INCOME

DETERMINATION
& MULTIPLIER
CHAPTER 9
 Meaning of Equilibrium Income
Equilibrium level of income is defined as that level of income where aggregate demand
for goods and services in the economy is equal to their aggregate supply.

Thus, at equilibrium point,

AD=AS

We know that AD=C+I and AS=C+S

Therefore, equilibrium is struck when:

C+I=C+S

S=I
The above derivation shows that the basic equilibrium condition AD = AS can also be expressed
as S =I. Thus, S = I condition of equilibrium is identical with AD = AS condition. This gives two
approaches, AD= AS and S=I, for determining the equilibrium level of income.

Assumptions

The determination of equilibrium income is based upon the following assumptions:

1) Short run: The equilibrium level of income is based on the assumption of short run. The
implication of this assumption is that the equilibrium output (income) in the short run can
differ from full employment equilibrium output. Short run equilibrium output can be less
than full employment output level. It can happen, when AD is not sufficient to match the full
employment AS.
2) Price level is fixed: The general price level is assumed to be fixed. By assuming it, the
effects of change in the price level on aggregate demand and aggregate supply are avoided.
3) Aggregate supply is perfectly elastic : It is further assumed that AS is perfectly elastic in the
short run. The implication of this assumption is that when aggregate demand increases,
aggregate supply also increases accordingly through the utilization of unemployed resources
mainly labour. The assumption of perfectly elastic AS implies that we are studying an
economy wherein excess production capacity is lying idle.
4) Closed economy: The determination of equilibrium income has been taken up with
reference to a closed economy. A closed economy is one which has no trade relations
with other countries. This assumption eliminates the net exports (X – M) component of
AD.

5) There is no government: This assumption means that there are no taxes and no
government expenditure. This eliminates government expenditure component of the
aggregate demand.
 Determination of Equilibrium Income

According to Keynes, an economy will be in equilibrium when aggregate demand equals

aggregate supply. Hence, in equilibrium, AD=AS

Income Planned C Planned I Planned S AD(C+I) AS(C+S)

0 100 100 -100 200 0
100 150 100 -50 250 100
200 200 100 0 300 200
300 250 100 50 350 300
400 300 100 100 400 400
500 350 100 150 450 500
600 400 100 200 500 600
• What happens when AD is greater than AS ?

When AD> AS, it means that buyers are planning to buy more goods and services than
producers are planning to produce (1.e., Supply). As a result, inventories start faling and
come below the desired level. To bring back the inventories at the desired level
producers expand production. This raises the income level which keeps on rising till the
AD and the AS once again become equal

• What happens when AD is less than AS ?

When AD < AS, it means that households and firms together would be buying less goods
than firms are willing to produce. As a result, the planned inventory would rise. To clear
the undesired increase in inventory, firms plan to reduce output until the economy is
back to equilibrium
 Saving-Investment Approach

Income Planned I Planned S

0 100 -100
100 100 -50
200 100 0
300 100 50
400 100 100
500 100 150
600 100 200
• What happens when S > I ?

When planned savings are more than planned investment, it means that households are not
consunming as much as firms expected them to do so. This will lead to build- up of
undesired inventory. To clear the undesired rise in inventory, firms will bring cuts in
production, which also means fall in income, and hence, saving reduces till planned
savings and planned investment are equal.

• What happens when S < I?

When S <1, this implies that households are saving less than what firms expected them. In
other words, households are consuming more than the firms expectations. AS a result,
planned inventory starts falling and goes below the desired level. To bring the inventory to
the desired level, firms would plan to increase the output (which means rise in income)
hence increase in savings till S = 1
 EQUILIBRIUM LEVEL

According to the classical economists, equilibrium level of income is attained always

at full employment level, 1.e. there is absence of involuntary unemployment.
However, as per the Keynesian theory, equilibrium level can be achieved at:

i) Full employment level

ii) Underemployment level, i.e. less than full employment level
iii) Over full employment level, 1.e. more than full employment level.

Full Employment Equilibrium

It refers to a situation when the aggregate demand is equal to the aggregate supply at
full employment level.
• In Fig E is the full employment
equilibrium because aggregate
demand 'EQ is equal to full
employment level of output 'OQ’.

