Scribd Logo
Upload

Welcome to Scribd!

  • 31 views

    AD As Chapter 8 - Handout

    Uploaded by

    Puja Bhardwaj

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    AD As Chapter 8 - Handout

    Uploaded by

    Puja Bhardwaj
    31 views18 pages

    Original Title

    AD as Chapter 8 - Handout

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    31 views18 pages

    AD As Chapter 8 - Handout

    Uploaded by

    Puja Bhardwaj

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 18

    ECONOMICS CLASS XII STUDY MATERIAL

    THE THEORY OF INCOME DETERMINATION (CHAPTER – 2)

    (2 approaches of Equilibrium)
    The equilibrium level of national
    income is determined at the point
    where AD equals AS.
    The equilibrium is where
    AD=AS ------- (i)
    As we know we are studying two sector
    model, therefore,
    AD= C + I --------- (ii)
    Since AS is the same as national income, and income is unable for
    making consumption expenditure (C) or for savings (S), therefore
    AS= C + S -------iii)
    Putting (i), (ii) and (iii) together; we get
    AD=AS
    C+I = C+S
    I = S or S = I

    Page 1 of 18
    The above derivation shows that the basic equilibrium condition
    AD=AS can also be expressed as PS (Planned Savings) = PI (Planned
    Investment)
    This gives 2 approaches, AD=AS
    PS=PI

    According to Prof. Keynes


    Determination of equilibrium level of
    income, output and employment is based on
    AD and AS and their respective components.

    1) AD-AS approach

    An economy is said to be equilibrium


    when AD in the economy is equal to AS
    during the financial year.

    Assumptions
    i) The determination of equilibrium output is to be
    studied in the context
    of two-sector model.
    ii) It is assumed that investment expenditure is autonomous.
    iii) Price level is assumed to remain constant.
    iv) Equilibrium output is to be determined in context of short
    run.

    Page 2 of 18
    Y C S I AD=C+I AS=C+S Remarks
    0 40 -40 40 80 0 AD>AS
    100 120 -20 40 160 100 AD>AS
    200 200 0 40 240 200 AD>AS
    300 280 20 40 320 300 AD>AS
    400 360 40 40 400 400 AD=AS
    500 440 60 40 480 500 AD<AS
    Diagram
    AS (NY)

    Income / Output / Employment

    i) AD=AS
    In this situation, buyers/consumers are planning to buy the same
    quantity which producers are planning to supply.
    Equilibrium level is determined at a point where AD=AS i.e point E
    (shown in the diagram)
    OM is the level of income. If there is any deviation from
    equilibrium level of income, interaction between AD & AS will
    bring it back to the equilibrium.

    Page 3 of 18
    ii) AD>AS
    In this situation, buyers are planning to buy more goods and
    services than producers are planning to supply. Producers keep a
    certain stock of goods called ‘inventory’.
    When AD>AS, it means that buyers are buying faster than sellers
    are supplying.
    In this situation, inventories start falling and come below the
    desired level.
    To bring back the inventories at desired level, producers expand
    production. To expand production, more people will be employed.
    This raises the income level which keeps on rising till the AD and
    the AS once again becomes equal.
    This brings economy back to equilibrium.

    iii) AD < AS

    Page 4 of 18
    2) PS-PI approach
    Under this approach equilibrium level of income is determined at
    a point where ex-ante (planned) savings in the economy are equal
    to ex-ante (planned) investments.
    Therefore, equilibrium condition will be:
    Derivation: (Same as given in AD –AS Approach)

    Assumptions:

    Page 5 of 18
    i) PS = PI
    According to this approach, the equilibrium level of income is
    determined at a level, when PS is equal to PI. As shown in the
    diagram, it is point E1 where PS = PI and corresponding to this
    point AD = AS.

    ii) PS < PI
    Prior to OY level of income, when PS < PI, this situation is
    corresponding to the situation where AD > AS.

    Page 6 of 18
    In this case the major part of income is consumed and a minor part
    is saved. It means buyers in the economy are buying faster than
    suppliers are supplying. (AD>AS)

    In this situation, inventories start falling and come below the


    desired level.

    To bring back the inventories at desired level, producers expand


    production. To expand production, more people will be employed.
    This raises the income level which keeps on rising till the AD and
    the AS once again becomes equal.
    This brings economy back to equilibrium.

    iii) PS > PI

    Page 7 of 18
    QUESTION - DEFINE ‘PARADOX OF THRIFT’. (1/2 MARKS)
    ANS-When two or more facts or qualities seem to contradict with each
    other is known as a situation of Paradox. When people are over
    cautious while using money and not wasting it, is called situation of
    thrift.
    This theory is given by Prof John Maynard Keynes.
     According to Prof. Keynes, where people start saving money
    instead of spending it, in response to growing concern about a
    recession, they actually make the recession worse.
    QUESTION: DISCUSS ALL TYPES OF EMPLOYMENT EQUILIBRIUM (each
    for 3-4 marks)

    LEVELS OF EMPLOYMENT
    EQUILIBRIUM
    Full Under Over Full
    Employment Employment Employment
    Equilibrium Equilibrium Equilibrium

    According to Prof. Keynes, equilibrium level of income, output and


    employment can be determined either at:-
    Page 8 of 18
    Full employment equilibrium

    It is a situation in the economy when AD = AS corresponding to full


    employment.

