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Class 12 Economics Chapter 2 Determination Of Income And Employment
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Determination Of Income And Employment
Chapter: 2
| PART – (A) INTRODUCTORY MACROECONOMICS |
(A) Very Short Types Question & Answers:
1. Fill in the blanks:
(a) The value of planned consumption is called ___________ consumption. (ex-ante/ex-post).
Ans: Ex-ante.
(b) The planned value of a variable as opposed to its actual value is called ___________ (Ex-post/ ex-ante/Inventory).
Ans: Inventory.
(c) Shift of a graph due to change in the value of a parameter is called ___________ (graphic shift/ parametric shift).
Ans: Parametric shift.
(d) The ratio of additional consumption to additional income is called __________ (marginal propensity to same/ marginal propensity to consume/marginal income)
Ans: Marginal Propensity to consume (MPC).
2. Name the situation is where people become more thrifty and they end up saving less or same as before in aggregate.
Ans: Propensity to save.
3. Show the relationship between multiplier and marginal.propensity to consume.
Ans: k = 1/1-MPC
4. What is aggregate demand?
Ans: Aggregate demand refers to the total expenditure that the residents of a country are willing to spend on the purchase of goods and services during a year.
5. Define involuntary unemployment.
Ans: Involuntary unemployment occurs when a person is unemployed despite being willing to work at the prevailing wage. It is distinguished from voluntary unemployment, where a person refuses to work because their reservation wage is higher than the prevailing wage.
6. What is marginal propensity to save?
Ans: It is the ratio of change in savings to change in income MPC = ΔS/ΔY
7. Why do we assume that the prices vary only in the long-run?
Ans: Because in the long run both demand and supply can change in the market.
8. What is output multiplier?
Ans: Output multiplier is related with the value of Marginal propensity consume (MPC). It is expressed as, Output multiplier = 1/1-MPC
9. What is effective demand?
Ans: In economics, effective demand (ED) in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market.
10. The autonomous consumption of an economy is ₹ 500 crores, autonomous investment is ₹ 150, government expenditure is ₹ 200 crores and personal disposable income is ₹ 600 crores. If the marginal propensity to spend is 0.8, find out the aggregate level of income of that economy.
Ans: We know that,
Y = C + I + G = (a+by) + I + G = (500 + 0.8 × 600) + 150 + 200 = 850 + 480 = 1330cr.
11. The level of autonomous consumption of an individual is ₹ 500 and his personal disposable income is ₹ 5000. If his marginal propensity to consume is 0.8, find out the level of aggregate consumption.
Ans: We know that,
C = a + by = 500 + 0.8 × 5000 = 500 + 4000 = 4500 cr.
12. Explain the concept of ex ante consumption.
Aus: Ex-ante consumption refers to the planned consumption which is mode by all the households in the economy.
13. Distinguish marginal propensity to consume from marginal propensity to save.
Ans: The ratio of change in consumption to change in income is termed as marginal propensity to consume. i.e. = MPC = ΔC/ΔY
It is the ratio of change in savings to change in income MPC = ΔS/ΔY
(B) Short Type Questions & Answers:
1. Explain the concept of ex ante investment.
Ans: Ex-ante investment refer to amount of investment, which firms plan to invest at different levels of income in the economy. The amount of ex-ante or planned investment is determined by the relation between investment demand and rate of interest i.e. by investment demand function.
2. What are the components of aggregate demand? Explain briefly.
Ans: Aggregate demand refers to the planned expenditure of the households on the purchase of goods and services in an accounting year. Components of aggregate demand (AD) = C + I + G = (X-N)
Where C = household consumption demand
I = Private investment demand
G = government’s demand for goods and services
(X-N) = Net demand by foreigners.
3. State any two measures of fiscal policy to correct the problem of excess demand in an economy.
Ans: (a) To control the situation of excess demand, Government should reduce its expenditure to the maximum possible extent.
(b) More emphasis should be placed to reduce expenditure on defence and unproductive works as they rarely help in growth of a country.
4. What is the difference between Ex-ante investment and Ex-post investment?
Ans: Ex-ante investment refer to the planned investment or desired investment.
Ex-post investment refer to actual investment in the economy.
5. What is aggregate supply? What are the components of aggregate supply.
Ans: Aggregate supply means total output of goods and services produced in an economy. Thus we can say that aggregate supply and national income are the same thing. A major part of the national income is spent on consumption and the rest is saved. So, national income is the sum total of consumption and saving in an accounting year.
AS = C + S where C = Consumption
S = Saving
6. The marginal propensity to consume (c) of an economy is 0.85, find out –
(i) the size of the income multiplier.
Ans: K = 1/1-MPC
= 1/1-0.85 = 6.66
(ii) the income to be generated in the economy if the government investment in increased by ₹ 250 crores.
Ans: ΔΙ/ΔY = MPS
∴ ΔΥ= ΔΙ/MPS = 250/I-MPC = 250/I-0. 85 = 250/0.15 = 1666.67cr.
7. Distinguish between autonomous investment and induced investment.
Ans: Investment which is independent of income level is called autonomous investment.
Investment that depends upon the level of income is known as induced investment.
8. What are the determinants of two sector economy?
Ans: In a two-sector economy, saving is the only source of withdrawal and investment is the only source of injection. Thus, an economy is said to be in equilibrium when saving (i.e., withdrawal) equals investment (i.e., injection).
9. How does the multiplier effect contribute to the determination of equilibrium income in the short run?
Ans: The multiplier effect plays a significant role in determining equilibrium income in the short run. It refers to the phenomenon where an initial change in spending (such as investment or government spending) leads to a more substantial overall impact on aggregate demand and income. The multiplier effect amplifies the initial change by generating additional rounds of spending as the increased income circulates through the economy, contributing to a higher equilibrium income.
10. What is the two sector model of aggregate demand?
Ans: In a two sector economy, the aggregate demand (C + I) refers to the total spending in the economy i.e. it is the sum of demand for the consumer goods (C) and investment goods (I) by households and firms respectively.
11. “As people become more thrifty they end up saving less or same as before.” Explain.
Ans: “As people become more thrifty they end up saving less or save as before” There is a direct relationship between income and savings. As income increases, lével of savings in the economy also increases, but by less than increase in income. It means as income increases, proportion of income round increases. At any level of income below the break even incomes savings are negative and at income levels higher than break even income, savings are positive.
12. What is ex ante and ex post?
Ans: Savings, which are planned (intended) to be made by all households in the economy during a period, in the beginning of the period is called planned or ex-ante savings.
The investment, which is planned to be made by all the firms or entrepreneurs in the economy during a period, in the beginning of the period is called. ex-ante investment.
Outpat, is at its equilibrium point, when aggregate quantity demanded = aggregate quantity supplied.
