CH-4 DETERMINATION OF INCOME AND EMPLOYMENT

1. What is marginal propensity to consume? How is it related to marginal

propensity to save?
MPC, or Marginal Propensity to Consume, is a vital component of the
Keynesian theory of macroeconomics, and it is defined as the increase in
consumer spending due to an increase in income. It is expressed as ∆C/∆Y,
which shows the change in consumption with a change in income.
Where ∆C = Change in consumption
∆Y = Change in Income
MPC and MPS (Marginal propensity to save) are related as follows:
MPC + MPS = 1
or MPS = 1- MPC
or MPC = 1- MPS
For example, if a person gets Rs. 1000 extra as a bonus, and if he spends around
Rs. 700 and saves Rs. 300, then his MPC will be 0.7 and MPS will be 300 or (1-
0.7) = 0.3.
2. What is the difference between ex-ante investment and ex-post
investment?

Ex-ante Investment Ex-post Investment

The investment planned by the firms in The actual investment that is made
the economy during a particular period of by all the entrepreneurs in the
time is called ex-ante investment. economy during a period is called
ex-post investment.

The planning is done based on future It is the result of actual investment

expectations.

3. 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?
Consider the equation of the straight line of form b = ma + ε, where m > 0 is
called the slope of the straight line (a) and ε > 0 is the intercept on the vertical
( b) axis. Any increase in a will result in increasing the value of b by a unit of m.
Here m and ε are known as parameters of the graph, and their role is to regulate
the graph’s position.
Parametric shift refers to the changes in the curve due to changes in the value of
the entities m and ε in the graph.
According to the conditions in question
i. If the slope decreases, then the consumption curve will shift downwards
ii. When the intercept increases, the consumption curve will move parallelly
with the intercept.
4. What is ‘effective demand’? How will you derive the autonomous
expenditure multiplier when price of final goods and the rate of interest are
given?
Effective demand is the demand for a product or service when purchasers
become constrained in a market. It also refers to their ability and willingness to
purchase goods at different levels. According to the macroeconomic theory by
Keynes, effective demand is referred to as the point of equilibrium where
aggregate demand equals aggregate supply.
Graphically it can be represented as :

In this graph, the x-axis represents income, and the y-axis represents the level of
aggregate demand. The two curves, AD and AS, meet at equilibrium point E.
Effective demand is shown by EG. AD represents the output level. The
autonomous expenditure multiplier can be derived as follows
Y = AD (at equilibrium)
AD = A + cY
Therefore
Y = A + cY
or A = Y – cY
A = Y (1 – c)
Y = A / (1 – c)
Where
A = Autonomous expenditure
c = MPC or Marginal Propensity to Consume
Y = Level of income
1 / 1-c = autonomous expenditure multiplier
Therefore we can say that the autonomous expenditure multiplier is dependent
on the MPC and Income level.
5. 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 Rs 4000 crores. State whether the economy is in equilibrium or not

(cite reasons).
 Aggregate demand refers to the money value of goods and services that all
sectors of the economy are planning to buy at a given level of income, in a
given period of time.
It is equal to Aggregate Expenditure.
COMPONENTS OF AGGREGATE DEMAND
Private consumption expenditure, Investment expenditure, Government
consumption expenditure and Net Exports are the components of aggregate
demand.
In a two sector economy aggregate demand consists of Private
consumption Expenditure and Investment Expenditure.
AD = C + I
Important features of Aggregate Demand
(i) In a two sector economy Aggregate demand is the sum of Consumption
Expenditure and Investment Expenditure.
AD = C + I
(ii) Even at zero level of income, there is consumption of some basic goods
and services. It is called autonomous consumption (C). So, there is Aggregate
demand even at zero level of income. Aggregate demand curve and
Consumption curve start from a point on Y axis.
(iii) Aggregate Demand and the Consumption curves slopes upward from left
to right because consumption increases as income increases.
(iv) It is assumed that Investment is autonomous. So, Investment curve is a
horizontal line parallel to X axis.
Aggregate Supply
Aggregate Supply is the money value of goods and services that all the
producers in the economy are planning to supply in a given period of time.
The value of total output in the economy is divided in
to the rewards for factors of production, such as Rent, Wages, Interest and
Profit. So, Aggregate Supply is always equal to National Income of the
country(Y).
A part of National Income is used for meeting consumption expenditure and
another part is saved. So, Consumption and Saving are the components of
Aggregate Supply.
 AS = Y = C + S
Investment Multiplier put forward by J M Keynes.
According to Keynes, a small change in Investment will lead to a
big change in Income.
Investment Multiplier is the rate of change in Income due to
change in Investment.
 Increase in Investment leads to increase in income.
 Increase in income leads to increase in consumption expenditure.
 One man’s consumption is another man’s income. So, increase in
consumption leads to increase in income.
 This process continues till change in consumption expenditure becomes
zero.
 The resultant increase in income depends upon the existing MPC.
 EXCESS DEMAND OR INFLATIONARY GAP
 Excess demand is a situation in which Aggregate Demand is more than
Aggregate Supply at full employment level of income. It is also called
Inflationary gap.
 AD > AS
 CAUSES OF INFLATIONARY GAP
 (i) Increase in consumption expenditure by households
 (ii) Rise in Investment by Firms.
 (iii) Increase in Government Expenditure.
 (iv) Decrease in Taxes.

