CBSE Class 12 Macroeconomics
Chapter 3: Determination of Income and Employment
Competency-Based Question Bank & Sample Paper (2026–27)
Section A – Multiple Choice Questions (MCQs)
(1 Mark Each)
Q1. In an economy, Aggregate Demand is equal to:
A. Consumption + Savings
B. Consumption + Investment
C. Savings + Investment
D. Consumption + Taxes
Answer: B. Consumption + Investment
Explanation: Aggregate Demand (AD) refers to total planned expenditure in the economy and includes Consumption Expenditure and Investment Expenditure.
Q2. Which of the following causes deficient demand?
A. Excessive investment
B. Rise in exports
C. Fall in consumption expenditure
D. Increase in government spending
Answer: C. Fall in consumption expenditure
Explanation: A decline in consumption reduces aggregate demand, leading to deficient demand and unemployment.
Q3. The point where Aggregate Demand equals Aggregate Supply is called:
A. Consumption point
B. Inflation point
C. Equilibrium level of income
D. Break-even point
Answer: C. Equilibrium level of income
Explanation: Equilibrium income is achieved when planned expenditure equals planned output.
Q4. Marginal Propensity to Consume (MPC) measures:
A. Total income consumed
B. Change in consumption due to change in income
C. Ratio of savings to income
D. Total consumption expenditure
Answer: B. Change in consumption due to change in income
Explanation: MPC = Change in Consumption ÷ Change in Income.
Q5. If MPC = 0.8, the value of multiplier will be:
A. 2
B. 3
C. 4
D. 5
Answer: D. 5
Explanation: Multiplier = 1 ÷ (1 – MPC) = 1 ÷ 0.2 = 5.
Q6. Which situation represents excess demand?
A. AD < AS at full employment
B. AD = AS before full employment
C. AD > AS at full employment
D. AD = AS at full employment
Answer: C. AD > AS at full employment
Explanation: Excess demand arises when aggregate demand exceeds aggregate supply at full employment.
Q7. Autonomous consumption refers to consumption:
A. Independent of income
B. Equal to income
C. Greater than savings
D. Dependent on taxes
Answer: A. Independent of income
Explanation: Autonomous consumption occurs even when income is zero.
Q8. Which policy helps correct deficient demand?
A. Increase in taxes
B. Reduction in public expenditure
C. Increase in bank rate
D. Increase in government expenditure
Answer: D. Increase in government expenditure
Explanation: Higher government expenditure raises aggregate demand and employment.
Q9. Average Propensity to Save (APS) can be calculated as:
A. Savings ÷ Income
B. Consumption ÷ Income
C. Income ÷ Savings
D. Consumption ÷ Savings
Answer: A. Savings ÷ Income
Explanation: APS measures the proportion of income saved.
Q10. Full employment equilibrium may still include:
A. Cyclical unemployment
B. Frictional unemployment
C. Deficient demand
D. Excess supply
Answer: B. Frictional unemployment
Explanation: Full employment does not mean zero unemployment; frictional unemployment may still exist.
Section B – Very Short Answer Questions (VSA)
(2 Marks Each | 50–80 Words)
Q1. Define Aggregate Demand.
Answer:
Aggregate Demand refers to the total planned expenditure on goods and services in an economy during a given period. It includes household consumption expenditure and investment expenditure by firms. In a two-sector economy, AD = C + I. Aggregate demand determines the level of income and employment in the economy.
Q2. What is meant by Aggregate Supply?
Answer:
Aggregate Supply refers to the total value of goods and services that firms are willing to produce and supply in an economy during a period. It is equal to national income generated. Aggregate supply depends on the level of employment, production capacity, and availability of resources.
Q3. Explain equilibrium level of income.
Answer:
The equilibrium level of income is achieved when Aggregate Demand becomes equal to Aggregate Supply. At this point, there is neither tendency for output to rise nor fall. Producers sell exactly what they produce, and the economy remains stable at that income level.
Q4. Define consumption function.
