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CHAPTER 4
DETERMINATION OF INCOME AND EMPLOYMENT

Part 1: Aggregate demand, aggregate supply and their components

TO DO:
❖ 4.1 Aggregate Demand and It’s Components
❖ 4.2 Aggregate Supply and It’s Components
❖ 4.3 Consumption Demand
❖ 4.4 Consumption Function
❖ 4.4 Propensity to Consume
1. Average Propensity to Consume
2. Marginal Propensity to Consume
❖ 4.5 Savings Function
❖ 4.6 Propensity to Save
1. Average Propensity to Save
2. Marginal Propensity to Save
❖ 4.7 Relationship between MPC and MPS
❖ 4.8 Relationship between APC and APS
❖ 4.9 Investment Demand
❖ 4.8 Investment Demand
4.1 AGGREGATE DEMAND AND IT’S COMPONENTS –

4.1.1 Introduction
Aggregate demand in an economy is measured in terms of total expenditure on all the
goods and services in the economy as a whole (It is different from market demand. Market
demand refers to the demand for one commodity in the market)

Note: While measuring AD we always refer to planned expenditure (also called ex- ante
expenditure) by the people.

4.1.2 Components of aggregate demand –

The components of aggregate demand are –

1) Private consumption demand (C) – It refers to the total amount of expenditure incurred
by the households on the purchase of goods and services for consumption purposes.

It is also called as the household consumption expenditure. Generally it depends on the level of
disposable income in the economy. Higher the level of disposable income higher is the private
consumption expenditure and vice versa.

2) Private Investment demand (I) - It refers to the total amount of expenditure incurred by
the private investors on currently produced capital assets/ real assets like buildings,
machines, raw materials etc. which help in production.
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Investment implies increase in the stock of capital goods or capital formation (Investment =
Capital formation) Rate of interest is the principal determinant of investment. Higher rate of
interest generally implies lower investment expenditure.

3) Government expenditure (G) – Government demand for goods and services refers to the
total amount of expenditure incurred by the government on the purchase of consumer and
capital goods to cater to the common needs of the society.

Government expenditure thus includes both government consumption expenditure and

government investment expenditure.Government consumption expenditure is like expenditure on
purchase of consumption goods for military use. Government investment expenditure is like
expenditure on construction of roads, dams, bridges etc. Investment expenditure by the
government is generally not profit oriented. Social welfare is the prime consideration. Such an
investment is called autonomous investment or independent investment.

4) Net Exports (x – m) – It is the difference between exports and imports.

Exports refer to the demand for domestically produced goods by the rest of the world. Imports
refer to the demand by our residents for the goods produced abroad.

Accordingly, expenditure by foreigners on our goods is added to AD (or total expenditure) in the
economy, while expenditure on imports is subtracted. Thus, it is x – m (net exports) which is
added to AD.

Expenditure on imports is determined by the income level of our residents, while expenditure on
our exports is determined by the income level of the rest of the world. Relative prices (i.e. price
of exports in relation to imports) are also another determinant of net exports.

Thus AD can be estimated as follows

AD = C + I + G + (x – m)

(Important Note: Keynes considers just 2 principal components of AD. According to Keynes
AD is the sum total of C and I. Keynes focused on closed economy with no exports/imports.
According to Keynes AD = C + I)

4.1.3 Behavior of AD or aggregate demand function –

Aggregate demand depends upon the level of income. Greater the level of income, greater the
purchasing power and therefore, greater the demand. So, as the income increases, aggregate
demand tends to rise. But two things need to be noted here –

1) There is always some minimum level of demand even when income is zero. Because for
survival, we must eat something, and so demand something even when we have to
borrow from others or draw on our past savings. This is called as autonomous
consumption
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2) As income rises demand also rises, but after a particular level of income is reached
people start saving a part of their income. So the expenditure tends to lag behind the
rising income. In other words the rate at which the income increases exceeds the rate at
which expenditure increases.
Diagram

Give the meaning of aggregate demand. (Delhi 2010)

4.2 AGGREGATE SUPPLY AND IT’S COMPONENTS –

4.2.1 Introduction

According to Keynes, aggregate supply (AS) refers to aggregate production as planned by the
producers during an accounting year. It is the money value of final goods and services or
national product produced in an economy during an accounting year.

We know, production of goods and services implies ‘value addition’, and value addition implies
‘income generation’. According to National Income Accounting ‘value added and ‘income
generated’ are identical to each other. Therefore, AS also implies flow of income in the economy
during an accounting year.

We can thus define AS as flow of goods and services as planned by the producers during an
accounting year. It is identical with the flow of income during an accounting year.

AS refers only to planned production. It is also called ex – ante production.

According to Keynes AS is determined by (i) level of employment of resources and (ii) Level of
technology. But in short run technology remains constant. Therefore level ofemployment is
taken as the sole determinant of the level of production. In fact level of employment and
level of production are taken as identical to each other.

Keynes assumes AS to be perfectly elastic. It means that production in the economy always
adapts itself to the level of AD. If the level of AD is high, production tends to be high; if the
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level of AD is low, production tends to be low. This is possible becauseKeynes assumes that
in the economy resources are often not fully employed. So long as resources are available,
they can be employed to cope with the level of AD in the economy.

Geometrically, AS is shown as a 45 degree line from the origin. This is because, each point on
AS shows the same vertical distance as horizontal distance on X axis, showing the level of
income

45 degree line is also the line of reference showing the equality between AD (on the Y axis)
and AS (on the X axis)
Diagram

4.2.2We can sum up AS as follows –

1) AS is the flow of goods and services as planned by the producers during an accounting
year. It is identical with the flow of income during an accounting year.

2) AS refers only to planned production. It is also called ex – ante production.

3) Level of employment is taken as the sole determinant of the level of production. In fact
level of employment and level of production are taken as identical to each other.

4) Keynes assumes AS to be perfectly elastic.Production in the economy always adapts itself to

the level of AD

5) This is possible because Keynes assumes that in the economy resources are often not fully
employed

6) Geometrically, AS is shown as a 45 degree line from the origin

7) 45 degree line is the line of reference showing the equality between AD (on the Y axis) and
AS (on the X axis)

Give the meaning of aggregate supply. (AI 2009)

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4.2.3 Components of AS –

AS implies level of income (Y) in the economy. Therefore Keynes has split AS into 2
components –
1) Consumption (C)
2) Savings (S)

AS = Y = C + S

4.3 CONSUMPTION DEMAND – Consumption demand is defined as the value of goods and
services that households are able and willing to buy at a particular time. It depends on many
variables such as price of goods and services, income, wealth, tastes and preferences, expected
income etc.

4.4 CONSUMPTION FUNCTION

It is the relationship between consumption and income

C = f (Y)

The consumption function of a society is determined by several factors –

1) Rate of interest
2) Level of prices
3) Income distribution
4) Size of population

Consumption function can be represented by following equation –

_
C = C + by

Where –

C = Consumption
_
C = Autonomous Consumption

b= Marginal Propensity to Consume (MPC)

y = Level of income

The slope of the consumption function is ‘b’. It measures the rate of change in consumption
per unit change in income (MPC)

Autonomous consumption –It is the consumption expenditure when income is zero. It

_
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is denoted by C and is always greater than zero.

Marginal Propensity to Consume - It is the change in consumption per unit change in income.
MPC = ∆C / ∆ Y

MPC is greater than zero and less than one. MPC cannot be greater than 1 because change in
consumption cannot be more than change in income.

Break Even Point -This is the point where households’ consumption is exactly equal to income.
C = Y so saving is 0 here.

Dissaving – When households’ consumption exceeds income the households liquidate their
assets or ask for loans. This is the process of dissaving.
Give the meaning of autonomous consumption. (Delhi 2009, Foreign 2009)

Consumption Function Schedule –

Keynes in his famous psychological law of consumption states that as income increases
consumption also increases but less than proportionately. There is also some minimum level of
demand even when income is zero

The relationship between consumption and income is called as the consumption function.
Consumption function can be represented by following equation –
_
C = C + by

Based on these observations we can explain the consumption function through the following
schedule and diagram.

