Here, you will find summaries, questions, answers, textbook solutions, pdf, extras etc. of (Nagaland Board) NBSE Class 12 (Arts/Commerce) Economics Chapter 6: Short-Run Equilibrium Output. These solutions, however, should be only treated as references and can be modified/changed.
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.
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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 aggregate demand?
Answer: Aggregate demand is the total demand for goods and services in an economy at different price levels. It is the sum of consumption expenditure, investment expenditure, government expenditure and net exports.
2. What is aggregate supply?
Answer: Aggregate supply refers to the total amount of goods and services supplied in an economy at different price levels. It is the total output produced by all the firms in an economy.
3. What is equilibrium level of income?
Answer: The equilibrium level of income is the level of national income at which aggregate demand equals aggregate supply. At this level, there is no tendency for income or output to change.
4. What happens when AD>AS?
Answer: When aggregate demand exceeds aggregate supply, it leads to an unintended accumulation of inventories. Producers will respond by increasing production to match demand. This will lead to an increase in income.
5. What happens when AD<AS?
Answer: When aggregate demand falls short of aggregate supply, it leads to an unintended decrease in inventories. Producers will respond by decreasing production to match demand. This will lead to a fall in income.
6. What are the two sectors assumed in determining equilibrium level of income?
Answer: The two sectors assumed are – household sector and business sector. The economy is assumed to have no government or foreign sector.
7. Why are prices kept constant in determining equilibrium output?
Answer: Prices are assumed to be constant in the short run because the economy takes time to respond to forces of excess demand or excess supply.
8. What is the relationship between multiplier and MPC?
Answer: The multiplier is directly related to the marginal propensity to consume. A higher MPC will lead to a higher multiplier.
9. What happens when planned savings exceed planned investment?
Answer: When planned savings exceed planned investment, it leads to unintended increase in inventories. Producers will cut production and income will fall until savings equal investment.
10. How is involuntary unemployment different from voluntary unemployment?
Answer: Involuntary unemployment refers to people willing and able to work at prevailing wages but unable to find jobs. Voluntary unemployment refers to people unwilling to work at prevailing wages despite availability of jobs.
11. What is meant by “effective demand”?
Answer: Effective demand refers to the level of aggregate demand that corresponds to full employment level of output and income in the economy.
12. What is the paradox of thrift?
Answer: The paradox of thrift refers to the situation where more savings can lead to less aggregate savings and lower economic growth due to decreased consumption.
13. What is frictional unemployment?
Answer: Frictional unemployment refers to unemployment arising from labor mobility issues, lack of information about jobs, and time taken by workers to find suitable jobs.
14. What is structural unemployment?
Answer: Structural unemployment arises from structural changes in the economy that affect demand for certain types of labor. This could include changes in technology or consumer demand patterns.
15. Define full employment.
Answer: Full employment refers to a situation where all able and willing to work at prevailing wages are employed. There is no involuntary unemployment.
16. Define under-employment.
Answer: Under-employment refers to a situation where people are employed below their skill levels and earning capacities, often involuntarily.
17. What is a deflationary gap?
Answer: Deflationary gap refers to the gap between aggregate demand and full employment level of aggregate supply, leading to lower output, income and employment.
18. What causes under-employment equilibrium?
Answer: Under-employment equilibrium is caused by deficient aggregate demand, where AD equals AS but at less than full employment of resources.
19. What is the natural rate of unemployment?
Answer: The natural rate of unemployment refers to the minimum unemployment level in an economy arising from voluntary and frictional factors. It is consistent with full employment.
20. What measures can achieve full employment equilibrium?
Answer: Measures like expansionary fiscal and monetary policies, lowering bank rate, increased government spending can help boost aggregate demand to achieve full employment equilibrium.
21. Explain the assumptions taken for determination of equilibrium output in the short run.
Answer: The key assumptions taken for determining equilibrium output in the short run are:
- Prices are assumed to be constant or fixed in the short run. This is because prices take time to adjust to changes in demand and supply.
- Supply is assumed to be perfectly elastic at the fixed price. Firms are willing to supply whatever quantity is demanded at the given price.
- The time period is short run during which technology and production capacity are fixed. Output can be varied by varying employment.
- It is a simple two-sector model of the economy with just households and firms. Government and foreign trade sectors are ignored.
