PPT CHAPTER 8 Economics_7244feb9-e1d7-4a1e-beb6-7e66ee28e86c_edited.pdf

Chapter 8 economics class 12

1. Class 12 Macroeconomics

2. Determination of Equilibrium Level
It must be kept in mind that AD, AS, Saving, and investment are all planned or
ex-ante variables.
Aggregate Demand-Aggregate Supply
Approach (AD-AS Approach)
Saving-Investment Approach (S-I Approach)
According to Keynes, there are two approaches to determining the equilibrium level of income,
output, and employment in the economy :
According to Keynesian theory, an economy is in equilibrium when aggregate
demand for goods and services is equal to aggregate supply during a period.
So, equilibrium is achieved when : AD = AS
We prove that : AD = C + I and,
AS = C + S
C + I = C + S
OR I = S
S = I

3. Assumptions made in the determination of
equilibrium output are :
Determination of equilibrium output is studied in the context of a
two-sector model (households and firms) i.e. there is no
government and foreign sector.
It is assumed that investment expenditure is
autonomous.
The price level is assumed to be constant.
Equilibrium output is to be determined in the
context of a short-run.

4. Aggregate Demand-Aggregate Supply Approach
According to Keynesian theory, the equilibrium level of income in an
economy is determined when aggregate demand, represented by the
C + I curve, is equal to the total output (Aggregate Supply or AS).
So, the AD curve is represented by C + I.
AS is the total output of the goods and services of the national income.
It is shown by the 450 line. Since income received is either consumed or saved.
Thus, the AS curve is represented by C+ S.
Consumption Expenditure (C) : It varies directly
with the level of income i.e. consumption rises with
a rise in income.
Investment Expenditure (I) : It is assumed to be
independent of the level of income i.e. investment
expenditure is autonomous.
Aggregate demand comprises two components :

5. Employment
(Lakhs)
Income
(Y)
Consumption
(C)
Saving
(S)
Investment
(I)
AD = C + I AS = C + S Remarks
0 0 40 -40 40 80 0 AD>AS
10 100 120 -20 40 160 100 AD>AS
20 200 0 40 240 200 AD>AS
30 300 280 20 40 320 300 AD>AS
40 400 360 40 40 400 400 Equilibrium(AD=AS)
50 500 440 60 40 480 500 AD<AS
60 600 520 80 40 560 600 AD<AS
Following schedule and diagram show the Equilibrium Level of Income :
O

Income / Output / Employment
Y
X
Y (or AS)
Equilibrium Level of
Income
AD (or C + I)
Equilibrium
(AD = AS)
Aggregate Demand (AD)

45°
Y
M
(

6. Explanation of the Curve
AD curve shows the desired level of expenditure by the consumers
and the firms corresponding to each level of income.
The economy is in equilibrium at point E where the AD curve
intersects the 45˚ line.
OY is the equilibrium level of output corresponding to point E.
The equilibrium level of income is 400 crores when AD is equal to
AS.
It is a situation of Effective Demand. Effective demand refers to
that level of AD that becomes effective because it is equal to AS.

7. When AD is less than AS then the C + I curve lies below the 45˚ line.
It means that firms and consumers together would be buying fewer goods than
firms are willing to produce.
As a result, the planned inventory would rise.
To clear the unwanted increase in inventory, firms plan to decrease
employment and output until the economy is back at the equilibrium level
where AD=AS.
AD < AS


When AD is more than AS then the C + I curve lies above the 45˚ line.
It means the firms and the consumers are together buying more goods than
firms are willing to produce.
As a result, the planned inventory will fall below the desired level.
To bring the inventory back to the desired level, firms would resort to an
increase in employment and output until the economy is back at the
equilibrium level where AD=AS.
AD > AS

8. Income (Y)
Consumption
(C)
Saving
(S)
Investment
(I)
Remarks
0 40 -40 40 S<I
100 120 -20 40 S<I
200 200 0 40 S<I
300 280 20 40 S<I
400 360 40 40
Equilibrium
(S = I )
500 440 60 40 S>I
600 520 80 40 S>I
According to this approach, the equilibrium level of
income is determined, when planned saving (S) is
equal to planned investment (I).
Saving-Investment approach
O
Y
X
Y (or AS)
AD (or C + I)
Equilibrium
(AD = AS)
Aggregate Demand (AD)

45°
E
Y
M
Income / Output / Employment
O
Y
X
S
I
Equilibrium
(S = I)
Saving / Investment

E
Y
Y’
I

9. Explanation of the Curve
The investment curve (I) is parallel to the X-axis because of the
autonomous character of investments.
The saving curve (S) slopes upward showing that as income
rises saving also rises.
The economy is in equilibrium at point (E) where saving and
investment curves intersect each other.
At point ‘E’ ex-ante saving is equal to the ex-ante investment.
OY is the equilibrium level of output corresponding to point E.
The equilibrium level of income is Rs 400 crores when planned
saving=planned investment= Rs 40 crores.

