NCERT Solutions For Class 12 Economics Chapter 7
Income Determination

The difference between ex ante investment and ex post investment is shown below:

Level of income (Y) = ₹400
Consumption expenditure (A) = ₹50 crores
MPS = 0.2
We know,
MPC = 1-MPS
MPC = 1-0.2 = 0.8
Exante aggregate demand is given by Y* =
Y* = 50 + 0.8 × 4000
Y* = 3250
The economy is not in equilibrium because exante aggregate demand i.e. Y* = 3250 not equal to expost demand i.e. Y= ₹400

Paradox of thrift refers to a situation in which all the people of the economy tend to save greater proportion of their income, i.e. marginal propensity to save, MPS, increases which may ultimately ends up as decline in total saving of the economy. When an individual saves, it leads to increase in investment and thereby its prosperity. But when an economy as whole saves, total savings in the economy will not increase- it will either decline or remain unchanged. It is because when individual’s saving increases, it leads to fall in aggregate demand as the proportion of income spent on consumption decreases. This will lead to decline in investment and production which thereby reduces employment and income level. As income decreases, individual’s saving and then total saving decreases. This concept is propounded by Keynes to state that as people become thriftier they end up saving less or same as before.

Marginal propensity to consume (MPC) refers to the rate at which aggregate consumption spending changes due to change in national income. Numerically, it can be written as: MPC = ∆C/∆Y

Here, ∆C= Change in consumption

∆Y = Change in income

We know,

Y = C + S

It implies, ∆Y = ∆C + ∆S

On dividing this equation by ∆Y, we get,

∆Y/∆Y = ∆C/∆Y + ∆S/∆Y

1 = MPC +MPS

It implies that MPC = 1- MPS and MPS = 1- MPC.

Thus, the relation between MPC and MPS is that there sum is always equal to 1.

Effective demand refers to the demand for commodity which determines the equilibrium output in the market. In macroeconomics it is assumed that the aggregate supply is inelastic in short run and in case of any inequality in aggregate demand and aggregate supply, the equilibrium output is solely determined by aggregate demand.

To maintain simplicity while deriving the aggregate demand we assume fixed price of final goods and constant rate of interest for an economy. Fixed price of final goods implies that the suppliers are facing horizontal supply curve i.e. the elasticity of supply is infinite. It implies that the suppliers are willing to supply whatever amount consumers will demand at that price. In an economy when equilibrium output is solely determined by the aggregate amount of demand at fixed price under these circumstances (fixed price of final goods and constant rate of interest), this is referred as effective demand principle.

Under the effective demand principle, the equilibrium output of the final goods is equal to ex ante aggregate demand, as represented in the below equation:

Consider the equation of a straight line as

b = ma + ε

Where variables ‘a’ is independent and ‘b’ is a dependent variable which can be plotted on the horizontal and vertical axis respectively. ‘m’ is the slope of straight line and > 0 and ε is the intercept on the vertical axis > 0. An increase in the value of ‘a’ by 1 unit, increases the value of ‘b’ by ‘m’ units.

The equation of a straight line incorporates the two entities:

Entity m: Let us take two values of m, say 1 and 0.5. Corresponding to these values of m, we can have two straight lines, one steeper than the other as shown in the following diagram. The higher the value of m, the steeper will be the straight line. It is referred as movement of the variable along the graph.

Entity ε: Any change in the value of ε, changes the intercept on Y axis. Starting from zero, the first straight line will undergo parallel upward shifts. Let us take two values of ε, say 3 and 2. Corresponding to these values we can have two straight lines as shown in the following diagram. The higher the value of ε, the upward will be the straight line.

These entities i.e. m and ε are called the parameters of the graph which do not appear as variables on the axes. Instead they act in the background to regulate the position of the graph. Any change in the graph due to change in any of these variables is known as parametric shift of a line.

1. The line swings downward along the same vertical intercept as its slopes decreases.
2. The line shifts upward with the same slope as its intercept increases.