class 12 notes

Class 12 Economics Notes Chapter 4 (Income Determination) – Introduction MacroEconomics Book

Philoid

Philoid

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Introduction MacroEconomics
Detailed Notes with MCQs of Chapter 4: Income Determination from your Macroeconomics textbook. This is a crucial chapter, forming the bedrock of Keynesian economics and frequently tested in government exams. Pay close attention to the concepts and relationships we discuss.

Chapter 4: Income Determination - Detailed Notes

1. Basic Concepts:

  • Ex-ante vs. Ex-post:
    • Ex-ante: Planned or intended values of variables (e.g., planned consumption, planned investment) before the event occurs.
    • Ex-post: Actual or realized values of variables (e.g., actual consumption, actual investment) after the event has occurred.
    • Keynesian analysis primarily deals with ex-ante concepts to determine equilibrium.
  • Aggregate Demand (AD): The total planned or desired spending on domestically produced goods and services by all sectors of the economy at a given level of income during an accounting year.
    • In a Two-Sector Economy (Households and Firms): AD = C + I
      • C: Planned Consumption Expenditure
      • I: Planned Investment Expenditure
    • In a Three-Sector Economy (Households, Firms, Government): AD = C + I + G
      • G: Government Expenditure
    • In a Four-Sector Economy (Households, Firms, Government, Rest of the World): AD = C + I + G + (X - M)
      • (X - M): Net Exports (Exports - Imports)
    • For simplicity, the basic model in this chapter focuses on the two-sector economy (AD = C + I).
  • Aggregate Supply (AS): The total value of final goods and services planned to be produced by all firms in an economy during an accounting year. It is conceptually equal to the National Income (Y).
    • AS = Y
    • National Income (Y) is either consumed (C) or saved (S). Therefore, AS = C + S.

2. Consumption Function (Propensity to Consume):

  • It shows the functional relationship between the level of income (Y) and the level of consumption expenditure (C). C = f(Y).
  • Keynesian Psychological Law of Consumption: As income increases, consumption also increases, but the increase in consumption is less than the increase in income. Some part of the increased income is saved.
  • Consumption Function Equation: C = C̄ + bY
    • C: Total Consumption Expenditure
    • C̄ (or 'a'): Autonomous Consumption (Consumption at zero level of income; minimum consumption needed for survival). It is always positive.
    • b: Marginal Propensity to Consume (MPC). It represents the slope of the consumption curve.
    • Y: Level of National Income.
    • (bY): Induced Consumption (Consumption that depends on the level of income).
  • Average Propensity to Consume (APC): The ratio of total consumption expenditure (C) to total income (Y). APC = C / Y.
    • APC can be greater than 1 (when C > Y, at very low income levels where dissaving occurs).
    • APC falls as income increases.
  • Marginal Propensity to Consume (MPC or 'b'): The ratio of the change in consumption expenditure (ΔC) to the change in income (ΔY). MPC = ΔC / ΔY.
    • MPC represents the slope of the consumption curve.
    • Value of MPC always lies between 0 and 1 (0 < MPC < 1).

3. Saving Function (Propensity to Save):

  • It shows the functional relationship between the level of income (Y) and the level of saving (S). S = f(Y).
  • Since Y = C + S, therefore S = Y - C.
  • Saving Function Equation: Substitute C = C̄ + bY into S = Y - C:
    • S = Y - (C̄ + bY)
    • S = Y - C̄ - bY
    • S = -C̄ + (1 - b)Y
    • -C̄: Autonomous Saving (Dissaving at zero income, equal in magnitude but opposite in sign to autonomous consumption).
    • (1 - b): Marginal Propensity to Save (MPS). It represents the slope of the saving curve.
    • (1 - b)Y: Induced Saving.
  • Average Propensity to Save (APS): The ratio of total saving (S) to total income (Y). APS = S / Y.
    • APS can be negative (when C > Y, dissaving occurs).
    • APS increases as income increases.
    • APC + APS = 1 (Because C/Y + S/Y = (C+S)/Y = Y/Y = 1)
  • Marginal Propensity to Save (MPS or 's'): The ratio of the change in saving (ΔS) to the change in income (ΔY). MPS = ΔS / ΔY.
    • MPS represents the slope of the saving curve.
    • Value of MPS always lies between 0 and 1 (0 < MPS < 1).
    • MPC + MPS = 1 (Because ΔC/ΔY + ΔS/ΔY = (ΔC+ΔS)/ΔY = ΔY/ΔY = 1). Therefore, MPS = 1 - MPC.

