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Determination of Income and Employment – Class 12 Economics notes, important questions and MCQs

NCERT Class 12 Economics, chapter 8. Notes, key terms, important questions with answers and MCQs.

Chapter overview

In the Keynesian theory, the level of income and employment in the short run is determined by aggregate demand. Aggregate demand consists of consumption and investment in a two-sector economy. Equilibrium income is where aggregate demand equals aggregate supply, or planned saving equals planned investment. A change in investment changes income by a multiple, called the investment multiplier.

Consumption and saving

Consumption function: C = C̄ + cY, where C̄ is autonomous consumption and c is the marginal propensity to consume (MPC).
MPC = change in consumption ÷ change in income; MPS = change in saving ÷ change in income; MPC + MPS = 1.
Average propensity to consume (APC) = C ÷ Y; APC + APS = 1.

Equilibrium income and the multiplier

Aggregate demand (AD) = C + I; equilibrium is where AD = AS (output) or planned S = planned I.
Investment multiplier k = change in income ÷ change in investment = 1 ÷ (1 − MPC) = 1 ÷ MPS.
For example, if MPC = 0.8, k = 5, so an increase in investment of ₹100 crore raises income by ₹500 crore.
The paradox of thrift: if everyone tries to save more, total saving may not rise because income falls.

Excess and deficient demand

Excess demand occurs when AD exceeds AD at full employment; it causes an inflationary gap and rising prices.
Deficient demand occurs when AD is less than needed for full employment; it causes a deflationary gap and unemployment.
Corrective measures: fiscal policy (government spending and taxes) and monetary policy (CRR, repo rate, open market operations).

Key terms

Aggregate demand: total planned expenditure on goods and services in an economy
Marginal propensity to consume: the share of additional income spent on consumption
Investment multiplier: the ratio of change in income to the change in investment that caused it
Inflationary gap: the excess of aggregate demand over the level needed for full employment
Deflationary gap: the shortfall of aggregate demand from the level needed for full employment

Important questions with answers

Define marginal propensity to consume.2 marks

The marginal propensity to consume is the ratio of the change in consumption to the change in income, that is MPC = ΔC ÷ ΔY. It shows the share of additional income that is spent on consumption and lies between 0 and 1.

What is the investment multiplier? How is it related to MPC?3 marks

The investment multiplier is the ratio of the change in income to the change in investment that caused it, k = ΔY ÷ ΔI. It is related to MPC by k = 1 ÷ (1 − MPC) = 1 ÷ MPS. The higher the MPC, the larger the multiplier, because more of each round of income is spent.

Explain the determination of equilibrium income using aggregate demand and aggregate supply, and explain the working of the multiplier.5 marks

In the Keynesian model for a two-sector economy, aggregate demand consists of consumption and investment, AD = C + I, where C = C̄ + cY and investment is autonomous. Aggregate supply is the total output, which equals income Y, shown by a 45-degree line. Equilibrium income is determined where AD equals AS, that is where the AD line cuts the 45-degree line. Equivalently, equilibrium is where planned saving equals planned investment. If AD exceeds AS, firms' inventories fall and they increase output, so income rises; if AD is less than AS, unsold stocks pile up and firms cut output, so income falls. When investment rises, income rises by a multiple of the increase. The extra investment becomes income for some people, who spend a part of it (MPC) on consumption; that spending becomes income for others, who again spend a part, and so on. The total increase in income is ΔY = k × ΔI, where k = 1 ÷ (1 − MPC). For example, with MPC = 0.8, k = 5, so an increase in investment of ₹100 crore raises income by ₹500 crore. The multiplier also works in reverse when investment falls.

Quick revision

C = C̄ + cY; MPC + MPS = 1.
Equilibrium: AD = AS or S = I.
k = 1 ÷ MPS.
Excess demand → inflationary gap; deficient demand → deflationary gap.

Exam tips

Memorise k = 1 ÷ (1 − MPC) and practise with MPC values 0.5, 0.75 and 0.8.
Pair each gap with its fiscal and monetary remedies.

Practice MCQs

MPC + MPS equals
1. 0
2. 1
3. 2
4. 100
Show answer
Answer: (b) 1. Extra income is either consumed or saved.
In a two-sector economy, aggregate demand equals
1. S + I
2. C − I
3. C + I
4. Y − C
Show answer
Answer: (c) C + I. Consumption plus investment.
Deficient demand leads to
1. inflation
2. higher prices
3. unemployment
4. excess demand
Show answer
Answer: (c) unemployment. Output falls below full employment.
If MPC is 0.75, the investment multiplier is
1. 2
2. 3
3. 4
4. 7.5
Show answer
Answer: (c) 4. 1 ÷ 0.25 = 4.
Equilibrium income is where planned saving equals
1. consumption
2. income
3. planned investment
4. government spending
Show answer
Answer: (c) planned investment. Leakages equal injections.
Autonomous consumption is consumption at
1. maximum income
2. zero income
3. full employment
4. equilibrium only
Show answer
Answer: (b) zero income. It is the intercept C̄.
If MPC = 0.8 and investment rises by ₹100 crore, income rises by
1. ₹80 crore
2. ₹125 crore
3. ₹500 crore
4. ₹800 crore
Show answer
Answer: (c) ₹500 crore. k = 5.
To reduce an inflationary gap, the government should
1. reduce spending and raise taxes
2. increase spending
3. lower the repo rate
4. reduce CRR
Show answer
Answer: (a) reduce spending and raise taxes. This lowers aggregate demand.

All chapters of Class 12 Economics

Written by Kundali IQ from standard, well-established facts to help with revision. This is not an official NCERT publication; always read your textbook too.