Consumption Function Schedule

Income (Rs Crores) Consumption (Rs Crores)

0 20
10 25
20 30
30 35
40 40
50 45
60 50

The above table shows that –

1) Consumption expenditure is Rs 20 Crores even when income is zero. This corresponds to the
minimum level of demand.
2) Consumption expenditure rises with every rise in the level of income.
3) After a certain level of income is reached (Rs 40 Crores) aggregate demand lags behind the
level of income. Consumption expenditure remains only Rs 45 Crores while income becomes Rs
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50 Crores. Likewise, Consumption expenditure rises only to Rs 50 Crores while income shoots
up tot Rs 60 Crores.
Diagram

In the above diagram income is represented on OX axis andConsumption expenditure on OY

axis

If C was to increase at the same rate as Y or if C was always equal to Y then C curve would have
merged with the Y curve. Both curves would have been the same. But it is never like that. C
starts from 20 on the Y axis indicating minimum level of consumption even when income is zero
(autonomous consumption)

With reference to the above diagram, we may note the following observations –

1) OC is the minimum level of consumption. It must be incurred even when income(Y)=0

because survival needs consumption
2) CC line or consumption function line constantly moves up showing a rise in consumption
as income rises
3) C = Y at point E, which therefore is the break even point.
4) Beyond point E, C falls below Y. This suggests that after a particular level of income is
reached, people save a part of their income. Hence before point E, C is above Y or above
45 degree line and after point E, it is below Y
5) Prior to E, C >Y: a situation of borrowing or negative saving. After point E,
C<Y: a situation of positive saving
6) The amount of saving and dissaving is measured by the vertical distance
between the consumption function and the 45 degree line Y.

4.4 PROPENSITY TO CONSUME –

Propensity to consume shows the level of consumption at different levels of income in an

economy. It means the ratio between consumption and income.
It has two aspects –
1) Average Propensity to Consume (APC)
2) Marginal Propensity to Consume (MPC)
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PROPENSITY TO CONSUME

Average Marginal
Propensity to Propensity to
Consume Consume

APC = C /Y MPC =∆C/∆Y

4.4.1 Average Propensity to Consume –

It is the ratio between total consumption (C) and total income (Y) at a given level of income
in an economy. It is the proportion of income that is consumed.

APC = C/Y

For example, if income (Y) is 100 and consumption (C) is 80, then APC will be-

APC = C/Y = 80/100 = 0.8 or 80 pre cent

This indicates that at any given level of employment in an economy, 80 % of income is spent by
way of consumption expenditure.

(APC can be greater than 1 in a situation when C>Y.)

4.4.2 Marginal Propensity to Consume –

It is the ratio between changes in Consumption (∆C) to a change in Income (∆Y). It is

denoted as follows –

MPC =∆C/∆Y

For example, if income of a country increases from Rs 1000 Crores to Rs 1,200 Crores and the
consumption expenditure increases from Rs 800 Crores to Rs 900 Crores then it means the
change in income by Rs 200 Crores has caused change in consumption expenditure by Rs 100
Crores. MPC will therefore be –

MPC =∆C/∆Y = 100/200 = 0.5 or 50%

Generally MPC is greater than 0 and less than 1. MPC can not be greater than 1 because
change in consumption can not be more than change in income. The part of increase in
income which is not consumed is equal to saving.
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4.5 SAVINGS FUNCTION:-

Saving function expresses the relationship between the level of saving and the level of
income. Income is either spent on consumption or it is saved i.e. Y = C+S

Saving is defined as the excess of income over consumption expenditure.

Therefore S = Y – C

Savings function is the counterpart of consumption function. It relates to the level of savings to
the level of income.

S = f(Y)

As income increases so does savings. Savings how ever can be both positive and negative.

Savings function can be expressed with the help of the equation given below –
_ _
S = -C + (MPS) Y OR S = - C + (1-b) Y

Where Where, (1-b) = MPS

S = Savings
_
-C = Dissavings at zero level of income
Y = Income

Savings function can be explained with the help of the following schedule and diagram-

Savings Function

Income(Rs) Consumption Savings (Rs)

Expenditure(Rs)
0 50 (-) 50
100 100 0
200 150 50
300 200 100
400 250 150
500 300 200
Diagram
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1) In the above diagram, savings function is a straight line beginning on Y axis below the origin.
At 0 level of income saving is negative. This is because consumption at 0 level of income is
positive (autonomous consumption)

2) The savings function intersects the X axis at point E. At this point savings is equal to zero
because consumption is exactly equal to income. This is the break even point.

3) At any point to the left of E, there is dissaving because consumption is greater than income

4) At any point to the right of E, there is positive saving as consumption expenditure is less than
income.

4.6 PROPENSITY TO SAVE –

Propensity to save may be defined as a schedule showing amounts that will be saved at
different levels of income.

Propensity to save has 2 aspects –

1) Average Propensity to Save (APS)
2) Marginal Propensity to Save (MPS)

PROPENSITY TO SAVE

Average Marginal
Propensity to Propensity to
save save

APS = S /Y MPS =∆S/∆Y

4.6.1 Average Propensity to Save (APS) -

It is the ratio between total saving (S) and total income (Y) at a given level of income and
employment in the economy.
It can be expressed as follows –
APS = S/Y

For example if Income (Y) is Rs 100 and saving is Rs 40, then

APS = S/Y = 40/100 = 0.4

This indicates that at a given level of income in an economy, 40% of income is saved. It implies
that 60% of income is consumed.
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4.6.2 Marginal Propensity to Save (MPS) -

It is the ratio between change in saving (∆S) caused by change in income (∆Y). It can be
expressed as follows –
MPS = ∆S / ∆Y

For example if income Y rises from Rs 100 Crores to Rs 200 Crores and consequently saving S
rises from Rs 20 Crores to Rs 80 Crores then change in income = Rs 100 Crores (200 – 100 =
100) and change in saving = Rs 60 Crores(80 – 20 = 60). MPS will therefore be –

MPS = ∆S / ∆Y = 60/100 = 0.6 or 60%

It indicates that 60% of additional income is saved.

Give the meaning of marginal propensity to save. (AI 2010)

4.7 RELATIONSHIP BETWEEN APC AND APS -

1) Average Propensity to Consume (APC) –

It is the ratio between total consumption (C) and total income (Y) at a given level of income in
an economy. It is the proportion of income that is consumed.
APC = C/Y

2) Average Propensity to Save (APS) –

It is the ratio between total saving (S) and total income (Y) at a given level of income and
employment in the economy.
It can be expressed as follows –
APS = S/Y
We know that –
3) APC = C/Y
4) APS = S/Y

We also know that –

5) Y = C + S

So,
6) APC + APS = [C/Y + S/Y]
=C+S/Y
= Y/Y = 1

Or
7) APC + APS = 1
Or
APC = 1 – APS
And
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APS = 1 - APC

4.8 RELATIONSHIP BETWEEN MPC AND MPS –

1) Marginal Propensity to Consume (MPC) –

It is the ratio between changes in Consumption (∆C) to a change in Income (∆Y). It is denoted
as follows –
MPC =∆C/∆Y

2) Marginal Propensity to Save (MPS) –

It is the ratio between change in saving (∆S) caused by change in income (∆Y).
It can be expressed as follows –
MPS = ∆S / ∆Y

We know that
3) MPC =∆C/∆Y
And
4) MPS or (1-b) = ∆S / ∆Y

We also know that

5) ∆Y = ∆C + ∆S

So,
6) MPC +MPS = ∆C/∆Y + ∆S / ∆Y
= ∆C + ∆S / ∆Y
= ∆Y/∆Y = 1

Or
7) MPC +MPS = 1
Or
MPC = 1 – MPS
And
MPS = 1 – MPC
Generally MPC is greater than 0 and less than 1. MPC can not be greater than 1 because change
in consumption cannot be more than change in income. The part of increase in income which is
not consumed is equal to saving. Thus, the aggregate of Marginal Propensity to Consume and
Marginal Propensity to Save is equal to unity. If half of the increase in income is spent on
consumption, then -
MPC = ½
Therefore
MPS = 1 – MPC i.e.1 – ½ = 0.5

Draw a diagram showing straight line Savings curve for an economy. From it derive the
Consumption curve. Show a point on the Consumption curve at which Average Propensity to
consume is equal to 1.
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Diagram

1) In the above diagram, savings function is a straight line beginning on Y axis below the origin.
At 0 level of income saving is negative. This is because consumption at 0 level ofincome is
positive (autonomous consumption)OC is the minimum level of consumption. It must be
incurred even when income(Y) =0 because survival needs consumption

2) The savings function intersects the X axis at point L. At this point savings is equal to zero
because consumption is exactly equal to income. Consumption curve CC passes through the
income curve Y. At point E, C = Y. This is the break even point.