 EFFECTS OF INFLATIONARY GAP:
 (i) Output will not change as the economy is already at full
employment level.
 (ii) Employment opportunities will not change because economy is
already at full employment level.
 (iii) Inflationary Gap leads to increase in prices.


a. Quantitative measures :-

Bank Rate

Repo Rate

Reverse Repo Rate

Open Market operations

Cash Reserve Ratio (CRR)

Statutory Liquidity Ratio (SLR)

i) Bank Rate: Commercial Banks may take loans to meet their long term
credit needs from the Central Bank. The interest for these loans is called
Bank Rate.

During Inflationary Gap, the Central Bank will increase the

Bank Rate. This will discourage Commercial Banks from taking loans from
Central Bank. Their lending power will decrease. They will lend less and
charge high rate of interest Money supply will fall. Consumption and
aggregate demand will fall.

2. Repo Rate: Commercial Banks may take loans to meet their short term
credit needs from the Central Bank. The interest charged on these loans is
called Repo Rate.

During Inflation Repo Rate will be increased. The lending capacity of

commercial banks will fall. They will advance less loans with high interest
 rate . Money supply will fall. Aggregate Demand will fall. Excess demand
will be corrected.

3. Reverse Repo Rate

Reverse Repo Rate: Sometimes, the Central Bank may borrow money from
Commercial Banks. This interest paid for these loans is called Reverse Repo
Rate. During Inflation, the Reverse Repo rate will be increased. The
Commercial Banks will lend more money to Central bank. They will lend
less to public. Money supply and Aggregate Demand will fall.

4. Open Market Operations:

During Inflation, the Central Bank will sell securities to the public and get
money. Money supply will decrease and . Aggregate Demand will fall and
Inflationary Gap will be reduced

5. Legal Reserve Ratio

Cash Reserve Ratio

Statutory Liquidity Ratio

LRR will be increased during inflation

 QUALITATIVE MEASURES
 (i) Margin Requirement: This can be explained with an example. A
person gives a collateral security worth Rs 100 to a commercial bank and
the bank may give him loan of Rs 80. This means the margin is 20%.
During Inflation bank will increase margin requirement.
 (ii) Rationing credit: Sometimes the central bank will instruct the
commercial bank to give some percent of loan to some sectors. This is
called fixing the quota. During Inflation rationing will be introduce
(iii) Warning and direct action: The central bank may warn or take direct
action against the commercial banks, which do not follow its guide lines. A
few months ago RBI slapped Rs 5 lakhs on IDBI.
(iv) Moral suasion: Sometimes central bank may persuade the commercial
banks to follow its guidelines.