Answer:
Consumption function refers to the functional relationship between consumption expenditure and income. It shows how consumption changes with changes in income. It is represented as:
C = a + bY
where ‘a’ is autonomous consumption and ‘b’ is MPC.
Q5. What is autonomous investment?
Answer:
Autonomous investment is investment that does not depend on the level of income or profits in the economy. It is generally influenced by technological progress, government policies, or business expectations and remains constant at different income levels.
Q6. Define multiplier.
Answer:
Multiplier refers to the ratio of change in national income to the initial change in investment. It explains how a small increase in investment leads to a larger increase in income and employment in the economy.
Q7. State the formula of MPC.
Answer:
Marginal Propensity to Consume (MPC) is calculated as:
MPC = Change in Consumption ÷ Change in Income
It measures the proportion of additional income spent on consumption.
Q8. What is deficient demand?
Answer:
Deficient demand refers to a situation where aggregate demand is less than aggregate supply at the full employment level. It leads to unemployment, decline in output, and underutilization of resources in the economy.
Q9. What is excess demand?
Answer:
Excess demand occurs when aggregate demand exceeds aggregate supply at the full employment level. It creates inflationary pressure because demand for goods and services becomes greater than available output.
Q10. Define involuntary unemployment.
Answer:
Involuntary unemployment refers to a situation where people are willing and able to work at the prevailing wage rate but are unable to get employment due to insufficient demand in the economy.
Section C – Short Answer Questions (SA-I)
(3 Marks Each | 80–120 Words)
Q1. Explain the components of Aggregate Demand.
Answer:
Aggregate Demand consists mainly of consumption expenditure and investment expenditure in a two-sector economy. Consumption expenditure is incurred by households on goods and services. Investment expenditure is incurred by firms on machinery, buildings, and inventories. Aggregate Demand determines total spending in the economy and influences income, output, and employment. A rise in AD increases production and employment, while a fall in AD causes unemployment and lower output.
Q2. Distinguish between MPC and APS.
Answer:
Marginal Propensity to Consume (MPC) measures the proportion of additional income spent on consumption. It is calculated as change in consumption divided by change in income. Average Propensity to Save (APS) measures the proportion of total income saved and is calculated as savings divided by income. MPC relates to incremental changes, while APS relates to total income. MPC always lies between 0 and 1, whereas APS may be positive or negative depending on savings.
Q3. Explain the concept of underemployment equilibrium.
Answer:
Underemployment equilibrium occurs when aggregate demand equals aggregate supply at a level lower than full employment. In this situation, resources are not fully utilized, and unemployment exists in the economy. Firms have no incentive to increase production because demand is insufficient. Keynes explained that economies can remain stuck in underemployment equilibrium for long periods unless government intervention increases aggregate demand.
Q4. Explain the relationship between MPC and multiplier.
Answer:
Multiplier and MPC are directly related. The formula of multiplier is:
K = 1 ÷ (1 – MPC).
As MPC increases, the multiplier value also increases because people spend a larger proportion of additional income. This increases consumption demand repeatedly, generating higher income and employment. Conversely, a lower MPC results in a smaller multiplier effect.
Q5. Explain the role of investment in income determination.
Answer:
Investment plays a crucial role in determining income and employment. An increase in investment raises aggregate demand, which encourages firms to increase production. Higher production creates more employment and income. Through the multiplier effect, even a small increase in investment can lead to a large increase in national income.
Q6. Explain the concept of full employment equilibrium.
Answer:
Full employment equilibrium occurs when aggregate demand equals aggregate supply at the full employment level of output. At this stage, all available resources are efficiently utilized, except frictional unemployment. Any increase in aggregate demand beyond this level causes inflation rather than increase in output.
Q7. Differentiate between autonomous and induced consumption.
Answer:
Autonomous consumption is independent of income and occurs even when income is zero. It is influenced by basic necessities. Induced consumption depends on the level of income and increases as income rises. Autonomous consumption remains constant, whereas induced consumption changes with changes in income.
Q8. Explain the paradox of thrift.
