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Determination of |
👉 Aggregate Demand (AD)
It refers to the total value of final goods and services which all the sectors of an economy are planning to buy at a given level of income during a period of one accounting year.
Components of Aggregate Demand
1. Private Consumption Expenditure
2. Investment Expenditure
3. Government Expenditure
4. Net Exports
In the context of two-sector model, AD is the sum total of consumption demand and investment demand, i.e. AD = C + I.
👉 Consumption Function (Propensity to Consume)
It refers to the functional relationship between consumption and national income.
Types of Propensities to Consume
(a) Average Propensity to Consume (APC) : It refers to the ratio of consumption expenditure (C) to the corresponding level of income (Y), i.e. APC = C / Y
(b) Marginal Propensity to Consume (MPC) : It refers to the ratio of change in consumption expenditure (delta C) to change in total income (delta Y), i.e. MPC = delta C / delta Y
👉 Break-even Point
It refers to the point at which consumption is equal to national income, i.e., saving are zero.
👉 Saving Function (Propensity to Save)
It refers to the functional relationship between saving and national income.
Types of Propensities to Save
(a) Average Propensity to Save (APS) : It refers to the ratio of saving (S) to the corresponding level of income (Y), i.e. APS = S / Y
(b) Marginal Propensity to Save (MPS) : It refers to the ratio of change in saving (delta S) to change in total income (delta Y), i.e. MPS = delta S / delta Y
👉 Investment
It refers to the expenditure incurred on creation of new capital assets.
Two Types of Investment
(a) Induced Investment = It is directly influenced by the income level. It is made when marginal efficiency of investment is more than the rate of interest.
(b) Autonomous Investment = It is not affected by changes in the level of income. It is not guided solely by the profit motive.
👉 Ex-ante / Ex-post (Saving / Investment)
1. Ex-ante Saving = It refers to the amount which savers plan to save at different levels of income in an economy.
2. Ex-ante Investment = It refers to the amount which investors plan to invest at different levels of income in an economy.
3. Ex-post Saving = It refers to the actual saving in an economy during a year.
4. Ex-post Investment = It refers to the actual investment in an economy during a year.
👉 Approaches for Determining Equilibrium
1. AD (or C + I) and AS Approach = Equilibrium is achieved when planned expenditure of the economy (AD) is equal to the planned availability of goods and services (AS), i.e. when AD = AS.
2. Saving and Investment Approach = Equilibrium level of income is determined at the level where planned saving is equal to planned investment, i.e., when S = I.
👉 Employment Equilibrium Conditions
1. Full Employment Equilibrium = It refers to a situation when aggregate demand is equal to the aggregate supply at full employment level.
2. Underemployment Equilibrium = It refers to a situation when aggregate demand is equal to the aggregate supply at a level where the resources are not fully employed.
3. Over Full Employment Equilibrium = It refers to a situation when AD is equal to AS beyond the full employment level.
👉 Investment Multiplier
It refers to the ratio of change in income (delta Y), to a change in investment (delta I). K = delta Y / delta I. The minimum value of multiplier can be one and the maximum value can be infinity.
Multiplier is directly related with the MPC, i.e., K = 1 / 1 - MPC
Multiplier is inversely related with the MPS, i.e., K = 1 / MPS
Working of Multiplier is based on the fact "One person's expenditure is another person's income". So, multiplier expresses the relationship between an initial increment in investment and the resulting increase in aggregate income.
👉 Excess Demand
It refers to a situation when AD > AS corresponding to the full employment level of output in the economy.
1. Inflationary Gap
It shows the gap by which actual AD exceeds the AD required to establish full employment equilibrium.
2. Reasons for Excess Demand
(i) Rise in the Propensity to consume
(ii) Reduction in taxes
(ii) Reduction in taxes
(iii) Increase in government expenditure
(iv) Increase in Investment
(v) Fall in Imports
(vi) Rise in Exports
(vii) Deficit financing
3. Impact of Excess Demand
Excess Demand leads to inflation (continuous rise in prices) without any increase in output and employment as the economy is already operating at the full employment level.
4. Measures to Correct Excess Demand
(i) Decrease in Government Spending : In this Fiscal measure, Central Government needs to reduce its expenditure in order to decrease level of aggregate demand.
