Determination of Income and Employment Class 12 Introductory Macroeconomics NCERT Solutions

Q1Exercises

What is marginal propensity to consume? How is it related to marginal propensity to save?

Solution

Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC) is the change in consumption expenditure per unit change in income. It represents the proportion of additional income that a household chooses to spend on consumption. It is denoted by 'c'.

Mathematically, it is expressed as:

MPC = \frac{\Delta C}{\Delta Y} = c

Where:

ΔC = Change in Consumption
ΔY = Change in Income

The value of MPC generally lies between 0 and 1 (inclusive). An MPC of 0 means that no part of the additional income is consumed, while an MPC of 1 means that the entire additional income is consumed.

Relationship between MPC and MPS

Marginal Propensity to Save (MPS) is the change in savings per unit change in income. It is the proportion of additional income that is saved. It is denoted by 's'.

Income (Y) is either consumed (C) or saved (S). Therefore, Y = C + S.

Any change in income (ΔY) will also be divided between a change in consumption (ΔC) and a change in savings (ΔS).

\Delta Y = \Delta C + \Delta S

Dividing the entire equation by ΔY, we get:

\frac{\Delta Y}{\Delta Y} = \frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y}

This simplifies to:

1 = MPC + MPS

Therefore, the sum of Marginal Propensity to Consume and Marginal Propensity to Save is always equal to one. They are complementary to each other. If we know the value of one, we can easily find the value of the other (e.g., MPS = 1 - MPC).

Q2Exercises

What is the difference between ex ante investment and ex post investment?

Solution

The difference between ex ante investment and ex post investment lies in the distinction between planned and actual outcomes. The terms 'ex ante' and 'ex post' refer to 'planned' and 'actual' values, respectively.

Ex Ante Investment:

Meaning: Ex ante investment refers to the planned or intended investment that firms decide to make during a specific period. It is the amount a producer plans to add to the stock of capital goods and inventories.
Nature: It is a forward-looking concept based on future expectations of demand, profits, and interest rates.
Example: A producer plans to add goods worth Rs 100 to her inventory by the end of the year. Here, the ex ante or planned investment is Rs 100.

Ex Post Investment:

Meaning: Ex post investment refers to the actual or realized investment that has taken place in the economy during a specific period. It is what firms end up doing, which may or may not be the same as what they planned.
Nature: It is a backward-looking concept, measured after the period is over. It is an accounting value.
Key Component: Ex post investment includes both planned investment and unplanned investment (unintended changes in inventories). Unplanned investment occurs when actual sales differ from expected sales.
Example: Continuing the previous example, if due to an unexpected surge in demand, the producer had to sell goods worth Rs 30 from her stock, her actual inventory at the end of the year would only go up by Rs 70 (Rs 100 - Rs 30). Here, the ex post or actual investment is Rs 70.

In summary, the key difference is that ex ante investment is the planned investment, while ex post investment is the actual investment, which includes any unplanned changes in inventories.

Q3Exercises

What do you understand by 'parametric shift of a line'? How does a line shift when its (i) slope decreases, and (ii) its intercept increases?

Solution

A 'parametric shift of a line' refers to a change in the position or slope of a line on a graph due to a change in one of its underlying parameters. In the context of macroeconomic models, a parameter is a value that is assumed to be constant within the model, such as autonomous consumption (C̄) or the marginal propensity to consume (c).

For a linear equation of the form Y = a + bX, 'a' is the intercept and 'b' is the slope. A change in either 'a' or 'b' will cause a parametric shift.

(i) How a line shifts when its slope decreases:

When the slope of a line decreases, the line becomes flatter. It pivots or rotates downwards around its intercept point on the vertical axis.
In the context of the aggregate demand (AD) function, AD = Ā + cY, the slope is the marginal propensity to consume (c). If 'c' decreases, the AD line will swing downwards. This means that for any given increase in income (Y), the increase in aggregate demand will be smaller than before.

(ii) How a line shifts when its intercept increases:

When the intercept of a line increases, the entire line shifts upwards in a parallel manner. Its slope remains unchanged, meaning the steepness of the line does not change.
In the context of the aggregate demand (AD) function, the intercept is the total autonomous expenditure (Ā), where Ā = C̄ + Ī. If autonomous consumption or autonomous investment increases, the value of Ā increases. This causes the entire AD line to shift vertically upwards, parallel to its original position. This indicates a higher level of aggregate demand at every level of income.

Q4Exercises

What is 'effective demand'? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?

Solution

Effective Demand

Effective demand refers to the level of aggregate demand which becomes 'effective' in determining the equilibrium level of national income because it is equal to the aggregate supply. In the Keynesian framework, it is assumed that the aggregate supply is perfectly elastic at a fixed price level as long as there are unused resources in the economy. Under this circumstance, the equilibrium output is determined solely by the level of aggregate demand. Therefore, effective demand is the point where planned aggregate demand equals aggregate supply (AD = Y).

Derivation of the Autonomous Expenditure Multiplier

The autonomous expenditure multiplier is the ratio of the change in the equilibrium level of income to the initial change in autonomous expenditure. It shows how many times the national income increases as a result of an increase in autonomous spending.

