Determination of Income and Employment- NCERT Notes UPSC

Aggregate Demand and Its Components

Aggregate demand is the total demand for all goods and services produced in an economy. Aggregate demand is the sum of consumption (both autonomous and induced consumption) and investment. 

Consumption

• It is the demand for goods and services used by people in an economy for day-to-day consumption. 
• Consumption is most importantly determined by the household income. In general, consumption expenditure increases with an increase in income and decreases with the decrease in household income. 
• A consumption function describes the relation between consumption and income. The simplest consumption function assumes that consumption changes at a constant rate as income changes. 
• Some important terms related to Consumption Function: 

• Autonomous Consumption: A certain level of consumption takes place even when income is zero. Since this level of consumption is independent of income, it is called autonomous consumption. 
• Induced Consumption: It is the portion of consumption that varies with the disposable income.
• Consumer Demand is the sum of Autonomous Consumption and Induced Consumption.
• Marginal propensity to consume (MPC): It is the change in consumption per unit change in income. MPC lies between 0 and 1, this means that as income increases wither the consumer does not increase consumption at all (MPC = 0) or use entire change in income on consumption (MPC = 1) or use part of the change in income for changing consumption (0< MPC<1). 
• Marginal propensity to save (MPS): It is the change in savings per unit change in income.
• Average propensity to consume (APC): It is the consumption per unit of income.
• Average propensity to save (APS): It is the savings per unit change in income. 

Investment

• It is defined as addition to the stock of physical capital (machines, buildings, roads etc.) that adds to the future productive capacity of the economy and changes in the inventory (stock of finished goods) of a producer.
• Investment goods (such as machines) are also part of the final goods unlike intermediate goods like raw materials, which are used up in the production process. 
• The decision to invest is taken by the producers, largely based upon the prevailing market interest rates.

Determination of Income

• Income is the money earned or received by individual or business, especially on a regular basis, for a work or through investments or through productions. 
• The national income can be determined by summing up the all the incomes earned by individuals, firms, governments from various economic activities. The term output can be interchangeably used as income. 
• Aggregate demand is an important determinant of income. The aggregate demand for final goods is the sum total of consumption expenditure and investment expenditure on goods.
• However, the major economic activities of the government also affect the aggregate demand for final goods and services can be summarized by the fiscal variables Tax (T) and Government Expenditure (G)

• Government, through its expenditure on final goods and services, adds to the aggregate demand like other firms and households. 
• On the other hand, taxes imposed by the government take a part of the income away from the household, which reduces the disposable income.
• Therefore, the income can be determined by summing up consumption (autonomous), investment (autonomous), government expenditure and induced consumption after taxes (Income – taxes).

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Equilibrium 

• An equilibrium situation in the market which arises, when the aggregate demand is equal to the aggregate supply. 
• Aggregate demand that is the demand for all finished goods and services produced in an economy, whereas the aggregate supply that is the total supply of finished goods and services available in an economy. 

Investment Multiplier

• It is the ratio of the change in national income to the initial change in planned investment expenditure. 
• It can also be defined as the ratio of the total increment in equilibrium value of final goods output to the initial increment in autonomous expenditure is called the investment multiplier of the economy.
• Thus, for instance, if a change in investment of Rs 2000 may cause a change in national income of Rs 8000, the multiplier (8000/2000) is 4.

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Interesting Points

• Full Employment Level of Income: That level of income where all the factors of production are fully employed in the production process. (Factors of production include Land, Labour, Physical Capital and Human Capital).  
• Deficient Demand: A situation where the equilibrium level is less than the full employment of output since demand is not enough to employ all factors of production. It leads to decline in prices in the long run.
• Excess Demand: A situation where the equilibrium level of output is more than the full employment level, since demand is more than the level of output produced at full employment level. It leads to rise in prices in the long run.

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