Ex-post saving refers to the actual saving in an economy during a year.
13. What is meant by determination of income and output?
Ans: The equilibrium income of the economy is determined at the point where aggregate demand equals the value of total output. It can be said that actual value of total output is same as the economy’s income. Let it be denoted as Y. It is also said that income is divided between consumption and saving.
14. What is deficit demand? Write one cause of deficit demand.
Ans: Deficient Demand refers to the situation when Aggregate Demand (AD) is short of Aggregate Supply (AS) corresponding to full employment in the economy.
One cause of deficit demand is decrease in household consumption demand due to fall in propensity to consume.
15. What is meant by equilibrium income in the short run?
Ans: Equilibrium income in the short run refers to the level of national income or output at which aggregate demand (AD) equals aggregate supply (AS) within an economy. It represents a state of balance where there are no unplanned changes in inventories.
16. What is the investment multiplier?
Ans: The investment multiplier refers to the magnification effect on income and output that results from an initial change in investment spending. It represents the total increase in income and output that occurs due to a change in investment, considering the subsequent rounds of spending and income generation.
17. What is the meaning of full employment?
Ans: Full employment refers to a situation in the economy where all available labor resources are being utilised efficiently, and the unemployment rate is at its minimum level. It is a state where the number of people seeking employment matches the number of job openings, and there is no involuntary unemployment.
18. Write differences between the Marginal propensity to consume and Average propensity to consume.
Ans: (a) Meaning: Average Propensity to Consume (APC) is the ratio between total consumption and total income whereas Marginal Propen-sity to Consume (MPC) is the ratio between additional consumption and additional income.
(b) Zero: APC can never be zero but MPC can be zero.
19. What is meant by an autonomous change in aggregate demand?
Ans: An autonomous change in aggregate demand refers to a change in the overall demand for goods and services in an economy that is independent of changes in price levels. It can arise from factors such as changes in consumer spending, investment, government spending, or net exports.
20. What factors influence equilibrium income in the short run?
Ans: Several factors can affect equilibrium income in the short run. Changes in consumption, investment, government spending, and net exports (exports minus imports) can shift the aggregate demand curve. Similarly, variations in input costs, technology, and the available labour and capital can impact the aggregate supply curve. Changes in these factors can lead to shifts in either curve and subsequently alter the equilibrium level of income.
21. What is the concept of equilibrium income in the short run with a fixed price level?
Ans: Equilibrium income in the short run with a fixed price level refers to the level of national income or output where aggregate demand (AD) equals aggregate supply (AS) when prices are held constant. It represents a state of balance in the economy, assuming that prices do not change in response to changes in demand or supply.
22. What is the consumption function?
Ans: Consumption function, in economics, the relationship between consumer spending and the various factors determining it. At the household or family level, these factors may include income, wealth, expectations about the level and riskiness of future income or wealth, interest rates, age, education, and family size.
23. What is the difference between consumption function and MPC?
Ans: Key differences between APC and MPC
APC (Average Propensity to Consume) is calculated by dividing total consumption expenditure by total disposable income. MPC (Marginal Propensity to Consume) is calculated by dividing the change in consumption expenditure by the change in disposable income.
24. What are the factors that affect investment demand in an economy?
Ans: The factors that affect investment demand in an economy are:
(a) Income per capita.
(b) Industrial and Economic situation.
(c) Trends.
25. How does income circulate between the household sector and the business sector?
Ans: Income circulates between the household sector and the business sector through a circular flow of economic activity. The business sector pays wages and salaries to the households, who, in turn, spend their income on goods and services produced by the business sector. This spending becomes revenue for the businesses, allowing them to pay wages and continue the cycle.
26. What is a two-sector model of income determination?
Ans: A two-sector model of income determination is an economic framework that simplifies the economy into two sectors: the household sector and the business sector. It helps analyse how income is generated, distributed, and spent within an economy.
27. What is the role of the household sector in the two-sector model?
Ans: The household sector consists of individuals or families who own factors of production (such as labour) and provide them to the business sector. They receive income in the form of wages, salaries, rents, and profits from their contributions to the production process.
28. What is the role of the business sector in the two-sector model?
Ans: The business sector comprises all the firms or businesses that produce goods and services for consumption. It hires labour and other inputs from the household sector to produce goods and services, generating income through sales revenue.
29. How do fiscal and monetary policies interact with an autonomous change in aggregate demand?
Ans: Fiscal and monetary policies can be used to respond to an autonomous change in aggregate demand. Expansionary fiscal policies, such as increased government spending or tax cuts, can be implemented to stimulate aggregate demand further and amplify the positive impact on income and output. Similarly, expansionary monetary policies, such as lowering interest rates or increasing the money supply, can encourage borrowing and investment, boosting aggregate demand and supporting the multiplier effect. Conversely, contractionary fiscal or monetary policies may be used to mitigate any potential inflationary pressures that arise from an autonomous increase in aggregate demand.
30. What is relationship between MPC and MPS?
Ans: The marginal propensity to consume (MPC) is the flip side of MPS. Economic theory tends to support that as income increases, so too does spending and consumption. Therefore, the MPC and MPS have a inversely proportional relationship with each other.
31. What is the difference between saving and propensity to save?
Ans: The average propensity to save equals the ratio of total saving to total income; the marginal propensity to save equals the ratio of a change in saving to a change in income. The sum of the propensity to consume and the propensity to save always equals one (see propensity to consume).
32. What is Marginal Propensity to Consume (MPC)?
Ans: In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income.
MPC is depicted by a consumption line, which is a sloped line created by plotting the change in consumption on the vertical “y” axis and the change in income on the horizontal “x” axis.
33. What is Marginal Propensity to Consume in Simple Terms?
Ans: The marginal propensity to consume measures the degree to which a consumer will spend or save in relation to an aggregate raise in pay. Or, to put it another way, if a person gets a boost in income, what percentage of this new income will they spend? Often, higher incomes express lower levels of marginal propensity to consume because consumption needs are satisfied, which allows for higher savings. By contrast, lower-income levels experience a higher marginal propensity to consume since a higher percentage of income may be directed to daily living expenses.
34. What are the mechanisms behind the investment multiplier?
Ans: The investment multiplier operates through two main mechanisms:
the consumption effect and the induced investment effect. The consumption effect refers to the initial increase in consumption resulting from higher income generated by the initial investment. As households receive additional income, they spend a portion of it on consumption, creating further demand and boosting output. The induced investment effect occurs when increased consumption leads to higher profits for businesses, which, in turn, incentivizes them to invest more, thereby stimulating additional rounds of spending and income generation.
