Introductory Macroeconomics Chapter 4 Determination Of Income And Employment

(a) Classical Theory of Employment. The classical economists believed that:
(i) An economy as a whole always functions at the level of full employment of resources. This belief is based on Say's Law of Market that states, 'Supply creates its own demand.” which implies that supply (production) creates a matching demand for it with the result that whole of it is sold out. Therefore, there is neither overproduction nor underproduction.
Thus full employment is a normal situation and if at all there arises any unemployment, it is automatically corrected by market forces. Hence equilibrium level of income occurs at level of full employment, i.e., there is always full employment equilibrium. Therefore, Classicals advocated for a free economy.
(ii) Flexibility of prices and wages. Even if at any time there is unemployment, it must be temporary because in a free economy, flexibility of prices and wages automatically bring about full employment. Suppose at a given wage rate there is unemployment which implies that supply of labour is greater than demand for it. Competition among labour to seek employment would lead to fall in wage rate. As a result demand for labour would continue to rise until unemployment is removed from the labour market. Thus wage-price flexibility is the built-in stabiliser to ensure full employment.
The Great Depression of 1929–33. During 1929-33 there was a world-wide depression. Fall in aggregate demand was so severe that investment came down to its minimum level resulting in vast unemployment. This situation which brought great disaster to U.S.A. and other European countries fully exploded the Classical's myth that there is always tendency of full employment equilibrium. The Great Depression led to break down of Classical theory.
It was at that time that J.M. Keynes, a British Economist propounded his own theory and in 1936 brought out his famous book, 'General Theory of Employment, Interest and Money,' which brought about a revolution in economic thought. This led to emergence of Macroeconomics as a separate branch of economics.
(b) Keynesian Theory of Income and Employment. According to Keynes:
(i)    An economy can be in equilibrium at less than full employment level Economic system does not ensure automatic equilibrium at full employment as believed by Classicals. There can be equilibrium (equality between aggregate demand and aggregate supply) even at less than full employment level whereas according to Classicals equilibrium is always at full employment. Thus there is divergence between the point of equilibrium attained by an economy and the point of equilibrium at which an economy has full employment of resources. This is the basic difference between Classical Theory and Keynesian Theory.
(ii)    'Demand creates its own supply' Unlike Classicals; Keynes believed that it is the demand that creates supply and not that supply creates demand. In fact, aggregate demand in the economy is the driving force that determines the level of output, employment and income. It is because the level of aggregate supply is constant during short period. If aggregate demand increases, level of output will increase to meet the increased demand. As a result, employment and income will also rise. Thus increase in demand has led to increase in output, employment and income.
This is the gist of Keynesian or Macro approach. The scope of this chapter is limited to Keynesian Theory. The core issue of macroeconomics is the determination of level of income, employment and output. According to this theory, in an economy income and employment are in equilibrium at the level at which Aggregate Demand (AD) = Aggregate Supply (AS). It needs to be noted that Keynesian theory is supposed to apply under short run and perfect competition. Since during short period supply is constant, it is because of deficiency in effective demand, which causes unemployment. So aggregate demand should be raised in order to raise level of employment. Let us, therefore, start with the meaning of aggregate demand (AD).

Aggregate supply is the money value of total output available in the economy for purchase during a given period. When expressed in physical terms, aggregate supply refers to the total output of goods and services produced for sale by all the entrepreneurs in an economy. It is assumed that in short-run, prices of goods do not change and elasticity of supply is infinite. At the given price level, output can be increased till all the resources are fully employed.
If we go deep, we will find aggregate supply is represented by national income. How? We know that money value of final output is distributed as rent, wages interest and profit among factors of production who help produce the output. Since sum of factor incomes (rent, wages, interest and profit) at national level is called national income, therefore, aggregate supply, output and national income are same. Alternatively AS = Y where Y is national income. Thus income or total output measures the aggregate supply of goods and services.
Aggregate Supply = Output = Income
A major portion of income is spent on consumption of goods and services and the balance is saved. Thus national income or aggregate supply (AS) is sum of consumption expenditure (C) and savings (S). Put in the form of an equation:
AS = C + S
Clearly aggregate supply has two components, namely, consumption expenditure and savings. AS curve is depicted in the adjoining Fig.(a) Aggregate supply or national income is shown on X-axis and total spending (consumption + savings) on Y-axis.
AS curve is shown by a 45° line from the origin. Why? Its significance is that every point on this line is equidistant from X-axis and Y-axis taking same scale on both the axes, i.e., at each point on this line, Expenditure (AD) = Income (AS,). Thus 45° line (also called a Guideline) helps us to identify equilibrium when two variables are to be shown graphically equal,
(Classical and Keynesian concepts of Aggregate Supply. There is difference between these two concepts. According to Classicals "Aggregate supply is perfectly inelastic with respect to prices and it (aggregate supply) is always at full employment level of output." According to Keynes "Aggregate supply is perfectly elastic with respect to prices till the full employment level of output is reached.").

Fig.(a)

Meaning of Consumption Function. Consumption function shows the mathematical relation between income and consumption i.e. how much of income is spent on consumption goods. Simply put, consumption function (or Propensity to consume) means proportion of income spent on consumption. Its two features are noteworthy. (i) At zero or very low level of income, consumption expenditure is higher than income because minimum consumption is necessary for survival, and (ii) As income increases, consumption expenditure also increases but increase in consumption is less than the increase in income. Mind, level of household consumption depends directly on the level of income. Thus consumption (C) is a function (f) of income. Symbolically: C = f(Y).
Consumption function (linear, i.e., straight line consumption function) is represented by the following equation.


Thus total consumption (C) comprises two components (i) Autonomous Consumption  not influenced by income, and (ii) Induced Consumption (bY) influenced by income. For example, the consumption equation C = 30 + 0.75 Y means र 30 is autonomous consumption which is incurred without having any income. As income increases, 75% of additional income is spent on consumption. In short, consumption equation  shows that Consumption (C) at a given level of income (Y) is equal to autonomous consumption  times of given level of income. Some numericals for further clarification are given below.

A consumption function schedule and diagram given below further clarify the concept of consumption function.

Relationship between income and consumption expenditure.
(i)    According to Keynes, as income increases, consumption expenditure also increases but by less than the increase in income. In other words, when income increases, consumption expenditure does not increase at the same rate as income. This is called Keynesian psychological law of consumption. There is tendency of people not to spend on consumption the whole of incremental income, i.e., additional consumption is less than additional income. In other words, MPC is less than 1 (MPC < 1). For instance, if income increases by र 100; the tendency is to spend a part, say र 75, on consumption and save the remaining part (i.e., र 25). This is known as induced consumption. It should be kept in mind that when income is zero, consumption is positive (+) because a person has to spend a minimum amount to keep his body and soul together. This is called autonomous consumption.
(ii)    When income is very low, consumption expenditure is higher than income. Its reason is that some minimum level of consumption has to be maintained irrespective of low level of income. In such a situation, value of APC (i.e., C/Y) becomes higher than 1. For example, if at the income level of र 2000, consumption expenditure is र 2,400, then APC = 2400/2000 = 1.2, i.e., higher than 1.