Answer:
The paradox of thrift states that if people try to save more during recession, aggregate demand falls because consumption decreases. As demand declines, production, income, and employment also fall. Consequently, actual savings may not increase despite people’s efforts to save more.
Q9. Explain how deficient demand causes unemployment.
Answer:
Deficient demand occurs when aggregate demand is less than aggregate supply at full employment. Due to low demand, producers reduce output and employment. Workers lose jobs, income declines further, and economic activity slows down. This creates involuntary unemployment in the economy.
Q10. Explain the saving function.
Answer:
Saving function shows the relationship between saving and income. As income increases, savings also increase because people can save a part of additional income after consumption. It is represented as:
S = –a + (1 – b)Y
where ‘a’ is autonomous consumption and ‘b’ is MPC.
Section D – Short Answer Questions (SA-II)
(4 Marks Each | 120–150 Words)
Q1. Explain Keynesian theory of income determination.
Answer:
According to Keynes, the level of income and employment in an economy is determined by Aggregate Demand and Aggregate Supply. Equilibrium occurs where AD equals AS. If aggregate demand is insufficient, the economy may settle at underemployment equilibrium. Keynes emphasized that investment plays an important role in increasing demand and employment. Government intervention through fiscal and monetary policies becomes necessary to achieve full employment.
Q2. Explain the working of investment multiplier with example.
Answer:
Investment multiplier shows how an initial increase in investment causes a multiple increase in national income. Suppose investment rises by ₹100 crore and MPC is 0.8. The multiplier becomes:
K = 1 ÷ (1 – 0.8) = 5.
Therefore, total increase in income will be ₹500 crore. The process occurs because one person’s expenditure becomes another person’s income, leading to repeated rounds of spending and income generation.
Q3. Explain measures to correct deficient demand.
Answer:
Deficient demand can be corrected by increasing aggregate demand in the economy. The government may increase public expenditure on infrastructure and welfare projects. Taxes may be reduced to increase disposable income. The central bank can reduce bank rate and reserve ratios to encourage borrowing and investment. These measures increase consumption and investment demand, helping to restore full employment.
Q4. Explain measures to control excess demand.
Answer:
Excess demand can be controlled by reducing aggregate demand. The government may reduce public expenditure and increase taxes to decrease disposable income. The central bank can increase bank rate and reserve ratios to reduce credit availability. These measures reduce consumption and investment expenditure, helping control inflationary pressure.
Q5. Explain the concept of Aggregate Supply curve.
Answer:
Aggregate Supply curve shows the relationship between national income and planned output. In the Keynesian framework, the AS curve rises as employment and production increase. At low levels of employment, output can increase easily. However, once full employment is reached, output cannot rise further due to limited resources.
Q6. Explain inflationary gap.
Answer:
Inflationary gap refers to the excess of aggregate demand over aggregate supply at full employment level. It creates upward pressure on prices because demand exceeds production capacity. Inflationary gap causes inflation without increasing real output. Fiscal and monetary measures are used to reduce the gap.
Q7. Explain deflationary gap.
Answer:
Deflationary gap is the deficiency of aggregate demand compared to aggregate supply at full employment level. It results in unemployment and fall in output. Producers reduce production because goods remain unsold. Government spending and lower taxes can help eliminate the gap.
Q8. Explain equilibrium through saving-investment approach.
Answer:
According to the saving-investment approach, equilibrium income is achieved when planned savings equal planned investment. If savings exceed investment, aggregate demand falls and income declines. If investment exceeds savings, demand rises and income increases. Equality between savings and investment ensures stable equilibrium income.
Q9. Explain assumptions of Keynesian theory.
Answer:
Keynesian theory assumes short-run analysis, constant prices, and existence of unemployed resources. It assumes that output can increase without affecting prices until full employment is reached. Consumption depends on income, and investment is autonomous. The theory emphasizes the importance of aggregate demand in determining income and employment.
Q10. Explain the relationship between income and consumption.
Answer:
Consumption and income are positively related. As income rises, consumption expenditure also rises, but not in the same proportion. People tend to save part of additional income. This relationship is represented through the consumption function and plays an important role in determining aggregate demand.
