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LESSON -8
SHORT RUN EQUILIBRIUM OUTPUT
Concept of short run:
In macroeconomics (and according to Keynes) short run is defined as a period of time during which level of output is
determined exclusively by the level of employment in the economy. Higher level of employment causes proportionately
higher level of output, and vice versa. Technology (another important determinant of output) is assumed to be constant.
The output can be measured in terms of employment. In other words, one can say that output and employment are
synonyms of each other; level of output means level of employment. Thus, in Keynesian Economics equilibrium level of
output/income implies equilibrium level of employment.
Q1. Explain determination of equilibrium level of income and employment using C + I curve.
Or
Why must aggregate demand be equal to aggregate supply at the equilibrium level of income and output?
Explain with the help of a diagram.
Ans. According to Keynes equilibrium level of income and employment is determined at that point where planned
aggregate demand becomes equal to planned aggregate supply. Clearly, there are two factors which determined
the level of income and output - AD and AS.
Aggregate Demand: Aggregate Demand is the total demand of all the goods and services in the economy
during an accounting year. In two sector economy, there are two components of aggregate demand –
Consumption (C) and Investment (I). So, AD curve is represented by (C+I) curve in the income determination
analysis.
Aggregate Supply: Aggregate Supply is the total output of goods and services of the national income. It
is depicted by a 450 line. Since income received is either consumed of saved, the AS curve is represented by the
(C+S) curve.
The determination of equilibrium level of income can be better understood with the help of the following
schedule and diagram:
Income consumption Saving investment AD(C+I) AS(C+S) Remarks
0 40 -40 40 80 0
100 120 -20 40 160 100
200 200 0 40 240 200 AD > AS
300 280 20 40 320 300
400 360 40 40 400 400 AD = AS
500 440 60 40 480 500 AD < AS
600 520 80 40 560 600

In the figure the AD or C+I curve shows the desired level of expenditure by consumers and firms corresponding
to each level of output. The economy is in equilibrium at point E where C+I curve intersects the 45 0 line.
Q.2 What happens to national income when aggregate supply exceeds aggregate demand?
Ans. When AD < AS, then C+I curve lies below the 450 line. It means that the consumers and firms together would
be buying less goods than firms are willing to produce. As a result, the planned inventory would rise.

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To clear the unwanted increase in inventory, firms plan to decrease the employment and output level until the
economy is back at equilibrium where AD = AS and there is no further tendency to change.
Q.3 What happens to national income when aggregate supply is less than aggregate demand?
Ans. When (AD > AS) planned spending is more than planned output, then C+I curve lies above the 45 0 line. It
means that consumers and firms together would be buying more goods than firms are willing to produce. As a
result, the planned inventory would fall below the desired level.
To bring the inventory back to the desired level, firms would resort to increase in employment and output until
the economy is back at output level where AS =AD and there is no further tendency to change.
Q.4 Explain how AD and AS can be in equilibrium at less than full employment.

Ans. In an economy equilibrium level of income and employment is determined at a point where AS =AD. But it is
not necessary that there will be always full employment at this level of income. AD and AS can be in
equilibrium at less than full employment. This situation is called deficient demand.
Example: - Suppose an economy can produce 5000 quintals of wheat by employing all its available resources.
This is economy’s aggregate supply of wheat, at full employment level. But the aggregate demand is only 4000
quintals of wheat. With the result, the economy produces only 4000 quintals of wheat. Hence some sources
capable of producing 1000 quintals will remain idle. This equilibrium can be considered at less than full
employment.

Q.5 Explain with the help of a diagram how is equilibrium level of income determined by savings and
investments?
Ans. National income is at its equilibrium where (a) Aggregate demand equals aggregate supply or (b) investments
equal to savings. Here we will discuss investments and savings.
SAVINGS: Savings refers to that portion of income which is not spent on consumption. Saving can also be
defined as the difference between the income and consumption expenditure.
INVESTMENT: - It is a sort of expenditure that is made on creation of new capital assts like machines,
equipment, building etc. Thus any expenditure that adds to the real stock of goods is called investment.
EQUILIBRIUM:-Equilibrium level of national income is established only at the level where saving is equal to
investment. How? AD is equal to sum of consumption expenditure(C) and investment expenditure (I) Put in
symbols: AD = C + 1
Aggregate supply (AS) is equal to consumption expenditure(C) and savings (S). Put in symbols: AS = C + S
AD = AS or
C + 1 = C + S or S = I

Q.6 Explain with the help of a diagram full-employment equilibrium.