4. Investment (I):

  • Refers to the addition to the capital stock (e.g., machines, buildings, inventory).
  • Autonomous Investment (Ī): Investment that is independent of the level of income. It is influenced by factors like technological progress, business expectations, government policy etc. In the basic Keynesian model, investment is assumed to be autonomous. Its curve is a horizontal line parallel to the X-axis (income axis).
  • Induced Investment: Investment that depends on the level of income or profit. It increases as income increases.

5. Determination of Equilibrium Income/Output:

  • Equilibrium level of income is determined where Aggregate Demand (AD) equals Aggregate Supply (AS).
    • AD = AS
    • In a two-sector economy: C + I = Y
  • Alternatively, equilibrium is reached where planned Saving (S) equals planned Investment (I).
    • We know Y = C + S (AS) and Y = C + I (AD equilibrium condition).
    • Therefore, C + S = C + I
    • S = I
    • This holds true only for planned (ex-ante) S and I. Ex-post S and I are always equal due to accounting identity.
  • Graphical Representation:
    • AD-AS Approach: Equilibrium is at the point where the AD curve (C+I) intersects the 45-degree line (AS curve, Y).
    • S-I Approach: Equilibrium is at the point where the Saving curve (S) intersects the Investment curve (I). (Assuming autonomous investment, the I curve is horizontal).

6. Investment Multiplier (K):

  • The concept of the multiplier states that an initial change in autonomous spending (usually investment, ΔI) leads to a larger final change in the equilibrium level of national income (ΔY).
  • Multiplier (K) = Change in Income (ΔY) / Change in Investment (ΔI)
    • K = ΔY / ΔI
  • The value of the multiplier depends on the Marginal Propensity to Consume (MPC).
    • K = 1 / (1 - MPC)
    • Since (1 - MPC) = MPS, K = 1 / MPS
  • Relationship: Higher the MPC, higher the multiplier. Lower the MPC (meaning higher the MPS), lower the multiplier.
  • Mechanism: An initial increase in investment leads to an increase in income. A part of this increased income is consumed (based on MPC), leading to further increases in income in subsequent rounds. This process continues until the total increase in income is K times the initial increase in investment.
  • Range: Since 0 < MPC < 1, the minimum value of K is 1 (when MPC=0) and the maximum value is infinity (when MPC=1). Practically, K is greater than 1.

7. Problems of Deficient and Excess Demand:

  • Full Employment Equilibrium: A situation where AD = AS at the level of income corresponding to full utilization of resources. There is no involuntary unemployment.
  • Deficient Demand (Deflationary Gap):
    • Occurs when Aggregate Demand (AD) is less than Aggregate Supply (AS) at the full employment level of income. (AD < AS at full employment Y).
    • It leads to a fall in the general price level (deflation) and involuntary unemployment.
    • Deflationary Gap: The amount by which actual AD falls short of the AD required to establish full employment equilibrium. (Gap = ADFE - ADActual).
    • Causes: Decrease in C, I, G, or Net Exports. Increase in taxes.
    • Consequences: Underemployment equilibrium, deflation, accumulation of unsold stock, loss of profits, low investment.
  • Excess Demand (Inflationary Gap):
    • Occurs when Aggregate Demand (AD) is more than Aggregate Supply (AS) at the full employment level of income. (AD > AS at full employment Y).
    • Since output cannot increase beyond the full employment level, this leads to a rise in the general price level (inflation).
    • Inflationary Gap: The amount by which actual AD exceeds the AD required to establish full employment equilibrium. (Gap = ADActual - ADFE).
    • Causes: Increase in C, I, G, or Net Exports. Decrease in taxes. Increase in money supply.
    • Consequences: Inflation (persistent rise in prices), wage-price spiral, potential fall in saving, misallocation of resources.

