Short-Run Equilibrium Output: NBSE Class 12 Economics notes

Introduction

The Keynesian perspective on the determination of equilibrium output and employment in the short run provides important insights into the workings of the macroeconomy. According to Keynesian theory, the level of output in the short run is determined by the level of employment. Keynes argued that there is a proportionate relationship between output and employment in the short run, implying that if employment doubles, output also doubles. This is because in the short run, the capital stock and technology are fixed, so more labor translates into more output.

The equilibrium level of output, in Keynesian analysis, is determined at the point where aggregate demand equals aggregate supply. Aggregate demand refers to the total planned expenditure on final goods and services produced in the economy. It consists of planned consumption expenditure by households and planned investment expenditure by firms. Aggregate supply refers to the total value of output produced. When aggregate demand equals aggregate supply, it indicates there is no surplus or shortage in the economy. This equilibrium level is also where planned investment equals planned saving, as whatever is produced is either consumed or invested.

According to Keynes’s effective demand principle, the equilibrium level of output and employment in the short run is determined exclusively by the level of aggregate demand, given sticky prices. Aggregate supply is assumed to be perfectly elastic at the prevailing price level. This means firms stand ready to supply whatever quantity is demanded by households and investors.

The equilibrium output is derived through the equation Y=A+bY, where Y is national income or output, A is autonomous expenditure consisting of autonomous consumption and investment, and b is the marginal propensity to consume. The values of A and b determine the equilibrium level of output and income.

A key concept in Keynesian theory is the investment multiplier. It shows the relationship between an initial increment in investment and the resultant increase in national income and output. For example, if investment increases by $100 million and income rises by $400 million, the multiplier is 4. It works through inducing consumption expenditures, as more income leads to more spending based on the marginal propensity to consume. The higher the MPC, the greater the multiplier effect.

Paradoxically, Keynes argued that as people become more thrifty and save more, total income may actually fall due to decreased consumption. This “paradox of thrift” results from the fact that one person’s spending is another’s income, so reduced spending can contract the economy.

The equilibrium level of output can also be determined by the point where planned saving equals planned investment (S=I). If planned saving exceeds investment, it indicates excess supply and unwanted inventories, causing output to fall. If planned investment exceeds saving, it suggests excess demand and unwanted inventory reduction, causing output to rise. Output adjusts until S=I.

Keynes emphasized the problem of involuntary unemployment, where able and willing workers cannot find jobs. It represents deficient aggregate demand, not high wages. True full employment equilibrium occurs when AD=AS at full employment, leaving no involuntary joblessness. Under-employment equilibrium happens when AD=AS at less than full employment, due to inadequate spending.

Fiscal policy tools like higher government spending can pump up aggregate demand to achieve full employment equilibrium. Monetary policy like lower interest rates can also stimulate investment and spending. Boosting aggregate demand is the key to utilizing the economy’s resources fully and closing deflationary gaps.

Textual questions and answers

A. Very short-answer questions (answer in one word/one sentence)

1. What happens in the economy when AD<AS?

Answer: This leads to an excess supply of goods and services, resulting in an increase in inventories of unsold stocks.

2. What is the algebraic relationship between multiplier (K) and saving?

Answer: K = 1 / (1 – MPC), where K represents the multiplier and MPC represents the marginal propensity to consume.

3. What is the value of multiplier?

Answer: The value of multiplier determines the rate of growth in the economy. A higher value of multiplier will attain a higher level of income and growth.

4. If MPC 1, what will be the value of multiplier?

Answer: We cannot determine the value of the multiplier when MPC is 1.

5. What is meant by multiplier?

Answer: The multiplier is a concept that explains the relationship between an initial increase in investment and the resulting increase in national income.

6. What will be the impact on the value of multiplier if MPC increases?

Answer: The value of the multiplier will increase if the marginal propensity to consume (MPC) increases.

7. What is the equilibrium level of income?

Answer: The equilibrium level of income refers to the level at which aggregate demand (AD) equals aggregate supply (AS) in an economy.

8. “Output always increases when AD increases”. True or False.

Answer: True.

9. “If investment > savings, then the level of income (Y) will rise”. True or False.

Answer: True.

10. What is investment multiplier?

Answer: The investment multiplier refers to the relationship between an initial increase in investment and the resulting increase in national income.

11. Define National Income.

Answer: National Income refers to the total value of goods and services produced within a country’s borders during a specific time period, typically a year.

12. What is voluntary employment?

Answer: Voluntary employment refers to a situation where individuals who are able to work choose not to work, even when suitable job opportunities are available to them.

B. Short-answer questions-I (answer in 30-50 words)

1. What happens when AD> AS?

Answer: When AD is greater than AS, it means that planned expenditure on goods and services is more than the planned output. As a result, there will be excess demand in the economy. To meet this excess demand, firms will increase production until inventories reach the desired level and AS becomes equal to AD. This will lead to an increase in employment and output in the economy.

2. What happens when AD<AS?

Answer: When AD < AS, it means that planned expenditure on goods and services is less than the planned output. This leads to an excess supply of goods and services, resulting in an increase in inventories of unsold stocks. To address this situation, producers will reduce production until aggregate demand (AD) is equal to aggregate supply (AS), i.e., AD = AS.