35. What is paradox of thrift – explain.
Ans: The paradox of thrift has been popularised by John Maynard Keytnes. This concept states that if everyone tries to save an increasingly larger proportion of income, they would become poorer instead of richer. This is because the economy will slow down from the reduction in demand and the very same people will loose their jobs. This theory however applies mainly to keynesian economics where increased saving represents a diminishing circular flow of income.
36. What consists of aggregate demand for final goods?
Ans: Aggregate demand for final goods consist of consumption demand (c), investment demand (i), Government’s demand for goods and services (G), Net demand by foreigners, i.e net exports (X-M).
ie AD = C + I + G + X-M
C implies demand for goods and services by the households of a country in a year.
I refers to the planned or ex-ante investment expenditure by the private firms.
G includes both government consumption expenditure and Government investment expenditure.
X – M is the net export.
(C) Long Type Questions & Answers:
1. Show that the output multiplier is equal to zero where C = MPC.
Ans: Higher MPC implies more consumption expenditure and vice versa. As a result of this increase in consumption expenditure, there will be excess demand in the economy. To meet this increased demand, producers will have to rundown their inventory. In the next production cycle, they will plan to increase their output to restore equilibrium. The extra output so produced is distributed among various factors of production as factor payments. Hence the income of the economy goes up by this extra output produced to meet extra demand. When income increases as a result of extra output, consumption expenditure again goes up. It will increase by MPC xΔy Since people spend a fraction (= MPC) of their additional income on consumption. Hence in the next round, aggregate demand in economy again goes up by further to restore equilibrium. Like before, this extra output will generate extra factor income in the economy. This process goes round after round, with producers increasing their output to meet the excess demand in each round and consumers spending a part of their additional income from this extra production or income on consumption there by creating further excess demand is the next round.
2. What are the determinants of investment demand? – Explain.
Ans: Investment refers to the expenditure incurred on creation of new capital assets. It includes the expenditure incurred on assets like machinery, building, equipment, raw material, etc. which lead to increase in the productive capacity of an economy.
The investment expenditure is classified under two heads:
(i) Induced Investment.
(ii) Autonomous Investment.
Induced investment refers to the investment, which depends on the profit expectations and is directly influenced by income level and autonomous investment refers to the investment, which is not affected by changes in the level of income and is not induced solely by profit native.
The main determinates of investment are:
(i) Marginal efficiency of investment (MEI).
(ii) Rate of interest.
Marginal efficiency of investment refers to the expected rate of return from an additional investment. MEI is determined by two factors—
(a) Supply price: It refers to the cost of producing a new assets of that kind. It is the price at which, the new capital asset can be supplied or replaced.
(b) Prospective yield: It refers to net return expected from the capital asset over its life time.
Rate of interest refers to cost of borrowing money for financing the investment. There exists an inverse relationship between rate of interest and the volume of investment. At a high rate of investment, the investment spending will be less and vice-versa.
3. What is investment multiplier? Explain with the help of a diagram.
Ans: The concept of multiplier is an important contribution of prof. J.M. Keynes. Keyness believed that an initial increment in investment increases the final income by many times. The literal meaning of multiplier is multiple. In an economy, when there is increase in investment by a certain amount, the resultant change in income is multiple of change in investment. The multiplier is defined as the ratio of the change in income to change in investment. Algebraically, K = ΔY/ΔΙ where K is change in income and Δl is the change in investment The concept of multiplier is diagrammatically presented with the help of AD and AS approach.
In the diagram, initial equilibrium is determined at point E, where AD curve intersects the AS curve. The equilibrium level of income is OY. Now, suppose investment increases by ΔI, so that the new aggregate demand curve (AD1) intersects the aggregate supply curve (AS) at point F. The new equilibrium level of income is OY. It is clear from the diagram that the increase in income.(YY1 or AY) is greater than increase in investment (ΔI). The value of multiplier is given by K = ΔY/ΔΙ.
4. Explain the principle of effective demand with the help of diagram.
Ans: The particular level of AD which is equal to AS is called effective demand. The level of effective demand determines the level of income, output and employment. Aggregate effective demand refers to that level of AD, where AD = AS. It correspondence to the equilibrium level of income and output.
In the diagram AD and AS are the aggregate demand and aggregate supply curve respectively. AD function shows various levels of AD like E0EE1. But it is only at point E the level of AD (= EY) is equal to the level of AS. Hence E point on AD curve represents effective demand for increasing the level of income and output in the economy, aggregate effective demand most increase.
5. Explain the working of the multiplier mechanism in the final goods market with the help of table.
Ans: The multiplier is defined as the ratio of the change in income to the change in investment. The working of the multiplier mechanism is shown with the help of a table below:
The multiplier process (MPC = 0.75)
| Round | Increase in Investment (ΔI) | Increase in income Rs. crore | Increase in consumption (ΔY) Rs. crore increase (ΔC) Rs. crore |
| 1 | 100 | 100 | 75 |
| 2 | – | 75 | 56.25 |
| 3 | – | 56.25 | 42.19 |
| 4 | – | – | – |
| 5 | – | – | – |
| 6 | – | – | – |
| 7 | – | – | – |
| 8 | – | – | – |
suppose there is an initial increase in investment of Rs. 100 crores in the economy. Further suppose the value of MPC is 0.75. Their increase of investment of Rs. 100 crore results an increase of income of Rs. 100 of people working in the investment industry. They will together spend Rs. 75 (3/4 of 100) on consumption goods. Their increase in consumption of Rs. 75 crores will increase the income of people working in consumption goods industry in the second round. This additional income of Rs. 75 crores will lead to an additional consumption of Rs. 56.25 crores in the economy. This is the time increase in the level of income in the economy. Since an additional income of Rs. 56.25 crores has been generated in the economy, it results in increase in consumption by Rs. 42.19 (3/4 of 56.25 crores) This will curve further increase in income in the economy. This process will continue with each round of income being 3/4 times the previous level. Thus there are many rounds of increase in income due to increase investment Δl in the first round Δy = ΔI But in subsequent rounds ΔY = ΔC
The table shows that initial increase in investment of Rs. 100 crore has resulted in an increase in income of Rs. 400 crore. This is the resultant increase in income is multiple of initial increase in investment. Thus in this case. Multiplier (u) = ΔY/ΔI = 400/100 = 4
6. The autonomous consumption of an individual is Rs. 500 and his personal disposable income is Rs. 5000. If his marginal propensity to consume is 0.8, find out the level of aggregate consumption.
Ans: We are given,
Autonomous consumption = Rs. 500
Disposable income = Rs. 5000
MPC = 0.8
According to formula
We know that consumption function is-
Where, C = Aggregate consumption.
Aggregate consumption = Rs. 4500
7. Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (Ā) is ₹ 50 crore, MPS is 0.2 and level of income (y) is ₹ 4,000 crore. State whether the economy is in equilibrium or not (cite reasons).