Average propensity to consume (APC). APC is the ratio of total consumption expenditure to total income. It is the percentage (or ratio) of income which is spent on consumption. Thus, it gives the average consumption-income relationship at different levels of income. It is worked out by dividing total consumption expenditure (C) with total income (Y). Symbolically:
APC = C/Y
For instance, if aggregate income of an economy is र 5,000 crores and aggregate consumption is र 4,500 crores, then:
. It shows 90% of income is spent on consumption.
Features of APC:
(i) APC can be > 1 when at very low level of income (say, र 1000 crore), consumption expenditure exceeds income (say, र 1200 crore). APC = 1200/1000 = 1.2.
(ii) APC can be < 1 when consumption expenditure (say, र 800 crore) is lesser than income (say र 1000 crore). APC = 800/1000 = 0.8
(iii) APC can never be zero since at zero income, survival needs minimum consumption (called- Autonomous Consumption).
(iv) APC falls as income increases.

Features of MPC:
(i) MPC is always greater than zero (MPC > 0) but less than 1 (MPC < 1). Thus value of MPC always lies between 0 and 1. Its reason is that incremental income can be either consumed or entirely saved. If entire incremental income is consumed, then change in consumption (ΔC) will be equal to change in income (ΔY) making MPC = 1. In case entire income is saved, then change in consumption is zero making MPC = 0.
(ii) MPC falls with increase in income. As a person becomes richer, he tends to consume a smaller portion of increase in income.
(iii) MPC is assumed to be constant for a straight line consumption curve.
(iv) MPC, i.e., ΔC/ΔY is graphically the slope of consumption curve.

Distinction between APC and MPC:
(i) Total consumption expenditure divided by total income is APC. Symbolically APC = C/Y. The change in consumption expenditure divided by change in income is MPC.
(ii) When income increases, both APC and MPC fall but MPC falls more rapidly.
(iii) Between APC and MPC, the value of APC can be greater than 1 only when consumption expenditure becomes greater than income.
Remember value of MPC cannot be greater than 1 because increase in consumption (ΔC) cannot be more than corresponding increase in income (ΔY).
The following consumption schedule illustrates the calculation of APC and MPC.

Relationship between income and saving.
(i) As income increases, saving also increases but the rate of increase in saving is more than the rate of increase in income after a particular level of income. This means that as income increases, the proportion of income saved increases (and the proportion of income consumed decreases).
(ii) At lower level of incomes, savings is negative. In the initial stages when there is no income or very low level of income, consumption expenditure is more than income leading to negative saving (i.e., dissaving). For instance, if income is, say र 5,000, and consumption expenditure is, say र 6,000, then saving will be र –1,000 (= 5,000 – 6,000), i.e., there is dissaving. Here average propensity to save is negative. APS = -1,000/5,000 = -0.2.
Propensity to save is of two types – Average Propensity to Save (APS) and Marginal Propensity to Save (MPS).

Meaning of Saving Function. The relationship between saving and income is called saving function. Simply put, saving function (or propensity to save) relates the level of saving to the level of income. It is the desire or tendency of the households to save at a given level of income. Thus saving (S) is a function (f) of income (Y). Symbolically, S =f(Y). Its two features are noteworthy: (i) Savings can be negative (-) at zero or low level of income and (ii) As income increases, savings also increase but more than the increase in income.
Remember, saving is residual income of households that is left after consumption.
Algebraically : S = Y – C

A diagrammatic representation of relationship between income and savings level gives the saving function curve. In the figure given below, saving function curve SS is a straight line because slope of saving is constant. The curve slopes upward which depicts direct relationship between income and saving. The saving function line SS cuts the income line at point B which is called Break-even point because at this point consumption expenditure is equal to income (or savings are zero). To the left of breakeven point savings are negative indicating consumption being more than income whereas to the right of breakeven point, savings are positive indicating consumption expenditure being less than income. The shaded area reflects dissavings which is equal to the area of autonomous consumption shown as  in the fig given below.

Average propensity to save (APS). APS is the ratio of total saving to total income. Alternatively it is that part of total income which is saved. By dividing total saving (S) with total income (Y), we get APS. Symbolically:
APS = S/Y
For instance, in the following table when national income is र 200 crores, saving is र 30 crores. In this case APS = S/Y = 30/200 = 0.15 cr or 15%. 
The value of APS can be negative when consumption expenditure becomes higher than income. For example, if income is र 1,000 and consumption expenditure is र 1,200, then saving is -200 (i.e., dissaving).
Then, 

Marginal propensity to save (MPS). MPS is the ratio of change in saving (ΔS) to change in income (ΔY). Alternatively, MPS is the part of additional income which is saved. In other words, it is a measure of additional saving as proportion of additional (incremental) income. MPS is worked out by dividing change in saving (ΔS) with the corresponding change in income (ΔY). Symbolically:
MPS = ΔS/ΔY
For instance, in the following table, when national income goes up from र 100 crores to र 200 crores, saving also goes up from zero to र 30 crores. In this case MPS = AS/AY -30/100 = 0.3 or 30%.
The value of MPS lies always between 0 and 1. Its reason is if additional income is entirely consumed then there is no saving making MPS = 0. If entire additional income is saved, then MPS = 1. In short, 0 < MPS < 1.

All the above concepts are further clarified in the following imaginary table.

The table shows that in the beginning saving is negative since consumption is never zero. But as income increases, consumption increases less than proportionally. Consequently saving becomes positive and increases at a faster rate than the increase in income.

From this, the relationship can also be expressed in the following way:
MPC = 1 – MPS
MPS = 1 – MPC
Clearly if one is given, we can find out the other because sum of MPC and MPS is equal to unity, i.e., incremental (additional) income.

Since income is either consumed or saved, therefore, consumption + saving is always equal to income. It implies that consumption and saving curves representing consumption and saving functions are complementary. Thus given the income, we can derive saving function directly from consumption function as shown in Fig,comprising Part A showing consumption function and Part B showing saving function.
In Part A of the adjoining Fig, CC curve shows consumption function corresponding to each level of income whereas 45° line OL represents income. The 45° line divides the graph in two equal parts and so each point on this line is equidistant from X-axis and Y-axis. CC curve intersects 45° line OL at point B at which BR = OR, i.e., consumption = income. Therefore, point B is called breakeven point. There is no saving at point B but to its left, consumption function lies above 45° line showing negative saving (dissaving) whereas to the right of point B, consumption function lies above 45° line showing positive saving.

