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Equilibrium level of Income - The Investment Function, Macroeconomics | Macro Economics - B Com PDF Download

We assumed that the government spends but doesn’t collect tax revenue. This means that the entire public expenditure is fi­nanced by deficit financing or money creation.

Now, let us assume that the government earns income in the form of tax revenue.

An increase in taxes reduces disposable in­come. Consumption now depends on after-tax income or disposable income.

Thus, taxes enter the model through the consumption function. Taxes are assumed to be exogenous. The basic equilibrium condition is the equality between aggregate supply and aggregate demand, i.e.,

Y = C + 1 + G

Or alternatively, leakages equal injections, i.e.,

S + T = 1 + G

As these two approaches are alternatives to each other here we consider the aggregate demand approach.

Aggregate demand approach suggests that equilibrium level of income is determined when aggregate demand equals aggregate value of output or aggregate supply. In this model, aggregate demand is affected by taxes. Taxes reduce disposable income.

Since con­sumption is a function of disposable income, an increase in taxes reduces consumption. Graphically, this means a downward shift in consumption function. Since consumption is a component of aggregate demand, aggregate demand schedule also shifts downward. Con­sequently, equilibrium level of income de­clines.

In Fig. 3.18, C1 is the initial or pre-tax consumption function. As usual, private in­vestment and government expenditure are autonomous. By summing up the consumption schedule and autonomous investment and gov­ernment spending, we obtain pre-tax aggregate demand schedule (C1 + I + g)- C+ I + g line cuts the 45° line at point E1.

The correspond­ing level of national income is, thus, OY1. Post- tax consumption line is Cr Since consumption line shifts downward following an increase in taxes, aggregate demand schedule now should shift to C2 + I + G. The new equilib­rium level of income is OY1, less than the ini­tial income level. Thus, an increase in taxes leads to a decline in national income. Or the effect of an increase in taxes on national in­come is contractionary.

Equilibrium level of Income - The Investment Function, Macroeconomics | Macro Economics - B Com


Mathematical Example of Equilib­rium National Income Determination in a three-sector Economy:

Let the consumption function be

C = 70 + 0.9Yd

(where Yd = Y – T)

1 = 35, G = 20.

T = 0.2Y + 25

Now find the equilibrium values of na­tional income, consumption, disposable in­come, tax.

Solution:

Putting the values of C, I, G and T, we get

Equilibrium level of Income - The Investment Function, Macroeconomics | Macro Economics - B Com

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FAQs on Equilibrium level of Income - The Investment Function, Macroeconomics - Macro Economics - B Com

1. What is the equilibrium level of income?
Ans. The equilibrium level of income refers to the point at which aggregate demand equals aggregate supply in an economy. It represents the level of income or output where there is no tendency for it to change. At this equilibrium level, there is neither a shortage nor a surplus in the economy.
2. How is the equilibrium level of income determined?
Ans. The equilibrium level of income is determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves in an economy. When AD equals AS, it indicates that spending by households, businesses, and the government is equal to the total output produced by firms. This equilibrium level can change if there are shifts in either the AD or AS curves.
3. What factors can cause a change in the equilibrium level of income?
Ans. Several factors can cause a change in the equilibrium level of income. Some of these factors include changes in government spending, taxes, consumer confidence, investment levels, and net exports. For example, an increase in government spending or investment can shift the AD curve to the right, leading to a higher equilibrium level of income.
4. How does the investment function affect the equilibrium level of income?
Ans. The investment function plays a crucial role in determining the equilibrium level of income. Investment refers to the expenditure made by businesses on capital goods, such as machinery and equipment. An increase in investment spending can lead to a multiplier effect, where it generates additional income and spending in the economy. This, in turn, raises the equilibrium level of income.
5. What are the implications of an equilibrium level of income below full employment?
Ans. When the equilibrium level of income is below full employment, it indicates that there is an economic recession or a state of underutilization of available resources. In such a situation, there will be unemployment and a lack of productive capacity in the economy. It is generally considered undesirable as it represents a waste of resources and lower living standards for individuals. Government policies, such as fiscal and monetary measures, are often implemented to stimulate economic activity and move the economy towards full employment.
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