Income Determination and Multiplier

(Macro Economics – Class 12)

1. Meaning of Income Determination

Income determination refers to the process by which the level of national income in an economy is determined in the short run.

In macroeconomics (Class 12 syllabus), income is determined mainly by:

• Aggregate Demand (AD)

• Aggregate Supply (AS)

The level of income is in equilibrium when Aggregate Demand = Aggregate Supply.

2. Assumptions of Income Determination (Simple Keynesian Model)

The theory of income determination is based on the following assumptions:

1. Economy is a closed economy (no foreign trade)

2. Government sector is ignored (initially)

3. Prices remain constant

4. There is unemployment in the economy

5. Investment is autonomous (constant)

6. Savings depend on income

3. Concepts of Aggregate Demand (AD)

Aggregate Demand refers to the total demand for goods and services in an economy at a given level of income.

Components of AD:

(a) Consumption Demand (C)

Consumption is the expenditure by households on goods and services.

Consumption depends on income:

Consumption Function:

C = a + bY

Where:

• C = Consumption

• a = Autonomous consumption (consumption at zero income)

• b = Marginal Propensity to Consume (MPC)

• Y = Income

(b) Investment Demand (I)

Investment refers to expenditure on capital goods.

In the Keynesian model:

• Investment is autonomous (constant)

Aggregate Demand Formula:

AD = C + I

4. Concepts of Aggregate Supply (AS)

Aggregate Supply refers to the total output of goods and services in an economy.

In the short run:

AS = Y (National Income)

This is because whatever is produced is distributed as income.

5. Equilibrium Level of Income

Equilibrium income is the level of income at which:

AD = AS

That is:

C + I = Y

At this point:

• There is no tendency for income to change

• Planned spending equals planned output

6. Determination of Equilibrium Income

(a) AD–AS Approach

Equilibrium is achieved at the level where:

• Aggregate Demand curve intersects Aggregate Supply line

If:

• AD > AS → Income rises

• AD < AS → Income falls

(b) Saving–Investment Approach

Equilibrium is achieved when:

S = I

Where:

• S = Saving

• I = Investment

If:

• S > I → Income falls

• S < I → Income rises

7. Saving Function

Saving is the part of income that is not consumed.

Saving Function:

S = –a + (1 – b)Y

Where:

• (1 – b) = Marginal Propensity to Save (MPS)

Relationship:

MPC + MPS = 1

8. Meaning of Multiplier

The Multiplier shows how many times national income increases as a result of an increase in investment.

Multiplier (k) = Change in Income / Change in Investment

9. Working of Multiplier

When investment increases:

1. Income increases

2. Consumption increases

3. This leads to further income generation

4. The process continues but at a diminishing rate

The final increase in income is multiple times the initial increase in investment.

10. Formula of Multiplier

k = 1 / (1 – MPC)

OR

k = 1 / MPS

11. Size of Multiplier

Higher MPC → Larger Multiplier

12. Assumptions of Multiplier

1. Prices are constant

2. MPC remains constant

3. Excess capacity exists

4. No government and foreign trade

5. Investment is autonomous

13. Importance of Multiplier

1. Explains income expansion

2. Useful for government policy

3. Helps in understanding business cycles

14. Leakages in Multiplier Process

Leakages reduce the size of the multiplier:

• Saving

• Taxes

• Imports

Higher leakages → Smaller multiplier

15. Numericals (Exam-Oriented)

Example:
If MPC = 0.8

k = 1 / (1 – 0.8) = 5

If investment increases by ₹100 crore:

Increase in income = 5 × 100 = ₹500 crore

16. Key Exam Tips

• Always write formulas

• Draw neat diagrams

• Explain assumptions clearly

• Use correct economic terms

End of Notes