Assuming the price of final goods and the rate of interest are given and constant, we can derive the multiplier as follows:

Equilibrium Condition: The equilibrium level of income (Y) is determined where aggregate demand (AD) equals aggregate supply (Y). $Y = AD$
Aggregate Demand Equation: In a two-sector economy, AD is the sum of consumption (C) and investment (I). $AD = C + I$
Substitute Component Functions: We substitute the consumption function C = C̄ + cY and the autonomous investment function I = Ī into the AD equation. $AD = (C̄ + cY) + Ī$
Establish Equilibrium: Now, we set Y equal to AD. $Y = C̄ + Ī + cY$
Group Autonomous Terms: Let Ā = C̄ + Ī be the total autonomous expenditure. $Y = Ā + cY$
Solve for Y: To find the equilibrium income, we solve the equation for Y. $Y - cY = Ā$ $Y(1 - c) = Ā$ $Y = \frac{Ā}{1-c}$
Derive the Multiplier: The multiplier measures the change in Y due to a change in Ā (ΔY/ΔĀ). If autonomous expenditure changes by ΔĀ, the change in income ΔY will be: $\Delta Y = \frac{\Delta Ā}{1-c}$ Rearranging the terms, we get the multiplier: $\frac{\Delta Y}{\Delta Ā} = \frac{1}{1-c}$ Since 1 - c = s (where c is MPC and s is MPS), the multiplier can also be expressed as 1/s.

Q5Exercises

Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is 4000 crores. State whether the economy is in equilibrium or not (cite reasons).

Solution

To solve this problem, we first need to calculate the ex-ante aggregate demand (AD) and then compare it with the level of income (Y).

Given:

Total Autonomous Expenditure (Ā) = Rs 50 crores
Marginal Propensity to Save (MPS) = 0.2
Level of Income (Y) = Rs 4000 crores

Step 1: Calculate the Marginal Propensity to Consume (MPC)

We know that MPC + MPS = 1.

MPC = 1 - MPS
MPC = 1 - 0.2
MPC (c) = 0.8

Step 2: Calculate Ex-ante Aggregate Demand (AD)

The ex-ante aggregate demand function is given by:

AD = Ā + cY

Substitute the given values into the equation:

AD = 50 + (0.8 × 4000)
AD = 50 + 3200
AD = Rs 3250 crores

Conclusion: Is the economy in equilibrium?

The economy is in equilibrium when aggregate supply (Y) equals aggregate demand (AD).

Aggregate Supply (Y) = Rs 4000 crores
Aggregate Demand (AD) = Rs 3250 crores

Here, Y > AD (4000 > 3250).

Therefore, the economy is not in equilibrium.

Reason: The economy is not in equilibrium because the planned aggregate supply (or national income) of Rs 4000 crores is greater than the planned aggregate demand of Rs 3250 crores. This situation implies that the producers have produced more than what the buyers are willing to purchase. As a result, there will be an unintended accumulation of inventories (unsold stock). To clear these stocks, producers will reduce production in the next cycle, leading to a decrease in income and employment until the economy reaches an equilibrium where Y = AD.

Q6Exercises

Explain 'Paradox of Thrift'.

Solution

The 'Paradox of Thrift' is a concept in Keynesian economics which states that if everyone in an economy tries to save more, the total savings of the economy may not increase; it might either decrease or remain unchanged. This outcome seems paradoxical because at an individual level, saving more leads to greater wealth, but when society as a whole saves more, it can lead to a fall in national income and no increase in total savings.

The mechanism behind this paradox is as follows:

Increased Saving: Suppose households decide to become more thrifty. This means they increase their Marginal Propensity to Save (MPS), which implies a decrease in their Marginal Propensity to Consume (MPC).
Fall in Aggregate Demand: Since consumption is a major component of aggregate demand (AD), a decrease in the MPC leads to a reduction in consumption expenditure at every level of income. This causes the aggregate demand curve to fall (or swing downwards).
Excess Supply: With the fall in aggregate demand, the planned spending in the economy becomes less than the total output (AD < Y). This leads to an unintended accumulation of inventories with producers.
Reduction in Output and Income: To clear the unwanted inventory, firms will cut back on production. A reduction in production leads to a decrease in factor payments (wages, rent, profit), and thus a fall in the national income.
New, Lower Equilibrium: This process of falling income continues through the multiplier effect until the economy settles at a new, lower equilibrium level of income where aggregate demand again equals aggregate supply.

The Result: Although people are now saving a larger proportion of their income (higher MPS), their total income is much lower. The net effect on total savings (S = Y - C) is that it may end up being the same as before or even lower. At equilibrium, we know that Savings (S) must equal planned Investment (I). Since we assume planned investment (I) is autonomous and has not changed, the new equilibrium level of total savings must return to its original level, equal to the unchanged level of investment. Therefore, the attempt to save more has only succeeded in reducing the national income, not in increasing total national savings.

Determination of Income and EmploymentClass 12 Introductory Macroeconomics NCERT Solutions

What is marginal propensity to consume? How is it related to marginal propensity to save?

Solution

Marginal Propensity to Consume (MPC)

Relationship between MPC and MPS

What is the difference between ex ante investment and ex post investment?

Solution

What do you understand by 'parametric shift of a line'? How does a line shift when its (i) slope decreases, and (ii) its intercept increases?

Solution

What is 'effective demand'? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?

Solution

Effective Demand

Derivation of the Autonomous Expenditure Multiplier

Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is 4000 crores. State whether the economy is in equilibrium or not (cite reasons).

Solution

Explain 'Paradox of Thrift'.

Solution