Ans. Full employment equilibrium refers to the situation when aggregate demand equals ‘aggregate supply’ at full
employment level. Thus, at this situation, all available resources are fully employed in producing the output and
aggregate demand is equal to full employment level of output. The situation of full employment can be illustrated with
the help of a diagram.

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. In the figure E is the full employment equilibrium because aggregate demand EM is equal to aggregate supply
OM. At OM level of output, all those who are willing to work at the prevailing wage rate, are able to find
employment, i.e. there is no involuntary unemployment.

Q.7 Explain underemployment equilibrium.

Ans. It refers to a situation when aggregate demand is equal to the aggregate supply when the resources are not fully
employed. It occurs prior to the full employment level.
In the figure AD1 = AS at point F which is lower than full employment level. As, OQ1 is less than OQ. point F
signifies the under employment equilibrium.

Q.8 Explain over full employment equilibrium.

Ans. It refers to a situation when AD is equal to AS beyond the full employment level. It occurs after the full
employment level.
In the figure AD1 = AS at point G which is higher than the full employment equilibrium.

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Q.9 Explain the concept of investment multiplier.
Ans. Investment multiplier shows a relationship between initial increment in investment and the resulting increment
in national income. In other words, multiplier is the ratio of increase in national income (∆Y) due to an increase
in national investment (∆I). Symbolically:
K = ∆Y
∆I
Suppose investment is increased  100 crores, then the aggregate income is increased  400 crores. Then
investment multiplier (k) is 400÷100 = 4

Q.10 How is investment multiplier related to MPC and MPS?

Ans. Value of multiplier (K) depends on value of marginal propensity to consume (MPC) and marginal propensity to
save (MPS). There is direct relationship between K and MPC. If MPC is high, K will also be high bit if MPC is
low, K will also be small. There is inverse relationship between K and MPS. If MPS is high, K will be low but
if MPS is low, K will be high as proved in the following examples.
i) k = 1÷MPS
ii) k = 1÷1-MPC
Examples:
i) Suppose MPC =3÷4. Then k = 4
ii) If MPS = 1÷3, then k = 3

Q.11 Explain the working of investment multiplier with the help of an example.
Ans. Definition of multiplier:- In the words of Kurihara, ‘The multiplier is the ratio of change in income to the
change in investment.’ Investment multiplier can be obtained by dividing the change in income to the change in
investment. Put into equation;
K = ∆Y ÷ ∆I
Working of multiplier:- The working of multiplier can be explained with the help of an example. Let the
investment is increased by Rs.100 crores and at every stage MPC is 0.8. As a result of an investment of Rs. 100
crores the income of the second person will be Rs. 100 crores. The money which this person (second person)
will spend will become the money of the third person. The expenditure of this man depends upon his MPC
which is 0.8 or 80%. Therefore this man will spend 100 x80/100 = 80 crores which will become the income of
the third person. This person will spend 0.8 or 80% of his income. 80x80/100 = 64 rupees and which will
become the income of the fourth person. In this way the process of expenditure and income will continue to
operate. The increase in income as a result of increase in investment can be found out by adding up income of
all the rounds. Total increase in income will be Rs. 500. Investment multiplier will be 5 = 500/100. The same
can be explained with the help of the given table and diagram

TABLE WORKING OF MULTIPLIER

Serials ∆I ∆C Extra aggregate income (∆y)
1 100 - 100
2 80 80
3 64 64
4 51.20 51.20
5 40.96 40.96
6 - -
Total 100 400 500

Aggregate change in income =Rs. 500 crores

K = ∆y÷∆I = 500÷100 = 5
K=5

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In the diagram II is an investment curve and SS is a saving curve. SS intersects II at point E. It means at
OI investment income is OY. If we increase investment, the investment curve shifts upwards I1I1. Here
SS curve intersects I1I1 curve at E1 point. With the result the level of income increase to OY1. Hence by
increment in investment (I1-I) or ∆I, the level of income increases (Y1-Y) to OY1. It is clear from the
diagram that income increases many times than the investment.

Important observations:
i) Minimum value of multiplier is 1(one) because minimum value of MPC can be zero.
K = 1÷1-MPC = 1÷1-0 = 1÷1 = 1
K=1
ii) Maximum value of k may be ∞ because maximum value of MPC can be 1
k = 1÷1-1 = 1÷0 = ∞
iii) Value of MPC cannot be greater than 1 because change in consumption cannot be more than change in
income.
iii) The value of APS can be negative when consumption expenditure becomes greater than income.
Numerical on multiplier

Q.1 If value of MPS is 0.25, what is the value of multiplier?