22. Describe what happens when aggregate demand is less than aggregate supply.
Answer: When aggregate demand (AD) falls short of aggregate supply (AS), it indicates excess supply in the economy. This leads to unplanned build-up of inventories and stocks with producers. To correct this imbalance, producers will cut back production and employment, leading to a fall in income and output. The fall in income will reduce consumption expenditure. This adjustment process continues until AD equals AS at lower level of income and employment.
23. Explain the paradox of thrift.
Answer: The paradox of thrift refers to the situation where an increase in savings rate leads to a decrease in total savings and economic growth. This happens because higher savings mean lower consumption which reduces demand and output. The fall in output reduces income, which leaves less savings in the economy. Thus, while people save more as individuals, total savings in the economy falls.
24. Discuss the causes when aggregate demand is greater than aggregate supply.
Answer: When aggregate demand exceeds aggregate supply in the economy, it leads to an unintended decrease in the inventories and stocks held by producers. To meet the excess demand, firms will expand production and employment, which increases income. The rise in income will further boost consumption demand. This expansionary process will continue until the increased supply matches the higher demand at equilibrium.
25. Explain how equilibrium output is determined in the short run.
Answer: In the short run, equilibrium output is determined by the intersection of aggregate demand (AD) and aggregate supply (AS) curves. With fixed prices and elastic supply, output adjusts to match demand. Equilibrium is achieved where AD=AS at the level of income corresponding to the equilibrium output. A rise in AD causes output to rise until the new equilibrium is established.
26. Derive the relationship between the multiplier and MPC.
Answer: The multiplier (K) is related to the marginal propensity to consume (MPC) in the following way:
Multiplier K = 1/1-MPC
This can be derived from the equilibrium income equation:
Y = A + MPC*Y
Where A is autonomous expenditure
Rearranging:
Y – MPC*Y = A
(1-MPC)*Y = A
Y = A/(1-MPC)
ΔY/ΔA = 1/(1-MPC) = K
Therefore, K and MPC are directly related. A higher MPC leads to a higher multiplier.
27. Discuss the adjustment mechanism in determination of equilibrium through the savings and investment approach.
Answer: The adjustment process works as follows:
- If planned savings > planned investment, it indicates excess supply. Producers cut output. Income and savings fall until savings = investment at lower income level.
- If planned savings < planned investment, it indicates excess demand. Producers raise output. Income and savings rise until savings = investment at higher income level.
This adjustment via output changes continues until saving-investment equality is achieved at equilibrium income.
28. Explain how the multiplier works with an example.
Answer: The multiplier effect can be illustrated with an example. Assume autonomous investment rises by Rs.100 million. With an MPC of 0.75, the multiplier K = 1/0.25 = 4.
Initial investment increase = Rs.100 million
First round income increase = Rs.100 million (MPC = 0.75)
Consumption increase = 0.75*Rs.100 million = Rs.75 million
Second round income increase = Rs.75 million (MPC = 0.75)
Consumption increase = 0.75*Rs.75 million = Rs.56.25 million
The process continues…
Total income increase = Rs.100 + Rs.75 + Rs.56.25 + … = Rs.400 million
Multiplier = Total income increase/Initial investment increase = Rs.400 million/Rs.100 million = 4
Therefore, Rs.100 million investment increased total income by Rs.400 million due to the multiplier effect.
29. Compare and contrast voluntary and involuntary unemployment.
Answer: Voluntary unemployment arises when people choose not to work at prevailing wage rates despite availability of work. Involuntary unemployment arises when people are willing to work at prevailing wages but do not find employment.
Voluntary unemployment does not signal a problem as workers choose not to work. Involuntary unemployment implies an excess supply of labor and deficiency of aggregate demand in the economy.
According to Keynes, the focus should be on involuntary unemployment as it represents unused resources and loss of output. Voluntary unemployment on the other hand is the worker’s choice.
30. Describe the process of achieving full employment equilibrium.
Answer: Full employment equilibrium can be achieved through expansionary fiscal and monetary policies. This involves measures like:
- Increasing government spending to directly pump up aggregate demand.
- Reducing taxes to increase disposable incomes and stimulate spending.
- Lowering interest rates to incentivize investment and consumption spending.
- Increasing money supply to expand liquidity and credit availability.
These policies aim to boost aggregate demand until all unemployed resources are absorbed into employment. The new equilibrium is established at higher income and output corresponding to full employment.
