Unit 6 Notes: Employment, Output, and Price Level Determination

Principle of Effective Demand

• The principle of effective demand is central to Keynesian economics, serving as the foundation for the Keynesian Theory of Employment.
• Dillard emphasizes its role as the logical starting point for understanding employment levels.
• Keynes introduces and discusses this concept in his book General Theory.
• Effective demand influences employment and output by determining demand for goods and services.
• Effective demand occurs where aggregate demand equals aggregate supply.
• It is represented by the total expenditure within an economy.

Keynes' Definition of Effective Demand

• Keynes defines effective demand as the “value of aggregate demand at the point of the demand function where it is intersected by aggregate supply function”.
• Effective demand is the key determinant of employment levels, deficiency leads to unemployment.
• Increases in employment lead to increases in output and real income.

Expenditure and Income Flow

• Effective demand is seen through spending or total expenditure in the economy.
• Expenditure determines the flow of income, as one person's spending becomes another's income.
• Total expenditure mirrors the value of total output, linking total price of national output to total expenditure and income.

Components of Effective Demand

• Total expenditure, representing total demand, includes consumption and investment expenditure.
• This demand drives employment of workers to produce consumer and investment goods.
• Effective demand (ED) is thus expressed as:
  • $ED = \text{total expenditure}$
  • $ED = \text{Expenditure on consumption goods (C)} + \text{Expenditure on investment goods (I)}$
  • $ED = \text{National income (Y)}$
  • $ED = \text{Value of national output (O)}$
  • $ED = \text{Total employment (N)}$

Equilibrium Conditions

• Effective demand signifies the economy's general equilibrium, where:
  • Aggregate supply equals aggregate demand: $Y = C + I$
  • Total saving equals total investment: $S = I$
  • (Since total saving is equal to total income minus total consumption $(S = Y – C)$, therefore $Y = C + I$ can be written as $Y – C = I$ or $S = I$)

Effective Demand and Equilibrium

• Effective demand determines the equilibrium level of employment, output, and income in a capitalist economy.
• At equilibrium, entrepreneurs maximize profits, providing no incentive to change employment levels.

Determinants of Effective Demand

• Effective Demand is influenced by Aggregate Demand and Aggregate Supply.
• Aggregate Demand Price (ADP), Aggregate Demand Function (ADF), Aggregate Demand Curve (ADC), Aggregate Supply Price (ASP), Aggregate Supply Function (ASF), and Aggregate Supply Curve (ASC) are components of the determinants of Effective Demand.

Aggregate Demand

• Aggregate Demand (AD) refers to total planned expenditure in an economy.
• It represents the total spending by people on goods produced at a given employment level.
• Key related concepts:
  • Aggregate Demand Price (ADP): Maximum expected receipts for producers from sales at a specific employment level.

Aggregate Demand Function and Curve

• Aggregate Demand Function (ADF): Shows producers' maximum expected receipts at various employment levels. Represented as $AD=f(N)$
• Example table:
  • Employment (in Lakh): 0, 10, 20, 30, 40, 50, 60
  • Aggregate demand price (ADP) in crore: 100, 360, 420, 480, 540, 600, 660
• Aggregate Demand Curve (ADC): Illustrates the relationship between aggregate demand price and employment.

Aggregate Supply

• Aggregate Supply refers to the total money producers spend to produce goods at a given employment level.
• It's the minimum amount producers need to receive to justify production.
• Key related concepts: ASP, ASF, ASC.
  • Aggregate Supply Price (ASP): The cost of production; the minimum proceeds producers must receive.

Aggregate Supply Function and Curve

• Aggregate Supply Function (ASF): Shows the minimum proceeds producers must receive at varying employment levels. Expressed as $AS=f(N)$
• Example table:
  • Employment: 0, 10, 20, 30, 40, 50, 60
  • Aggregate Supply Price (crore rs): 0, 120, 240, 360, 480, 600, 720
• Aggregate Supply Curve (ASC): Illustrates the relationship between employment and minimum expected proceeds.