(Ans. 4)
Q.2 If value of MPC is 0.25, what is the value of multiplier?
(Ans. 1.33)
Q.3 In an economy investment increases by Rs 100 crores. As a result, income increases by Rs 500 crores. What is
the value of multiplier?
(Ans. 5)
Q.4 Find change in income if MPC = 0.8 and change in investment Rs 1,000.
(Ans. Rs 5,000 crores)
Q.5 If an increase of Rs 10,000 in investment in an economy results in an increase in income of Rs 40,000,
calculate MPS in the economy.
(Ans. 0.25)
Q.6 MPC in an economy is 0.8. If investment were increased by Rs 5 crores, how much would be increase in
income?
(Ans. Rs 25 crores)
Q.7 If in an economy, MPC is 0.8 and investment increases by Rs 1,000 crores, calculate total increase in income.
(Ans. Rs 5,000 crores)
Q.8 In an economy, the actual level of income is Rs 500 crores whereas the full employment level of income is Rs
800 crores. The MPC is 0.75. Calculate the increase in investment required to achieve full employment level
of income. (Ans. Rs. 75crores)

Q.9 In an economy investment, expenditure is increased by Rs 400 crores and MPC is 0.8. Calculate total increase
in income and savings.
(Ans. Rs 2,000 crores; Rs 400 crores)
Q.10 Due to increase in investment Rs 20 crores, national income increases by Rs 100 crores. Find out MPC.
(Ans.Rs.0.8)

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Q.11 In an economy investment increase by 120 crores. The value of multiplier is 4. Calculate MPC.
(Ans. Rs. 0.75)
Q.12 In an economy every time income rises, 75% of increase in income is spent on consumption. Now suppose in
the same economy, investment rises by Rs 750 crores. Calculate the following:
a) Change in income
b) Change in saving.
(Ans. - increase in income-Rs. 3000crores; change in saving- Rs.750crores)

Q.13 There is increase in investment of Rs 100 crores in an economy. MPC is 1. What can you say total increase in
income? Calculate. (Ans. income can increase many time because value of multiplier is infinity.)

Q.14 In an economy, 75% of increase in income is spent on consumption. Investment is increased by Rs 1,000
crores. Calculate:
1) Total increase in income, and
2) Total increase in consumption expenditure.
(Ans. MPC= 0.75; Increase in income- Rs.4000crores; increase in consumption-3000)

Q.15 In economy equilibrium, level of income is Rs 12,000 crores. The ratio of MPC to MPS is 3:1. Calculate the
additional investment needed to reach a new equilibrium level of income of Rs 20,000 crores.
(Ans. Rs. 2000)
Q.16 An increase of Rs. 250 crores in investment in an economy resulted in total increase in income of Rs.1,000
crores. Calculate the following: (a) MPC; (b) Change in saving; (c) Change in consumption expenditure; (d)
Value of multiplier.
Ans. (a) MPC= 0.75; (b) Change in saving= Rs.250crores; (c) Change in consumption expenditure=Rs. 750
crores; (d) Value of multiplier=4.
Q.17 In an economy, an increase in investment leads to increase in national income which is three times more than
the increase in investment. Calculate marginal propensity to consume.
(Ans. MPC= 0.75)
Q.18 In an economy, with every increase in income, 10% of the increase in income is saved. Suppose a fresh
investment of Rs. 120 crores places in the economy. Calculate the following: (a) Change in income; (b) Change
in consumption expenditure.

(Ans.. (a) Change in income= Rs. 1200 crores (b) Change in consumption= Rs.1080 crores.)

Q.19 State briefly the classical theory of income and employment.

Ans. Classical economists like Adam Smith, Ricardo and Marshall believed that: An economy, as a whole always
functions at the level of full employment. According to them full employment is a normal situation and
unemployment is a temporary and rare situation and it can be cured by reducing cash wages of the labors.

This theory of classical economists is based on J.B.Says’s law of market. According to this law ‘supply
creates its own demand.’ It means that supply creates a matching demand for it. With the result, the whole of
output is sold out. Whatever amount of goods and services is produced, the whole of it is demanded and sold
out. Thus there is no deficiency in aggregate demand and hence no possibility of over-production and
unemployment.

