Determination of Equilibrium Income and Output:
There are two approaches to determination of the equilibrium income. These are:
1. Aggregate Demand – Aggregate Supply Approach
2. Saving – Investment Approach
Aggregate Demand – Aggregate Supply Approach:
According to this approach –
- Equilibrium level of income and output in the economy is the one where the desired aggregate demand for goods and services is equals to the aggregate supply.
- Aggregate demand refers to the total desired expenditure of the community. Total desired expenditure comprises planned (desired) expenditure on consumer goods by the households and planned investment expenditure on capital goods by business firms.
Equilibrium level of Income and Output
- In the given figure, upward sloping curve – C is Keynesian Consumption function.
- Planned investment expenditure is illustrated by curve I, which is a horizontal line because investment expenditure is assumed to be autonomous i.e., it is independent of the level of income.
- Therefore the desired aggregate demand curve is vertical summation of the C – line and I – line. Since level of planned investment remains the same at all levels of curves. (C+ I) curve is parallel to C -line with a constant vertical distance between the two curves.
- Aggregate supply refers to the value of total output of goods and services produced in an economy in a year.
- Therefore aggregate supply is equal to the value of national product i.e. national income
AS = Y = C + S
- Aggregate supply is represented by 45° line originating from the point of origin i.e., Y – curve or income line.
- According to Aggregate demand – Aggregate supply approach the point at which aggregate demand becomes equal to aggregate supply determines the equilibrium level of national income.
- Thus, at the point of intersection, of aggregate demand (AE = C + I) curve and aggregate supply (Y = AS = C + S) curve, the income Y0 is equilibrium level of income.
- Suppose the output produced in economy is Y1, which is greater than equilibrium level of income Y0, at this level of income aggregate supply is greater than aggregate demand.
- Therefore, firms are not able to sell the entire output, so they are forced to add the unsold goods which is of AB amount, to their stock of inventories.
- This rise in inventories induces firms to reduce the production hence decrease in national product and national income.
- This process continues until income falls to the equilibrium level Y0.
- On the other side, if the income level is Y2 which is lower than Y0, where aggregate demand is greater than aggregate supply.
- Hence, to meet the higher level of sales, firms draw down their inventories. This leads to decline in inventories of goods below desired level.
- This results in increase in production which further result in increase in national income.
- This process of falling inventories and increase in output and income continues until income increases to the equilibrium level Y0.
Saving – Investment Approach:
Equilibrium level of Income and Output
- According to the Saving – Investment approach, equilibrium level of income is determined at the level where planned or desired investments equals to desired saving.
- The upward sloping curve – S represents the Keynesian Saving function, which shows the relation between saving and income.
- Planned investment expenditure is illustrated by curve I, which is a horizontal line because investment expenditure is assumed to be autonomous i.e., it is independent of the level of income.
- The point of intersection (E) of saving curve (S) and investment curve (I), corresponds to the Y0 level of income which is equilibrium level of income.
- At OY1 level of output and income, the planned saving is greater than planned investment. At this level aggregate supply is also higher than aggregate demand.
- At this point consumption expenditure of household and investment expenditure of the firms (i.e. C + I) will not be sufficient to purchase the entire output produced.
- Thus the firms are forced to add up this extra supply to their inventories. Which will result in reduction in production.
- This leads to decrease in national income.
- This process continues until the income falls down to equilibrium level of income Y0.
- On the other side, if the level of income is Y2, the planned investment of the firms exceeds saving by GH amount.
- Thus, the demand for goods will be more than production.
- In this situation, to meet the demand, firms are forced to draw down their inventories which induces them to increase production.
- This will result in increase in national product and national income.
- This process will continue until output increase to OY0 where saving equals planned investment.
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