Now in Part B, we derive saving function in the form of saving curve. Remember in Part A, amount of saving (or dissaving) is the vertical distance between CC curve and 45° line. By plotting in Part B of the Figure vertical distances of part A representing saving/ dissaving and by joining them, we derive a saving curve. For instance, (i) at 0 (zero) level of income in Part A, vertical distance OC (representing dissaving) is plotted as OS₁ in Part B. Similarly, (ii) at OR level of income in Part A, vertical distance between CC curve and 45° line at point B which is nil (indicating zero saving) is shown as point Bj at the same level of income in Part B. Likewise (iii) at OS level of income, LM vertical distance of Part A is shown as L₁M₁ in Part B. By joining points S_t, B_t, L_v we get saving curve. Thus saving function is diagrammatically derived from consumption function in the form of saving curve. (In the same way consumption curve can be derived from saving curve.)

In the adjoining Fig.(a). a straight line saving curve SS is drawn showing saving function at different levels of income. For example, at zero level of income, vertical distance OS shows dissaving (indicating autonomous consumption) whereas at OR level of income, there is zero saving, i.e., whole of income is spent on consumption. At point R, consumption = income. To the left of R, consumption is more than income and to the right of R, consumption is less than income. Since consumption + saving is always equal to income, it implies that consumption and saving curves representing consumption and saving functions are complementary. So we can derive directly consumption curve from saving curve keeping in mind that amount of saving/dissaving is the vertical distance between saving curve and X-axis.

At zero level of income, vertical distance of negative saving of OS is shown as consumption expenditure of OC which is equal to OS. Thus, point C is the starting point of consumption curve. Since at OR level of income saving is zero (at point R), it implies consumption expenditure is equal to income of OR. This enables us to plot OD as consumption expenditure equal to OR which, in turn, gives a point B on 45° line. Remember, 45° dotted line is called expenditure equals income line where each point shows expenditure equal to income. Thus point B becomes the point on consumption curve at which OD (or BR) = OR. By joining points C and B and extending it further, we get consumption curve.
B is the point on consumption curve at which total consumption expenditure (C) is equal to income (Y), i.e., C/Y = 1. In other words at point B, the APC (or C/Y) = 1.

Fig.(a)

Investment meaning. In money terms investment means expenditure made on purchase of new capital assets like machines, equipment inventories, etc. Investment is an addition to the existing stock of real assets (like creation of new machinery, buildings, etc.) and changes in inventories (like stock of finished goods). It includes anything that adds to the future productive capacity of the economy.
Determination of Investment. According to Keynes, volume of investment is determined by two main factors — marginal efficiency of capital and rate of interest. Thus investment decision by producers (entrepreneurs) depends on marginal efficiency of capital (MEC) or rate of return and rate of interest. (MEC is rate of return from marginal unit of capital.) Firms undertake investment as long as return from investment is greater than cost, i.e., rate of interest on borrowing funds for investment. In short, firms invest when they expect enough reward from their investment to pay back rate of interest and yet obtain reasonable profit. Thus, investment demand function is the relationship between investment demand and rate of interest. It needs to be noted that equilibrium level of investment demand for an economy is when MEC=Rate of interest in the economy.

Induced Investment and Autonomous Investment. Investment means expenditure on creation of new capital assets. Alternatively, investment is addition to the existing stock of physical (or real) assets like machinery, building, equipment, raw material, etc. which adds to the future productive capacity of an economy. Investment can be induced as well as autonomous.
(i) Induced investment refers to the investment which is made with the motive of earning profit as it is done in private sector. Induced investment depends directly upon profit expectations. It is income-elastic. If national income goes up, induced investment also goes up, i.e., increase in income induces investment. Its reason is that increase in national income leads to an increase in demand for goods and services which raises the expected profitability of producers. Thus producers are induced to make great investments. In short, induced investment takes place when level of income and demand in the economy goes up. That is

Fig. (a)
why induced investment curve, like supply curve is positively sloped, i.e., with increase in income, induced investment also goes up as shown in Fig.(a). According to Keynes, induced investment is determined by (i) MEI or rate of return from new investment, and (ii) rate of interest at which funds are borrowed. Private investment is always induced investment.
(ii) Autonomous investment refers to the investment which is made irrespective of level of income as is generally done in government sector. It is income-inelastic, i.e., it is not affected by change in income level. The volume of autonomous investment is the same at all levels of income. That is why autonomous investment curve is a straight line parallel to X-axis as shown in Fig.(b). Autonomous investment becomes essential when there is depression and level of demand is low and accordingly level of induced investment also becomes low. As a result economy suffers from large scale unemployment of resources. Then it becomes essential for government to make investment in public utility works, construction of railways and roads, changes in nature of consumer demand, increase in population, discovery of new resources, new technology, etc. For instance, government investment in public utilities like construction of railways, roads, post and telegraphs, electricity, etc. is normally autonomous investment.

Fig.(b)

Comparison between Induced and Autonomous Investments:
(i)    Induced investment is income-elastic (i.e., rise in level of national income implies rise in level of investment) whereas Autonomous investment is income-inelastic.
(ii)    Induced investment is positively related to national income but Autonomous investment is unrelated to national income.
(iii) Induced investment is determined by consideration of profit, whereas Autonomous investment is determined by consideration of social welfare.
(iv) Induced investment curve is positively sloped (Fig. (a)) but Autonomous investment curve is horizontal straight line parallel to X-axis, (Fig. (b)) According to Keynes during short period firms plan to invest same amount every year. Ex-ante investment demand (I) may be written as I indicating autonomous (constant demand,  i.e. 

In the context of saving-investment approach to determine equilibrium level of income in the economy, it is important to understand the difference between the words Ex-ante and Ex-post because equilibrium occurs only when ex-ante savings and ex-ante investment are equal.
Briefly ex-ante expression indicates before the event and ex-post expression indicates after the event. For instance, what the households plan to cosume during the year in the beginning of the period is called ex-ante consumption but the amount of actual consumption measured at the end of the year is called ex-post consumption. Similarly, the amount of investment which the firms plan (or intend) to make during a period is ex-ante investment but what the firms have actually invested measured at the end of the period is ex-post investment. At any level of income, ex-post savings are always equal to ex-post investment. The significance of distinction between ex-ante and ex-post is that in the theory of determination of income, all variables are ex-ante (planned) variables.

