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Economics – ISC Handbook of Economics – Theory of Income and Employment - Quick Revision

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Economics – ISC Handbook of Economics – Theory of Income and Employment - Quick Revision – Notes : Aggregate Demand, Aggregate Supply, Consumption Function, Saving Function, Determination of Equilibrium of Income and Employment, Multiplier, Excess and Deficit Demand, Situation of Demand, Defi...

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theory of income and employment
theory of income and employment notes
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9
THEORY OF INCOME AND
EMPLOYMENT

QUICK
1. Aggregate Demand:
(i) Aggregate demand refers to the total expenditure that the residents of a country are ready to incur on the
purchase of goods and services, given their level of income.
(ii) Components:
(a) Consumption demand (C),
(b) Investment demand (I),
(c) Government's demand for goods and services (G) and
(d) Net demand by foreigners Or Net Exports (X-M)
There are only two components of AD in a two sector economy that is consumption demand (C) and investment
demand (1). Thus, AD = C + I.
(ii) Nature of AD: AD depends upon the level of income. Higher the level of income, higher will be the level of
AD. AD curve is upward sloping.

2. Aggregate Supply:
(i) Aggregate supply refers to the total output of goods and services available for purchase by the economy
during a period of one year.
(ii) Components: Aggregate supply is the sum of consumption expenditure (C) and savings (S).Thus, AS = C+S.
(ii) Nature of AS: Aggregate Supply (or flow of goods and services in the economy) increases or decreases in
proportion to increase in employment. As line is 45° line which implies identify between Y on the X-axis and
C+S on the Y-axis.

3. Consumption Function:
(i) The functional relationship between consumption and income is called consumption function. C = f(Y)
(ii) Keynes's Psychological Law of Consumption: This law states that as income of the people rises, their
consumption also rises but increase in consumption is less than increase in income.
(iii) Measures of Propensity of Consume: (a) Average Propensity to Consume (APC) and (b) Marginal
Propensity to Consume (MPC)
APC = C/Y; MPC = AC/AY
APC is the value of consumption function at a particular level of national income. Marginal propensity to
consume measures change in consumption per unit change in income.
ISC HANDBOOK OF ECONOMICS 1

,THEORY OF INCOME AND EMPLOYMENT

4. Saving Function:
(i) It expresses the functional relationship between savings and income and is given by:
S = f(Y)
(ii) Two Measures of Propensity to Save: (a) Average propensity to save (APS) and (b) Marginal propensity to
save (MPS). Average propensity to save is the ratio of total saving to total income. Marginal propensity to save
in the ratio between changes in saving to change in income.
(iii) Negative Savings or Dissavings: It refers to a phenomenon when consumption exceeds income.
(iv) Slope: The slope of saving function is given by 1-b where b denotes marginal propensity to consume.

5. Determination of Equilibrium Level of Income and Employment: Equilibrium level is that level of income
where aggregate demand equals to aggregate supply and the level of planned savings equals to planned
investment. Thus, there are two approaches to determine the level of equilibrium:
(i) AD-AS Approach: Equilibrium level of output (income) is determined when quantity of output produced
(AS) is equal to quantity demanded (AD). That is in equilibrium AD = AS.
(ii) S-1 Approach: The equilibrium level of income is determined at a level when planned savings (S) equal to
planned investment (1), i.e., S = 1.
When aggregate demand is equal to the aggregate supply at full employment level, it is called full employment
equilibrium.
When aggregate demand is equal to the aggregate supply at a level where the resources are not fully employed,
it is called under employment equilibrium.
When AD is equal to AS beyond the full employment level it is called over full employment equilibrium.
Multiplier:
(i) Multiplier (K) refers to the ratio of change in income (AY), to a change in investment (AI). K = 𝛥Y / 𝛥I. The
minimum value of multiplier can be one and the maximum value can be infinity.
(ii) Multiplier is directly related with the MPC, i.e., K = 1/1 - MPC.
(iii) Multiplier is inversely related with the MPS, K = 1/MPS.

6. The Concepts of Full Employment and Involuntary Unemployment: Full employment refers to a situation
in which all able and willing persons are able to find jobs at given wage rate.
In a situation of full employment, frictional unemployment and structural unemployment can exist. If some
able persons are unemployed against their wishes they are called involuntarily unemployed.

EXCESS AND DEFICIENT DEMAND

1. Situation of Demand: There are three situations of demand. These are: (i) Deficient demand, (ii) Excess
demand and (ii) Sufficient demand.
2. Deficient Demand:
(i) Meaning: Deficient demand is a situation which arises when AD is less than the AS corresponding to the full
employment in the economy. This gives rise to a deflationary gap.
(ii) Causes: Deficient demand may be caused by the following factors:
(a) Credit contraction (b) Cut in Government expenditure (c) Rise in taxes (d) Rise in propensity to save.
(iii) Consequences:
(a) Inventory stock of unsold goods will pile up with the producers beyond the desired level.