Ans: We know, MPC = 1- MPS =1 – 0.2
∴ MPC = 0.8
= 50 + (0.8) × 4000 = 50 + 3200 = Rs. 3250 crores
Since AS (y) is Rs 4000 crores, and
AD (which is Rs. 3250 crores) falls short of AS.
Hence, the economy is not in equilibrium.
8. Analyse the concept of ex ante aggregate demand for final goods in an economy without government.
Ans: (i) If planned saving are greater than planned investment, i.e. after point E as shown in figure, 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 the production till savings and investment become equal to each other.
(ii) If planned savings are less than planned investment i.e. before point ‘E’ as shown in the above diagram, it means that households are consuming more and savings less than what the firms expected them to. As a result, the planned inventory starts falling and moves below the desired level. To bring the inventory back to the desired level, firms plan to increase the production till savings and investments become equal to each other.
9. Explain the relationship between investment multiplier and marginal propensity to consume.
Ans: A constant final goods price and constant rate of interest over short run determine the level of aggregate demand for final goods in the economy. The aggregate supply is perfectly elastic at this price. Under such circumstances, aggregate output is determined solely by the level of aggregate demand. This is known as effective demand principle.
The increment in equilibrium value of total output thus exceeds the initial increment in autonomous expenditure. The ratio of the total increment in equilibrium value of final goods output to the initial increment in autonomous expenditure is called the output multiplier of the economy.
The output multiplier = Δy/ΔA = 1/I-C where ⊲ y is the total increment in final goods output and C = MPC. The size of the multiplier depends on the value of C. As c becomes larger, the multiplier increases.
10. Explain the process of equilibrium income determination of an economy with the use of aggregate demand and aggregate supply curves.
Ans: According to the Keynessian theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C + I curve is equal to the total output (aggregate supply).
In the figure, the AD or (C + 1) curve shows the desired level of expenditure by consumers and firms corresponding to each level of output. The economy is in equilibrium at point ‘E’ where (C + I) curve intersects the 45° line.
OY is the equilibrium level of income. If there is any deviation from the equilibrium level of output, i.e., when planned spending (AD) is not equal to planned output (AS), then a process of readjustment will start in the economy and the output will tend to adjust up or down until AD and AS are equal again.
11. What are the Factors Influencing Consumption Function?
Ans: There are certain factors affecting the propensity to consume in the long-run:
(i) Objective Factors:
(a) Distribution of income: It is generally observed that the average and marginal propensities to consume of the poor are greater than those of the rich. This is because the poor has a lot of unsatisfied wants and he is likely to seize every opportunity that comes his way to satisfy them. On the other hand, the rich have already a high standard of living and relatively less urgent wants remain to be satisfied, so that in their case, an addition to their incomes is more likely to be saved than spent on consumption.
(b) Fiscal policy: Fiscal policy of the government will also influence the consumption behaviour of an economy. A reduction in taxation will leave more post-tax incomes with the people and this will stimulate higher expenditure on consumptions. Similarly, an increase in taxes will depress consumption.
(c) Changes in business expectations: Business expectations by affecting the incomes of certain classes of people affect consumption function.
(d) Windfall gains and losses: The windfall losses and gains arising out of changes in capital values affect the ‘saving brackets’ mostly and not the spending sections. Hence, their influence on consumption function is not so well marked.
(e) Liquidity preferences: Another factor is the people’s liquidity preferences. If people prefer to keep their income in liquid ford, consumption is reduced correspondingly.
(f) Substantial changes in the rate of interest.
(ii) Subjective Factors:
(a) Individual motives to save:
(i) Building of reserves for unforeseen contingencies as illness or unemployment.
(ii) To provide for anticipated future needs such as daughter’s wedding, son’s education, etc.
(iii) To enjoy an enlarged future income by investing funds out of current income, etc.
(b) Business motives:
(i) The desire to expand business.
(ii) The desire to face emergencies successfully.
(iii) The desire to have successful management.
(iv) The desire to ensure sufficient financial provision against depreciation and obsolescence.
12. What is the theory of two sector model?
Ans: The two-sector model, also known as the basic or simplest economic model, is a theoretical framework used to analyse the interrelationship between two sectors of the economy: the household sector and the business sector. This model simplifies the complex interactions within an economy by focusing on the basic flow of goods and money between these two sectors. It serves as a foundational model for understanding key economic concepts such as production, consumption, savings, and investment.
The two-sector model assumes the following:
(a) Household Sector: The household sector consists of individuals or households who own the factors of production, namely labour and capital. They supply labour to the business sector in exchange for wages, and they receive income from their participation in production.
(b) Business Sector: The business sector refers to the firms or businesses that produce goods and services. They employ labour and capital from the household sector to produce output. They generate revenue by selling the produced goods and services in the market.
The basic flow of the two-sector model can be summarised as follows:
(a) Production: The business sector combines labour and capital inputs to produce goods and services. This production process generates income in the form of wages, salaries, and profits.
(b) Income Distribution: The income generated from production is distributed to the household sector as wages, salaries, and profits. This income serves as a reward for the factors of production provided by households.
(c) Consumption: The household sector consumes a portion of their income by purchasing goods and services produced by the business sector. Consumption represents the demand side of the economy.
(d) Saving and Investment: The household sector may choose to save a portion of their income rather than spending it on consumption. The saved income is then channelled back to the business sector as investment, which helps finance new capital goods and productive activities.
(e) Circular Flow: The flow of income and spending between the household sector and the business sector creates a circular flow in the economy. The business sector provides income to households, and households, in turn, spend that income on goods and services produced by businesses.
The two-sector model serves as a starting point for analysing more complex economic models and understanding the basic relationships between households, businesses, income, consumption, savings, and investment. It provides a simplified framework to study economic concepts and their interplay within an economy.
13. What are the major determinants of income distribution?
Ans: The distribution of income in an economy is influenced by various factors.
Some of the major determinants of income distribution include:
(a) Education and Skills: The level of education and skills possessed by individuals plays a significant role in determining their earning potential. Higher levels of education and specialised skills are often associated with higher incomes, leading to income disparities between those with different educational backgrounds.
(b) Labor Market Factors: Factors such as supply and demand for labour, occupational choices, and wage differentials contribute to income distribution. In competitive labour markets, wages tend to be determined by the interaction of labour supply and demand. Occupations that require rare or specialised skills may command higher wages, leading to income inequality.
(c) Technology and Automation: Technological advancements and automation can have both positive and negative effects on income distribution. While technological progress can lead to increased productivity and higher wages for skilled workers, it can also lead to job displacement and lower wages for workers whose skills become obsolete.
(d) Discrimination and Inequality of Opportunities: Discrimination based on factors such as gender, race, ethnicity, or social class can contribute to income inequality. Unequal access to employment opportunities, education, and resources can result in disparities in income distribution.
