NIOS Class 12 Economics Chapter 27 Theory of Income Determination

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NIOS Class 12 Economics Chapter 27 Theory of Income Determination

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Theory of Income Determination

Chapter: 27

Module – X: Theory of Income And Employment

TEXT BOOK QUESTIONS WITH ANSWERS

INTEXT QUESTIONS 27.1.

Q. 1. Aggregate expenditure is a measure of aggregate demand .True/ false.

Ans. True.

Q. 2. What is the difference between exports and imports of an economy called?

Ans. Import refers to an item coming inside a country from any other country while export refers to an item going out of the country to any other country of the world. Since no country in the world is self sufficient, all countries both import as well as export.

If a country is rich in a particular ore as it has natural reserves of that ore in the form of mines, the country can export that ore to other countries of the world. This is particularly true of oil producing countries that are exporters of crude oil. However, all such countries are dependent on other countries for many other products and services which is why they need to import such items from other countries of the world.

Exports earn money for a country, while imports mean expenses. For example, India is a country that has a huge number of qualified manpower in the IT sector. This manpower exports its services to companies doing business in other countries thus earning foreign currency for India. On the other hand, India is dependent for oil and arms on other countries and needs to import them for its energy requirements as well as its army. It can spend the foreign currency it earns through exports to import goods and services it is deficient in. This is the basic concept behind exports and imports.

It is the endeavour of all countries of the world to achieve parity in their exports and imports. But in reality it is never so and this is where balance of payment creeps in. In an ideal situation, where exports equal imports, a country can utilize the money earned through exports to import goods and services it requires.

Q. 3. Whose demand is called final demand for goods and services.

(a) Firms.

(b) Government.

(c) Households.

(d) Rest of the world.

Ans. (c) Households.

Q. 4. The condition for equilibrium income is given as-

(a) C = S

(b) C + I = C + S

(c) C + S = S + 1

(d) S = Y

Ans. (b) C + I = C + S

INTEXT QUESTIONS 27.2.

Q. 1. What is the difference between aggregate demand and consumption is.called _____________?

Ans. Investment.

Q. 2. The rate at which aggregate demand increases is known as _______________?

Ans. MPC.

Q. 3. Differentiate between aggregate demand (AD) and Effective demand (ED)?

Ans. Aggregate Demand (AD) is the total demand for final goods and services in an economy at a given time. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. The aggregate demand curve illustrates the relationship between two factors-the quantity of output that is demanded and the aggregate price level. Aggregate demand is expressed contingent upon a fixed level of the nominal money supply. There are many factors that can shift the AD curve. Rightward shifts result from increases in the money supply, in government expenditure, or in autonomous components of investment or consumption spending, or from decreases in taxes.

Effective demand is the point where aggregate demand equals the level of output in the short run in a given price level. The equilibrium level of income reflects the effective demand in the economy.

INTEXT QUESTIONS 27.3.

Q. 1. If MPS = 0.5. What us multiplier?

Ans. Multiplier = 1/0.5 = 10/5 = 2

Q. 2. If MPS = 0.8, what is multiplier?

Ans. Multiplier = 1/0.8 = 10/8 = 5/2

Q. 3. If increase in investment is 50 crores and income increases from 1000 crores to 1200 crores then find out multiplier?

Ans. Multiplier = ∆Y/ΔΙ

= 1200 -1000/50 = 200/500 = 4

Q. 4. If MPC is more than multiplier is less. True/ False

Ans. False.

Q. 5. If MPS is higher, then multiplier is lower. True/ False

Ans. True.

Q. 6. Given that MPC = 0.8 and increase in investment in 100 crores find out increases in consumption in the second round? What is total increase in income after the rounds?

Ans. 80 crores, 180 crores.

INTEXT QUESTIONS 27.4.

Q. 1. Excess demand creates inflationary pressure. True/ False

Ans. True.

Q. 2. Deficiency in demand leads to increase in price. True/ False

Ans. False.

Q. 3. Increase in money supply creates excess demand. True/ False

Ans. True.

Q. 4. Decrease in credit supply leads to deflation. True/ False

Ans. True.

Q. 5. Tax policy is a part of monetary policy. True/ False

Ans. False.

Q. 6. Public expenditure should be increased to cure deflation. True/ False

Ans. False.

Q. 7. Reduce public borrowing to cure excess demand. True/ False

Ans. True.

Q. 8. Bank rate must be increased to allow increase in money supply. True/ False

Ans. Flase.

Q. 9. Open market operation is a fiscal policy instrument. True/ False

Ans. True.

TERMINAL EXERCISE

Q. 1. Discuss the various components of aggregate demand in brief?

Ans. Aggregate demand of an economy is defined as the total demand for goods and services at the given price level.

Price are given or fixed because in a short run period prices of goods and services do not change.