3. Which two sectors are assumed in determining the equilibrium level of income?

Answer: The two sectors assumed in determining the equilibrium level of income are consumption (C) and investment (I). Consumption represents the spending by households on goods and services, while investment represents the spending by firms on capital goods and infrastructure.

4. Why are the prices kept constant in the determination of equilibrium output?

Answer: Prices are kept constant in the determination of equilibrium output because the focus is on analyzing the relationship between aggregate demand (AD) and aggregate supply (AS) without considering the impact of price changes. By assuming constant prices, the analysis can focus solely on the quantity of goods and services demanded and supplied.

5. What is the relationship between K and MPC?

Answer: The prices are kept constant in the determination of equilibrium output under the short run because it is assumed that in the short run, the economy takes time to respond to forces of excess supply or excess demand.

6. What is the relationship between K and MPS?

Answer: The relationship between K and MPS is inverse, that is, if MPS falls, the value of K rises and if MPS rises, K falls. This is because K is equal to 1/MPS algebraically.

7. What happens when planned savings are greater than planned investment?

Answer: When planned savings are greater than planned investment, it indicates that expenditure in the economy is less than what producers had expected. This results in undesired build-up of unsold stock and excess supply. As a result, AD falls short of AS, producers cut production and employment, and national income falls until planned saving equals planned investment.

8. What is K, if MPS = 0.2?

Answer: If MPS is 0.2, then K = 1/MPS = 1/0.2 = 5. This is because the formula for multiplier K is 1/MPS, where MPS is marginal propensity to save.

9. When C=100+ 6.54 and Y=1200, what would be the autonomous consumption?

Answer: When the consumption function is C=100+ 6.54, autonomous consumption refers to the level of consumption when income Y is zero. So when Y is zero, C=100. Therefore, the autonomous consumption is 100.

10. If MPS=1/4, then what will be the value of multiplier?

Answer: If MPS is 1/4, then the multiplier K = 1/MPS = 1/(1/4) = 4. This is because the formula for multiplier is K = 1/MPS, where MPS is marginal propensity to save.

11. Define full employment.

Answer: Full employment refers to a situation in which every able-bodied person who is willing to work at the prevailing rate of wages is employed. It is a state where there is no involuntary unemployment, meaning that all resources, particularly the labor force, are fully utilized. However, there may still be some frictional, structural, and voluntary unemployment even in a state of full employment.

C. Short-answer questions-II (answer in 60-80 words)

1. What are the assumptions taken for the determination of equilibrium output in the short run?

Answer: Assumptions taken for the determination of equilibrium output in the short run:

Prices are constant: Prices of final goods are assumed to be constant (fixed) in the short run because it takes time for the economy to respond to forces of excess supply or excess demand through price adjustments.

Supply is perfectly elastic at fixed price: At a given fixed price, suppliers are willing to supply whatever quantity is demanded by consumers. The supply curve is horizontal implying producers can supply any amount at the prevailing price in the short run.

Short-run analysis: The theory of equilibrium output determination is applicable only in the short run. The short run is defined as the period during which the level of output is determined solely by the level of employment of resources.

Two-sector economy: A simple two-sector model (Household and Firm sector) is assumed with no government sector or foreign trade. Households make consumption expenditures while firms undertake investment expenditures.

2. What will happen if AD is less than AS?

Answer: When aggregate demand (AD) is less than aggregate supply (AS), it indicates that planned expenditure in the economy is lower than what the producers had expected. This leads to an excess supply of goods and services, resulting in unplanned or unwanted increase in inventories of unsold stocks. To address this situation, producers will reduce production until aggregate supply falls enough to be equal to aggregate demand, i.e., until AS = AD. This adjustment continues until there is no surplus or shortage in the economy, and the level of income and output stabilizes.

3. What is the paradox of thrift?

Answer: The paradox of thrift refers to the idea that as people become more thrifty, they end up saving less or the same as before. This is because the principle of the multiplier shows a direct relationship between the multiplier (K) and MPC – if MPC is high, K (national income) will also be high. In other words, an economy can earn more by increasing consumption. If an economy were to save the whole of the additional income generated due to additional investment, it will lose the additional round of income. This will reduce the economy’s capacity to save more, leading to a fall in total savings. This is called the paradox of thrift.

4. Explain what happens when planned savings are greater than planned investment.

Answer: When planned (ex-ante) saving is more than planned investment, it means that expenditure in the economy is less than what producers had expected. This would result in an undesired build-up of unsold stock. Consequently, AD falls short of AS. Due to excess supply resulting from the stockpiling of unsold goods (i.e. unintended inventories), producers will cut down employment and production. National income will fall and as a result, planned saving will start falling until it becomes equal to planned investment. It is at this point that the equilibrium level of income is determined.

5. Explain what happens when planned savings are less than planned investment.

Answer: When planned (ex-ante) saving is less than planned investment, it indicates that expenditure on buying goods in the economy is more than what the producers had expected. This will result in an unplanned reduction in the inventories of unsold stock. It is a situation of AS falling short of AD. This will induce producers to expand production to meet the excess demand. As a result, national income will increase which, in turn, will lead to higher savings. Thus, planned saving will start rising until it becomes equal to planned investment. It is here that the equilibrium level of income is established.

