ECONOMICS

CHAPTER 12: THEORY OF INCOME AND EMPLOYMENT

Class: XII (ISC)
2017-2018
1. What is meant by aggregate demand?
Ans: Aggregate demand refers to the desired or planned demand or spending by the
people. It is represented as AE = C+I+G+(X-M)
Where, AE => Aggregate demand
C => consumption expenditure
I=> Investment expenditure
G=> Government expenditure
(X-M)=> Rest of the world

2. What is meant by consumption function?

Consumption function represents the functional relationship between the desired
consumption expenditure and income.
where:
C=Consumer spending
a = Autonomous consumption, or the level of consumption that would still exist even
if there is no income.
c = Marginal propensity to consume, which is the ratio of consumption changes to
income changes
Y = Real disposable income
3. What is meant by APC and MPC?
Consumption function is explained w.r.t. two technical terms:-
a) Average propensity to consume (APC) - The concept of APC indicates the ratio
of aggregate consumption expenditures to aggregate income APC = C/Y.
For example at income 400 crores the consumption expenditure is Rs. 360
crores, the APC=C/Y=360/400 - 9/10 = 0.9
b) Marginal propensity to consume (MPC) - The concept marginal propensity to
consume (MPC) refers the ratio of small change in consumption to small change
in income.

For example if income increases from 400 crores to 500 crores, and consumption
expenditure increases from 300crores to 350 crores, then
50/100 = 0.50.

(1)
4. State the three basic properties of consumption function.
The main properties of the Keynesian consumption function can be summarized as
follows.
(i) There is a direct relationship between income and the desired or planned
consumption expenditure.
(ii) The marginal propensity to consume (MPC) – the proportion of the marginal income
consumed-ranges between 0 and 1, that is 0 < MPC < 1 (0 and 1 included.)
(iii) The APC declines as income increase, that, is the proportion of marginal income
consumed goes on decreasing.

5. What is meant by saving function?

Saving function represents the functional relationship between level of saving and level
of income.
It can be explained with the help of two technical terms:-
a) Average propensity to save (APS)
b) Marginal propensity to save (MPS)
6. Define
a. Investment.- it refers to that part of the aggregate output which takes the form
of new plants, new capital equipment and machinery, new structures ( factories,
office building etc.) and addition to business inventories (stock of goods).
b. Investment Multiplier – the investment multiplier is defined as the amount by
which the income increases as a result of increase in investment expenditure.
c. Full Employment – full employment mat be defined as the situation where all
those persons who are willing to work at a prevailing wage rate are getting work
and are in fact employed.
7. Explain:
a. Private and public investment – Public investment refers to investment
undertaken by the government in projects like hospitals, school, gas, water, etc.
Private investment refers to expenditure incurred by the private entrepreneurs
on the purchase of capital goods like plant, machinery, inventory, etc.
b. Induced and autonomous investment – Induced investment refers to investment
undertaken as a result of change in the level of income. The induced investment
is income-elastic.

(2)
 Autonomous investment is that type of investment which is not affected by the
change in the level of income. The autonomous investment is income-inelastic.

8. What is meant by voluntary and involuntary unemployment?

Voluntary unemployment refers to those persons who are voluntarily unemployed i.e.
unemployed by their choice.
Involuntary unemployment refers to a situation when people are willing to work at at
the prevailing wage rate but are unable to find work.

9. Explain the determination of equilibrium level of income through aggregate demand

and aggregate supply approach.
Ans: According to aggregate demand and aggregate supply approach, equilibrium level of
income and output in the economy is the one where the aggregate demand for goods equals
aggregate supply AE = Y.

The equilibrium level income is at point E corresponding to the point of intersection of

aggregate demand curve line AE (C+ I) with the Y line. Hence the economy produces Y0 units
of output. At this level purchasers can fulfil their spending plans and firms are able to sell
whatever they desire to produce.
If the output produced by the economy is, say, Y1, which is beyond the equilibrium level of
output the economy, there will be a situation of excess stock lying unsold which in turn induces
the producers to reduce production and thereby income. This happens until the equilibrium
level is restored.

(3)
 Similarly if the output produced in the economy is, say, Y2, which is within the equilibrium
level of output, there exist a situation of excess demand and to meet that, firms will be motivated
to increase the production sand thereby income.

10. Explain the determination of equilibrium level of income through saving and
investment approach.
Ans: According to this approach, equilibrium level of income is determined at that level
where planned investment equals planned saving.

Equilibrium level of income is OY0

corresponding to the point of intersection of the
S and I curves. At this point aggregate demand
equals aggregate supply because the part of
output which is not purchased by households is
purchased by the firms.

At OY1 level of output, saving exceeds planned

investment by AB. Here, aggregate supply
exceeds aggregate demand, since consumption is
low due to higher amount of saving.
Consumption expenditure of the households and
the investment expenditure of firms will not be
sufficient to purchase the entire output produced.
There would be excess supply, therefore
inventories will pile up with the producers. In a
bid to cut down the inventories, the firm will cut
down production and lay off workers. As a result
the level of income, output and employment will
decreases and will continue till the income decreases to the equilibrium level OY0.