3) Prior to point E, C>Y: a situation of borrowing or negative saving

4) After point E, C<Y: a situation of positive saving.

Average Propensity to consume = C/Y

APC = 1 when consumption is equal to income i.e. C=Y. This occurs at point E where saving =
0.
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4.9 INVESTMENT DEMAND-

Investment refers to the total amount of expenditure incurred by the producers on the
purchase of capital assets/ real assets like buildings, machines, and raw materials etc. which
help in production.

Investment is an addition to capital stock. It is therefore also known as capital formation.

4.9.1 Types of Investment

Investment is of two types –
1) Induced Investment
2) Independent or Autonomous Investment

1) Induced investment - It is positively related to the level of income. It increases with the
increased level of income

At higher level of income, consumption expenditure will be higher. This raises the expected
profitability of the producers who are induced to make greater investments due to increased
level of demand.

2) Independent or Autonomous Investment – It is not influenced by expected profitability

or level of income. It is an investment expenditure incurred by the government to promote the
level of aggregate demand in the economy. It is undertaken to promote social welfare. It is not
influenced by profitability or the level of income.
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4.9.2 Three important elements/ determinants of investment –

1) Expected returns or revenue form investment – An investment is undertaken only if it

generates additional revenue. Investment will not be done if it is not profitable. It is undertaken
on the basis of expected demand or expected returns to the producers. Investment is undertaken
in anticipation of future demand.

2) Cost of investment – It has three components -

i) Cost of purchase of equipment, also called the supply price of equipment
ii) Cost of maintenance of equipment, also called depreciation
iii) Cost of funds borrowed for investment, also called the interest rate.
3) Business expectations – Investment is present expenditure for future gains. But future is
uncertain. Therefore business expectations become significant for investment

Businessmen may have –

i) Bearish expectations, implying that they expect the prices to go down in the near future
ii) Bullish expectations, implying that they expect the prices to go up in the near future
Bullish expectations attract more investment

Question Bank

1) Find out the marginal propensity to consume from the following data
Income (Rs) Consumption (Rs)
1,000 1,500
2,000 2,000

Answer:
Income Change in Consumption Change in
(Rs) Income(Rs) (Rs) Consumption(Rs)
(∆Y) (∆C)
1000 - 1500 -
2000 2000- 1000 = 1000 2000 2000-1500 =500
MPC = ∆C/∆Y = 500/1000 = 0.5

2) Find the MPC from the following

Income (Rs) Saving (Rs)
100 60
200 100

Answer: MPC = 0.6

Income Change in Saving Consumption Change in
(Rs) Income(Rs) (Rs) (Rs) Consumption(Rs)
(∆Y) (∆C

3) Find MPC and APC from the following

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1) Initial consumption – Rs 4000

2) Consumption after increase in income – Rs 5000
3) Income at the beginning of the year – Rs 10,000
4) Income at the end of the year – Rs 15,000
(Answer – MPC = 0.2 APC = 0.4 on initial income)

4) Calculate MPS from the following

Income (Rs) Consumption expenditure (Rs)
2000 300
4000 1300
(Answer- 0.5)

5) From the table given below, find APC and MPC

Income (Rs) Consumption (Rs) APC(Rs) MPC(Rs)
50 40 - -
100 65 - -
150 75 - -
(Answer- APC= 0.8, 0.65, 0.5 MPC= 0.5, 0.2)
6) Calculate MPC and MPS from the following
Income (Rs) 150 200
Consumption (Rs) 130 170
(Answer – MPC = 0.8 MPS = 0.2)

7) Complete the following table

Level of income Consumption MPC MPS
(Rs) Expenditure (Rs) (1 –MPC)
400 240
500 320
600 395
700 465
(Answer- MPC= 0.80, 0.75, 0.70 & MPS= 0.20, 0.25, 0.30)

8) (i) How much is the MPC in an economy in which the MPS is 0.3
(ii) How much is the MPS in an economy where the MPC is 0.8
Answer:
(i) MPC = 1 – MPS
= 1 – 0.3 = 0.7
(ii) MPS = 1 – MPC
= 1 – 0.8 = 0.2

9) If the disposable income is Rs 1000 Crore and consumption expenditure is Rs 750 Crore, find
the APS.
Answer:
S=Y–C
Rs 1000 Crore – Rs 750 Crore = Rs 250 Crore
APS = S/Y = 250/1000 = 0.25
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10) What is the value of MPC when MPS is zero?

Answer: MPC = 1

11) Out of APC and MPC, the value of which can be greater than 1 and when?
Answer: APC can be greater than 1 in a situation when C > Y

12) What can be the maximum value of MPS?

Answer: The maximum value of MPS can be 1(one)

13) Why can MPC not be greater than 1?

Answer: It is because the change in consumption can not be greater than change in income.

14) Suppose consumption equals C = 40 + 0.75Y, Investment equals I = Rs 60 and Y = C + I.

Find – (i) the equilibrium level of income (ii) Level of consumption (iii) Level of saving at
equilibrium
Answer:
(i) Y = 40 + 0.75y + 60
_
Y = C + by + I
Y – 0.75 = 100
0.25Y = 100
Y = 100x100/ 25 = 400
Y = 400

(ii) C = 40 + 0.75y
C = 40 + 0.75(400)
C = 340
_
(iii) S = - C + (MPS)y
S = -40 + (0.25) y
S = -40 +0.25(400)
S = -40 + 100
S = 60

15) Complete the given chart and determine the equilibrium level of income
Aggregate Consumption Saving (Y-C) Investment Aggregate
Supply (Y) Demand (C+I)

100 140 40
200 220
300 300
400 380
500 460
600 540
700 620
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800 700
900 780
(Answer- Saving = (-) 40, (-) 20, 0, 20, 40, 60, 80, 100, 120 &Aggregate Demand = 180, 260,
340, 420, 500, 580, 660, 740, 820)

16) Suppose consumption function C = 20 + 0.50Y, investment equals I = 50 and Y= C+I

Find – (a) The equilibrium level of income (b) Level of consumption at equilibrium
(c) Level of savings at equilibrium
(Answer- (a) Y=140 (b) C=90 (c) S=50)
Note
Y=C+I
_
C = C+by
_
S = - C+ (MPS) y

17) Suppose the planned saving function is S = -50 +0.2y and intended investment is
Rs 100.Find the equilibrium level of income.
(Answer – Y = Rs 750)

18) If planned consumption equals 40 + 0.9y and planned investment is Rs 50, find the
equilibrium level of income
(Answer – Y = Rs 900)

19) If saving function is S = - 15 + 0.15y and planned investment is Rs 75, find the equilibrium
level of income and savings
(Answer – Y = Rs600, S = Rs 75)
Note-Remember equilibrium condition is S= I

Giving reasons, state whether the following statements are true or false:- (Delhi, AI, Foreign 2010)
a) The value of MPS can never be negative
b) APS is always greater than zero
c) APS can never be less than zero
d) When APS is negative, MPS will also be negative.
e) Sum of APC and MPC is always equal to one.
f) The value of APS can never be greater than one
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Part 2: Determination of Equilibrium Level of Income, Employment & Output

TO DO:
❖ 4.10 AD- AS Approach
❖ 4.11 S-I Approach
❖ 4.12 Simultaneous Equality between AD and AS

The determination of equilibrium level of output, income and employment can be explained by
adopting two different approaches –

4.10 CONSUMPTION- INVESTMENT APPROACH - (AD – AS Equilibrium)

Explain the theory of determination of equilibrium level of income and employment with the
help of AD and AS curves

Explain the equilibrium level of income/output/employment with the help of C + I approach.