(ii) Increase in Taxes : It this Fiscal measure, government increases the rates of taxes and even imposes some new taxes to decrease the level of aggregate demand.
(iii) Decrease in Money Supply or Availability of Credit : Central Bank aims to reduce money supply through 'Monetary Policy'. It includes :
Quantitative Instruments : (a) Increase in Bank Rate, (b) Increase in Repo Rate, (c) Open Market Operation (Sale of securities), (d) Increase in legal reserve requirements.
Qualitative Instruments : (a) Increase in margin requirements, (b) Moral Suasion (Advise to Discourage Lending), (c) Selective Credit Controls (Introduce Credit Rationing).
👉 Deficient Demand
It refers to a situation when AD < AS corresponding to the full employment level of output in the economy.
1. Deflationary Gap
It shows the gap by which actual AD falls short of the AD required to establish full employment equilibrium.
2. Reasons for Deficient Demand
(i) Decrease in the Propensity to consume
(ii) Increase in taxes
(ii) Increase in taxes
(iii) Decrease in government expenditure
(iv) Fall in Investment Expenditure
(v) Rise in Imports
(vi) Fall in Exports
3. Impact of Deficient Demand
Deficient Demand leads to fall in prices which, in turn, leads to fall in the output and employment level.
4. Measures to Correct Deficient Demand
(i) Increase in Government Spending : In this Fiscal measure, Central Government needs to increase its expenditure in order to decrease level of aggregate demand.
(ii) Decrease in Taxes : Government reduces the rates of taxes and even abolishes some of the taxes to raise the level of aggregate demand.
(iii) Increase in Money Supply or Availability of Credit : Central Bank aims to reduce money supply through 'Monetary Policy'. It includes :
Quantitative Instruments : (a) Decrease in Bank Rate, (b) Decrease in Repo Rate, (c) Open Market Operation (Purchase of securities), (d) Decrease in legal reserve requirements.
Qualitative Instruments : (a) Decrease in margin requirements, (b) Moral Suasion (Advise to Encourage Lending), (c) Selective Credit Controls (Withdraw Credit Rationing).
👉 Multiple Choice Questions (MCQs)
Que 1. Out of the following, which can have a value more than one ?
(a) MPC (b) APC (c) APS (d) MPS
Ans. (b) APC
Que 2. Break-even point is achieved when :
(a) National Income = Consumption (b) Consumption = Saving
(c) Consumption = Investment (d) National Income > Consumption
Ans. (a) National Income = Consumption
Que 3. Tick the wrong option :
(a) APC can be more than 1 (b) APC can be equal to 1
(c) APC rises with increase in income (d) APC can never be 0
Ans. (c) APC rises with increase in income
Que 4. If investment falls to zero, national income does not fall to zero because of :
(a) Autonomous Consumption (b) Induced investment
(c) Autonomous investment (d) Multiplier
Ans. (a) Autonomous Consumption
Que 5. The value of multiplier is :
(a) 1 / MPC (b) 1 / MPS
(c) 1 / 1 - MPS (d) 1 / MPC - 1
Ans. (b) 1 / MPS
Que 6. If MPC = 1, the value of multiplier is :
(a) 0 (b) 1 (c) Between 0 and 1 (d) Infinity
Ans. (d) Infinity
Que 7. When aggregate demand is greater than aggregate supply, inventories :
(a) Fall (b) Rise (c) Do not change (d) First fall, then rise
Ans. (a) Fall
Que 8. If the marginal propensity of consume is greater than marginal propensity to save, the value of the multiplier will be :
(a) greater than 2 (b) less than 2
(c) equal to 2 (d) equal to 5
Ans. (a) greater than 2
Que 9. If an economy is to control recession like most of the Euro-Zone nations, which of the following can be appropriate :
(a) Reducing Repo Rate (b) Reducing CRR
(c) Both (a) and (b) (d) None of (a) and (b)
Ans. (c) Both (a) and (b)
Que 10. Aggregate demand can be increased by :
(a) increasing bank rate (b) selling government securities by Reserve Bank of India
(c) increasing cash reserve ratio (d) none of the above
Ans. (d) none of the above
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