Planned saving and Planned investment.
The savings which are planned (intended) to be made by all the households in the economy faring a period (say, a year) in the beginning of a period is called planned (or Wflnte) savings, The amount of planned or desired savings is given by the saving function ((.e., propensity to save).
The investment which is planned to be made by the firms or entrepreneurs in the economy during a period (say, a year) in the beginning of a period is called planned (or ex–ante) investment. The amount of planned investment is given by the investment demand function.
The following points in this context need to be noted.
(i) Equilibrium in the economy occurs only when planned investment is equal to planned savings. Ex-ante savings and investment may or may not be equal. It is only when ex-ante savings = ex–ante Investment that equilibrium takes place. It means that an economy invests what it has saved. Such equilibrium is rare because savers and investors are different people who save and invest with different motives. [Mind, expost (actual) savings and expost (actual) investment are always equal at all levels of income.]

(ii) When planned saving is not equal to planned investment, i.e., when planned spending is not equal to planned output, then output will tend to adjust up or down until the two are equal again.

Adjustment Mechanism (when planned saving is not equal to planned investment).

(i) When planned (ex-ante) saving is more than planned investment. Suppose firms plan to invest र 20,000 crores but households plan to save र 25,000 crores, it shows consumption expenditure has decreased. Consequently, AD falls short of AS. Due to excess supply there will be stock piling of unsold goods, i.e., unintended unplanned inventories will accumulate. At this, the producers will cut down employment and produce less. National income will fall and as a result planned saving will start falling until it becomes equal to planned investment. It is at this point that equilibrium level of income is determined.

(ii) When planned (ex-ante) saving is less than planned investment. Suppose producers plan to invest र 20,000 crores but households plan to save र 15,000 crores, then AD (or consumption expenditure) is more than AS. Production will have to be increased to meet the excess demand. Consequently national income will increase leading to rise in saving until saving becomes equal to investment. It is here that equilibrium level of income is established because what the savers intend to save becomes equal to what the investors intend to invest. Sum and substances is that if planned saving and planned investment are equal, then output, income, employment and price level will be constant.

Actual savings is the actual amount of savings that took place, measured after the fact. Alternatively ex-post savings are those which the households actually save from their income. In short, realised savings of a period, say, a year, are called actual savings (or ex– post savings).
Actual investment is the actual amount of investment that took place, measured after the fact. Alternatively it refers to the actual investment made by all the entrepreneurs in the economy during a given period. In short, the realised investment of a period, say, a year, is called actual investment (or ex-post investment). In Keynesian terminology, investment means real and non–financial investment. The point to be noted is that ex-post investments of firms are always equal to ex-post savings by households at all levels of income as savings finance investments. Ex-post or realised (or actual) saving and investment are necessarily equal and this is brought about by fluctuations in income. Since unplanned investment also gets included in realised investment, realised investment is always equal to realised saving. This equality is proved from the following equations:
Y    (Realised income) = C + S (Realised saving)
Y    (Realised income) = C + I (Realised investment)
C + S = C + I
S (Realised saving) = I (Realised investment)

Difference between Ex-ante (planned) and Ex–post (actual) investment. Planned investment is the investment which is desired to be made by the firms and planners in the economy during a particular period in the beginning of the period. As against it, the actual or realised investment of a period (e.g., a year) measured after the fact is called ex-post or actual investment. It needs to be noted that Keynes included in investment the inventories of unsold goods which he called unplanned investment. Thus actual investment equals planned + unplanned investment. Briefly put, ex-ante investment is intended or desired investment whereas ex-post (realised or actual) investment is equal to planned investment + unplanned investment.
Hence actual investment may differ from planned investment because of unplanned addition or reduction in inventories (i.e., stock of goods).

ΔY = 4 x 750 = 3000 crores
(change in income is र 3000 crores)

(ii)    MPS = 1 – MPC = 1 – 75% = 25%
Change in Saving = 25% of change in income
= 25% of 3000 = र 750 crores

(i) 
(ii) When income rises to 100 crores and consumption expenditure to 78 crore, then ΔY = 20(=100 – 80)    and ΔC = 16(=78 - 64).

We know that 
Increase or change in national income i.e., 
                               
Note: ‘Determination of income and employment: two-sector model' is deleted from syllabus from academic session 2009-2010 and in its place ‘Short run equilibrium output' has been added.

1.    When AS > AD (or when AD < AS). When aggregate supply (output) is more than ex-ante aggregate demand, it means consuming households are saving more. This will result in unplanned undesired increase in inventories of unsold stock. As excess inventories accumulate, firms will reduce use of factors of production and cut down production until aggregate supply (output) and aggregate demand are in equilibrium.
2.    When AS < AD (or when AD > AS). When output is less than aggregate demand, it means consuming households are saving less. This will result in unplaned reduction in inventories of unsold stock. Firms will expand production by hiring more workers until AS and AD once again become equal, i.e., until equilibrium is restored (AD = AS).
In short, firms reduce output as long as AS>AD and increase output as long as AS<AD until equilibrium is restored.

(i)For equilibrium level of income,
Y = C + I    
Substituting the values of C and I

                   
(ii) Consumption
   

iii) Saving S = Y (income) - C (consumption)
    = 600 – 540 = 60

Tips: -

(i) For equilibrium
         
         
(ii)              
                       
                           (Consumption expenditure)

Tips: -

Equilirium Output. Output is at its equilibrium level when quantity of output produced (AS) is equal to quantity demanded (AD). The economy is in equilibrium when aggregate demand represented by C + I is equal to total output.
(a) Determination of Equilibrium level of output
Under short run fixed price, equilibrium level of output is determined solely by level of ex-ante aggregate demand. How? To keep the explanation of theory simple, certain assumptions are made. (I) Prices of final goods are assumed to be constant (fixed) in short run because the economy takes time to respond to forces of excess supply or demand.
(ii) Theory is applicable under only short run. (iii) Supply is perfectly elastic, which means at given price suppliers are willing to supply whatever amount of goods consumers will demand, (iv) It is a two-sector (Household and Firms) economy assuming no government and foreign trade.
Under such circumstances, in short run (when supply is infinitely elastic at constant price) equilibrium output will be solely determined by aggregate amount of demand at that price in the economy. This is known as effective demand principle. Aggregate supply is relatively a passive force in determining level of output in short run. Now the question is how is aggregate demand at fixed price derived.

(b) Derivation of equilibrium output and Aggregate demand.
At short run fixed price value of ex-ante aggregate demand is equal to sum of consumption expenditure and investment expenditure i.e., AD = C + I. Under effective demand principle, equilibrium outnut or aggregate supply(Y) is equal to aggregate demand (AD), i.e.. Y = AD. Again Y is represented bv equation 
This is further simplified as under:
               

Equilibrium output and equilibrium demand at fixed price and constant rate of interest is derived by solving the equation, 
Clearly value of equilibrium output Y will depend on values of  and b. Let us illustrate it with a numerical example. Suppose values of autonomous expenditure are  and value of b = 0.8. What will be equilibrium value of output Y?

