CBSE Class 12 Economics - Income Determination and Multiplier
Determinants of Equilibrium Level
According to Keynes Theory,
An economy is in equilibrium when aggregate demand is equal to aggregate supply during a period of time.
So, equilibrium is achieved when,
AD=AS …… (1)
Since AD= C+1 and
AS=C+S
C+1 = C + S
I=S
So, the two approaches for equilibrium are:-
(A)AD-AS approach. (B)S-I approach
Before proceeding, we will make some assumption which will make it easy to understand:-
- Only two-sector exists in an economy (households and firms). There is no government & foreign sector.
- It is assumed that Investment is autonomous i.e. it is not influenced by the level of income.
- Price level is assumed to be constant
- Equilibrium output is to be determined in the context of shot-run.
AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH
(AD - AS APPROACH )
According to Keynesian Theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C+I curve is equal to the total output (Aggregate Supply or AS)
Aggregate Demand Comprises of Two components:-
- Consumption Expenditure (C):- It varies directly with the level of income i.e. consumption rises with the increase in income.
- Investment Expenditure (I):- It is assumed to be independent level of income i.e. investment expenditure is autonomous.
Aggregate Supply is the total output of goods and services of the national income, since income is either consumed or saved, the AS curve is represented by the (C+S) curve.
Equilibrium by AD and AS approach
Equilibrium by AD and AS approach |
|||||||
Employment (Lakhs) |
Income (Y) |
Consumption'(C) |
Saving (S) |
Investment(I) |
AD (C+I) |
AS (C+S) |
Remarks |
0 |
0 |
40 |
-40 |
40 |
80 |
0 |
AD>AS |
10 |
100 |
120 |
-20 |
40 |
160 |
100 |
AD>AS |
20 |
200 |
200 |
0 |
40 |
240 |
200 |
AD>AS |
30 |
300 |
280 |
20 |
40 |
320 |
300 |
AD>AS |
40 |
400 |
360 |
40 |
40 |
400 |
400 |
AD=AS, Equilibrium |
50 |
500 |
440 |
60 |
40 |
480 |
500 |
AD<AS |
60 |
600 |
520 |
80 |
40 |
560 |
600 |
AD<AS |
Observation from the above Schedule and Diagram
(1) Investment Curve -(I) is parallel to X-axis as it is autonomous and does not depends upon the level of income whereas saving curve(S) is upward sloping as saving increase with rising in Income. The Economy would be in equilibrium at point E where saving and investment intersect each other. At this level planned savings are equal to planned investments.
(2) When savings are more than Investments -If planned savings are more than planned investment, i.e. after point E, a household is not consuming as much as firms expected them to as a result, the inventory would rise above the desired level.
(3) When savings are less than investments- If planned savings are less than Investments, i.e. before point E, a household is consuming more, and savings less than what firms expected them to as a result planned inventory would fall below the desired level.
The economy is in equilibrium at point E where AD=AS
- E is the equilibrium point because, at this point, the level of the desired spending on consumption and investment exactly equals the level of total output.
- OY is the equilibrium level of output corresponding to point E.
- The equilibrium level of income is rupees 400 crores, where AD=AS
- It is a situation of effective demand. Effective demand refers to that level of AD which become effective because it is equal to AS.
- When AD is more than AS
When planned spending is more than planned output ( AS) it means that people are ready to spend more and firms are willing to produce less as a result planned inventory would fall below the desired level.
- When AD is less than AS
When planned to spend a less than planned output it means that people are not ready to spend more and firms are willing to produce more as a result planned inventory would rise above the desired level.
Saving - Investment Approach
According to SI approach equilibrium level is determined at a point where planned savings are equal to planned Investments.
INCOME (Y) |
CONSUMPTION (C) |
SAVINGS (S) |
INVESTMENT ( I) |
All figures in crores REMARKS |
0 |
40 |
-40 |
40 |
S < 1 |
100 |
120 |
-20 |
40 |
S < 1 |
200 |
200 |
0 |
40 |
S < 1 |
300 |
280 |
20 |
40 |
S < 1 |
400 |
360 |
40 |
40 |
S = 1 ( EQUILIBRIUM) |
500 |
440 |
60 |
40 |
S> 1 |
600 |
520 |
80 |
40 |
S> 1 |
Investment Curve is parallel to the x-axis as it is autonomous and does not depends upon the level of income. Whereas the saving curve is upward sloping as savings increases with rising in income .the economy would. Be in equilibrium at point E Where saving and investment intersect each other. at this level planned savings are equal to planned investment.
When savings are more than investment
If planned savings are more than planned investment that is after. Point E houses are not consuming as much as firms expected them to. As a result, the inventory would rise above the desired level.
