Determination of Income and Employment | Chapter 3 Notes

Determination of Income and Employment

Aggregate Demand And Its Components

Aggregate demand is an economic measurement of the total amount of demand for all finished goods and services at a specific price produced in an economy. 

It is the number of goods and services people buy. It’s usually reported for a specific time period, such as month, quarter, or year.

Demand changes as the price increases. That’s called the law of demand. It says people will want more goods and services when prices fall. They will buy less as prices increase.

The aggregate demand formula is AD = C + I + G +(X-M).

Aggregate demand has four components: consumption, investment, government spending, and net exports.

Consumption of goods and services can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

Investment can change based on expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. 

Investment also changes when interest rates rise or fall.

Government spending and taxes are determined by political considerations.

Exports and imports of goods change according to relative growth rates and prices between two economies.

An inflationary gap exists when equilibrium is at a level of output above potential GDP.

Propensity to consume and propensity to save (average and marginal). 

Marginal Propensity To Consume (MPC)

The marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, instead of saving it. 

Marginal propensity to consume is a component of Keynesian macroeconomic theory which is calculated as the change in consumption divided by the change in income. 

MPC varies by income level. It is typically lower at higher incomes.

The marginal propensity to consume is equal to Change in income/ change of consumption If consumption increases by 80 cents for each additional Rupees of income, then MPC is equal to 0.8 / 1 = 0.8.

Suppose you receive a Rupees 50000 bonus on Diwali on top of your normal annual earnings. You suddenly have 50000 more in income. 

If you decide to spend 40000 of this marginal increase in income on a new suit and save the remaining 10000, your marginal propensity to consume will be 0.8 (40000 divided by 50000).

On the other hand your saving of 0.2 (10000/50000) will be your MPS (Marginal Propensity to Save). 

If you decide to save the entire 50000, your marginal propensity to consume will be 0 (0 divided by 50000), and your marginal propensity to save will be 1 (50000 divided by 50000).

Marginal Propensity to Save (MPS)

The marginal propensity to save (MPS) refers to the proportion of an aggregate raise in income that a consumer saves rather than spends on the consumption of goods and services. 

This save is the proportion of each added dollar of income that is saved rather than spent. 

MPS is a component of Keynesian macroeconomic theory which is calculated as the change in savings divided by the change in income, or as the complement of the marginal propensity to consume (MPC).

This savings is the proportion of an increase in income that gets saved instead of spent on consumption.

MPS varies by income level. It is higher at higher incomes.

Short Run Equilibrium Output

Short run is a period of time during which the level of output is determined by the level of employment in the economy.

In short run the firm can try varying its output by bringing about a change in the variable factors of production, which can lead to maximum profit or losses.

In this short period, the prices and wages are slow to adjust to equilibrium level thereby creating sustained periods of shortage or surplus and thus prevents the economy from operating, as per its full potential 

An economy is in short run equilibrium when the level of aggregate output demanded is equal to the level of aggregate output supplied.

Equilibrium Output refers to the level of output where the Aggregate Demand is equal to the Aggregate Supply (AD = AS) in an economy. 

It signifies that whatever the producers produce during the year is exactly equal to what the buyers intend to buy during the year.

Therefore, AD = C + I (for a two-sector economy) and AS = C + S

(AD = Aggregate Demand, AS = Aggregate Supply, C = Consumption, I = Investment, S = Saving)

Investment multiplier and its mechanism

Investment Multiplier refers to increase in national income as a multiple of a given increase in Investment.

It refers to the concept that any increase in public or private investment spending has a more than proportionate positive impact on aggregate income and the general economy.

It is multiplying investment spending beyond those immediately measurable. The larger an investment’s multiplier, the more efficient it is in creating and distributing wealth throughout the economy.

Investment Multiplier is rooted in the economic theories of John Maynard Keynes.

The range of the investment multiplier depends on two factors: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).

The investment multiplier tries to determine the economic impact of public or private investment. For instance, extra government spending on roads can increase the income of construction workers and materials suppliers. 

These workers may spend the extra income in the retail, consumer goods, or service industries, boosting the income of the workers in those sectors which boost the economy.

Suppose increase in investment is Rs 1000 and MPC = 0.8. The increase in national income is in the following sequence: 

  • Increase in investment on goods raises income of those who supply investment goods by Rs 1000. This is the first round increase   
  • Since MPC = 0.8, the income earners spend Rs 800 on consumption, which raises the income of the suppliers of consumption goods by Rs 800. This is a second round increase.   
  • In the similar way, the third round increase is Rs 640 = 800 × 0.8. In this way, national income goes on increasing round after round.    
  • The total increase in income is Rs 5000.

Full employment and involuntary unemployment

Full Employment

Full employment refers to the people, who are willing and able to work at the existing wage rate, get work without any difficulty.

