Determination of Income and Employment

Determination of Income and Employment explains how the level of national income and employment is decided in the short run, using the Keynesian idea that output depends on aggregate demand when prices are fixed. In this chapter you will study the components of aggregate demand in a two-sector economy, consumption and investment, and the consumption function C = c + bY, where c is autonomous consumption and b is the marginal propensity to consume. You will calculate the average and marginal propensities to consume and save, and see why MPC + MPS = 1. Investment is treated as autonomous. You will learn how equilibrium income is reached where aggregate demand equals aggregate supply, or where planned saving equals planned investment, and what happens to inventories when the economy is away from equilibrium. The investment multiplier, k = 1/(1 - MPC), shows how a change in investment changes income by a larger amount. The chapter also explains full employment, involuntary unemployment, excess and deficient demand, the paradox of thrift and the policy measures used to correct demand imbalances.

Detailed Worksheet: Determination of Income and Employment Section A - Definitions (10 marks) 1. Define aggregate demand and state its components in a two-sector economy. (2 marks) 2. What is meant by marginal propensity to consume? Can its value be greater than one? Give a reason. (2 marks) 3. Distinguish between autonomous and induced consumption. (2 marks) 4. What is ex-ante investment? How does it differ from ex-post investment? (2 marks) 5. Define involuntary unemployment and full employment equilibrium. (2 marks) Section B - Calculations and Applications (15 marks) 6. In an economy, C = 100 + 0.8Y and investment I = 50 (Rs crore). Calculate (i) the equilibrium level of income, (ii) consumption at equilibrium and (iii) saving at equilibrium. (3 marks) 7. If the marginal propensity to consume is 0.75 and investment increases by Rs 500 crore, calculate the investment multiplier and the total increase in income. (3 marks) 8. Complete the following and find MPC and MPS: when income is Rs 0, 100, 200 and 300 crore, consumption is Rs 50, 120, 190 and 260 crore respectively. Calculate saving at each level, the APC at income 200 and the break-even level of income. (3 marks) 9. The saving function of an economy is S = -50 + 0.25Y and autonomous investment is Rs 100 crore. Calculate the equilibrium level of income and the value of the multiplier. (3 marks) 10. In an economy, C = 100 + 0.8Y, I = 80 and the full employment level of income is Rs 1,000 crore. Calculate the equilibrium income, identify whether there is excess or deficient demand, and find the increase in investment needed to reach full employment. (3 marks) Section C - Diagrams (10 marks) 11. Draw the consumption and saving curves on one diagram, with the 45 degree line. Mark autonomous consumption, the break-even point and the region of dissaving. (4 marks) 12. Draw a diagram showing determination of equilibrium income by the AD-AS approach (Keynesian cross). Label AD = C + I, the 45 degree line and equilibrium income. (3 marks) 13. Draw a diagram showing a deficient demand situation, marking the full employment income, the AD curve and the deflationary gap. (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. Explain the working of the investment multiplier with a numerical example, showing the rounds of income and consumption. Why is the multiplier larger when MPC is higher? Explain with reasons why the multiplier may be smaller in practice. (5 marks) 15. Explain what happens when (i) planned saving is greater than planned investment and (ii) aggregate demand is greater than aggregate supply. Discuss the adjustment through changes in inventories and output until equilibrium is restored. (5 marks) 16. What is the paradox of thrift? Explain with a diagram how an increase in the propensity to save can reduce income without increasing total saving. Suggest two fiscal and two monetary measures to correct excess demand. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show all steps in numericals with units (Rs crore). Draw neat, labelled diagrams.