Determination of Income employment output

6 C HAPTER (cid:1) (cid:10) (cid:10)(cid:6) (cid:13) (cid:2)(cid:3)(cid:2)(cid:4)(cid:5)(cid:6)(cid:7)(cid:8)(cid:3)(cid:6)(cid:9)(cid:7) (cid:9)(cid:11) (cid:7)(cid:12)(cid:9)(cid:5)(cid:2) (cid:2) (cid:10) (cid:10)(cid:9) (cid:5)(cid:14)(cid:15)(cid:9)(cid:16)(cid:5)(cid:2)(cid:7)(cid:3) (cid:8)(cid:7)(cid:1) (cid:17)(cid:3)(cid:14)(cid:17)(cid:3) In the previous chapter we saw the Output Determination by components of aggregate demand. In Consumption plus Investment the Keynesian framework, the Approach equilibrium level of output is We may show output determination determined solely by the level of using the consumption plus investment aggregate demand. The first section of (C+I) approach. This is illustrated in Fig. this chapter will show the 6.1, which shows total spending or determination of the equilibrium level aggregate demand plotted against of output in the Keynesian framework. output or income. The line CC is the Then, the concept and working of the consumption function, showing the multiplier will be introduced. The desired level of consumption second section will deal with the corresponding to each level of income. problems of excess and deficient We now add desired investment (which demand, followed by the measures to is at fixed level I to the consumption o correct these problems. function. This gives the level of total desired spending or aggregate demand, Determination of Equilibrium Level represented by the C + I curve. At every of Output o point, the (C + I ) curve lies above the CC o We shall confine our analysis of the curve by an amount equal to I . o determination of the equilibrium level The 45o line will enable us to of output to an economy with only two identify the equilibrium. At any sectors, households and firms. Hence, point on the 45o line, the aggregate the only components of aggregate demand (measured vertically) equals demand will be consumption demand the total level of output (measured and investment demand. The absence horizontally). of the government sector and the The economy is in equilibrium foreign sector means that income when aggregate demand, represented equals output, which is equal to Gross by the C + I curve is equal to the 0 National Product. total output. DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 69 C&I C+Io C E Io C+Io Io C 45o M Q* Output Fig. 6.1: Output Determination by Consumption plus Investment approach The aggregate demand (C + I ) curve Consider the case when the economy 0 shows the desired level of expenditure is at a level of output greater than the by consumers and firms corresponding equilibrium level M in Figure 6.1. At any to each level of output. The economy is such greater level of output, the C + I o in equilibrium at the point where the line lies below the 45o line, that is, C + I curve intersects the 45o line - point planned spending is less than planned 0 E in Fig. 6.1. At point E, the economy is output. This means that consumers and in equilibrium because the level of firms together would be buying less desired spending on consumption and goods than firms were producing. This investment exactly equal the level of total would lead to an unplanned, undesired output. The level of output increase in inventories of unsold goods corresponding to point E, is the level of (representing goods neither sold to output 0M. Thus, 0M is the equilibrium households for consumption nor level of output. bought by firms for investment). Firms would then respond to this unplanned The Adjustment Mechanism inventory increase by decreasing Equilibrium occurs when planned employment and hence output. This spending equals planned output. When process of decrease in output will planned spending is not equal to continue until the economy is back at planned output, then output will tend output level M, where again aggregate to increases or decreases until the two demand equals planned output and are equal again. there is no further tendency to change. 70 INTRODUCTORY MACROECONOMICS Consider another case when the producing. This would lead to an economy is at a level of output less unplanned, undesired decrease in than the equilibrium level 0M. At any inventories. Firms would then such lower level of output, the C + I respond to this unplanned inventory o line lies above the 45o line, that is, decrease by increasing employment planned spending is more than and hence output. This process of planned output. This means that increase in output will continue until consumers and firms together would the economy is back at output level be buying more goods than firms were 0M, where again aggregate demand Consumption Consumption (C) Function B 45 o O M Q* Output Savings Savings (S) Function B O Q* Output Fig 6.2: The Consumption Function and the corresponding Savings Function DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 71 equals planned output and there is depends mainly upon the interest rate. no further tendency to change. Here, however, for simplicity, we shall assume that firms plan to invest exactly Output Determination Using the the same amount every