31. Explain the determination of equilibrium through the AD/AS approach.
Answer: Equilibrium level of income is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. The AD curve slopes downwards reflecting the inverse relationship between price level and real output demanded. The AS curve slopes upwards showing direct relationship between price level and real output supplied.
At the intersection point, the quantity of goods and services demanded equals the quantity supplied. This determines the equilibrium level of real national income and employment. If AD shifts right, equilibrium income rises and vice versa. The economy constantly moves towards this income equilibrium via price and output adjustments.
32. Discuss Keynes’ theory of effective demand.
Answer: According to Keynes’ effective demand theory, the level of aggregate demand determines the equilibrium level of employment and real output. If aggregate demand is deficient compared to full employment capacity, the economy will operate at under-employment equilibrium.
Effective demand refers to the level of demand that corresponds to full employment of resources. Thus, government policies should aim to boost aggregate demand until the full employment level of output is reached and there is no involuntary unemployment.
33. Explain the investment multiplier and its significance.
Answer: The investment multiplier refers to the ratio of change in national income to the change in investment that caused it. It measures the multiple expansion of income from an autonomous increase in investment.
If investment rises by Rs.100 and income rises by Rs.400, the multiplier is Rs.400/Rs.100 = 4. This multiplier effect is caused by the rise in incomes leading to more spending and rise in subsequent incomes.
The multiplier effect magnifies the impact of changes in investment on national income. This allows policy makers to influence income via investment. A higher multiplier means a larger impact on income and growth.
34. Discuss measures to reach full employment equilibrium.
Answer: The following measures can help increase aggregate demand to reach full employment equilibrium:
- Expansionary fiscal policy like increased government spending on public infrastructure.
- Expansionary monetary policy like lowering interest rates and increasing money supply.
- Direct employment generation schemes to provide jobs.
- Boosting exports and reducing imports through exchange rate policies and trade reforms.
- Structural reforms and training to address skill gaps and structural unemployment.
- Public works programs to increase employment opportunities.
A combination of these demand-side and supply-side measures can help fill the output gap at full employment.
35. Explain the Classical perspective on full employment equilibrium.
Answer: Classical economists believed that a free market economy would automatically achieve full employment equilibrium through flexible wages and prices. Markets always clear with no surplus or shortage.
Unemployment would be voluntary arising from rigid or high wages. Equilibrium is reached through wage and price adjustments rather than output changes. The focus is on long run supply side factors as markets move to potential output.
36. Discuss the significance of the multiplier for economic growth.
Answer: The multiplier plays a key role in influencing the pace of economic growth. A higher multiplier means that any new autonomous investment spending will have a larger expansionary effect on national income and output.
This allows policy makers to use investment as a tool to accelerate growth. When the economy is in recession, an increase in government spending on infrastructure multiplied through the multiplier process can provide a thrust to growth.
The numerical size of the multiplier is critical in determining the growth impact of any new investment. A higher MPC leads to a larger multiplier and greater growth impetus.
37. Explain the adjustment process when planned savings and investment are unequal.
Answer: The adjustment process works as follows:
- If planned S > planned I, it indicates excess supply. Producers cut output to reduce unintended build-up of inventories. This lowers income and brings down savings until S = I.
- If planned S < planned I, it indicates excess demand. Producers raise output to meet the shortfall in supply. This increases income and raises savings until S = I.
This output adjustment continues until saving-investment equality is restored at a new equilibrium level of income.
38. Discuss types of unemployment that can co-exist with full employment.
Answer: The following types of unemployment are consistent with a full employment economy:
- Frictional unemployment due to labor mobility and mismatch issues.
- Structural unemployment arising from skills mismatch and sectoral shifts.
- Voluntary unemployment due to personal choices and preferences.
- Short-term transitional unemployment as workers change jobs.
Though some unemployment exists, there is no deficiency of aggregate demand or involuntary joblessness in a full employment economy.
39. Explain how under-employment equilibrium occurs.
Answer: Under-employment equilibrium happens when aggregate demand is deficient relative to full employment level of output in the economy. While AD = AS, the intersection occurs at an output level below potential full employment capacity.
This equilibrium is characterized by unemployed resources, unutilized capacity and lower national income relative to possible full employment level. It reflects inadequate aggregate spending rather than a supply-side constraint.
