Economics Chapter 1.4 – Determination of Income and Employment

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Chapter 1.4 – Determination of Income and Employment

Economics Chapter 1.4 – Determination of Income and Employment

1. Introduction to Macroeconomic Determination:

  • This chapter addresses how national income, employment, and other key economic variables are determined using macroeconomic models.
  • The primary goal is to explain why economies experience recessions, slow growth, inflation, or unemployment.
  • Theoretical models help describe these phenomena, often relying on the assumption of ceteris paribus (holding other factors constant).

Macroeconomic Focus:

  • The chapter employs a simple model that assumes a fixed price level and constant interest rate to analyze the short-run determination of national income, largely based on John Maynard Keynes’ theories.

2. Aggregate Demand (AD) and its Components

2.1 Ex-Ante and Ex-Post Concepts:

  • Ex-ante refers to planned or expected values, such as planned consumption or investment.
  • Ex-post refers to the actual values realized after economic activities have taken place.

2.2 Components of Aggregate Demand:

  1. Consumption (C):
    • The most important determinant of consumption is income.
    • The consumption function explains the relationship between consumption and income: C=Co+cY
      • Co​ is autonomous consumption, representing consumption that happens even with zero income.
      • c is the marginal propensity to consume (MPC), which measures how much consumption increases with each unit of additional income.
  2. Investment (I):
    • Investment is defined as an addition to the stock of capital (e.g., machines, buildings) and changes in inventories.
    • In the basic model, investment is assumed to be autonomous, meaning it is not dependent on income: I=Io​

3. Determination of Income in a Two-Sector Model

  • Aggregate Demand (AD) in a two-sector economy (without government) is the sum of consumption and investment:

AD=C0​+cY+Io

  • At equilibrium, aggregate supply (total output or income, YYY) equals aggregate demand:

Y=Co​+cY+Io​

  • Rearranging the equation gives:

 Y= Co​+Io / 1−c

  • This equation shows how equilibrium income is determined by autonomous consumption, autonomous investment, and the marginal propensity to consume.

4. Equilibrium in the Short Run:

4.1 Graphical Representation:

  • In this model, equilibrium is achieved where aggregate demand (AD) equals aggregate supply (Y).
  • The 45-degree line represents points where output equals demand, and equilibrium occurs at the intersection of the AD line and the 45-degree line.

4.2 The Role of Investment and Consumption:

  • Changes in investment or autonomous consumption shift the AD curve and, consequently, change the equilibrium level of income.
  • For example, if investment increases, the AD curve shifts upward, resulting in a higher equilibrium income.

5. The Multiplier Mechanism:

5.1 Understanding the Multiplier:

  • The multiplier explains how an initial change in autonomous spending leads to a larger change in national income.
    • If investment increases by a certain amount, it generates additional income for workers, which they spend on consumption.
    • This increased consumption leads to further increases in demand, and the process continues in rounds, amplifying the effect of the initial change.
    • The formula for the investment multiplier is:

Multiplier= 1 / 1−MPC​

  • For example, if MPC=0.8, the multiplier is:

1 / 1−0.8=5

  • This means that an increase in autonomous investment of 10 units will ultimately increase total income by 50 units.

6. Paradox of Thrift:

  • The Paradox of Thrift refers to a situation where, if everyone tries to save more (increase MPS), the total savings in the economy may actually decrease.
    • As people save more, they consume less, leading to lower aggregate demand and lower income.
    • This paradox occurs because, while saving is beneficial for individuals, if all consumers reduce spending simultaneously, the overall economy shrinks, reducing the total income available to be saved.

7. Aggregate Demand and Supply with Government Intervention:

7.1 Introduction of Government in the Model:

  • When the government is included, aggregate demand becomes: AD=C+I+G
    • G represents government spending on goods and services.
    • Taxes (T) reduce disposable income, so consumption depends on disposable income: C=Co+c(Y−T)

7.2 Government’s Role:

  • Government spending increases aggregate demand, while taxes reduce households’ disposable income, thereby decreasing consumption.
  • The net effect of government intervention depends on the balance between spending (G) and taxation (T).

8. Effects of Changes in Aggregate Demand on Income and Output:

8.1 Changes in Autonomous Components:

  • Changes in autonomous consumption (C_0) or autonomous investment (I_0) can shift the AD curve and lead to changes in equilibrium income.

8.2 Impact of Credit and Interest Rates:

  • Although the basic model assumes constant investment, real-world investment depends on factors like interest rates and the availability of credit.
    • Lower interest rates make borrowing cheaper, encouraging firms to invest more.

9. Full Employment vs. Unemployment:

9.1 Full Employment Equilibrium:

  • The equilibrium level of income determined by the equality of aggregate demand and aggregate supply does not necessarily correspond to full employment.
    • If aggregate demand is insufficient, the economy may be in equilibrium with unemployment.

9.2 Excess and Deficient Demand:

  • Excess demand: When demand exceeds the full employment level, causing upward pressure on prices (inflation).
  • Deficient demand: When demand is below full employment, leading to unemployment and unused capacity.

10. The Concept of Effective Demand:

  • The concept of effective demand emphasizes that output and income are determined by the level of aggregate demand in the economy.
  • In situations where there are unused resources (like unemployment), the supply of goods adjusts to meet the effective demand.

11. Recap of Key Concepts:

  1. Marginal Propensity to Consume (MPC): The fraction of additional income spent on consumption.
  2. Marginal Propensity to Save (MPS): The fraction of additional income saved, and is equal to 1−MPC.
  3. Multiplier Effect: How changes in autonomous expenditure lead to a multiplied change in income.
  4. Paradox of Thrift: Increased savings can reduce overall income and savings in the economy.
  5. Full Employment: The level of income where all resources (labor, capital) are fully employed.

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