CHAPTER –Aggregate

Demand & Aggregate

Supply
Q. a) Assume the following for a hypothetical economy:
(i) Autonomous Consumption Expenditure (𝒄) ഥ = ₹ 25 crore
(ii) Marginal Propensity to Save (MPS) = 0.1
(iii) Level of Income (Y) = ₹ 2,000 crore
(iv) Autonomous Investment (I) = ₹ 25 crore
Is the economy in equilibrium situation? Justify your answer with valid
calculations.

b) “When ex-ante Aggregate Demand (AD) falls short of ex-ante

Aggregate Supply (AS) it results in fall in unintended inventories.”
Defend or refute the given statement, giving valid arguments.

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Ans. a) Given, Autonomous Consumption Expenditure (𝒄) ഥ = ₹ 25 crore Marginal
Propensity to Save (MPS) = 0.1
Level of Income (Y) = ₹ 2,000 crore
Autonomous Investment (I) = ₹ 25 crore
Marginal Propensity to Consume (MPC) = 1 - MPS
1 - 0.1 = 0.9
At equilibrium level of income, Y= C + I
Substituting the value of Y in (C + I)
C + I = 𝒄ത + (MPC)Y + I
= 25 + 0.9 x 2000 + 25
= 1,850 crore
Y > C + I at an income level of ₹ 2,000 crore.
Thus, the economy is not in equilibrium at an income level of ₹ 2,000 crore.
Alternative answer:
At equilibrium level of income, S= I
Substituting the value of Y in S
ഥ + (MPS)Y
S = -(𝒄)
= −𝟐𝟓 + 0.1 x 2000
= ₹ 175 crore
S > I at an income level of 2,000 crore.
Thus, the economy is not in equilibrium at an income level of ₹ 2,000
crore.

b) The given statement is refuted.

If ex-ante Aggregate Demand falls short of ex-ante Aggregate Supply, it
implies that households and firms are planning to buy less than what
the firms expected them to. As a result, inventories will be piled up
with the producers, which may lead to unintended accumulation of
inventories.
Q. a) Complete the following table. Construct/Express the
Consumption function at ₹ 200 crore level of income.
Income (Y) Savings Average Marginal
(in ₹ Crore) (in ₹ Crore) Propensity to Propensity to
Consume (APC) Save (MPS)
0 (-) 30 - -
100 ……. 1 …….
200 ……. 0.85 …….
300 ……. 0.8 …….
b) “In an economy, ex-ante Aggregate Supply is less than ex-ante
Aggregate Demand.”
Explain its impact on the level of output, income and employment.
Ans. a)
Income (Y) Savings Average Marginal
(in ₹ Crore) (in ₹ Crore) Propensity to Propensity to
Consume (APC) Save (MPS)

0 (-) 30 - -
100 0 1 0.3
200 30 0.85 0.3
300 60 0.8 0.3

Consumption function, C = 𝒄̅ + bY
C = 30 + 0.7Y
Working Note:
At an income level of ₹ 200 crore, Marginal Propensity to Save (MPS) = 0.3
and Marginal Propensity to Consume (MPC) = 1- MPS ⇒1- 0.3 = 0.7

b) In an economy, if ex-ante Aggregate Supply is less than ex-ante

Aggregate Demand, it implies that households are planning to consume
more than what the firms expected them to. This will lead to an
unintended fall in inventories. To restore the desired level of inventories,
producers may plan to expand production. As a result, there may be an
increase in the level of output, employment and income in the economy.

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Q. For a hypothetical economy, assume the government increased an
infrastructural investment by ₹10,000 crore. 80% of additional income is
consumed in the economy. Estimate the increase in income and the
corresponding increase in consumption expenditure in the economy.

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Ans. Given, ∆ I = ₹ 10,000 crore
Marginal Propensity to Consume(MPC)=80% of additional income consumed i.e.
0.8
As we know,
𝟏
K=
𝟏−𝐌𝐏𝐂

𝟏
= =5
𝟏−𝟎.𝟖

Increase in Income (∆Y) = K x ∆I

= 5 x 10,000
= ₹ 50,000 crore
∆𝑪
MPC =
∆𝒀
 ∆𝑪
0.8 =
50,000

∆C = ₹ 40,000 crore

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Q. a) For a hypothetical economy, the government incurs an additional
investment expenditure of ₹ 5,000 crore. Assuming that the Marginal Propensity
to Save (MPS) becomes half from its present level of 20%, estimate the change in
income due to this fall in Marginal Propensity to Save (MPS).

b) State the meaning of autonomous investment.