40. Discuss the implications of under-employment equilibrium.
Answer: Under-employment equilibrium has the following implications:
- Resource unemployment leading to lower output and incomes compared to potential full employment capacity.
- Existence of a deflationary gap representing the shortfall in AD relative to full employment output.
- Lower growth, utilization, and living standards due to unemployed capacity.
- Loss of potential output and tax revenues due to unused resources.
- Social issues like poverty and inequality exacerbated by unemployment.
- Need for expansionary policies to boost AD and fill the output gap.
Thus, under-employment equilibrium represents significant opportunity cost for the economy compared to possible full employment scenario.
41. Provide a detailed explanation of how equilibrium level of income is determined through the aggregate demand and aggregate supply approach.
Answer: The equilibrium level of national income is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves.
The downward sloping AD curve represents the total spending on domestic goods and services at different price levels. AD comprises of consumption, investment, government spending and net exports.
The upward sloping AS curve represents the total value of output produced in the economy at different price levels.
The intersection of the AD and AS curves determines the equilibrium level of real GDP and employment. At this point, the quantity of goods and services demanded equals the quantity supplied.
If AD shifts rightwards due to increased spending, the new equilibrium will be at a higher level of national income and employment. Similarly, a leftward shift of AD will lead to a new equilibrium with lower real GDP.
The economy constantly moves towards the income equilibrium through changes in inventories, production and prices. This equilibrium may or may not correspond with full employment of resources.
42. Give an in-depth explanation of the differences between voluntary and involuntary unemployment. Discuss the significance of this distinction according to Keynesian theory.
Answer: Voluntary unemployment occurs when a person chooses not to work at the prevailing wage rate, even though he or she is able to work and employment opportunities are available. It is a conscious choice made by the worker.
Involuntary unemployment arises when a person is willing to work at the prevailing wage rate but is unable to find work. It is unemployment against the will and choice of the worker.
The key differences are:
- Voluntary unemployment is deliberate while involuntary unemployment is beyond the control of the worker.
- Voluntary unemployment does not signal a macroeconomic problem while involuntary unemployment represents unused resources and lower output in the economy.
- Voluntary unemployment is consistent with equilibrium while involuntary unemployment due to deficient demand implies disequilibrium.
According to Keynes, involuntary unemployment is the real policy issue due to its implications for lost output and incomes. It represents an equilibrium below full employment arising from inadequate aggregate demand.
Keynesian policies should aim to boost aggregate demand till involuntary unemployment is eliminated and full employment equilibrium is reached. Voluntary unemployment on the other hand does not warrant policy intervention.
43. Give a detailed analysis of government policy measures recommended by Keynes to achieve full employment equilibrium.
Answer: Keynes advocated expansionary fiscal and monetary policies by the government to boost aggregate demand in the economy to reach full employment equilibrium.
Fiscal Policy Measures:
- Increasing government expenditure on public works, infrastructure and social sector. This directly increases aggregate demand.
- Reducing tax rates to increase disposable incomes of people, thereby increasing private consumption expenditure.
- Providing unemployment benefits and doles to increase incomes and purchasing power of the unemployed.
- Funding employment generating schemes and training programs to improve employability.
Monetary Policy Measures:
- Reducing interest rates and bank reserve requirements to increase credit supply and incentivize investment.
- Purchasing government securities from commercial banks to increase their excess reserves for lending.
- Increasing money supply in the economy through open market operations.
These policies aim to stimulate total spending through higher consumption, investment and government expenditure until full employment output is reached.
44. Provide an extensive discussion of the importance of the multiplier concept in Keynesian theory. Explain its role in influencing economic growth.
Answer: The concept of the multiplier occupies a central place in Keynesian theory because it explains the mechanism by which a change in autonomous spending leads to a magnified change in total income and output.
The multiplier captures the interdependence of different sectors of the economy. An increase in spending adds to someone’s income which then leads to subsequent rounds of spending and income generation.
By quantifying the multiplier effect, policymakers can estimate the impact of any new investment or spending injection on national income and output. A relatively large multiplier will imply a greater expansionary effect on the economy.
Keynes suggested fiscal measures to stimulate investment and spending during periods of high unemployment and economic stagnation. The effectiveness of such policies depends on the size of the multiplier. The higher the MPC, the larger the multiplier and the greater the growth impact of new spending.
