DETERMINATION OF EQUILIBRIUM OF INCOME, OUTPUT, EMPLOYMENT

In the context of Keynesian economics the concepts Income,output,employment are closely related to each other. Output refers to value addition and value addition implies generation of income. Further Keynes believes that there is one to one relationship between the level of output and level of employment. Accordingly the level of output is identified with the level of employment. Thus equilibrium level of output implies equilibrium level of income, equilibrium level of output implies equilibrium level of employment.

WHAT IS EQUILIBRIUM?

Equilibrium is a state of balance.

WHAT IS EQUILIBRIUM LEVEL OF INCOME

Equilibrium level of income ( output) refers to that level of income where AS= AD What is AS? What are its components? What is AD? What are its components?

Another angle of looking at the equilibrium, AS = AD AS = C+S AD = C+I AS = AD = C+S = C+I

AS = AD OR S= I

AS FUNCTION
(As function is assumed to be constant in the Keynesian framework) AS is identified as 45 degree line from the origin. This is because each point on the 45-degree line equates the variable measured on the vertical axis with the variable measured on the horizontal axis.

AS curve does not move upward or downward. Moving along the AS function Any movement from left to right shows increase in AS (corresponding to the proportionate increase in employment) Any movement from right to left is decrease in AS ( corresponding to the proportionate decrease in employment)

AS IS SAID TO BE PERFECTLY ELASTIC.

It means that AS converges at all levels of AD. If AD happens to be more than of less than AS, then AS will adjust itself to AD to restore the equilibrium level of output.

QUESTIONS
What is Aggregate demand (AD)? What is Aggregate supply? (AS)? List the components of Aggregate demand and Aggregate supply.

AD FUNCTION
AD is the sum of C+ I What is consumption function? The relationship between consumption and income. C= Autonomous consumption + marginal Propensity to consume. There is consumption even when the income is zero. That is autonomous consumption. Consumption increases with increase in income. The ratio of change in consumption to the change in income is called marginal propensity to consume.

DIFFERENCE BETWEEN AVERAGE PROPENSITY TO

CONSUME AND MARGINAL PROPENSITY TO CONSUME

The average propensity to consume is the ratio of consumption expenditure to any level of income. If income is Rs.100 crore and consumption is RS.80 crores then, Then the average propensity to consume is 80/100.

If the income increases from 100 to 200 crores and consumption from 80 -120 crores the Marginal propensity to consume = ratio of increase in consumption/ increase in income. Thus MPC = 40/100

MARGINAL PROPENSITY TO CONSUME

Diagramatic illustration

DIAGRAM ( CONSUMPTION FUNCTION)

In the diagram OC is the minimum level of consumption. =(a) C increases as Y increases Increase in C, per unit increase in Y refers to Marginal propensity to consume. It is the slope of the C function. Rate of increase in C < Rate of increase in Y. Eg. Increase in income by Rs.100 part of it used for consumption and rest is saved. At point Q, Y=C Prior to the point Q , C> Y Beyond point Q , C< Y .

INVESTMENT FUNCTION
In the context of equilibrium level of income /output , Keynes focuses on autonomous investment rather than induced investment. What is autonomous investment? An investment which is not influenced by profitability or level of income is called autonomous investment. Hence investment function of Keynisian framework is drawn as a horizontal line. Whatever is the level of income ,the investment remains constant.

INVESTMENT FUNCTION ( DIAGRAM)

SUMMATION OF C FUNCTION AND I FUNCTION

Diagram.

Cfunction and I function are combined to get AD function. Constant value of I is added to different values of C to get C+I Example If I = 20 and C= 40 so that C+I= 60 .this is when Y=0. Likewise when Y= 80 , when C= 60 and I=20 and C+I= 80.

EXPLAIN WITH THE HELP OF A DIAGRAM AD=AS

DETERMINING EQUILIBRIUM LEVEL OF INCOME

Equilibrium level is determined at that point when AD=AS. AD represents total expenditure on goods and services. AS refers to total production or countrys national income. Thus AS =Y Diagram.

WHY is there an equilibrium when AS=AD

It is a situation in an economy all that is produced is fully purchased. The producer do not suffer 1) the burden of unwanted supply 2) the loss of unfulfilled demand due to lack of stocks.

S=I Approach
Explain with the help of S&I curve the equilibrium level of income in an economy. Diagram.

The equilibrium level of income is determined at a point where saving and Investment are equal. In the diagram Q is the point of equilibrium where S= I.

TABLE
Income (Y) ConsumptionC Saving (Y-C) Investment

0 100 175 300 350 400 450 500 Equilibrium is struck when S=I=75

25 100 156 250 287.5 325 362.5 400 Equilibrium level of income=400.

-25 0 19 50 62.5 75 87.5 100

75 75 75 75 75 75 75 75

SIMULTANEOUS EQUALITY BETWEEN AD=AS AS WELL AS S=I.

Diagram. In the diagram OL is the equilibrium level of income , output and employment.

Explain the equilibrium level of income with the help of Saving and Investment curves and aggregate supply and aggregate demand curves.

WHAT HAPPENS

IF AS> AD

The flow of goods and services in the economy tends to exceed their demand. Some of the goods remain unsold. To clear unwanted stocks, the producers would plan a cut in the production . In the following year , AS would reduce to become equal to AD.

WHAT HAPPENS IF AS<AD

When AS< AD flow of goods and services tend to be less than their demand. The existing stock of producers would be sold. To re-build the desired stock the producers would plan greater production for the following year for AS would become equal AS.

DIAGRAMATIC REPRESENTATION
AS >AD AS < AD

WHAT HAPPENS WHEN

S>I OR S<I

diagram

WHAT HAPPENS WHEN THE ECONOMY IS NOT IN

EQUILIBRIUM AND SAVING EXCEEDS INVESTMENT

This leads to accumulation of unintended inventories. To avoid this, businessmen will reduce production . Consequently output , income, and employment will be reduced till the equilibrium level of income.

UNDER EMPLOYMENT EQUILIBRIUM

It is a situation of equilibrium between aggregate demand and aggregate supply at which all the resources are not fully used. Some resources are underutilised. This situation is caused not by low level of aggregate supply but by the deficiency of aggregate demand. When level of demand is less than full employment level of output it is called deficient demand which pushes the economy into underemployment. Diagram.

Equilibrium level of income , output or employment does not necessarily mean full employment. What the producers plan to produce and what the buyers plan to buy may or may not coincide with fuller utilisation of resources. Your resources may permit production worth Rs.10 million in an accounting year. but with a view to maximising profit , you may plan output worth Rs.5 billion in the accounting year. Equilibrium will be struck if buyers also plan to buy worth Rs. 5 billion only. Thus resources are not fully utilised , you could increase output by Rs. 5 billion.

SHIFT IN EQUILIBRIUM
Injections can cause increase in the level of AD, withdrawals cause decrease in AD. Injections come in the form of government expenditure or exports or such variables. Withdrawals come in the form of government govt taxes or imports or such other variables. Diagram. Owing to injections of govt expenditure , equilibrium level of income /output shifts upwards from point A to point B and Owing to withdrawals in the form of taxes, equilibrium level of income/output shifts downwards from A to C.

INJECTIONS AND WITHDRAWALS HAVE MULTIPLIER EFFECT.