Section E – Long Answer Questions (LA-I)
(5 Marks Each | 120–150 Words)
Q1. Explain equilibrium level of income with the help of a diagram.
Answer:
The equilibrium level of income is determined where Aggregate Demand equals Aggregate Supply. At this point, planned expenditure equals planned output. If AD exceeds AS, firms increase production and income rises. If AD is less than AS, firms reduce production and income falls. The intersection point of AD and AS curves determines equilibrium income. It represents stability in the economy because there is no tendency for output to change further.
Q2. Explain the concept and working of multiplier.
Answer:
Multiplier refers to the ratio of change in income to change in investment. An increase in investment raises income and employment. The increased income further increases consumption expenditure, leading to repeated rounds of spending. The value of multiplier depends on MPC. Higher MPC means larger multiplier effect because people spend more from additional income.
Q3. Explain causes of deficient demand.
Answer:
Deficient demand may arise due to fall in consumption expenditure, decline in investment, increase in taxes, reduction in government spending, or pessimistic business expectations. It reduces aggregate demand, causing unemployment and lower output. During recession, consumers spend less and firms reduce investment, worsening the problem of deficient demand.
Q4. Explain causes of excess demand.
Answer:
Excess demand occurs due to excessive government expenditure, high investment, increase in money supply, reduction in taxes, or rise in exports. When demand exceeds production capacity at full employment, prices rise continuously. This creates inflationary pressure in the economy.
Q5. Explain the importance of effective demand.
Answer:
Effective demand refers to the level of aggregate demand that equals aggregate supply. It determines income, output, and employment in the economy. According to Keynes, inadequate effective demand leads to unemployment. Therefore, maintaining sufficient effective demand is necessary for economic growth and stability.
Q6. Explain relationship between APC and MPC.
Answer:
Average Propensity to Consume (APC) measures total consumption divided by total income, whereas MPC measures change in consumption divided by change in income. APC generally falls as income rises because consumption increases less proportionately. MPC remains positive and usually less than one. Both help understand consumer behavior.
Q7. Explain the role of government in achieving full employment.
Answer:
Government plays an important role in increasing aggregate demand through public expenditure, taxation policies, and monetary measures. During recession, the government increases spending and reduces taxes to boost demand. The central bank lowers interest rates to encourage investment. These measures help achieve full employment.
Q8. Explain involuntary unemployment.
Answer:
Involuntary unemployment occurs when workers are willing to work at prevailing wage rates but cannot find jobs due to lack of aggregate demand. Producers reduce output because goods remain unsold, leading to unemployment. Keynes believed that deficient demand is the main cause of involuntary unemployment.
Q9. Explain the significance of consumption function.
Answer:
Consumption function helps understand consumer spending behavior and its impact on aggregate demand. It explains how income changes affect consumption expenditure. Policymakers use it to estimate multiplier effects and design fiscal policies for economic stability and employment generation.
Q10. Explain leakages and injections in circular flow of income.
Answer:
Leakages refer to withdrawals from income flow such as savings, taxes, and imports. Injections refer to additions like investment, government expenditure, and exports. Equilibrium is achieved when injections equal leakages. Excess leakages reduce income and employment, whereas excess injections increase economic activity.
Section F – Long Answer Questions (LA-II)
(6 Marks Each | 150–200 Words)
Q1. Explain determination of equilibrium income using AD-AS approach.
Answer:
The equilibrium level of income in an economy is determined where Aggregate Demand equals Aggregate Supply. Aggregate Demand consists of consumption and investment expenditure, while Aggregate Supply represents total output produced in the economy.
When AD equals AS, producers are able to sell their entire output, and there is no tendency for production to change. If AD exceeds AS, inventories decline and firms increase production, leading to higher income and employment. Conversely, if AD is less than AS, firms reduce output and employment because goods remain unsold.
The equilibrium point may occur at full employment or underemployment level. Keynes argued that economies often settle at underemployment equilibrium due to insufficient aggregate demand. Government intervention becomes necessary to increase demand and achieve full employment.
