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

Determination of Equilibrium Level of Income!

According to the Keynesian Theory, equilibrium condition is generally stated in terms of aggregate demand (AD) and aggregate supply (AS). An economy is in equilibrium when aggregate demand for goods and services is equal to aggregate supply during a period of time.

So, equilibrium is achieved when:

AD = AS … (1)

We know, AD is the sum total of Consumption (C) and Investment (I):

AD = C + I … (2)

Also, AS is the sum total of consumption (C) and saving (S):

AS = C + S … (3)

Substituting (2) and (3) in (1), we get:

C + S = C + I

Or, S = I

It means, according to Keynes, there are Two Approaches for determining the equilibrium level of income and employment in the economy:

It must be noted that Equilibrium level of income and employment can also be determined according to ‘Classical Theory’. However, the scope of syllabus is limited to the Keynesian theory.

Two Approaches for Determination of Equilibrium Level:

The two approaches to determine equilibrium level of income, output and employment in the economy are:

1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)

2. Saving-Investment Approach (S-I Approach)

It must be kept in mind that AD, AS, Saving and Investment are all planned or ex- ante variables.

Assumptions:

Before we proceed further, let us first state the various assumptions made in determination of equilibrium output:

(i) The determination of equilibrium output is to be studied in the context of two-sector model (households and firms). It means, it is assumed that there is no government and foreign sector.

(ii) It is assumed that investment expenditure is autonomous, i.e. investments are not influenced by level of income.

(iii) Price level is assumed to remain constant.

(iv) Equilibrium output is to be determined in context of short-run.

Aggregate Demand-Aggregate Supply Approach (AD-AS Approach):

According to the Keynesian theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C + I curve is equal to the total output (Aggregate Supply or AS).

Aggregate demand comprises of two components:

1. Consumption expenditure CC):

It varies directly with the level of income, i.e. consumption rises with increase in income.

2. Investment expenditure (I):

It is assumed to be independent of the level of income, i.e. investment expenditure is autonomous. So, AD curve is represented by (C + I) curve in the income determination analysis. Aggregate supply is the total output of goods and services of the national income. It is depicted by a 45° line. Since the income received is either consumed or saved, the

AS curve is represented by the (C + S) curve.

The determination of equilibrium level of income can be better understood with the help of the following schedule and diagram:

Table 8.1 Equilibrium by AD and AS Approach:

Amount in Rs crores

In Fig. 8.1, the AD or (C +1) curve shows the desired level of expenditure by consumers and firms corresponding to each level of output. The economy is in equilibrium at point ‘E’ where (C + I) curve intersects the 45° line.

1. ‘E’ is the equilibrium point because at this point, the level of desired spending on consumption and investment exactly equals the level of total output.

2. OY is the equilibrium level of output corresponding to point E.

3. In Table 8.1, the equilibrium level of income is Rs 400 crores, when AD (or C +1) = AS = Rs 400 crores.

4. It is a situation of ‘Effective Demand’. Effective demand refers to that level of AD which becomes ‘effective’ because it is equal to AS.

If there is any deviation from the equilibrium level of output, i.e. when planned spending (AD) is not equal to planned output (AS), then a process of readjustment will start in the economy and the output will tend to adjust up or down until AD and AS are equal again.

When planned spending (AD) is more than planned output (AS), then (C + I) curve lies above the 45° line. It means that consumers and firms together would be buying more goods than firms are willing to produce. As a result, the planned inventory would fall below the desired level.

To bring the inventory back to the desired level, firms would resort to increase in employment and output until the economy is back at output level OY, where AD becomes equal to AS and there is no further tendency to change.

When AD is less than AS:

When AD < AS, then (C +1) curve lies below the 45° line. It means that consumers and firms together would be buying less goods than firms are willing to produce. As a result, the planned inventory would rise. To clear the unwanted increase in inventory, firms plan to decrease the employment and output until the economy is back at output level OY, where AD becomes equal to AS and there is no further tendency to change.

It must be noted that equilibrium level may or may not be at the level of full employment, i.e. equilibrium is possible even at a level lower than the full employment level.

For instance, in Table 8.1, employment level is 40 lakhs corresponding to equilibrium income of Rs 400 crores. It is not the full employment level since employment increases even after the equilibrium level.

Saving-Investment Approach (S-l Approach):

According to this approach, the equilibrium level of income is determined at a level, when planned saving (S) is equal to planned investment (I).

Let us understand this with the help of following schedule and diagram:

Table 8.2 Equilibrium by Saving and Investment Approach

Amount in Rs crores

In Fig 8.2, Investment curve (I) is parallel to the X-axis because of the autonomous character of investments. The Saving curve (S) slopes upwards showing that as income rises, saving also rises.

1. The economy is in equilibrium at point ‘E’ where saving and investment curves intersect each other.

2. At point ‘E’, ex-ante saving is equal to ex-ante investment.

3. OY is the equilibrium level of output corresponding to point E.

4. In Table 8.2, the equilibrium level of income is Rs 400 crores, when planned saving – planned investment = RS 400 crores.

If there is any deviation from the equilibrium level of income, i.e., if planned saving is not equal to the planned investment, then a process of readjustment will start which will bring the economy back to the equilibrium level.

When saving is more than Investment:

If planned saving is more than planned investment, i.e. after point ‘E’ in Fig. 8.2, it means that households are not consuming as much as the firms expected them to. As a result, the inventory rises above the desired level. To clear the unwanted increase in inventory, firms would plan to reduce the production till saving and investment become equal to each other.

When saving is less than Investment:

If planned saving is less than planned investment, i.e. before point ‘E’ in Fig. 8.2, it means that households are consuming more and saving less than what the firms expected them to. As a result, planned inventory would fall below the desired level. To bring the inventory back to the desired level, firms would plan to increase the production till saving and investment become equal to each other.