Determination of Effective Demand

• Equilibrium occurs where Aggregate Demand (AD) equals Aggregate Supply (AS).
• Example Table:
  • Employment: 0, 10, 20, 30, 40, 50, 60
  • AD (crore rs): 100, 360, 420, 480, 540, 600, 660
  • AS (crore rs): 0, 120, 240, 360, 480, 600, 720
  • Equilibrium: Disequilibrium (AD>AS), Disequilibrium (AD>AS), Disequilibrium (AD>AS), Equilibrium (ED), Disequilibrium (AD<AS)

Aggregate Demand Components

• Aggregate demand (AD) is economists' term for total planned expenditure.
• In a two-sector economy, aggregate demand for final goods consists of:
  • Ex ante aggregate demand for consumer goods (C)
  • Ex ante aggregate demand for investment goods (I)
• $AD = C + I$

Consumption Expenditure

• Consumption expenditure accounts for the largest portion of GDP.
• Investment (I) is considered exogenous and constant in the short run: $AD = C + \bar{I}$, where $\bar{I}$ is constant investment.
• Short-run AD depends heavily on aggregate consumption expenditure.

The Consumption Function

• The consumption function shows the functional relationship between aggregate consumption expenditure and aggregate disposable income, expressed as $C = f(Y)$.
• When income is low, consumption exceeds disposable income, leading to dissaving.
• As disposable income increases, consumption also increases, but by less than the income increase.

Keynesian Consumption Function

• Keynes proposes a specific consumption-income relationship:
  • $C = a + bY$
    • Where:
      • $C$ = aggregate consumption expenditure
      • $Y$ = total disposable income
      • $a$ = autonomous consumption (consumption at zero income)
      • $b$ = marginal propensity to consume (MPC), calculated as $\frac{\Delta C}{\Delta Y}$
• $MPC = \frac{\Delta C}{\Delta Y} = b$

Consumption Function Graph

• The consumption function illustrates the level of consumption at each level of disposable income.
• Keynes assumes that consumption increases with income, but not as much as the income increase (0 < b < 1).
• This income-consumption relationship is vital in Keynesian income determination theory.

Income and Consumption Relationship

• Average propensity to consume (APC) is the ratio of total consumption to total income. $APC = \frac{\text{Total Consumption}}{\text{Total Income}} = \frac{C}{Y}$.

Example of APC and MPC

• Illustrative table showing Income (Y), Consumption (C), Saving, APC, and MPC:
  • Income (Y) (` Crores): 0, 100, 200, 300, 400, 500
  • Consumption (C) (` Crores): 50, 125, 200, 275, 350, 425
  • Saving (` Crores): -50, -25, 0, 25, 50, 75
  • APC (C/Y): ∞, 1.25, 1.00, 0.92, 0.88, 0.85
  • MPC (∆C /∆Y): -, 0.75, 0.75, 0.75, 0.75, 0.75

Income, Consumption, and Saving

• Saving is a function of disposable income: $S = f(Y)$
• The saving function illustrates the relationship between national income and saving.

Relation between Income, Consumption and Savings

• Table:
  • Disposable Income (Yd) (` Crores): 0, 60, 120, 180, 240
  • Consumption (C) (` Crores): 20, 70, 120, 170, 220
  • Saving (S) (` Crores): -20, -10, 0, 10, 20

Saving Function Graph

• The saving function illustrates the level of saving at each level of disposable income.
• Consumption at zero income is positive, implying dissaving.
• National income is defined as $Y = C + S$, so $S = Y – C$.
• The slope of the saving function represents the marginal propensity to save (MPS).
• If a one-unit increase in income leads to an increase of 'b' units in consumption, the remainder (1 - b) is the increase in saving.
• Marginal propensity to save (MPS) is the increase in saving per unit increase in disposable income, $MPS = \frac{\Delta S}{\Delta Y} = 1-b$.

Marginal Propensity to Consume and Save

• Marginal Propensity to Consume (MPC) is always less than unity but greater than zero: 0< b < 1.
• $MPC + MPS = 1$
• Saving increases with income because the marginal propensity to save (MPS) is positive.

Average Propensity to Save

• The ratio of total saving to total income is the average propensity to save (APS).
• $APS = \frac{\text{Total Saving}}{\text{Total Income}} = \frac{S}{Y}$

Aggregate Supply Definition

• Planned aggregate supply is the total supply of goods and services that firms plan to sell during a specific period.
• It equals the national income, which is either consumed or saved: $AS = C + S$.