6. How is involuntary unemployment different from voluntary unemployment?

Answer: Involuntary unemployment means a situation in which people who are willing and able to work at the prevailing wage rate are unable to find work. Their unemployment is involuntary and against their wishes.

On the other hand, voluntary unemployment occurs when people who are able to work choose not to work even when suitable jobs are available. Their unemployment is by choice.

The key difference is that involuntary unemployment indicates a deficiency of aggregate demand and economic problems in the economy, while voluntary unemployment does not necessarily imply any economic troubles. The magnitude of involuntary unemployment reflects the true unemployment situation in the economy.

D. Long-answer questions-I (answer in 90-120 words)

1. Discuss the causes when aggregate demand is greater than aggregate supply.

Answer: When aggregate demand (AD) is greater than aggregate supply (AS), it indicates that planned expenditure on goods and services in the economy is more than the planned output. As a result, the producers’ inventories will fall below the desired level. There are two key reasons for this situation:

Increase in consumer expenditure: If consumers increase spending due to factors like higher incomes, easy availability of credit, or optimistic expectations, it will lead to AD exceeding AS.

Increase in investment expenditure: If businesses increase investment spending on new factories, machinery etc., it raises AD. Unless production is increased correspondingly, AD will exceed AS.

To meet the excess demand, firms will start raising production until inventories (stocks) reach the desired level and AS becomes equal to the higher AD. The equilibrium output will increase until the equality between AD and AS is restored.

2. How is equilibrium output determined in the short run?

Answer: In the short run, equilibrium level of output is determined exclusively by the level (amount) of planned aggregate demand as per the effective demand principle proposed by Keynes. This is based on the following assumptions:

Prices are fixed as the economy takes time to respond to excess demand or supply.
Supply is perfectly elastic at the fixed price i.e. suppliers can meet any demand.
It is a two-sector economy with just households and firms.
AD = C + I, where C is consumption and I is investment.

The equilibrium output is derived by solving the equation Y = C + I or Y = A + bY, where A is autonomous expenditure and b is MPC.

Since supply is perfectly elastic, the AD curve determines the equilibrium output. At the fixed price, whatever quantity is demanded will get supplied. Equilibrium is reached when AD=AS i.e. quantity demanded = quantity supplied. The level of output and income will adjust until this equality is achieved.

3. What is multiplier? Derive the relationship of K with MPC.

Answer: The investment multiplier (K) shows the relationship between an initial increment in investment (ΔI) and the resulting increase in national income (ΔY). It is the ratio of ΔY to ΔI i.e. K = ΔY/ΔI.

The multiplier works through the change in consumption. An initial increase in investment leads to an increase in income. Higher income causes higher consumption due to the marginal propensity to consume (MPC). Higher consumption leads to further rise in income and so on.

The value of multiplier can be derived as:

K = 1/1-MPC

This shows an inverse relationship between K and MPC. As MPC increases, 1-MPC declines, resulting in a higher value of the multiplier K.

For example, if MPC is 0.75,

K = 1/1-0.75 = 1/0.25 = 4

So the multiplier is 4. A Rs.1 crore increase in I will lead to Rs.4 crore increase in Y.

4. What is the adjustment mechanism in determination of equilibrium through savings and investment approach?

Answer: When planned savings and planned investment are unequal, the following adjustment mechanism comes into play:

When planned savings > planned investment: It indicates excess supply and unintended build up of inventories. Producers will cut production and income will fall. This will reduce savings until S = I.

When planned savings < planned investment: It indicates excess demand and depletion of inventories. Producers will raise production and income will rise. This will increase savings until S = I.

In both cases, the change in income leads to a change in consumption due to the marginal propensity to consume. This causes a further change in income in the same direction till savings become equal to investment.

Equilibrium is achieved when planned savings = planned investment at a particular income level. This equilibrium income is where unplanned change in inventories is zero and there is no tendency for income to change further.

5. Explain investment multiplier with the help of an example.

Answer: Let’s assume there is an initial increase in investment of Rs.100 crores in an economy. The MPC is 0.75.

In the first round, the Rs.100 crores investment leads to Rs.100 crores increase in income. With MPC of 0.75, Rs.75 crores (0.75 x Rs.100 crores) will be consumed.

In the second round, this Rs.75 crores consumption leads to Rs.75 crores increase in income. With MPC of 0.75, consumption will now be Rs.56.25 crores (0.75 x Rs.75 crores).

This process continues in multiple rounds with each round of consumption and income being smaller than previous round.

Finally the total increase in income is Rs.400 crores. The investment multiplier is Rs.400 crores/Rs.100 crores = 4.

So the multiplier is 4 implying each Rs.1 increase in I leads to Rs.4 increase in Y. A higher MPC leads to larger rounds of consumption and a higher multiplier.

6. Show the working of multiplier.

Answer: The concept of the multiplier is based on the idea that one person’s expenditure is another person’s income. For example, A’s spending becomes B’s income, B’s spending becomes C’s income, and so on.

Let’s take an example. Suppose the government invests Rs. 100 crores in building a new highway. This is new investment in the economy.

The first impact of this investment is that the income of the workers and contractors hired for building the highway will increase by Rs. 100 crores (the amount of new investment).

