CUET UG Economics Macroeconomics Aggregate Demand and Supply Keynesian Model Multiplier

Must-Know

• Aggregate demand (AD) in a closed economy = Consumption (C) + Investment (I) + Government Spending (G). Example: If C = ₹400 cr, I = ₹100 cr, G = ₹80 cr, then AD = ₹580 cr.
• Aggregate supply (AS) refers to the total value of final goods and services producers plan to supply, equal to national income (Y). At equilibrium, AS = AD.
• Consumption function: C = $\bar{C}$ + cY, where $\bar{C}$ is autonomous consumption (independent of income), c is marginal propensity to consume (MPC), and Y is income.
• Marginal Propensity to Consume (MPC) = ΔC / ΔY. If income rises by ₹200 and consumption rises by ₹150, MPC = 0.75.
• Marginal Propensity to Save (MPS) = ΔS / ΔY. If income increases by ₹300 and saving increases by ₹60, MPS = 0.2.
• MPC + MPS = 1. If MPC = 0.8, then MPS = 0.2. This is always true by definition.
• Autonomous consumption ($\bar{C}$) is consumption at zero income level; it is financed by past savings or borrowing. Example: ₹50 crores even when Y = 0.
• Break-even point occurs when consumption equals income (C = Y), so saving = 0. Example: If C = 200 + 0.75Y, break-even at Y = 800.
• Ex-ante investment refers to planned investment; ex-post investment includes unplanned inventory changes.
• Equilibrium in the Keynesian model occurs when ex-ante aggregate demand = ex-ante aggregate supply.
• If AD > AS, inventories fall, firms increase production until equilibrium is restored.
• If AD < AS, inventories rise, firms cut production until equilibrium is restored.
• Investment multiplier (k) = 1 / (1 – MPC) = 1 / MPS. If MPC = 0.75, k = 4.
• Multiplier effect: An initial increase in investment of ₹100 cr with MPC = 0.8 leads to total income increase of ₹500 cr (k = 5).
• Full employment equilibrium occurs when output is at full employment level; beyond this, inflationary gap arises.
• Inflationary gap = AD at full employment > AS at full employment. Example: AD = ₹1,200 cr, AS = ₹1,000 cr → gap = ₹200 cr.
• Deflationary gap = AD at full employment < AS at full employment. Example: AD = ₹800 cr, AS = ₹1,000 cr → gap = ₹200 cr.
• The multiplier works faster in economies with higher MPC because more of each income increment is spent.
• In the Keynesian model, prices and wages are assumed to be rigid in the short run.
• The AD curve slopes downward due to wealth effect, interest rate effect, and foreign trade effect.

Difficulty Level

Intermediate — requires understanding of behavioral functions (C, I), equilibrium conditions, and numerical application of multiplier, but avoids advanced calculus or open economy complications.

Common CUET Traps

• Trap: Confusing MPC with average propensity to consume (APC). Students use total C/Y instead of ΔC/ΔY. Avoid: MPC is always about change in consumption due to change in income, not ratios at a point.
• Trap: Assuming equilibrium always means full employment. Avoid: Equilibrium can occur below, at, or above full employment; full employment is a special case.
• Trap: Thinking that an increase in investment directly increases income by the same amount. Avoid: Use multiplier: income increases by k × ΔI, not just ΔI.

Practice MCQs

1. Question: In an economy, MPC = 0.8. What is the value of the investment multiplier?
   
   A) 4
   
   B) 5
   
   C) 6
   
   D) 8
   Answer: B) 5
   Explanation: k = 1 / (1 – MPC) = 1 / (1 – 0.8) = 5.
   Why others fail: Option A (4) is chosen if MPC = 0.75 is mistakenly assumed.

2. Question: Which of the following represents aggregate demand in a closed economy?
   
   A) C + I
   
   B) C + I + G + (X – M)
   
   C) C + I + G
   
   D) C + S + T
   Answer: C) C + I + G
   Explanation: In a closed economy, no foreign trade, so AD = C + I + G.
   Why others fail: Option B includes net exports, which applies only to open economies.

3. Question: If income increases from ₹500 crore to ₹600 crore and saving increases from ₹50 crore to ₹80 crore, what is the MPS?
   
   A) 0.3
   
   B) 0.4
   
   C) 0.5
   
   D) 0.7
   Answer: A) 0.3
   Explanation: ΔY = ₹100 cr, ΔS = ₹30 cr, so MPS = 30/100 = 0.3.
   Why others fail: Option D (0.7) is MPC (ΔC = ₹70 cr → 70/100), mistaken for MPS.

4. Question: What happens when aggregate demand exceeds aggregate supply at full employment level?
   
   A) Deflationary gap
   
   B) Increase in output and employment
   
   C) Inflationary gap
   
   D) Fall in price level
   Answer: C) Inflationary gap
   Explanation: When AD > AS at full employment, excess demand causes inflationary gap.
   Why others fail: Option A is tempting if students confuse excess demand with deficient demand.

5. Question: Suppose autonomous consumption is ₹100 crore, MPC = 0.75, and investment = ₹50 crore. What is the equilibrium level of income?
   
   A) ₹400 crore
   
   B) ₹500 crore
   
   C) ₹600 crore
   
   D) ₹700 crore
   Answer: C) ₹600 crore
   Explanation: Y = (Ā) / (1 – MPC), Ā = C̄ + I = 100 + 50 = 150; Y = 150 / (1 – 0.75) = 150 / 0.25 = ₹600 cr.
   Why others fail: Option B is chosen if investment is not added to autonomous consumption.

Last-Minute Revision

• ⚠️ AD = C + I + G (closed economy); exclude (X – M).
• ⚠️ AS = Y (national income) in macroeconomic equilibrium.
• ⚠️ MPC = ΔC / ΔY; never C/Y.
• ⚠️ MPC + MPS = 1 — always.
• ⚠️ Break-even point: C = Y, so S = 0.
• ⚠️ Autonomous consumption > 0 even when Y = 0.
• ⚠️ Equilibrium: AD = AS (ex-ante).
• ⚠️ If AD > AS → inventory depletion → increase output.
• ⚠️ If AD < AS → inventory accumulation → reduce output.
• ⚠️ Multiplier k = 1 / (1 – MPC) = 1 / MPS.
• ⚠️ Higher MPC → higher k → larger income change.
• ⚠️ Inflationary gap: AD > AS at full employment.
• ⚠️ Deflationary gap: AD < AS at full employment.
• ⚠️ Keynes assumed price rigidity in short run.
• ⚠️ Full employment ≠ automatic in Keynesian model.
• ⚠️ Ex-ante: planned; ex-post: actual including unplanned changes.
• ⚠️ k = 4 when MPC = 0.75 — memorize common values.
• ⚠️ Initial ΔI = ₹20 cr, k = 5 → total ΔY = ₹100 cr.
• ⚠️ APC = C/Y; decreases as income rises.
• ⚠️ APS = S/Y; increases as income rises.