Can there be unemployment at equilibrium level of income explain.

In the Keynesian framework, C + I function (or AD function) is shown as upward sloping

curve parallel to the C function. State the principal reason.

Why must AD be equal to AS at the equilibrium level of income and output. Explain with the
help of diagram and schedule. What happens when the two are not equal?

The economy in equilibrium when Aggregate Demand (AD) represented by C + I curve is equal
to total output or Aggregate Supply (AS). It can be explained with the help of a schedule and
diagram given below –

Income Level of Consumption Investment Savings AD AS(C+S)

(Rs Employment (C) (I) (S) (C+I)
Crores) ( Thousand
workers)
0 0 10 10 (-)10 20 0
10 10 15 10 (-) 5 25 10
20 20 20 10 0 30 20
30 30 25 10 5 35 30
40 40 30 10 10 40 40
Under Equilibrium
employment
50 50 35 10 15 45 50
60 60 40 10 20 50 60
(Full
Employment)
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Diagram

In the above diagram:-

1) C is the consumption function. It shows the desired level of consumption at different levels
of income.

2) I is the desired investment which is constant at all levels of income (Autonomous

Investment)

3) The C+I curve i.e. AD curve shows the desired spending in the economy.
• AD curve is parallel to the Consumption function Cbecause investment i.e. I is
constant. (Note: We assume that there are only 2 sectors in the economy i.e. households
and firms. Therefore AD = Consumption demand + Investment demand only)
• The gap between the C and AD curve is equal to the value of investment i.e. I.
• Since C + I > C, therefore C + I function (AD) is drawn above the C function.

4) The Aggregate Supply curve i.e. AS curve is a 45 degree line.

• AS = Consumption +saving
• AS curve shows the flow of goods and services in the economy.
(Note: AS or output is also equal to the flow of income in an economy. Therefore we can say AS
= Flow of goods and services = flow of income = Consumption +Savings. Or we can say AS = Y
= C+S)
• At any point on the 45 degree AS line, the Aggregate Demand i.e. AD (measured
vertically) equals the total level of output i.e. AS (measured horizontally). In other words
the 45 degree line shows the equality between aggregate demand and aggregate
supply.

EQUILIBRIUM POSITION:-
 P a g e | 21

1) The economy is in equilibrium at point E where aggregate demand curve intersects the
45 degree line i.e. aggregate supply curve.
2) It is in equilibrium because the desired level of spending = total level of output. This is the
point of equality between AD and AS.
3) In such a situation all that is producedin the economy is fully purchased. The producers
do not suffer –
1) The burden of unwanted supplies (unsold stocks)
2) The loss of unfulfilled demand (due to lack of stocks)
In the schedule and the diagram the equilibrium point is at the output level of 40 Crores. The
aggregate demand is also 40 Crores and the employment is 40 Lakhs.

DISEQUILIBRIUM POSITIONS:-
At any other level of output there is disequilibrium which can be in the form of following two
situations –

1) Planned output is greater than planned spending –(AS>AD) –

• In this situation AD curve lies below the AS curve.
• This implies that planned spending is less than the planned output.
• The producers would not be able to sell all the produced goods leading to an unplanned
increase in inventories (goods remain unsold).
• The firms would respond by reducing employment and output till the economy is back
in equilibrium at point E.
• This situation arises when the output level is 50 Crores.

2) Planned output is less than planned spending – (AS<AD) –

• In this situation AD curve lies above the AS curve.
• This implies that planned spending is more than the planned output.
• Producers would respond by selling their stocks resulting in an unplanned decrease in
inventories (existing stocks sold).
• The firms will increase employment and output till the economy attains equilibrium at
point E.
• This happens at the output level of Rs 30 crores.

The above equilibrium has been achieved at less than full employment level. It is termed as
under employment equilibrium.

What is effective demand?

Ans:The particular level of AD which is equal to AS is called effective demand. The economy is
in equilibrium at this level of AD

4.11 SAVING - INVESTMENT APPROACH –

 P a g e | 22

Why should planned savings and planned investment be equal at equilibrium level of income?
Explain with the help of a schedule and a diagram.

In an economy planned savings exceed planned investment or planned investment exceed

planned saving. How will the equality between the two be achieved?

Equilibrium level of output is determined when planned saving = planned investment in an

economy.
The schedule and the diagram given below show the determination of the equilibrium level of
income, output and employment.

Income Level of Consumption Investment Savings AS(C+S)

(Rs Employment (C) (I) (S)
Crores) ( Thousand (Y – C)
workers)
0 0 10 10 (-)10 0
10 10 15 10 (-) 5 10
20 20 20 10 0 20
30 30 25 10 5 30
40 40 30 10 10 40
-50 50 35 10 15 50
60 60 40 10 20 60
(Full
Employment)

Diagram

• Investment is assumed to be constant. It is independent of the level of income and

employment (autonomous investment). Hence investment function is drawn as a horizontal
straight line parallel to X axis.
• Saving function is an upward sloping line beginning on the Y axis with a negative intercept.
(Note: S and I in context of equilibrium are only ex – ante saving and ex – ante investment.
These are not ex – post S and ex – post I)
 P a g e | 23

EQUILIBRIUM POSITION:-
1) In the above diagram, the saving and investment function intersect at point E.
2) At this point planned savings of households = planned investments of the firms.
3) This happens when the output level is 40 crores and employment is 40 lakhs.

DISEQUILIBRIUM POSITION:-
At any other level of output, there is disequilibrium which can be in the form of following two
situations –

1) Planned saving is greater than planned investment (S>I) –

• In this situation, the saving function lies above the investment function.
• Greater savings than investment implies a situation when buyers are not spending to
match the investment plans of the producers.
• As a result some goods will remain unsold. It would lead to an unplanned increase in
inventories.
• To cope with this situation lesser output would be planned for the following year.
• It implies
- lesser investment,
- lesser production,
- lesser income,
- lesser savings.
• This process will continue till S and I match (S =I)

2) Planned saving is less than planned investment (S<I) -

• In this situation, the saving function lies below the investment function.
• It implies a situation where buyers are planning to spend beyond what the producers
are planning to invest.
• As a result output would fall short of demand. It leads to an unplanned decrease in
inventories.
• To cope with stronger demand in the market the producers would plan to increase
output.
• Consequently it would lead to
- greater investment,
- greater production,
- greater income,
- greater savings.
• This process will continue till S and I match (S =I) and the economy in equilibrium at
point E.
 P a g e | 24

4.12 SIMULTANEOUS EQUALITY BETWEEN C + I (AD and AS) AND S +I

APPROACH

Explain the equilibrium level of income with the help of consumption+ investment (C +I)
approach. If planned saving is greater than planned investment, what adjustments will bring
about equality between the two.

Diagram

The above diagram shows equality between AS and AD, as well as between S and I. Equality is
attained at point E when AS= AD, and S=I. OL is the equilibrium level of income, output and
employment.

Equality between AS and AD implies equality between S and I.

In a free economy AS and AD have a tendency to be equal to each other.

Or
S and I have the tendency to be equal to each other.
 P a g e | 25

If AS > AD
If AS < AD Explain from the previous pages (check only these headings)
If S>I
If S<I.

Question Bank

1)Equality between AS and AD implies the equality between S and I. Write equations to
prove this fact.
Answer: Equilibrium level of income and output refers to that level of income and output where,
in the economy as a whole
AD = AS
Since,
AD = C+I
And
AS = C+S
We can say that C is the common factor in both the equations, therefore equilibrium is struck
where
S=I
Thus there are 2 ways of looking at the equilibrium level of income, output and employment in
the economy –
i) AD = AS
ii) S = I

2) Does equilibrium level of income, output and employment necessarily mean full employment
in the economy?
Answer:Equilibrium level of income, output and employment does not necessarily mean
fullemployment in the economy. Equilibrium level of income, output and employment is
simply struck when AS = AD or when S = I .It is that level of output or employment where what
the producers plan to produce (ex – ante output) happens to match with what the buyers plan to
buy (ex – ante expenditure). In a free economy (or a capitalist economy) planned production
and planned expenditure have nothing to do with what happens to the level of employment
in the economy. What the producers plan to produce and what the buyers plan to buy may not
coincide with fuller utilization of resources. There can be underemployment equilibrium also.