Q.20 Distinguish between classical theory and Keynesian theory of income and employment.

CLASSICAL THEORY KEYNESIAN THEORY

1. Equilibrium level of income and Equilibrium level of income is established at a point

employment is established only at the level where AD = AS. But this need not be full
of full employment. employment level since it can be at, below or above
the level of full employment.

2. Full employment equilibrium is a normal Under-employment equilibrium is a normal situation.

situation.

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Ans. 3. This theory is based on the belief that Supply by itself cannot create a matching demand.
‘supply creates its own demand’. On the contrary ‘demand creates its own supply’.

4. In case of temporary situation of Employment can be increased by increasing effective

unemployment a cut in money wage increase demand (AD) and not by money wage cut.
employment

5. Advocated policy of opposed govt. Advocate govt. intervention to bring about

intervention since equilibrium is established equilibrium between AD and AS and to ensure full
automatically be market forces of demand employment and its continuity.
and supply.

Question Bank

Q.1. Give meaning of full employment.

Q.2. What is meant by Aggregate supply?
Q.3. Give meaning of involuntary unemployment.

Q.4. Define consumption function.

Q.5. State the meaning of Aggregate demand and components of Aggregate demand.

Q.6. Give the meaning of MPC and MPS and what is the relationship between the two?

Q.7. Can the value of APC be greater than One?

Q.8. Explain consumption function with the help of schedule and Curve.

Q.9. Draw a straight line consumption curve. From it derive saving curve explaining the process of derivation. Show
in this diagram:

a. The level of income where APC=1

b. The level of income where APS is negative

10. If National income is Rs90 crore and consumption expenditure Rs81 crore, Find out APS. When income rises to
Rs.100 crore and consumption to 88 crore, What will be the MPC and MPS?

11. Complete the following table:

INCOME SAVING MPC APC

0 -20
50 -10
100 0
150 30
200 60

12 Complete the following table

INCOME CONSUMPTION EXPENDITURE MPS APS

0 80 - -
100 140 0.4 -
200 - - 0
- 240 - 0.2
- 260 0.8 0.35
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13. Explain determination of equilibrium level of National income with the help of AD and AS approach. Use
Diagram. 14. Explain determination of equilibrium level of National income with the help of Saving and
Investment Approach.

15. If planned Saving exceeds planned Investment, How will equality between them is achieved?

16. Define Investment multiplier .Explain the working of Investment multiplier.

17. What is the minimum value and maximum value of investment multiplier?

18. What will be the change in income if MPC=0.6 and investment rises by Rs100 crore?

19. In a two sector Economy C=50+0.8Y and I=50 Calculate:

a. Equilibrium level of National income

b. What will be change in income if Investment rises by Rs200 crore

c. Also calculate change in consumption and saving

Q.20. What is Inflationary gap/ Excess demand and how it can be corrected with the help of: a. Repo Rate b. CRR

Q. 21. Can an economy be in state of Under-employment equilibrium? Explain with the help of a diagram.

Q.22. Define Deflationary gap/Underemployment Equilibrium. How it can be corrected with help of Fiscal policy?

Q.23. Define Open market operation and how it used to control the situation of Deficient demand in an economy?

Q.24. State whether the following statements are true or false, Give reason for your answer

a. When Investment multiplier is 1, Value of MPC is Zero

b. The value of APS can never be greater than 1

c. Value of MPC can be greater than 1

d. Value of APC can be zero

Q. 25. In an economy S= -50+0.5Y and I=700 Calculate:

a. Equilibrium level of Income

b. Saving at equilibrium level

c. What will be the change in Income if Investment rises by Rs500 crore

Q.26. Calculate Autonomous consumption from the following data

a. National Income 500

b. MPS 0.30

c. Investment 100

Q. 27. In an economy every time income rises and 75% of rise in income spent on consumption. Now suppose in an
economy investment rises by Rs.750 crore. Calculate

a. Change in income b. Change in Saving

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Q.28. In an economy Equilibrium level of income is Rs12000. The ratio of MPC to MPS is 3:1. Calculate the
additional investment needed to reach a new equilibrium level of income of Rs20000 Crore.

Q. 29. Given MPC=0.8 and Investment=40,From the following schedule, Calculate the following

INCOME SAVING
0 -60
100 -
200 -
300 -
400 -
500 -

a. Identify Break even point

b. Locate equilibrium level of income

c. Calculate MPS d. Calculate APS at income of Rs 200