If the marginal propensity to consume (MPC) of these workers is 0.75, meaning they spend 75% of their additional income, then they will consume Rs. 75 crores (0.75 x Rs. 100 crores). This becomes income for other producers.

The producers of the consumption goods will earn Rs. 75 crores of additional income. With MPC again being 0.75, they will spend 0.75 x Rs. 75 crores = Rs. 56.25 crores. This becomes income for another set of producers.

This process continues round after round, with each round of spending becoming income for others.

The rounds continue until the increase in spending becomes zero.

In this example, the initial Rs. 100 crore investment has resulted in a total increase in income of Rs. 400 crores (as shown in the table below).

So the multiplier is 400/100 = 4.

E. Long-answer questions-II (answer in 130-200 words)

1. Explain the derivation of equilibrium output and AD at fixed price and fixed interest rate.

Answer: In the Keynesian model, equilibrium output is determined in the short run at a fixed price level. The assumptions are:

Prices and wages are constant or rigid.
Aggregate supply is perfectly elastic at the fixed price, i.e., firms supply whatever quantity is demanded by consumers at that price.
Analysis is done in the short run, where output depends only on the level of employment.
It’s a two sector economy – households and firms, with no government or foreign trade.

Under these assumptions, equilibrium output depends entirely on the level of aggregate demand.

The equilibrium condition is:

Aggregate Demand (AD) = Aggregate Supply (AS)
Or in algebraic terms:
Y = C + I
Where,
Y is equilibrium output/income
C is consumption expenditure
I is investment expenditure

Consumption function is written as:

C = Ca + bY
Where Ca is autonomous consumption, b is marginal propensity to consume.

Substituting this in the equilibrium equation, we get:

Y = Ca + bY + I
Y – bY = Ca + I
Y(1-b) = Ca + I

Dividing by (1-b), which is equal to MPS, we get:

Y = (Ca + I)/MPS

Therefore, in the short run at fixed prices, equilibrium level of output (Y) and aggregate demand (AD) depend on the autonomous consumption (Ca), autonomous investment (I) and the marginal propensity to save. A higher Ca and I will lead to higher output and AD.

2. How is equilibrium determined from saving and investment approach?

Answer: The saving-investment approach states that equilibrium level of national income is determined at the point where planned/ex-ante saving equals planned/ex-ante investment.

This means:
Equilibrium level of Y: Saving (S) = Investment (I)

Where,

Y = National income
S = Planned saving
I = Planned investment

The saving function shows the relationship between income level and planned saving, typically written as:

S = -Sa + sY

Where Sa is autonomous saving and s is marginal propensity to save.

The investment function shows planned investment at different income levels. It is autonomous of income.

When S > I:

Planned savings exceed planned investment, which means expenditure in the economy is less than output.
This leads to unintended increase in inventories and fall in output and income.
The process continues until S = I at lower income level. This is the new equilibrium.

When S < I:

Planned investment exceeds planned savings, so expenditure is more than output.
Firms face shortage of inventories, so they expand output.
This raises income, which raises saving.
The process continues until saving rises to be equal to investment at a higher income level. This is the new equilibrium point.

Therefore, according to the S-I approach, the equilibrium level of national income is attained at that level of income where ex-ante S equals ex-ante I, through adjustments in income, output and inventories. The equilibrium is unstable if S ≠ I.

3. Discuss the working of investment multiplier with an example.

Answer: The investment multiplier refers to the phenomenon where an initial increase in investment leads to a total increase in income that is a multiple of the initial investment.

For example, suppose the government invests Rs. 100 crores to build a new highway.

First round – The highway contractors and workers hired have Rs. 100 crores of extra income. If their marginal propensity to consume (MPC) is 0.75, they will consume Rs. 75 crores (0.75 x 100 crores).

Second round – The producers of the consumption goods (worth Rs. 75 crores) now have Rs. 75 crores of extra income. With MPC at 0.75 again, they will consume Rs. 56.25 crores (0.75 x 75 crores).

Third round – Those producing these goods (worth Rs. 56.25 crores) earn Rs. 56.25 crores. They consume Rs. 42.19 crores (0.75 x 56.25 crores).

Fourth round – Producers of Rs. 42.19 crores worth of goods earn Rs. 42.19 crores. Their consumption is 0.75 x 42.19 crores = Rs. 31.64 crores.

This process continues until the rounds of new consumption spending reduce to zero.

If we add up, the initial Rs. 100 crores investment has led to a total increase in income of Rs. 400 crores (100 + 75 + 56.25 + 42.19 + 31.64).

Therefore, the investment multiplier is ΔY/ΔI = 400/100 = 4.

So the multiplier quantifies the phenomenon where an initial change in investment brings about a total change in income that is a multiple of the investment. A higher MPC leads to greater rounds of spending and a higher multiplier.

The multiplier effect forms the basis of suggestions that increasing government spending can boost total output and income in times of economic slowdown. It demonstrates the power of fiscal policy.

4. How is equilibrium achieved through AD and AS approach?

Answer: The AD-AS model explains how an economy reaches equilibrium output by the intersection of aggregate demand (AD) and aggregate supply (AS) curves.

The AD curve slopes downwards from left to right, indicating that as price level rises, demand for goods and services falls, ceteris paribus.

The AS curve shows the quantity of total planned output that firms will produce at different price levels. In the short run, the AS curve is fairly elastic.