Q2. Explain the concept, assumptions, and limitations of multiplier.
Answer:
Multiplier refers to the ratio of change in national income to change in investment. It explains how an increase in investment causes a multiple increase in income and employment. The formula is:
K = 1 ÷ (1 – MPC).
The main assumptions are:
- Constant prices
- Availability of unemployed resources
- Closed economy
- Constant MPC
- No time lag in investment and income generation
The multiplier process works because one person’s expenditure becomes another person’s income, creating repeated rounds of spending.
However, the multiplier has limitations. In real economies, leakages such as taxes, imports, and savings reduce its effect. Inflation and shortage of resources may also limit the increase in output. Therefore, actual multiplier effect may be smaller than theoretical estimates.
Q3. Explain measures to correct deficient demand with diagrammatic explanation.
Answer:
Deficient demand occurs when aggregate demand is less than aggregate supply at full employment level. It causes unemployment, decline in output, and economic slowdown.
To correct deficient demand, the government can adopt expansionary fiscal policy by increasing public expenditure and reducing taxes. Increased government spending raises aggregate demand directly, while tax reduction increases disposable income and consumption expenditure.
The central bank can adopt easy monetary policy by reducing bank rate, CRR, and repo rate to encourage borrowing and investment.
In a diagram, deficient demand is shown as the gap between aggregate demand and full employment output. By increasing AD through fiscal and monetary measures, equilibrium shifts towards full employment level.
Q4. Explain measures to control excess demand with suitable explanation.
Answer:
Excess demand arises when aggregate demand exceeds aggregate supply at full employment level. It leads to inflationary pressure because demand becomes greater than productive capacity.
The government can control excess demand through contractionary fiscal policy. It may reduce public expenditure and increase taxes to reduce disposable income and consumption expenditure.
The central bank can use contractionary monetary policy by increasing bank rate, CRR, and reserve requirements. This reduces credit creation and discourages borrowing and investment.
Public borrowing and reduction in money supply also help control inflation. These measures reduce aggregate demand and restore price stability in the economy.
Q5. Explain consumption function and saving function with schedule.
Answer:
Consumption function shows the relationship between consumption expenditure and income. As income rises, consumption also rises but by a smaller proportion. It is represented as:
C = a + bY
Saving function shows the relationship between savings and income. Savings increase as income rises because people save part of additional income. It is represented as:
S = –a + (1 – b)Y
| Income | Consumption | Savings |
|---|---|---|
| 0 | 50 | –50 |
| 100 | 130 | –30 |
| 200 | 210 | –10 |
| 300 | 290 | 10 |
The table shows that consumption rises with income, while savings become positive after a certain level of income.
Q6. Explain inflationary and deflationary gaps.
Answer:
Inflationary gap refers to excess aggregate demand over aggregate supply at full employment level. It leads to rise in prices without increase in output. Causes include excessive government expenditure, increase in money supply, and high investment demand.
Deflationary gap refers to deficiency of aggregate demand compared to aggregate supply at full employment level. It results in unemployment and fall in output. Causes include decline in investment, reduced consumption, and pessimistic business expectations.
Inflationary gap is corrected through contractionary fiscal and monetary policies, while deflationary gap is corrected through expansionary policies.
Q7. Explain the paradox of thrift with suitable example.
Answer:
The paradox of thrift states that while saving is beneficial for individuals, excessive saving by all people in the economy can reduce national income and employment.
Suppose during recession, households decide to save more and reduce consumption expenditure. Lower consumption decreases aggregate demand. As demand falls, firms reduce production and employment. Consequently, income declines, and actual savings may remain unchanged or even decrease.
Thus, attempts by everyone to save more can worsen recession. Keynes used this concept to explain why government intervention is necessary during economic slowdown.
Q8. Explain underemployment equilibrium with diagrammatic explanation.
Answer:
Underemployment equilibrium occurs when aggregate demand equals aggregate supply at a level below full employment. In this situation, unemployed resources and labour exist in the economy.