Investment Function

• $Y = C + I$
• Investment strategically determines the level of income, output, and employment.
• In Keynesian economics, investment refers to real investment in new machines, buildings, roads, and inventories.

Real vs. Financial Investment

• Real investment increases demand for human and physical resources, boosting employment.
• Purchasing existing stocks, shares, and securities is financial investment and does not directly impact employment.

Types of Investment

• Investment can be private or public and induced or autonomous.
• Induced investment changes with income and is income elastic.
• In a free-enterprise economy, profit motivates induced investment, which responds to income changes.
• The induced investment curve is upward sloping, indicating increased investment with increased income.

Autonomous Investment

• Autonomous investment is independent of output variations.
• Hicks notes that public investment, investment responding to inventions, and long-range investment can be considered autonomous.

Autonomous Investment Characteristics

• Autonomous investment is not sensitive to changes in income or profit motives.
• It is primarily made by the Government, often irrespective of profit considerations.
• Autonomous investments are typical in war or planned economies, such as defense spending.

Multiplier Effect

• The multiplier effect describes how a change in expenditure leads to a proportionately larger change in national income.
• The eventual change in national income is a multiple of the initial change in spending.

Understanding the Multiplier

• Changes in components of AD, like investment, can have a magnified impact on GDP due to the multiplier effect.

Example of Multiplier

• An injection of money into government-provided healthcare leads to salary increases for doctors, new employment, and purchases of equipment.
• This initial effect boosts spending, but the doctors and producers then spend their increased income, further stimulating the economy.
• The effect diminishes with each round, but the overall injection is greater than the initial sum.

Calculating the Multiplier

• Multiplier = Change in GDP / Change in Investment
• Example: If a $10m increase in government spending raises GDP by $50m, the multiplier is 5 ($50m / $10m).

Determinants of Multiplier Value

• Savings ratio: Higher savings reduce spending at each stage.
• Spending on imports: Spending on imports leaks money out of the country.
• Level of taxation: Higher taxes reduce income, but government spending of tax revenue can offset this.

Marginal Propensity to Consume (MPC)

• The multiplier's value depends on the proportion of increased income that is spent (MPC).
• Higher MPC leads to a higher multiplier value.

Formula for Multiplier

• Multiplier = $\frac{1}{1 – MPC} = \frac{1}{MPS}$
• Marginal propensity to consume (MPC) is the proportion of each extra pound of income spent by households. If a person earns £1 more and consumes 70p of it, then the MPC is 0.7.

Accelerator Effect

• The Accelerator effect explains how changes in demand for goods and services (ΔY) influence the level of investment (I) in an economy.
• The idea is that when demand increases, businesses need to produce more goods, which often requires new investment in machinery, factories, or other resources.
• $I=v \cdot \Delta Y$
  • I: Investment.
  • v: This indicates the amount of capital (investment) required to produce one additional unit of output.
  • ΔY: Change in income/output.

The Accelerator Effect Explained

• The Accelerator Effect is the phenomenon where a small change in demand (ΔY) results in a proportionally larger increase in investment (I).
• It describes how sensitive investment is to changes in demand.
• Example:
  • Demand for cars increases by 1,000 units.
  • Each car requires an investment of ₹5 lakh (capital- output ratio).
  • Total investment = 1,000×₹5 lakh = ₹50 crore.

Combined Effect: Multiplier and Accelerator

• The government builds a road (Multiplier effect), creating jobs and income for people.
• Because of this, people demand more goods like bikes or furniture. Businesses invest in factories to meet this higher demand (Accelerator effect).
• Both effects boost the economy!

Definition of Business Cycles

• A business cycle is the fluctuation in GDP around its long-term growth rate.
• It explains the expansion and contraction in economic activity over time.
• A cycle completes with a single boom and a single contraction.
• The length of the cycle measures the time to complete this sequence.
• A boom is rapid economic growth while a recession is stagnated growth, measured by real GDP.

Stages of the Business Cycle

• Stages in a business cycle:
  • Expansion
  • Peak
  • Recession
  • Depression
  • Trough
  • Recovery

Expansion Phase

• Expansion: positive economic indicators increase, including employment, income, output, wages, profits, supply.
• Debtors pay debts on time, money supply velocity is high, and investment is high.
• Process continues as long as economic conditions are favorable.