Y = 375 is the equilibrium output of the economy at fixed price and fixed interest rate combination.

Effective demand. The level of aggregate demand required to achieve full employment equilibrium is called effective demand. Alternatively, aggregate demand at the point of equilibrium is called an effective demand. How? Equilibrium level of national income is determined by aggregate demand and aggregate supply which become rarely equal. The particular aggregate demand which is equal to aggregate supply and determines the equilibrium national income is called effective demand. Effective demand is the total expenditure which the people are prepared to spend for purchase of goods and services.
In Keynesian framework which deals with short run analysis, it is assumed that prices of goods do not change and elasticity of supply is infinite. At the given price, output can be increased till all resources are fully employed. How much will be the aggregate output will primarily depend on how much is the aggregate demand in the economy. Thus aggregate output is determined solely by aggregate demand principle. This is called effective demand principle. Also because in short run, physical and technical conditions affecting aggregate supply do not change, so it is the level of effective demand or aggregate demand which determines the level of output, income and employment. Thus for increasing the level of income and employment, increase in effective demand is essential.

Paradox of thrift. Since start of human civilisation it was considered a virtue to keep consumption level at the minimum but the lasting effects and chain reactions of keeping consumption in check were not realised. People were taught that thrift or savings are good because a penny saved today will bring increased income. In this connection, Keynes pointed out paradox of thrift and showed that as people become more thrifty, they end up saving less or same as before. If all the people of an economy increased the proportion of income which is saved (i.e., MPS), the value of savings in the economy will not increase, rather it will decline or remain unchanged. Let us understand this statement with the help of the figure (a).
In Fig (a), initial saving curve is SS and investment curve is II. Economy attains equilibrium (saving = investment) at E and equilibrium level of income is OY. Now, suppose the society decides to become thrifty and increases saving by, say, AE. As a result saving curve shifts upward to S₁S₁ intersecting investment curve II at E₁ Unplanned inventories will increase and firms will cut down production and employment and move to new equilibrium E₁ The Figure shows that in the end, planned saving has fallen from AY to E₁Y₁. Notice at new point of equilibrium E_1,, the investment level and also realised saving remain the same (E₁Y₁) but level of income has fallen from OY to OY_1. The decline in equilibrium level of income shows the paradox of thrift as the reverse process of multiplier has worked on reducing consumption expenditure. In fact, increased saving is virtually a withdrawal from circular flow of income.

Fig. (a)

Voluntary unemployment vs. Involuntary unemployment. It needs to be understood that involuntary unemployment is different from voluntary unemployment. Voluntary unemployment refers to those persons who are not willing to do work although suitable work is available for them. In other words, they are voluntarily unemployed, i.e., unemployed of their own will. Such persons are not included in labour force of the country. On the contrary, involuntary unemployment refers to a situation when those who are able and willing to work at the prevailing wage rate do not get work. Hence they are unemployed against their wishes.
Significance of this distinction is that the magnitude of unemployment in an economy is reflected by the magnitude of involuntary unemployment since the former includes only involuntary unemployment.

Concept of Full Employment. Full employment refers to a situation when every able bodied person who is willing to work at the prevailing rate of wages is, in fact, employed. Alternatively, it is a situation when there is no involuntary unemployment. That is why full employment is also defined as a situation where there is no involuntary unemployment. It needs to be understood although full employment means a situation when all resources in the economy – land, labour, capital, etc. – are fully employed but for simplicity meaning of full employment is restricted to labour market only, i.e., a situation when all able persons who are willing to work at the prevailing wage rate find jobs. Every economy in the world aims at achieving the level of full employment equilibrium where all its available resources are fully and efficiently employed because it leads to maximum level of output produced by the economy.
In reality full employment never exists because it is always possible to find some people unwilling to do any productive work though they may be fit physically and mentally. Also some people remain temporarily without jobs over short period when they try to change employment from one job to another (called frictional unemployment) or when new machines are introduced or when a plant may break down (called structural unemployment). Thus frictional, structural and voluntary unemployment can co-exist within the state of full employment. In short, full employment does not stand for zero unemployment.
Classical economists and Keynes, view full employment in different ways. According to Classicals full employment is a situation where there is no involuntary unemployment. But according to Keynes full employment indicates that level of employment where increase in aggregate demand does not lead to increase in level of output and employment.

Meaning of equilibrium level of income. Equilibrium level of income is that level of income at which aggregate demand equals aggregate supply (and planned savings equal planned investment). At equilibrium, whatever output of goods and services is produced, is either consumed by the households or invested by the firms. There is neither surplus nor shortage in production of output in the economy. That is why equilibrium level of income is also called equilibrium level of output. Such an equilibrium can be established at both full employment level and at under-employment level.

Equilibrium in an economy. An economy is in equilibrium when aggregate demand is equal to aggregate supply (output). But equality between AD and AS does not imply that there will essentially be full employment because equality can take place even at underemployment. Equality between the two can occur even when aggregate demand is not sufficient to support aggregate supply at full employment level. In other words, equilibrium can take place even at less than full employment level, i.e., under-employment equilibrium can exist. Hence an economy can be in equilibrium when there is unemployment in the economy. Thus it is not essential that there will always be full employment at equilibrium level of income. It can be (full employment equilibrium) but it need not be. Clearly deflationery gap can exist at equilibrium level of income.
Equilibrium level of employment. The level of aggregate employment corresponding to equilibrium level of aggregate supply (i.e., when AD = AS) is known as equilibrium level of employment. And equilibrium level of employment may be of two types —full employment equilibrium and under-employment equilibrium .

Under-employment equilibrium. Under-employment equilibrium means equality of aggregate demand and aggregate supply at less than full employment level. It is a state of equilibrium where level of demand is less than 'fall employment level of output'. In other words, in producing the output, all resources are not fully employed, i.e., some resources are under-employed. This situation is caused not by low level of aggregate supply but by deficiency of aggregate demand. When level of demand is less than full employment level of output, it is called deficient demand which pushes the economy into under-employment equilibrium. It results in deflationary gap, i.e., gap between aggregate demand and aggregate supply at full employment. The situation of under-employment equilibrium has been shown in Fig.(a),wherein full employment equilibrium is at point E but under-employment equilibrium occurs at point Ej because ADj curve intersects the same AS curve at E₁ due to inadequacy of demand. OM_T is the under-employment equilibrium level of income which is less than OM, the full employment equilibirum level of income. Since aggregate demand (AD) falls short of aggregate supply (AS) at full employment by EB, therefore, additional investment expenditure equal to the level of EB (i.e., deflationary gap) is required to reach the full employment equilibrium.

