Revision: Theory of Income and Employment Economics ISC (Commerce) Class 12 CISCE

• "The consumption function shows what changes can be expressed in the consumption from given changes in income." — Hansen
• "Consumption function is nothing more than a statement of the relation between consumption, expenditure and income." — R.G. Lipsey
• "It is a functional relationship indicating how consumption varies when income varies." — Dillard
• "Consumption function may be defined as a schedule showing amounts that will be spent for consumer goods and services at different income levels." — Peterson

Aggregate supply refers to the aggregate production planned by all the producers during an accounting year. In other words, aggregate supply indicates the total amount of goods and services produced within an economy at a given general (or overall) price level during an accounting period. The aggregate supply function is represented as follows.

`"AS" = f (barN, barL, barK, barT)`

where,

AS = Aggregate supply

N = Natural resources

L = Labour

K = Stock of capital

T = State of technology

The Aggregate Supply Function (ASF) is a schedule that presents the different amounts of income that all entrepreneurs in an economy need to obtain from selling output at different levels of employment.

Aggregate demand: Aggregate demand implies the total demand of final goods and services by various individuals in all the sectors in an economy. It expresses the total demand in terms of money. In this manner, it can be defined as the actual aggregate expenditure incurred by all the people in an economy on different goods and services.

AD = C + I + G + (X – M)
Where,
Demand by households - Private consumption expenditure (C)
Demand by firms - Private investment expenditure (I)
Demand by government - Government expenditure (G)
Demand by foreign sector- Net exports (X – M)
Where, X is exports and M is imports.

Investment multiplier or simply ‘multiplier’ implies that any change in the investment leads to a corresponding change in the income and output by multiple times. That is, in other words, the change in the income and output is more than (or multiple times) the change in investment. For example, if investment increases by 10%, then the corresponding increase in the income and output will be more than (let's say 30% or 40%) the increase in the investment. Algebraically, the investment multiplier is expressed as a ratio of the change in output to the change in investment. 

The investment multiplier is defined as the multiple amount by which income increases as a result of increase in investment expenditure.

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.

If all the people in an economy increase the proportion they save (mps increases), the total savings of the economy will not increase - they will remain the same or even decrease. This is known as the Paradox of Thrift.

According to Oxford Dictionary of Economics, "A quantity which is liable to change is known as a variable."

According to Prof. Stigler, a partial equilibrium is one which is based only on a restricted range of data.

• "General equilibrium for the entire economy could exist only if all economic units were to achieve simultaneous partial equilibrium adjustment." - Leftwitch
• According to Stigler, theory of general equilibrium is the theory of inter-relationship of all units of economy. 

• "The stationary state is an economy in which the tastes, resources and technology do not change through time." - Prof. Stigler
• "Economic statics are those parts of economic theory where we do not trouble about dating. Thus, 'statics' studies stationary situations which are devoid of any change and which do not require any relation to the past or future." - Hicks

• "Dynamic analysis may be defined as the study of the behaviour of systems, single markets or whole economics, in disequilibrium conditions." - Prof. Lipsey
• "Economic dynamics refers to those parts of economic theory where the problem of dating is conspicuously important." - Prof. Hicks
• "Economic dynamics is the study of economic phenomenon in preceding and succeeding events." - Baumol

“The psychology of the community is such that when aggregate real income is increased, aggregate consumption is also increased, but not by so much as income.” — Keynes

According to Gardner, “Frictional Unemployment is the unemployment associated with the changing of jobs in dynamic economy”.

According to Gardner, “Structural unemployment is the unemployment that results from the long term decline of certain industries.”

“Inflationary gap is an excess of total disposable income over the value of the available supply of goods at a specified price level sufficient to cause an inflation of prices.” — Webster Dictionary

“The inflationary gap is defined as the excess of aggregate demand over the available supply of output measured at the full employment level of money income at existing level of prices.” — Dernburg and McDougall

“Inflationary gap is then the difference between what the population will try to consume out of their income and the amount available for consumption at pre-inflation prices.” — Dr. Klein

Aggregate demand (AD) is the total planned spending on domestically produced final goods and services in an economy during a given period.

