Explain the adjustment mechanism, if in an economy, ex-ante Aggregate Demand (AD) is less 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. 2,500 crore.

Question

Accepted Answer

**Adjustment Mechanism when AD < AS:**

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

1. **Inventory Accumulation:** Firms produce more than what is demanded, leading to unplanned increase in inventories.
2. **Production Cut:** Firms reduce production to match lower demand.
3. **Income Fall:** Lower production leads to lower factor payments, decreasing national income.
4. **Employment Decrease:** Less production requires less 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 (decrease in investment) and MPS = 0.2:
- K = 1/0.2 = 5
- ΔY = K × ΔI = 5 × (-100) = -₹500 crore

The multiplier works in reverse — a decrease in investment leads to a magnified decrease in national income through the round-by-round process of reduced consumption expenditure.