year, regardless Savings Functions and the of the level of output. Investment Schedule If we plot on a graph the level of Savings Function investment demand at every level of output (and therefore income), we will Figure 6.2 shows the consumption have the investment schedule. Figure 6.3 function and the corresponding savings shows the investment schedule. function. Is it not similar to Fig. 5.2? Since firms plan to invest the same Recall that each point on the amount I regardless of the level of consumption function shows desired or o output, the investment schedule will be planned consumption at that level of a horizontal line. This is because every income. Each point on the savings point on the investment schedule lies at function shows the desired or planned the same height above the horizontal saving at that income level. axis. That is, the level of investment The two functions are closely related, demand is the same at every level since income always equals of output. consumption plus saving. Therefore, these can be called complementary Equilibrium Output curves. The level of output 0Q* is the full-employment level of output. By examining the interaction of savings and investment, we can find the Investment schedule equilibrium level of output. Fig. 6.4 We have seen in the previous chapter combines the savings function of Fig. 6.2 that the level of investment demand and the investment schedule of Figure 6.3. Investment (I) (cid:1) Investment (cid:2) O B M Q* Output Fig 6.3: The Investment Schedule 72 INTRODUCTORY MACROECONOMICS We see that the savings function and save an amount equal to ME. However, the investment schedule intersect at in general, there is no necessity for actual point E. This point corresponds to a level saving (or investment) to be equal to of output M, which is the equilibrium planned saving (or investment). This level of output. may be due to mistakes, incorrect This intersection of the savings forecasting of events, or for a variety of function and the investment schedule other reasons. In any case, actual gives the equilibrium towards which, savings or investment might be different output will gravitate. from planned savings or investment. We will look at the mechanism of Meaning of the Equilibrium how output adjusts until planned Point E is the point of intersection of the savings and planned investment are savings function and the investment equal, under three separate cases. schedule. Thus, only at point E will The first case is where the economy is planned savings of households equal at a level of output equal to 0M. At this level planned investment of firms. When of output, planned savings of households planned savings and planned equals planned investment of firms. Since investment are not equal, output will the plans of households and firms are tend to adjust up or down till they are satisfied, they will be content to continue equal again. doing exactly what they had been doing The savings function and the till then. Thus, output, employment and investment schedule of Fig. 6.4 income will remain the same. In this case, represent planned levels of savings and it is rightly called an equilibrium. investment respectively. Thus, at output The second case is where the level 0M, firms plan to invest an amount economy is at a level of output greater equal to ME. Also, households plan to than 0M. At the corresponding level of Savings, Investment(S,I) Savings function E Io O B M Output Fig 6.4: Intersection of the Savings Function and the Investment Schedule DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 73 income, the savings function lies above investment. Again, since firms’ plans have the investment schedule. Therefore, at not materialised, they will act in order to this level of income households are correct the situation. In order to increase saving more, that is, they are refraining inventories to the desired, planned level, from consuming by an amount greater firms will increase production and than firms are investing. The effect of this increase employment. The effect of this will be to cause an undesired, will be to increase output till the economy unplanned build-up of inventories of returns to output level 0M, where planned savings equal planned investment, unsold goods. The effect of an undesired, planned investment equals actual unplanned inventory build-up is to investment, and there is thus no further increase the actual level of investment tendency to change. to a level greater than the planned level All three cases lead to the same of investment.1 Since firms’ plans have inference. The only equilibrium level of not materialized, they will act in order output is M, where planned saving to correct the situation. In order to equals planned investment. At any other reduce the unsold inventories to the level of output, the discrepancy between desired level firms will cut back planned saving and planned investment production and reduce employment. will cause firms to change their The effect of this will be to reduce output production and employment levels, until the economy returns to thereby returning the economy to