CBSE Class 12 Economics (Macroeconomics)
Chapter 3: Determination of Income and Employment
20 Important Questions and Answers
As per CBSE Syllabus 2026–27
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.