Peak Phase

• The economy reaches a saturation point or peak.
• Maximum growth is attained; economic indicators do not grow further.
• Prices are at their peak.
• This stage marks a reversal in economic growth, with consumers restructuring budgets.

Recession Phase

• Recession follows the peak.
• Demand for goods and services declines rapidly.
• Producers don't immediately notice the demand decrease, leading to excess supply.
• Prices fall.
• Positive economic indicators (income, output, wages) start to decline.

Depression Phase

• Unemployment rises.
• Economic growth continues to decline, falling below the steady growth line.

Trough Phase

• In the depression stage, the economy's growth rate becomes negative.
• Prices and demand contract to their lowest point.
• The economy reaches the trough, a negative saturation point.
• National income and expenditure are significantly depleted.

Recovery Phase

• After the trough, the economy recovers from negative growth.
• Demand picks up due to low prices, causing supply to increase.
• The population shows a positive attitude toward investment and employment.
• Production starts increasing.

Continued Recovery

• Employment rises, and lending increases due to accumulated cash balances.
• Depreciated capital is replaced, leading to new investments.
• Recovery continues until the economy returns to steady growth levels.
• One full business cycle (boom and contraction) is completed.
• The peak and trough are the extreme points.

Internal Causes of Business Cycles

• Internal causes:
  • 1. Change in Demand: Changes affect production, supply, and output, potentially causing inflation.
  • 2. Investment Fluctuations: Investment changes affect output; increased investment leads to expansion, while decreased investment leads to recession.
  • 3. Macroeconomic Policies: Monetary and fiscal policies influence the business cycle. Beneficial policies lead to expansion, while restrictive policies cause recession.
  • 4. Supply of Money: Increased money supply can lead to growth, but excessive money can cause inflation.

External Causes of Business Cycles

• External causes arise outside the economy but affect it.
  • 1. Wars: Resources shift to war efforts, slowing down the economy.
  • 2. Technology: Technological developments change demand, supply, employment, and progress.
  • 3. Natural Causes: Disasters affect transportation, employment, and agriculture, increasing prices and potentially causing depression.
  • 4. Population Expansion: Excessive population expansion puts pressure on demand and prices.

Types of Inflation

• Inflation is a persistent rise in the general price level.
  • #1 – Demand Pull Inflation: Occurs when demand exceeds supply, e.g., during the Lawson boom in the UK.
  • #2 – Creeping Inflation: Prices rise gradually at a minimal rate (2-5%).

Cost-Push and Walking Inflation

• #3 – Cost-Pull Inflation: Production costs increase, leading firms to raise prices due to expensive labor, raw materials, and technology.
  • #4 – Walking Inflation: The rate rises by 3-10% yearly; e.g., Sweden's 9% inflation in September 2022.

Galloping and Hyperinflation

• #5 – Galloping Inflation: The rate is between 20-1000%, causing economy instability; e.g., Russia in the 1990s.
  • #6 – Hyperinflation: The rate is above 1000%, causing rapid depreciation of money.

Causes of Inflation

• Causes of inflation that affects the economy:
  • #1 – Increased Money Supply: Printing more currency than the prevailing growth rate; e.g., Zimbabwe in 2009.
  • #2 – Government Policies: Restrictions on imports cause the cost of production to rise.

Exchange Rates and Wage Rates

• #3 – Changes In Exchange Rates: Fluctuations in currency value affect purchasing power and product prices.
  • #4 – Rising Wage Rates: Increased salaries lead to higher product prices.

Control of Inflation

• Measures for controlling inflation:
  • 1) Monetary Measures: Central banks increase interest rates to reduce borrowing and spending.
  • 2) Fiscal Measures: Governments adjust spending and taxation policies, such as increasing taxes to reduce demand.

Direct Controls and Phillips Curve

• 3) Direct controls and other measures: Government-imposed price controls or trade restrictions to stabilize prices.
• Example: Price caps or export bans.
• Phillips Curve: Explains the inverse relationship between inflation and unemployment in the short run.

Trade-Off

• Trade-Off:
  • Low unemployment results in increased spending and demand, pushing up prices and causing inflation to rise.
  • High unemployment leads to lower spending, reducing inflation or causing deflation.