Note: In fact, the idea of under-employment equilibrium was introduced by Keynes who believed that an economy generally functions at less than full employment level, i.e., at under-employment equilibrium. Strictly speaking Keynes considered supply curve to be perfectly elastic with respect to prices till full employment level of output is reached. So the equilibrium depends upon level of aggregate demand. When aggregate demand falls short of full employment level of output, under-employment equilibrium occurs at the point where AD curve intersects horizontal aggregate supply curve before full employment level of output.

Meaning of an excess demand.

When in an economy, aggregate demand is in excess of 'aggregate supply at full employment', the demand is said to be an excess demand and the gap is called inflationary gap. In other words, excess demand refers to the excess of aggregate demand over the available output (aggregate supply) at full employment. The gap is called inflationary because it causes inflation (continuous rise in prices) in the economy.
Inflationary Gap. When aggregate demand is more than 'level of output at full employment' then the excess or gap is called inflationary gap. Alternatively, it is the amount by which actual aggregate demand exceeds the level of aggregate demand required to establish full employment equilibrium. Thus inflationary gap is a measure of amount of the excess of aggregate demand over 'aggregate supply at full employment'. It indicates that the buyers intend to buy more than the maximum physical output the producers can produce by employing all the available resources. In such a situation an increase in demand means only an increase in money expenditure without any corresponding increase in output and employment because all the resources have already been fully employed. A simple example will further clarify it. Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 qtls. of rice. If actual aggregate demand for rice is, say 12,000 qtls., this demand will be called an excess demand, because output (aggregate supply) at level of full employment of resources is only 10,000 qtls. As a result the excess of 2,000 (=12,000 - 10,000) qtls. will be called an inflationary gap.
This situation is depicted in Fig.(a). Here point E lying on 45° line is the full employment equilibrium point. This is an ideal situation because aggregate demand represented by EM is equal

Fig.(a)

to full employment level of output (aggregate supply) represented by OM. Suppose the actual aggregate demand is for a level of output BM which is greater than full employment level of output EM (OM). Thus the difference between the two is EB (BM – EM) which is measure of inflationary gap or excess demand.
In short, inflationary gap is the amount by which aggregate demand exceeds the aggregate demand required to establish the full employment equilibrium.
Impact of Excess Demand. (i) It causes rise in prices. Since there is already full capacity production, excess demand does not cause any rise in output and employment but it leads to rise in prices. In such a situation when resources have been fully employed, increase in demand implies pressure on existing supplies of goods causing rise in prices and a situation of inflation. Clearly, this is demand pull inflation, i.e., demand induced increase in price level. A persisting rise in general level of prices after full employment is called inflation.(ii) It causes inequalities. Inflation creates inequalities of distribution of wealth, loss to creditors and salaried people, social unrest and revolt, loss of faith in government and morality. Remember, in such a situation real income (i.e., in terms of physical output) cannot rise but money income (i.e., in terms of money value of physical output) will rise.

Measures to control situation of excess demand

Keeping in view the adverse effects as stated above, aggregate demand has to be reduced by an amount equal to inflationary gap. Here we include Government sector which affects the economic activity through its expenditure and tax programme. This inclusion of government sector means that aggregate demand is now equal to sum of consumption, investment and Government expenditure, i.e., AD = C + I + G. The three most important measures to control excess demand are fiscal policy, monetary policy and foreign trade policy. Fiscal policy is used by the government whereas monetary policy is used by Central Bank of the country. However, the following measures are suggested to rectify the situation of excess demand.

1. Fiscal Policy. Fiscal policy is the expenditure and revenue (tax) policy of the government to accomplish the desired objectives. In case of excess demand (i.e., when current demand is more than AS at full employment), objective of fiscal policy is to reduce aggregate demand. Main tools of fiscal policy are:

(i) Expenditure policy (Reduce expenditure). In a situation like that of excess demand, government should curtail its expenditure on public works such as roads, buildings, rural electrification, irrigation works thereby reducing the money income of the people and their demand for goods and services. In this way, government should reduce the budget deficit which shows excess of expenditure over revenue. When government expenditure increases, AD of an economy increases by the same amount.

(ii) Revenue policy (Increase taxes). The other important part of fiscal policy is revenue policy which is expressed in terms of taxes. During inflation, government should raise rates of all taxes especially on rich people because taxation withdraws purchasing power from the tax payers and to that extent reduces effective demand. Care should be taken that measures adopted to raise revenue should be disinflationary and at the same time have no harmful effects on production and savings.

Here distinction is made between discretionary and non-discretionary measures used by the government. The non-discretionary elements refer to inbuilt stabilizers of income which operate automatically. Progressive income-tax, grants, subsidies, old age pension and other such like transfer payments are non-discretionary measures which operate automatically in both the situations of excess demand and deficient demand. As against it, discretionary measures refer to reduction in expenditure on public works, on public health and education, on defence and internal administration, etc.

(iii)    Public borrowing (Increases it). Additionally, government should resort to large scale public borrowing to mop up excess money with the public.

(iv)    Deficit financing (Reduce it). At the same time deficit financing (Printing of currency-notes) should be cut down drastically. Reducing deficit financing will reduce government ability to spend which, in turn, will decrease AD in the economy. Deficit financing is a method adopted by the government for financing its deficit through printing of more currency-notes.

2. Monetary Policy (Raise bank rate and cash reserve ratio). Monetary policy is the policy of the central bank of a country to regulate and control money supply and credit in the economy. Money broadly refers to currency-notes and coins whereas credit refers to loans. Monetary measures (instruments) affect the cost of credit (i.e., rate of interest) and availability of credit. Thus it helps in checking excess demand when credit availability is restricted and credit is made costlier. Measures of monetary policy may be (a) quantitative (which influences volume of credit indiscriminately), and (b) qualitative (which regulates flow of credit for specific uses).

(I) Quantitative Measures.

(i) Bank rate (Increase bank rate). Bank rate is the rate of interest at which Central Bank lends to commercial banks. Changing bank rate to influence credit availability is called Bank Rate Policy. Mind, Central Bank lends to only commercial banks and not to general public. In a situation of excess demand leading to inflation, Central Bank raises bank rate. This raises cost of borrowing which discourages commercial banks in borrowing from Central Bank. Increase in bank rate forces the commercial banks to increase their lending rate of interest to consumers and investors. Thus makes credit costlier. As a result, demand for loans falls. Again high rate of interest slows down the demand for goods and services and induces households to increase their savings by restricting expenditure on consumption and discourages investment. Thus expenditure on investment and consumption is reduced and this reduces credit creation by commercial banks. Remember rate of interest represents cost of money. Presently (February, 2012) bank rate or repo rate (rate at which banks borrow from RBI) is 8.5% and Reverse repo rate (rate at which banks park their surplus funds with RBI) is 7.5%.

