CHAPTER:4 DETERMINATION OF INCOME AND EMPLOYMENT

Choose the correct answer (one mark)

1.Consumption which is independent of income is called
a)Induced consumption
b)Autonomous consumption
c)Wasteful consumption
d)Past consumption
2.Value of MPC lies between
a)1 and 2
b)0 and 1
c)2 and 4
d)0 and 0.5
3.The point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be
a)Equilibrium
b)Excess demand
c)Disequilibrium
d)Excess supply
4.Easy availability of credit and encourages
a)​Saving
b)Investment
c)Rate of interest
d)None of the above
5.In the situation of excess demand
a)Demand is less that the level of output
b)Demand is more than the level of output
c)Supply is less than the level of output
d) Supply is more than the level of output
Fill in the Blanks (one mark)
1.cY shows the dependence of consumption on ​income​.
2.Savings is that part of income that is ​not consumed.
3.Average Prospensity to Consume (APC) is the consumption ​income​ (APC = C/Y)
4.​Investment​ is defined as the addition to the stock of physical capital.
5.Size of the multiplier depends on the value of ​C​. (C = MPC)
6.​ī ​is a positive consonant which represents the ​autonomous​ investment in the economy.
Match the following (one mark)
(Already matched)

A B

1.Savings a.Y-C

2.Raw material b.Intermediate good

3.Consumption c.APC (Average

per unit of income Prospensity to
 Consume)

4.Aggregate d.​c̄ + ī = c Y
demand

5.Excess demand e.Leads to the rise

in the prices in the
long run for final
goods.

Answer the following questions in a word/sentence (one mark)

1.Write the meaning of autonomous consumption.
Ans. ​When the consumption is independent of income, it is called autonomous consumption.
If consumption takes place even when the income of the consumer is zero, it is because of
autonomous consumption. Autonomous consumption is deducted by c̄.
2.Give the meaning of Marginal Prospensity to Save (MPS)
Ans. ​Marginal propensity to save MPS is the rate of change in saving as income increases.
MPS = ∆S/∆Y =S
3.Define Average Prospensity to Save (APS).
Ans. ​Average propensity to save (APS) is the savings per unit of income.
APS = S/Y
4.Write the meaning of full employment level of income.
Ans. ​Full employment level of income is that level of income where all the factors of production
are fully employed in the production process.
5.Mention to Fiscal variables which influence aggregate demand.
Ans. ​Ex-ante consumption and Ex-ante investment.
6.Write the formula of MPC
Ans. ​MPC = ∆C/∆Y = C
Answer the following questions in about 4 sentences (two marks)
1.Write the meaning of excess demand and deficient demand.
Ans. ​Excess demand:​ If the equilibrium level of output is more than the full employment level.
Demand is more than the output produced at full employment level. This situation is called
Excess Demand.
Deficient demand:​ If the equilibrium level of output is less than the full employment level.
Demand is not enough to employ all factors of production. This situation is called Deficient
Demand.
2.Give the meaning of Investment Multiplier. Write it's formula.
Ans. ​The ratio of the total increment in equilibrium value of final goods output to the initial
increment in autonomous expenditure is called Investment Multiplier.
Investment Multiplier = ∆Y/∆A = I/ I-C = I/S
3.Give the meaning of paradox of thrift.
Ans. ​If all the people of the economy increase their proportion of savings then total savings in
the economy will either reduce or remain the same.
Because when people become more thrifty, they end up saving less or same as before. This is
called as Paradox of Thrift.
4.What are the fiscal factors which cause the Aggregate demand?
Ans. ​This fiscally factors which cause the aggregate demand are Tax and Government
Expenditure.
Answer the following in 12 sentences each (four marks)
1.Give the meaning of aggregate demand function. How can it be obtained graphically?
Ans. ​Aggregate demand function is the total demand made up of consumption and investment
at each level of income.
Aggregate demand = c̄ +ī +cY
Graphically, the aggregate demand function is obtained by vertically adding the consumption
and investment function.

