Class 12 Economics (Macroeconomics) Chapter 4 Determination of Income and Employment Important Questions with Answers

Q. Define marginal propensity to consume.

Answer: The change in consumption per unit change in income: MPC = ΔC/ΔY.

Q. What is the value of APC at the break-even point?

Answer: 1, because there consumption equals income (C = Y) and saving is zero.

Q. What is autonomous investment?

Answer: Investment that does not depend on the level of income and is taken as a given constant in a year (I = Ī).

Q. State the minimum and maximum value of the investment multiplier.

Answer: Minimum 1 (at MPC = 0) and maximum infinity (at MPC = 1).

Q. What is meant by involuntary unemployment?

Answer: When people who are able and willing to work at the going wage rate do not get work.

Q. What does the effective demand principle state?

Answer: At a fixed price, with aggregate supply perfectly elastic, aggregate output is determined solely by the level of aggregate demand.

Q. Give two differences between APC and MPC.

Answer: (1) APC is the ratio of total consumption to total income (C/Y); MPC is the ratio of their changes (ΔC/ΔY).
(2) APC can exceed 1 (below break-even); MPC never exceeds 1.

Q. Why is the aggregate demand line parallel to the consumption line?

Answer: AD = C + Ī, and Ī is autonomous, so the same amount is added to consumption at every level of income. The slope of AD therefore stays c, and the vertical gap between the two lines is Ī everywhere.

Q. What is full employment? Is equilibrium income always full employment income?

Answer: The full employment level of income is where all factors of production are fully employed in the production process. (1)
No; equilibrium only means income will not change if left to itself, even with unemployment. Equilibrium may be below or above full employment. (1)

Q. State and explain the two components of the consumption function.

Answer: Consumption function: C = C̄ + cY (1)
• Autonomous consumption (C̄): consumption independent of income; it takes place even at zero income (subsistence consumption). In the diagram it is the intercept of the consumption line on the vertical axis. (1)
• Induced consumption (cY): the part that depends on income; when income rises by ₹1 it rises by the MPC (c). c is the slope of the consumption line. (1)

Q. Prove that MPC + MPS = 1 and APC + APS = 1.

Answer: Income is either consumed or saved: Y = C + S (½)
• Taking changes, ΔY = ΔC + ΔS; dividing by ΔY, 1 = ΔC/ΔY + ΔS/ΔY = MPC + MPS (1)
• Dividing Y = C + S by Y, 1 = C/Y + S/Y = APC + APS (1)
Interpretation: whatever part of extra income or of total income is not consumed is saved. (½)

Q. C = 60 + 0.6Y and I = 40 (₹ crore). Find equilibrium income, and consumption and saving at that income.

Answer: Equilibrium: Y = C + I = 60 + 0.6Y + 40 (½)
0.4Y = 100 ⇒ Y = ₹250 crore (1)
C = 60 + 0.6 × 250 = ₹210 crore (½)
S = Y − C = 250 − 210 = ₹40 crore (½)
Check: S = I = 40, so this is equilibrium. (½)

Q. Explain the difference between ex ante and ex post investment with an example.

Answer: • Ex ante investment is what the producer plans; ex post investment is what actually happens. (1)
• Example: a producer plans to add goods worth ₹100 to her stock (ex ante = ₹100). A sudden rise in demand makes her sell ₹30 of goods from the stock, so her inventory rises by only ₹70 (ex post = ₹70). (1)
• The difference is the unplanned change in inventory; ex post investment includes both planned and unplanned inventory investment. (1)

Q. State whether true or false, with reasons: (a) APC at the break-even level of income is always 1. (b) When ex ante saving is more than ex ante investment, inventories fall.

