INCOME DETERMINATION -ratheeshthapasya

CHAPTER 4

INCOME DETERMINATION

v    Ex-ante consumption

v    Ex – ante aggregate demand

v    Determination of equilibrium income

v    Excess demand and excess supply

v    Paradox of thrift

Income Determination

        The classical approach is based on the existence of full employment without inflation.  Full employment is regarded as a normal situation and any deviation from this level is something abnormal which is automatically tends towards full employment. The classical theory believed that whatever is produced will be demanded in the market (Say’s Law of market). Price flexibility, interest rate flexibility and wage rate flexibility will ensure the equilibrium in the economy.

          The classical theory was proved wrong by the Great Depression of 1930’s. Over production, insufficient demand and massive unemployment discredited the classical theory.           Keynes rejected the classical notion of full employment. The effective demand is the basis of Keynesian theory. Effective demand is determined at the point where aggregate demand and aggregate supply are equal. To him, all the problems in the economy are generated due to the deficiency of the effective demand.

One of the most important objectives of Macro economics is the construction of Macro economic models.  Macro economic variables such as savings, investment, consumption etc. can be used under ex-ante and ex-post senses.  The word ex-ante means planned or desired.  In the ex-ante sense the value of these variables means the planned value. Ex-post means realized or actual.  So in the ex-post sense the value of these variables means the realized value of planned economic variables. 

The ex-ante variables are taken to consider for the construction of macro economic models we take in to consideration. In order to predict about the GDP of a country next year, the knowledge about the planned demand and supply of goods and services are essential. So we should study about the ex-ante variables such as consumption, savings, investments etc.

Ex-ante consumption

           People spend a part of their income and save the rest

Y = C + S

Where,        Y - ex-ante income

                   C - ex-ante income

                   S - ex-ante saving

Consumption depends on income. The relationship between income and consumption is known as consumption function.

          C = f(Y)

          The consumption function states that as income increases consumption also increases, but increase in consumption is not proportionate to increase income.  The proportion or percentage of income spent on consumption is called Marginal Propensity to Consume (MPC).

          The ratio between changes in consumption to change in income is known as MPC.

                    MPC =

Where,        Δ C = change in consumption

                    Y = change in income

MPC is denoted by ‘c’. 

People save a portion of their income after consumption. Therefore, if there is an increase in income, saving increases.

          S = Y - C

          When there occurs an increase in income a certain percentage of it is saved.  This proportion is known as Marginal Propensity to Save (MPS).

          The proportion between changes in savings to change in income is known as MPS.

                   MPS =

                   Δ S = change in saving

                    Y = change in income.

The value of MPC and MPS will lie between 0 and 1.

MPC plus MPS is always equal to one

                   MPC + MPC = 1

                   MPC = 1 – MPS

                   MPS = 1 – MPC

          Even when the income is zero, there is a certain amount of subsistence level of consumption. This is known as autonomous consumption. It is denoted by

Therefore the consumption function can be expressed as,

                   C =  + cY

And then saving function will be S=  + (1-c) Y

          Consumption function helps to understand two ratios – Average Propensity to Consume and Average Propensity to Save.

          Average Propensity to Consume (APC) is the ratio between consumption and income. 

APC =  

          Average Propensity to Save (APS) is the ratio between total saving to total income.

                   APS =   

Ex – ante Investment

          Investment is defined as addition to the stock of physical capital and changes in the inventory of firms.

          Investment depends on market rate or interest and marginal efficiency of capital.  Marginal efficiency of capital means the expected rate of return from an additional unit of investment.

          For the simplicity, it is assumed that the firm plans to invest the same amount every year.  Therefore ex-ante investment is taken as 

          I =

Ex-ante aggregate demand

The ex-ante aggregate demand means the expected expenditure of the economy on goods and services in an accounting year. Thus the aggregate demand and total expenditure in the economy are one and the same.

In a four sector economy the components of aggregate demand in the ex-ante sense are

(1) ex-ante private final consumption expenditure

(2) ex-ante private final investment expenditure

(3) ex-ante government expenditure

(4) ex-ante net exports

          In a two sector economy, the ex-ante aggregate for final goods depend on ex ante consumption demand and ex ante investment demand.

                   AD = C + I

                   As C =  + cY ,  and  I =  then

AD = +   + cY

If,    = +  , then Aggregate Demand

          AD =   + cY

Aggregate supply

          Aggregate supply (AS) is gross output in the economy.  This shows total supply of goods and services in an economy.

                   AS = Y

Where, Y is the gross output.

AS curve is a  line with the income.

Determination of Equilibrium income

          An economy will be in equilibrium when aggregate demand and aggregate supply are equal.

          In a two sector model, equilibrium income is

                     =

                =

At equilibrium, Y = AD. E is the equilibrium point and   is the equilibrium income.

Excess demand and excess supply

                  

When income is less the  (suppose Y₁) then aggregate demand for goods and service is greater than the Aggregate supply. This is the case of excess demand. Excess demand leads to fall in inventory.

          When income is greater than   (suppose Y₂), then aggregate supply is greater than aggregate demand. This is the case of supply and leads to increase in inventory.

          The change in equilibrium due to change in autonomous components (autonomous investment)

          Increase in autonomous investment results in the upward shift of aggregate demand curve parallally and attains the new equilibrium point E2. The new equilibrium income is greater than first one.

         

The change in income is greater than change in investment. This is due to the working of multiplier.

           Y = K ×  I

                   K =  

Where, K is the multiplier.

Multiplier Mechanism

          Multiplier has a dominant role in income determination.  An initial increase in investment leads to multiple increases in income is known as multiplier mechanism.

          MPC plays a vital role in increase in the income.  If MPC is high, increase in income is also high.

 =

The change in equilibrium when there is change in MPC

          When MPC increases the aggregate demand curve will shift upwards without changing the vertical intercept.

         

AD₁ is the initial aggregate demand. Y* is the initial equilibrium income.  If MPC increases the AD curve will shift to AD₂. Yi is the new equilibrium income. The equilibrium income will increase.

If MPC decreases the curve will shift downwards without changing the vertical intercept. So equilibrium income will decline.

If MPC increases, equilibrium income will increase. If the MPC decreases equilibrium income will decrease

Paradox of thrift

          If the MPS in an economy has increased, it may not lead to increase in total savings. Instead the total savings may remain constant or may decrease. This tendency is known as paradox of thrift