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Ans. a) Given, Change in Investment (∆𝐈) = ₹ 5,000 crore

MPS Investment Multiplier Change in Income (𝐘)

𝟏 ∆𝐘=𝐊 𝐱 ∆𝐈
K=
𝐌𝐏𝑺
(₹ in crore)

0.20 1 5 x 5,000 = 25,000

=5
0.2
0.10 1 10 x 5,000 = 50,000
= 10
1 0.𝟏
( X 20% )
2

Hence, with the change in MPS from 0·20 to 0·10,

Increase in Income (ΔY) = 50,000 – 25,000 = ₹ 25,000 crore
b) Investments which are independent of the level of income in an economy, are
known as Autonomous Investment.

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Q. Elaborate the two components of Aggregate Supply in a two-sector economy.
Ans. In a two-sector economy, Aggregate Supply comprises of:
● Consumption (C): It refers to the total value of final goods and services that the
household sector is planning to buy, during a given period of time. There exists a
direct relationship between Consumption (C) and Income (Y).
● Savings (S): Savings is that part of income which is not consumed. There exists a
direct relationship between Savings (S) and Income (Y).

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Q. Suppose an economy is in equilibrium. From the following data, calculate
Investment Expenditure in the economy:
(i) National Income = ₹ 40,000 crore
(ii) Marginal Propensity to Consume (MPC) = 0.8
(iii) Autonomous Consumption (c̅) = ₹ 100 crore
Ans. Given, Y = ₹ 40,000 crore
Marginal Propensity to Consume (MPC) = 0·8
Autonomous Consumption = ₹ 100 crore
At equilibrium level of income, Y= C + I
Y = 𝐜 + (MPC)Y + I
40,000 = 100 + (0.8) x 40,000 + I
Investment Expenditure (I) = 7,900 crore

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Q. Suppose, the Indian Government decides to boost public investments with a
defence project of ₹ 40,000 crore.
Explain the likely impacts of the given situation on the Income, Employment and
Output of the economy, assuming all other factors constant.

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Ans. Assuming all other factors constant, any increase in investments generally
leads to multiple increase in final income which in turn leads to increase in
employment.
If the Indian government decides to infuse additional investment of ₹ 40,000
crore in the defence project, it would lead to increase in demand for goods and
services leading to rise in output and employment, and consequent increase in
income.
Q. a) "With an objective to reduce inflation, government may reduce public
Expenditure.“
Discuss the rationale behind such a step which may be taken by the Government.

b) Define Effective Demand Principle.

c) State the meaning of ‘unintended accumulation of inventories’.
d) “In an economy, Aggregate Demand (AD) is more than Aggregate Supply (AS).”
Elaborate the possible impacts of the same, on the level of output, income and
employment.

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Ans. a) Government through its public expenditure policy can control the
situation of inflation. Reduced public expenditure by the government will lead to
a fall in the money supply in an economy. Consequently, it leads to a reduction in
the level of Aggregate Demand. This helps to tackle the situation of inflation
prevailing in the economy.
b) Effective Demand Principle indicates that level of Aggregate Demand which
can be met by the corresponding Aggregate Supply in the economy.
c) Unintended accumulation of inventories refers to an increase in the stock of
unsold goods with the firms due to an unexpected fall in sales.
d) When Aggregate Demand is more than Aggregate Supply, it implies that
households are planning to consume more than what the firms expected them
to. This will lead to an unintended fall in inventories. To restore the desired level
of inventories, producers may plan to expand production. As a result, there may
be an increase in the level of output, employment and income in the economy.
Q. Suppose, an economy is in equilibrium. From the following data, calculate
investment expenditure in the economy:
(a) National Income (Y) = ₹ 10,000 crore
(b) Marginal Propensity to Consume (MPC) = 0.8
(c) Autonomous Consumption (𝑪)= ₹100 crore

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Ans. Given, National Income (Y) = ₹ 10,000 crore
Marginal Propensity to Consume (MPC) = 0.8
Autonomous Consumption (𝐜) = ₹ 100 crore
At equilibrium level of income, Y= C + I
Y = 𝐜 + (MPC) Y + I
10,000 = 100 + (0.8) x 10,000 + I
I = ₹ 1,900 crore

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Q. a) State the meaning of the following:
(i) Investment multiplier
(ii) Full employment
b) Describe the adjustment mechanism, if ex-ante aggregate demand (AD) is less
than ex-ante aggregate supply (AS).