Underemployment equilibrium is a situation when equilibrium between AS and AD or

between S and I is struck without achieving fuller employment of resources. Level of output
(AS) and level of expenditure on output (AD) happen to be equal (in a state of equilibrium) even
when resources are yet not fully employed.

For example resources in a country may permit production worth Rs 10 crores. But, with a view
to maximizing profits, the producers plan output worth Rs 5 crores only. Equilibrium will be
struck if buyers also plan expenditure worth Rs 5 crores. Therefore equilibrium can be struck
even though resources are not fully employed. It will be called as underemployment equilibrium
 P a g e | 26

3) When are actual stocks with the producers equal to the desired stocks?
Answer:When AS = AD actual stocks with the producers = desired stocks with the producers.

When AS < AD then actual stock is less than desired stock

When AS > AD then actual stock is more than desired stock

4) Define the following –

1) Full Employment – A situation in which all those who are able to work and are willing to
work at the existing wage rate are getting work.

2)Involuntary unemployment – It occurs in a situation when some people are not getting jobs
even when they are able to work and are willing to work at the existing wage rate.

3) Voluntary employment – It is a situation where a worker is not willing to work at the current
wage rate, even when work is available.

4) Frictional unemployment - It is the temporary unemployment of people who switch over

from one job to another. So, for that period they remain unemployed.

5) Equilibrium situation – All that is produced in the economy is fully purchased or when AS =
AD.

5) Difference between full employment and underemployment equilibrium-

Full Employment Equilibrium Underemployment Equilibrium

1) It refers to a situation where AD = AS
and all the resources in the economy are
fully employed.
2) It is a stable equilibrium and real
output reaches its maximum point
3) Attempt to increase production
beyond full employment equilibrium
causes inflationary gap.
1) ) It refers to a situation where AD = AS
but all the resources in the economy are
not fully employed
2) It is not a stable equilibrium and real
output does not reach its maximum point
3) Attempt to increase production
beyond underemployment equilibrium does
not cause inflationary gap

6) Difference between planned investment (ex – ante investment) and actual investment (ex –
post investment)

Planned Investment/ Ex – ante Actual investment/ Ex – post investment

Investment
1) Planned investment refers to the desired 1) Actual investment refers to the realized
level of investment at different levels of level of investment
income in the economy. It is what the
investors intend/plan to invest
 P a g e | 27

2) In the context of equilibrium level of 2) According to the principle of national

output, planned investment may or may income accounting, actual investment is
not be equal to planned savings always equal to actual savings
7) Differentiate between Ex ante saving and investment –

Ex ante savings Ex ante investment

1) It refers to what the savers plan / intend
to save at different levels of income in the
economy
2) Ex ante savings may or may not be equal
to ex ante investment corresponding to any
level of income. This is because the savers
and investors in the economy are a
different set of persons and guided by a
different set of factors.
1) It refers to what the investors plan /
intend to invest at different levels of
income in the economy
2) Ex ante investment may or may not be
equal to ex ante savings corresponding to
any level of income. This is because the
savers and investors in the economy are
a different set of persons and guided by a
different set of factors

8) Differentiate between Ex post saving and investment -

Ex post saving Ex post investment

1) It refers to realized savings
2) Ex post saving and ex post investment
form an accounting identity. Therefore
according to the principle of national
income accounting ex post saving is always
equal to ex post investment. They are
bound to be equal to each other at all levels
of income and employment.
1) It refers to realized investment
2) Ex post saving and ex post investment
form an accounting identity. Therefore
according to the principle of national
income accounting ex post saving is always
equal to ex post investment. They are
bound to be equal to each other at all levels
of income and employment.

1) Give the meaning of ex-ante savings. (Delhi 2010)

2) Give the meaning of ex-ante investment. (Delhi 2010, Foreign 2010)
3) When is there equilibrium level of national income? (AI 2010)
4) What is ex-ante aggregate demand? (AI 2010)
5) Define involuntary unemployment. (Delhi 2009, AI 2009)
6) Explain the distinction between voluntary and involuntary unemployment (AI 2011)
 P a g e | 28

Part 3: Problem of Deficient Demand and Excess Demand

TO DO:
❖ 4.13 Concept Deficient Demand & Deflationary Gap (Causes,
Consequences and Remedy)
❖ 4.14 Concept Excess Demand & Inflationary Gap (Causes, Consequences
and Remedy)

4.13 DEFICIENT DEMAND –

Deficient Demand refers to a situation when aggregate demand (AD) is short of aggregate
supply (AS) corresponding to full employment in the economy.

AD < AS: Corresponding to full employment.

It implies two things –

1) The level of aggregate demand happens to be short of its full employment level -In order
that the resources are fully employed and there is ‘full capacity’ production, the
entrepreneurs would expect aggregate demand to come up to the desired level. But it may
not. As a result full capacity production may not be possible. Resources will remain partly
unutilized and there will be some unemployment of labor. In other words, there will be
involuntary unemployment.

2) The level of aggregate demand fails to cope with the level of aggregate supply up to the
point of full employment in the economy - Accordingly aggregate supply is reduced to
match the existing level of demand. So that AD and AS become equal at a level lower than
the full employment level. In other words there is underemployment equilibrium in the
economy.

This gives rise to a situation known as deflationary gap. Deflationary gap is the difference
between the actual level of aggregate demand and the level of aggregate demand required
to establish the full employment equilibrium. It measures the shortfall in aggregate
demand.

It is a measure of the amount of deficiency of aggregate demand. In this sense, the economy
attains underemployment equilibrium. The deflationary gap is so called because it sets in motion
forces that cause a decline in the economy’s output, income and employment.

The concept of deficient demand can be explained with the help of the following diagram
P a g e | 29
 P a g e | 30

Diagram

In the above diagram ADU is the aggregate demand curve which intersects the 45 degree
aggregate supply curve AS at point EU. This is a situation of underemployment equilibrium or a
situation of deficient demand. The equilibrium quantity produced is Q. The desired level of
demand for full capacity production is indicated by ADF.The level of full employment output is
Q1

Deflationary gap is measured as the difference between the desired AD corresponding to full
employment and the actual AD corresponding to underemployment. Therefore in the above
diagram deflationary gap is equal to FG. It shows the extent of deficient demand. In order to
achieve full employment equilibrium aggregate demand (C + I) needs to increase to the extent of
the deflationary gap and intersect the 45 degree AS curve at point F.

Causes of Deficient Demand:

1) Reduction in Private Consumption Expenditure

2) Reduction in Investment Expenditure
3) Reduction in Government Expenditure
4) Decline in Exports
5) Rise in Imports
6) Increase in Tax Rates
 P a g e | 31

Consequences of Deficient Demand

1) When AD fails to catch up with full utilization of resources, producers will build up
inventory beyond what they desire (undesired inventory stock)
2) It will force the producers to plan lesser production for subsequent years
3) It will imply reduction in planned aggregate savings
4) It will further lead to reduction in income and employment.
Briefly economy is driven to the state of low level of output, income, employment

Remedy for Deficient Demand

If aggregate demand is for a level of output less than the full employment level of output, then
the situation of deficient demand exists. In order to remedy the problem of deficient demand, the
aggregate demand has to be increased by an amount equal to the deflationary gap. This will
move the economy to the full employment equilibrium at point F.

The aggregate demand can be increased by taking recourse to fiscal policy, monetary policy or
both

A. Fiscal Policy Measures -

Fiscal policy refers to the budgetary policy of the government or the policy related to
revenue and expenditure of the government.
Fiscal measures to correct the deficient demand can be discussed as follows –

1) Increase in Public Expenditure –In a situation of deficient demand the government should
raise its expenditure in the following ways -
a) Expenditure on public works programmes- for example construction of roads, dams,
bridges, canals etc. should be raised
b) Greater expenditure should be incurred on public health, education etc
c) Greater expenditure should be incurred on the maintenance of law and order and defence
of the country.
d) Greater expenditure should be incurred on subsidies and transfer payments

Increase in Government Expenditure will raise the level of employment. It will in turn increase
wages and purchasing power. Thus it will increase the AD.