the equilibrium at output level 0M, where equilibrium output and employment. planned savings equals planned investment, equals actual investment, Planned versus Actual Amounts and there is therefore no further Till now we have repeatedly used the tendency to change. words ‘planned’ or ‘desired’ and ‘actual’ The third case is where the economy amounts of consumption, investment, is at a level of output less than 0M. At the output, etc. There is a difference between corresponding level of income, the (a) the amount of planned or desired savings function lies below the consumption or investment, given by the investment schedule. Therefore, at this consumption function or by the level of income households are saving an investment demand function, and (b) the amount less than firms plan to invest. actual amounts of consumption or Households are thus, refraining from investment that is measured after the consuming by an amount less than firms accurrence. plan to invest. The effect of this will be to The distinction between the two cause an unplanned, undesired emphasises the fact that output is at reduction in inventories of unsold goods. equilibrium only when firms and Thus, the actual level of investment will consumers are actually on their be less than the planned level of schedules of desired spending and 1 Actual investment equals planned investment plus unplanned investment. The unplanned investment changes due to unplanned inventory increase or decrease. 74 INTRODUCTORY MACROECONOMICS investment. As measured by the National example using a consumption function Income Accounts, savings will always be and the associated savings function. identically equal to investment in a two- The consumption function is sector economy. This is because C = 1000 + 0.67Y C + S ≡ Y ≡ C + I The associated savings function is Y ≡ C + I S = -1000 + 0.33Y and Y ≡ C + S, Column (2) represents the level of C + S ≡ C + I planned consumption at various levels Therefore, S ≡ I. of income. The values in column (2) are However, actual investment will differ derived from the consumption function from planned investment when actual used above. Column (3) represents the sales are unequal to planned sales and levels of planned saving at various levels firms thus face an unplanned build-up of income. The values in column (3) are or reduction in inventories. Only when derived from the savings function used the level of output is such that aggregate above. Column (5) is a reproduction of demand equals planned output will column (1). Column (6) shows the level there be no tendency for output, income of aggregate demand at various levels of and employment to change. income – it is the sum of consumption demand in column (2) and investment A Numerical Example demand in column (4). It shows what A numerical example will show why the firms actually manage to sell. equilibrium level of output occurs The level of income at which when planned spending and planned consumption is exactly equal to income output are equal. Table 6.1 shows an (that is, all income is consumed), and Table 6.1: Determination of Output (All Figures in Rs. Crores) Output and Planned Planned Planned Output and Aggregate Tendency Income consum- Saving Invest- Income Demand of Output to ption (3)=(1)–(2) ment (5) = (1) (6)=(2)+(4) (1) (2) (3) (4) (5) (6) (7) 4200 3800 400 200 4200> 4000 Decrease 3900 3600 300 200 3900> 3800 Decrease 3600 3400 200 200 3600= 3600 Equilibrium 3300 3200 100 200 3300< 3400 Increase 3000 3000 0 200 3000< 3200 Increase 2700 2800 -100 200 2700< 3000 Increase DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 75 therefore, savings is exactly equal to zero operations, causing output to fall. is known as the break-even level of When they are temporarily selling more income. In our example, the breakeven than their current production, they will level of income is Rs.3600 crores. expand their operations, causing Now, each change of income of output to rise. Rs.300 crores causes a change of Rs.100 Only when the level of output in crores in saving, and a change of Rs.200 column (5) is equal to aggregate crores in consumption. Thus, MPS is a demand in column (6) will output be in constant and is equal to 1/3 and MPC is equilibrium. Firms’ sales will be just a constant and is equal to 2/3. enough to justify continuing their Investment is assumed to be current level of aggregate output. Thus, exogenous. Firms plan to invest a aggregate output will neither expand constant amount of Rs.200 crores as nor contract, and will be in equilibrium. shown in column (4). That is, at each The equilibrium level of output in our level of income, firms plan to purchase example is Rs.3600 crores. Rs.200 crores of investment goods. The Multiplier Consider the top row of the Table 6.1. A change in the investment spending If firms are producing Rs.4200 crores of will affect output and therefore output, then the planned spending or aggregate demand is only Rs.4000 employment. It is logical that an crores. In this situation, there will be an increase in fixed investment will increase unplanned accumulation of inventories the level of output