Determination of Income and Employment — NCERT Solutions

Effective demand means the level of aggregate demand at which, at a given price level, aggregate demand for final goods equals aggregate supply of final goods. At this point the product market is in equilibrium, and output is determined by demand.

When the price of final goods and the rate of interest are given, the autonomous expenditure multiplier is derived from the equilibrium condition in the two-sector model:

$$Y=\bar{C}+\bar{I}+cY$$

Let autonomous expenditure be

$$\bar{A}=\bar{C}+\bar{I}$$

Then equilibrium becomes

$$Y=\bar{A}+cY$$

So,

$$Y-cY=\bar{A}$$

$$Y(1-c)=\bar{A}$$

$$Y=\frac{\bar{A}}{1-c}$$

Hence the multiplier is

$$\text{Multiplier}=\frac{\Delta Y}{\Delta \bar{A}}=\frac{1}{1-c}$$

Since $c=MPC$ and $MPS=1-c$, this can also be written as

$$\boxed{\text{Multiplier}=\frac{1}{MPS}}$$

Given:

• Autonomous expenditure, $\bar{A}=50$ crores
• $MPS=0.2$
• Income, $Y=4000$ crores

First find $MPC$:

$$MPC=1-MPS=1-0.2=0.8$$

Ex ante aggregate demand is

$$AD=\bar{A}+cY$$

So,

$$AD=50+0.8\times 4000$$

$$AD=50+3200=3250\text{ crores}$$

Now compare with income:

$$AD=3250\text{ crores} < Y=4000\text{ crores}$$

So the economy is not in equilibrium.

Reason: in equilibrium, ex ante aggregate demand must equal ex ante aggregate supply, i.e. $AD=Y$. Here demand is less than output, so there is excess supply.

The Paradox of Thrift means that if all people in the economy try to save a larger proportion of their income, total savings in the economy may not increase. It may remain unchanged or even fall.

This happens because when people increase saving, they reduce consumption. As consumption falls, aggregate demand falls. Producers then cut output, which reduces income. With lower income, people’s savings do not rise as expected.

In the chapter’s example, when the economy’s MPC falls from 0.8 to 0.5, income falls from 250 to 100. Yet aggregate savings remain the same at 10. So, although people become more thrifty individually, the economy as a whole does not save more.

Thus, the paradox is: more thrift by everyone can lead to the same or even lower total savings.