Q.(a) You are given the consumption function of an imaginary economy, C = 100 + 0·8 Y, where C = Consumption and Y = Income. Calculate :

Marginal Propensity to Consume (MPC)

Start with everyday intuition

Think about what happens when you get some extra money — say, a ₹500 bonus from your part-time job, or a cash gift on your birthday. You don't save all of it, and you don't spend all of it either. Most people spend a part and save the rest. That part you spend — the fraction of the extra income that goes into consumption — is exactly what economists call the Marginal Propensity to Consume.

The word "marginal" here means "extra" or "additional." So MPC answers one simple question: Out of every extra rupee you earn, how much do you spend?

The precise meaning

Formally, MPC is the ratio of change in consumption expenditure to the change in income that brought it about.

For example, if your income rises by ₹1,000 and your consumption rises by ₹750, your MPC is $750/1000 = 0.75$ (or 75%). This means you spend 75 paise of every extra rupee and save the remaining 25 paise.

The other side of the coin is the Marginal Propensity to Save (MPS) — the fraction of extra income that is saved. Since every extra rupee is either spent or saved:

This is not a theory; it's an accounting identity. If MPC = 0.75, then MPS must be 0.25.

Why MPC matters

MPC is not just a number — it is the engine of the multiplier effect, one of the most powerful ideas in macroeconomics.

When someone spends money, that spending becomes someone else's income. That second person, in turn, spends a fraction (their MPC) of that income, which becomes a third person's income, and so on. A single initial injection of spending — say, government investment in a road — ripples through the economy, generating total income many times larger than the original spending.

The size of this ripple depends directly on MPC. The higher the MPC, the larger the multiplier.

If MPC = 0.8, the multiplier is $1/(1-0.8) = 5$. An initial ₹100 crore investment can generate ₹500 crore of total income. If MPC = 0.5, the multiplier is only 2.

A word on the diagram …

Aggregate Demand Equilibrium: The Economy's Balancing Act

Think of a seesaw. On one side sits everything people, firms, and the government want to buy. On the other side sits everything firms produce. When the seesaw is perfectly level — when total spending exactly matches total output — the economy is in equilibrium. That's the core idea.

But why should you care? Because when the seesaw tilts, real things happen. If spending exceeds output, prices rise (inflation). If output exceeds spending, factories shut down and people lose jobs. Equilibrium is the sweet spot where neither happens.

The Precise Meaning

In macroeconomics, Aggregate Demand (AD) is the total planned spending on final goods and services in an economy during a given period. Aggregate Supply (AS) is the total output firms plan to produce.

Equilibrium occurs where:

At this point, what buyers intend to spend exactly equals what sellers intend to produce. No unwanted inventories pile up, and no shortages force prices up. The economy is "at rest."

This is the AD identity from your NCERT textbook. It tells you that total spending in the economy comes from four sources: households, firms, government, and foreigners (net of what we buy from them).

How Equilibrium Actually Works

Imagine a simple economy with only households and firms. Households earn income $Y$ from firms. They spend part of it on consumption $C$ and save the rest $S$. Firms produce output and also invest $I$ (buying machines, building factories).

Equilibrium condition becomes:

But households don't spend all their income. They save. So $C = Y - S$. Substituting:

Which simplifies to:

The 45° Line Diagram (Describe It)

Draw a graph with Aggregate Demand (AD) on the vertical axis and National Income (Y) on the horizontal axis.

• Draw a 45° line from the origin. Every point on this line represents $AD = Y$ — the equilibrium condition.
• Draw the AD curve (which is $C + I + G + (X-M)$). It slopes upward because as income rises, consumption rises.
• Where the AD curve crosses the 45° line — that's the equilibrium point. …