Determination of Income and Employment

About this unit

This unit asks what determines the level of output and employment in an economy in the short run. Following Keynes, it treats aggregate demand as the main driver when there is spare capacity. You study consumption and saving functions, investment, the equilibrium level of income, the multiplier, and what happens when demand is too high or too low compared with full employment.

Key ideas

• Aggregate demand (AD) in a two-sector economy = C + I.
• Consumption function C = c̄ + bY, where b is the MPC.
• MPC + MPS = 1 and APC + APS = 1.
• Equilibrium income is where AD = AS, or planned saving = planned investment.
• The investment multiplier k = 1 ÷ (1 − MPC) = 1 ÷ MPS.
• Excess demand causes an inflationary gap; deficient demand a deflationary gap.

How to prepare

Memorise the formulae and practise solving for equilibrium income from a consumption function. Draw the 45° line diagram and the saving–investment diagram. Expect numericals on the multiplier, propensities and equilibrium, and questions on fiscal and monetary measures to correct gaps.