Determination of Income and Employment – AHSEC Class 12 Economics Chapter 4 Part – A

” Introductory Macroeconomics” Chapter 4: Determination of Income and Employment

Chapter 4: Determination of Income and Employment

This chapter explains how the equilibrium level of income and employment is determined in an economy, based on the Keynesian framework. According to Keynes, in the short run, when the price level is assumed to be constant, the equilibrium level of output is determined solely by Aggregate Demand (AD).

Aggregate Demand and its Components:
Aggregate Demand (AD) is the total planned expenditure on goods and services in an economy during a given period. In a simple two-sector economy (without government or foreign trade), AD has two main components:

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1. Consumption (C): This is the expenditure by households on goods and services. It is primarily dependent on income. The consumption function is given by: C = C̅ + cY, where C̅ is Autonomous Consumption (the minimum consumption even when income is zero) and ‘c’ is the Marginal Propensity to Consume (MPC).
2. Investment (I): This is the expenditure by firms on capital goods. In this basic model, investment is assumed to be Autonomous Investment, meaning it does not depend on the level of income (I = I̅).

Therefore, Aggregate Demand, AD = C + I.

Determination of Equilibrium Income:
An economy is in equilibrium when planned Aggregate Demand (AD) equals planned Aggregate Supply (AS). Since Aggregate Supply is equal to National Income (Y), the equilibrium condition is:
Y = AD
or, Y = C + I

The Multiplier Mechanism:
When there is an increase in autonomous spending (like investment or government expenditure), the equilibrium level of income increases by a multiple amount. This process is called the multiplier mechanism. The initial increase in investment leads to an increase in income, which in turn leads to an increase in consumption, which further increases income, and this cycle continues.
The value of the multiplier (k) is given by:
Multiplier (k) = 1 / (1 – MPC) = 1 / MPS
Where MPC is the Marginal Propensity to Consume and MPS is the Marginal Propensity to Save.

Paradox of Thrift:
This paradox states that if all people in an economy try to save more (i.e., the marginal propensity to save, MPS, increases), the total savings of the economy will either not increase or may even decrease. The reason is that an attempt to save more leads to less consumption, which reduces aggregate demand and, consequently, the equilibrium level of income and output. A lower level of income leads to lower total savings.

Role of the Government:
Government spending (G) and taxes (T) are the tools of fiscal policy. An increase in government spending directly increases aggregate demand, while an increase in taxes reduces disposable income and thereby lowers aggregate demand.

Complete Textual Question Answers (Exercise)

1. What is the marginal propensity to consume? How is it related to the marginal propensity to save?
Answer: The Marginal Propensity to Consume (MPC) is the change in consumption per unit change in income. It shows what proportion of an additional unit of income is consumed.
MPC (c) = ΔC / ΔY
The Marginal Propensity to Save (MPS) is the change in savings per unit change in income.
MPS (s) = ΔS / ΔY
The relationship between them is that their sum is always equal to 1. This is because any additional income (ΔY) is either consumed (ΔC) or saved (ΔS).
Therefore, MPC + MPS = 1.

2. What is the difference between ex-ante investment and ex-post investment?
Answer:

• Ex-ante Investment: This refers to the planned or intended investment that firms plan to make during a particular period.
• Ex-post Investment: This refers to the actual or realized investment that takes place in the economy during a particular period.
  The difference between ex-ante and ex-post investment arises from unplanned changes in inventories. For example, if sales are unexpectedly low, there is an unplanned accumulation of inventories, making ex-post investment greater than ex-ante investment.

3. What do you understand by ‘parametric shift of a line’? How does a line shift when its (i) slope decreases, and (ii) its intercept increases?
Answer: A parametric shift of a line refers to a change in the position or slope of the line due to a change in the value of its underlying parameters (i.e., the slope or the intercept).

• (i) When its slope decreases: The line becomes flatter.
• (ii) When its intercept increases: The line shifts upwards parallel to its original position.

4. What is ‘effective demand’? How will you derive the autonomous expenditure multiplier when the price of final goods and the rate of interest are given?
Answer: According to Keynes, effective demand is that level of aggregate demand which is equal to aggregate supply. It is the point where the economy is in equilibrium, and it determines the equilibrium level of income and output.
The autonomous expenditure multiplier shows how many times the equilibrium income increases for a unit increase in autonomous expenditure. It is derived as follows:
Multiplier (k) = 1 / (1 – MPC) or 1 / s
Where ‘c’ is the Marginal Propensity to Consume (MPC) and ‘s’ is the Marginal Propensity to Save (MPS).

5. Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is Rs 4,000 crores. State whether the economy is in equilibrium or not (cite reasons).
Answer:
Given:

• Autonomous Expenditure (A̅) = Rs 50 crores
• Marginal Propensity to Save (MPS or s) = 0.2
• Level of Income (Y) = Rs 4,000 crores

First, we find the Marginal Propensity to Consume (MPC or c):
MPC = 1 – MPS
MPC = 1 – 0.2 = 0.8

Now, we calculate the ex-ante Aggregate Demand (AD):
The formula for AD is: AD = A̅ + cY
AD = 50 + (0.8 × 4,000)
AD = 50 + 3,200
AD = Rs 3,250 crores.

Equilibrium Check:
For the economy to be in equilibrium, Aggregate Supply (Y) must equal Aggregate Demand (AD).
Here, Y = Rs 4,000 crores and AD = Rs 3,250 crores.
Since Y > AD (4,000 > 3,250), the economy is not in equilibrium.

Reason: The aggregate supply (output) is greater than the aggregate demand. This will lead to an unplanned accumulation of inventories with the producers, who will then cut back on production in the next cycle to clear the stocks, causing the income level to fall until it reaches the equilibrium level.

6. Explain the ‘paradox of thrift’.
Answer: (The answer is provided in the “Chapter Summary” section above).

Previous Years’ AHSEC Question Answers (2015-2025)

1. Question: What is balance of payment? Explain its components. (AHSEC 2025)
Answer: The Balance of Payments (BoP) is a systematic record of all economic transactions between the residents of a country and the rest of the world in a given period of time.
Components: The BoP has two main components:

1. Current Account: This includes the balance of trade (export and import of visible goods), balance of invisibles (services, investment income), and unilateral transfers (gifts, grants).
2. Capital Account: This includes all capital transactions such as foreign investment (direct and portfolio), loans, banking capital, etc.

2. Question: Explain the process of credit creation by commercial banks. What is money multiplier? (AHSEC 2025)
Answer: Commercial banks create credit by lending out the money they receive as deposits. They are legally required to keep a certain fraction of their deposits as reserves (Cash Reserve Ratio – CRR) and can lend the rest. When a loan is given, it is often deposited back into the banking system, creating a new deposit which can be lent out again. Through this process, banks are able to create credit that is a multiple of the initial deposit.
Money Multiplier: It is the ratio by which the total money supply can increase for every unit increase in the high-powered money. Its formula is 1 / CRR.

3. Question: What is aggregate demand? Write about its components. (AHSEC 2025)
Answer: Aggregate Demand is the total value of all final goods and services that all sectors of an economy are planning to buy at a given level of income during a period of time.
Components:

• Consumption Expenditure (C): Spending by households.
• Investment Expenditure (I): Spending by firms.
• Government Expenditure (G): Spending by the government.
• Net Exports (NX): The difference between exports and imports.
  AD = C + I + G + NX.

4. Question: Is GDP an indicator of welfare of a nation? Justify your answer. (AHSEC 2025)
Answer: No, GDP is not always a good indicator of welfare.
Justification:

• Distribution of GDP: If the rise in GDP is concentrated in the hands of a few rich individuals, the welfare of the general population may not increase.
• Non-Monetary Exchanges: Many non-monetary transactions that contribute to welfare (e.g., services of a homemaker) are not included in GDP.
• Externalities: GDP does not account for negative externalities like pollution, which reduce welfare.
• Population Growth: If the rate of population growth is higher than the rate of GDP growth, the per capita availability of goods and services will fall, reducing welfare.

5. Question: What do you understand by ‘paradox of thrift’? (AHSEC 2025)
Answer: The ‘paradox of thrift’ is a situation where if all individuals in an economy try to save more simultaneously, the total savings of the economy may not increase and could even decrease. This happens because an increase in saving leads to a decrease in consumption expenditure. This fall in consumption reduces aggregate demand, which in turn reduces output and income. A lower level of income ultimately leads to a lower level of total savings.

1. What is a multiplier? Explain the multiplier mechanism. (AHSEC 2015, 2018, 2022)
Answer: The multiplier is the ratio of the change in equilibrium income to the change in autonomous expenditure. The multiplier mechanism explains how an initial change in autonomous spending (like investment) leads to a much larger final change in income. For example, an initial increase in investment increases the income of those who receive it. They spend a part of this new income (determined by MPC), which becomes income for others. This second group also spends a part of their new income, creating further income. This chain reaction continues, with each round of spending being smaller than the last, until the total increase in income is a multiple of the initial investment.