Equilibrium is achieved at the intersection of the AD and AS curves, where AD = AS. At this point, the quantity demanded by households/firms (AD) equals the quantity that firms plan to produce (AS).

If AD > AS:

Planned expenditure is greater than planned production.
This leads to unintended depletion of inventories, signaling excess demand.
Firms respond by increasing production and prices. AS curve shifts right.
The process continues until AD = AS at higher price level and output.

If AD < AS:

Planned expenditure is less than planned production.
This leads to excess supply and unintended buildup of inventories.
Firms respond by decreasing production and prices. AS curve shifts left.
The process continues until AD = AS at lower price level and output.

Therefore, through shifts in the AS curve, the economy moves towards the equilibrium where AD = AS. At this point, there are no pressures for further changes, as quantity demanded equals quantity supplied. This determines the equilibrium price level and real GDP.

5. How is equilibrium achieved through I-S approach?

Answer: The I-S approach states that equilibrium level of national income is attained at the point where planned investment equals planned savings.

The saving function shows the relationship between income level and planned saving. It is written as:

S = -Sa + sY

Where Sa is autonomous saving and s is marginal propensity to save.

Investment function shows planned investment, which is autonomous of income.

Equilibrium condition: Saving (S) = Investment (I)

If S > I:

Planned savings exceed planned investment.
This indicates expenditure is less than output, leading to unintended increase in inventories.
Firms respond by cutting production and income starts falling.
This process continues until S = I at a lower income level.

If S < I:

Planned investment exceeds planned savings.
This means spending is greater than output, leading to depletion of inventories.
Firms respond by expanding production and income starts rising.
This process continues until S = I at a higher income level.

Therefore, through changes in output and income, the economy moves towards the equilibrium level where ex-ante S equals ex-ante I.

If S ≠ I, firms either accumulate unintended inventories or face shortage of inventories. This leads them to adjust production and income level.

The equilibrium is unstable until planned S and I are equalized. At equilibrium, there are no pressures for further changes, as saving equals investment.

The S-I approach emphasizes how unplanned inventory accumulation or decumulation helps adjust national income to establish equilibrium where saving equals investment.

6. How is full employment equilibrium achieved?

Answer: Full employment equilibrium refers to a situation where the equilibrium between aggregate demand (AD) and aggregate supply (AS) occurs at the full employment level of output and resources.

Equilibrium means AD = AS. But this equality can occur at less than full employment.

For full employment equilibrium:

The economy must have enough aggregate demand to generate the level of output that corresponds to full employment of all available resources.
The AD curve should intersect the 45° AS line at the full employment level of output.
At this point, the economy utilizes all its capital, labor, entrepreneurship, and technology. No resources are left idle involuntarily.

This requires the right combination of consumption, investment, government spending and net exports.

If AD is deficient and intersects AS at less than full employment level, there is involuntary unemployment of labor and other resources.

Policies to achieve full employment equilibrium:

Expansionary fiscal policy – Higher government spending and/or lower taxes to boost AD.
Expansionary monetary policy – Lower interest rates and higher money supply to increase I and AD.
Boosting exports relative to imports – This increases net exports, adding to AD.
Direct job creation schemes by the government.
Investment in infrastructure, technology, education and health to enhance productivity.

The economy should aim for a sustained full employment equilibrium by calibrating AD in line with growth in productive capacity. This ensures optimum utilization of resources.

7. How is under-employment equilibrium achieved?

Answer: Under-employment equilibrium refers to a situation where the equality between aggregate demand (AD) and aggregate supply (AS) occurs at a level of output and employment that is below the full employment level.

Some key points:

At under-employment equilibrium, the economy has unemployed or underemployed resources, especially labor. There is involuntary unemployment.
This happens not due to inadequacy of aggregate supply but due to deficiency of aggregate demand. AD is not enough to generate full employment output.
The AD curve intersects the AS curve to the left of the full employment level of output.
This gives rise to a deflationary gap – the gap between AD and the AS at full employment level.

An under-employment equilibrium can arise due to the following reasons:

Low consumer spending and high saving rate, reducing consumption expenditure.
Low business investment due to pessimism, excess capacity.
Contractionary fiscal and monetary policies.
Appreciation of domestic currency, reducing net exports.

Measures to reach full employment equilibrium from under-employment equilibrium:

Expansionary fiscal and monetary policies to boost AD.
Large investments to stimulate multiplier effect.
Boosting consumption through transfers, welfare schemes.
Improving productivity, reducing production costs.
Depreciating currency to promote net exports.

The economy should continuously monitor and adjust AD to ensure it matches the full employment productive capacity at all times.

Additional/extra questions and answers

1. What is the relationship between employment and output in the short run?

Answer: In the short run, a higher level of employment implies a higher level of output in the economy. As technology is assumed to remain constant, there is a proportionate relationship between output and employment. This implies that if employment is doubled, then output will also get doubled.

2. What does the equilibrium condition AD = AS imply?

Answer: The equilibrium condition of AD = AS implies that whatever is produced in the economy (AS) is either consumed by the households or invested by the firms.

3. What is the role of the 45° line in the AD-AS equilibrium diagram?

Answer: In the AD-AS equilibrium diagram, the 45° line represents the Aggregate Supply (AS) curve. The equilibrium point is where the AD curve intersects the 45° line AS curve, indicating that AD = AS.