Thus the multiplier constitutes a strategic policy tool to influence overall economic performance, growth, employment and standard of living over the short and medium term.
45. Provide a comprehensive analysis of Keynes’ theory of effective demand and its role in determining equilibrium output and employment.
Answer: Keynes introduced the concept of ‘effective demand’ in his General Theory. According to this theory, the level of aggregate demand or effective demand determines the equilibrium levels of output and employment in the economy.
Effective demand refers to the total spending on consumer and investment goods corresponding to full employment of resources. Thus, it represents the demand needed to fully employ all available labor and capital.
If aggregate demand falls short of the requirement for full employment, the economy will operate at an under-employment equilibrium characterized by involuntary unemployment. Unemployment represents idle resources due to deficient effective demand.
Keynes argued that government policies should aim to stimulate aggregate demand through public spending until full employment is reached. The emphasis is on demand management rather than wage flexibility.
Thus, in the Keynesian framework, equilibrium output and employment are determined by the level of effective demand rather than labor market conditions. The goal is to boost aggregate spending up to the point where unwanted unemployment is eliminated and the economy’s resources are fully utilized.
46. Give a detailed comparison of voluntary versus involuntary unemployment and explain the policy implications of each according to Keynesian theory.
Answer: Voluntary unemployment occurs when workers choose not to work at the prevailing wage rate despite having the ability to work and availability of jobs suited to their skills. It is a conscious decision made by workers.
In contrast, involuntary unemployment arises when workers are willing to work at the going wage rates but are unable to find employment. They are unemployed against their choice.
Some key differences:
- Voluntary unemployment represents desired leisure while involuntary unemployment represents wasted resources.
- Voluntary unemployment is consistent with equilibrium while involuntary unemployment due to weak demand implies disequilibrium.
- Voluntary unemployment does not require policy intervention. Involuntary unemployment necessitates demand management policies.
- Voluntary unemployment acts as a labor supply buffer allowing wages to remain flexible. Involuntary unemployment reflects wage rigidities and imbalance between labor demand and supply.
According to Keynesian theory, eliminating demand-deficient involuntary unemployment should be the key policy focus. Voluntary unemployment on the other hand is the worker’s choice and does not hurt the economy. Suitable aggregate demand policies can help achieve full employment by absorbing involuntary joblessness.
47. Provide an analysis of the differences between Classical and Keynesian theories regarding full employment equilibrium and underlying assumptions.
Answer: The Classical and Keynesian theories differ significantly in their explanation of full employment equilibrium:
Assumptions:
- Classical theory assumes flexible wages and prices which continuously adjust to maintain full employment equilibrium. Keynes assumed rigid wages in the short run.
- Classical theory focuses on the supply side and long run full employment equilibrium. Keynes focused on demand factors and short run equilibrium which may not ensure full employment.
Equilibrium:
- Classical theory holds that the economy always tends towards full employment through price and wage adjustments. Keynes said equilibrium can be at under-employment due to weak aggregate demand.
- Unemployment is voluntary arising from rigid wages in the Classical view. Keynes saw unemployment as involuntary due to deficient demand.
Policy Implications:
- For Classical economists, the economy self-corrects to full employment so government intervention is not required.
- For Keynes, active fiscal and monetary policies are required to increase aggregate demand to ensure full employment.
48. Write an extensive essay on the types of unemployment that can co-exist with full employment and their causes.
Answer: Certain types and levels of unemployment are consistent with a full employment economy. They do not indicate deficient demand or represent idle resources.
Frictional Unemployment:
This type of unemployment is caused by the normal labour mobility process as workers change jobs, take time off in between jobs, or temporarily pause work for family reasons. It arises from lack of perfect information about job opportunities and time taken to search for new jobs.
Frictional unemployment exists even when the economy is at full employment since labor mobility is an ongoing process.
Structural Unemployment:
Structural unemployment occurs due to changes in the structure of the economy that affect the demand for certain kinds of labor. For example, technological changes and automation may reduce demand for unskilled workers. Competition from cheaper imports may reduce demand for labour in certain industries.
These structural shifts cause unemployment even in periods of full employment and economic growth. Workers need time to learn new skills and move between declining and emerging sectors.
Voluntary Unemployment:
Some level of voluntary unemployment exists even at full employment as some workers may choose not to work due to personal reasons or because they are not satisfied with the wages offered. Others may opt for more leisure.