8. Measures to Correct Deficient and Excess Demand:

  • Fiscal Policy (Government Budgetary Policy):
    • To Correct Deficient Demand (Increase AD):
      • Increase Government Spending (G).
      • Decrease Taxes (increases disposable income, thus C).
    • To Correct Excess Demand (Decrease AD):
      • Decrease Government Spending (G).
      • Increase Taxes (decreases disposable income, thus C).
  • Monetary Policy (Central Bank Policy):
    • To Correct Deficient Demand (Increase Money Supply/Credit Availability - Cheaper Credit):
      • Decrease Bank Rate.
      • Decrease Repo Rate.
      • Decrease CRR (Cash Reserve Ratio).
      • Decrease SLR (Statutory Liquidity Ratio).
      • Buy government securities in the open market (Open Market Operations).
      • Decrease Margin Requirements.
    • To Correct Excess Demand (Decrease Money Supply/Credit Availability - Costlier Credit):
      • Increase Bank Rate.
      • Increase Repo Rate.
      • Increase CRR.
      • Increase SLR.
      • Sell government securities in the open market (Open Market Operations).
      • Increase Margin Requirements.

Multiple Choice Questions (MCQs):

  1. In the Keynesian framework, Aggregate Supply is assumed to be:
    a) Perfectly inelastic
    b) Perfectly elastic up to full employment
    c) Downward sloping
    d) Equal to Aggregate Demand always

  2. If the consumption function is C = 50 + 0.75Y, what is the value of Autonomous Consumption?
    a) 0.75
    b) 50
    c) 125
    d) Cannot be determined

  3. The value of the Marginal Propensity to Save (MPS) lies between:
    a) 0 and 1
    b) -1 and +1
    c) 0 and infinity
    d) 1 and infinity

  4. If MPC = 0.8, the value of the investment multiplier (K) is:
    a) 0.2
    b) 1.25
    c) 5
    d) 4

  5. The equilibrium level of income in a two-sector economy is determined where:
    a) C = S
    b) Y = C
    c) S = I (Planned Saving = Planned Investment)
    d) AD > AS

  6. A situation where Aggregate Demand exceeds Aggregate Supply at the full employment level is known as:
    a) Deflationary Gap
    b) Inflationary Gap
    c) Underemployment Equilibrium
    d) Full Employment Equilibrium

  7. Which of the following is a measure to correct Deficient Demand using Fiscal Policy?
    a) Increase in taxes
    b) Decrease in government spending
    c) Decrease in taxes
    d) Selling government securities

  8. The relationship APC + APS = ?
    a) 0
    b) 1
    c) Less than 1
    d) Greater than 1

  9. If an economy plans to save ₹200 crore out of an income of ₹1000 crore, the Average Propensity to Save (APS) is:
    a) 0.2
    b) 5
    c) 0.8
    d) 1.2

  10. Ex-ante investment refers to:
    a) Actual investment realized
    b) Planned investment
    c) Investment equal to saving always
    d) Investment at zero income level

Answers to MCQs:

  1. b) Perfectly elastic up to full employment
  2. b) 50
  3. a) 0 and 1
  4. c) 5 (K = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5)
  5. c) S = I (Planned Saving = Planned Investment)
  6. b) Inflationary Gap
  7. c) Decrease in taxes
  8. b) 1
  9. a) 0.2 (APS = S/Y = 200/1000 = 0.2)
  10. b) Planned investment

Make sure you understand the definitions, the relationships between different propensities (APC, APS, MPC, MPS), the equilibrium conditions (AD=AS and S=I), and the concept of the multiplier. The distinction between deficient and excess demand and the policy measures are also very important for your exams. Revise these notes thoroughly. Good luck!

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