Determination of Income and Employment

In macroeconomics the level of income and employment is decided by total spending and total output. Aggregate Demand (AD) is the total planned expenditure on goods and services in the economy in a period. Its components are C + I + G + (X − M) — consumption, investment, government spending and net exports. Aggregate Supply (AS) is the total value of goods and services that all producers plan to supply, which equals the total income generated. The level of output where AD equals AS is called effective demand, and it determines the equilibrium income and employment.

The largest part of AD is consumption. The consumption function shows how consumption (C) depends on income (Y): C = a + bY, where a is autonomous consumption (consumption even at zero income) and b is the slope. The line slopes upward but is flatter than the 45° line (where C = Y); the two cross at the break-even point, where consumption exactly equals income.

Income is either consumed or saved, so Y = C + S. Four ratios describe how income is split:

• APC (Average Propensity to Consume) = C ÷ Y — the fraction of total income consumed.
• MPC (Marginal Propensity to Consume) = ΔC ÷ ΔY — the fraction of extra income consumed (the slope of the consumption function).
• APS (Average Propensity to Save) = S ÷ Y; MPS (Marginal Propensity to Save) = ΔS ÷ ΔY.

Since income is consumed or saved, APC + APS = 1 and MPC + MPS = 1. For example, if MPC = 0.8, then MPS = 0.2.

Now the key macro idea: a change in investment causes a larger change in income, because of the investment multiplier (k). When firms invest, that spending becomes someone's income, who spends a part of it (MPC), becoming further income, and so on — a chain that multiplies the original investment:

k = 1 ÷ (1 − MPC) = 1 ÷ MPS

and the change in income is ΔY = k × ΔI. For example, if MPC = 0.8, then k = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5. An extra investment of ₹100 crore then raises income by 5 × 100 = ₹500 crore. The higher the MPC, the bigger the multiplier (more is re-spent each round). The multiplier is one of the most powerful ideas in macroeconomics — it shows how a small injection of spending can have a large effect on the whole economy.

The economy is in equilibrium at the income level where planned AD = AS (equivalently, where planned saving = planned investment). At this income, total spending exactly buys total output, so producers have no reason to change output.

An important point of Keynesian economics is that this equilibrium need not be at full employment (where everyone willing to work has a job). The economy can settle at an underemployment equilibrium — output is steady, but below the full-employment level, leaving people unemployed. This is exactly what happened in the Great Depression. The level of aggregate demand decides whether we reach full employment.

Comparing actual AD with the AD needed for full employment gives two important "gaps":

• Deflationary gap (recessionary gap) — when AD is less than the level needed for full employment. There is too little spending, so output and employment fall below full employment — causing unemployment and falling prices. The cure is to raise AD (the government spends more or cuts taxes; the RBI eases money).
• Inflationary gap — when AD is more than the full-employment level. Demand exceeds what the economy can produce, so prices are pulled up — causing inflation. The cure is to reduce AD (the government spends less or raises taxes; the RBI tightens money).

So the whole theory comes together: aggregate demand determines income and employment; if AD is too low we get a deflationary gap and unemployment, and if AD is too high we get an inflationary gap and rising prices. The government uses fiscal and monetary policy to push AD toward the full-employment level — the central task of macroeconomic management.