1. Equilibrium income: AD = AS
- AD = C + I (two sectors); AS = Y, shown by the forty-five degree line.
- Equilibrium: AD = AS. With C = a + bY and investment I, Y = (a + I) ÷ (1 − b).
- Imagined Tarangpur: C = 60 + 0.8Y, I = 40, so Y = 100 ÷ 0.2 = 500.
- Break-even income (C = Y) is 300, a different point: there saving is zero, but investment is 40.
| Y | C | S | I | AD = C + I | Output will… |
|---|---|---|---|---|---|
| 0 | 60 | -60 | 40 | 100 | rise |
| 100 | 140 | -40 | 40 | 180 | rise |
| 200 | 220 | -20 | 40 | 260 | rise |
| 300 | 300 | 0 | 40 | 340 | rise |
| 400 | 380 | 20 | 40 | 420 | rise |
| 500 | 460 | 40 | 40 | 500 | stay (equilibrium) |
| 600 | 540 | 60 | 40 | 580 | fall |
| 700 | 620 | 80 | 40 | 660 | fall |
Key terms
- Equilibrium income
The income at which planned aggregate demand equals aggregate supply.
- Forty-five degree line
The line on which spending equals income; it represents aggregate supply.
2. Equilibrium income: S = I, and adjustment
- AS = C + S and AD = C + I, so AD = AS is the same as planned S = planned I.
- AD > AS (I > S): stocks fall below plan, firms expand, income rises.
- AD < AS (S > I): unsold stocks build up, firms cut back, income falls.
- The adjustment stops only at equilibrium.
Key terms
- Leakage
Income not passed on as spending, such as saving.
- Injection
Spending added from outside consumption, such as investment.
- Unplanned inventory change
A rise or fall in stocks that firms did not intend; the signal that output is not at equilibrium.
3. The investment multiplier
- k = ΔY ÷ ΔI = 1 ÷ (1 − MPC) = 1 ÷ MPS.
- Working: new investment becomes income; a share (the MPC) is spent and becomes others' income; rounds shrink by the MPC; their sum is k × ΔI.
- Imagined metro project: ΔI = 100, MPC = 0.8: rounds 100, 80, 64, 51.2…, total 500.
- Range: k = 1 when MPC = 0; k grows without limit as MPC approaches 1. It works backwards too.
- Tarangpur: ΔI = 20 raises income from 500 to 600.
| MPC | MPS | k = 1 ÷ MPS |
|---|---|---|
| 0 | 1 | 1 |
| 0.5 | 0.5 | 2 |
| 0.75 | 0.25 | 4 |
| 0.8 | 0.2 | 5 |
| 0.9 | 0.1 | 10 |
Key terms
- Investment multiplier
The number of times income changes for a given change in investment.
- Marginal propensity to save
The share of extra income that is saved; the multiplier is its reciprocal.
4. Full employment and involuntary unemployment
- Full employment: no involuntary unemployment; frictional and voluntary idleness can remain.
- Involuntary unemployment: willing to work at the prevailing wage, but no work available.
- In Keynesian theory equilibrium depends on effective demand, so the economy can rest at an underemployment equilibrium with output below its full-employment level.
| Term | Meaning | Example (imagined) |
|---|---|---|
| Full employment | All able and willing to work at the going wage have jobs | A town where any willing worker finds work at the going wage |
| Involuntary unemployment | Willing to work at the going wage but cannot find work | A trained welder who would accept the going wage, with no openings |
| Frictional unemployment | Short spells between jobs | A nurse moving to a new hospital next month |
| Voluntary unemployment | Not willing to work at the going wage | Someone who chooses to wait for a far higher wage |
Key terms
- Full employment
A state in which all who are able and willing to work at the going wage are employed.
- Involuntary unemployment
Unemployment of people willing to work at the going wage who cannot find jobs.
- Underemployment equilibrium
An equilibrium in which output is below the full-employment level.
5. Excess and deficient demand
- Inflationary gap (excess demand) = AD at full-employment output − that output. Main effect: prices rise, since output cannot.
- Deflationary gap (deficient demand) = full-employment output − AD there. Effects: output and employment fall, involuntary unemployment.
- Imagined Hiranagar, AD = 120 + 0.6Y: with Yf = 400, gap = 40 (deflationary); with Yf = 250, gap = 20 (inflationary).
- To close a deflationary gap, extra spending equal to the gap is enough: k × gap = 2.5 × 40 = 100.
| Full-employment output Yf | AD at Yf | Gap | Kind |
|---|---|---|---|
| 400 | 360 | 40 | Deflationary (AD < Yf) |
| 250 | 270 | 20 | Inflationary (AD > Yf) |
| Excess demand | Deficient demand | |
|---|---|---|
| Causes | More public spending, easy credit, higher exports, lower saving | Lower investment, lower exports, higher saving, tighter credit |
| Effect on output | Cannot rise beyond full employment | Falls below full employment |
| Effect on prices | Rise | Stay low or fall |
| Effect on jobs | No new jobs | Involuntary unemployment |
Key terms
- Inflationary gap
The excess of aggregate demand over output at full employment.
- Deflationary gap
The shortfall of aggregate demand below output at full employment.
6. Measures to correct excess and deficient demand
- Fiscal: government spending and taxes (and public borrowing). Excess demand: spend less, tax more. Deficient demand: spend more, tax less.
- Monetary (quantitative): repo and bank rate, CRR and SLR, open market operations. Excess demand: raise rates and ratios, sell securities. Deficient demand: the reverse.
- Monetary (qualitative): margin requirements, credit rationing, moral suasion, direct action — aimed at particular uses of credit.
- Fiscal steps change AD directly; monetary steps work through borrowing, which may respond slowly when expectations are weak.
| Instrument | Against excess demand | Against deficient demand |
|---|---|---|
| Government spending | Cut | Raise |
| Taxes | Raise | Cut |
| Repo rate / bank rate | Raise | Cut |
| CRR and SLR | Raise | Cut |
| Open market operations | Sell securities | Buy securities |
| Margin requirements | Raise | Lower |
Key terms
- Fiscal policy
Changes in government spending and taxation to influence aggregate demand.
- Monetary policy
Changes in the cost and availability of credit by the central bank.
- Repo rate
The rate at which the central bank lends short-term funds to commercial banks.
Exam tips
Common mistakes
- Calling the break-even income (C = Y) the equilibrium income.
- Measuring a gap at the equilibrium income instead of at full-employment output.
- Saying the multiplier can be less than one.
- Suggesting a tax cut or a repo cut for excess demand.
- Saying excess demand at full employment raises output.
How marks are usually awarded
- 1 mark: one correct choice or a precise term.
- 2 marks: a definition with an example, or two short points.
- 3 marks: three steps of a calculation or three distinct points.
- 5 marks: parts with working, a described diagram and reasons.
All economies and figures in SOYL practice are imagined; state units (₹ crore) in every answer.