Keynes argued that economies can remain in underemployment equilibrium because firms produce according to existing demand. If demand is low, they do not increase production even though resources are available.
The equilibrium point is determined by intersection of AD and AS before full employment output. Government intervention through higher expenditure and investment is required to shift aggregate demand upward and achieve full employment.
Q9. Explain the role of aggregate demand in employment determination.
Answer:
Aggregate demand plays a central role in determining income and employment. According to Keynes, producers employ labour according to expected demand for goods and services.
When aggregate demand rises, firms increase production to meet higher demand. This requires additional labour and resources, leading to higher employment and income. Conversely, a fall in aggregate demand reduces production and employment.
Thus, insufficient aggregate demand leads to involuntary unemployment. Policies aimed at increasing consumption and investment help raise aggregate demand and employment levels.
Q10. Explain the saving-investment approach to equilibrium income determination.
Answer:
According to the saving-investment approach, equilibrium income is achieved when planned savings equal planned investment. Savings represent leakages from income flow, while investment represents injections into the economy.
If savings exceed investment, aggregate demand becomes insufficient. Firms experience unsold stock and reduce production, causing income to fall. As income declines, savings also decline until equality with investment is restored.
If investment exceeds savings, demand rises and firms increase production and employment. Income continues to rise until savings become equal to investment.
Therefore, equality between savings and investment ensures stable equilibrium income in the economy.
1. What is Aggregate Demand (AD)? Explain its components.
Answer:
Aggregate Demand (AD) refers to the total expenditure planned by all sectors of the economy on final goods and services during a given period. It represents the total demand for goods and services at different levels of income. The main components of aggregate demand are: (i) Consumption Expenditure (C) by households, (ii) Investment Expenditure (I) by firms, (iii) Government Expenditure (G), and (iv) Net Exports (X – M) in an open economy. In the two-sector model studied in this chapter, aggregate demand consists only of consumption and investment expenditures. Thus, AD = C + I. A rise in any component increases aggregate demand and national income.
2. Define Aggregate Supply (AS).
Answer:
Aggregate Supply (AS) refers to the total value of goods and services that producers are willing and able to supply in an economy during a given period. In the short run, aggregate supply is measured by the total income generated from production activities. Since income received by households is either consumed or saved, aggregate supply can be expressed as AS = C + S, where C is consumption expenditure and S is savings. The aggregate supply curve generally starts from the origin and rises upward. Equilibrium in an economy is achieved when aggregate demand becomes equal to aggregate supply, determining the equilibrium level of income and employment.
3. What is effective demand?
Answer:
Effective demand refers to the level of aggregate demand that equals aggregate supply and determines the equilibrium level of income and employment in an economy. According to Keynes, employment depends on effective demand rather than merely the desire to purchase goods. Effective demand occurs when producers find that the total spending on goods and services is sufficient to purchase the output they produce. At this point, firms have no incentive to increase or decrease production. If aggregate demand exceeds aggregate supply, production increases. If aggregate demand falls short of aggregate supply, production declines. Therefore, effective demand plays a crucial role in determining equilibrium income and employment.
4. Explain the concept of equilibrium level of income.
Answer:
The equilibrium level of income is the level of national income at which aggregate demand equals aggregate supply. At this point, planned expenditure by households and firms is exactly equal to the total output produced in the economy. There is no tendency for income, output, or employment to change. Equilibrium can be expressed as AD = AS or Savings = Investment (S = I). If aggregate demand exceeds aggregate supply, producers increase output, causing income to rise. If aggregate demand is less than aggregate supply, output and income decline. Thus, equilibrium income represents a stable situation where the economy functions without any pressure for expansion or contraction.
5. Explain the savings-investment approach to equilibrium.
Answer:
The savings-investment approach states that equilibrium income is achieved when planned savings are equal to planned investment. Savings represent leakages from the income flow, while investment represents injections into the economy. When savings exceed investment, aggregate demand falls short of output, leading firms to reduce production and income. Conversely, when investment exceeds savings, aggregate demand rises, encouraging firms to expand production and income. Equilibrium occurs at the income level where S = I. At this point, there is no tendency for income to change. This approach provides an alternative method of determining equilibrium income and employment in the economy.