4. What happens to producers’ inventories when AD is greater than AS?

Answer: When AD > AS, it means that planned expenditure on goods and services is more than planned output. As a result, the producer’s inventories will fall below the desired level.

5. How do firms react to meet excess demand in the economy?

Answer: To meet the excess demand, firms will start raising production until inventories (stocks) reach the desired level and AS is equal to AD.

6. What happens to inventories of unsold stock when AD is less than AS?

Answer: When AD < AS, there would be an excess supply of goods and services due to an unplanned or unwanted increase in inventories of unsold stocks.

7. How do producers respond to an unplanned increase in inventories?

Answer: To remedy the situation of an unplanned increase in inventories, producers will produce less. This continues until AS falls enough to be equal to AD.

8. Why is AD = AS a necessary condition for equilibrium?

Answer: AD = AS is a necessary condition for equilibrium because at this level of income, there is no surplus or shortage in the economy. There is stability and no tendency for income and output to change as planned production is equal to planned purchases of goods and services produced in the economy.

9. What are the two approaches to determining the equilibrium level of income?

Answer: The equilibrium level of income is determined at a point where Aggregate Demand equals Aggregate Supply (AD = AS) or where Investment equals Saving (I = S).

10. What does the term ‘perfectly elastic’ supply at a fixed price mean?

Answer: A perfectly elastic supply at a fixed price means that at a given price, suppliers are willing to supply whatever amount of goods consumers will demand.

11. What is the principle of effective demand?

Answer: The principle of effective demand is that under circumstances of fixed prices and perfectly elastic supply, the equilibrium output will be exclusively determined by the level or amount of aggregate demand (AD).

12. What does the equation Y = Ā + bY represent in determining equilibrium?

Answer: The equation Y = Ā + bY is used to derive the equilibrium output and aggregate demand at a fixed price and fixed interest rate in a two-sector economy.

13. What do the components Ā and b stand for in the equilibrium equation?

Answer: In the equilibrium equation Y = Ā + bY, Ā stands for total autonomous expenditure, where Ā = C + I (Autonomous Consumption + Autonomous Investment). The component b stands for MPC (Marginal Propensity to Consume).

14. What is the ‘paradox of thrift’?

Answer: The paradox of thrift is that ‘as people become more thrifty, they end up saving less or the same as before’.

15. Why is equilibrium rare in the saving and investment approach?

Answer: In the saving and investment approach, such equilibrium is rare because savers and investors are different people who save and invest with different motives.

16. What is the investment multiplier?

Answer: When investment increases by a certain amount, aggregate income increases by a multiple of that investment. This multiple is called a multiplier. The investment multiplier shows the relationship between an initial increment in investment and the resulting increment in national income. It is a measure of the change in national income caused by a change in investment.

17. What does a multiplier value of 6 imply for the economy?

Answer: The implication of a multiplier (K) value of 6 is that for any level of change in investment in the economy, income will change 6 times the investment amount.

18. How does the multiplier process stop?

Answer: The process of increase in income stops when the change in investment becomes equal to the change in saving.

19. What is the cause of involuntary unemployment?

Answer: Involuntary unemployment is due to a deficiency of aggregate demand sufficient to ensure full employment. It is due to a lack of aggregate demand caused by less investment by a businessman.

20. What is the key difference between voluntary and involuntary unemployment?

Answer: The key difference lies in the willingness to work at the prevailing wage rate. Voluntary unemployment refers to persons who are not willing to do work at the existing wage rate even when work is available. Involuntary unemployment occurs when those who are able and willing to work at the going wage rate do not get work.

21. Define frictional unemployment. What are its causes?

Answer: Frictional unemployment is a kind of unemployment that arises due to the immobility of labour, shortage of raw material, lack of information regarding the opportunity of employment, shortage of power, and wear and tear of machines, etc. It is the unemployment associated with the changing of jobs in a dynamic economy.

22. Define structural unemployment. What causes it?

Answer: Structural unemployment is a kind of unemployment that results from structural changes in the economy. These changes could be when some factors of production (other than labour) are in short supply, or when there is a change in the production technique.

23. What is a deflationary gap? How does it arise?

Answer: A deflationary gap is the gap between aggregate demand and aggregate supply at full employment. It arises from a deficiency of aggregate demand, where the actual aggregate demand falls short of the aggregate supply required for full employment. This situation of deficient demand results in a deflationary gap.

24. What is the classical view of the aggregate supply curve?

Answer: The Classical aggregate supply curve is a vertical straight line parallel to the Y-axis at the full employment level of output because they considered supply to be perfectly price-inelastic.

25. What changes take place when aggregate demand is not equal to aggregate supply?

Answer: When AD > AS, it means that planned expenditure (AD) on goods and services is more than planned output (AS). As a result, the producer’s inventories will fall below the desired level. To meet the excess demand, firms will start raising production until inventories (stocks) reach the desired level and AS is equal to AD.

When AD < AS, it indicates that planned expenditure in the economy is less than what the producers had expected. In such a situation, there would be an excess supply of goods and services due to an unplanned or unwanted increase in inventories of unsold stocks. To remedy the situation, producers will produce less. This continues until AS falls enough to be equal to AD.

