(a)OR(b)

Explain the adjustment mechanism, if in an economy, ex-ante Aggregate Demand (AD) is more than ex-ante Aggregate Supply (AS).

(a) When ex-ante Aggregate Demand is more than ex-ante Aggregate Supply, it means that the households and firms are planning to consume more than what the firms are planning to produce. Thus, the inventories with the producers will fall below the desired level. As a result, the producers may increase the output to restore the desired stock of inventories till the equilibrium level of output is attained.(b) The working process of the Investment Multiplier is based on the assumption that one’s expenditure is another’s income.For the given hypothetical economy, the change in investment is of ₹ $\displaystyle 2,000$ crore Marginal Propensity to Consume (MPC) is 0.8.

Round	Increase in investment (ΔI) (₹ in crore)	Increase in income (ΔY) (₹ in crore)	Increase in consumption (ΔC) (₹ in crore)	Increase in savings (ΔS) (₹ in crore)
$\displaystyle 1$	$\displaystyle 2,000$	$\displaystyle 2,000$	$\displaystyle 1,600$	$\displaystyle 400$
$\displaystyle 2$	—	$\displaystyle 1,600$	$\displaystyle 1,280$	$\displaystyle 320$
$\displaystyle 3$	—	$\displaystyle 1,280$	.	.
—	—	.	.	.
Total	$\displaystyle 2,000$	$\displaystyle 10,000$	$\displaystyle 8,000$	$\displaystyle 2,000$

Thus, an increase in investment (∆I) of $\displaystyle 2,000$ leads to a total increase in national income (∆Y) by $\displaystyle 10,000$, which is $\displaystyle 5$ times the increase in investment.Investment Multiplier = $\displaystyle \frac{1}{1-\text{MPC}}$= $\displaystyle \frac{1}{1-0.8}$ = $\displaystyle 5$