and employment to the tune of Rs.4200 crores – Rs.4000 through increase in productive crores = Rs.200 crores. Firms will respond capacity. Conversely, a decrease in to this unplanned inventory build-up by investment will decrease the level of sealing down their operations and thus output and employment. output will decrease. The operation of the multiplier The opposite case is represented by ensures that a change in investment the bottom row of Table 6.1. Here, firms causes a change in output by an are producing Rs.2700 crores of output amplified amount, which is a multiple but aggregate demand is Rs.3000 of the change in investment. crores. In this situation, there will be The multiplier is the number by an unplanned decrease in inventories which the change in investment must to the tune of Rs.3000 crores – Rs.2700 be multiplied in order to determine the crores = Rs.300 crores. Firms will resulting change in output. respond to this unplanned inventory For example, if an increase in decrease by expanding their operations, investment of Rs.100 crores causes an thus causing an increase in output. increase in output of Rs.300 crores, Thus, when firms as a whole are then the multiplier is 3. If, instead the temporarily producing more than they resulting increase in output is Rs.400 can sell, they will contract their crores, then the multiplier is 4. 76 INTRODUCTORY MACROECONOMICS We may derive an expression for the The actual size of the multiplier multiplier as follows: depends on the value of MPC. For At equilibrium, we have example, if MPC is 2/3, then the multiplier is 3. If MPC be at 4/5, the Y = C + I multiplier is 5. i.e., income equals the sum of A numerical example will enable us consumption plus investment. to see the operation of the multiplier. We can use the consumption Let the MPC be at 4/5. Suppose there function to substitute C with the is an increase in investment of Rs.1000, expression C +bY, to give which results in the construction of a new building. Then, the builder, the Y = C + bY + I architect and the labourers together will so Y – bY = C + I get an increase in income of Rs.1000. Since the MPC is 4/5, they will together or, Y (1–b)= C + I spend 800 (4/5 of Rs.1000) on new 1 consumption goods. The producers of or, Y = (C + I) (1–b) those consumption goods will thus have an increase of Rs.800 in their incomes. Since b is nothing but the MPC, we Since their MPC is also 4/5, they will in have turn spend Rs.640 (4/5 of Rs.800, or 1 Y = (C + I) 4/5 of 4/5 of Rs.1000). This will cause (1–MPC) an increase in income of other people To find out the effect of a change in by Rs.640. This process will go on, with investment on income, we differentiate each new round of spending (and the equation to obtain therefore increase in income) being 4/5 of the previous round. 1 ∆Y = ∆I Thus, an endless chain of secondary (1–MPC) consumption spending is set in motion So,(Change in Income) = (Multiplier) by the primary investment of Rs.1000. × (Change in Investment) However, not only is the chain of The multiplier is equal to 1/(1–MPC). secondary consumption spending endless, it is also ever-diminishing. It is the number by which the change in Eventually, the sum of the secondary investment must be multiplied in order consumption expenditures will be a to determine the resulting change finite amount. in output. We can calculate the total increase As we can see, the size of the in consumption plus investment multiplier depends on value of the MPC. spending and therefore the total Since 0 < MPC < 1, the multiplier increase in income as follows: will be greater than 1. Hence, a change Rs. 1000 = 1 × Rs.1000 in investment will cause a ‘multiple’ + + change in output. Rs.800 4/5 × Rs.1000 DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 77 + + ∆Y = Rs. 5000 Rs. 640 (4/5)2 × Rs. 1000 We can see that with an MPC of 4/5, + + the multiplier is 5. Rs. 512 (4/5)3 × Rs. 1000 We may also express multiplier in + + terms of the marginal propensity to Rs. 409.6 (4/5)4 × Rs. 1000 save, that is MPS. + + ... ... Multiplier= 1 1–MPC Rs. 5000 [1/{1-(4/5)}] × Rs. 1000 Multiplier Since MPS= 1 – MPC, we have We have said that the chain of secondary consumption spending is an 1 Multiplier= endless ever-diminishing chain, whose MPS sum is a finite amount. i.e., if MPS were 1/x, then the We may find the sum of the total multiplier would be x. increase in spending by using the In our example, the MPS is 1/5. Let formula for the sum of an infinite geometric progression. the investment expenditure increase by The sum of the total increase in Rs.1000 crores. Planned saving will have spending and the total increase in to rise till it equals the new and higher income is: level of investment, in order to bring output to a new equilibrium. The only ∆Y= 1 × Rs.1000 + (4/5) × Rs.1000 way that saving can rise is for income to + (4/5)2 × Rs.1000 + (4/5)3 × rise. With an MPS of 1/5 and an increase Rs.1000 + … in investment of Rs.1000 crores, income ∆Y= Rs.1000 + [ 1 + (4/5) + (4/5)2 + must rise by Rs.5000 crores to bring to forth Rs.1000 crores of additional saving (4/5)3 +...