CBSE Class 12 Economics HOTs National Income And Related Aggregates Set 03

Unit-3 - Determination of Income and Employment

Aggregate demand refers to the total value of final goods and services which all sectors of an Economy are planning to buy at a given level of income during a period of time.

\( AD= C + I + G + NX \)

Where, C= Consumption Expenditure of Household, I= Investment Expenditure, G= Government Expenditure, NX = Exports -Imports [X-M].

Aggregate supply refers to money value of final goods and services that all the producers are willing to supply in an economy in a given period of time. \( AS = \text{National Income}(Y) \).

For Two Sector Economy: - \( AD=C+I \); \( (Y)AS= C+S \).

Consumption function: - \( C=C+bY \)
Where, \( C = \text{Total Consumption} \), \( \bar{C} = \text{Autonomous Consumption} \) (minimum survival), \( b = \text{Change in consumption/change in Income} [ \Delta C / \Delta Y ] = \text{MPC} \), \( Y = \text{Income} \).

Saving Function: -
i.e. \( Y = C + S \)
\( S = Y - C \)
\( = - \bar{C} + (1 - b) Y \)
\( = - \bar{C} + (MPS)Y \) where \( [-\bar{C} = \text{Autonomous Savings/Dissavings}] \)

MPS = Change in saving/Change in income = \( [ \Delta S / \Delta Y ] \)

SLOPE OF CONSUMPTION CURVE:- MPC
SLOPE OF SAVING CURVE:- MPS

TYPES OF PROPENSITIES TO CONSUME

\( APC=C/Y \)
i. APC=1 [when C=Y]
ii. APC>1 [when C>Y]
iii. APC<1 [when Civ. APC can never be zero [Consumption can never be zero]
v. APC can never be negative or less than zero
vi. APC falls with increase in income

\( MPC= \Delta C / \Delta Y \)
i. MPC=1 [when change in consumption = change in income]
ii. MPC can never be greater than one
iii. MPC=0 [when change in consumption is zero]
iv. 0 < MPC < 1
(V) MPC falls with successive increase in income

TYPES OF PROPENSITIES TO SAVE

\( APS= S/Y \)
i. APS can never be equal to one [Saving can never be equal to income]
ii. APS=0 [when saving is zero]
iii. APS < 0 [when saving is less than income / dissavings]
iv. APS can never be greater than one

\( MPS= \Delta S / \Delta Y \)
i. MPS=1 [when change in saving = change in income]
ii. MPS= 0 [when change in saving=0]
iii. MPS can never be negative or less than zero
iv. MPS can never be greater than one

Break-Even point is a point when consumption is equal to income [i.e. C=Y or S=0] and savings are zero.

RELATIONSHIP BETWEEN APC & APS AND MPC & MPS:-
\( APS + APC = 1 \)
\( MPS + MPC = 1 \)

INVESTMENT refers to increase the stock of capital goods during a financial year.

INDUCED INVESTMENT: It refers to the investment which depends on the profit expectations and is directly influenced by income level.

AUTONOMOUS INVESTMENT: It refers to the investment which is not affected by changes in the level of income and is not induced by profit motive.

Ex-Ante Investment/ Planned Investment: Refers to amount of investment which firms plan to invest at the beginning of the period.
Ex-Post Investment: Refers to actual or realised investment at the end of the period.

Question. Giving reasons state whether following statements are true or false. The value of MPS can never be negative.
Answer: True, since MPS= Change in saving/Change in income and change in savings can never be negative.

Question. Value of APC can be zero.
Answer: False, since consumption can never be zero.

Question. The value of APS can never be greater than one.
Answer: True, because savings can never be greater than income.

Question. Define Full Employment.
Answer: It is a situation in which all those who are able to and willing to work at the prevailing wage rate gets the job.

Question. Define Involuntary Unemployed.
Answer: It is a situation where worker is willing and able to work at the prevailing wage rate but does not get work.

Excess demand/ Inflationary gap refers to the situation when AD > AS corresponding to full employment level of output.
• Output: It does not affect output since economy is already at full employment level.
• Employment: No impact on employment since full employment exist.
• General price level: It leads to rise in general price level (inflation) as AD > AS.

