Determination of Equilibrium Income and output

After discussing about consumption and investment function in my previous posts, we are now in a position to study and analyse the equilibrium level of income and output.

Basic Assumptions:

1) Short Period analysis – Keynesian theory of equilibrium output is determined only with reference to short period of time.Short run is defined as a period of time during which level of output is determined exclusively by the level of employement in the economy. Technology is assumed to remain constant.

2) Closed economy – Keyenes discuss the theory of equilibrium GDP in the context of a closed economy.This is an economy which has no relations with  the rest of the world,there is no import or export.

Its two sector economy consisting of the household sector and business sector.All the decisions concering consumption expenditure is taken by the individiula household, while the business firms take decisions regarding investment.

3) We also assume that consumption function is linear and planned investment is autonomous.

There are two approaches to determination of the equilibrium level of income. These are:

1. Aggregate demand – Aggregate Supply approach (AD – AS approach)

2. Saving Investment approach.

Aggregate demand – Aggregate Supply approach (AD – AS approach)

According to this approach, equilibrium GDP is achieved when AS = AD.

Aggregate Demand(AD)

AD refers to desired expenditure in the economy during an accounting year. It has two components:
Desired Consumption Expenditure

Desired Investment Expenditure

Desired Investment Expenditure is assumed to be autonomous, so that it is not related to the level of income in the economy.

Desired Consumption Expenditure is related to the level of income, there is a positive relationship between consumption(C) and income (Y). C rises as income rises. However, there is always some minimum level of C, independent of Y(autonomous consumption)   

Consumption function and investment function is already explained in detail in previous posts

Based on this description, I- function and C-function are drawn as below

consumption function

saving function

Combine C and I function to get AD function. As shown in the graph below:  

The aggregate demand curve is represented by (C + I) curve. It is derived by taking the vertical summation of the C-line and the I-line. Since level of planned investment remains the same at all levels of income, (C+I) curve is parallel to C curve with a vertical distance(equal to I) between the two curves at all levels of income.

Aggregate Supply:

Aggregate Supply refers to the aggregate value of total output of goods and services produced in an economy. It is equal to the value of nationa product, i.e national income. It is depicted by the 45^◦ line originating from the point of origin. Since in a two sector model, income is partly spent in the form of consumption expenditure and is partly saved, so national income is the sum total of consumption expenditure and savings.

AS = Y = C+S

Explaination of the equilibrium Output

equilibrium income and output

1) Income is measured along the X-axis and Consumption(C) and Investment(I) are shown on the Y-axis.

2)E is the equilibrium level of output as it the intersection of C+I and 45^◦ line.

3) Y₀ is the equilibrium level of income (AD = AS)

Taking two different level of income to explain the equilibrium income and output

AT Y₁ level of income

Suppose the output produced in the economy is Y₁, which is greater than the equilibrium level (Y₀)

At Y₁ level of income AS(aggregate supply) is more than AD(aggregate demand) by AB, which means that firms are selling lesser amount than they are producing, which leads to unsold stock of goods equal to AB amount to their existing stock of inventories. This rise in unsold stock will force the producer to reduce production and thereby income (reducing production will leads to reduce factors of production and therby their factor income).

This process of accumulating unsold stock goods and falling output and income continues until income falls to the equilibrium level of Y₀.

AT Y₂ level of income

Suppose the output produced in the economy is Y_2, which is lesser than the equilibrium level (Y₀)

At Y₂ level of income AD(aggregate demand) is greater than AS(aggregate supply)  by GH, firms will be able to meet higher level of sales by drawing down their inventories.When producer stock of inventories will fall, they will increase their production and thereby income (increasing production will leads to increase in factors of production and therby their factor income)..

This process of falling inventories and increasing output and income continues until income rises to the equilibrium level of Y₀.

 The above two explaination can be best understood by the above table:

The table illustrates the equilibrium level of output/income in terms of the equality

between aggregate demand and aggregate supply

Aggregate Supply (Rs. Crore)	Aggregate Demand (Rs. Crore)	Tendency of Income
0 10 20 30 40 50 60	20 25 30 35 40 45 50	Expansion Expansion Expansion Expansion Equilibrium Contraction Contraction

Equilibrium is struck where AD = AS = 40 Rs. Crore.