(e) Government Policies: Government policies and interventions can significantly impact income distribution. Progressive taxation, social welfare programs, minimum wage laws, and income redistribution policies are examples of measures that aim to reduce income inequality and promote a more equitable distribution of income.
(f) Capital Ownership: Ownership of financial assets, property, and capital plays a role in income distribution. Individuals who own significant amounts of capital or have access to investment opportunities can earn income through returns on their investments, leading to wealth accumulation and income concentration.
(g) Globalization and Trade: Globalisation and international trade can influence income distribution within a country. While trade can lead to economic growth and increased income for some sectors, it can also result in job losses and wage pressures in industries that face competition from lower-cost foreign producers.
(h) Social and Cultural Factors: Social and cultural factors, such as social norms, inheritance patterns, and social mobility, can affect income distribution. In societies where wealth and income are concentrated within certain social groups or inherited across generations, income disparities may be more pronounced.
14. How is income determined in the two-sector model?
Ans: In the two-sector model, income determination is based on the interaction between the household sector and the business sector. The model simplifies the economy by dividing it into two sectors: the household sector and the business sector.
(a) Household Sector: The household sector consists of individuals or households who own factors of production, such as labor, and provide them to the business sector in exchange for income. In the two-sector model, households are assumed to spend all their income on consumption.
(b) Business Sector: The business sector includes all firms and businesses that produce goods and services. They hire labor from households and use other factors of production, such as capital and technology, to produce output.
The determination of income in the two-sector model follows these steps:
(a) Consumption: The model assumes that households spend all their income on consumption (C), implying that consumption equals income (C = Y).
(b) Production: The business sector uses the factors of production, including labor, capital, and technology, to produce goods and services (output). The level of output (Y) depends on the amount of labor employed (L) and the productivity of other inputs.
Equilibrium: Equilibrium is achieved when the level of production (Y) equals the level of consumption (C). This implies that the income earned by households from providing labor is equal to the total amount spent on consumption.
(c) Aggregate Expenditure: Aggregate expenditure (AE) is the sum of consumption (C) and investment (I). In the two-sector model, investment is assumed to be autonomous and independent of income.
Income-Expenditure Equilibrium: Income (Y) is determined at the level where aggregate expenditure (AE) equals income (Y). Mathematically, Y = AE.
(d) Determination of Equilibrium Income: The equilibrium income level is determined by the level of autonomous investment (I) and the consumption function. The consumption function reflects the relationship between income and consumption, representing the proportion of income that households choose to spend on consumption. In the two-sector model, consumption is assumed to be a constant fraction of income (C = cY), where c is the marginal propensity to consume (MPC).
By equating aggregate expenditure (AE = C + I) to income (Y), the equilibrium level of income (Y*) can be calculated as: Y* = C + I.
15. What factors can affect income determination in the two-sector model?
Ans: In the two-sector model, several factors can affect income determination and the equilibrium level of income.
These factors include:
(a) Consumption Function: The consumption function determines the relationship between income and consumption. The marginal propensity to consume (MPC), which represents the proportion of each additional unit of income that is spent on consumption, plays a crucial role in determining the level of consumption and thus the equilibrium income.
(b) Investment: Investment is another key factor that affects income determination in the two-sector model. Autonomous investment, which is independent of income, contributes to aggregate expenditure (AE) and influences the equilibrium level of income. Changes in investment spending can shift the aggregate expenditure curve and impact the equilibrium income level.
(c) Government Spending and Taxes: In the two-sector model, government spending and taxes are not explicitly considered. However, their inclusion can affect income determination. Government spending, through its impact on aggregate expenditure, can increase the equilibrium income level. Taxes, by reducing households’ disposable income, can influence consumption and thus affect the equilibrium income.
(d) Saving: The two-sector model assumes that all income is spent on consumption. However, the inclusion of saving as a component of household behaviour can modify the consumption function and affect income determination. Saving reduces consumption and can result in a lower equilibrium income level.
(c) Technological Progress: Technological advancements and changes in productivity can affect income determination in the two-sector model. Improved technology can increase the productivity of labor and capital, leading to higher output levels and potentially raising the equilibrium income.
(d) Resource Availability: The availability and utilisation of productive resources, such as labor and capital, can impact income determination. Changes in the quantity and quality of labor, for example, through changes in the labor force or educational levels, can influence the equilibrium income level.
16. How is equilibrium income determined in the short run?
Ans: In the short run, equilibrium income is determined by the interaction of aggregate demand (AD) and aggregate supply (AS) in the economy. The equilibrium income level occurs when the total spending in the economy (AD) is equal to the total production (AS). Here are the key steps involved in determining equilibrium income in the short run:
(i) Aggregate Demand (AD): Aggregate demand represents the total spending on goods and services in the economy. It consists of four main components: consumption (C), investment (I), government spending (G), and net exports (NX). AD = C + I + G + NX.
(ii) Aggregate Supply (AS): Aggregate supply represents the total production of goods and services in the economy. It can be divided into two components: short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS). In the short run, SRAS is influenced by factors such as input costs, technology, and expectations.
(iii) Equilibrium Condition: Equilibrium income is determined at the point where aggregate demand (AD) equals aggregate supply (AS). Mathematically, AD=AS.
(iv) Determination of Equilibrium Income: To find the equilibrium income level, compare the aggregate demand (AD) and aggregate supply (AS) schedules or curves. The point where they intersect represents the equilibrium level of income (Y*).
(v) If AD > AS: There is an excess demand for goods and services, indicating that actual production is lower than the level of spending. This situation puts upward pressure on prices and leads to firms increasing production to meet the higher demand, eventually reaching the equilibrium income level.
(vi) If AD < AS: There is an excess supply of goods and services, indicating that actual production is higher than the level of spending. This situation puts downward pressure on prices and leads to firms reducing production to match the lower demand, eventually reaching the equilibrium income level.
(vii) IfAD = AS: The level of spending matches the level of production, indicating that the economy is in equilibrium.
Changes in Equilibrium Income: Various factors can cause a shift in the aggregate demand or aggregate supply curves, resulting in a new equilibrium income level. For example, changes in consumption, investment, government spending, taxes, or net exports can shift the aggregate demand curve. Changes in input costs, technology, or productivity can shift the short-run aggregate supply curve.
17. How does an increase in aggregate demand affect equilibrium income in the short run?
Ans: An increase in aggregate demand (AD) can have a positive impact on equilibrium income in the short run. Here’s how an increase in aggregate demand affects equilibrium income:
(i) Increase in Aggregate Demand: When aggregate demand increases, it implies that there is an increase in total spending on goods and services in the economy. This increase can be due to various factors such as increased consumption, investment, government spending, or net exports.