6. What is involuntary unemployment?
Answer:
Involuntary unemployment refers to a situation where people are willing and able to work at the prevailing wage rate but are unable to find employment. According to Keynes, involuntary unemployment occurs because aggregate demand in the economy is insufficient to generate enough jobs. During periods of low demand, firms reduce production and hire fewer workers, resulting in unemployment. This type of unemployment is not due to workers refusing jobs or demanding higher wages. Instead, it arises from inadequate spending in the economy. Increasing aggregate demand through investment or government expenditure can help reduce involuntary unemployment and increase employment opportunities.
7. What is the consumption function?
Answer:
The consumption function shows the relationship between consumption expenditure and income. It explains how much households spend on consumption at different income levels. According to Keynes, consumption increases with income but not by the same proportion. This means that when income rises, consumption also rises, but some part of additional income is saved. The consumption function can be expressed as C = a + bY, where ‘a’ is autonomous consumption, ‘b’ is the marginal propensity to consume, and ‘Y’ is income. The consumption function is important because consumption expenditure forms a major component of aggregate demand and influences national income determination.
8. Define Autonomous Consumption.
Answer:
Autonomous consumption refers to the minimum level of consumption expenditure that takes place even when income is zero. People need basic necessities such as food, clothing, and shelter regardless of their current income level. Therefore, they may use past savings or borrow funds to maintain consumption. Autonomous consumption is represented by the intercept of the consumption function on the vertical axis. It does not depend on current income and remains constant in the short run. Autonomous consumption plays an important role in determining aggregate demand and equilibrium income because it ensures some level of spending even during periods of low income.
9. What is Marginal Propensity to Consume (MPC)?
Answer:
Marginal Propensity to Consume (MPC) refers to the proportion of additional income that is spent on consumption. It measures the change in consumption resulting from a change in income. It is calculated using the formula:
MPC = ΔC / ΔY
where ΔC is change in consumption and ΔY is change in income. For example, if income increases by ₹100 and consumption increases by ₹80, MPC equals 0.8. Keynes stated that MPC is positive but less than one because people spend only part of their additional income and save the rest. MPC is important because it determines the size of the multiplier effect in the economy.
10. Define Average Propensity to Consume (APC).
Answer:
Average Propensity to Consume (APC) is the ratio of total consumption expenditure to total income. It shows the proportion of income spent on consumption. The formula is:
APC = C / Y
where C is consumption expenditure and Y is income. If a household earns ₹10,000 and spends ₹8,000 on consumption, APC is 0.8. APC generally declines as income increases because consumption rises at a slower rate than income. It helps economists understand consumer spending behavior at different income levels. APC is useful in analyzing aggregate demand and the determination of national income in an economy.
11. What is Marginal Propensity to Save (MPS)?
Answer:
Marginal Propensity to Save (MPS) refers to the proportion of additional income that is saved rather than consumed. It measures the change in savings resulting from a change in income. The formula is:
MPS = ΔS / ΔY
where ΔS is change in savings and ΔY is change in income. If income rises by ₹100 and savings increase by ₹20, MPS equals 0.2. Since additional income is either consumed or saved, MPC + MPS = 1. MPS is important because it influences the multiplier process. A higher MPS means lower spending and a smaller multiplier effect in the economy.
12. Define the Investment Multiplier.
Answer:
The investment multiplier refers to the ratio of change in national income to the initial change in investment. It explains how a small increase in investment can lead to a much larger increase in income and employment. The formula for the multiplier is:
K = 1 / (1 – MPC)
or
K = 1 / MPS
For example, if MPC is 0.8, the multiplier is 5. This means an investment increase of ₹100 crore will raise national income by ₹500 crore. The multiplier works because one person’s expenditure becomes another person’s income, generating repeated rounds of spending throughout the economy.