ISC HANDBOOK OF ECONOMICS 2

,THEORY OF INCOME AND EMPLOYMENT

(b) Producers would plan to cut in production in next round.
(c) Reduction in planned output would cause reduction in the level of income and employment.
(iv) Remedial Measures:
Fiscal Measures: (a) Taxes should be reduced. (b) Government should send more on public works like
construction of roads, bridges, buildings canals, education, health, etc.
Monetary Measures: (a) The central bank should reduce the bank rate and thus making the credit cheaper. (b)
The central bank should buy Government securities from the open market and thus enhance the money supply
in the economy. (c) Reduction in margin requirement of loan to encourage borrowings.

3. Excess Demand:
(i) Excess demand refers to a situation when AD in the economy is more than AS at full employment level of
Output.
(ii) Causes: Excess demand in an economy may be caused by any one of the following factor: (a) Increase in
money supply (b) Rise in propensity to consume (c) Increase in Government expenditure (d) Cut in taxes (e)
Increase in exports.
(iii) Consequences: When aggregate demand increases beyond full employment level, price level rises which
implies a situation of inflation.
(iv) Remedial Measures:
Fiscal Measures: (a) Taxes should be increased. (b) Government expenditure should be reduced.
Monetary Measures: (a) Reduction in availability of credit through: (1) increase in bank rate. (II) increase in
legal reserve requirements.

1 MARK
QUESTIONS
A. FILL IN THE BLANKS
1. The slope of the consumption function is called ______ .
2. The slope of saving curve is called ______ .
3. The sum of APC and APS is equal to ______ .
4. At break-even point savings are ______ .
5. The investment function gives the relationship between investment and the ______ .
6. Net export is the difference between ______ and ______ .
7. If MPC is 0.8 and Y = 100, C would be, ______ .
8. If MPS is zero, MPC would be ______ .
9. If consumption is 100 and income is 200, APS = ______ .
10. If savings are 250 and income is 1000, APC = ______ .
11. At equilibrium level of income ______ is equal to planned investment.
12. The functional relationship between ______ and ______ is known as consumption function.
13. AS is a ______ line.
14. Aggregate supply is ______ + ______ .
15. AD curve starts from ______ .
16. If MPS is 0.2, the value of multiplier is ______ .
17. Raising taxes would help in correcting ______ demand.
18. Consumption and ______ are directly related to each other.
19. Multiplier is the ratio of change in income to the change in ______ .
ISC HANDBOOK OF ECONOMICS 3

, THEORY OF INCOME AND EMPLOYMENT

20. If MPS is 0.1, the multiplier = ______ .
21. Consumption done at zero level of income is known as ______ .
22. Investment done with the profit motive is known as ______ .
23. There is a negative relationship between ______ and multiplier.
24. APS can never be 1 or more than 1 because saving can never be ______ or the national income.
25. Autonomous investment curve is a ______ line.
26. Y = ______ .
27. AD= ______ .
28. AS= ______ .
29. APC = ______ .
30. APS = ______ .
31. MPC = ______ .
32. MPS = ______ .
33. Multiplier K = ______ , ______ ,______ .
34. EQUILIBRIUM = AD = ______ , S = ______ .

ANSWERS

1. MPC 2. MPS 3. One 4. Zero
5. Rate of interest 6. Exports and imports 7. 80 8. One
9. 0.5 10. 0.75 11. Planned saving 12. Consumption and
Income
13. 45 degree 14. Consumption, Saving 15. Above the origin 16. 5
Income
17. Excess 18. Income 19. Investment 20. 10
21. Autonomous 22. Induced investment 23. MPS 24. Equal to or more than
consumption
25. Horizontal straight 26. C+S 27. C+1 28. C+S
29. C/Y 30. S/Y 31. AC/AY 32. AS/AY
33.
𝛥𝑌
,
1
,
1 34. AS, I
𝛥𝐼 1−𝑀𝑃𝐶 𝑀𝑃

B. TRUE OR FALSE
1. The value of APS can never be more than national income.
Ans. [True] Because saving can never be more than national income.

2. Sum of APC and MPC is always equal to one.
Ans. [False] Because APC is the ratio of consumption and income and MPC is the ratio of change in
consumption to the change in income.

3. Value of APS can never be less than zero.
Ans. [False] Value of APS can be less than zero when consumption is more than income.

4. Value of investment multiplier varies between zero and infinity.
ISC HANDBOOK OF ECONOMICS 4

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