An economy has unused machines, buildings and labour. Autonomous investment rises by Rs 20 crore and the MPC is 0.75. According to the fixed-price model of income determination, what happens?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Output rises by Rs 80 crore and the price level stays the same.
With unused machines, buildings and labour, more output can be made without raising marginal cost, so the price level stays the same. Output rises by the multiplier times the rise in investment:
\( \displaystyle k = \frac{1}{1 - 0.75} = 4 \)
\( \Delta Y = 4 \times 20 = 80 \)
Option (1) Output rises by Rs 80 crore and the price level stays the same. — Correct. Output rises by Rs 80 crore at the same price level.
Option (2) Output rises by Rs 20 crore and the price level rises. — Incorrect. Rs 20 crore is only the first rise in demand; the multiplier makes output rise by Rs 80 crore. The price level does not change.
Option (3) Output rises by Rs 80 crore and the price level rises in the same proportion. — Incorrect. With unused resources the price level stays fixed in this model.
Option (4) The price level rises, and output stays the same. — Incorrect. Output, not the price level, adjusts to the rise in demand.
NCERT (2026-27): “4.3 Determination of Equilibrium Income in the Short Run You would recall that in microeconomic theory when we analyse the equilibrium of demand and supply in a single market, the demand and supply curves simultaneously determine the equilibrium price and the equilibrium quantity. In macroeconomic theory we proceed in two steps: at the first stage, we work out a macroeconomic equilibrium taking the price level as fixed. At the second stage, we allow the price level to vary and again, analyse macroeconomic equilibrium. What is the justification for taking the price level as fixed? Two reasons can be put forward: (i) at the first stage, we are assuming an economy with unused resources: machineries, buildings and labours. In such a situation, the law of diminishing returns will not apply; hence additional output can be produced without increasing marginal cost. Accordingly, price level does not vary even if the quantity produced changes (ii) this is just a simplifying assumption which will be changed later.”
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