Such voluntary unemployment represents the worker’s choice rather than lack of aggregate demand in the economy.
Thus, these forms of unemployment are inevitable in a dynamically growing economy and do not hurt efficiency. They represent short periods of adjustment and transformation rather than sustained involuntary joblessness due to weak demand.
49. Provide a comprehensive analysis of government fiscal and monetary policies recommended by Keynes to achieve full employment equilibrium. Explain how each policy works.
Answer: Keynes advocated active fiscal and monetary policies to expand aggregate demand in the economy to reach full employment equilibrium.
Fiscal Policy Measures:
- Higher government spending: Increases AD directly through higher purchases of goods and services. Multiplier effect amplifies impact.
- Lower tax rates: Increase disposable incomes and private consumption expenditure, thereby expanding AD.
- Unemployment benefits: Raise incomes and purchasing power of the unemployed, which boosts consumption demand.
- Employment programs: Directly generate jobs for the unemployed. Improves employability.
Monetary Policy Measures:
- Lower interest rates: Make borrowing cheaper for investors and consumers. Boosts I and C.
- Buying bonds: Pumps more liquidity into the banking system. Increases availability of credit/money supply.
- Higher money supply: More money in the system reduces interest rates and incentivizes spending.
- Lower reserve requirements: Increase bank lending capability allowing credit expansion.
These policies aim to stimulate AD via higher consumption, investment and output until unwanted unemployment is eliminated and full employment equilibrium is restored in the economy.
Additional/extra MCQs
1. What is defined as short-run time period by accounting to Keynes?
A. Period of change in technology B. Period when level of output is determined by employment C. Period when prices are assumed to be variable D. Period when interest rates are assumed to be fixed
Answer: B. Period when level of output is determined by employment
2. What is the proportionate relationship between output and employment in short run?
A. If employment doubles, output halves B. If employment doubles, output quadruples C. If employment doubles, output doubles D. No relationship between output and employment
Answer: C. If employment doubles, output doubles
3. What does equilibrium level of employment imply in Keynesian view?
A. Equilibrium level of interest rates B. Equilibrium level of wages C. Equilibrium level of output D. Equilibrium level of employment
Answer: D. Equilibrium level of employment
4. When does national income equilibrium occur as per AD and AS approach?
A. When AD is greater than AS B. When AD is less than AS C. When AD is equal to AS D. When AD is not related to AS
Answer: C. When AD is equal to AS
5. What happens when AD is greater than AS?
A. Inventories rise above desired level B. Inventories fall below desired level C. Inventories remain at desired level D. No relation between inventories and AD vs AS
Answer: B. Inventories fall below desired level
6. What happens when AD is less than AS?
A. Inventories rise above desired level B. Inventories fall below desired level C. Inventories remain at desired level D. No relation between inventories and AD vs AS