If the Government Expenditure is increased by an amount equal to the deflationary gap, it will
restore the economy to the full employment equilibrium.

2) Reduction in Taxes – Taxes should be decreased leaving the households with more
purchasing power and the firms with more cash reserves.

A reduction in the level of taxes will increase the disposable income by the amount of reduction
in taxes. As a result, consumption demand will increase by an amount of MPC times the increase
in disposable income. The increase in consumption demand will increase the AD by an equal
amount. Thus, by lowering the taxes, the AD can be increased.
 P a g e | 32

3) Increase Deficit Financing – Deficit Financing ( by way of printing more notes for additional
expenditure) is increased during times of deficient demand so that the over all level of
purchasing power is increased in the economy.

B. Monetary Policy Measures –

Monetary Policy is that policy by which the government of a country and the Central bank
try to control the supply of money, availability of credit and the cost of credit (rate of
interest) in the economy, with the view to achieving economic stability.
Monetary Measures can be taken in the following ways –

1) Reducing the Cash Reserve Ratio – Cash Reserve Ratio refers to the minimum
percentage of bank’s total deposits which is required to be kept with the Central bank.

All the banks have to keep with the central banks a certain percentage of their deposits in the
form of minimum cash reserve ratio. For example, if the minimum reserve ratio is 10% and the
total deposit of a bank is Rs 100 crores, then it will have to keep Rs 10 crores with the central
bank. If the minimum reserve ratio is 20%, then the bank will have to keep Rs 20 crores with the
central bank.

When the cash flow or credit is to be increased, cash reserve ratio is reduced, thus giving
commercial banks greater ability to create credit.

2) Reduction in interest rates - Reduction in interest rate makes the credit cheaper.
Accordingly, the demand for credit expands.

There is an inverse relationship between the rate of interest and the level of investment demand.
If the central bank lowers the rate of interest then there would be an increase in investment
demand. This increase in investment demandwould cause an increase in AD. In this way the
economy can be restored to full employment equilibrium.

1) Give the meaning of excess demand in an economy. (Delhi 2009)

2) Give the meaning of deflationary gap. (Foreign 2009, Delhi 2010)
3) Explain the role of the following in correcting deficient demand in an economy: (i) Open Market
4) Operations (ii) Bank Rate (Delhi 2011, Delhi 2012)
5) Explain the role of the following in correcting deficient demand in an economy: (i) Government
Expenditure (ii) Legal Reserves (Foreign 2011)
6) Explain the role of the following in correcting deflationary gap in an economy: (i) Open Market
Operations (ii) Margin Requirements (AI 2011, AI 2012, Foreign 2012)

4.14 EXCESS DEMAND –

 P a g e | 33

Excess Demand refers to a situation when aggregate demand (AD) is in excess of aggregate
supply (AS) corresponding to full employment in the economy.

AD > AS: Corresponding to full employment.

It implies two things –

1) Planned aggregate demand in the economy happens to excess its full employment level –
Since resources in the economy have already been fully utilized (corresponding to full
employment level) therefore the aggregate supply cannot be raised. Demand only implies
greater pressure on the available goods and services in the economy. Accordingly prices tend
to rise.
2) The level of aggregate demand (or planned expenditure) surpasses the level of
aggregate supply even when there is full capacity production in the economy – Due to
this the market value of the existing goods and services tends to rise.

Excess demand gives rise to inflationary gap.

Inflationary gap is the difference between the actual level of aggregate demand and the
level of aggregate demand required to establish the full employment equilibrium. It
measures the extent of excess demand over and above its level required to maintain full
employment equilibrium in the economy.

The inflationary gap gives rise to sharp increase in prices. However, it has no effect on output,
income and employment as these are already at full employment level.

(Note very carefully –Be intelligent enough to understand that the inflationary gap occurs only
after a situation of full employment is reached. Hence there is no question of increase in output,
employment and income)

Excess demand and inflationary gap can be explained with the help of the following diagram –
Diagram

In the above diagram aggregate demand or AD is measured on Y axis and

income/output/employment on Y axis. The 45% line is aggregate supply curve AS which
becomes vertical on point E. Point E shows the full employment equilibrium. AD F is full
 P a g e | 34

employment aggregate demand curve which intersects the aggregate supply curve AS at point E.
If the level of aggregate demand increases to ADB, it is in excess of what is required to maintain
full employment. ADB is aggregate demand beyond full employment. This causes increase in
prices while the output remains the same. In other words it leads to inflation within the
economy. The difference between ADB and ADF (FE) is the inflationary gap.

Inflation/ Excess demand is measured as the difference between ‘AD beyond full employment’
and ‘AD at full employment’
Inflationary gap/ Excess demand = ADB –ADF = FE

(Interesting Fact for your information – Due to inflation the economy is driven into a situation
of ‘wage – price – spiral’ where wages catch prices and prices catch wages. It is a situation of
escalating expenditure in the economy without a rise in the flow of goods and services. Cost of
production tends to rise due to mounting pressure on existing resources. Accordingly, prices of
final goods tend to rise and we have wage-price-spiral)

Consequences of Excess Demand-

1) When AD increases beyond its full employment level, output remains constant as
output cannot exceed its full employment level
2) Flow of goods and services remain constant so excess demand implies excess pressure
of purchase on existing supplies.
3) Excess pressure of purchase on existing goods must cause rise in prices. This implies a
situation of inflation
4) Inflation causes increase in cost of production so prices tend to rise further.

Remedy for Excess Demand –

A. Fiscal Policy Measures -

Fiscal policy refers to the budgetary policy of the government or the policy related to
revenue and expenditure of the government.
Fiscal measures to correct the deficient demand can be discussed as follows –

1) Decrease in Public Expenditure –In a situation of deficient demand the government should
decrease its expenditure in the following ways -
a) Expenditure on public works programmes- for example construction of roads, dams,
bridges, canals etc. should be decreased
b) Lesser expenditure should be incurred on public health, education etc
c) Lesser expenditure should be incurred on the maintenance of law and order and defence of
the country.
d) Lesser expenditure should be incurred on subsidies and transfer payments

Decrease in Government Expenditure will reduce the level of employment. It will in turn
decrease wages and purchasing power. Thus it will decrease the AD.

If the Government Expenditure is decreased by an amount equal to the inflationary gap, it will
restore the economy to the full employment equilibrium.
 P a g e | 35

2) Increase in Taxes – Taxes should be increased leaving the households with less purchasing
power and the firms with less cash reserves.

An increase in the level of taxes will decrease the disposable income by the amount of increase
in taxes. As a result, consumption demand will decrease by an amount of MPC times the
decrease in disposable income. The decrease in consumption demand will decrease the AD by an
equal amount. Thus, by increasing the taxes, the AD can be decreased.

3) Increase Public Borrowing- Public borrowing should be increased, so that people are left
with lesser purchasing power. Thus, during periods of excess demand, the government should
adopt the policy of surplus budget

4) Reduce Deficit Financing - Deficit Financing should be restricted. Printing of more notes
would only increase the rate of inflation. So it should be avoided.

B. Monetary Policy Measures –

Monetary Policy is that policy by which the government of a country and the Central bank
try to control the supply of money, availability of credit and the cost of credit (rate of
interest) in the economy, with the view to achieving economic stability.
Monetary Measures can be taken in the following ways –

1) Increasing the cash Reserve Ratio – cash Reserve Ratio refers to the minimum
percentage of bank’s total deposits which is required to be kept with the Central bank.

All the banks have to keep with the central banks a certain percentage of their deposits in the
form of minimum cash reserve ratio. For example, if the minimum reserve ratio is 10% and the
total deposit of a bank is Rs 100 crores, then it will have to keep Rs 10 crores with the central
bank. If the minimum reserve ratio is increased to 20%, then the bank will have to keep Rs 20
crores with the central bank.

When the cash flow or credit is to be decreased, minimum reserve ratio is increased, thus
reducing the ability of commercial banks to create credit.

2) Increasing the interest rates -Increasing the interest rate makes the credit costlier.
Accordingly, the demand for credit contracts.

