Macro

Income & Employment

Medium

Determination of Income and Employment

When, at a particular price level, the aggregate demand for final goods equals the aggregate supply of final goods, the final goods or product market reaches its equilibrium. Aggregate demand for final goods consists of ex ante consumption, ex ante investment, government spending etc. The rate of increase in ex ante consumption due to a unit increment in income is called marginal propensity to consume. For simplicity, we assume a constant final goods price and constant rate of interest over the short run to determine the level of aggregate demand for final goods in the economy. We also assume that the aggregate supply is perfectly elastic at this price. Under such circumstances, aggregate output is determined solely by the level of aggregate demand. This is known as the effective demand principle. An increase (decrease) in autonomous spending causes aggregate output of final goods to increase (decrease) by a larger amount through the multiplier process.

In the short run, to determine the level of aggregate demand for final goods in the economy, what will be the affect on price and rate of interest?

Price will increase and rate of interest will constant.

Price will constant and rate of interest remain constant.

Price will increase and rate of interest will increase.

Price remain constant and rate of interest will increase.

✅ Correct Option: 2

Option 1 -> In short run, prices are sticky and don't immediately increase when determining aggregate demand.

Option 2 -> In the short run, both prices and interest rates are held constant to determine the equilibrium level of aggregate demand and output.

Option 3 -> Both price and interest rate increases contradict the short-run assumption of sticky prices and fixed parameters.

Option 4 -> While interest rate might adjust in some models, the standard short-run aggregate demand determination assumes both remain constant.

Hence, Option 2: Price will constant and rate of interest remain constant -> In the short run, when determining the level of aggregate demand for final goods (particularly in the Keynesian framework), both prices and interest rates are treated as constant or given. This is because prices are "sticky" in the short run due to menu costs, contracts, and wage rigidities. The focus is on determining the equilibrium level of output/income at these given price and interest rate levels through the income-expenditure approach (Y = C + I + G + NX). This simplification allows us to analyze how changes in autonomous spending affect aggregate demand without immediate price or interest rate adjustments. -> correct

Question 46

The equilibrium in the final goods or production market reaches when .......

Question 47

Consumption, investment and government spending are the major components of ......?

Question 49

Effective demand principle situation occurs when _________

Question 50

A decrease in autonomous spending causes aggregate output of final goods to .................... through the multiplier process.

In the short run, to determine the level of aggregate demand for final goods in the economy, what will be the affect on price and rate of interest?

Solution

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