13. Why is the multiplier always greater than one?
Answer:
The multiplier is always greater than one because an initial increase in investment creates multiple rounds of income generation. When firms invest, they pay wages and purchase resources. The recipients spend a portion of this income on consumption, creating additional income for others. This process continues repeatedly, although the amount spent decreases in each round due to savings. Since total income generated exceeds the original investment, the multiplier value is greater than one. Mathematically, the multiplier equals 1/MPS. Since MPS is less than one, the multiplier becomes greater than one. Therefore, investment has a magnified effect on national income.
14. Explain the relationship between MPC and Multiplier.
Answer:
There is a direct relationship between Marginal Propensity to Consume (MPC) and the multiplier. The multiplier formula is:
K = 1 / (1 – MPC)
A higher MPC means people spend a larger portion of additional income, creating more rounds of expenditure and income generation. As a result, the multiplier becomes larger. Conversely, a lower MPC means more income is saved, reducing the multiplier effect. For example, if MPC is 0.9, the multiplier is 10, whereas if MPC is 0.5, the multiplier is only 2. Thus, the size of the multiplier depends directly on consumers’ spending behavior and the level of MPC.
15. Explain the paradox of thrift.
Answer:
The paradox of thrift is a concept introduced by Keynes. It states that while saving is beneficial for an individual, excessive saving by all individuals may harm the economy. If everyone tries to save more and spend less, aggregate demand decreases. Lower demand causes firms to reduce production, resulting in lower income and employment. As income falls, actual savings may not increase and may even decline. Thus, an attempt by society to increase savings can lead to lower national income and no increase in total savings. This contradiction between individual and collective outcomes is known as the paradox of thrift.
16. What is deficient demand?
Answer:
Deficient demand refers to a situation where aggregate demand is less than the aggregate supply required for full-employment output. In such a case, firms cannot sell all their production, leading them to reduce output and employment. Deficient demand is a major cause of involuntary unemployment according to Keynes. It usually occurs during economic recessions when consumer spending and investment are low. To overcome deficient demand, governments may increase expenditure, reduce taxes, or encourage investment. These measures raise aggregate demand, stimulate production, and create employment opportunities in the economy.
17. What is excess demand?
Answer:
Excess demand occurs when aggregate demand exceeds the level of output available at full employment. In this situation, consumers and firms want to purchase more goods and services than the economy can produce. Since production cannot increase significantly beyond full employment in the short run, prices begin to rise, creating inflationary pressures. Excess demand generally results from excessive consumption, investment, or government expenditure. To control excess demand, policymakers may reduce government spending, increase taxes, or adopt tighter monetary policies. These measures help reduce spending and maintain price stability in the economy.
18. Distinguish between Autonomous and Induced Investment.
Answer:
Autonomous investment is investment that does not depend on the level of income. It is influenced by factors such as technological progress, government policies, and business expectations. It remains constant regardless of changes in national income. Induced investment, on the other hand, depends on income levels and market demand. As income and demand increase, firms invest more to expand production capacity. Conversely, induced investment decreases when income falls. Autonomous investment is represented as a fixed amount, whereas induced investment varies with economic activity. Both types of investment contribute to aggregate demand and income determination.
19. How does an increase in investment affect income?
Answer:
An increase in investment raises aggregate demand, leading firms to expand production. As production increases, employment and incomes also rise. The newly earned income generates additional consumption expenditure, which further increases demand and output. Through the multiplier process, the total increase in national income becomes much larger than the initial increase in investment. For example, if investment rises by ₹100 crore and the multiplier is 5, national income increases by ₹500 crore. Therefore, investment acts as an important driver of economic growth, employment generation, and income expansion in the economy.
20. Why is the concept of income determination important?
Answer:
The concept of income determination is important because it explains how national income, output, and employment are established in an economy. It helps economists understand the relationship between aggregate demand and aggregate supply. The theory highlights the role of consumption, savings, investment, and the multiplier in influencing economic activity. It also explains the causes of unemployment and economic fluctuations. Policymakers use this concept to design fiscal and monetary measures for increasing employment, reducing recessionary conditions, and achieving economic stability. Thus, income determination provides a foundation for understanding macroeconomic performance and economic policy decisions.