A measure of aggregate demand is the aggregate expenditure incurred by the different consuming sectors of the economy on consumption of goods and services at the prevailing price level. Now the Questions arises:

Who are the consuming sectors in the economy? It must be noted that the economy’s total product is used for final consumption as well as for further production. Accordingly, we can identify the following consuming sectors

1. Household.

2. Firm.

3. Government.

4. Rest of the world.

Aggregate demand consists of the demand for goods and services by these sectors taken together.

1. Household consumption demand: Individuals, families and on-profit organisations come under the household consumption demand. They demand both durable as well as non-durable goods. Durable goods include Television, radio, mobile phones, refrigerator and washing machines and non-durable items include food items, vegetables and clothes.

2. Producers or Firm’s Investment Demand: Producers or firms require goods and services for farther production. They get these goods and services as their investment. These are intermediate consumption. When firms consider investment spending, they routinely take into account the nominal interest rate, inflation and the real interest rate. Examples of investment spending include machinery, buildings, education and new housing.

3. Government Expenditure: Government makes purchases for the benefit of public. The government makes immediate purchases. The total amount of money spent by the government is often surprising. In fact, it is not unusual for government spending to constitute upwards of one third of gross domestic product. The level of government spending is a hotly debated topic as political parties vie for their programs in the annual budget.

4. Purchases by Rest of the World: A country makes exports and imports if it is an open economy. Net export is exports minus imports. The net export is the measure of demand for goods and services by rest of the world. It is important to recognize that net exports are dependent upon the real exchange rate. As the real exchange rate rises, domestic currency is relatively more valuable and thus the price of domestic goods is relatively more expensive than the price of foreign goods. In this case, exports fall and imports rise, causing net exports to decline. Interestingly, a thriving domestic economy will result in a higher real exchange rate and thus lower net exports.

Q. 2. Explain determination of equilibrium income, in a two sector economy? Give diagram.

Ans. In a two sector economy, the equilibrium level of national income can be determined by the equality of aggregate demand and aggregate supply or by the equality of saving and investment.

Aggregate demand is the summation of consumption expenditure on newly produced consumer goods by households and on their services (C), and investment expenditure cn newly produced capital goods and inventories by businessmen (I).

It is shown by the following identities:

Y = C + I …(1)

Personal Income:

Yd = C + S …(2)

But Y = Yd

C + I = C + S

or I = S

Where Y= national income,

Yd = disposable income,

C = consumption,

S = saving, and

I = investment.

In the above identities, C + 1 relate to consumption and investment expenditures which represent aggregate demand of an economy. C is the consumption function which indicates the relation between income and consumption expenditure.

The consumption function is shown by the slope of the C curve in Fig. which is MFC (marginal propensity to consume). I is investment demand which is autonomous. When investment demands (I) is added to consumption function (C), the aggregate demand, function becomes C + I.

C + S identity is related to the aggregate supply of an economy. That is why, consumer goods and services are produced from total consumption expenditure and aggregate savings are invested in the production of capital goods.

In an economy, the equilibrium level of national income is determined by the equality of aggregate demand and aggregate supply (C + I = C + S) or by the equality of saving and investment (S = I).

Q. 3. Define multiplier and derive its value.

Ans. The concept of multiplier was first of all j developed by F.A. Kahn in the early 1930s. But Keynes 1 later further refined it. F.A. Kahn developed the concept I of multiplier with reference to the increase in employment, I direct as well as indirect, as a result of initial increase in J investment and employment.

Keynes, however, propounded the concept of multiplier with reference to the increase in total income direct as well as indirect, as a result of original increase in investment and income. Therefore, whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’s multiplier is known as investment or income multiplier.

The essence of multiplier is that total increase in income, output or employment is manifold the orignal increase in investment. For example, if investment equal to 100 crores is made, then the. income will not rise by 100 crores only but a multiple of it.

Q. 4. Explain the working of multiplier through various rounds.

Ans. The working of multiplier is based on the fect 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 this with the help of an example.

1. Suppose, an additional investment of 100 crore (AI) is made to construct a flyover. This extra investment will generate an extra income of 100 crores in the first round.

2. If MPC is assumed to be 0.90, then recipients, of this additional income will spend 90% of 100 crores, i.e. 90 crores as consumption expenditure and the remaining amount will saved. It will increase the income by 90 crore in the second round.

3. In the next round, 90% of the additional income of 90 crores, i.e. 81 crores will be spent on consumption and the remaining amount will be saved.

4. This multiplier process will go on and the consumption expenditure in every round will be 0.90 times of the additional income received from the previous round. The multiplier process is shown in Table below.

Thus, an initial investment of Rs 100 crores leads to a total increase of Rs 1,000 crors in the income. As a result, Multiplier (K) = ∆Y/∆I = 1000/100 = 10.

Q. 5. Define excess demand. Explain it by using suitable diagram.

Ans. Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P,, the quantity of goods demanded by consumers at this price is Q₂. Conversely, the quantity of goods that producers are willing to produce at this price is Q,. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.

Q. 6. Define deficiency in demand. Explain it by using suitable diagram.