Income (ΔY)

7. Marginal propensity to Save Y S S= -a+(1-b) y dS dY MPC = b MPS= 1-b or dS/dY -a Autonomous saving ( negative at low income)

8. Marginal propensity to Consume Marginal Propensity to Consume or MPC is an important component of the Keynesian macroeconomic theory. This theory suggests that the individual has a propensity to consume more with an additional rise in income. In other words, Marginal Propensity to Consume (MPC) measures the proportionate rise in the consumption with increase in income or we can say it measures the proportion of extra pay that is spent on consumption of goods and services rather than saving it. Marginal Propensity to Consume or MPC is dependent on the income level. It may vary with the income levels and it can be seen that the MPC is lower at higher income levels. MPC can be calculated by determining the change in consumption divided by the change in income. MPC is represented by the consumption line, which is a sloped line that is formed when change in consumption is plotted on the vertical y-axis with change in income on the horizontal x-axis.

9. Marginal propensity to consume C onsumption Income Marginal propensity to consume MPC = C Y C= Change in consumption Y= Change in Income

10. Average propensity to consume The average propensity to consume (APC) is a measure of the fraction of the total disposable income consumed. It is considered a significant concept for both individual consumers and economists. The average propensity to consume (APC) is the cumulative measure of the fraction of spent income. The APC is graphically represented by the slope of the consumption function. An estimate of the average propensity to consume not only shows the proportion of household income that is saved but also the total amount saved.

11. Average Propensity to Save The ratio of total saving to total income is called APS. Alternatively, it is that part of total income which is saved. By dividing total saving (S) with total income (Y), we get APS APS = S/Y For instance, in the following table when national income is Rs 200 crore, saving is Rs 30 crore. In this case APS = SA’ = 30/200 = 0.15 or 15%.

12. Equilibrium output ( Aggregate demand and Aggregate supply approach ) According to the Keynesian theory, the equilibrium level of income in an economy is determined at the intersection point of AD and AS curves. Aggregate demand Aggregate demand means the total demand for final goods in an economy. The AD curve has a positive slope, which means that when income increases, AD (expenditure) also increases. It is represented by C + I. Aggregate supply It is the value of the total quantity of final goods and services produced in the economic territory of a country. An aggregate supply curve is the sum total of consumption and saving.It is a positively sloped 45° straight line curve starting from the origin .

13. E AD=C+I C= C + cY AS = Y= Expenditure T Planned output   I C AD Planned expenditure

14. Aggregate demand is more than Aggregate supply. When AD > AS i.e., the economy is operating at any level before the equilibrium It means that households and firms taken together are willing to buy more than what the firms are planning to produce, i.e., the AD curve lies below the AS curve. It would lead to the unplanned and undesired decrease in inventories. Remedy If some unemployed or under-employed resources are there in the economy, firms would utilise them and increase production. This will increase the level of income and employment. This process of increase in the output will continue until the economy reaches the equilibrium level, where AD = AS.

15. Aggregate demand is less than Aggregate supply. It means that households and firms taken together are willing to buy less than what the firms are planning to produce, i.e., the AD curve lies above the AS curve. It would lead to unplanned/unwanted accumulation of inventories. Remedy In this situation, firms would decrease production and employment. This will decrease the level of income as well as the aggregate demand. This process of decrease in the output and income will continue until the economy reaches the equilibrium level, where AD = AS.

16. Equilibrium output (Savings and Investment Approach ) S 1 Y M1 I E1 S=I Equilibrium I=S o Y’ Saving / Investment Income / Output / Employment

17. Equilibrium output: Savings and Investment approach According to this approach of equilibrium, the equilibrium is reached only when Investment(I) equals Savings(S) because at this level there is no tendency for income and output to change. In the diagram the equilibrium is at E where savings intersects investment curve At this point, I=S. When S is more than I , then the planned inventory would fall below the desired level. To bring back the Inventory at the desired level, the producers expand the output More output means more income. Rise in output means rise in I and rise in income means rise in S. Both continue to rise till they reach E, S=I. When S is less than I, then the planned inventory rises above the desired level. To clear the unwanted increase in inventory, firms plan to reduce the output till S becomes equal to I. So, equilibrium takes place only at point E, when S=I.

