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    Document 399

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    Piyush Hazra
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    < DETERMINATION OF EQUILIBRIy OUTPUT M INCOME AND aving discussed sa consumption |, investment functions in the previous €CtHgne we are now in a position to study and ana\,,, the equilibrium level of income and outpu: ,, the short-run. As stated already, to simpii: our analysis, we assume a simple two-secto; economy consisting of the household sector ani the business sector. All the decisions concemin consumption expenditure are taken by th individual households, while the business fim take decisions relating to investment. We 2 assume that consumption function is lineat 2’ planned investment is autonomous. There are two approaches to the determirat" of the equilibrium level of income. Thes? am 1. Aggregate demand-Aggresat® super approach . Saving-Investment approach H In terms of aggregate demand-aggrepate output in the economy is the one where desired aggregate demand for goods and services is equal to the aggregate supply. The aggregate demand refers to the total desired expenditure (spending) of the community. Total desited expenditure comprises planned (desired) expenditure on consumer goods by the households and planned investment expenditure on capital goods by the business firms. Planned consumption expenditure is indicated by upward sloping straight line curve C in Fig. 5(i, showing the positive and linear relation between consumption and income, as explained by the Keynesian consumption function. Planned investment expenditure is illustrated by II curve, which is a horizontal line because investment expenditure is assumed to be autonomous, ie, it is independent of the level of income. The desired aggregate demand curve is, therefore, represented by (C + 1) curve. It is derived by taking the vertical summation of the C-line and the Il-line. Since level of planned investment remains the same at all levels of income, (C+D) curve is parallel to C curve with a constant vertical distance (equal to Il) between the two curves at all levels of income. Aggregate supply refers to the value of total output of goods and services produced in an economy in a year. In other words, aggregate supply is equal to the value of national product, ie, national income. It is depicted by the 45° line originating from the point of origin. Thus, the straight line from the origin which makes 45° angle with X-axis shows both the aggregate Supply and national income in money terms. The aggregate supply is measured by the vertical distance between 45° line and a point on the ‘axis. This vertical distance is exactly equal to income shown by the horizontal axis at all levels of output. Thus, the level of income can Measured either along the horizontal axis or the vertically on the 45° line. Since in a two sector model, income is partly spent in the form of consumption expenditure and is partly saved, therefore, national income is the sum total of consumption expenditure and saving(s). AS=Y=C+S In Panel (i) of Fig. 5, income is measured along the X-axis and desired consumption (C) and investment (Il) are shown on the Y-axis. C +I curve represents the aggregate demand and 45° line represents the aggregate supply. The intersection of aggregate demand and aggregate supply curves determines the equilibrium level of national income. The equilibrium level is at point E corresponding to the point of intersection of the desired aggregate demand curve (C+1) with the 45° line. Accordingly, equilibrium level of income is Y, because at this level of income desired aggregate demand equals aggregate supply. At this level of income desired aggregate spending is equal to national output. Buyers can fulfil their spending plans, and the firms are able to sell whatever they desire to produce. There is no incentive for the firms to change their output. Therefore, output and income are at equilibrium. Let us understand why the economy cannot be at equilibrium if the level of output is different form Y,. For instance, suppose the output produced in the economy is Y,, which is greater than the equilibrium level of income (Y,), as shown in Fig. 4(j). In this case, planned (desired) aggregate demand (BY,) is less than the production level of OY, (or AY,) by AB amount. Aggregate expenditure or demand falls short of aggregate supply. Therefore, firms are not able to sell the entire output they have produced. Firms are forced to add unsold goods equal to AB amount to their stock of inventories. This unplanned rise in i i i Ss tan rae eee a i 'y income (as indicated by the direction of arrow <), Thus unintended inventories forces firms