} to match the new investment. Hence, at The term in square brackets is of the equilibrium, Rs.1000 crores of form of the sum of an infinite geometric additional investment induces Rs.5000 progression, whose first term is 1 and crores of additional income, in line with where constant multiplier ‘r’ is 4/5. our multiplier arithmetic. The formula for the sum of such an infinite geometric progression is Problems of Excess and Deficient 1/(1–r). In our case, Demand and Measures to Correct r = 4/5, therefore the sum of the Them geometric progression is Thus far, we have studied the determination of output, income and 1/[1 – (4/5)] = 5 employment in the Keynesian Replacing the term in the square framework. The equilibrium level of brackets by 5, we have output, income and employment were ∆Y = Rs. 1000 x 5 determined solely by the level of 78 INTRODUCTORY MACROECONOMICS aggregate demand. The economy will rise to a ‘deflationary gap’, which causes be in full-employment equilibrium if the the economy’s income, output and aggregate demand is for an amount of employment to decline, thus pushing output that is equal to the full- the economy into an under- employment level of output. If the employment equilibrium. Figure 6.5 aggregate demand is for an amount of depicts the situation of deficient output less than the full employment demand. level of output, then it is known as The Y-axis measures consumption deficient demand. If the aggregate demand, investment demand, and their demand is for a level of output more sum the aggregate demand. The X-axis than full-employment level of output, measures the level of output and then it is known as excess demand. We income. OQ* is the full employment level will take up the problems of and of output and income. (C+I) and (C+I) , o 1 remedies for excess and deficient are two parallel aggregate demand demand individually. curves, differing only by the amount of investment expenditure. Problem of Deficient Demand For the economy to be at a full- If aggregate demand is for a level of employment equilibrium, the aggregate output less than the full-employment demand should be for a level of output level, then a situation of deficient equal to the full-employment level of demand exists. Deficient demand gives output OQ*. In other words, aggregate Aggregate Demand (C+I) 1 F (C+I) o G E Deflationary Gap 45o O M Q* Output&Income Fig 6.5: Deficient Demand DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 79 demand should be equal to Q*F. The amount of deficiency of aggregate economy will then be in a full demand. employment equilibrium, corresponding The deflationary gap will set in to the point F on the aggregate demand motion forces that will cause a decline curve (C+I) , and the economy in the economy’s output, income and 1 will produce full-employment level of employment. At point G, the aggregate output OQ*. demand curve (C+I ) lies below the 45o o Suppose, however, that the line. As a result, the aggregate demand aggregate demand is for a level of Q*G is less than the level of output OQ*. output Q*G. Q*G is less than Q*F. Then Firms will experience an unplanned aggregate demand is for a level of build-up of inventories of unsold goods. output which is less than the full- They will respond by reducing employment level. This level of employment and cutting back aggregate demand corresponds to point production. This will reduce the G on the aggregate demand curve (C+I ). economy’s output, income and o This results in a situation of deficient employment, until a new equilibrium demand. The resulting deflationary gap is reached at point E. This is an created due to deficient demand is equilibrium, because the aggregate represented in Figure 6.5 by FG. demand EM is equal to output OM The deflationary gap is the difference (since point E lies on the 45o line). between the actual level of aggregate It will be noted that point E is an demand, and the level of aggregate under-employment equilibrium. The demand required to establish the full- equilibrium levels of output, income employment equilibrium. The and employment corresponding to deflationary gap is a measure of the point E are less than the full Aggregate Demand InflationaryGap (C+I) G E 1 (C+I) 0 F 45o Q* M Output&income Fig 6.6: Excess Demand 80 INTRODUCTORY MACROECONOMICS employment levels of output, income the aggregate demand curve (C+I) , and o and employment corresponding to the economy will produce full- point F. Thus, the deficient demand employment level of output OQ*. caused deflationary gap has pushed the While analysing the output-cum- economy into an under-employment income axis, one important point must equilibrium. be kept in mind. The axis measures nominal output and income. Due to the Problem of Excess Demand peculiar shape of the Keynesian, If aggregate demand is for a level of aggregate supply curve (reproduced in output more than the full employment Figure 6.7) prices are rigid till the full- level, then a situation of excess demand employment level of output. Thereafter, exists. Excess demand gives rise to an the aggregate supply curve becomes ‘inflationary gap’, which causes a rise perfectly inelastic with respect to prices. in the price level or inflation. Figure 6.6 This has the following depicts the situation of excess demand. repercussions on the analysis of the The X-axis measures the level of output-cum-income axis of Figure 6.6. output and income. The Y-axis measures Uptil point Q*, increases in nominal consumption demand, investment income and output correspond to demand, and their sum, the aggregate increases in real income and output demand. 