26. Explain the key assumptions on which the Keynesian theory of equilibrium is based.

Answer: The Keynesian theory is based on the following assumptions:

(i) Prices are constant—Prices of final goods are assumed to be constant (fixed) in the short-run because the economy takes time to respond to forces of excess supply or excess demand.
(ii) Supply is perfectly elastic at a fixed price—It means at a given price, suppliers are willing to supply whatever amount of goods consumers will demand.
(iii) Short-run analysis—This theory is applicable only under the short-run. The short-run is the period of time during which the level of output is determined solely by the level of employment (of resources).
(iv) Two-sector economy—It is a two-sector (Household and Firms) economy assuming no government and no foreign trade. Thus, AD = C + I.

27. What is effective demand? How does it determine the level of output and employment?

Answer: The level of aggregate demand required to achieve full employment equilibrium is called effective demand. Simply put, aggregate demand at the point of equilibrium is called an effective demand. “Effective demand refers to that level of demand which is met by the corresponding supply so that there may be no tendency on the part of entrepreneurs to either expand or contract production”, Keynes.

Under a short-run fixed price, it is the level of aggregate demand or effective demand which determines the level of output, income and employment.

28. What is the adjustment mechanism when planned saving is not equal to planned investment?

Answer: When planned (ex-ante) saving is more than planned investment, it means that expenditure in the economy is less than what producers had expected. This would result in an undesired build-up of unsold stock. Consequently, AD falls short of AS. Due to excess supply resulting from the stock piling of unsold goods, i.e., unintended inventories, the producers will cut down employment and will produce less. National income will fall and as a result, planned saving will start falling until it becomes equal to planned investment. It is at this point that the equilibrium level of income is determined.

When planned (ex-ante) saving is less than planned investment, it indicates that expenditure on buying goods in the economy is more than what the producers had expected. This will result in an unplanned reduction in the inventories of unsold stock. It is a situation of AS falling short of AD. This will induce producers to expand production to meet the excess demand. As a result, national income will increase which, in turn, will lead to higher savings. Thus, planned saving will start rising until it becomes equal to planned investment. It is here that the equilibrium level of income is established because what the savers intend to save becomes equal to what the investors intend to invest.

29. Explain the concept of the investment multiplier with a suitable numerical example.

Answer: Investment increases productive capacity which, in turn, raises the level of output, employment and income. When investment increases by a certain amount, aggregate income increases by a multiple of that investment. This multiple is called a multiplier. The investment multiplier shows the relationship between an initial increment in investment and the resulting increment in national income. It is a measure of the change in national income caused by a change in investment.

For example, if an increase in investment of ₹ 50 crore causes an increase in national income of ₹ 300 crore, then the value of the multiplier would be 6 (300 ÷ 50). This equals the increase in income divided by the increase in investment. The implication of K = 6 is that for any level of change in investment in the economy, income will change 6 times the investment amount. Multiplier (K), thus, is the ratio of the increase in national income (ΔY) due to an increase in investment (ΔI).

30. Differentiate between full employment equilibrium and under-employment equilibrium.

Answer: Full employment equilibrium refers to the equilibrium (AD = AS) where all resources in the economy are fully utilised (employed). Simply put, when equilibrium between AD and AS takes place at full employment of resources, i.e. when factors of production are fully utilised, it is called full employment equilibrium. There are no unused resources and no involuntary unemployment. Aggregate demand is just sufficient to ensure full utilisation of all available resources.

Under-employment equilibrium occurs when aggregate demand and aggregate supply are equal at a level at which all resources are not fully employed. It is a state of equilibrium between AD and AS at less than full employment. In other words, the economy’s resources are not fully employed, i.e., some resources are lying idle.

31. What is under-employment equilibrium? Explain how it occurs.

Answer: Under-employment equilibrium is a situation where aggregate demand and aggregate supply are equal at a level at which all resources are not fully employed. It is a state of equilibrium between AD and AS at less than full employment. In other words, the economy’s resources are not fully employed, i.e., some resources are lying idle.

This situation is caused not by a low level of aggregate supply but by a deficiency of aggregate demand. It is a situation of deficient demand which results in a deflationary gap, i.e., a gap between aggregate demand and aggregate supply at full employment. The gap is called deflationary because the economy’s output, employment and income decline.

32. What measures can be adopted to correct a deflationary gap and reach full employment?

Answer: Measures to reach full employment equilibrium are:

(i) Increase in Govt. expenditure to pump more money in the system to increase demand.
(ii) Bank rate (Repo rate) should be decreased.
(iii) The Central Bank should buy Govt. bonds and securities from commercial banks to increase the cash stock of banks for lending.

33. Discuss the determination of equilibrium output under the short-run fixed price model. What are the key assumptions of this model and why are they important?