Answer: (a) True. At break-even consumption equals income (C = Y) and saving is zero; so APC = C/Y = 1. (1½)
(b) False. S > I means people plan to spend less than is produced; unsold goods pile up, that is, unplanned accumulation of inventories, and producers cut output. (1½)

Q. MPC = 0.75 and investment rises by ₹200 crore. Find the rise in income, consumption and saving.

Answer: k = 1/(1 − MPC) = 1/(1 − 0.75) = 4 (½)
ΔY = k × ΔI = 4 × 200 = ₹800 crore (1)
ΔC = MPC × ΔY = 0.75 × 800 = ₹600 crore (½)
ΔS = MPS × ΔY = 0.25 × 800 = ₹200 crore (½)
Check: new saving (200) = new investment (200), so this is the new equilibrium. (½)

Q. Why is the price level taken as fixed at the first stage of income determination? Under this assumption, what decides output?

Answer: • The economy has unused resources (machinery, buildings, labour); the law of diminishing returns does not apply and extra output is produced without raising marginal cost, so the price does not change. (1)
• It is a simplifying assumption, to be changed later. (1)
• Aggregate supply is then perfectly elastic, so output is decided solely by aggregate demand (the effective demand principle). (1)

Q. Give three differences between deficient demand and excess demand.

Answer: (1) Meaning: under deficient demand AD falls short of AS at full employment income; under excess demand it exceeds AS. (1)
(2) Gap: deficient demand creates a deflationary gap, excess demand an inflationary gap. (1)
(3) Effects: deficient demand means low output, involuntary unemployment and falling prices in the long run; excess demand does not raise output or employment, only prices. (1)

Q. How does the economy reach equilibrium when ex ante aggregate demand is not equal to planned output? Explain.

Answer: Case 1: AD > planned output (at income below equilibrium)
• Households and firms want to buy more than is produced, so firms’ stocks fall unexpectedly. (1)
• Producers raise output and employment; income rises until AD = Y. (1)
Case 2: AD < planned output (at income above equilibrium)
• Unsold goods become an unplanned accumulation of inventories. (1)
• Producers cut output and employment; income falls back to equilibrium. (1)
In saving-investment terms these are S < I (income rises) and S > I (income falls).

Q. The saving function is S = −50 + 0.25Y and investment is ₹100 crore. Find (a) equilibrium income (b) consumption at equilibrium (c) APC at equilibrium.

Answer: (a) Equilibrium: S = I ⇒ −50 + 0.25Y = 100 (½)
0.25Y = 150 ⇒ Y = ₹600 crore (1)
(b) C = Y − S = 600 − 100 = ₹500 crore (1)
[from the consumption function C = 50 + 0.75Y also 50 + 450 = 500]
(c) APC = C/Y = 500 ÷ 600 = 0.833 (1)
Interpretation: about 83% of equilibrium income is consumed; the rest is saved, which equals investment. (½)

Q. Explain any four monetary measures to correct a situation of excess demand.

Answer: • Raise the bank rate/repo rate: borrowing from the central bank becomes dearer, interest rates rise, investment and AD fall. (1)
• Raise the cash reserve ratio (CRR) or statutory liquidity ratio (SLR): banks have less to lend, credit creation falls. (1)
• Sell securities in the open market: cash moves from buyers and banks to the central bank, money supply falls. (1)
• Raise the margin requirement / moral suasion: less credit is given against securities; banks are persuaded to cut lending. (1)
If AD falls by the inflationary gap, the pressure on prices is removed.

Q. Explain the role of government spending and taxes in correcting deficient demand.

Answer: • Raise government spending: G is a direct component of AD; more spending on public works such as roads and buildings raises AD, and through the multiplier income rises by several times as much. (1½)
• Cut taxes: disposable income Y − T rises, households spend the fraction c of it, so AD rises. (1½)
• Amount needed: AD must rise by the deflationary gap. For a gap of ₹60 crore with MPC 0.8, raising G by ₹60 crore or cutting taxes by ₹75 crore (0.8 × 75 = 60) is enough. (1)

Q. C = 100 + 0.75Y and I = 50 (₹ crore). Find AD when income is (a) ₹800 crore and (b) ₹500 crore, and state what happens to inventories and income. Also find equilibrium income.