Here, OM = c̄
OJ = ī
OL = c̄ + ī
OX access measures income
OY axis measures aggregate demand
From the diagram we can understand that consumption is positive function of income, C is
always positive even at zero level income.
I is autonomous investment which is not influenced by income.
AD is sum of consumption and investment and has a positive slope.
AD curve is parallel to consumption curve, both have the same slope 'c'.
2.Briefly explain consumption function.
Ans. ​Consumption function describes the relation between consumption and income.
Consumption function assumes that consumption changes at it a constant rate as income
changes. But, even if income is zero, consumption takes place. This level of consumption is
independent of income, it is called autonomous consumption.​ Equation of consumption
function:
C = c̄ + cY
Where,
C = consumption expenditure by households, it consists of two components
c̄ = autonomous consumption
cY = induced consumption
Autonomous consumption is independent of income because consumption takes place even
when income is zero.
Induced consumption cY shows the dependence of consumption (c) on income (Y)
When income rises, induced consumption
rises by MPC i.e.
MPC is the rate of change in consumption as income changes.
Answer the following questions in about 20 sentences (six marks)
1.Explain the effect of an autonomous change in aggregate demand on income and output.
Ans. ​Equilibrium level of income depends on aggregate demand. If aggregate demand
changes, the equilibrium level of income changes.
This can happen in the following situations:
1. Change in consumption:​ this happens due to change in c̄ and change in C (MPC)
2. Change in investment​: we have assumed that investment is autonomous. It means that it
does not depend on income. But it will be affected by availability of credit and interest
rate.

When autonomous investment increased AD​1 shifts​ to AD​2

The value of aggregate demand at output Y​1​ is Y​1​F which is greater than the value of output
OY​1 = ​ Y​1​F by an amount E​1​F
E​1​F measures the amount of excess demand due to increase in autonomous expenditure.
E​1​ is no longer equilibrium.
New equilibrium will be at point E​2​, where new aggregate demand AD​2 ​ intersects the 45° line
and the new equilibrium value output is Y​2
In the new Equilibrium, output and aggregate demand E​2​G =E​1​G is greater than the initial
increase in autonomous expenditure E​1​F
Thus, an initial increase in autonomous expenditure cancel multiplier effect on the equilibrium
values aggregate demand and output.
2.Explain the supply side of macroeconomic equilibrium.
Ans. ​In macroeconomics, we assume price level as fixed.
Resources of all types are unused.
Whatever is the level of GDP, that much will be supplied, and prices have no role to play as
shown in the diagram.

This 45° line means whatever may be the level of GDP (supply of goods) price level (demand)
has no role to play on the supply curve.
Equilibrium​ is it a point where ex-ante aggregate demand is equal to ex-ante aggregate supply.
Equilibrium point is E and equilibrium level of income is OY​1
Equilibrium; ex-ante aggregate demand = ex-ante aggregate supply.
i.e. ​ī + c̄ + cY = Y
Y(I - C) = c̄ + I
Y = c̄ +ī/(I - c)
3.Explain the multiplier mechanism.
Ans. ​If with increase and investment, income increases multiple times, it is known as forward
multiplier. Multiplier mechanism works on the principle that more the consumption expenditure,
more will be the income generated.
The multiplier process works on the basis of the following principles:
a) Investment generates income.
b) Additional income causes change in consumption.
c) Change in consumption depends on MPC.
d) Additional consumption expenditure genrates additional income for producers of goods
and services.
e) This process keeps repeating till the total increase in income is equal to the product and
the change in output.
Illustration:​ The concept of investment multiplier mechanism can be understood as follows.
Let us assume that an economy makes its investment of 10 units and MPC is 0.8. Let us
remember that National Income is equal to aggregate value of final goods and the value of final
output is distributed among factors of production- wages to labour, rent to land, interest to
capital and whatever remains is profit of the organiser.
When the 10 units of investment leads to the creation of 10 units of output, it gets distributed
among various factors as factor payments and hence income of the economy goes up by 10.
When income increases by 10, consumption expenditure goes up by (0.8) 10. Since MPC is 0.8.
Thus, in the next aggregate round aggregate demand increases by (0.8) 10, as a result
producers increases their planned output (0.8) 10 to restore equilibrium. When this extra output
is distributed among factors the income of the economy again goes up by (0.8) 10 and
consumption demand increases further by (0.8)​2​10.
This process goes one round after round and finally with a change in the autonomous
expenditure of 10 units, the change in equilibrium is equal to 50 units i.e.
10 + (0.8) 10 + (0.8)​2​ + ………... + ∞
= 10 [1 + (0.8) + (0.8)​2​ +.............+ ∞
10 and 0.8 represents the value of ​∆ī = ∆Ā ​and MPC
Thus, ​Investment Multiplier = ​ ​∆Y/∆Ā =I/I-c = I/S
4.Discuss the paradox of thrift.
Ans. ​Paradox of Thrift states that when all the people of the economy increase their savings.
The value of the savings in the economy will not increase.
The total value of the savings in the economy will either decline or remain unchanged.
For example, if the savings increase (MPS), then the consumption expenditure will fall resulting
in the decrease of employment and income level.
This will ultimately reduce the savings of the country.
Thus, increase in MPS will reduce the aggregate demand which in turn leads to excess supply.
Producers reduce production and factor income falls. Fall in factor income reduces consumption
expenditure, the process continuous and gradually leads to slow down of the economy.