Measures to correct excess demand:
Fiscal policy :- (I) Decrease in government spending. (ii) Increase in taxes.
Monetary policy:- (i) Increase in bank rate. (ii) Increase in Repo rate (iii) Sale of securities in open market. (iv) Increase in CRR (v) Increase in SLR (vi) Increase in margin requirements (vii) Increase in Reverse Repo Rate.

Deficient demand/ Deflationary gap refers to the situation when AD < AS corresponding to full employment level of output.
• Output: Due to lack of sufficient demand output decreases.
• Employment: It causes involuntary unemployment in economy.
• General price level: It leads to fall in general price level (deflation) as AD < AS.

Measures to correct deficient demand:
Fiscal policy :- (I) Increase in government spending. (ii) Decrease in taxes.
Monetary policy:- (i) Decrease in bank rate. (ii) Decrease in Repo rate (iii) Purchase of securities in open market. (iv) Decrease in CRR (v) Decrease in SLR (vi) Decrease in margin requirements (vii) Increase in Reverse Repo Rate.

Question. Define Repo rate?
Answer: Repo rate is the rate at which the central bank of a country lends money to commercial banks against securities for their short-term needs.

Question. Explain the role of the following in correcting deficient demand in an economy? a. Open market operations b. Bank rate
Answer: (a) Open market operations: Central bank purchases securities, which increases cash reserves of banks and enhances their lending capacity. (b) Bank rate: Central bank decreases the bank rate, making loans cheaper for commercial banks, leading to an increase in credit supply.

Question. Distinguish between excess demand and deficient demand.
Answer: Excess demand occurs when \( AD > AS \) at full employment, leading to inflation. Deficient demand occurs when \( AD < AS \) at full employment, leading to deflation and involuntary unemployment.

Determination of equilibrium level: determined when Aggregate Demand (i.e., C+I) is equal to Aggregate Supply (i.e., Total Output or C+S).

1. AD – AS Approach: Equilibrium where AD=AS.
• When AD > AS: Buyers buy more than what sellers plan to produce. Inventory decreases
\( \implies \) producer will increase production
\( \implies \) starts increasing Income until AD=AS.
• When AD < AS: Buyers buy less than produced. Inventory increases
\( \implies \) producer will decrease production
\( \implies \) starts decreasing Income until AD=AS.

2. SAVING- INVESTMENT Approach: Equilibrium where Planned Saving= Planned Investment.
• When S > I: Buyers buy less than produced. Inventory increases
\( \implies \) producer will decrease production
\( \implies \) starts decreasing Income until S=I.
• When S < I: Buyers buy more than produced. Inventory decreases
\( \implies \) producer will increase production
\( \implies \) starts increasing Income until S=I.

INVESTMENT MULTIPLIER (K): measures the change in Income (\( \Delta Y \)) due to change in Investment (\( \Delta I \)).
\( K = \Delta Y / \Delta I \)
\( K = 1 / (1 - \text{MPC}) \)
\( K = 1 / \text{MPS} \)

Question. State True or False with reason :- MPC and multiplier are directly related
Answer: True, because \( K=1/(1-MPC) \).

Question. If aggregate demand exceeds aggregate supply, Income rises
Answer: True, since AD > AS
\( \implies \) Inventory decreases
\( \implies \) Production increases
\( \implies \) Income increases

Question. When Investment multiplier is 1, then value of MPS is Zero
Answer: False, because \( K = 1/\text{MPS} \)
\( \implies \) \( 1 = 1/\text{MPS} \)
\( \implies \) \( \text{MPS}=1 \).

Question. In an Economy, the consumption function is C=500+0.75Y, when C= Consumption expenditure and Y is income. Calculate equilibrium level of income & consumption expenditure, when I=5000. Also find value of multiplier.
Answer: At equilibrium, \( Y = C + I \)
\( Y = 500 + 0.75Y + 5000 \)
\( Y - 0.75Y = 5500 \)
\( 0.25Y = 5500 \)
\( Y = 22,000 \)

\( C = 500 + 0.75 (22,000) \)
\( C = 17,000 \)
Consumption expenditure at equilibrium level = Rs.17,000.

\( K = 1 / (1 - \text{MPC}) = 1 / (1 - 0.75) \)
\( K = 4 \)