Answer: (a) AD = 100 + 0.75 × 800 + 50 = ₹750 crore < 800: unplanned accumulation of ₹50 crore, output and income fall. (1½)
(b) AD = 100 + 0.75 × 500 + 50 = ₹525 crore > 500: inventories fall unexpectedly by ₹25 crore, output and income rise. (1½)
Equilibrium: Y = 150 ÷ 0.25 = ₹600 crore. (1)

Q. What is a ‘parametric shift’? Explain the effect on the line AD = A + cY of (a) a rise in A and (b) a fall in c.

Answer: A parametric shift is a change in the position of a line caused by a change in a parameter of its equation (intercept or slope). (1)
(a) When A (the intercept) rises, the AD line shifts up in parallel with the same slope; equilibrium income rises by the multiplier (e.g. I from 10 to 20 raises income from 250 to 300). (1½)
(b) When c (the slope) falls, the AD line swings down about A and becomes flatter; equilibrium income falls (e.g. MPC from 0.8 to 0.5 lowers income from 250 to 100). (1½)

Q. Defend or refute: ‘The aggregate demand curve moves further away from the investment curve as income rises.’

Answer: The statement is correct. (1)
• AD = C + I, so at any income the vertical gap between the AD curve and the investment curve = consumption (C). (1)
• Investment is autonomous (a horizontal line), while C = C̄ + cY rises with income (c > 0). (1)
• So as income rises the gap (C) widens; the larger the MPC, the faster it widens. (1)

Q. In an economy with MPC = 0.5, investment rises by ₹100 crore. Show the first four rounds of the multiplier mechanism in a table and find the total rise in income.

Answer: As in the book’s Table 4.1 (rise in consumption | rise in aggregate demand | rise in income):
Round 1: 0 | 100 (autonomous increment) | 100
Round 2: 50 | 50 | 50
Round 3: 25 | 25 | 25
Round 4: 12.5 | 12.5 | 12.5 (2)
Rise in income over the first four rounds = 187.5; total rise = 100 ÷ (1 − 0.5) = ₹200 crore (k = 2). (1)
Total rise in consumption = 200 − 100 = ₹100 crore; each round is half the previous one, so the process converges. (1)

Q. Explain the determination of equilibrium income by the AD-AS (45° line) method, with a diagram and algebra.

Answer: Aggregate demand: AD = C + I = C̄ + Ī + cY; a line parallel to the consumption line with intercept C̄ + Ī. (1)
Aggregate supply: with a fixed price and unused resources, whatever the GDP, that much is supplied, so the 45° line (equal coordinates at every point). (1)
Diagram: income on the horizontal axis, AD and AS on the vertical; the AD line cuts the 45° line at E; the income OY* below E is equilibrium income. (1)
Algebra: C̄ + Ī + cY = Y ⇒ Y(1 − c) = C̄ + Ī ⇒ Y* = (C̄ + Ī)/(1 − c). Book: C = 40 + 0.8Y, I = 10 ⇒ Y* = 50 ÷ 0.2 = 250. (1½)
Adjustment: left of E, AD > Y, inventories fall and output rises; right of E, AD < Y, inventories pile up and output falls; so the economy settles at E. (1½)

Q. Explain the meaning of the investment multiplier and its mechanism with a numerical example and a table.

Answer: Meaning: the ratio of the total rise in income to the initial rise in autonomous investment: k = ΔY/ΔI = 1/(1 − MPC) = 1/MPS. (1)
Example (book): C = 40 + 0.8Y; when I rises from 10 to 20, income rises from 250 to 300; ΔY = 50 = 5 × 10. (1)
Mechanism: the whole value of output is distributed as factor payments, so extra output of 10 is extra income of 10; people spend 0.8 of it, creating excess demand and new output of 8, and so on. (1½)
Table: round 1: 10; round 2: 8; round 3: 6.4; round 4: 5.12; … (1)
Sum: 10{1 + 0.8 + 0.8² + …} = 10/(1 − 0.8) = 50. The larger the MPC, the larger the multiplier; it lies between 1 and infinity and works the same way for a fall in spending. (1½)