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Ans. a)
(i) Investment multiplier is the ratio of the total change in final income to a
given change in initial investment.
(ii) Full employment refers to a situation where all those who are willing and
able to work at the prevailing wage rate, are getting work.
b) When ex-ante Aggregate Demand (AD) is less than ex-ante Aggregate Supply
(AS), it means that households are planning to consume lesser than what the
firms expect them to. This may lead to the unintended accumulation of
inventories.
To bring back the inventories to the desired level, producers may reduce output
(AS) till it becomes equal to the Aggregate Demand and there is no further
tendency to change.
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Q. Describe the adjustment mechanism, if ex-ante savings are less than ex-ante
investments.

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Ans. If ex-ante savings are less than ex-ante investments, it means that the
buyers are intending to buy more than what the producers are intending to
produce. Thus, the inventories will fall below the desired level. To restore the
desired level of inventories, producers may intend to increase output and
employment in the economy. This mechanism will continue till the equilibrium is
reinstated.
Q. a) "In an economy ex-ante Aggregate Demand is more than ex-ante Aggregate
Supply." Explain its impact on the level of output, income and employment.
b) For a hypothetical economy, assuming there is an increase in the Marginal
Propensity to Consume (MPC) from 75% to 90% and change in investment to be
₹1,000 crore. Using the concept of investment multiplier, calculate the increase in
income due to change in Marginal Propensity to Consume (MPC).

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Ans. a) When ex-ante Aggregate Demand is more than ex-ante Aggregate Supply,
it means that households are planning to consume more than what the firms
expect them to. This will lead to unintended fall in inventories. To restore the
desired /intended level of inventories, producers may expand production. As a
result, there may be an increase in the level of output, employment and income
in the economy.
b) Given, Change in Investment (Δ𝐈) = ₹ 1,000 crore
MPC Investment Change in Income
Multiplier (𝐘)
𝟏 ∆𝐘=𝐊 𝐱 ∆𝐈
K=
𝟏−𝐌𝐏𝑪
(₹ in crore)

0.75 𝟏 4 x 1,000 = 4,000

=4
𝟏−𝟎.𝟕𝟓
0.90 𝟏 10 x 1,000 = 10,000
=10
𝟏−𝟎.𝟗𝟎
Hence, with the change in MPC from 0·75 to 0·90
Increase in income = 10,000 – 4,000 = ₹ 6,000 crore

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Q. Suppose an imaginary economy is facing a situation of deficient demand in the
short run time period.
Discuss briefly, the probable impacts of the same on the economy.
Ans. Deficient Demand may have an adverse impact on output, employment and
income level.
As Aggregate Demand is less than Aggregate Supply at full employment level of
income, this may lead to unintended accumulation of inventories. To restore
desired/intended level of inventories, producers may contract production which
in turn may reduce the employment, output, and income level in the economy.
Lack of demand for goods and services may also lead to a fall in the general price
level in the economy.

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Q. Suppose the following information is given about a hypothetical economy:
C = 100 +0.75 Y (where, C = Consumption and Y = Income)
Io=200 (Io = Autonomous Investment)
Calculate the following on the basis of the given information:
(a) Equilibrium Level of Income
(b) Aggregate Demand at Equilibrium Level of Income
(c) Marginal Propensity to Save

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Ans.
Given, C = 100 + 0.75Y; Io = 200
(a) We know that;
At equilibrium level of income
Y = C+I
Y = (100 + 0.75Y) + 200
0.25Y = 300
Y = 1,200
(b) At the Equilibrium level of income
AD = Y
⸫ AD = 1,200
(c) MPS = 1 – MPC
MPS = 1 – 0.75 = 0.25
Q. If planned savings exceeds planned investments in an economy, explain its
likely impact on income, output and employment.

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Ans. When planned savings exceeds planned investments it means households
are planning to consume less than what the firms expected them to consume.
This will lead to unintended accumulation of inventories. To restore the
desired/intended level of inventories, producers may contract production which
in turn reduces the employment, output and income level.

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Q. As per the following news published in “The Hindu” on 6th August, 2022:
“The Monetary Policy Committee (MPC) of the Reserve Bank of India raised the
Repo Rate by 50 basis points."
Identify and explain the likely cause and consequences behind this type of action
taken by the Reserve Bank of India.
Ans. Inflation in the economy may be the cause behind the rise in repo rate by
the Monetary Policy Committee (MPC) of Reserve Bank of India (RBI).
This step may force commercial banks to increase the lending rates. It may
discourage the borrowings by the general public. This may lead to fall in
Aggregate Demand and thus may result in fall in rate of inflation.