(ii) Excess Demand: Initially, the increase in aggregate demand leads to a situation of excess demand. The level of spending exceeds the economy’s current production capacity, creating a gap between aggregate demand and aggregate supply.
(iii) Increase in Production: In response to the excess demand, firms increase their production levels to meet the higher level of spending. They may hire additional workers, use idle resources, or increase utilisation of existing capacity to ramp up production.
(iv) Increase in Employment and Income: The increased production requires firms to hire more workers, leading to an increase in employment levels. As employment rises, workers earn income from their jobs. The higher income earned by workers contributes to an increase in household disposable income.
(v) Increase in Consumption: With higher income, households have more purchasing power, leading to an increase in consumption expenditure. As consumption rises, aggregate demand further increases, creating a positive feedback loop.
18. What is the role of fiscal policy in determining equilibrium income in the short run?
Ans: Fiscal policy plays a significant role in determining equilibrium income in the short run. Fiscal policy refers to the use of government spending and taxation to influence the economy. By adjusting its fiscal policy, the government can affect aggregate demand (AD) and, consequently, equilibrium income. Here’s how fiscal policy influences equilibrium income in the short run:
(i) Expansionary Fiscal Policy: Expansionary fiscal policy involves increasing government spending and/or reducing taxes to stimulate aggregate demand. This policy is implemented to boost economic activity and increase equilibrium income. The key mechanisms through which expansionary fiscal policy affects equilibrium income are:
(a) Increased Government Spending: When the government increases its spending on goods and services, it directly contributes to aggregate demand. The higher government spending increases the overall level of spending in the economy, leading to higher output and income.
(b) Tax Reductions: Reducing taxes increases households’ disposable income, providing them with more money to spend on consumption. This increase in consumption expenditure raises aggregate demand and leads to higher equilibrium income.
(c) Multiplier Effect: Expansionary fiscal policy sets off a multiplier effect, where the initial increase in government spending or reduction in taxes leads to a larger increase in overall income. This occurs as the income earned by individuals is spent, creating additional rounds of spending and income generation.
(ii) Contractionary Fiscal Policy: Contractionary fiscal policy involves decreasing government spending and/or increasing taxes to reduce aggregate demand. This policy is implemented to control inflationary pressures or to address an overheating economy. The key mechanisms through which contractionary fiscal policy affects equilibrium income are the opposite of expansionary fiscal policy:
(a) Reduced Government Spending: Decreasing government spending reduces the overall level of spending in the economy, which can lead to a decrease in output and income.
(b) Tax Increases: Increasing taxes reduces households’ disposable income, which decreases consumption expenditure. This reduction in consumption leads to a decrease in aggregate demand and equilibrium income.
(c) Automatic Stabilisers: Fiscal policy can also rely on automatic stabilisers, which are built-in features of the tax and transfer systems that automatically adjust government revenues and spending in response to economic conditions. For example, during an economic downturn, automatic stabilisers such as progressive taxation and unemployment benefits provide an automatic boost to aggregate demand and help support equilibrium income.
19. How is equilibrium income determined in the short run when the price level is fixed?
Ans: In the short run, when the price level is fixed, equilibrium income is determined by the level of aggregate demand (AD) and aggregate supply (AS) in the economy. The concept of equilibrium income is based on the idea that total spending in an economy, known as aggregate demand, should be equal to the total output, known as aggregate supply.
In this scenario, equilibrium income is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. The aggregate demand curve represents the total spending by households, businesses, and the government at different levels of income, while the aggregate supply curve represents the total output that firms are willing to produce at different levels of income.
At the equilibrium income level, aggregate demand equals aggregate supply. This means that the total spending in the economy matches the total output produced. If aggregate demand exceeds aggregate supply, there will be a shortage of goods and services, leading to upward pressure on prices and an incentive for firms to increase production. Conversely, it aggregate supply exceeds aggregate demand, there will be an excess supply of goods and services, leading to downward pressure on prices and an incentive for firms to reduce production.
In the short run, factors such as consumer spending, investment levels, government spending, and net exports (exports minus imports) influence aggregate demand. These factors can change due to various economic conditions, such as changes in consumer confidence, fiscal policy, monetary policy, or international trade conditions.
It’s important to note that in the short run, the price level is assumed to be fixed, meaning that changes in aggregate demand primarily affect output and employment levels rather than prices. In the long run, however, when prices and wages have more flexibility, changes in aggregate demand can lead to changes in both output and the price level.
20. What are the limitations of analysing equilibrium income in the short run with a fixed price level?
Ans: Analysing equilibrium income in the short run with a fixed price level has certain limitations. Here are some of the key limitations to consider:
(i) Unrealistic assumption: Assuming a fixed price level in the short run is an oversimplification of the real world. In reality, prices are likely to adjust in response to changes in aggregate demand and supply. In the short run, there can be sticky prices, where some prices may not adjust immediately due to contracts, social norms, or other factors. However, over time, prices and wages tend to adjust, affecting the relationship between aggregate demand and aggregate supply.
(ii) Ignoring price-level effects: By assuming a fixed price level, the analysis overlooks the potential effects of changes in aggregate demand on the price level. In the short run, shifts in aggregate demand can lead to changes in output and employment levels, but they can also have an impact on the price level. For example, an increase in aggregate demand might lead to both higher output and inflationary pressures in the long run as prices adjust.
(iii) Incomplete picture of the economy: Focusing solely on equilibrium income with a fixed price level neglects important factors that can influence economic outcomes. Variables such as investment, technological progress, government policies, and international trade can all have significant impacts on economic growth, employment, and inflation. Ignoring these factors can limit the accuracy and comprehensiveness of the analysis.
(iv) Dynamic nature of the economy: The short-run analysis assumes a static snapshot of the economy, disregarding the dynamic nature of economic processes. In reality, the economy is subject to constant changes and adjustments, including shifts in consumer and business expectations, policy interventions, and external shocks. These dynamic factors can influence the relationship between aggregate demand and aggregate supply, making the short-run analysis less accurate in capturing real-world complexities.
(v) Assumption of ceteris paribus: Short-run analysis with a fixed price level often assumes that other factors remain constant (ceteris paribus), isolating the impact of changes in aggregate demand on equilibrium income. However, in practice, economic variables are interrelated, and changes in one factor can have ripple effects on others. Ignoring these interdependencies can limit the accuracy of the analysis and overlook important feedback mechanisms in the economy.
21. How does an autonomous change in aggregate demand affect income and output?
Ans: An autonomous change in aggregate demand refers to a shift in the aggregate demand curve that is not caused by changes in income or prices. It can result from various factors such as changes in consumer confidence, government spending, investment levels, or net exports. The impact of an autonomous change in aggregate demand on income and output depends on the nature of the change.