2. Explain the Paradox of Thrift. (AHSEC 2016, 2020)
Answer: (The answer is provided in the “Chapter Summary” section above).

3. Explain the determination of income in a simple economy with the help of a diagram. (AHSEC 2017, 2024)
Answer: In a simple two-sector economy, equilibrium income is determined at the point where Aggregate Demand (AD) equals Aggregate Supply (AS). The Aggregate Supply curve is represented by a 45° line from the origin, as AS = Y. The Aggregate Demand curve (AD = C + I) is an upward-sloping line with a positive intercept. The point where the AD curve intersects the 45° AS curve is the equilibrium point (E). The level of income corresponding to this point is the equilibrium level of income.

Short Questions:

1. What is the relationship between MPC and MPS? (AHSEC 2015, 2019)
Answer: The sum of MPC and MPS is always equal to one (MPC + MPS = 1).

2. If MPC = 0.75, what will be the value of the multiplier? (AHSEC 2016)
Answer: Multiplier (k) = 1 / (1 – MPC) = 1 / (1 – 0.75) = 1 / 0.25 = 4.

3. What is autonomous consumption? (AHSEC 2017)
Answer: It is the minimum level of consumption expenditure that occurs even when the level of income is zero.

4. Write two components of Aggregate Demand. (AHSEC 2018, 2023)
Answer: Consumption expenditure (C) and Investment expenditure (I).

5. If MPS = 0.2, what will be the value of the multiplier? (AHSEC 2020)
Answer: Multiplier (k) = 1 / MPS = 1 / 0.2 = 5.

6. What is the difference between Ex-ante and Ex-post?
Answer: Ex-ante refers to the planned or intended value of a variable, while ex-post refers to the actual or realized value of that variable.

7. What is a consumption function?
Answer: The consumption function is the functional relationship between consumption and income.

8. What is the condition for equilibrium income?
Answer: Aggregate Demand = Aggregate Supply (AD = AS or Y).

9. Write the formula for the investment multiplier.
Answer: k = ΔY / ΔI = 1 / (1 – MPC).

10. What happens to the Average Propensity to Consume (APC) as income increases?
Answer: As income increases, the APC tends to fall.

Additional Most Important Question Answers

A. Very Short Answer Questions (1 Mark)

1. Question: Name the two components of Aggregate Demand (AD) in a two-sector economy.
   Answer: Consumption (C) and Investment (I).
2. Question: What is the relationship between the Marginal Propensity to Consume (MPC) and the Marginal Propensity to Save (MPS)?
   Answer: MPC + MPS = 1.
3. Question: If MPC = 0.6, what will be the value of MPS?
   Answer: MPS = 1 – MPC = 1 – 0.6 = 0.4.
4. Question: What is Autonomous Consumption?
   Answer: The minimum level of consumption expenditure that occurs even when the income level is zero.
5. Question: Write the formula for the investment multiplier.
   Answer: Investment Multiplier (k) = 1 / (1 – MPC) or 1 / MPS.
6. Question: What is ‘Ex-ante’ investment?
   Answer: ‘Ex-ante’ or planned investment is the amount of investment that firms plan to make during a specific period.
7. Question: What is ‘Ex-post’ saving?
   Answer: ‘Ex-post’ or actual saving is the actual amount of saving that takes place in an economy at the end of a specific period.
8. Question: What is the condition for equilibrium income?
   Answer: Aggregate Demand (AD) = Aggregate Supply (AS) or Y.
9. Question: What is meant by the ‘Paradox of Thrift’?
   Answer: The Paradox of Thrift states that if everyone in an economy tries to save more, the total savings of the economy may not increase; instead, it might decrease.
10. Question: Can an economy be in equilibrium when there is unemployment?
    Answer: Yes, according to Keynes, an economy can be in equilibrium at a level below full employment.