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Q. ‘India has been dealing with the problem of Deficient Demand, since the
imposition of Covid lockdown in March 2020’.
State and discuss any two monetary policy measures to combat the situation of
Deficient Demand in India.
Ans. Two monetary measures which may be used to solve the problem of
deficient demand are:
(i) Under Deficient Demand situation, the Central Bank may reduce the bank
rate, which further decreases the lending rates of commercial banks. This
induces the public to borrow more funds and ultimately leads to an increase
in Aggregate Demand.
(ii) Under Deficient Demand situation, the Central Bank may purchase securities
from open market. It will increase the money supply in the hands of the
public and enhances the purchasing power and ultimately increases level of
Aggregate Demand in the economy.

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Q. Using a hypothetical example, elaborate the working of investment multiplier
in an economy.
Ans. The working of multiplier is based on the fact one’s expenditure is other’s
income. Suppose the increase in investment is by ₹ 4,000 crore and marginal
propensity to consume is 0.5:

Round Increase in Increase in Increase in Increase in

investment income (ΔY ) consumption savings
(ΔI ) (₹ in crore) (ΔC ) (ΔS )
(₹ in crore) (₹ in crore) (₹ in crore)
1 4000 4000 2000 2000
2 --- 2000 1000 1000
3 --- 1000 500 500
4 --- 500 250 250
--- --- . . .
--- --- . . .
Total 4000 8000 4000 4000
The above table shows that an increase in investment of ₹ 4,000 crore leads to a
total increase of ₹ 8,000 crore in income.
Working Note:
𝟏 𝟏 𝟏
K= = = = 2
𝟏−𝐌𝐏𝑪 𝟏−𝟎.𝟓 𝟎.𝟓
ΔY
K=
Δ𝑰
ΔY
2=
𝟒𝟎𝟎𝟎
ΔY = 8000 crore

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Q. a) Calculate equilibrium level of income for a hypothetical economy, for which
it is given that:
(i) Autonomous Investments (Io)= ₹ 2,500 crores, and
(ii) Consumption Function; C= 1000+0.8Y
where C= Consumption and Y = Income.

b) Calculate, change in Income (ΔY) for a hypothetical economy, for which it is

given that:
(i) Marginal Propensity to Consume (MPC) = 0.75, and
(ii) Change in Investments (Δl)= ₹ 20,000 crore.
Ans. a) Given, 𝐶 = 1,000+0⋅8𝑌
I = ₹ 2,500 𝑐𝑟𝑜𝑟𝑒𝑠
At the equilibrium level, Y = C + I
Therefore, Y = 1,000 + 0⋅8𝑌 + 2500
Y − 0⋅8𝑌 = 3,500
Equilibrium level of Income(Y) = ₹ 17,500 crore

b) Given, 𝛥𝐼=₹ 20,000 crore

MPC= 0.75
As we know
𝟏 𝟏 𝟏
Multiplier(𝐾) = = = =4
𝟏−𝐌𝐏𝑪 𝟏−𝟎.𝟕𝟓 𝟎.𝟐𝟓
ΔY
We know, k =
Δ𝑰
ΔY
4=
20,000
Change in Income (𝛥𝑌)= ₹ 80,000 crore
Q. Justify the following statement with valid argument:
‘At higher levels of income people generally have lower Marginal Propensity to
Consume (MPC).’

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Ans. At a lower level of income, a consumer generally spends a larger proportion
of his/her income on consumption expenditure (basic survival requirement). As
the income increases, owing to the psychological behaviour of a rational
consumer he tends to save more.
Hence, at higher levels of income people generally have lower Marginal
Propensity to Consume (MPC).

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Q. a) Justify the following statement:
"Full employment is an essential condition to be fulfilled under Keynesian
Economics Principles.“

b) )"Involuntary Unemployment is a situation where an able bodied person

unwilling to work does not get work at the prevailing wage rate." Do you agree
with the given statement? Elucidate briefly.

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Ans. a) The given statement is not an essential condition. According to Keynesian
theory, an economy may attain equilibrium even at less than full employment
level of income as well.
b) The given statement is not true. Involuntary unemployment is the situation in
which, all those who are willing and able to work at existing wage rate, do not get
work.

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Q. State and discuss any one component of Aggregate Demand in a two-sector
economy.
Ans. Consumption Expenditure (C) refers to total expenditure incurred by
households and non-profit institutions on purchase of goods and services during
an accounting year. There exists a positive relation between income and
consumption expenditure, i.e., higher the income, higher shall be the
consumption expenditure.

