Determination of equilibrium level of income/output/employment�

According to Keynesian theory, equilibrium is determined in terms of aggregate demand and aggregate supply. Income/employment/output are in equilibrium at the level at which AD=AS

AD = AS

AD = C + I

AS + = C + S

Therefore, S = I (because AD = AS at equilibrium)

Here AD = Aggregate demand; C = Consumption; I = Investment; AS = Aggregate supply; S = Savings

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Determination of equilibrium by AD and AS approach

• According to Keynesian theory,

The equilibrium level of income is determined where planned level of aggregate demand (AD) is equal to planned level of aggregate supply (AS)

• Since AD is aggregate expenditure on consumption (by households) and investment (by firms) therefore AD is represented by C+I curve

(₹ in crores)

The above table shows that economy is at equilibrium at ₹300 crore of income, as at this level.

Aggregate demand = Aggregate supply = ₹300 crore (planned)

Observations:

AD is C+I curve as demand is for consumption and investment in a two sector economy

• Before this income level (₹300 crore) AD>AS (planned) so, an economy will produce further till it reaches equilibrium
• After this income level (₹300 crore) AS> AD (planned) hence an economy should reduce production till it reaches equilibrium

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Adjustment mechanism

1. If AD>AS ( when economy is planning to produce at OM1)

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• Meaning. It refers to the excess of AD in relation to supply. It means that buyers (consumers and firms) are planning to buy more goods and services than what producers are planning to produce (i.e., supply)

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• Implication. In this situation, inventory level (stock of goods) starts falling and comes below the desired level to maintain full employment equilibrium. In other words, the available resources are not fully employed

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• Adjustment. To bring back the on inventories at desired level, producers expand production. This raises the employment level, output level and in turn income level. These levels keep raising till AD=AS (equilibrium) i.e., when economy reaches equilibrium at OM level of income.

• If AD<AS (when economy is planning to produce at OM2)

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• Meaning. It means that buyers (consumers and firms) are consuming and spending less or they are planning to buy less then what sellers are planning to sell
• Implication. This will lead to accumulation of inventories(stock of goods) with producers. In other words producers are left with unsold stock of goods
• Correction/Adjustment. To avoid further accumulation of inventories, producers will reduce production. This reduces the level of employment, level of output and in turn income level. These levels keep falling till AD=AS (equilibrium) i.e., when economy reaches equilibrium at OM level of income

Determination of equilibrium through S and I approach

• According to this approach, the equilibrium level of income/output/employment is determined at a point where planned or ex-ante saving(S) are equal to planned or ex-ante investment (I).

Since AD = C + I

AS = C + S

Therefore, if AD=AS

C+I = C+S or S = I

(₹ in crores)

The equilibrium level of income is ₹300 crore as at this level S=I=₹100 crore

• Before this income level S < I (planned) so an economy will produce further till it reaches equilibrium
• After this income level S > I, (planned) hence an economy should reduce production till it reaches equilibrium

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1. If I > S ( when economy is planning to produce at OM1)
1. Meaning. It refers to the excess of AD in relation to supply. It means that buyers (consumers and firms) plan to consume more and save less than what producers are planning to produce (i.e., supply)
2. Implication. In this situation, inventory level (stock of goods) starts falling and comes below the desired level to maintain full employment equilibrium. In other words, the available resources are not fully employed
3. Adjustment. To bring back the on inventories at desired level, producers expand production. This raises the employment level, output level and in turn income level. These levels keep raising till S=I

2. If AD<AS (when economy is planning to produce at OM2)

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• Meaning. It means that buyers (consumers and firms) are consuming less and saving more or they planning to buy less then what sellers are planning to sell
• Implication. This will lead to accumulation of inventories(stock of goods) with producers. In other words producers are left with unsold stock of goods
• Correction/Adjustment. To avoid further accumulation of inventories, producers will reduce production. This reduces the level of employment, level of output and in turn income level. These levels keep falling till AD=AS (equilibrium

Equilibrium level of employment

• According to the Keynesian theory, equilibrium level of income/output/employment can be determined at the full employment level, under-employment level or at over full employment level.

Full employment equilibrium�

• Full employment equilibrium refers to a situation when aggregate demand is equal to the aggregate supply at full employment level, i.e., all those who are willing to work at the prevailing wage are able to find employment. In other words actual aggregate demand is equal to required aggregate demand to maintain full employment. So full employment means there is no involuntary unemployment

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• Observations
• AD and AS curves intersect at point E, which is full employment equilibrium because aggregate demand EM corresponds to full employment level of output OM
• At OM level of output, economy is at full employment equilibrium because all those who are willing to work at the prevailing wage rate have got employment
• Here, actual level of aggregate demand (EM) is equal to required level of aggregate demand (EM) to maintain full employment

EM = EM. Hence full employment

Over full employment equilibrium

• Over employment equilibrium refers to a situation when the aggregate demand is equal to the aggregate supply beyond the full employment level

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1. In the diagram at point E, AD=AS and there is full employment in the economy
2. If aggregate demand rises to AD1, then there is excess demand in the economy as AD>AS
3. The difference between AD1 and AD0 is the inflationary gap i.e.,

Inflationary gap/ excess demand (measured at full employment output)

= Actual AD – Required AD = FM – EM = EF

4. Point E is a point of equilibrium corresponding to full employment of resources. Point E1 is also a point of equilibrium but, corresponding to over full employment of resources

observations

5. AD0 is the desired aggregate demand curve corresponding to full employment level of resources (OM)
6. AD1 is the actual aggregate demand at beyond full employment level of resources (OM1) when equilibrium is at ‘E1’, implying over full employment of resources equal to MM1

Under employment equilibrium

• Under employment equilibrium refers to a situation when the aggregate demand is equal to the aggregate supply corresponding to under-employment of resources. It occurs prior to the full employment

• Observations
• In the diagram at point E, AD = AS and there is full employment in the economy
• If aggregate demand falls to AD2, then there is deficient demand in the economy as AD < AS
• The difference between AD0 and AD2 is the deflationary gap i.e.,

Deflationary gap/Deficient demand

(measured at full employment output)

= Required AD – Actual AD = EM – FM = EF

4. Point E is a point of equilibrium but, corresponding to under employment of resources

Meaning of investment multiplier

• Investment multiplier is the ratio of change in investment expenditure

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For e.g., if investment increases by 4 crore and due to which income increases by 20 crores, multiplier would symbolically be:

K=∆Y/∆I = 20crore/4crore = 5

∆Y= K x ∆I

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1. Find multiplier if : (a) MPC = 0.5 (b) 75% of increased income is consumed

SOLUTION.

(a) K = 1/1-MPC

= 1/1-0.5

K = 1/0.5 = 2

(b) K = 1/1-MPC

= 1/1-0.75

K = 1/0.25 = 4

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2. Find multiplier if (a) 50% of additional income is saved. (b) MPC = 0.25

SOLUTION.

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(a) K = 1/MPS

= 1/0.5

K = 2

(b) K = 1/1-MPC

=1/1-0.25

K = 1/0.75 = 4/3 = 1.33

3. Find change in income if multiplier is 4 and increase in investment is ₹15 crore

SOLUTION.

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K = ∆Y/∆I = ∆Y/15

4 = ∆Y/ 15 crore

∆Y = ₹60 crore

(4) Find change in investment if multiplier is 2 and increase in income is ₹8 crore

SOLUTION.

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K = ∆Y/ ∆I

2 = 8/ ∆I

∆I = ₹4 crore