Generally, the term ‘full employment’ means that there is no unemployment that means everyone gets work. And the demand for labor is equal to its supply. 

However, in macroeconomics, there can be some types of unemployment even during full employment. 

Under full employment, there can be two types of unemployment:

  • Frictional Unemployment:

It is temporary unemployment, which exists during the period wherein workers leave one job and join some other. 

It happens due to labor market imperfections such as lack of market information about availability of jobs and lack of perfect mobility on the part of workers. 

Introduction of new machines, nationalization in the production process or breakdown of plants may also lead to frictional unemployment.

  • Structural Unemployment

In this type of unemployment, people remain unemployed due to a mismatch between unemployed persons and the demand for specific types of workers. It is associated with structural changes in the economy. 

For example, due to computerization, workers who do not have enough knowledge of computers will be unemployed until they do some computer courses or training.

These two types of unemployment are referred as ‘Natural rate of Unemployment’. It must be noted that the concept of Full Employment is explained only in the context of ‘labor force’.

Labor force refers to that part of the population which is physically and mentally able and willing to work. Children and old persons will not be considered as they are not supposed to be employed even during full employment.

Involuntary Unemployment

Involuntary unemployment refers to all those people, who are willing and able to work at the existing wage rate, do not get work. 

Under involuntary unemployment, people are unemployed against their wishes or under compulsion. It must be noted that only involuntary unemployment is considered while estimating the total unemployment in an economy.

Problems Of Excess Demand And Deficient Demand

Problem of Excess Demand 

Excess demand is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. 

When in an economy, aggregate demand exceeds aggregate supply, the demand is said to be an excess demand.

Suppose by employing all its available resources a company can produce 10,000 quintal of rice. But aggregate demand of rice is 12,000 quintal, this extra demand of 2000 will be called an excess demand, 

Causes of Excess Demand 

The main reasons for excess demand are apparently the increase in the following components of aggregate demand:

Reason of Excess Demand

  • Increase in household consumption demand due to rise in propensity to consume.  
  • Increase in private investment demand because of rise in credit facilities.  
  • Increase in public (government) expenditure.   Increase in export demand.  
  • Increase in money supply or increase in disposable income.

Effects of excess demand on price, output, employment:

  • Increase in General Price Level: Excess demand rise general price level, it arises when aggregate demand is more than aggregate supply at a full employment level. 
  • Output: Excess demand has no effect on the level of output, because the economy is at full employment level and there is no idle capacity in the economy. 
  • Employment: There will be no change in the level of employment also.

The economy is already operating at full employment equilibrium, and hence, there is no unemployment.

Measures to control the excess demand:

We can control the excess demand with the help of the following policy:

a) Fiscal Policy     b) Monetary Policy

  • Fiscal Policy:

Fiscal policy is the expenditure and taxation policy of the government to accomplish the desired objectives. The objective of fiscal policy is to reduce aggregate demand.

Determination of Income and Employment, tools of fiscal policy

The main tools of fiscal policy are:

(i) Reduce Expenditure policy:

In case of excess demand, government should reduce its expenditure on public works such as roads, buildings, rural electrification, irrigation works, thereby reducing the money income of the people and their demand for goods and services. 

In this way, government can reduce the budget deficit which shows excess of expenditure over revenue.

(ii) Increase Tax Revenue policy:

Revenue policy is expressed in terms of taxes. During inflation, government should raise rates of all taxes especially on rich people because taxation withdraws purchasing power from the tax­payers and to that extent reduces effective demand.

(iii) Increase Public borrowing: 

Government should resort to large scale public borrowing to mop up excess money with the public.

(iv) Reduce Deficit financing:

Deficit financing (printing of currency/notes) should be reduce drastically because it leads to increase in demand. To keep deficit financing low, government may raise small savings such as PPF, NSC, etc. by offering incentives.

  • Monetary Policy

It is the policy of the central bank of a country to control money supply and credit in the economy. 

Measures of monetary policy 

(a) Quantitative (which influence the total volume of credit) 

(b) Qualitative (which regulates flow of credit for specific uses) as explained below:

Quantitative Measures:

  • Bank rate or Repo rate (Increase bank rate):

Bank rate (Repo rate) is the rate of interest charged by central bank on loans given to all commercial banks. 

Increase in bank rate forces commercial banks to increase their own lending rate of interest which makes loan costlier. As a result, the demand for credits falls.

High rate of interest slows down the demand for goods and services and encourage people to increase their savings.

  • Open Market Operation (Sell securities):

It refers to buying and selling of government securities and bonds in the open market by the central bank to influence the cash reserves with commercial banks. This brings flow of money. Thereby restricting their lending capacity.

