Find the missing steps P and Q in this chain about an economy whose people suddenly become more thrifty:
People become more thrifty and the mpc falls → P → an excess supply appears at the old output → Q → income and consumption fall round after round.
Which option gives P and Q correctly?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → P: aggregate demand falls at the old income level; Q: producers cut production, so factor payments fall
A fall in the mpc cuts consumption at the old income, so AD falls (P). Output is now more than demand, and stocks pile up. Producers cut output, so factor payments and income fall (Q). Consumption falls again, and the process goes on.
Option (2) P: aggregate demand rises at the old income level; Q: producers raise production, so factor payments rise — Incorrect. A fall in the mpc lowers consumption, so AD falls, not rises.
Option (3) P: autonomous investment falls; Q: unsold stocks run down, so factor payments fall — Incorrect. Investment is not what changes here; consumption falls. And with excess supply, stocks pile up rather than run down.
Option (4) P: aggregate demand falls at the old income level; Q: unsold stocks run down and producers raise output — Incorrect. With excess supply, stocks pile up and producers cut output. They do not raise it.
NCERT (2026-27): “Paradox of Thrift … At the initial income level of AD*1 = Y*1 = 250, this sudden decline in mpc will imply a decrease in aggregate consumption spending and hence in aggregate demand, AD = A + cY , by an amount equal to (0.8 – 0.5) 250 = 75. This can be regarded as an autonomous reduction in consumption expenditure, to the extent that the change in mpc is occurring from some exogenous cause and is not a consequence of changes in the variables of the model. But as aggregate demand decreases by 75, it falls short of the output Y*1 = 250 and there emerges an excess supply equal to 75 in the economy. Stocks are piling up in warehouses and producers decide to cut the value of production by 75 in the next round to restore equilibrium in the market. But that would mean a reduction in factor payments in the next round and hence a reduction in income by 75. As income decreases people reduce consumption proportionately but, this time, according to the new value of mpc which is 0.5. Consumption expenditure, and hence aggregate demand, decreases by (0.5)75, which creates again an excess supply in the market. …” |