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Q. Calculate the Equilibrium level of Income for an imaginary economy, if it is
given that:
(a) Consumption function, C = 500 +0-80 Y
Where C = Consumption, Y = Income
(b) Autonomous Investments (I) = ₹ 1,000 crore.
Ans. Given, Consumption Function C = 500 + 0.8Y
Autonomous Investment (I) = ₹ 1,000 crore
We know that, at equilibrium level
Y=C+I
Y = 500 + 0·8 Y + 1,000
0·2 Y = 1,500
Y = ₹ 7,500 crore
Thus , Equilibrium level of Income = ₹ 7,500 crore

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Q. "In a hypothetical economy, planned savings fall short of planned investments,
leading to fall in employment and income."
Do you agree with the given statement? Support your answer with a valid
explanation.

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Ans. The given statement is not true. When planned savings are less than the
planned investments it means households are planning to consume more than
what the firms expected. As a result, planned inventory would fall below the
desired level. To bring back the inventories at the desired level, producers may
expand production raising the employment and income level.
Q. Define Inflationary Gap. State, how the government can control the situation
of inflationary gap, using the taxation policy.

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Ans. Inflationary gap refers to the situation when Aggregate Demand is greater
than Aggregate Supply, corresponding to full employment level of output.
The government may raise the existing taxes rates/levy new taxes to reduce the
disposable income in the hands of general public. This will help to manage
inflationary situation in the economy.
Q. Excess demand creates greater opportunities of employment in the economy.
Defend or refute the given statement with valid explanation.

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Ans. The given statement is refuted. Excess demand is a situation when AD > AS
corresponding to full employment level in the economy. Under the situation of
full employment there is no further possibility/scope of creating more
employment opportunities. At full employment level, it is assumed that all the
resources are already fully and efficiently employment.
Q. On the basis of following schedule, answer the given questions:

Income 0 50 100 150 200

(in ₹ crores)
Savings -20 -10 0 30 60
(in ₹ crores)

a) Calculate Marginal Propensity to Save (MPS) at 150 crores level of income.

b) What is the value of Autonomous Consumption?
c) In an economy 75 percent of the increase in income is spent on consumption.
Investment increased by ₹ 1,000 crore.
Calculate the total increase in income on the basis of given information.
 Δ𝑺
Ans. a) MPS =
Δ𝒀
30−0 30
= = = 0.6
150−100 50

b) According to the question, at zero level of income S= (-)20 Therefore,

correspondingly the value of Autonomous Consumption (C) would be 20

c) Given MPC = 0·75, ∆I = ₹1,000 crore

1
Multiplier (K) =
1−MPC
1
= =4
1−0.75

Δ𝒀
We know that; k =
Δ𝑰
 Δ𝒀
4=
1000
Y= ₹ 4,000 crore
Q. Explain the concept of deficient demand. How can government spending
policy be helpful in correcting the situation of deficient demand?

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Ans. Deficient demand refers to a situation when Aggregate Demand falls short of
Aggregate Supply corresponding to full employment level of output in an
economy.
The government may plan to increase its spending, to correct deficient demand.
This may lead to increase in disposable income (purchasing power) in the hands
of the general public. Thus, Aggregate Demand will rise and deficient demand will
be managed accordingly.

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Q. a) If planned savings exceed planned investments in an economy, state its
likely impact on output and employment.
b) If planned savings fall short of planned investments in an economy, state its
likely impact on output and employment.
Ans. a) When planned savings exceeds planned investments it means households
are planning to consume less than what the firms expected. As a result, planned
inventory would rise above the desired level. To manage the inventories at the
desired level, producers may contract production, reducing the employment and
income level.
b) When planned savings are less than the planned investments it means
households are planning to consume more than what the firms expected. As a
result, planned inventory would fall below the desired level. To bring back the
inventories at the desired level, producers may expand production raising the
level of employment and output.

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Q. a) You are given the consumption function of an imaginary economy,
C = 100 + 0.8Y, where C = Consumption and Y = Income. Calculate:
(i) The value of Marginal Propensity to Save (MPS)
(ii) The level of income at Break-Even Point

b) S = -60 + 0.1 Y is the saving function, where S is Saving and Y is National

Income and Investment Expenditure (I) is ₹ 4,000 crore in an economy.
Calculate the Equilibrium level of Income.
Ans. a)
(i) Given, C = 100 + 0·8Y
We know that, MPC + MPS = 1
MPS = 1 – MPC
MPS = 1 – 0·8 = 0.2
(ii) As we know, at break-even point; Y = C
Y = 100 + 0.8Y
0.2 Y = 100 Y= ₹ 500

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b) Given, S = –60 + 0·1Y
I = ₹ 4,000 crores
We know that, at equilibrium; S = I
-60 + 0·1Y = 4,000
0·1 𝑌= 4,060
4,060
Y= = ₹ 40,600 crores
0.1