Chapter 6 complete

6.4 Income Theory of money or Saving-Investment Theory of Money 
The quantity theory of money neglects the process by which the fluctuations in the prices 
take place in the economy and it states that changes in the supply of money brings changes in 
the price level. The income theory of money seeks to relate price fluctuations with several 
other elements such as income, expenditure, saving, and investment etc. This is why this 
theory of money is called income theory of income or saving-investment theory of money. 
The income theory of money states that it is income that determines price and not the supply 
of money as stated by the quantity theory of money. The income theory of money states that 
changes in the aggregate demand are the resultant of changes in income, rather than supply of 
money. Thus, changes in the aggregate money income or nominal income, and not the supply 
of money, are the main determinants of aggregate demand and hence of prices. Increase in 
nominal income or money income leads to increase in aggregate demand and thereby 
increase in prices. In fact, supply of money may change due to change in the level of income, 
prices and economic activities. 
The term ‘income’ in this theory is interpreted in two senses: (i) nominal 
income/output, and (ii) real income/ real output. Nominal income is the monetary value of 
output such as price of output times the quantity of output (i.e., Y), and real output/income is 
the quantity of output (Q). So, price (P) is the ratio of changes in nominal income/output to 
the real income/output, so 
Price = 
,
- 8
- /.
.
=
1 
6.32 
The money income (Y) is utilised by people in two ways that it is one part of income is 
consumed (C) and remaining part of income is saved (S) for future use. Therefore income 
must equal consumption plus saving: 
Y = C + S
6.33 
Where, Y refers to income; C represents consumption; and S denotes saving. Saving means 
8.
Mankiw, Gregory, N, 2004, Macroeconomics, Worth Publishers: 85. 
9.
Ibid., 86. 
10.
Ibid., 84. 

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that part of income, which is not consumed; it can be expressed as 
S = Y – C 
6.34 
In an economy, two types of expenditure are incurred, one by the household on consumer 
goods (C) and another by the corporate/ entrepreneurs on investment goods. As we know that 
expenditure of one man’s expenditure is another man’s income, so it can be written
Y = C + I 
6.35 
The expenditure on consumer goods depends on the real income and the marginal propensity 
to consume (MPC), 
MPC = 
9:
91
6.36 
Where, MPC is marginal propensity to consume; 
∆
C is change in consumption; and 
∆
Y is 
change in income. The investment expenditure depends on marginal efficiency of capital (i.e., 
profitability of capital) and the current rate of interest.
Thus, income theory states that changes in income beings changes in expenditure that 
determines output and employment and prices. So it is income, which determines prices.
When we summarised income theory we find that expenditure (E) is equal to income (Y), as 
E = Y
6.37 
C + I = C + S
6.38 
I = S
6.39 
Therefore, the income theory of money is also called saving-investment theory. This credit 
for income theory and saving-investment theory is presented by Lord Keynes. According to 
Keynesian theory economy will be in equilibrium if saving (S) equals investment (I). This is 
illustrated in Figure 6.2. Equilibrium income means the only income that the economy will be 
able to sustain, in that there is the balance of forces consistent with the actions of demanders 
and suppliers. It does not necessarily mean full employment. The total amount of output that 
could be produced under full employment is called potential Gross National Product 
(GNP). When actual GNP and potential GNP differ, there is a GNP gap or income gap. When 
actual GNP is less than potential GNP (i.e., full employment), this GNP is called