(i) Increase in autonomous aggregate demand: If there is an autonomous increase in aggregate demand, it will lead to an increase in both income and output in the economy. The higher level of spending will stimulate firms to increase production to meet the increased demand for goods and services. As a result, firms will hire more workers and utilise their resources more intensively, leading to higher levels of income and output.
(ii) Decrease in autonomous aggregate demand: Conversely, it there is an autonomous decrease in aggregate demand, it will lead to a decrease in income and output in the economy. The reduced level of spending will result in lower demand for goods and services, prompting firms to reduce production. This reduction in production will lead to lower employment levels and income in the economy.
It’s important to note that the impact of an autonomous change in aggregate demand on income and output can be magnified through multiplier effects. The multiplier effect refers to the phenomenon where an initial change in spending leads to a larger overall impact on income and output. This occurs because an increase in spending generates income for workers, who in turn spend part of that income on goods and services, leading to further rounds of spending and income generation. Similarly, a decrease in spending can trigger a downward multiplier effect, causing a larger decline in income and output.
The size of the multiplier effect depends on various factors, including the marginal propensity to consume (MPC), which is the proportion of additional income that is spent rather than saved. A higher MPC implies a larger multiplier effect, as more of the additional income is spent and circulates through the economy.
22. How does an autonomous decrease in aggregate demand impact income and output?
Ans: An autonomous decrease in aggregate demand refers to a shift in the aggregate demand curve caused by factors such as a decrease in consumer spending, government spending cuts, reduced investment levels, or a decline in net exports. The impact of an autonomous decrease in aggregate demand on income and output can be significant and can lead to a decrease in both.
When there is an autonomous decrease in aggregate demand, it implies a reduction in overall spending in the economy. This reduction in spending affects businesses and their production decisions, leading to a decline in output and income.
Here’s how it generally unfolds:
(i) Reduced consumer spending: A decrease in consumer spending, which could be due to factors like decreased consumer confidence or a decline in household wealth, lowers the demand for goods and services. As a result, businesses receive fewer orders and reduce their production levels.
(ii) Reduced business investment: If there is a decrease in business investment, such as a decline in capital expenditures or a lack of confidence in future economic conditions, it leads to lower investment spending. This reduction in investment affects businesses’ expansion plans, limits their capacity to increase production, and can result in lower income and output.
(iii) Government spending cuts: When there are cuts in government. spending, it directly reduces the demand for goods and services in the economy. Government spending is often a significant component of aggregate demand, and reductions in spending can have a contractionary effect on income and output.
(iv) Decline in net exports: If there is a decrease in net exports (exports minus imports), it means there is reduced demand for a country’s goods and services from foreign markets. This decline in net exports reduces the overall demand for domestic production and can lead to a decrease in income and output.
The decrease in aggregate demand can trigger a multiplier effect, which can further amplify the negative impact on income and output. As businesses reduce production and lay off workers in response to the decreased demand, the decline in income affects consumer spending, leading to further reductions in demand and potentially a downward spiral.
23. How does the investment multiplier work?
Ans: The investment multiplier, also known as the expenditure multiplier or simply the multiplier effect, refers to the phenomenon where an initial change in investment spending leads to a larger overall impact on income and output in an economy. It is based on the idea that changes in investment can have ripple effects throughout the economy, influencing spending, income, and production.
The investment multiplier works through the following steps:
Initial increase in investment: Let’s assume there is an initial increase in investment spending by businesses. This increase can result from factors such as business optimism, lower interest rates, or government policies encouraging investment.
(i) Increased production and income: When businesses increase their investment spending, they create additional demand for capital goods, such as machinery, equipment, and construction materials. To meet this increased demand, other businesses, such as suppliers and manufacturers of capital goods, increase their production levels. This rise in production requires more labor and other inputs, leading to increased income for workers.
(ii) Rise in consumer spending: The increase in income generated from the higher production and employment levels leads to an increase in consumer spending. Workers who receive higher incomes tend to spend a portion of that income on goods and services, creating additional demand for consumer goods.
(iii) Further rounds of spending and income generation: As consumers spend their increased income, businesses that produce consumer goods experience higher demand. This prompts these businesses to increase their production, leading to higher employment and income for workers in these sectors. The cycle continues as the increased income from consumer spending further stimulates consumption and, in turn, leads to additional rounds of spending and income generation.
The investment multiplier indicates that the total increase in income and output in the economy is greater than the initial increase in investment. The size of the multiplier effect depends on the marginal propensity to consume (MPC), which is the proportion of additional income that is spent rather than saved. If the MPC is higher, more of the additional income is spent, resulting in a larger multiplier effect.
The formula to calculate the investment multiplier is:
Multiplier = 1/ (1-MPC)
For example, if the MPC is 0.8 (meaning 80% of additional income is spent), the investment multiplier would be:
Multiplier=1/ (1- 0.8) = 5
This means that a $1 increase in investment spending would ultimately lead to a $5 increase in income and output in the economy.
24. How does the marginal propensity to consume (MPC) relate to the investment multiplier?
Ans: The marginal propensity to consume (MPC) is a key determinant of the size of the investment multiplier. The MPC represents the proportion of additional income that individuals or households spend on goods and services rather than saving. It indicates how much of an increase in income will be channelled into consumption.
The relationship between the MPC and the investment multiplier is inverse.
Here’s how the two are related:
(i) Higher MPC: When the MPC is higher, it means that a larger proportion of additional income is spent on consumption. In this case, a given increase in investment spending will lead to a larger increase in consumer spending, resulting in a greater overall impact on income and output. The higher the MPC, the larger the multiplier effect.
(ii) Lower MPC: Conversely, when the MPC is lower, it means that a smaller proportion of additional income is spent on consumption. In this case, a given increase in investment spending will result in smaller increase in consumer spending, leading to a relatively smaller overall impact on income and output. The lower the MPC, the smaller the multiplier effect.
The relationship between the MPC and the investment multiplier can be expressed using the formula:
Multiplier = 1/ (1 – MPC)
This formula highlights the inverse relationship between the MPC and the multiplier. As the MPC approaches 1 (indicating that most of the additional income is spent), the denominator of the formula approaches zero, leading to a larger multiplier. Conversely, as the MPC approaches 0 (indicating that most of the additional income is saved), the denominator approaches 1, resulting in a smaller multiplier.
For example, if the MPC is 0.8 (meaning 80% of additional income is spent), the investment multiplier would be:
Multiplier = 1 / (1 – 0.8) = 5
This means that a $1 increase in investment spending would ultimately lead to a $5 increase in income and output in the economy.
Therefore, the MPC plays a crucial role in determining the magnitude of the investment multiplier. A higher MPC implies a larger multiplier effect, indicating a more significant impact on income and output from changes in investment spending.
