Explain the adjustment mechanism, if in an economy, ex-ante Aggregate Demand (AD) is more than ex-ante Aggregate Supply (AS). Explain the process of working of Investment Multiplier, for a hypothetical economy with Marginal Propensity to Consume (MPC) as 0.8 and Incremental Investment as Rs. 2,000 crore.

Question

Accepted Answer

**Adjustment Mechanism when AD > AS:**

When ex-ante Aggregate Demand is more than ex-ante Aggregate Supply, there is excess demand in the economy. The adjustment mechanism works as follows:

1. **Inventory Depletion:** Firms sell more than they produce, leading to unplanned decrease in inventories.
2. **Production Increase:** To meet excess demand, firms increase production.
3. **Income Rise:** Higher production leads to higher factor payments, increasing national income.
4. **Employment Increase:** More production requires more labor.
5. **New Equilibrium:** The process continues until AD = AS.

**Working of Investment Multiplier:**

Investment Multiplier (K) shows the magnified effect of change in investment on national income.

K = ΔY/ΔI = 1/MPS

**Example:** If ΔI = ₹100 crore and MPS = 0.2:
- K = 1/0.2 = 5
- ΔY = K × ΔI = 5 × 100 = ₹500 crore

The multiplier works through the round-by-round process of consumption expenditure. Each round of spending generates income for someone else, who then spends a portion of it (MPC), creating further income and expenditure.