FISCAL POLICY

 It refers to the policy related with the income and expenditure of

the Government.
  (i) Decrease in Government Expenditure: During excess demand, the
Government will reduce its expenditure. Income of the people will fall and
aggregate demand will fall.
 (ii)Increase in Taxes: During Inflation, the Government will increase taxes.
The disposable income of the people will fall. This will lead to fall in
aggregate demand.
 (iii) Increase public borrowing: During Inflation, Government will increase
borrowing from the public. This will reduce money supply and aggregate
demand will fall.
 DEFICIENT DEMAND ( DEFLATIONARY GAP)
 Deficient demand is a situation in which Aggregate
Demand is less than Aggregate Supply at full employment level of income.
It is also called deflationary gap.
 AD < AS
 Causes of Deflationary Gap
 (i) Fall in consumption expenditure by households
 (ii) Fall in Investment by Firms.
 (iii) Fall in Government Expenditure.
 (iv) Increase in Taxes


 Measures that can be taken to correct deficient demand

(Deflationary Gap)

 MONETARY POLICY: It refers to the policy of the Central Bank in
relation to money and financial institutions.

 MONETARY POLICY

 QUANTITATIVE MEASURES
 QUALITATIVE MEASURES
QUANTITATIVE METHODS
 (i) Bank Rate: Commercial Banks may take loans to meet their long term
credit needs from the Central Bank. The interest for these loans is called
Bank Rate. During deflationary Gap, the Central Bank will reduce the Bank
Rate. This will encourage commercial banks to take loans from Central
Bank. Their lending power will increase. They will collect less interest.
Fall in interest will encourage people to take loan and buy goods and
services. Aggregate demand will increase.
  (ii) Repo Rate: Commercial Banks may take loans to meet their short
term credit needs from the Central Bank. The interest for these loans is
called Repo Rate.
 During deflationary Gap, the Central Bank will reduce the Repo Rate.
This will encourage commercial banks to take loans from Central Bank.
Their lending power will increase. They will collect less interest. Fall in
interest will encourage people to take loan and buy goods and services.
Aggregate demand will increase.
 (iii) Reverse Repo Rate: Sometimes, the Central Bank may borrow
money from Commercial Banks. The interest paid for these loans is
called Reverse Repo Rate.
 During Deflation, the Reverse Repo rate will be reduced. The
Commercial Banks will not lend to Central bank. Instead, they will
advance more loans to people. Money supply and Aggregate Demand
will increase.


(iv) Open Market Operations: During deflationary Gap, the Central Bank will
buy back securities from the public and give them money. Money supply will
increase and aggregate demand will increase.
 iii) Cash Reserve Ratio (CRR): Commercial Banks have to keep a part of
the deposits with the Central Bank. It is called Cash Reserve Ratio.
During deflation, the CRR will be reduced. This will allow Commercial
Banks to give more amount as loans. Money Supply will increase and
aggregate demand will increase.
 (iv)Statutory Liquidity Ratio (SLR): Commercial Banks have to keep a
part of the deposits with them to meet day today withdrawals. It is called
SLR. During deflation, the SLR will be reduced. This will allow
Commercial Banks to give more amount as loans. Money Supply will
increase and aggregate demand will increase.
Qualitative Measures
 (i) Margin Requirement: This can be explained with an example. A
person gives a collateral security worth Rs 100 to a commercial bank and
the bank may give him loan of Rs 80 as loan. This means the margin is
20%. During deflation bank will reduce margin requirement.
 (ii) Rationing credit: Sometimes the central bank will instruct the
commercial bank to give some percent of loan to some sectors. This is
called fixing the quota. During deflation rationing will be removed.(iii)
Warning and direct action: The central bank may warn or take direct
 Commercial banks, which do not follow its guide lines. A few months
ago RBI slapped Rs 5 lakhs on IDBI.
 (iv) Moral suasion: Sometimes central bank may persuade the
commercial banks to follow its guidelines.
 FISCAL POLICY
 It refers to the policy related with the income and expenditure of
the Government.
 (i) Increase in Government Expenditure: During deficient demand,
the Government will increase its expenditure. The Government will
construct roads, canals, bridges etc. This will create employment
opportunities. Income of the people will increase and aggregate demand
will increase.
 (ii) Reduction in Taxes: During deflation, the Government will reduce
taxes. The disposable income of the people will increase. This will lead to
increase in aggregate demand.
 (iii) Printing more currency: The Government may ask the central bank to
print more currency notes. Money supply in the economy will increase
and aggregate demand will increase.
 (iv) Reduce public borrowing: During deflation, Government will reduce
borrowing from the public. This will increase money supply and
aggregate demand will increase.