INCOME DETERMINATION

AND MULTIPLIER
CHAPTER-8
MACROECONOMICS
 DETERMINATION OF EQUILIBRIUM

According to Keynesian theory, an economy is in

equilibrium when planned aggregate demand for
goods and services is equal to planned
aggregate supply during a given period of time ,
or when Ex –ante savings are equal to Ex-ante
investment during a given period of time.
 TWO APPROACHES OF EQUILIBRIUM
LEVEL OF INCOME AND EMPLOYMENT

AD=AS S=I
 ASSUMPTIONS

► This approach is studied in the context of two sectors

only. So there are no government and no foreign
sector.
► It is assumed that investment is autonomous.
► Price level is assumed to be constant.
► Equilibrium output is to be determined in the context of
short run.
AD - AS APPROACH
AD –AS APPROACH
 AD-AS APPROACH

At point E, AD is
equal to AS. OY
is the equilibrium
level of income.
 EFFECTIVE DEMAND

► The equilibrium level income is at E, when AD =

AS = 160 Crores
► It is a situation of “EFFECTIVE DEMAND”
► EFFECTIVE DEMAND refers to the level of AD at
equilibrium. It is called effective because it is
equal to AS and is able to establish equilibrium.
AD > AS (to the left of E)

Output will
increase until
the economy
Firms will resort
is back at
to increase in
Inventories equilibrium
employment.
fall below the level.
desired level
AD < AS (to the right of E)
7.9 EX-ANTE INVESTMENT AND EX- ANTE SAVINGS
EX-POST INVESTMENT AND EX-POST SAVING

Ex-post saving Ex-post investment

1.

2.
refers to the refers to actual or
actual or realised realised
savings in an investment in an
economy during economy during a
a year. year.
 POINTS TO NOTE (NCERT)

► EQUILIBRIUM level of income is determined at a level, when

Ex-ante saving = Ex-ante investment (PS = PI)
► It is a RARE phenomenon, because savers and investors are two
different entities with different motives
► Whenever PS ≠ PI, OUTPUT adjusts in such a way that these two
become equal.
► Ex- post (actual) level of investment of firms are always equal to
ex-post (actual) savings by households at any level of income (as
savings finance investment).
 POINTS TO NOTE (NCERT)

Actual Investment = Planned Investment + Unplanned Investment

Actual investment > Planned Investment (Unplanned investment will be positive)
Actual investment < Planned Investment (Unplanned investment will be negative)
► Change in inventory can be negative or positive – if there is a rise in the inventory, it
is positive inventory investment, while a depletion of inventory is negative inventory
investment.
► Inventory investment can take place due to 2 reasons:
a) Firm decides to keep some stocks for various reasons (Planned inventory
investment)
b) The sales differ from the planned level of sales, so the firm has to add to / run down
existing inventories (Unplanned inventory investment)
 SAVING INVESTMENT APPROACH

EQUILIBRIUM Ex- post (actual) AD = AS

1. Meaning

2. Ex-post

3. Derivation
level of income level of
is determined investment of C + I = C + S.
firms are always
at a level, equal to ex-post Therefore,
when Ex-ante savings by
(planned) households at I=S
saving = any level of
Ex-ante income (as
(planned) savings finance
investment. investment).
SAVING INVESTMENT APPROACH
SAVING INVESTMENT SCHEDULE
 SAVING > INVESTMENT (RIGHT SIDE)

• Households are S>I • Reduction in

not consuming employment
• Inventories rises
as the firms and output.
above the
expect them
desire level.

S>I S=I
 SAVING < INVESTMENT (LEFT SIDE)

S<I S<I S=I

• Households • Planned • Firms will
are inventories increase
consuming will fall below EMPLOYMENT
more and the desire • And OUTPUT
saving less level till S = I
 SAVING IS MORE THAN INVESTMENT

► Suppose, Saving is greater than Investment (S>I). High saving

means lower consumption. Lower consumption leads to fall in
Aggregate Demand. Inventories increase. This will make the
producers to reduce production. Aggregate Supply falls and
becomes equal to Aggregate Demand. When AD and AS are
equal S and I will also be equal.
 SAVING IS LESS THAN INVESTMENT

► Suppose, Saving is less than Investment (S < I). Low saving means
higher consumption. Higher consumption leads to rise in
Aggregate Demand. Inventories fall. This will encourage the
producers to increase production. Aggregate Supply increases
and becomes equal to Aggregate Demand. When AD and AS are
equal S and I also will be equal.
► At point E the economy is in equilibrium because at that point
Saving and Investment are equal.
Let’s study the
explanation of
this diagram
given on Pg
8.4
“ The difficulty lies not so much in
developing new ideas as in
escaping from old ones.
”
JOHN MAYNARD KEYNES
Equilibrium level
● According to the classical economists, equilibrium level of
income is attained always at full employment level. However,
as per the Keynesian theory, equilibrium level can be
achieved at:

● Full employment level.