0Q* is the full employment level (since prices are constant). Beyond of output and income. (C+I) and (C+I) , point Q*, increases in nominal income o 1 are two parallel aggregate demand and output do not correspond to any curves, differing only by the amount of change in real income and output. This investment expenditure. is because real income and output The economy will be in a full- cannot increase beyond the full employment equilibrium at point F on employment level, as all resources are Price Level Q* isthefullemployment levelofoutput. E O Output Fig 6.7: Keynesian Aggregate Supply Curve DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 81 already fully employed. The increases equilibrium E. Correspondingly, the in nominal income and output are equilibrium level of employment also is merely due to increases in the price level. the same. All that has happened is that Suppose that the aggregate nominal output and income have demand is for a level of output Q*G, increased due to an increase in the price which is greater than the full- level. Thus, the excess demand caused employment level of output. This level an inflationary gap, which caused of aggregate demand corresponds to inflation, and therefore, the price level to point G on the aggregate demand curve rise. In other words, the economy remains (C+I) . This is a situation of excess at a full-employment equilibrium, o demand. The resulting inflationary gap, although at a higher price level. created due to the excess demand is The Government Sector represented in Figure 6.6 by FG. The inflationary gap is the amount Before entering into a study of the by which the actual aggregate demand measures to correct the problems of exceeds the level of aggregate demand excess and deficient demand, it will be required to establish the full-employment necessary to include the government equilibrium. The inflationary gap is a sector in the economy. Then the measure of the amount of the excess of economy under consideration becomes aggregate demand. a three-sector economy; the three The inflationary gap is so called sectors being households, firms and because it sets in motion forces that will government. It is well known that fiscal cause inflation or a rise in the price level. policy (Government expenditure and At point G, the aggregate demand curve tax programmes) has a major impact (C+I) lies above the 45o line. As a result, on economic activity, specifically on o the aggregate demand Q*G is greater output, employment and prices. In fact, than the level of output OQ*. The effect it is this knowledge that led to the of this will be to create demand pull Keynesian policy of demand inflation (an aggregate demand induced management through fiscal policy in rise in the price level). The rise in price order to correct excess of or deficiency level, given the constant real output, will of aggregate demand. cause an increase in the nominal To simplify the analysis, we may output until a new equilibrium is focus on the effects of government reached at point E. This is an expenditure with the total taxes collected equilibrium because the aggregate held constant.2 In the face of taxes, demand ME is equal to the output OM consumption is no longer a function of (since point E lies on the 45o line). income – Rather, consumption is a It will be noted that the real output function of disposable income.3 However, and real income are the same at the new under simplifying assumptions 2 Taxes that do not change with income or other economic variables are called lump sum taxes. 3 Disposable income equals income minus taxes. 82 INTRODUCTORY MACROECONOMICS Aggregate Demand InflationaryGap (C+I) G E 1 (C+I) 0 F 45o Q* M Output,income Fig 6.8: Effect of Constant Tax on Consumption Function (absence of foreign trade, transfers, will be reduced by an amount equal to depreciation, etc.) we have output equals MPC times the tax. disposable income plus taxes. Since tax Algebraically, the new consumption revenues are held constant, output and function is disposable income will always differ by C1 = C + b (Y ) the same amount. Thus, after taking into d account such taxes, we can still plot the Where Y is disposable income d consumption function against output, C1 = C + b (Y–T) rather than against disposable income. where T is constant taxes We may plot the new consumption function as a parallel downward shift of C1 = C + bY - bT the old consumption function. The C1 = C – bT justification of this is as follows. In the where C is the old consumption function face of constant taxes, at every income level the disposable income will be less i.e. C = C + bY, than the income level