You are on page 1of 8

Algebraic Analysis: Determination of

Equilibrium Level of National Income


by Supriya Guru National Income

Advertisements:
Algebraic Analysis: Determination of Equilibrium Level of
National Income!
A study of how the level of national income is determined will become
more clear by using simple mathematics.The level of national income
is in equilibrium at which aggregate demand equals aggregate supply
of output.
In a simple model of income determination in which we do not
consider the impact of Government expenditure and taxation and also
exports and imports, the national income is the sum of consumption
demand (C) and investment demand (I), that is,
Y= C + I
where Y stands for the level of national income.
Suppose the consumption function is of the following form:
C= a + bY
a is the intercept term in the consumption function and therefore
represents the autonomous consumption expenditure which does not
very with income, b is a constant which represents the marginal
propensity to consume (mpc C/Y)- Thus total consumption
demand is equal to the sum of autonomous consumption expenditure
(a) and the induced consumption expenditure (bY).
Now suppose that investment demand equals Ia. This investment Ia is
autonomous because this does not depend on income. Thus, we get the

following three equations for the determination of the equilibrium


level of national income.
Y=C+I
C = a + bY
I=Ia
Substituting the values of C and I in equation (i) we have
Y= a + bY + Ia
Y bY = a + Ia
Y (I b) = a + Ia
Y = I / (I + b) (a + Ia)
The equation (v) shows the equilibrium level of national income when
aggregated demand equals aggregate supply. The equation (v) reveals
that autonomous consumption and autonomous investment (a + I a)
generates so much expenditure or aggregate demand which is equal to
the income generated by the production of goods and services. From
the equation (v) it also follows that the equilibrium level of national
income can be known from multiplying the elements of autonomous
expenditure (that is, a + Ia) by the term 1/1-b which is equal to the
value of multiplier.
The multiplier tells us how much increase in income occurs when
autonomous investment (or consumption) increases by Re. 1, that is,
multiplier is Y/I and its value is equal to 1/1-b where b stands for
marginal propensity to consume (MPC). Thus, multiplier Y/I = 1/1b. Further, it also follows that equilibrium level of income is higher,
the greater the marginal propensity to consume (i.e. b) and
autonomous investment (I).
Now, higher the marginal propensity to consume (b), the greater the
value of multiplier. For example, if marginal propensity to consume
(b) is 0.8, investment multiplier is
Y/I = 1/1-08 = 1/0.2 = 1X 10/2 = 5
If MPC or b = 0.75, multiplier is

=Y/I = 1/1-0.75 = 1-0.25 = 100/25 = 4


We can find out the increase in income (Y) resulting from a certain
increase in investment (I) by using this multiplier relationship. Thus
Y/I = 1/1-b
Y = I 1/1-b
If marginal propensity to consume is equal to 0.8, with the
increase in investment by Rs. 100 crore the increase in
income will be:
Y/I = 1/1-b
Y = I X 1/1-b = 100 X 1/1-0.8
100x 1/0.2 = 1005 = 500 crore
Illustrations of Equilibrium Level of Income with Numerical
Examples:
A few numerical examples will make it clear how the equilibrium level
of national income is determined.
Problem 1:
Suppose in an economy, autonomous investment (I) is Rs. 600 crores
and the following consumption function is given:
C = 200 + 0.8Y
Given the above, find out the equilibrium level of income.
Solution:
The equilibrium level of income is
Y=C+I
C =200 + 0.8Y

I = 600
Putting the values of C and I in the equilibrium (i) we have
Y = 200 + 0.8Y + 600
(Y 0.8Y) = 200 + 600
Y (1 0.8) = 800
Y = 800/0.2 = 800/2/10= Rs. 4000
Problem 2:
Suppose the consumption function of an economy is C = 0.8 Y.
Planned investment by entrepreneurs for a year is Rs. 500 crores. Find
out what will be the equilibrium level of income.
Solution:
Y= C + I
C = 0.8Y
I = Rs. 500 crores
Substituting the values of C and I in (i) we have
Y = 0.8Y + 500
Y 0.8Y = 500
Y (1 0.8) = 500
0.2 = 500
y = 500 x 10/2 = Rs. 2500 crores.
Problem 3:
Suppose the consumption of an economy is given by