● Underemployment level.
● Over full employment level.
 Under
Over Full
Full Employment Employment
Employment
equilibrium - It equilibrium - It
equilibrium - It
refers to a refers to a
refers to a
situation when the situation when the
situation when the
aggregate demand aggregate demand
aggregate demand
is equal to the is equal to the
is equal to the
aggregate supply aggregate supply
aggregate supply
at full employment when resources
beyond the full
level are not fully
employment level
employed

Let’s read all three in detail with the help of diagrams given on Pg 8.5 and 8.6
Let’s read all three in detail with the help of diagrams given on Pg 8.5 and 8.6
 INVESTMENT
MULTIPLIER
JOHN M KEYNES

Economic Development - the multiplier effect - YouTube

The Multiplier Effect (In less than 5 minutes) - YouTube

MEANING OF INVESTMENT MULTIPLIER

1.MEANING
2. FORMULAE
The investment
Multiplier is 3. MPC and K
1. K=∆Y, ∆Y=
defined as the k(∆I)
ratio of the 1.Higher the MPS, less is
∆I the multiplier (Inverse
change in relation).
income to the 2. K = _ 1__
2.Higher the MPC more
change in 1-MPC will be the value of
investment multiplier and vice versa
3. K = _ 1__ (Direct relation)
MPS
 INVESTMENT MULTIPLIER

Change in income is a multiple of change in investment. That is, multiplier

explains how many times the income increases when investment
increases by a certain amount.
ASSUMPTIONS OF MULTIPLIER

Assumptions
One person’s expenditure
is other person’s income
Govt invests ₹ 100 crores

Value of MPC = 0.5

 MULTIPLIER PROCESS

Change in Change in Change in Change in

Investment (∆I) Income (∆Y) Consumption (∆C) Saving (∆S)
100 100 50 50
- 50 25 25
- 25 12.5 12.5
- 12.5 6.25 6.25
- ----- ---- ----
- ----- ---- -----
100 200 100 100
 INVESTMENT PROCESS

► An additional investment of ₹100 crores leads to an increase in income of

₹100 crores in the first round.
► MPC is 0.5. So, 50% of additional income of ₹100 crores (₹ 50 crores) is
consumed and another 50% (₹ 50 crores) is saved.
► One man’s expenditure is another man’s income. So, in the next round,
consumption of ₹ 50 crores creates an income of ₹ 50 crores. 50% of this
additional income of ₹ 50 crores (₹ 25 crores) is consumed and remaining
50% is saved.
► This will go on until consumption becomes zero.
► Total income generated will be 200. K = 1 / 1- MPC = 1/ 0.5 = 2
∆ Y = K (∆ I) = 2 (100) = 200
MULTIPLIER PROCESS
 MULTIPLIER THROUGH A DIAGRAM

Initial Equilibrium is at point E (AD intersects AS)

Equilibrium income is OY

When investment increases by ∆I, AD curve shifts up

New Equilibrium is established at E’ (AD’ intersects AS)
New Equilibrium level of income is OY’
Increase in income is YY’

From the diagram, it is clear that ∆Y > ∆I

∆Y = k (∆I)
 VALUE OF MULTIPLIER

MPC = 0
• K = I/1-MPC
• K = 1/0 = ∞ • K= 1/1-MPC • VALUE OF K
• K=1/1-0 = 1 • 1 TO ∞

MPC = 1 K = 1 to ∞
REVERSE MULTIPLIER
“ LET’S CHECK OUT THIS VIDEO

”
PARADOX OF THRIFT (for reference only)
AN EXAMPLE
 FORMULAE AT A GLANCE

AD = C+I At BEP APS = S/Y

AS = Y Y = C, S=0 APC = C/Y

At Eqm, K = ∆Y/∆I APC+APS = 1

Y=C+I or S = I ∆Y = K(∆I) MPC+MPS = 1

AD = C+by+I K = 1/MPS MPC = ∆C/∆Y

AD = A+bY
A – Autonomous expenditure K = 1/1-MPC MPS = ∆S/∆Y
Numerical practice (solved examples)

Let’s try out the following examples

today

Pg 8.15 to Pg 8.26 Example 8, 10, 13,

16, 18, 24, 25, 33 and 34
Numerical practice (unsolved practicals)

Let’s try out the following questions

today:

Pg 8.44 onwards Q14, Q17, Q27,

Q29, Q38, Q50, Q85, Q86, Q87,
Q88 and Q89