18. Investment multiplier Investment multiplier is an important part of economic theories suggested by notable economist John Maynard Keynes. According to this concept, in the event of an increase in the investment activities either public or private which can be in the form of private consumption spending, government spending in an economy, there is a corresponding increase in the Gross Domestic Product (GDP) of the economy by a value more than the amount invested. In simple words, investment multiplier refers to the increase in the aggregate income of the economy as a result of an increase in the investments done by the government in the form of new projects. The size of the investment multiplier is determined by the decisions of the households in an economy in the areas of spending (which is known as marginal propensity to consume) or saving (known as marginal propensity to save).

19. The multiplier can be represented by the following formula. K = ΔY / ΔI Where, ΔY = Increase in GDP or National Income ΔI = Increase in Investment Also, k = 1/ 1- MPC Where k = Investment Multiplier MPC = Marginal Propensity to Consume And, k = 1/ MPS MPS = Marginal Propensity to Save Therefore, it can be concluded that K = 1/ 1- MPC = 1/ MPS

20. It can be said that in order to find the value of the investment multiplier, either the value of MPC or MPS should be determined or the value of the multiplier can be determined if MPC or MPS values are provided. Let us understand the mechanism of investment multiplier with an example.

21. Suppose the government has made an investment of 100 crores in a road construction project. This will lead to hiring of labourers, engineers and suppliers of raw materials, logistics. In short such an investment will lead to job opportunities for many people. It will result in income generation, which will result in their tendency to consume and save.Let’s say the MPC of the labourers is 0.5, that means that for every 1 rupee earned they spend 0.50 rupees in consumption of goods and services. Simple Numerical

22. Similarly, we can find the value of the multiplier when MPS = 0.2 K = 1/MPS K= 1/0.2 K= 5 Therefore, it can be seen that if the MPS value is less than the multiplier, the value increases, and when the value of MPC is more then the investment multiplier becomes more. The value of MPS or MPC can be used to find the total increase in income obtained from the initial investment by using the following formula

23. K = ΔY / ΔI and, K = 1/MPS Therefore, in the above example an investment of 100 crores will bring total income of ΔY / ΔI = 1/MPS ΔY / 100 = 1/0.2 ΔY / 100 = 5 ΔY = 500 Therefore, the total increase in income will be 500 Crores.

24. Full Employment Full employment refers to a situation in which all those people, who are willing and able to work at the existing wage rate, get work without any undue difficulty. It also refers to employment of all the other available resources and factors of production for the production of optimum output.

25. Excess demand EF indicates the excess demand or the inflationary gap. Excess demand is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. It implies two things- 1) Planned aggregate demand in the economy happens to exceed its full employment level. 2) The level of aggregate demand surpasses the level of aggregate supply even when the available factors are fully utilized.

26. Deficient Demand Deficient demand refers to a situation wherein aggregate demand in the economy falls short of aggregate supply of goods and services at full employment. Impacts: 1)Deficient demand leads to a fall in the income level, output and employment. 2)A persistent fall in the deficient demand leads to a state of depression in the economy.

27. Measures to correct excess demand and deficient demand Two measures by which a central bank can check the excess demand or inflation are as follows: 1) Increase in bank rate: During inflation bank rate is increased. As a follow-up action, the commercial banks rise the market rate of interest. This reduces the demand for credit and thus inflation can be combated. 2) Open market operation is the policy that focuses on increasing and decreasing the stock of liquidity with the people, through sale and purchase of securities by the central bank. During excess demand or inflation, the central bank tries to sell securities. The sale of securities reduces purchasing power from the market. Consequently, aggregate demand is decreased and excess demand or inflationary gap gets combated.

28. Presentation by Himaan Harish S BSc Economics ( Honours ) BASE University