10. If planned saving is less than planned investment i.e. before point E it
means that households are consuming more and saving less than what
the firms expected them to.
As a result, the planned inventory would fall below the desired level.
To bring the inventory back to the desired level, firms would plan to
increase production till saving and investment become equal to each other.
S < I : (Refer above curve)

If planned saving is more than planned investment i.e. after point E, it
means that households are not consuming as much as the firms expected
them to.
As a result, the inventory rises above the desired level.
To clear the unwanted increase in inventory, firms would plan to reduce
production till saving becomes equal to each other.
S > I : (Refer above curve)

11. It refers to the situation when the aggregate demand is equal
to the aggregate supply at the full employment level.
Full Employment Equilibrium
E is the full employment equilibrium because aggregate
demand 'EQ' is equal to the full employment level of
output ‘OQ’.
At the OQ level of output, all those who are willing to
work at the prevailing wage rate can find employment i.e.
there is no involuntary unemployment.
Equilibrium Level
Full employment level
Underemployment level, less
than full employment level
Over full employment level,
more than full employment level
According to classical economists, the equilibrium level of income is attained always at full employment
level i.e. there is the absence of involuntary unemployment. According to Keynesian theory, an
equilibrium level can be achieved at :
Y
O
X
Income / Output / Employment
AD (or C + I)
Aggregate Demand (C + I)

Full Employment Equilibrium
E
45°
Q

12. 1)It refers to a situation when AD is equal to AS beyond the full
employment level.
2)It occurs after the full employment level.
3)AD
1 = AS at point G which is higher than the full employment
level.
4)Point G signifies the over-full employment equilibrium, which
results in inflation.
1)It refers to a situation when the aggregate demand is equal to
the aggregate supply when the resources are not fully
employed.
2)It occurs before the full employment level.
3)AD
1 = AS at point E1 which is lower than the full employment
level.
4)As OY
1 is less than OY, point E
1 signifies the under-employment
equilibrium.
Under Employment Equilibrium
Over Full Employment Equilibrium
National Income / Output / Employment
0
Y
X
AS
Point of Under-Employment
Equilibrium
AD
1
AD
0
Point of Full Employment Equilibrium
Aggregate Demand (AD)

45°
E
1
E
B
A
Y
1 Y
Y
X
Y (or AS)
Full employment
Equilibrium
AD
1 (Actual)
G
45°
Income / Output / Employment
Over Full Employment
Equilibrium
O
AD (Full Employment AD)
Aggregate Demand (AD)

E

13. Over-full
Employment
Creates Inflationary
Pressure :
Over full employment, equilibrium
signifies that planned expenditure (AD) is
equal to planned output (AS) at a level
higher than the full employment level.
However, in reality, the actual output
cannot increase beyond this level as the
economy is already at full employment
and there is no idle capacity.
So, any increase in AD beyond the full
employment output will lead to an
increase in the general price level.

14. Concept of
Investment
Multiplier :
Multiplier (K) is the ratio of an increase in national
income (ΔY) due to an increase in investment (ΔI).
K =
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Keynes believed that an initial increment in
investment increases the final income by many
times.
Multiplier explains how many times the income
increases as a result of an increase in the
investment.
For example : An additional investment (ΔI) of Rs
4,000 crores in an economy generates an
additional income (ΔY) Of Rs 16,000 crores. The
value of the multiplier in this case will be :
K =
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=
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??????&#3627409358;&#3627409358;&#3627409358;
=?????? times

15. Multiplier (K) is the ratio of an increase in national income (ΔY) due to an increase in investment (ΔI).
K =
????????????
????????????
=
&#3627409359;
&#3627409359;−??????????????????
=
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Working of Multiplier is based on the fact that one person’s expenditure is another person’s income.
When an additional investment is made, then income increases many times more than the increase in
investment.
Let us understand with the help of an example :
Working of Multipliers :
There exists a direct relationship between MPC and the value of the multiplier.
Higher the MPC more will be the value of the multiplier, and vice-versa.
Multiplier is based on the fact that one person’s expenditure is another person’s income.
When investment is increased, it also increases the income of the people.
People spend a part of this increased income on consumption, which depends on the value of MPC :
1)In the case of higher MPC, the value of the multiplier will be more.
2)In the case of low MPC, the value of the multiplier will be comparatively less.
Relationship between Multiplier and MPC

16. Round
Increase in Investment
(ΔI)
(₹ crores)
Increase in Income
(ΔY)
(₹ crores)
Increase in Consumption
(ΔC)
(ΔY X MPC)
Increase in Saving
(₹ crores)
(ΔS = ΔY - ΔC)
1
st
100 100 90 ( 100 X 0.9 ) 10
2
nd
90 81 ( 90 X 0.9 ) 9
3
rd
81 72.90 (81 X 0.9 ) 8.10
4
th
72.90 65.61 ( 72.90 x 0.9) 7.29
5
th
65.61 -- --
-- -- -- --
-- -- -- --
-- -- -- --
-- -- -- --
-- -- -- --
TOTAL 100 1,000 900 100
Suppose an additional investment of (△I) ₹ 100 crores is made to
construct a flyover. This extra investment will generate an extra
income of ₹ 100 crores in 1
st
round.
If MPC is assumed to be 0.90, then recipients of this additional income
(₹ 100) crores will spend 90 crores as consumption expenditure.
Explanation :

17. Formula of Multiplier (K)
K =
????????????
????????????
K =
&#3627409359;
&#3627409359; −??????????????????
K =
&#3627409359;
??????????????????

It will increase the income by 90 crores in the second round. Now 90% of 90 crores will be
spent on consumption (81 crores) and the rest will be saved (9 crores).
This multiplier process goes on and the consumption expenditure in every round will be
0.90 times the additional income received from the previous round.
At last, an initial investment of 100 crores leads to a total increase of 1000 crores in income.
As a result, Multiplier K =
&#3627409359;&#3627409358;&#3627409358;&#3627409358;
&#3627409359;&#3627409358;&#3627409358;
= 10 times.

18. We know that,
Y = C + I or
ΔY = ΔC + ΔI
Δܻ
Δܻ
=
Δܥ
Δܻ
+
Δܫ
Δܻ

1 = MPC +
1
K

1 =
K (MPC) + 1
K

K = KMPC + 1
K – KMPC = 1
K (1 – MPC) = 1
K =
1
1 − MPC

Dividing
both sides
by ΔY