AD = C + I + G + (X − M)

Where:

• AD: Aggregate demand or aggregate expenditure (total planned spending).
• C: Desired consumption expenditure by households.
• I: Desired investment expenditure by firms.
• G: Desired government expenditure on goods and services.
• X: Exports of goods and services (what foreigners buy from us).
• M: Imports of goods and services (what we buy from other countries).
• (X – M): Net exports (exports minus imports).

In a simple closed economy (no government and foreign sector):

AD = C + I

Consumption and investment have different determinants and are studied separately.

\[\mathrm{MPS}=\frac{\Delta S}{\Delta Y}\]

Where:

• ΔS = change in saving
• ΔY = change in income

\[K=\frac{\Delta Y}{\Delta I}\]

where:

• K = investment multiplier
• ΔY = change in income
• ΔI = change in investment

\[\frac{\Delta Y}{\Delta\bar{A}}=\frac{1}{1-c}=\frac{1}{s}\]

where,

• ΔY: Total increment in equilibrium value of final goods output (national income).
• ΔĀ: Initial increment in autonomous expenditure (e.g., ΔĪ).
• c: MPC (Marginal Propensity to Consume).
• s: MPS (Marginal Propensity to Save), equal to 1 − c.

\[Y^*=\frac{\bar{A}}{1-mpc}\]

where,

• \[\overline{A}\] = Autonomous expenditure
• \[Y^∗\] = Equilibrium income
• mpc = Marginal propensity to consume

\[\Delta Y=\frac{\Delta A}{1-mpc}\]

where,

• \[\Delta A\] = Change in autonomous expenditure
• mpc = Marginal propensity to consume

mpc + mps = 1

where,

• mpc = Marginal propensity to consume
• mps = Marginal propensity to save

If:

• N₂ = primary employment
• N = total employment
• K′ = employment multiplier

Then:

\[N=K^{\prime}N_2\quad\Rightarrow\quad K^{\prime}=\frac{N}{N_2}\]

\[K=\frac{1}{I\times S}\]
Where:

• K = foreign trade multiplier
• I = marginal propensity to import
• S = marginal propensity to save

\[K_p=\frac{PL}{P}\]

Where:

• K_p = price multiplier
• PL = ultimate change in general price level
• P = change in the price of the basic commodity

The balanced budget multiplier is always equal to one.

This means: if the government raises both its spending and taxes by the same amount, national income rises by exactly that amount — no more, no less.

• The Keynesian model explains determination of income, output, and employment in the short run.
• Given by J. M. Keynes (1936), it states that income depends on aggregate demand (aggregate spending).
• Higher aggregate demand leads to higher output and employment.
• This simple model is the foundation of modern macroeconomic analysis.

• Short‑run national income in Keynesian theory is determined by desired aggregate demand or aggregate spending.
• Aggregate demand can be viewed as desired (ex‑ante) demand and effective (ex‑post) demand.
• In a two‑sector closed economy, AD consists of consumption and investment: AD = C + I.
• In a four‑sector economy, AD = C + I + G + (X – M).
• Ex‑ante and ex‑post concepts apply to macro variables like consumption, investment and output and are essential for understanding income determination.

• Investment refers to expenditure on capital goods like machinery, buildings, and inventories that increase productive capacity.
• It is a key component of aggregate demand, affecting income, output, and employment.
• Investment can be private (profit-motivated) or public (welfare-oriented), but Keynesian analysis mainly considers private investment.
• Investment is of two types: Induced investment (depends on income) and Autonomous investment (independent of income and taken as constant in the simple Keynesian model).

• Equilibrium income is determined where planned saving equals planned investment (S = I).
• Since AD = C + I and AS = C + S, equilibrium requires I = S.
• If S > I, income falls due to excess supply; if I > S, income rises due to excess demand.
• Thus, income adjusts until S = I, giving the same equilibrium as the AD–AS approach.

• Investment Multiplier measures the ratio of the increase in equilibrium income to the initial increase in autonomous expenditure.
• An increase in autonomous expenditure raises income, consumption, and output through repeated rounds of spending.
• The size of the multiplier depends on the Marginal Propensity to Consume (MPC) - higher MPC results in a larger multiplier.
• Total increase in income is greater than the initial increase in autonomous expenditure due to the multiplier effect.
• Investment Multiplier Formula: \[K=\frac{\Delta Y}{\Delta\bar{A}}=\frac{1}{1-c}=\frac{1}{s}\]

• Full employment exists when all people willing to work at the prevailing wage rate are employed.
• It does not include voluntary unemployment (e.g., idle rich).
• Frictional unemployment (about 3–4%) due to job changes or structural shifts is normal.
• An economy is at full employment even with this natural rate of unemployment.

