Revision: Theory of Income and Employment >> 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

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.

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).

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

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

• 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.

• AD determines income levels through its four components, each with unique drivers like income for C and rates for I.
• Policy can boost AD by increasing G or lowering interest rates to stimulate growth.
• Understanding planned vs actual demand explains inventory adjustments and equilibrium.
• For exams, memorize the AD formula and one key driver per component.

• 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.

• 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.

• Involuntary unemployment is when someone wants and is able to work but cannot find a job.
• Voluntary unemployment is by personal choice and not considered in economic unemployment rates.
• Full employment does not mean zero unemployment but the absence of involuntary 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.