There is an inverse relationship between the rate of interest and the level of investment demand.
If the central bank increases the rate of interest then there would be a decrease in investment
demand. This decrease in investment demandwould cause a decrease in AD. In this way the
economy can be restored to full employment equilibrium.

A few monetary policies in short:-

1) Bank rate should be increased to discourage borrowing
2) The central bank starts selling securities in open markets so that some purchasing power is
withdrawn from the economy
 P a g e | 36

3) Cash reserve ratio is raised with a view to decrease the flow of credit
4) Liquidity ratio is raised to decrease lending in banks
5) Requirement of the margin is raised for speculative business activities so that borrowing
becomes costly and thus declines
6) Rationing of credit is introduced so that there is no excessive flow of credit
7) Commercial banks are generally advised to be selective in lending.

1) Give the meaning of inflationary gap. (AI 2010)

2) Explain the role of the following in correcting excess demand in an economy: (i) Open Market
Operations (ii) Bank Rate (Delhi 2011, Delhi 2012 and Foreign 2012)
3) Explain the role of the following in correcting inflationary gap in an economy: (i) Government 4)
Expenditure (ii) Open Market Operations (Foreign 2011)
4) Explain the role of the following in correcting inflationary gap in an economy: (i) Legal Reserves
(ii) Bank Rate (AI 2011, AI 2012)

Question Bank
1) Explain the concept of underemployment equilibrium with the help of a diagram. On the
same diagram show the additional investment expenditure required to reach full employment
equilibrium
2) With the help of a diagram explain the concept of deflationary gap. Can deflationary gap
exist at equilibrium level of income?(Yes deflationary gap can exist at equilibrium level of
income- Explain through diagram)
3) Explain the situation of deficient demand in an economy with the help of a diagram
4) Define deficient demand OR When does a situation of deficient demand arise in an economy
5) When does the situation of deficient demand arise in an economy? Mention its impact on
output, employment and prices.
6) Give the meaning of deficient demand. Explain a few fiscal and monetary policies to correct
it
7) Explain 2 measures by which central bank can attempt to reduce the deflationary gap.
8) Define excess demand OR When does a situation of excess demand arise in an economy
9) Explain the concept of –(i) underemployment equilibrium (ii) excess demand in an economy
with the help of diagrams
10) With the help of a diagram explain the concept of inflationary gap.
11) Explain the situation of excess demand in an economy with the help of a diagram
12) When does the situation of excess demand arise in an economy? Mention its impact on
output and prices.
13) Give the meaning of excess demand. Explain a few fiscal and monetary policies to correct it
14) Explain 2 measures by which central bank can attempt to reduce the inflationary gap.
15) Does an excess AD over AS always imply a situation of inflationary gap
Answer: No, excess of AD over AS does not always imply a situation of inflationary gap.
Inflationary gap occurs only when AD is more than AS corresponding to the full employment
level of output.
16) Distinguish between deflationary gap and inflationary gap.
Answer:
DIFFERENCE BETWEEN DEFLATIONARY GAP AND INFLATIONARY GAP

Basis of Difference Deflationary Gap
1) Definition It measures the shortfall in
aggregate demand required
to maintain full employment
equilibrium in the economy.
2) Type of Demand Deflationary gap is
generated by deficient
demand
3) Relationship Aggregate demand (AD) is
between short of aggregate supply
Aggregate (AS) corresponding to full
Demand and employment in the economy
Aggregate Supply
4) Impact on It sets in motion forces that
Output, Income , cause a decline in the
Employment and economy’s output, income
Price and employment
5) Causes 1) Reduction in Private
Consumption Expenditure
2) Reduction in Investment
Expenditure
3) Reduction in Government
Expenditure
4) Decline in Exports
5) Rise in Imports
6) Increase in Tax Rates
6) Diagram and
explanation
P a g e | 37
Inflationary Gap
It measures the extent of excess
demand over and above its level
required to maintain full employment
equilibrium in the economy.
Inflationary gap is generated by excess
demand
Aggregate demand (AD) is in excess of
aggregate supply (AS) corresponding to
full employment in the economy.
It has no effect on output, income and
employment as these are already at full
employment level. Inflationary gap
gives rise to sharp increase in prices
1) Increase in Private Consumption
Expenditure
2) Increase in Investment Expenditure
3) Increase in Government
Expenditure
4) Increase in Exports
5) Decrease in Imports
6) Decrease in Tax Rates
 P a g e | 38

Part 4: Investment multiplier and It’s working

TO DO:
❖ 4.15 Introduction
❖ 4.16 Derivation of the expression of the multiplier
❖ 4.17 Relationship between Multiplier and Marginal Propensity to Consume
❖ 4.18 Working of the Multiplier
❖ 4.19 Multiplier Process
❖ 4.20 Importance of the multiplier
❖ 4.21 Paradox of thrift
4.15 Introduction

Keynes’ concept of investment multiplier depicts the relationship between change in

investment and the resulting change in income. Increase in investment cause an increase in
income. But the increase in income is not exactly the same as the increase in investment. Rather,
it is many times more than the increased investment. The number of times the income
increases is called is called the multiplier.

Keynesian concept of multiplier establishes a relationship between additional investment

and additional income. That is why it is called as the investment multiplier. It is the ratio
between change in income and change in investment.

The multiplier is that number which when multiplied by the amount of change in investment
gives us the value of change in income.
For example – if investment increases by 100 crores and the income increases by 500 crore then
the multiplier is 5.

Thus,
K=∆Y/∆I = 500/100 = 5 Therefore K =5
Or
∆Y=K∆I = 5 x 100 = 500 Therefore ∆ Y = 500

Here,
K = Multiplier
∆ I = Change in investment
∆ Y = Change in income

The effect of multiplier can be depicted through the following diagram –

Diagram
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In the above diagram, the equilibrium level of output is OQ. When investment is increased from
I0 to I1, the equilibrium shifts and is attained at OQ1 level of output. The change in output/income
i.e. QQ1 is greater than the change in investment i.e.I 0I1.
4.16 Derivation of the expression of multiplier –

At the point of equilibrium, we know that Y = C+I. Income is equal to the sum of consumption
and investment.
We also know that the consumption function equation
_
C = C + bY

Substituting the above equation we get –

_
Y = C + By + I
_
Y – by = C + I

C = Autonomous consumption
b = Marginal propensity to consume
Y = Income
_
Y = 1/ (1-b) (C + I)
We know that b = MPC.

So,
_
Y = 1/ (1 – MPC) (C + I)
_
Since C is constant so to find the effect of change in investment on income we come to the
following formula –

∆ Y = 1/ (1 – MPC) ∆ I
Or
∆Y=K∆I

Thus,
K = ∆ Y/∆ I
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Since, MPC is always greater than 0 and less than 1, therefore, the multiplier will always be
greater than 1 (K > 1). Hence, a change in investment will lead to a multiple change in
income/output

4.17 Relationship between Multiplier and Marginal Propensity to Consume (MPC)

(Note: MPC is the ratio between change in consumption and change in income.
MPC =∆C / ∆Y).

The coefficient of multiplier i.e. K is positively related to the value of MPC. The larger the
Marginal Propensity to Consume (MPC), the larger will be the value of K and vice versa.

It is because from the point of view of the entire economy, expenditure of one individual is the
income of another.

When investment is increased, income of the people is also increased.

They spend a part of the increased income on consumption and save the rest.
The amount of income people spend on consumption depends on their Marginal Propensity to
Consume (MPC).

If MPC is more, they will spend large portion of their income on consumption.

As a result of this expenditure on consumption, income of some other people will increase.

These people will also spend some part of their increased income on consumption which will
cause the income of yet other people to increase.

Thus increase in investment causes multiple changes in income.

The factor by which income increases (i.e. multiplier) depends on MPC.

Higher the MPC, greater the value of multiplier and hence greater the increase in income
MPC and multiplier are directly related while MPS and multiplier are inversely related.