• Excess Demand occurs when aggregate demand exceeds aggregate supply at full employment, leading to inflation (inflationary gap).
• It is caused by rise in consumption, investment, government spending, exports, or money supply.
• It is corrected by reducing aggregate demand using fiscal policy (higher taxes, lower public spending), monetary policy (higher bank rate, CRR, open market sales), increasing imports, or raising output.
• Deficient Demand occurs when aggregate demand is less than aggregate supply at full employment, leading to unemployment (deflationary gap).
• It is corrected by increasing aggregate demand through lower taxes, higher government spending, easy credit policy, and increase in investment and exports.

• The Paradox of Thrift states that higher individual saving does not lead to higher aggregate savings in the economy.
• When mps rises (mpc falls), equilibrium income falls through the multiplier chain.
• The multiplier chain is an infinite convergent geometric series.
• Aggregate savings remained at 10 in both equilibria, confirming the paradox.
• This is a Keynesian concept under the topic of Income and Employment Determination.

• Equilibrium means a position of rest, with no tendency to change under existing conditions.
• Partial equilibrium looks at one unit or one market at a time, assuming all other things are constant.
• Consumer’s, producer’s, firm’s, and industry’s equilibria are all examples of partial equilibria.
• General equilibrium exists when all important markets and units in the economy reach equilibrium simultaneously, and their decisions are mutually consistent.
• Walras used a system of simultaneous equations to show general equilibrium for all markets, while Leontief used input–output analysis to trace interdependence among industries.

• Static analysis: one equilibrium, no change in conditions.
• Comparative statics: two equilibria, before and after a change in an outside factor.​
• Change in demand or supply shifts the curve, giving a new equilibrium price and quantity.​
• Both methods ignore the adjustment path; they only compare equilibrium “snapshots.”

• Dynamics in economics means study of change through time.
• Static analysis compares equilibrium positions at a point; dynamic analysis explains how we move from one position to another.
• Time and sequence of events (past → present → future) are central in dynamic economics.
• In price determination, dynamic analysis traces the path of price adjustment from disequilibrium to equilibrium.
• Dynamic economies show growth in population, capital, technology, and changing habits and institutions.

• Consumption increases when income increases, but less than income.
• Part of the extra income is saved.
• MPC < 1 (Marginal Propensity to Consume is less than one).
• Formula: ΔY = ΔC + ΔS
• Break-even point: Income = Consumption (Saving = 0).
• Higher income → higher savings.
• Investment and government action may be needed to maintain demand.

• Investment is the key driver of income, output, and employment in an economy.
• Through the multiplier effect, an increase in investment leads to a multiple increase in income.
• Investment promotes capital formation, raising productive capacity and economic growth.
• It helps reduce unemployment and depression and ensures long-term prosperity.

• In a static multiplier, there is no time lag; increase in investment raises income in the same period.
• All variables (income, consumption, investment) belong to the same time period.
• Multiplier works in two directions:
  Forward: Increase in investment → multiple increase in income.
  Reverse: Decrease in investment → multiple fall in income.
• Size of income change depends on MPC and saving–investment equality.

• The dynamic multiplier considers the time lag between changes in investment and changes in income.
• Income adjustment takes place over successive periods, not instantly as in the static multiplier.
• Consumption depends on past income, and investment in one period affects income in the next period.
• Since MPC changes over time, the multiplier process becomes dynamic and more realistic.

• When government expenditure (ΔG) and taxes (ΔT) increase by the same amount, the budget is balanced.
• The Balanced Budget Multiplier (BBM) is always equal to 1.
• This means national income increases by exactly the same amount as ΔG.
• So, ΔY = ΔG, even when taxes rise along with government spending.

• Introduced by J.M. Keynes in "How to Pay for the War"
• Formula: Disposable Income − Net Output for Consumption
• Arises only at full employment when AD > AS
• Only prices rise — employment and output stay the same
• Fixed by contractionary fiscal and monetary policy