(ii) Open Market Operation (Sell securities). It refers to buying and selling of government securities and bonds in the open market by the Central Bank. This is done to influence the volume of cash reserves with the commercial banks. Sale by Central Bank brings flow of money to Central Bank from commercial banks thereby restricting their lending capacity. Such operations affect amount of cash reserves with the commercial banks and their capacity to offer loans. During inflation, Central Bank sells government securities to commercial banks which lose equivalent amount of cash reserve thereby affecting their capacity to offer loans. This absorbs liquidity from the system. As a result, there is fall in investment and aggregate demand. Thus it is an effective measure to control credit.

(iii) Cash Reserve Ratio (Raise CRR) (D 2011). It is ratio (or fraction) of bank deposits that a commercial bank must keep as reserve with the Central Bank. Every commercial bank is required under law to keep with central bank a minimum percentage (say, 8 per cent) of its deposits or reserve in the form of cash. This is called Cash Reserve Ratio. The bank is free to lend the remaining deposits. Higher the CRR, lessei is bank's lending capacity. When there is an inflationary situation, Central Bank raises the rate of minimum cash reserve ratio thereby curtailing the lending capacity of commercial banks. The RBI fixes rates of CRR according to market conditions. At present CRR is 5.5% w.e.f. 28th January 2012.

Statutory Liquidity Ratio (SLR). In addition to CRR, there is another measure called SLR according to which every bank is required to hold a minimum proportion of its total demand and time deposits in the form of liquid assests (e.g. government securities) as per regulation of RBI. When RBI wants to contract credit or lending by banks, it raises SLR and thereby reduces credit availability.

Legal Reserve Ratio (LRR). It is the minimum ratio of demand deposits fixed by RBI which is legally compulsory for every commercial bank to keep as cash reserves. It has two components – CRR and SLR as explained above.

(II) Qualitative Measures (The control purpose and direction of credit).

(iv) Moral Suasion (Restrict credit). This refers to written or oral advice given by Central Bank to commercial banks to restrict or expand credit.It is a combination of persuation and pressure which is exercised through letters, discussion and speeches. During inflation, the Central Bank of a country employs selective credit control measures like moral suasion. For instance, it persuades its member banks not to advance credit for speculation or prohibits banks from entering into certain transactions. This advice is generally followed by member banks.

(v) Margin Requirements (Increase it). Margin requirements refer to the amount of security that banks demand from borrower of loan. It is the difference between the amount of loan granted and the current value of security offered for taking loan. In a situation of excess demand, Central Bank raises the limit of margin requirements. This discourages borrowing because it makes traders get less credit against their securities. On the other hand, in case of deficient demand, margin requirements are lowered to encourage borrowing.

Other anti-inflationary measures of monetary policy are credit rationing, control of consumer credit, wage freeze, compulsory saving scheme for households, etc.

3. Foreign Trade Policy (Enlarge import surplus). In a situation of excess demand, import surplus (excess of imports over exports) should be created and enlarged because imports act a leakage from income stream. Thus the excess demand will be reduced to the extent of import of goods produced by other countries. Hence, a liberal policy is very helpful. However, import surplus can be financed (i) by drawing upon foreign exchange reserve or gold reserves, (ii) by taking loans from foreign governments or World Bank, etc., and (iii) by taking aid from other countries in the form of grants.

Meaning of deficient demand. When in an economy aggregate demand falls short of aggregate supply at full employment, the demand is said to be a deficient demand and the difference (gap) is called deflationary gap. Deficient demand gives rise to deflationary gap which causes income, output and employment to full and thus pushes the economy to an under-employment equilibrium. As a result some of the resources including labour remain partly unutilised showing under-employment. In other words, it means that the demand is not sufficient or adequate to eliminate involuntary unemployment. It indicates that there are people who are willing to take up jobs at the prevailing wage rate but the economy cannot provide jobs to them because current AD falls short of aggregate demand required to reach the level of full employment. Thus deficient demand is a situation of under-employment equilibrium.
Impact: Deficient demand leads to fall in prices which, in turn, leads to fall in output and employment. Again a persistent fall in deficient demand leads to state of depression in the economy.

Deflationary gap. When aggregate demand is less than the level of output at full employment, then the deficiency or gap is called deflationary gap. It is the difference between the actual level of aggregate demand and the level of aggregate demand required to establish the full employment equilibrium. It is a measure of the amount of deficiency in aggregate demand. Briefly, deflationary gap is synonym of deficient demand. The gap is called deflationary gap because it leads to deflation. For instance, suppose an economy by fully utilising all its available resources can produce 10,000 qtls. of rice. If the actual aggregate demand for rice is, say 8,000 qtls. This demand will be termed as deficient demand and the gap of 2,000 qtls as deflationary gap. Clearly, here equilibrium between AD and AS is at 8,000 qtls. Keynes called it an under-employment equilibrium. Deflationary gap or deficient demand causes low income, low output and low employment in the economy.
Deflationary gap has been illustrated in Fig.(a). Here, E lying on 45° line is the full employment equilibrium point. This is an ideal situation because aggregate demand represented by EM is equal to 'aggregate supply at full employment' represented by OM. Suppose actual aggregate demand is for a level of output BM. For the economy to maintain level of output at full employment, aggregate demand should be EM (OM) but actual aggregate demand is BM. The gap between the two (i.e. EM and BM) is EB which is measure of deflationary gap or deficient demand. In short, deflationary gap is the difference between the actual level of aggregate demand and the level of aggregate demand required to establish full employment equilibrium.

 
Impact of deficient demand. (i) Deficient demand reduces economy s output, income and employment. How? Due to deficient demand, inventories (stock) of unsold goods will accumulate, and therefore, the producers will cut down production by reducing employment. Thus both output and employment will continue to fall until a new equilibrium is reached at E_r In fact, basic problem with deficient demand is lack of full utilisation of available resources in the form of idle labour force, unutilised industrial capacity and uncultivated lands, i.e., involuntary unemployment.
(ii) It causes situation of depression. If deficiency in demand (or deflationary gap) is not bridged, it can lead to fall in output, employment and prices, and therefore, to depression. Depression refers to a phase of economic activity where falling production and incomes lead to fall in demand, and therefore, fall in prices. Once started, the process of depression is self-generating. This is what happened during Great Depression of 1929-33. It is under such like situation that Keynes advocated government intervention in the form of fiscal policy measures to correct situation of deficient demand.
Causes of deficient demand. These are: (i) Fall in government expenditure, (ii) Fall in level of Autonomous investment, (iii) Decrease in Marginal Propensity to consume, and (iv) Fall in supply of money and credit.