Thus,

K = 1/ 1 – MPC
Or
K = 1/ MPS

Suppose MPC = ½, then multiplier (K) will be –

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K = 1/1-MPC
= 1/ 1 – ½
= 1/ ½ = 2

Multiplier can thus be calculated by following methods-

i) K = ∆ Y / ∆ I
ii) K = 1/ 1 – MPC
iii) K = 1/ MPS

Example: Value of multiplier at different rates of MPC

MPC(∆C/∆Y) Multiplier Answer

(K = 1 / 1-MPC)
0 1 / 1-0 1
1/3 1/ 1-1/3 1.5
½ 1/ 1-1/2 2
¾ 1/ 1-3/4 4
4/5 1/ 1-4/5 5
9/10 1/ 1-9/10 10
1 1/ 1-1 ∞

THREE BASIC FUDAMENTALS TO BE KEPT IN MIND

1) Higher MPC implies higher Multiplier (K), as K = 1/ 1 – MPC

2) Higher MPS implies lower Multiplier (K), as K = 1 / MPS
3) Since MPC is always greater than 0 and less than 1, therefore
K>1

1) What can be the minimum value of investment multiplier? (Delhi 2009)

2) What will be the value of MPC if investment multiplier is 1? (Delhi 2009)
3) What is the relationship between MPS and multiplier? (Foreign 2009)
4) Giving reasons, state whether the following statements are true or false: 1) When MPC is greater
than MPS, the value of investment multiplier will be greater than 5. 2) Value of investment
multiplier varies between zero and infinity (Delhi 2010)
5) Explain the relationship between investment multiplier and MPC (Delhi 2011)

4.18 WORKING OF THE MULTIPLIER –

The working of the multiplier can be explained keeping in mind the following points –
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1) Investment generates income

2) Additional income causes change in consumption
3) Change in consumption resulting from additional income depends on MPC i.e. (∆C/∆Y)
4) Additional consumption expenditure generates additional income. This is because one
man’s expenditure is another man’s income
5) Additional income in turn leads to additional consumption and the process repeats itself
till the total increase in income equals the multiplier times the change in investment i.e. ∆Y =
K∆I

The entire process can be explained with the help of a table given below.

It is assumed that MPC is 0.5

Rounds Increase in Change in Change in Savings /

Investment Income Consumption leakage
expenditure (Rs crores) (∆ C)
(Rs crores) (∆ Y) (MPC = ½)
(∆I)
0 10 10 → 5 5
1 - 5 → 2.5 2.5
2 - 2.5 → 1.25 1.25
3 - 1.25 → 0.625 0.625
4 - 0.625

10 20 10 10

In the above table –

1) An investment of Rs 10 crores is made which leads to an increase in income by Rs 10

Crores. Our assumption is that MPC is 0.5 (½). Hence an increase in income by Rs 10
crores will increase consumption by Rs 5 crores and remaining 5 crores will be saved.
2) Expenditure of one man is an income of another in an economy. People who receive Rs
10 crores spend 50% of it i.e. Rs 5 crores on buying (say) consumer goods. This would
increase the income of the people who supply consumer goods by Rs 5 crores, who
would then, again spend 50% of it i.e. Rs 2.5 crores.
3) In this way the chain of consumption expenditure would continue and the income of the
people would go on increasing. But every additional increase in income will go on
diminishing as a part of the income will also be saved. Thus an initial investment of Rs
10 crores ultimately leads to an increase of income / output by Rs 20 crores. It proves that
multiplier (K) is ∆Y /∆ I = 20 / 10 = 2

The process continues till the increase in investment is equal to the increase in saving through
successive rounds of income and consumption expenditure.
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4.19 MULTIPLIER PROCESS –

Change in → Change in → Change in →Change in

Investment Income Consumption Income

∆I →∆Y →∆ C → ∆Y

Change in investment leads to change in income. As a result, there is change in consumption.

Consumption expenditure of one person is an income of another. Hence, change in consumption
leads to change in income. This process continues till ∆ C falls to zero

Process of multiplier works in two ways-

1) Forward action of the multiplier

2) Backward action of the multiplier

1) Forward action of the multiplier: Forward action of multiplier indicates that as a result
of increase in initial investment there is several times more increase in ultimate income. For
instance supposing investment increases by Rs 100 crore and multiplier is 2 then income will
increase to Rs 100 crore x 2= Rs 200 crore
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2) Backward action of the multiplier:Backward action of multiplier shows that as a result

of decrease in initial investment there is several times more decrease in final income. It is
also called reverse action of the multiplier. Supposing in an economy, investment falls from
Rs 100 crore to Rs 50 crore i.e. investment decreases by Rs 50 crore. If multiplier is 2 then
income will finally decrease by Rs 50 crore x 2= Rs 100 crore.

The forward and backward action of the multiplier can be shown with the help of the following
diagram -

In the above diagram, income is shown on OX-axis and investment on OY axis. AS curve
indicates aggregate supply curve. Supposing initially the aggregate demand curve is AD. This
demand curve intersects aggregate supply curve at point M. Hence, equilibrium level of income
is OA. On account of increase in investment, demand curve shifts upward to AD 1 therefore the
equilibrium income also increases to OB. It is clear from the diagram that compared to II 1
increase in investment; AB increase in income is double. The reason being that value of
multiplier is 2. Forward action of the multiplier is shown by the movement from point A to
point B.

On the contrary, if investment decreases, the aggregate demand curve shifts downward as AD 2.
It intersects aggregate supply curve at point E. In this case equilibrium income will be OC. It is
obvious from the diagram that compared to II2 decrease in investment; decrease in income i.e.
AC is double, because multiplier is 2.Movement from point A to point C indicates backward
action of the multiplier.

Hence, multiplier is a two edged sword. As a result of it, any increase in investment leads to
many times more increase in income, likewise any decrease in investment may cause many times
more decrease in income
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4.20 Importance of the multiplier

Since the increase in income is many times the increase in investment, Keynes suggested that
during depression when income/ output is low, government should invest in public works and
adopt policies which encourage private investment.

4.21 Paradox of thrift

The multiplier helps us to conclude that an economy can earn more and save more only by
increasing consumption. If an economy were to save the entire amount of additional income
generated due to additional investment, it would lose the additional rounds of income and this
would reduce the capacity to save. Thus, an attempt to increase savings may lead to a fall in
total savings. This is the paradox of thrift. Thus, though individual saving is a virtue, saving
by the economy as a whole is not desirable in the long run.

Question Bank
1) If the value of MPS is 0.25 what is the multiplier?
2) If MPC is 0.8 what is the value of multiplier?
3) As a result of an increase in investment of Rs 1000 in the economy the total N.I rises by Rs
5000. What’s the value of multiplier?
4) Given MPC is 0.9 and increase in investment is Rs 60 crores. Calculate ‘K’ and total increase
in income.
5) In an economy K =5. What is MPC?
6) Value of multiplier [K] =8. Find MPS.
7) In an economy investment is increased by Rs 500 crores. If the MPC=0.75, calculate the total
increase in income and consumption expenditure.
8) In an economy investment is increased by Rs 600 crores. If MPS=0.4, calculate the total
increase income and consumption expenditure.
9) In an economy investment is increased by Rs 750 crores, MPC=0.9. Calculate total increase
in income and amount of savings.
10) If MPS=0.1 and increase in National Income is Rs 500 crores. Calculate increase in
investment.
11) If MPS=0.2 and increase in investment is Rs 120 crores. Calculate increase in National
Income.
12) Increase in investment is Rs 125 crores and increase in National Income is Rs 500 crores.
Calculate MPS
13) In an economy level of income is Rs 2000 crores and MPC is 0.75. Calculate total increase in
income if investment increases by Rs 200 crores.
14) In an economy the actual level of income is Rs 500 crores whereas the full employment level
of income is Rs 800 crores. MPC is 0.75. Calculate the increase in investment required to
achieve the full employment level of income.
15) What increase in investment is needed to raise the income by Rs 1000 crores if MPC is 0.75?
16) There is an additional investment of Rs 50 crores in the economy. How much additional
income will be created if MPS=0.3?
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17) Calculate the value of MPC and MPS if an additional investment of Rs 200 crores guaranteed
an additional income of Rs 800 crores.
18) What is the value of MPC if an additional investment of Rs 40 crores leads to an increase in
income by Rs 100 crores.