by the constant Finally, we get C - C1 = bT amount of the tax. The effect of this uniformly lower disposable income This equation may be interpreted as level is to cause a uniformly lower level follows: of consumption. The decrease in The new consumption function is consumption at every income level will uniformly less than the old be an amount MPC times the reduction consumption function by an amount in income. This is because MPC is the equal to the MPC times the decrease in change in consumption for a given income (i.e., the constant tax T). Since change in income. If income is reduced b and T are constants, we have the term by the amount of tax, then consumption bT being a constant. Therefore, we can DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 83 depict the new consumption function constant amount. The new aggregate as a parallel downward shift of the old demand curve C+I+G lies parallel above consumption function. The amount of the old aggregate demand curve C+I. the downward shift will be bT. The new This is because, at every level of output consumption function is depicted the vertical distance between the C+I in Fig. 6.8. curve and the C+I+G curve is the C is the old consumption function. constant amount of government C1 is the new consumption function expenditure. in the face of taxes. Thus, the inclusion of government This is as regards the effect of taxes expenditure in aggregate demand on consumption demand. We may now causes a parallel upward shift by an turn to the effect of government amount G, in the aggregate demand expenditure G on aggregate demand. curve. Recall that in a three-sector economy, We are now in a position to return where the three sectors are households, to the measures that can be taken to firms and government; aggregate remedy the problems of excess and demand is equal to the sum of deficient demand. In the following consumption, investment and discussion, aggregate demand will be government expenditure. Figure 6.9 taken to mean the sum of shows the effect of G on aggregate consumption, investment and demand. For simplicity, we consider government expenditure, since we are government expenditure to be a now considering a three-sector Aggregate demand C+I+G C+I G G 45o Output Fig 6.9: The Effect of Government Expenditure on Aggregate Demand 84 INTRODUCTORY MACROECONOMICS Aggregate Demand F C+I+G G DeflationaryGap E 45o O M Q Output Fig 6.10: Deficient Demand in a Three-sector Economy economy. This modification to the The aggregate demand may be definition of aggregate demand does increased by taking recourse to fiscal not however change the nature of or policy, monetary policy or both. definition of excess and deficient demand. Fiscal Policy Measures We will first consider the remedy to We shall first consider the fiscal policy the problem of deficient demand. measures to increase aggregate demand. Remedy for Deficient Demand This may be done by either increasing the level of government expenditure, or As we have seen earlier, if aggregate by reducing the amount of taxes. If the demand is for a level of output less than government expenditure is increased by the full employment level of output, then an amount equal to the deflationary gap, a situation of deficient demand exists. it will restore the economy to the full- Figure 6.10 depicts the situation of employment equilibrium. This increase deficient demand in the context of the in government expenditure is shown in three-sector economy. Figure 6.11. In order to remedy the problem of The new level of aggregate demand deficient demand, the aggregate is C+I+G corresponding to a higher 1 demand has to be increased by an level of government expenditure G . 1 amount equal to the deflationary gap. This level of aggregate demand is This will move the economy to the full sufficient to keep the economy at the employment equilibrium at point F. full employment equilibrium, thus DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 85 eliminating the problem of deficient may be increased, thus combating the demand. Thus,increase in government problem of deficient demand. expenditure by an amount FG will eliminate the problem of deficient Monetary Policy Measures demand. The problem of deficient demand can The other fiscal policy measure that also be solved by taking resort to will increase aggregate demand is the monetary policy measures. The aim of reduction in the level of taxes. A the monetary policy measure is to cause reduction in the level of taxes will an increase in the investment increase the disposable income by the expenditure by firms. This may be done amount of the reduction in taxes. As a in a two step manner. The first step is result, consumption demand will to increase the availability of credit. This increase by an amount of MPC times may be done by reducing the reserve the increase in disposable income. The ratios, thus giving commercial banks increase in consumption demand will greater ability to create credit. The next increase the aggregate demand by an step is to lower the interest rate by equal amount. Thus, by lowering the increasing the supply of money. The taxes, the aggregate demand may be purpose of this step is to ensure the off increased. take of the increased credit by firms. This way, by a mix of fiscal policy Recall that there is an inverse measures of increasing government relationship between the rate of interest expenditure and decreasing the level of and the level of investment demand. If taxes, the level of aggregate demand the economy’s Central Bank4 lower the Aggregate demand C+I+G 1 F C+I+G o G 45o O M Q Output Fig 6.11: Increase in Government Expenditure 4 Reserve Bank of India (RBI) is the Central Bank for the Indian Economy. 