Determination of Income and Employment (Aggregate Demand & Supply) — Practice

Question 1

In an economy, MPC = 0.6. (i) What is the MPS? (ii) Calculate the investment multiplier. (iii) If investment increases by ₹500 crore, by how much will national income increase?

Accepted Answer

(i) MPS = 1 − MPC = 1 − 0.6 = 0.4. (ii) Investment Multiplier k = 1/MPS = 1/0.4 = 2.5. (iii) Change in Income (ΔY) = k × ΔI = 2.5 × ₹500 crore = ₹1,250 crore. Therefore, national income will increase by ₹1,250 crore when investment increases by ₹500 crore. Intuition: MPC = 0.6 means people spend 60 paise out of every additional rupee earned — so the multiplier effect is moderate (2.5). If MPC were 0.8, the multiplier would be 5 and the income increase would be ₹2,500 crore.

Question 2

In a two-sector economy, the consumption function is C = 200 + 0.8Y. Investment (I) = ₹500 crore. Find the equilibrium level of income.

Accepted Answer

METHOD 1 (AD = AS): At equilibrium: Y = AD = C + I. Y = (200 + 0.8Y) + 500. Y = 700 + 0.8Y. Y − 0.8Y = 700. 0.2Y = 700. Y = 700/0.2 = ₹3,500 crore. METHOD 2 (S = I): First find the savings function. S = Y − C = Y − (200 + 0.8Y) = −200 + 0.2Y. At S = I: −200 + 0.2Y = 500. 0.2Y = 700. Y = ₹3,500 crore. Both methods give the same answer: Equilibrium Income = ₹3,500 crore. VERIFICATION: At Y = 3,500: C = 200 + 0.8(3,500) = 200 + 2,800 = 3,000. AD = C + I = 3,000 + 500 = 3,500 = Y. ✓

Question 3

What is the Paradox of Thrift? Explain it with reference to the multiplier. What are its implications for government policy during a recession?

Accepted Answer

THE PARADOX OF THRIFT — DEFINITION: The Paradox of Thrift (or Paradox of Savings) refers to the situation where an attempt by ALL members of society to SAVE MORE actually results in the same or LOWER total savings — because the act of collectively saving more REDUCES national income. Saving is a private virtue — for an individual, saving more builds wealth. But if everyone saves more simultaneously, it becomes a collective problem. MECHANISM — THE MULTIPLIER IN REVERSE: Suppose the economy is in a recession and everyone becomes worried. Each household decides to save more by reducing consumption. Let MPC fall from 0.8 to 0.6 (MPS rises from 0.2 to 0.4). Multiplier FALLS from 1/0.2 = 5 to 1/0.4 = 2.5. The decline in consumption acts like a NEGATIVE INVESTMENT SHOCK: ΔC = ΔAD = negative → through the multiplier in reverse, income FALLS by a multiplied amount. Suppose consumption falls by ₹100 crore. With the original multiplier of 5: ΔY = −₹100 × 5 = −₹500 crore fall in income. Income has fallen by ₹500 crore. Even though each household tried to save more (higher MPS), their INCOME has fallen by ₹500 crore — so their actual savings may not increase and may even fall (since savings = MPS × Y, and Y has fallen dramatically). THE FALLACY OF COMPOSITION: What is rational for ONE individual (save more when worried → protect against bad times) is IRRATIONAL for the WHOLE ECONOMY when done simultaneously. One person saving more → becomes richer. Everyone saving more simultaneously → everyone becomes poorer. This is the fallacy of composition: the whole is not the sum of its parts when there are FEEDBACK EFFECTS through income. POLICY IMPLICATIONS — GOVERNMENT RESPONSE TO RECESSION: Keynes's insight from the Paradox of Thrift was that during a recession, the government MUST increase its spending even as the private sector is cutting back. Specifically: (1) During a recession with deficient demand, the government should run a FISCAL DEFICIT — increase G (government spending) and/or cut taxes. This directly increases AD, counteracting the fall in private consumption. (2) The multiplier works for government spending just as for investment: ΔY = ΔG × (1/MPS). A ₹100 crore increase in government spending can generate ₹500 crore of income (with multiplier = 5). (3) 'Fiscal austerity' (cutting government spending during a recession) DEEPENS the recession — it is exactly the wrong policy. This lesson was relearned during the 2008-09 Global Financial Crisis and the 2020 COVID recession: governments worldwide increased spending to prevent depression. CONCLUSION: The Paradox of Thrift shows that macroeconomics is NOT just the sum of microeconomic decisions. Individually rational behaviour can be collectively self-destructive. This is why Keynes argued that the government has a PERMANENT STABILISING ROLE in a market economy — not to replace markets, but to compensate when collective irrationality (panic saving) threatens to destroy the economy.

Practice — Determination of Income and Employment (Aggregate Demand & Supply)

Sign in to save attempts to your dashboard and track your accuracy over time

Find a verified tutor

Join a live course

Browse coaching centres

About

Categories

Support

Documentation

Get Study Tips & Updates

Download Our App

Download for iOS

Download for Android

Popular Cities