Q. Explain the paradox of thrift with the book’s numerical example and a diagram.

Answer: Statement: if everyone raises the MPS, total saving does not rise; it falls or stays the same. (1)
Start: C̄ = 40, Ī = 10 (A = 50), MPC = 0.8 ⇒ Y₁ = 50/0.2 = 250; S₁ = 250 − (40 + 200) = 10. (1)
Change: news of war or disaster lowers the MPC to 0.5; at income 250 AD falls by (0.8 − 0.5) × 250 = 75, excess supply appears and output is cut. (1)
Rounds: 75 + (0.5)75 + (0.5)²75 + … = 75/(1 − 0.5) = 150 fall; Y₂ = 100. (1)
Saving: S₂ = 100 − (40 + 0.5 × 100) = 10; saving did not rise, because at equilibrium S = I and I = 10 is fixed. (1)
Diagram: the AD line swings down about A = 50 (AD₁ to AD₂); its intersection with the 45° line moves from E₁ (250) to E₂ (100). (1)

Q. Explain the meaning of deficient demand, the deflationary gap with a diagram, its effects on the economy and the measures to correct it.

Answer: Meaning: at full employment income aggregate demand falls short of aggregate supply; equilibrium is below full employment. (1)
Diagram: at Yf, point F on the 45° line and point G on AD; G lies below F; FG = deflationary gap; equilibrium E lies to the left of Yf. (1½)
Effects: low output with idle resources; involuntary unemployment (under-employment equilibrium); prices fall in the long run. (1½)
Measures (raise AD by the gap): fiscal: raise government spending, cut taxes. Monetary: cut the repo/bank rate, cut CRR/SLR, buy securities in the open market, lower the margin requirement. (2)

Q. What is excess demand? Measure the inflationary gap with a numerical example and state the fiscal and monetary measures to correct it.

Answer: Meaning: aggregate demand exceeds full employment output; since full employment already exists, real output cannot rise and prices rise. (1)
Example: C = 200 + 0.75Y, I = 300, Yf = 1,600 (₹ crore). Y = 500 ÷ 0.25 = 2,000 > Yf. AD at Yf = 200 + 1,200 + 300 = 1,700; inflationary gap = 1,700 − 1,600 = ₹100 crore. (2)
Fiscal measures: reduce autonomous spending by the inflationary gap (₹100 crore), for example by cutting government spending; raise taxes (disposable income and consumption fall). (1½)
Monetary measures: raise the repo/bank rate, raise CRR/SLR, sell securities in the open market, raise the margin requirement, moral suasion; these reduce credit and investment. (1½)

Q. In the fixed-price two-sector model, explain the determination of equilibrium income by (a) the AD-AS method and (b) the saving-investment method, with diagrams. Taking C = 40 + 0.8Y and I = 10, find equilibrium income by both methods and explain the adjustment when the economy is out of equilibrium. (UP Board 10 marks)

Answer: 1. Assumptions: two sectors (households, firms); fixed price and rate of interest; unused resources, so aggregate supply is the 45° line; investment autonomous. (1)
2. AD-AS method: AD = C̄ + Ī + cY, AS = Y (45° line). Equilibrium at AD = AS, point E. Diagram: AD line with intercept C̄ + Ī and slope c; 45° line from the origin. (2)
Calculation: Y = 40 + 0.8Y + 10 ⇒ 0.2Y = 50 ⇒ Y = 250. (1)
3. Saving-investment method: S = −C̄ + (1 − c)Y = −40 + 0.2Y; I = 10 (horizontal line). Equilibrium at S = I: −40 + 0.2Y = 10 ⇒ Y = 250. Diagram: the saving line rises from −40, the investment line is flat at 10; they cross at income 250. (2)
4. Why both give the same answer: Y = C + S and at equilibrium Y = C + I, so AD = Y ⇔ S = I. (1)
5. Adjustment: at Y = 300, AD = 290 < 300 and S = 20 > I = 10: unplanned accumulation of 10, output falls. At Y = 200, AD = 210 > 200 and S = 0 < 10: inventories fall, output rises. So income settles at 250. (2)
6. Conclusion: equilibrium income need not equal full employment income; below it there is deficient demand, above it excess demand. (1)