25. What factors can influence the size of the investment multiplier?
Ans: The size of the investment multiplier, which represents the overall impact of changes in investment spending on income and output in an economy, can be influenced by various factors. Here are some key factors that can affect the magnitude of the investment multiplier:
(i) Marginal Propensity to Consume (MPC): The marginal propensity to consume (MPC) is the proportion of additional income that individuals or households spend on goods and services rather than saving. A higher MPC means that a larger portion of additional income is spent, leading to a larger multiplier effect. Conversely, a lower MPC results in a smaller multiplier effect.
(ii) Leakages: Leakages from the economy, such as savings, taxes, and imports, can reduce the size of the multiplier effect. When individuals save a larger portion of their income or when taxes and imports absorb a significant portion of income, the leakage from the spending cycle reduces the subsequent rounds of consumption and, therefore, the multiplier effect.
(iii) Time Frame: The time frame considered can influence the size of the investment multiplier. In the short run, when the economy may not have enough time to fully adjust to changes in investment, the multiplier tends to be smaller. As time passes, prices, wages, and other economic variables can adjust, potentially increasing the multiplier effect.
(iv) Spare Capacity: The presence of spare capacity in the economy can affect the size of the multiplier. If there is idle or underutilised capacity in industries, an increase in investment spending can be absorbed more easily, leading to a larger multiplier effect. However, if the economy is operating near full capacity, the scope for expanding output in response to increased investment may be limited, resulting in a smaller multiplier.
(iv) Monetary and Fiscal Policy: The stance of monetary and fiscal policy can influence the investment multiplier. Expansionary monetary policy, such as lower interest rates or increased money supply, can stimulate investment spending and amplify the multiplier effect. Similarly, expansionary fiscal policy, such as increased government spending or tax cuts, can boost aggregate demand, including investment, and enhance the multiplier effect.
(v) Expectations and Confidence: Business and consumer expectations and confidence play a role in determining the size of the investment multiplier. Positive expectations and increased confidence can lead to higher investment spending, resulting in a larger multiplier effect. Conversely, negative expectations and low confidence can dampen investment spending and reduce the multiplier effect.
26. How is full employment typically measured?
Ans: Full employment is typically measured using various labor market indicators to assess the utilisation of available labor resources within an economy. Here are some common measures used to gauge full employment:
(i) Unemployment Rate: The unemployment rate is a widely used indicator to assess the degree of employment in an economy. It measures the proportion of the labor force that is actively seeking employment but is currently unemployed. A lower unemployment rate suggests a higher level of employment and is often considered an indication of full employment. However, it’s important to note that a 0% unemployment rate is not necessarily achievable or desirable due to factors such as frictional unemployment and structural unemployment.
(ii) Labor Force Participation Rate: The labor force participation rate measures the percentage of the working-age population (usually 16 years and older) that is either employed or actively seeking employment. A higher labor force participation rate implies a larger proportion of the population engaged in the labor market, which can be an indication of a more fully utilised workforce.
(iii) Employment-to-Population Ratio: The employment-to-population ratio compares the number of employed individuals to the total working-age population. It provides a measure of the proportion of the population that is employed and can give an indication of the extent to which available labor resources are utilised.
(iv) Underemployment: Underemployment refers to a situation where individuals are employed but are working part-time involuntarily or are employed in jobs that are below their skill level or desired work hours. Monitoring underemployment can provide insights into the quality of employment and the degree to which individuals are able to fully utilise their skills and preferences in the labor market.
(v) Job Vacancy Rates: Job vacancy rates measure the number of job openings that are available in relation to the total number of jobs in the economy. A lower job vacancy rate suggests a tighter labor market, where a higher proportion of available jobs are filled, indicating closer proximity to full employment.
27. Explain diagrammatically how equilibrium level of employment and income is determined in a two sector economy with the concept of aggregate demand and aggregate supply.
Ans: The equilibrium is determined only when aggregate demand (AD) equals aggregate supply (AS) because at this level there is no tendency for income and output to change.
In the diagram, the equilibrium is at K where AD intersects 45 line. At this point, AD = AS.
When AD is more than AS, then the planned inventory would fall below the desired level. To bring back the Inventory at the desired level, the producers expand the output More output means more income. The rise in output means rise in AS and rise in income means rise in AD. Both continue to rise till they reach E, where AD = AS.
When AD is less than AS, then the planned inventory rises above the desired level. To clear the unwanted increase in inventory, firms plan to reduce the output till AD becomes equal to AS.
So, equilibrium takes place only at point K, when AD = AS.
28. How does full employment relate to the concept of potential output?
Ans: Full employment and potential output are closely related concepts that provide insights into the utilisation of resources and the productive capacity of an economy. Here’s how they are connected:
(i) Full Employment: Full employment refers to a state in the economy where the labor market is operating at its maximum level of employment without causing upward pressure on inflation. It represents a situation where the economy is utilising its available labor resources effectively, and the unemployment rate is at its natural or equilibrium level. Full employment does not mean zero unemployment but rather a level of unemployment consistent with normal job turnover and individuals transitioning between jobs.
(ii) Potential Output: Potential output, also known as potential GDP, is an estimate of the maximum level of output an economy can produce when all available resources, including labor, capital, and technology, are fully employed. It represents the productive capacity of an economy under normal circumstances and reflects the sustainable long-term average level of output that can be achieved without putting excessive strain on resources or causing inflationary pressures.
The relationship between full employment and potential output is as follows:
Full employment is a condition that relates specifically to the labor market, indicating that the economy is utilising its labor resources efficiently and that the unemployment rate is at its natural level. It represents a state of maximum employment without excessive inflationary pressures.
Potential output, on the other hand, is a broader concept that encompasses the overall productive capacity of the economy, taking into account not only labor but also capital, technology, and other factors of production. It represents the level of output an economy can sustainably produce in the long run without causing inflation or resource constraints.
In an ideal scenario, full employment should align with potential output. When the economy is at full employment, it implies that the economy is operating close to its productive capacity, and resources, including labor, are fully utilised. This suggests that the actual output of the economy is in line with its potential output.
However, it’s important to note that in practice, there can be a temporary mismatch between full employment and potential output due to various factors such as cyclical fluctuations, structural changes, or other shocks affecting the economy. For example, during economic recessions, there may be a gap between actual output (below potential) and full employment (above natural rate of unemployment). Over time, as the economy recovers and adjusts, it should converge towards both full employment and potential output.
Understanding the relationship between full employment and potential output is crucial for policymakers and economists as it provides insights into the health and performance of the economy. Achieving and maintaining full employment, while ensuring that actual output is close to potential output, is a key goal for policymakers to promote stable and sustainable economic growth.