Measures to rectify the situation of deficient demand. In view of adverse effects as stated above, there is great need to close the deflationary gap. Aggregate demand has to be increased by an amount equal to deflationary gap. The most important measures to remedy such a situation are fiscal policy, monetary policy and foreign trade policy. Even then some important measures are briefly discussed below:

1.    Fiscal Policy (Increase investment and reduce taxes). Fiscal policy comprises expenditure policy and taxation policy of the government. Government has legal powers to impose taxes and to spend. Main tools of fiscal policy are (i) expenditure policy, (ii) revenue policy, (iii) deficit financing, and (iv) public borrowing.

(i)    Expenditure Policy (Increase expenditure). The objective of expenditure policy should be to pump more money in the system that gives a fillip to the demand. During period of deficiency in demand, the government should make large investments in public works like construction of roads, bridges, buildings, railway lines, canals and provide free education and medical facilities although it may enlarge budget deficit. The aim is to give more money in the hands of people so that they should also spend more. Keynes, in fact, advocated deficit budget to step up aggregate demand.

(ii)    Revenue Policy (Reduce tax rate). Taxes on personal incomes and taxes on expenditures on buildings, etc. should be reduced. If possible, tax on lower income groups be abolished. This will increase their disposable income for spending. In addition, subsidies, old age pension, unemployment allowance and grants, interest free loans should be given.

(iii) Deficit financing (printing of currency-notes) should be encouraged as additional currency causes additional purchasing power.

(iv) Government borrowing from public should be discouraged, so as to increase aggregate demand.

2.    Monetary Policy (Reduce bank rate and Cash reserve ratio). Monetary policy is the policy of the Central Bank of a country to control credit and money supply. Mind, credit generally refers to the finance provided to others at a certain rate of interest. The aim of monetary policy in times of depression is to cause an increase in the investment expenditure by firms. Thus credit is made cheap and easily available in the following ways:

(a) Quantitative Measures
(i) Bank rate (Reduce it). Bank rate is the rate at which Central Bank lends to the commercial banks. The banks, in turn, increase or decrease lending rates of interest accordingly. To check depression, the Central Bank reduces bank rate thereby enabling the commercial banks to take more loans from it and, in turn, give more loans to producers at a lower rate of interest. At present (February 2012) bank rate (also called Repo Rate) is 8.5%.

(ii)    Open Market Operation (Buy securities). These refer to buying and selling of government securities which influence money supply in the economy. During depression, Central Bank buys Government bonds and securities from commercial banks by paying in cash to increase their cash stock and lending capacity.

(iii)    Cash Reserve Ratio (Reduce CRR). Central Bank lowers rate of cash reserve ratio thereby increasing bank's capacity to give credit. Similarly, Central Bank lowers Statutory Liquidity Ratio (SLR) to increase availability of credit.

Among these three instruments of monetary policy, the instrument of bank rate is more effective to lift the economy out of recession.

The above-mentioned three measures are quantitative credit control measures since they affect the quantity of cash and credit available in the economy.

(b) Qualitative Measures

There are qualitative measures also which regulate credit for specific purposes. They channelise credit into priority sectors and impede its use in undesirable sectors of economy as explained below.

(iv) Margin Requirement (Reduce it). To check depression, Central Bank reduces margin requirement which encourages borrowing because it induces businessmen to get more credit against their security.

(v) Moral Suasion. In a situation of deficient demand, Central Bank persuades, requests, appeals or advises its member banks to be liberal in lending and expand credit facilities.

(vi) Rationing of credit and sometimes direct action are also resorted to promote social justice while checking state of depression.

3. Foreign trade policy (Enlarge export surplus). In national accounting, it was made clear that exports are a part of domestic investment. So additional exports, like domestic investment, increase income and spending. Exports constitute foreign demand for domestic products. More exports have the effect of increasing aggregate demand. Therefore, when an economy suffers from deficient demand, it can reduce its deflationary gap by creating and increasing export surplus (excess of exports over imports). All efforts should be made to encourage export and discourage imports for generating more employment and income. For this the country may set apart for export a part of its domestic product which is in demand abroad.

Having discussed the two theories in the foregoing pages, we can now make the following comparison:

Inflationary gap is the amount by which the actual aggregate demand exceeds aggregate supply at the level of full employment. For instance, in Fig.(a),  BE is show'n as inflationary gap. It is a measure of amount of the excess of aggregate demand. It causes a rise in price level called inflation.
Deflationary gap is the amount by which the actual aggregate demand falls short of aggregate supply at the level of full employment (i.e., falls short of full employment output). For example, in Fig.(b) EB is shown as deflationary gap. It is a measure of amount of deficiency of aggregate demand which is required to establish full employment equilibrium. It causes a decline in output, income and employment along with fall in prices.
Between inflationary gap (causing inflation) and deflationary gap (causing deflation or depression), the latter is worse because of its serious economic consequences. Moreover, deflation (fall in price level) is difficult to control than inflation.

Fig.(a)

Fig.(b)
Deflationary gap and equilibrium level of income
Equilibrium level of income indicates mere equality between aggregate demand and aggregate supply irrespective of whether it is a full employment equilibrium or under-employment equilibrium. If it is a full employment equilibrium where all resources are employed to their full limit, deflationary gap cannot exist at equilibrium level of income. On the other hand, if it is an under-employment equilibrium where all resources are not fully employed, i.e., some resources are under-employed, then deflation gap can exist at equilibrium level of income.
Conclusion. We may conclude our discussion in this way. Equilibrium level of national income is determined by the equality between aggregate demand and aggregate supply (or between savings and investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate demand and aggregate supply are in equilibrium at such a point where all the resources of the economy are employed fully. Every economy aspires for it. India should put in all efforts to achieve and stay at full employment equilibrium level of income.

(i) Voluntary unemployment refers to unemployment of those persons who are not willing to do work although suitable work is available for them, i.e., they are voluntarily unemployed.(ii) Involuntary unemployment refers to a situation in which all able persons who are willing to work at prevailing wage rate cannot get work.

(i) Private consumption demand (C), (ii) Private Investment demand (I), (iii) Govt, demand for goods and services (G), (iv) Net exports (X – M).
Symbolically : AD = C + I + G + (X – M).

The functional relationship between income (Y) and saving (S) (i.e., part of income which is not spent on consumption) is called saving function.
Symbolically: S = f(Y).