When savings are less than Investments.
If plant savings are less than investment before Point E households are consuming more and saving less than what firms expected them to. as a result planned inventory would fall below the desired level.
Equilibrium Level
According to the classical economics equilibrium level of income is attained always at full employment level i.e. there is the absence of involuntary unemployment. However as per the Keynesian Theory of Equilibrium level can be achieved at:-
- Full Employment Level or
- Under Employment Level i.e. less than full employment level or
- Over Employment Level i.e. more than full employment level.
Employment Equilibrium
It refers to a situation when equality between AD and AS takes place at the full employment level of income.
In the given figure, Full Employment equilibrium is achieved at Point ‘E’ where EQ is equal to OQ. At this particular point, there is no involuntary unemployment i.e. those who are willing and able to work are getting it at a prevailing wage rate.
Under Employment Equilibrium
It refers to a situation when an equilibrium between AS and AS takes place at less than full employment level.
Here, AD = AS at Point F which is lower than full employment level.
As OQ1, is less than OQ, Point ‘F’ signified the underemployment equilibrium.
Over full Employment Equilibrium
It refers to a situation when the equilibrium between AD & AS takes place at more than full Employment Level.
Here, AD, = AS at point G which is higher than the full employment level. Point G signifies the over full-employment equilibrium.
INVESTMENT MULTIPLIER
Prof. J.M. Keynes believed that an initial increment in investment increases the final income by many times.
Multiplier (K) is the ratio of increase in national income (Y) due to an increase in investment (I) symbolically, K=Y / I
Multiplier and MPC
There exist a direct relationship between MPC and the value of the multiplier, higher the MPC, more will be the value of the multiplier, and vice-versa. The reason for this is:
- In the case of higher MPC, people will spend a large proportion of their income on consumption. In such case, the value of multiplier will be more.
- In case of low MPC, people will spend lesser proportion of their increased income on consumption. In such case, value of multiplier will be comparatively less.
Algebraically, since, Y = C =I
Therefore Y = C + I
Dividing both sides by Y
Y/Y = C/Y + I/Y
I= MPC + I/K (:. Y/Y = I, C/Y = MPC, I/Y = I/K)
I – MPC = I/K
K= I /I-MPC or I / PC (:. I-MC =MPS)
Formula of Multiplier |
||
K= Y/I |
K=I/I-MPC |
K=I/MPS |
Multiplier is directly related to MPC and inversely related to MPS
The above statement can be easily proved through the following table:-
Consumption Schedule |
||
MOC |
MPS(I-MPC) |
Multiplier(K),K=I/I-MPC |
0 |
1 |
1 |
0.50 |
0.50 |
2 |
0.67 |
0.33 |
3 |
0.75 |
0.25 |
4 |
0.80 |
0.20 |
5 |
0.90 |
0.10 |
10 |
1.00 |
0.00 |
0 |
It is clearly seen in the above table that as MPC is increasing, Multiplier is also increasing which shows positive relationship whereas it is increase with fall in MPS, which shows negative relationship.
The maximum value of the multiplier can be infinity when MPC is I and MPS is Zero whereas the minimum value of the multiplier can be I when MPC is 0 and MPS is 1.
Working of Multiplier
The working of multiplier is based on fact that ‘One person’s expenditure is another person’s income’. When an additional investment is made, then income increased many times more than the increase in investment. Let us understand this with the help of an example:-
- Suppose an additional investment of Rs.1000 crores is made by the government for some infrastructural activities. This will generate an extra income of Rs.1000 crores in the first round. But this is not the end of the story.
- If MPC is assumed to be 0.80, then the recipient of this additional income will spend 80% of Rs.1000 crore i.e. Rs 8000 crore as consumption and remaining amount will be saved. It will increase the income by Rs. 800 Crore in second round.
- In next round, 90% of additional income of Rs.8000 crore i.e. Rs. 640 crore will be spent on consumption and the remaining amount will be saved.
- This multiplier process will go on and consumption in every round will be 0.80 times of additional income received from the previous round.
- Here value of Multiplier(K) =Y/I = 5000/1000=5 times Or I/MPS (I/I-MPC) =1/0.20 = 5 times
- Therefore an initial increase in investment by one unit will increase total national income by 5 times.
Important formula at glance:
- Multiplier (K) = Y/I = I/I-MPC= I/MPS
- AD = C=I
- Y=AS = C=S
- Equilibrium is achieved when AD = AS and S = I
- C= C’ + b(Y)
- S + -C’ + (I-b) (Y) EXCESS Demand and deficient demand