Income Determination and Multiplier Class 12 Notes

According to Keynesian theory, “An economy is in equilibrium when aggregate demand for goods & services is equal to aggregate supply during a period”. Here are the income determination and multiplier class 12 notes.

So Equilibrium is achieved when:
AD = AS

We know that,
AD = C+I and,
AS = C+S
so, C+I = C+S
or S = I

According to Keynes, there are two approaches to determining the equilibrium level of income & employment in the economy:

1) AD-AS approach
2) S-I approach

Assumptions in the determination of equilibrium output

• Determination of equilibrium output is studied in the context of two sector models i.e., there is no government & foreign sector.
• It is assumed that investment expenditure is autonomous.
• The price level is assumed to be constant.
• Equilibrium output is determined in the context of the short run.

AD-AS Approach

According to Keynesian theory, the equilibrium level of income in an economy is determined when aggregate demand represented by the C+I curve is equal to the total output (Aggregate supply or AS).

AD comprises of two components:

• Consumption Expenditure (C): It varies directly with the level of income, i.e., consumption rises with the rise in income.
• Investment Expenditure (I): It is assumed to be independent of the level of the level of income, i.e., investment expenditure is autonomous. Therefore, the AD curve is represented by C+I.

Aggregate supply is the supply of total output of goods & services of the national income. It is depicted by a 45-degree line. Since income received is either consumed or saved. Thus AS C+S represents curve.

The following schedule & diagram shows the equilibrium level of income:

Explanation of the curve

• AD curve shows the desired level of expenditure by the consumers & the firms corresponding to each level of income.
• The economy is in equilibrium at point E where the AD curve intersects the 45-degree line.
• At point E, the level of desired spending on consumption & investment is exactly equal to the level of total output.
• OY is the equilibrium level of output corresponding to point E.
• The equilibrium level of income is 400 crores when AD is equal to AS.
• It is a situation of effective demand. Effective demand refers to that level of AD which becomes effective because it is equal to AS.

When AD is more than AS

• When AD is more than AS, the C+I curve lies above the 45-degree line.
• It means consumers & the firms together would be buying more goods than the firms are willing to produce.
• As a result, the planned inventory would fall below the desired level.
• To bring the inventory back to the desired level firms would resort to an increase in employment & output until the economy is back at the equilibrium level where AD=AS.

When AD is less than AS

• When AD is less than AS, then the C+I curve lies below the 45-degree line.
• It means that consumers & firms together would be buying less goods than firms are willing to produce.
• As a result, the planned inventory would rise.
• To clear the unwanted increase in inventory firms planned to decrease employment & output until the economy was back at the equilibrium level where AD=AS.

Savings-Investment Approach

According to this approach, the equilibrium level of income is determined when planned saving(S) is equal to planned investment(I).

Schedule of Savings and Investment

Explanation of the Curve

• The investment curve is parallel to the x-axis because of the autonomous character of investments.
• The saving curve slopes upward showing that as income rises savings also rise.
• The economy is in equilibrium at point E where the saving & investment curves intersect each other.
• At point E, ex-ante savings are equal to ex-ante investment.
• OY is the equilibrium level of output corresponding to point E.
• The equilibrium level of income is 400 crores where planning saving = planned investment = 40 crores.

When Saving is More Than Investment

• If planned saving is more than a planned investment that is after point E, it means that households are not consuming as much as firms expected them to.
• As a result, the inventory rises above the desired level.
• To clear the unwanted increase in inventory firms would plan to reduce the production till savings become equal to investment.

When Saving is less than the Investment

• If planned saving is less than planned investment i.e., before point E, it means that households are consuming more & saving less than what the firms expect them to.
• As a result, the inventory falls below the desired level.
• To bring back inventory to the desired level firms would plan to increase the production till savings become equal to investment.

Equilibrium Level

According to classical economics, the equilibrium level of income is attained at full employment level, i.e. there is the absence of involuntary unemployment.
However, according to Keynesian theory, the equilibrium level can be achieved at:

a) Full employment level
b) Under Employment level
c) Over full employment level

Full Employment Level

It refers to a situation AD = AS at full employment situation.

E is the full employment equilibrium because aggregate demand EQ is equal to the full employment level of output OQ.

At the OQ level of output, all those who are willing to work at the prevailing wage rate can find employment i.e., there is no involuntary unemployment.

Under Employment Equilibrium

It refers to a situation when the aggregate demand is equal to the aggregate supply when the resources are not fully employed. It occurs before the full employment level.

AD = AS at point F which is lower than the full employment level. As OQ1 is less than OQ point F, it signifies underemployment equilibrium.

Over Full Employment Equilibrium

It refers to a situation when AD is equal to AS beyond the full employment level. It occurs after the full employment level.

AD1 = AS at point G which is higher than the full employment level. Point G signifies an overfull employment level.

Excess Demand and Deficient Demand Class 12 Notes

Investment Multiplier

Multiplier is the ratio of an increase in national income due to an increase in investment.
K = Delta Y/ Delta I

Example: An additional investment of Rs. 4,000 crores generates an additional income of Rs. 16,000 crores.
K = 16,000/4000
k = 4

Relationship between MPC & Multiplier

There exists a direct relationship between MPC & Multiplier, the higher the MPC, more will be the value of the multiplier.

Note: MPC is based on the fact that one person’s expenditure is another person’s income. When investment increases, the income of the people also increases.
People spend a part of this income on consumption but the amount of proportion spent on consumption depends on the value of MPC.

• In the case of higher MPC, the value of the multiplier will be higher.
• In the case of low MPC, the value of the multiplier will be comparatively less.

Working of Multiplier

Multiplier is the ratio of an increase in national income due to an increase in investment.
K = delta Y/ delta I or K = 1/ 1-MPC

Multiplier is based on the fact that one person’s expenditure is another person’s income. When an additional investment is made then income increases many times more than the increase in investment.

Explanation

1. Suppose an additional investment of 100 crores is made to construct a flyover. This extra investment will generate an extra income of 100 cr. in the first round.
2. If MPC is assumed to be 0.90 then the recipient of this additional income (100cr.) will spend 90cr. as consumption expenditure.
3. It will increase the income by 90cr. in the second round. Now, 90% of 90cr. will be spend on consumption (81cr.) & the rest will be saved (9cr.).
4. This multiplier process will go on & the consumption expenditure will be 0.90 times of the additional income received from the previous round.
5. At last, an initial investment of 100cr. leads to a total increase of 1000cr. in the income. As a result, Multiplier (K) = 1000/100 = 10

Algebraic relation between Multiplier & MPC

We know that, Y = C+I
Or
delta Y = delta C + delta I
Dividing both sides by delta Y
delta Y/delta Y = delta C/deltaY + delta I/delta Y
1 = MPC + 1/K
1/K = 1-MPC
K = 1/1-MPC
Or
K = 1/MPS

So, there are a total 3 formulas for calculating Multiplier:

1) K = delta Y/delta I
2) K = 1/1-MPC
3) K= 1/MPS