Answer: A. Inventories rise above desired level
7. What is the condition for national income equilibrium?
A. AD > AS B. AD < AS C. AD = AS D. No relation between AD and AS
Answer: C. AD = AS
8. What principle states that equilibrium output depends on aggregate demand in short run?
A. Relative demand principle B. Effective supply principle C. Effective demand principle D. Relative supply principle
Answer: C. Effective demand principle
9. What is defined as aggregate demand required for full employment equilibrium?
A. Relative demand B. Effective demand C. Relative supply D. Effective supply
Answer: B. Effective demand
10. Which variables are assumed constant in short run analysis?
A. Technology and employment B. Prices and interest rates C. Prices and technology D. Employment and interest rates
Answer: B. Prices and interest rates
11. How many sectors are assumed in short run analysis?
A. 1 sector B. 2 sectors C. 3 sectors D. 4 sectors
Answer: B. 2 sectors
12. What is the equation used to derive equilibrium output?
A. Y = A + bY B. Y = A – bY C. Y = A x bY D. Y = A / bY
Answer: A. Y = A + bY
13. What does A represent in the equilibrium output equation?
A. Marginal propensity to consume B. Total autonomous expenditure C. National income D. Consumption
Answer: B. Total autonomous expenditure
14. What does b represent in the equilibrium output equation?
A. Marginal propensity to consume B. Total autonomous expenditure C. National income D. Consumption
Answer: A. Marginal propensity to consume
15. What shows the impact of change in investment on national income?
A. Investment function B. Savings function C. Investment multiplier D. Consumption function
Answer: C. Investment multiplier
16. How is investment multiplier defined?
A. Ratio of change in investment to change in income B. Ratio of change in income to change in consumption C. Ratio of change in consumption to change in income D. Ratio of change in income to change in investment
Answer: D. Ratio of change in income to change in investment
17. How does investment multiplier work?
A. Through change in interest rates B. Through change in income C. Through change in prices D. Does not work
Answer: B. Through change in income
18. What is paradox of thrift?
A. As saving increases, income decreases B. As income increases, saving decreases C. As saving increases, income increases D. As saving increases, income remains same
Answer: D. As saving increases, income remains same
19. What approach equates planned saving and planned investment?
A. AD-AS approach B. Investment-savings approach C. Effective demand approach D. Multiplier approach
Answer: B. Investment-savings approach
20. When does an economy adjust output in investment-savings approach?
A. When S > I B. When S = I C. When S < I D. No adjustment
Answer: A. When S > I
21. What happens when planned saving is greater than planned investment?
A. Output increases B. Output remains same C. Output decreases D. Unpredictable effect on output
Answer: C. Output decreases
22. What happens when planned saving is less than planned investment?
A. Output increases B. Output remains same C. Output decreases D. Unpredictable effect on output
Answer: A. Output increases
23. What is involuntary unemployment?
A. Willing to work at prevailing wages but unemployed B. Unwilling to work at prevailing wages C. Willing to work at higher wages only D. Unrelated to prevailing wages
Answer: A. Willing to work at prevailing wages but unemployed
24. What is voluntary unemployment?
A. Willing to work at prevailing wages but unemployed B. Unwilling to work at prevailing wages C. Willing to work at higher wages only D. Unrelated to prevailing wages
Answer: B. Unwilling to work at prevailing wages
25. What does full employment refer to?
A. Zero unemployment B. Employment of all resources C. No involuntary unemployment D. Maximum possible employment
Answer: C. No involuntary unemployment
26. What is included in full employment?
A. Only voluntary unemployment B. No unemployment C. Frictional and structural unemployment D. All kinds of unemployment
Answer: C. Frictional and structural unemployment
27. What do Classical economists consider full employment?
A. Zero unemployment B. No involuntary unemployment C. Maximum employment D. Natural rate of unemployment
Answer: B. No involuntary unemployment
28. What do Keynesians consider full employment?
A. Zero unemployment B. No involuntary unemployment C. Maximum employment D. Further increase in AD causes inflation
Answer: D. Further increase in AD causes inflation
29. What is under employment?
A. Zero unemployment B. Employment below potential C. Frictional unemployment D. Voluntary unemployment
Answer: B. Employment below potential
30. When does full employment equilibrium occur?
A. AD = AS at full employment B. AD = AS at zero unemployment C. AD > AS D. AD < AS
Answer: A. AD = AS at full employment
31. What causes under employment equilibrium?
A. Deficiency of aggregate supply B. Excess of aggregate supply C. Deficiency of aggregate demand D. Excess of aggregate demand
Answer: C. Deficiency of aggregate demand
32. What exists in under employment equilibrium?
A. Inflationary gap B. Deflationary gap C. Neither gap D. Both gaps
Answer: B. Deflationary gap
33. When does under employment equilibrium occur?
A. AD = AS at full employment B. AD = AS at zero unemployment C. AD = AS below full employment D. AD ≠ AS
Answer: C. AD = AS below full employment
34. What measures can achieve full employment equilibrium?
A. Decrease government expenditure B. Increase tax rates C. Increase government expenditure D. Increase bank rate
Answer: C. Increase government expenditure
35. How can central bank help achieve full employment equilibrium?
A. Sell securities to commercial banks B. Buy securities from commercial banks C. Increase bank rate D. Decrease bank rate
