Rajasthan Board RBSE Class 12 Economics Notes Chapter 21 Income Output Determination
In this chapter, we shall determine the income and output equilibrium with the help of aggregate demand and aggregate supply curve.
Aggregate Expenditure in an economy is equal to the Aggregate Demand.
Aggregate demand is the total goods and services demanded in an economy in a year.
In an open economy, aggregate demand has four parts :
- Consumption Expenditure (C)
- Investment Expenditure (I)
- Government Expenditure (G)
- Net Export (X-M),
In a two-sector Economy, demand consists of:
- Consumption demand
- Investment demand.
Consumption demand depends upon Marginal Propensity to Consume and level of income.
Investment demand depends on change in the marginal efficiency of capital.
Investment demand depends upon two factors :
- Marginal Efficiency of Capital.
- Rate of Interest.
Domestic Investment Demand = Gross domestic capital formation + Change in stock of the unsold goods.
Aggregate supply refers to the total supply of goods.
Aggregate supply in an economy is the summation of Total Consumption Expenditure (C) and Total Savings (S).
Consumption expenditure is done on production of goods & services. Total savings are invested in production of capital goods.
Bi-level economy has two sectors : Domestic sector and Production sector.
Straight line of 45° in aggregate supply curve indicates two important points :
- Aggregate Production.
- National Income in Monetary terms.
National product is synonymous to National Income.
The level of income and output, where AD = AS, is the level of equilibrium of income.
In 1931, R. F. Kahn developed the concept of Employment Multiplier for the first time.
America and Europe were facing Great Economic Depression during 1930’s.
The Concept of multiplier is an important factor of Income, Production and Employment.
Investment multiplier establishes a relation between initial investment and income derived as the increase in income.
Value of investment multiplier is equal to the ratio of change in income to the change in investment.
In mathematical form :
\(K=\frac { \triangle Y }{ { \triangle I } } \)
Investment multiplier (K) is directly related to the Marginal Propensity to Consume.
Higher the Marginal Propensity to Save, lower the value of Investment Multiplier. Therefore, there exists an inverse relation between the investment multiplier and Marginal Propensity to Save.
Value of multiplier lies between 1 and ∞ (infinity).
Aggregate demand is equal to the consumption expenditure plus (+) investment expenditure.
Concept of multiplier has an important place in Keynesian principle of Income and Employment.
At any particular level of income where AD > AS, inflation happens.
When at any particular level of income, Aggregate Demand is more than the Aggregate Supply, situation of inflation happens.
At a certain level of income, if aggregate demand is less than aggregate supply, a state of deflation arises.
If there is a situation of inflationary gap, it can be corrected by reducing the Aggregate Demand.
Multiplier help in understanding the business cycles.
Equilibrium can be established between savings and investment with the help of a multiplier.
Value of multiplier determines how much investment is essential to attain the objective of full employment.
Important Terminology
- Aggregate Demand : It is the sum total of demand for goods and services in an economy during a particular year, at a given level of income and employment.
- Marginal Efficiency of Capital: It is the expected rate of profit which can be obtained on the investment of capital assets.
- Aggregate Supply : It refers to the total supply of products. It is equal to the National Income.
- Aggregate Supply Curve : It is a Bi-sector economy, where demand in domestic sector is for the final consumption, and demand in production sector is for the domestic investment.
- Equilibrium Level of Income : The level of income or product, where, aggregate demand = aggregate supply (AD = AS).
- Inflationary Gap : At any level of production income, a state of full employment occurs, where aggregate demand exceeds aggregate supply.
- Investment Multiplier : Value of Investment Multiplier is equal to the ratio of change in income to the change in investment.
\(K=\frac { \triangle Y }{ { \triangle I } } \) - Process Forward Working of Multiplier : When investment increases, income also increases. This method is called forward multiplier.
- Process Backward Working of Multiplier : A decline in investment decreases the level of income, which is known as Backward Multiplier.
- Inflationary gap : When aggregate demand is greater than the aggregate supply, it is called Inflationary gap.
- Deflationary Gap : When aggregate demand is less than the aggregate supply, it is called deflationary gap.
- Average Propensity to Save : Ratio of Total Income and Savings is called the average propensity to save.
- Break-Even Point: It is the point where, National Income and Consumption Expenditure are equal, where there are no savings.
- Principle of Effective Demand : The principle of effective demand is the principle where the Aggregate Demand function and the Aggregate Supply Function intersect each other at the point of the effective demand.