to cut dows production which leads to fall in income. This rocess of unintended i i nd falling output int noon accumulation continues until ‘Thus, Team _ ‘sumption and moar oxperctue Dosirad saving and investment Fig. 5 Equilibrium Level of Income and Output income falls to the equilibrium level Yo. On the other hand, suppose income level is lower than the equilibrium level such as Y, in Fig. 5 @. In this case, planned (desired) demand (cy,) is greater than the production level of OY, (or HY.) by GH amount. Firms will be able to meet higher level of sales by drawing down their inventories. Thus, excess demand will lead to the decline in inventories of goods below the desired level. When firms find their stock of inventories falling, they increase their production to ‘meet the extra demand and, as a result, income increases (as indicated by the direction of arrow >). This process of falling inventories and increase in output and income continues until income increases to the equilibrium level Y,, An alternative approach to the determina, of equilibrium level of income is s : investment approach. According to this approag equilibrium level of income is determined 7 that level where planned investment equal, desired/planned saving, It is clear from Fig. 5 iy that equilibrium level of income is oy corresponding to the point of intersection e the $ and II curves. At this level of incon (OY,), aggregate demand equals aggregan supply because the part of output which not purchased by households is purch by the firms. At all other levels of incom, desired aggregate demand will not be equ: to aggregate supply and, therefore, Producers would either contract or expand their o; as the case may be. AVing. utput Let us consider OY, level of output! At ths level of income, planned saving exceeds planne: investment by AB amount. Here, aggresot: supply exceeds desired aggregate demand since consumption is low due to higher amount of saving. Consumption expenditure of the households and the investment expenditure of firms will not be sufficient to purchase the entire output produced. There would be exces Production (supply) equal to AB amount Inventories will pile up with the producers. ine bid to cut down the inventories, the firms will Ge down production and lay off workers. As a result the level of income, output and employmen will decrease. This process will continue till income decreases to the equilibrium level OY On the other hand, if the level of income e OY, the planned investment of the firms i saving of the households by GH amount: +? Tesult, the demand for the goods will be a than the current production by GH es high consumption expenditure (as ae by households is low). A part of the sod demand will'be met by reducing inventory pd Of goods. Therefore, firms will like to build Production and hire more workers 0 Og up their inventories. Thus, the Jey proces Output and employment will rise. TP yee will continue until output increases to Oo saving equals planned investment. oH! FRANK ISC ECONOM™ Table 12.2: Determination of Equilibrium Level of income Planned | Planned consumption! saving | terme | cea, saeaate] Tendency demand income 20 20 t CDE a 40 60 > 0 | Expansion (7) 100 0 40 140 = > 100 Expansion (7) 180 20 40 220° > — 200_| Expansion (7) | 260 40 40 300 = 300 Equilibrium (+) 340 60 40 380 < ~—-400_| Contraction (4) | 00 420 80 40 460 < 500 _| Contraction (4) We have discussed two approaches for ining the equilibrium level of income— | jggregate demand —aggregate supply approach jx sving-investment approach. Both of them give the same level of equilibrium income as can teverified from upper and lower panels of Fig. 5. Alternative Presentation Determination of equilibrium level of income can as be explained with the help of a numerical aample given in Table 12.2. It is dear from Table 12.2 that equilibrium ‘evel of income is €300 crore where the desired aggregate demand is equal to aggregate supply, iz AD = AS (or planned I = S). Buyers are able ‘omeet their spending plans, and firms are able ‘osell whatever they plan to produce. Any level ‘foutput more than or less than %300 crore leads “© disequilibrium. In case desired aggregate éenand exceeds aggregate supply (AD > AS) (or Panned'I > $) income will increase. For instance, ‘ims produce output worth 200, there will be “tess demand of %20 crore, since corresponding, ‘the output level of 2200 crore, planned “Betegate demand is %220 crore. This would = the firms to expand their output to meet cess demand. The same would happen long as the level of output is less than the ‘tiibrium output. Likewise, if aggregate SuPPIY Beater than desired aggregate demand (AS > or 1 59> D, income and output will increase. 