86 INTRODUCTORY MACROECONOMICS C+I+G Aggregate Demand E G C1+I+G F ADgegmreagnadteO45oMGQF*InflatiEonaryGapOutpuCt1+CI++IG+G InflationaryGap 45o O M Q* Output Fig 6.12 Excess Demand in the Context of the Three-sector Economy interest rate, then there would be an the economy at full employment increase in investment demand. equilibrium but will lower the price level This increase in investment demand and thus combat the inflation. The would cause an increase in aggregate aggregate demand may be reduced by demand. Thus, by sufficiently lowering taking recourse to fiscal policy or to the interest rate, the Central Bank may monetary policy. increase investment demand and Fiscal Policy Measures therefore aggregate demand, until the The fiscal policy measures to reduce economy is restored to a full- aggregate demand are (a) reducing the employment equilibrium. government expenditure, and (b) Remedy for Excess Demand increasing the amount of taxes. For As we have seen earlier, if aggregate example, where tax was uniformly demand is for a level of output greater Rs.300 crores at every level of income, than the full employment level of output, it may be increased to say Rs.400 then a situation of excess demand crores at every level of income. If the tax exists. Figure 6.12 depicts the situation rate is increased it will uniformly of excess demand in the context of the reduce the disposable income, thus three-sector economy. causing a parallel downward shift of the In order to remedy the problem of consumption function. Consequently, excess demand, the aggregate demand the level of aggregate demand will fall. has to be reduced by an amount equal If the amount of taxes is increased to the inflationary gap. This will keep sufficiently so that aggregate demand DETERMINATION OF INCOME, EMPLOYMENT AND OUTPUT 87 falls enough to eliminate the inflationary fiscal measures for correcting encess/ gap, then the economy will come back deficient demand, the monetary policy to the full employment equilibrium, measure to combat the problem of without inflation. excess demand will operate through a In Figure 6.12, if taxes are raised reduction in the investment demand by such that aggregate demand falls from firms. Recall that there is an inverse C+I+G to C1+I+G, then the price level relationship between the rate of interest falls and inflation is successfully and the level of investment demand. If combated. the economy’s Central Bank were to Thus, reduction of aggregate demand by an amount GF through the mechanism increase the interest rate, then there of increasing the taxes eliminates the would be a decrease in investment problem of excess demand. demand. Alternatively, the level of aggregate This decrease in investment demand may be reduced by reducing demand would cause a decrease in the amount of government expenditure. aggregate demand. Thus, by A mix of fiscal policy measures of sufficiently raising the interest rate, the reducing government expenditure and Central Bank may decrease increasing the taxes are employed to investment demand and therefore, combat excess demand. aggregate demand, until the Monetary Policy Measures inflationary gap is eliminated, and the Contrary to keynesian emphasis on price level reduced. SUMMARY (cid:1) The equilibrium level of income is that level of income where the aggregate demand equals the level of output, and the level of planned savings equals planned investment. (cid:1) A situation of deficient demand arises if the aggregate demand is for a level of output that is less than the full-employment level of output. This gives rise to a deflationary gap. (cid:1) A situation of excess demand arises if the aggregate demand is for a level of output that is more than the full-employment level of output. This gives rise to an inflationary gap. (cid:1) The introduction of government sector means that aggregate demand is now equal to the sum of consumption, investment and government expenditure. (cid:1) The government sector impacts the level of aggregate demand through both government expenditure and taxes. (cid:1) Excess and deficient demand may be corrected through fiscal policy and monetary policy measures. 88 INTRODUCTORY MACROECONOMICS EXERCISES 1. What is equilibrium income? 2. What is the difference between planned and actual investment? 3. What is multiplier? 4. What is deficient demand? 5. What is excess demand? 6. How does the introduction of the government sector affect the economy? 7. How can the problems of excess and deficient demand be combated?