Question

equilibrium level of the national income = 2,500

full employment level of national income = 3,000

C= 200+ 0.6Y

1. What is deflationary gap ?

2. To full employment level, How much increase effective demand ?

Answer 1

Solution:

1. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium.

It indicated under employment equilibrium.

2. To reach full employment level, the effective demand should be increased by 200.

Explanation:

The full employment level of national income = 3,000

The equilibrium level of the national income = 2,500

The equilibrium level of national income is 500 less than the full employment level of national income.

This means that to reach the full employment level of national income, we have to increase consumer spending or investment in the economy.

We also know that an initial increase in consumer spending or investment leads to an increase in income in much more proportion than the initial increase.

This increase can be calculated by Income multiplier,

Value of multiplier (K) = Total increase in income / Initial increase in spending

OR

Value of multiplier (K) = 1 / 1 - MPC

C = 200 + 0.6Y

0.6 in the equation is the MPC (Marginal Propensity to Consume)

Value of multiplier (K) = 1 / 1 - 0.6

Value of multiplier (K) = 1 / 0.4

Value of multiplier (K) = 2.5 times

We have to reach full employment equilibrium. so, we require a total increase in income to be 500.

Therefore,

Value of multiplier (K) = Total increase in income / Initial increase in spending

2.5 = 500 / Initial increase in spending

Initial increase in spending= 500 / 2.5

Initial increase in spending= 200

To reach the full employment level, we have to increase consumer spending by 200.

Therefore, The effective demand should be increased by 200 to reach full employment equilibrium.