At OY2 level of income the planned investment of the firms exceeds saving of the house
hold by GH amount. As a result, the demand for the goods will be more than the current
production by GH due to high consumption expenditure. Therefore, firms will like to
expand production and hire more workers to build up their inventories. Thus, the level of
income, output and employment will rise. The process will continue until output increases
to OY0 where saving equals planned investment.

11. A given increase in the autonomous investment will lead to a more than proportionate
increase in income. Explain why?
Ans: A given increase in the autonomous investment will lead to a more than proportionate
increase in income because of the multiplier effect of each single investment.

The Keynesian multiplier showed that any government spending brought about cycles of
spending that increased employment and prosperity regardless of the form of the spending. For
example, a $100 million government project, whether to build a dam or dig and refill a giant
(4)
hole, might pay $50 million in pure labor costs. The workers then take that $50 million and,
minus the average saving rate, spend it at various businesses. These businesses now have more
money to hire more people to make more products, leading to another round of spending.
The investment multiplier is defined as the amount by which the income increases as a result
of increase in investment expenditure.
The magnitude of this increase is measured by how much income is passed on any each stage.
K= Y/ I
This in turn is related to consumption expenditure or MPC.
K = 1/(1 - MPC)
OR
K = 1/MPS

It is evident from the graph above that I< Y

11. Explain the concept of deficient demand with the help of a diagram. Suggest two measures
to overcome it.

Deficient demand is defined as the amount by which aggregate expenditure falls short of the
aggregate output at full employment level.

As shown in the diagram, aggregate expenditure curve AE0 intersects the 45 degree line at E,
equilibrium income 0Yf. This is full employment level of income.

(5)
Now, suppose government expenditure falls, as a result of which new aggregate expenditure
becomes AE1.

Whenever deficient demand occurs, the economy cannot be in equilibrium at full employment
at full employment level. This will lead to fall in income to OY1, causing unemployment in the
economy. As aggregate demand is not sufficient to purchase the potential output, income,
output and employment in the economy will fall. Deficient demand leads to fall in prices as
well because of excess supply.

Measures to correct deficient demand:

1. Fiscal policy:
a. Taxation: A reduction in taxes on personal incomes like income tax will increase personal
disposable income and will increase consumption expenditure. A cut in taxes on corporate
profit will increase the incentive to undertake investment. A reduction in indirect taxes like
excise duties, VAT etc. will also increase the disposable income of the households and will
increase aggregate consumption expenditure thereby.

b. Public expenditure: The government should increase public expenditure. The government
should undertake large investment in public works like construction of roads, bridges etc.
The government should also provide production subsidies and other such incentives to
producers to stimulate investment expenditure.

c. Public borrowing: The government should discourage large scale borrowing. This will leave
more income and purchasing power with the public.

d. Deficit financing: The government should pursue the policy of deficit financing. As a result,
the aggregate demand will increase.

2. Monetary policy:
a. Bank rate: The central bank of the country should reduce bank rate to overcome the situation
of deficient demand in the economy. Lower cost of credit from the banks would increase the
amount of credit borrowed from them.

b. Open market operations: The central bank should purse the policy of buying government
bonds and securities from the commercial banks. This will increase the cash holdings of
commercial banks and will increase their loans and advances in economy.
(6)
c. Cash reserve ratio: CRR ratio needs to be reduced to overcome the situation of be reduced to
overcome the situation of deficient demand. Consequently, cash with the commercial banks
increases, which will increase capacity of banks to give loans and advances. This will have
expansionary effect on the economy.

3. Export promotion: The government should undertake various export-promotion measures

like subsidies and tax incentives to exporters to stimulate export. The foreign markets and will
help in wiping out the deficient demand.

12. Explain and show graphically the concept of inflationary gap.

The difference between the aggregate demand and aggregate output at full employment in
known as excess demand.
This excess demand will push up price level. A high level of aggregate spending relative to full
employment level of output will generate shortage of goods in the economy, which would push
up prices and cause inflation or inflationary gap.

(7)
EXTRA QUESTIONS:
1. Distinguish between desired (ex-ante) demand and effective (ex-post) demand.
2. Differentiate between marginal propensity to save and average propensity to save.
3. Explain the derivation of multiplier formula.
4. What is meant by excess demand? Explain measure to correct excess demand.
5. State properties of consumption and saving function.

INSTRUCTIONS TO STUDY THIS CHAPTER:

 Please read your book for detailed information of the above topics.
 The length of the answer depends on the marks in the question paper and may not
only be
 Substituted with what is mentioned in the notes.
 Draw diagram wherever necessary.
 Examples can be used to elaborate your points for this chapter.

_____________________________________________________________________

(8)