  • Cash-Reserve Ratio (Raise CRR)

When there is an inflationary situation, the central bank raises the rate of minimum cash-reserve ratio thereby. As a result banks keep more cash reserve with RBI which in turn curtails the lending capacity of commercial banks. 

  • Statutory Liquidity Ratio (Raise SLR)

In addition to CRR, there is another measure called SLR. When RBI wants to contract credit by banks, it increases SLR and thereby reduces credit availability. 

Qualitative Measures:

  • Moral Suasion (Restrict credit):

This means written or oral advice given by the central bank to commercial banks to restrict or expand credit.

During inflation, the central bank persuades its member banks not to advance credit for speculation or prohibit banks from entering into certain transactions. This advice is generally followed by member banks.

  • Increase Margin Requirements 

Margin requirement refers to the amount of security that banks demand from borrower of loan.

This discourages borrowing, it makes traders get less credit against their securities. In case of deficient demand, margin requirements are lowered to encourage borrowing.


There are certain other measures which can be: import promotion, wage freeze, control and blocking of liquid assets, compulsory savings scheme for households, increase in production by utilizing idle capacities, etc.

Deficiency Of Demand 

Deficient demand (deflationary gap) is an excess of available aggregate output over anticipated aggregate expenditure, at full employment level.

The situation of deficient demand builds deflationary pressures leading to a fall in the general price level in the economy. When AD is less than AS (at full employment condition), the producers are forced to reduce their output as prices and profits are hit adversely.

This may result in unemployment of resources and reduced income in the economy which further reduces the demand for goods and services, 

Causes of Deficient Demand:

  • Fall in Consumption

Any decrease in the consumption demand of the households may lead to a fall in AD 

  • Fall in Investments

Any decrease in the investment expenditure incurred by the households and firms may lead to a fall in AD and result in deficient demand-like situation.

  • Fall in Government Expenditure

Government decreases its consumption or investment expenditure, it may result in a fall in money supply in the economy.

  • Decrease in Net Exports

When the export of goods and services from an economy is less and import is more, this may result in lesser money at the disposal of the people in the economy leading to deficient demand.

  • Budget Surplus

If an economy is facing budgetary surplus, it may result in deflationary gap.

  • Higher Taxes

When the tax structure in the economy is stringent and doesn’t leave money at the disposal of the general public in the economy, this could prove to be deflationary in nature.

Measures to Correct Deficient Demand:

The problem of deficient demand in an economy can be tackled either by increasing budget deficits (using the fiscal policy measures) or by encouraging the availability of credit (using the monetary policy measures)

Fiscal Policy Measures

These are the steps taken by the government which affect either revenue or expenditure of the government.

Two fiscal policy measures are as follows:

  • Taxation Policy:

The government can use taxation policy (both direct and indirect taxes) to regulate the money in the pockets of the public. 

  • Government Expenditure Policy:

Any increase in the public expenditure by government will directly affect the demand of goods and services and as a result AD may be equal to AS.

Monetary Policy Measures:

Central bank concentrating on the money supply and availability of credit in the economy using various qualitative and quantitative tools of controlling funds in the hands of the general public.

Quantitative Methods:

  • Bank Rate/Discount Policy:

A lower Bank Rate aims to reduce the cost of funds that are made available by the central bank to these commercial banks which, in turn, reduce their own lending rates to the borrowers. 

  • Open Market Operations:

If there is lower money supply in the market, the central bank may start purchasing the treasury bills and other securities in the open market with an aim of creating a gap in the funds in the market from banks and other financial institutions.

  • Legal Reserve Ratio:

There are two major reserve ratios in this regard:

(i) Cash Reserve Ratio (CRR):

If the central bank feels that the credit availability in the economy is in deficiency, it may reduce the Cash Reserve Ratio, leaving more cash with the commercial banks to create lending.

(ii) Statutory Liquidity Ratio (SLR):

In order to push money, the central bank will reduce SLR, which will give more money to the commercial banks to lend and increase money supply to reduce deflation as per the requirements of the economy.

  • Repo Rate/Reverse Repo Rate:

A fall in repo rate may promote borrowings due to cheaper fund availability. 

Reverse Repo Rate when falls it ensures liquidity in the market.

Qualitative Methods:

  • Margin Requirements:

Lower margin requirements promote credit-creating power of the banks, as a result the money supply in the economy enhanced.

  • Regulation of Consumer Credit:

During adverse conditions, the central bank may ask the commercial banks to grant more loans and advances to the consumers.

Determination of Income and Employment Unit 3 CBSE, class 12 Economics notes. This cbse Economics class 12 notes has a brief explanation of every topic that NCERT  syllabus has. You will also get ncert solutions, cbse class 12 Economics sample paper, cbse Economics class 12 previous year paper.

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