1. Question: For which time period is Keynesian theory applicable?
   Answer: The short run.
2. Question: What is the range of the value of the Marginal Propensity to Consume (MPC)?
   Answer: Between 0 and 1 (0 < MPC < 1).
3. Question: If there are unutilized resources in an economy, what will be the shape of the aggregate supply curve?
   Answer: It will be perfectly elastic (a horizontal line).
4. Question: What is the savings function?
   Answer: The functional relationship between savings and income. It is given by S = -C̅ + (1-c)Y.
5. Question: What happens if aggregate demand is greater than aggregate supply in an economy?
   Answer: Producers’ inventories will fall below the desired level, and they will increase production to replenish them.
6. Question: What is considered a ‘leakage’ from the circular flow of income?
   Answer: Savings (S) is considered a leakage.
7. Question: What is considered an ‘injection’ into the circular flow of income?
   Answer: Investment (I) is considered an injection.
8. Question: What is the alternative condition for equilibrium?
   Answer: Savings = Investment (S = I).
9. Question: If government expenditure increases, what happens to the aggregate demand curve?
   Answer: The aggregate demand curve shifts upward.
10. Question: According to Keynes, what is the primary cause of unemployment?
    Answer: Deficiency of Aggregate Demand.

B. Short Answer Questions (2/3 Marks)

1. Question: What is Aggregate Demand (AD) and what are its components?
   Answer: Aggregate Demand is the total value of all final goods and services that all sectors of an economy are planning to buy at a given level of income during a period of time. In a two-sector economy, its two main components are:
   1. Consumption Expenditure (C): Expenditure by households on goods and services.
   1. Investment Expenditure (I): Expenditure by firms on capital goods.
2. Question: Differentiate between Marginal Propensity to Consume (MPC) and Average Propensity to Consume (APC).
   Answer:
   1. MPC: It is the ratio of the change in consumption to the change in income (MPC = ΔC/ΔY). It represents the slope of the consumption function.
   1. APC: It is the ratio of total consumption to total income (APC = C/Y).
      The value of MPC is always between 0 and 1, whereas the value of APC can be greater than 1 (at very low income levels).
3. Question: Briefly explain the working of the multiplier.
   Answer: The multiplier mechanism shows that an initial increase in investment leads to a multiple increase in national income. When investment increases, it increases the income of some people. These people spend a part of their increased income (the MPC fraction) on consumption, which becomes income for others. This process continues in several rounds, and the total increase in income is many times the initial increase in investment.
4. Question: What is Deficient Demand? Write its two consequences.
   Answer: Deficient Demand refers to a situation where Aggregate Demand is less than Aggregate Supply at the full employment level of output.
   Consequences:
   1. Deflationary Gap: It creates deflationary pressure in the economy, leading to a fall in prices.
   1. Involuntary Unemployment: As output falls due to lack of demand, firms reduce production, leading to unemployment.

C. Long Answer Questions (5 Marks)

1. Question: Explain the determination of equilibrium income with the help of a hypothetical schedule and diagram.
   Answer: According to Keynesian theory, equilibrium income is determined at the level where Aggregate Demand (AD) equals Aggregate Supply (AS).
   Assumptions:
   1. AD = C + I
   1. AS = Y (since income generated is either consumed or saved)
   1. Equilibrium Condition: AD = AS or Y = C + I

Hypothetical Schedule: (Assuming C = 40 + 0.8Y and I = 60)

Explanation: The table shows that when income is 500, Aggregate Demand (500) equals Aggregate Supply (500). Thus, 500 is the equilibrium income. If income is less than 500 (e.g., 400), AD > AS, which will encourage producers to increase output. If income is more than 500 (e.g., 600), AD < AS, which will lead producers to cut back on production.

(For the diagram, refer to Figure 4.6 in the textbook, which shows the AD and AS curves intersecting at point E to determine the equilibrium income.)

• Question: What is an investment multiplier? Explain its working with the help of an example.
  Answer: The investment multiplier is the ratio of the change in national income to the change in investment. It shows that an initial increase in investment leads to a manifold increase in income.
  Formula: k = ΔY / ΔI = 1 / (1 – MPC) Working Mechanism:
  Let’s assume there is a new investment of Rs 100 crores (ΔI = 100) and the MPC is 0.8.
  • Round 1: The investment of Rs 100 cr becomes income for the people involved.
  • Round 2: These people will spend 80% (the MPC) of this new income, i.e., Rs 80 cr, on consumption. This Rs 80 cr becomes income for another group of people.
  • Round 3: This second group will spend 80% of their new income, i.e., Rs 64 cr (80 × 0.8), and so on.
    This process continues in successive rounds.
    The total increase in income (ΔY) will be the sum of this geometric series: 100 + 80 + 64 + …
    Using the formula:
    ΔY = ΔI × [1 / (1 – MPC)] = 100 × [1 / (1 – 0.8)] = 100 × 5 = Rs 500 crores.
    Thus, an initial investment of Rs 100 crores leads to a total increase in income of Rs 500 crores.