Full Employment, Inflationary & Deflationary Gap; Measures to Correct

Explanation:

(i) Equilibrium income ($Y^{\ast }$):
At equilibrium, $Y=C+I$
$Y=200+0.8Y+50$
$Y-0.8Y=250$
$0.2Y=250$
$Y^{\ast }=\text{₹}1,250\text{ crore}$

Since the equilibrium income ($Y^{\ast }=1,250$) is less than the full employment income ($Y_f=1,500$), the economy is facing a Deficient Demand situation, leading to a Deflationary Gap.

(ii) Deflationary Gap:
The gap is measured as the shortfall in Aggregate Demand at the full employment level of income.
AD at $Y_f=C(1,500)+I=[200+0.8(1,500)]+50=200+1,200+50=1,450$
Deflationary Gap = AS (at $Y_f$) − AD (at $Y_f$) = $1,500-1,450$ = ₹50 crore

(iii) Additional investment needed ($\mathrm{\Delta }I$):
Required change in income ($\mathrm{\Delta }Y$) = $1,500-1,250=250$
Multiplier ($K$) = ${\displaystyle \frac{1}{1-0.8}}={\displaystyle \frac{1}{0.2}}=5$
$\mathrm{\Delta }I={\displaystyle \frac{\mathrm{\Delta }Y}{K}}={\displaystyle \frac{250}{5}}=\text{₹}\mathbf{50}\mathbf{\text{ crore}}$
(Notice that the required new investment exactly equals the initial Deflationary Gap ✓)

Explanation:

(i) Equilibrium income ($Y^{\ast }$):
At equilibrium, $Y=C+I$
$Y=100+0.75Y+300$
$Y-0.75Y=400$
$0.25Y=400$
$Y^{\ast }=\text{₹}1,600\text{ crore}$

Since the equilibrium income ($Y^{\ast }=1,600$) is greater than the full employment income ($Y_f=1,200$), the economy is facing an Excess Demand situation, leading to an Inflationary Gap.

(ii) Inflationary Gap:
The gap is measured as the excess of Aggregate Demand over Aggregate Supply at the full employment level.
AD at $Y_f=C(1,200)+I=[100+0.75(1,200)]+300=100+900+300=1,300$
Inflationary Gap = AD (at $Y_f$) − AS (at $Y_f$) = $1,300-1,200$ = ₹100 crore

(iii) Fall in investment needed ($\mathrm{\Delta }I$):
Required change in income ($\mathrm{\Delta }Y$) = $1,200-1,600=-400$
Multiplier ($K$) = ${\displaystyle \frac{1}{1-0.75}}={\displaystyle \frac{1}{0.25}}=4$
$\mathrm{\Delta }I={\displaystyle \frac{-400}{4}}=\text{₹}\mathbf{-}\mathbf{100}\mathbf{\text{ crore}}$
(Investment must fall by ₹100 crore to close the Inflationary Gap ✓)

Explanation:

1. Increase Repo Rate: The repo rate is the interest rate at which the RBI lends money to commercial banks. By increasing it, the RBI makes borrowing costlier for banks. Banks respond by raising their lending rates for the public, which discourages businesses and households from borrowing for investment and consumption. This contracts credit and reduces Aggregate Demand.
2. Increase Cash Reserve Ratio (CRR): CRR is the minimum percentage of total deposits that commercial banks must keep as cash reserves directly with the RBI. Increasing the CRR mathematically reduces the amount of money banks have available to lend. This credit contraction leads to a fall in investment and consumption spending, thus reducing AD.
3. Open Market Operations (Sell Securities): The RBI can actively sell government securities to commercial banks and the public in the open market. When banks buy these securities, they hand over their cash reserves to the RBI. This reduces their lending capacity, leading to a contraction of credit, a fall in spending, and a reduction in inflationary pressure.

Answer: B) Excess of AD over AS at full employment income.

Explanation: The inflationary gap is explicitly defined as the vertical distance by which Aggregate Demand (AD) exceeds Aggregate Supply (AS) when evaluated strictly at the full employment level of income ($Y_f$). Because the economy is already at maximum capacity (full employment), this excess demand cannot be fulfilled by producing more goods; it only serves to pull the general price level upward, causing inflation.

Explanation:

Excess demand, by definition, arises when Aggregate Demand exceeds the economy's productive capacity at full employment. At full employment, all available factors of production—labor, capital, land, and entrepreneurship—are already being fully and efficiently utilized. There are virtually no idle resources left to employ to manufacture additional physical output.

Therefore, the extra demand cannot be physically satisfied by producing more goods. Instead, eager buyers compete against each other for the exact same limited stock of goods, bidding prices upward. This creates demand-pull inflation ("too much money chasing too few goods"). Real output remains stuck at $Y_f$, while the nominal price level continuously rises.

Explanation:

1. Increase Government Expenditure: The government can directly increase its spending on public goods, infrastructure projects (roads, bridges, schools, hospitals), and defense. This directly injects money into the economy, increasing the 'G' component of Aggregate Demand. Through the multiplier effect, this initial spending raises national income by a multiple amount and reduces unemployment.
2. Reduction in Taxes: Reducing personal income taxes increases the disposable (post-tax) income of households, prompting them to increase consumption spending (raising 'C'). Similarly, reducing corporate taxes increases firms' retained profits, encouraging them to increase investment spending (raising 'I'). Both actions shift AD upward toward full employment.
3. Increase Transfer Payments: The government can increase social welfare payments such as old-age pensions, unemployment benefits, and agricultural subsidies. This puts direct cash into the hands of lower-income groups who typically have a very high Marginal Propensity to Consume (MPC). They quickly spend a large fraction of these transfers on consumer goods, significantly boosting AD.