• At OQ level of output, all those who

are willing to work at the prevailing
wage rate, are able to find
employment, i.e. there is no
involuntary unemployment.
Underemployment Equilibrium

• It refers to a situation when the aggregate

demand is equal to the aggregate supply
when the resources are not fully employed. It
occurs prior to the full employment level.

• In Fig. AD1= AS at point 'F which is

lower than full employment level.

• As OQ1 is less than OQ, point F signifies

the under employment equilibrium.
Over Full Employment Equilibrium

• It refers to a situation when AD is equal to AS

beyond the full employment level. It occurs after
the full employment level.

• In Fig, AD1 = AS at point 'G which is higher

than the full employment level.
• Point 'G signifies the over full employment
equilibrium.
Over Full Employment Equilibrium creates Inflationary Pressure.

• Over Full Employment Equilibrium signifies that planned expenditure (AD) is

equal to planned output (AS) at a level higher than full employment level.

• However, in reality, actual output cannot increase beyond this level as economy is
already at full employment and there is no idle capacity.

• So, any increase in AD beyond the full employment output, will lead to increase in
general price level (.e, inflation) and there will be no real increase in output.
 CONCEPT OF INVESTMENT MULTIPLIER
The concept of Investment Multiplier' is an important contribution of. J.M. Keynes. Keynes
believed that an initial increment in investment increases the final income by many times.
Multiplier expresses the relationship between an initial increment in investment and the
resulting increase in aggregate income.

In practice, it is observed that when investment is increased by a certain amount, then the
change in income is not restricted to the extent of the initial investment, but it changes several
times the change in investment. In other words, change in income is a multiple of the change in
investment. Multiplier explains how many times the income increases as a result of an increase
in the investment.

Multiplier (k) is the ratio of increase in national income (Change in Y) due to an increase in
investment (Change in

k= Change in Income / Change in Investment

 Suppose an additional investment of R 4,000 crores in an economy generates an additional
income of R 16,000 crores. The value of multiplier (k), in this case will be:

k= 16000/4000=4

It means, income increased 4 times with a single increase in investment.

Multiplier and MPC

There exists a direct relationship between MPC and the value of multiplier. Higher the MPC
more will be the value of multiplier, and vice-versa. The concept of multiplier is based on
the fact that one person's expenditure is another person’s income. When investment is
increased, it also increases the income of the people. People spend a part of this increased
income on consumption. However, the amount of increased income spent on consumption
depends on the value of MPC.
• In case of higher MPC, people will spend a large proportion of their increased income on
consumption. In such case, value of multiplier will be more.

• In case of low MPC, people will spend lesser proportion of their increased income
consumption. In such case, value of multiplier will be comparatively less.
• Thus, the value of multiplier depends upon the MPC
Algebraic Relationship between Multiplier & MPC

At equilibrium, Income is a sum of consumption and investment.

Y=C+I

Similarly,

ΔY= ΔC+ΔI

ΔY/ΔY= ΔC/ΔY+ ΔI/ΔY

1= MPC+1/k

k= 1/1-MPC

In terms of MPS, k= 1/MPS

 Multiplier is directly related to MPC and inversely related to MPS

The value of multiplier depends upon the value of marginal propensity to consume.
Multiplier (k) and MPC are directly related, i.e., when MPC is more, k is more and vice-
versa. On the contrary, higher the MPS, lower will be the value of multiplier and vice-
versa. This can be made clear with the help of the following table:

MPC MPS k= 1/1-MPC

0 1 1
0.5 0.5 2
0.67 0.33 3.03
0.75 0.25 4
0.8 0.2 5
0.9 0.1 10
1 0 Infinity
 Maximum and Minimum value of Multiplier

The maximum value of multiplier is infinity when the value of MPC is 1. MPC=1
indicates that the economy decides to consume the whole of its additional income.
Here, not even a bit of additional income is saved. It will lead to a continuous
increase in consumption expenditure and the value of multiplier will be infinity.

The minimum value of multiplier is 1 when the value of MPC is zero. MPC=0
indicates that the economy decides to save the whole of its additional income and
nothing is spent as consumption expenditure. So there will be no further increase in
income. As a result, total increase in income will be equal to the increase in
investment i.e Change in Y= Change in I. Here, the value of multiplier is equal to 1
Working of Investment Multiplier