Answer: Under the short-run fixed price model, the equilibrium level of output is determined exclusively by the level (amount) of planned demand, as aggregate supply is assumed to be perfectly elastic. This is a Keynesian theory which is based on the following assumptions:

(i) Prices are constant: Prices of final goods are assumed to be constant (fixed) in the short-run. This is important because the economy takes time to respond to the forces of excess supply or excess demand.
(ii) Supply is perfectly elastic at a fixed price: This means that at a given price, suppliers are willing to supply whatever amount of goods consumers will demand. This assumption is important because it makes aggregate demand the primary determinant of output.
(iii) Short-run analysis: This theory is applicable only in the short-run. The short-run is the period of time during which the level of output is determined solely by the level of employment of resources.
(iv) Two-sector economy: It is a two-sector (Household and Firms) economy, assuming no government and no foreign trade. This is an important simplifying assumption, meaning that Aggregate Demand (AD) is composed only of Consumption (C) and Investment (I), so AD = C + I.

Under these circumstances, equilibrium output will be exclusively determined by the level of aggregate demand (AD). This is known as the effective demand principle.

Additional/extra MCQs

1: In an economy, if planned expenditure is less than planned output, what is the likely outcome?

A. Producers will increase production.
B. Inventories will fall below the desired level.
C. Producers will reduce production.
D. The level of income will remain constant.

Answer: C. Producers will reduce production.

2: The value of the investment multiplier is determined by which of the following?

A. 1 / MPS
B. 1 / MPC
C. 1 / (1 – MPS)
D. 1 / (MPC – 1)

Answer: A. 1 / MPS

3: According to Keynesian economics, the equilibrium level of income is determined at a level where:

A. ex-post savings equal ex-post investments.
B. ex-ante savings equal ex-ante investments.
C. aggregate demand is greater than aggregate supply.
D. aggregate supply is greater than aggregate demand.

Answer: B. ex-ante savings equal ex-ante investments.

4: If the Marginal Propensity to Consume (MPC) is 1, what will be the value of the multiplier?

A. 0
B. 1
C. Between 0 and 1
D. Infinity

Answer: D. Infinity

5: What is the term for a situation where able-bodied individuals willing to work at the prevailing wage rate cannot find employment?

A. Voluntary unemployment
B. Frictional unemployment
C. Structural unemployment
D. Involuntary unemployment

Answer: D. Involuntary unemployment

6: In the Aggregate Demand-Aggregate Supply model, the equilibrium level of income is determined where the Aggregate Demand curve:

A. is parallel to the 45° line.
B. is above the 45° line.
C. intersects the 45° line.
D. is below the 45° line.

Answer: C. intersects the 45° line.

7: The “paradox of thrift” suggests that as people become more thrifty, they may end up:

A. saving significantly more than before.
B. saving less or the same as before.
C. increasing the national income.
D. stimulating investment immediately.

Answer: B. saving less or the same as before.

8: The level of aggregate demand at the point of equilibrium is referred to as:

A. Autonomous demand
B. Induced demand
C. Effective demand
D. Latent demand

Answer: C. Effective demand

9: A situation where aggregate demand equals aggregate supply at a level where some resources in the economy are lying idle is known as:

A. Full employment equilibrium
B. Deflationary equilibrium
C. Under-employment equilibrium
D. Inflationary equilibrium

Answer: C. Under-employment equilibrium

10: If an increase in investment of ₹50 crore leads to an increase in national income of ₹300 crore, what is the value of the multiplier?

A. 0.16
B. 5
C. 6
D. 250

Answer: C. 6

11: In the Keynesian short-run model, what is the relationship between output and employment?

A. Inverse
B. Logarithmic
C. Proportional
D. No relationship

Answer: C. Proportional

12: The shortfall in aggregate demand from the level required to maintain full employment is known as:

A. Inflationary gap
B. Deflationary gap
C. Output gap
D. Employment gap

Answer: B. Deflationary gap

13: Which of the following is NOT an assumption of the Keynesian theory for determining equilibrium output in the short run?

A. Prices of final goods are constant.
B. Aggregate supply is perfectly elastic.
C. The economy includes government and foreign trade.
D. The analysis is applicable only in the short run.

Answer: C. The economy includes government and foreign trade.

14: In a simple two-sector economy, which of the following is NOT a component of Aggregate Demand (AD)?

A. Consumption expenditure (C)
B. Investment expenditure (I)
C. Government spending (G)
D. Planned expenditure by households and firms

Answer: C. Government spending (G)

15: Which of the following types of unemployment is NOT considered compatible with a state of full employment?

A. Frictional unemployment
B. Structural unemployment
C. Involuntary unemployment
D. Voluntary unemployment

Answer: C. Involuntary unemployment

16: Which of the following is NOT a measure to correct a deflationary gap and reach full employment equilibrium?

A. Increase in government expenditure.
B. Decrease in the bank rate.
C. The central bank selling government bonds.
D. Pumping more money into the system.

Answer: C. The central bank selling government bonds.

17: Which of the following is NOT a cause of frictional unemployment?

A. Immobility of labour
B. Shortage of raw material
C. Structural changes in the economy
D. Lack of information regarding job opportunities

Answer: C. Structural changes in the economy

18: At the equilibrium level of income, which of the following is NOT true?

A. There is no surplus or shortage in the economy.
B. Planned production equals planned purchases.
C. There is a strong tendency for income and output to change.
D. Aggregate demand equals aggregate supply.

Answer: C. There is a strong tendency for income and output to change.

19: Assertion (A): When planned expenditure exceeds planned output, firms will increase production.
Reason (R): An excess of aggregate demand over aggregate supply leads to a fall in producers’ inventories below the desired level.