C = 20 + 0.6Y
The following investment function is given:
I = 10 + 02 Y
What will be the equilibrium level of national income?
Solution:
Note that in this problem, investment varies with income. However,
this wills not hang our method of determining equilibrium level of
income.
Y=C+I
C = 20 + 0.6Y
I = 10 + 0.2Y
Substituting the values of C and I in (i) we have
Y = 20 + 0.6Y + 10 + 0.2Y
Y = 30 + 0.8Y
Y 0.8Y = 30
Y (1 0.8Y) = 30
0.2Y = 30
Y = 30 x 10/2 = 150
Thus, we find that the equilibrium level of income to be equal to 150.
How to Overcome Recession: Shifting Aggregate
Expenditure Curve Upward:
Now, an important question is what measures can be adopted to
overcome recession or involuntary unemployment which comes into

existence as a result of deficiency of aggregate demand brought about


by fall in investment.
From our above analysis it is clear that increase in equilibrium level of
national income can be brought about by increases in any components
of aggregate demand, namely, consumption demand (C), private
investment demand (I), Government expenditure (G), and net exports
(NX). In order to increase national income through upward shift in the
consumption function, the Government can reduce personal income
taxes. In 1964, the reduction in income tax by John Kennedy
Government in USA was quite successful in boosting consumption
demand and thereby raising aggregate output.
As a result, more income and employment were generated. The rate of
unemployment sharply declined and the American economy was lifted
out of depression. Recently, in 2002 and again in early 2008, the
President George W. Bush made a significant cut of 3.5 billion dollars
in income tax to revive the American economy. He refunded good
amount of income tax collected from the people in these years. The cut
in direct taxes increase the disposable income of the people which
tends to raise their consumption demand.
However, there is a limitation of cut in direct taxes for raising
aggregate demand because a part of the increase in disposable income
can be saved rather than being spent on goods and services. This
happened in the United States in the year 2008.
To boost aggregate demand, indirect tax can also be also be reduced.
In India in December 2008, to correct the sagging demand for
industrial products under the fiscal stimulus package 4 per cent across
the board cut in central excise duty was made. This too has a
limitation because benefit of this cut in excise duty may not be fully
passed on to the consumers by reducing prices.
Secondly, the equilibrium level of national income (GNP) and
employment can be increased by raising the rate of private investment
(I). Through monetary policy measures businessmen can be induced

to invest more by lowering the rate of interest and increasing the


availability of credit. We know that lower the rate of interest, the
higher will be the level of private investment.
Alternatively, the Government may encourage private investment by
reducing tax on profits so that post-tax rate of profit will be higher
than before. The higher level of investment will shift the aggregate
demand curve (C + I+ G) upward and determine a higher level of
national income and employment.
Thirdly, the recession can be overcome and national income (GNP)
and employment can more efficiently be increased by increasing
Government expenditure (G). It was the increase in Government
expenditure on Public Works Programme which was the main
recommendation of Keynes to raise the level of national output and
income to restore equilibrium at full-employment level. Recently in
1993-94, President Clinton stepped up public expenditure on public
works in the USA to overcome recession in the American economy and
reduce unemployment.
Now in 2009 president Obama has planned to give a fiscal stimulus of
over $ 800 billion the major part of which is the increase in
Government expenditure to raise aggregate demand to overcome
recession in the American Economy. In India also fiscal stimulus
packages were announced in 2008-09 under which government
expenditure, especially on infrastructure, was increased to revive
slowing Indian economy.
Lastly, the expansion in positive net exports (NX) will also cause an
increase in equilibrium level of national income and employment.
Exports can be promoted through tax concession on profits earned
through exports as well as making credit available at lower interest
rate for purpose of exporting goods. Another common measure
adopted to promote exports is the depreciation of national currency.
Depreciation makes the exports cheaper and imports costlier which
raise net exports (NXn).

However, when there is global recession depreciation of its currency


by each country will offset the effect of others. It follows from above
that a mix of fiscal and monetary policy measures are adopted to
increase aggregate demand and thereby to left the economy out of
recession.