Answer: B. Buy securities from commercial banks
36. When does economy adjust output in AD-AS approach?
A. When AD > AS B. When AD = AS C. When AD < AS D. No adjustment
Answer: C. When AD < AS
37. What happens when AD > AS?
A. Inventories decrease B. Inventories increase C. No change in inventories D. Unpredictable change in inventories
Answer: A. Inventories decrease
38. What happens when AD < AS?
A. Inventories decrease B. Inventories increase C. No change in inventories D. Unpredictable change in inventories
Answer: B. Inventories increase
39. What is the significance of voluntary vs involuntary unemployment?
A. Voluntary affects economy more B. Involuntary affects economy more C. Both affect equally D. Neither affects economy
Answer: B. Involuntary affects economy more
40. What causes involuntary unemployment according to Keynes?
A. Excessive growth B. Low government spending C. Deficient aggregate demand D. High interest rates
Answer: C. Deficient aggregate demand
41. How can involuntary unemployment be solved according to Keynes?
A. Increase aggregate demand B. Decrease aggregate demand C. Increase interest rates D. Decrease government spending
Answer: A. Increase aggregate demand
42. What determines equilibrium income in S-I approach?
A. Equality of AD and AS B. Inequality of S and I C. Equality of S and I D. Inequality of AD and AS
Answer: C. Equality of S and I
43. What is the adjustment process when S > I?
A. Income increases B. Income decreases C. Income remains same D. No adjustment
Answer: B. Income decreases
44. What is the adjustment process when S < I?
A. Income increases B. Income decreases C. Income remains same D. No adjustment
Answer: A. Income increases
45. What causes change in income in investment multiplier?
A. Change in employment B. Change in consumption C. Change in prices D. Change in interest rates
Answer: B. Change in consumption
46. What is the relationship between MPC and multiplier?
A. Direct B. Inverse C. No relation D. Unpredictable
Answer: A. Direct
47. How does the paradox of thrift impact saving?
A. Saving increases B. Saving decreases C. Saving remains same D. Unpredictable impact
Answer: B. Saving decreases
48. Which approach determines equilibrium when S = I?
A. AD-AS approach B. Multiplier approach C. Paradox of thrift approach D. Investment-savings approach
Answer: D. Investment-savings approach
49. What causes change in output when S ≠ I?
A. Change in interest rates B. Change in income C. Change in prices D. No change
Answer: B. Change in income
50. What is the impact on unemployment if economy is at under employment equilibrium?
A. Unemployment decreases B. Unemployment increases C. No impact on unemployment D. Unpredictable impact
Answer: B. Unemployment increases
51. What causes change in output when AD ≠ AS?
A. Change in interest rates B. Change in income C. Change in prices D. No change
Answer: B. Change in income
52. What gap exists at under employment equilibrium?
A. Deflationary gap B. Inflationary gap C. Neither D. Both
Answer: A. Deflationary gap
53. Which equilibrium has no involuntary unemployment?
A. Under employment equilibrium B. Over employment equilibrium C. Full employment equilibrium D. Zero unemployment equilibrium
Answer: C. Full employment equilibrium
54. What happens when economy is at full employment equilibrium?
A. Resources underutilized B. Excess demand C. Excess supply D. Resources fully utilized
Answer: D. Resources fully utilized
55. What is the ideal economic situation for an economy?
A. Under employment equilibrium B. Deflationary gap C. Full employment equilibrium D. Inflationary gap
Answer: C. Full employment equilibrium
56. What policy can help achieve full employment equilibrium?
A. Increase bank rate B. Decrease government spending C. Sell bonds to commercial banks D. Buy bonds from commercial banks
Answer: D. Buy bonds from commercial banks
57. What is the classical view of full employment?
A. Zero unemployment B. Maximum employment C. No involuntary unemployment D. Natural rate of unemployment
Answer: C. No involuntary unemployment
58. What causes inflation at full employment according to Keynesians?
A. Increase in employment B. Increase in interest rates C. Increase in aggregate demand D. Increase in taxes
Answer: C. Increase in aggregate demand
59. What causes under employment equilibrium?
A. Deficiency of aggregate supply B. Excess of aggregate supply C. Deficiency of aggregate demand D. Excess of aggregate demand
Answer: C. Deficiency of aggregate demand
60. How can economy reach full employment from under employment equilibrium?
A. Increase aggregate supply B. Decrease aggregate demand C. Increase aggregate demand D. Decrease aggregate supply
Answer: C. Increase aggregate demand
Ron’e Dutta is a journalist, teacher, aspiring novelist, and blogger who manages Online Free Notes. An avid reader of Victorian literature, his favourite book is Wuthering Heights by Emily Brontë. He dreams of travelling the world. You can connect with him on social media. He does personal writing on ronism.
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