Income Determination

EconomicsArticles / Tutorial Titles

Determining income is an indispensable part of our lives because it helps us manage our lifestyles. In macroeconomics, income determination helps countries or economies to restrict their expenditures within limits. If income is high, it means that the economy is growing while in the case where income is going down, it means that the economy is contracting.

Income is, therefore, a part of macroeconomics that has two sides −

  • the demand side and
  • the total national output.

There are various theoretical models in macroeconomics that deal with these principles. There are models in macroeconomics that consider the theories by keeping one variable constant at a time. The result helps in measuring the effect due to the other factors. This also helps in measuring other macroeconomic factors, such as the growth rate of the economy, unemployment rates, etc.

Ex-ante and Ex post Income Determination

Ex-ante Income Determination

Ex-ante and ex-post are two Latin words where ex-ante means before the event. In the case of income determination, it means the prediction of income before the event occurs. It is, therefore, uncertain how much income a nation would make when ex-ante calculations are done. However, although ex-ante is a prediction, it can be a handy tool to manage future expenses depending on a theoretical prediction that is as accurate as possible. Ex-ante values are often compared with results to see how much accuracy was present in the prediction of the event.

One example of an Ex-ante event would be the determination of the synergies of companies in case of a merger. The analysts usually predict the outcome of mergers and later on check the accuracy of the prediction when results become available.

Since ex-ante decisions are made before the actual occurrence or for future events, they are most uncertain. One example of such an outcome is an increase in the repo rate by the RBI. Since such decisions are not made on available data, there are chances of mistakes in making the decisions. In the case of RBI’s rate increment, if a recession hits India, the decision would be considered wrong while if the economy stays stable it would be the right decision.

Ex post Income Determination

Ex-post is the opposite of ex-ante. Here, decisions are made depending on available data. Once an event has occurred and decisions are taken depending on the outcome, such occurrence would be considered ex-post.

An example of ex-post determination would be the investors who invest depending on readily available ex-post data. The ex-post data provides them the information about the performance and capability of their potential investment outcomes. Therefore, they can determine whether the investment would be profitable or not. The use of ex-post data is applied to forecast and projections of market shock too.

The ex-post value of the investments can be measured by subtracting the previous data from the current data. This also helps investors and analysts determine the price fluctuations and predict future fluctuations and market prices accordingly. A comparison is then made with the ex-post value and predicted return to get the precision of the risk assessment procedure applied for this purpose.

Effective Demand Principle

The effective demand principle is related to the level of employment in an economy. The law that was considered supreme traditionally was that of Say’s Law of Markets. The Say’s Law of Market stated that all income or effective demand in the economy is enough to lift all the goods and services of the economy.

Keynes however proved Say’s theory wrong with the principle of effective demand. It states that, in the short term, an economy’s aggregate demand and employment are satisfied by the level of aggregate demand. Moreover, it is simple to realize then that the aggregate demand is fulfilled by aggregate supply in the economy. This means that total employment depends fully on total demand.

  • As employment increases, the demand also increases. But the total demand does not increase equal to employment. Therefore, to maintain full employment, the investment must be made externally to fill the gap between demand and employment. In simple words, investments would be required to equalize income and consumption derived from that demand.
  • Consumption actually goes on to increase with an increase in employment and income. The demands at various income levels are different but all of these demands are not effective. The demands that are met by supply in an economy so that neither contraction nor expansion in production is required are effective. Therefore, the demand that exists with equilibrium with supply is effective demand.
  • In a community, the effective demand or supply-borne demand is the money entrepreneurs derive from people’s expenditure on goods and services. This money is used in the factors of production in the form of rent, wages, profit, and interest. So, the effective demand or the actual expenditure is equal to national income which is the added sum of all receipts of all the members of a community.
  • Moreover, the total value of national outputs is equal to receipts for entrepreneurs from the sale of goods. Therefore, it can be stated that effective demand is equal to national expenditure on consumption added to investment goods.

Therefore,

ED = Y = C + I = 0 = Employment

Thus, effective demand (ED) = national income (Y) = value of national output = Expenditure on consumption goods (C) + expenditure on investment goods (I).

The Multiplier Mechanism

Production of commodities requires investment in factors of production which are land, labor, capital, and entrepreneurship. When taxes or subsidies are absent, the final output value is distributed among the factors of manufacturing, such as wages for labor, rent for land, etc. If there is an excess, it is retained by the entrepreneur which is known as profit.

Therefore, the average factor payments (total) or the national income of an economy is equal to the average price of output commodities and the GDP of the nation. The extra output obtained or the profit is generally distributed among various factors of the economy. So, there is an additional input in the factors of production in each new cycle of production. With such an increase, the utility of the products also goes up and as income increases, the increased amount of output is soaked by consumption.

So, with each new cycle, there is a multiplication of input factors that increase the output and the process goes on increasing until an equilibrium is reached. This process of increasing extra demand and therefore production is known as the multiplier mechanism.

Conclusion

Income determination is a much-revered topic in macroeconomics because it offers insight into growth and employment factors. As income growth is directly related to growing demand, one can realize that it would be good for economies to increase their income in order to increase demand. It would make the economy run smoother and help citizens live better life.

FAQs

Q1. What is meant by ex-ante and ex-post events?

Ans. Ex-ante and ex-post are used to mean before and aftermath of an event. Usually, economists have to make decisions depending on predictions of future events taking the help of data that are available before the event or occur after the event. That sis why ex-ante and ex-post terms are used.

Q2. Is the effective demand principle related to income?

Ans. Yes. The effective demand principle is directly related to income because demand is increased due to increasing income.

Q3. Is the multiplier mechanism related to demand?

Ans. Yes. The multiplier mechanism deals with the increased demand in each round of production of a product or service.

raja
Updated on 13-Oct-2022 11:19:47

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