    • This means all the factors which are willing and able to work, get
    the work at prevailing wage rate. This will also mean that there is
    no involuntary unemployment in the economy during this period
    of time.
    • It is the ideal most situation for an economy since the basic aim of
    an economy is to attain a situation where there is neither the
    shortage nor the surplus of factors of production, output and
    income generated.

    Considering point Q on x-axis as full employment we gather the


    following from the above diagram.
    Page 9 of 18
    a) OQ is the total volume of all the factors of production available
    for employment in the economy.
    b) AD & AS curves intersect (i.e AD = AS) exactly against OQ level of
    employment in the economy.
    c) All the factors of production available for employment are
    employed or get employment in the economy.
    d) Thus, equilibrium between AD and AS is corresponding to full
    employment level of income and output in the economy.

    Under Employment Equilibrium

    It is a situation in the economy when AD=AS prior to full


    employment level of income or output.

    • This means all the factors which are willing and able to work
    at prevailing wage rate does not get work.

    • This will mean that there is involuntary unemployment


    prevailing in the economy during this period of time.

    • This is not a good situation for an economy, since there will


    be surplus of idle factors of production which will reduce the
    output and income in the economy.

    Page 10 of 18
    As shown in the above diagram, we observe:
    a) OQ is the total volume of all the factors of production available
    for employment in the economy.

    b) Among OQ level of factors of production, only OQ1 level of


    factors get employment in the economy.

    c) Q1 Q= (OQ-OQ1) level of factors of production are unemployed.

    d) Thus, we see that equilibrium between AD & AS is before full


    employment level of income and output in the economy and
    thus known as under employment equilibrium.

    Page 11 of 18
    Over full employment equilibrium

    It is a situation in the economy when AD = AS after the full


    employment level of output and income.

    • It is known as beyond full employment equilibrium.

    • There will be shortage of factors of production in comparison to


    their demand.

    • It is not a good situation for an economy since short supply of


    factors of production in comparison to their demand will lead to
    increase in wage rate.

    Page 12 of 18
    We observe from above diagram:-
    a) In the diagram, AD1 = AS at point ‘E1’ which is higher than the full
    employment level.

    b) As OY1 is more than OY, point ‘E1which signifies over full


    employment equilibrium.
    Over full employment equilibrium creates inflationary pressure.

    MULTIPLIER
     Relationships

    1) Multiplier and MPC

    The equation shows there is direct relationship between the


    value of MPC and the value of multiplier.
    The higher the value of MPC, the higher is the value of
    multiplier.
    Page 13 of 18
    eg. If MPC= 0.8
    Multiplier 5 times
    And, If MPC= 0.2
    Multiplier 1.25 times
    Hence, it shows with a fall in MPC, Multiplier also decreases.

    2) Multiplier and MPS

    There is an inverse relation between the value of MPS and the value of
    multiplier. The lower the value of MPS the higher is the value of
    multiplier.
    Eg. If MPS= 0.5
    Multiplier = 2 times
    If MPS = 0.2
    Multiplier= 5 times
    Hence, it shows with a fall in MPS, Multiplier increases.

    Page 14 of 18
    Algebraic relationship between multiplier and MPC
    We know, at equilibrium, (Y) income is the sum total of C & I.

    Similarly, any change in income, will


    also be equal to ∆C & ∆I

    Dividing both sides by ∆Y, we get

    Page 15 of 18
    INVESTMENT MULTIPLIER

    Meaning: It is a measure of the effect of change in investment


    on national income. According to Prof. Keynes, multiplier is a
    quantitative expression of relationship between changes in
    level of income because of specific change in investment.

    The multiplier mechanism works on certain assumptions.


    a) The economy is a two sector closed economy.
    b) Investment expenditure is autonomous.
    c) Consumption expenditure is linear.
    d) The price level, wage rate, interest rate etc. are constant.

    Page 16 of 18
    MPC = 0.80
    Rounds ∆I ∆Y ∆C ∆S
    (Increase (Increase in (Increase in (Increase
    in consumption) consumption) in savings)
    investment)
    I 100 100 80 20
    II 80 64 16
    III 64 51.20 12.80
    IV - - -
    - - -
    - - -
    All 100 cr. 500 cr. 400 cr. 100 cr.
    rounds

    K = 1/ 1- 0.80 = 1 / 0.20 = 5 Times


    K = ∆Y
    ∆I
    5 = ∆Y
    100
    Therefore, ∆Y = 100 × 5 = Rs. 500 cr.
    WORKING OF MULTIPLIER

    Suppose we are given that ∆I = rs.100 cr. and MPC = 0.80,


    Page 17 of 18
    Investment is undertaken to generate income. The total increase in
    income is in several rounds, and not increases in one go.
    1) First round
    Investment means expenditure on producer goods. So, an
    investment of Rs.100 cr. raises the income of the producers of
    these goods by Rs. 100 cr.

    2) Second round increase


    Given the MPC = 0.80, people spend 80% of increase in income i.e
    Rs. 80 cr. on consumption. This raises the income of producers of
    consumer goods by Rs. 80 cr.

    3) Third round increase


    Given the MPC = 0.80, people again spend 80% i.e Rs.64 cr. on
    consumption. This leads to another increase in the income of
    Rs.64 cr. of the producers of consumer goods. At the end of third
    round, total increase in income stands
    at Rs. 244 cr. (= 100+80+64)

    In this way, national income goes on increasing in round after


    round. But the increase in each round is restricted to 80% of the
    increase in previous round. It is important to note that, when
    initial increase in investment (∆I) becomes equal increase in
    savings (∆S), income stop rising.

    Page 18 of 18

    You might also like