3 ‘stance, if firms in the economy decide to beat Output worth %500 crore, there would ‘og Supply of %40 crore, as corresponding Sutput of %500 crore, planned aggregate eon 7 OF INCOME AND EMPLOYMENT demand is 7460. Therefore, firms are not able to sell the entire output they have produced. Unsold stock of goods will induce the firms to reduce production, which leads to fall in income. 12.8 INVESTMENT MULTIPLIER It is obvious from the above analysis that aggregate expenditure plays an important role in the Keynesian theory of income and output determination. A rise in the amount of desired aggregate demand due to increase in desired consumption expenditure or desired investment expenditure will shift the AD (C + I) curve upward and thereby will result in an increase in equilibrium level of income and output. On the other hand, a fall in desired aggregate demand will shift the AD line downward and will thereby lower equilibrium level of income and output. We explain the change in the equilibrium level of income and output in response to a change in the investment expenditure. If investment expenditure increases by a particular amount, say 100 crore, one would think that since investment expenditure has increased by 100 crore, aggregate expenditure and, therefore, equilibrium income will increase by 2100 crore. But Keynesian theory of income and output gives us a surprising result that increase in income and output will be some multiple of (or more than) increase in the investment expenditure. This is what we are going to discuss in this section in terms of what is known. a as ‘investment multiple’. The multiplier occupies an important place in the modern theory © income and employment. 42.8.1 Investment Multiplier Defined slier is defined as the multiple amount by rohch income increases a8 result of increase in investment expenditure. In other words, the number of times income increases because of increase in investment “4 walled investment multiplier. Since increase in js studied with respect to increase in investment multiplier. diture increases The investment multip income investment, it is called ‘An increase in investment expen equilibrium level of income by @ multiple swount, that is by an amount greater than itself, The multiplier is the ratio of the change in income to the change investment. ‘AY Thus, -—— us K aI where, K indicates investment multiplier AY and Al indicate change in income and change in investment respectively. For instance, if an increase in investment by 7100 crore leads to an increase in income by AY _ 50 % 500 crore, the multiplier is 5 [k= a 2-5], In our example, income has increased by 5 times the increase in investment. Thus, the multiplier provides a measure of magnitude of change in income as a result of change in investment. The essence of multiplied is that increase in income is manifold the initial increase in investment. 12.82 Multiplier Mechanism (Process) Let us illustrate the working of multiplier with the help of a simple example. Let us begin with a situation when the economy is in equilibrium. Suppose Reliance Industry Limited (RIL) spends 100 crore in setting up a new plant. Initiall this will create more demand for goods ae services required for the setting up of this new plant. There will be more demand for machinery, materials, land, labour services, etc. This will generate income for all those people who are associated with the establishment Richard Kam (voor) dern theory The mo was of multiplier develope 19308 by Keynes, Giblen and others. Kahn, @ British economist, rofessor of at King’s mbridge Universi in was his principle of multipie, Kahn's mathematical formulatcg Kevine argument for multiplier Kahn was = of the five members (other members bein James Meade, Joan Robinson, Austin Robinsz, ‘and Piero Sraffa) of Keynes Cambridge Ciras Keynes Cambridge Circus was a group of young Cambridge economists closely associated wits Keynes. They regularly met in Kahn's room at King’s College to discuss various economic issues and provide feedback to Keynes ator his theoretical work. was PI economics College, Ca contributio Keynes u! y. His most notable of this plant, There will be more outpst income. As a result, national income in the f round will increase by an amount equal to amount of investment. Income of the suppl of the investment goods, income of the wa eamers, etc, associated with the setting up © new plant will increase by 7100 crore. But not the end of the story. The increase in nation! income of 100 crore will cause an increase disposable income, which in turn will induce * increase in consumption spending. People who receive this new incom (100 crore) directly from the building“ the factory will spend some part of it consumer goods like food, clothing, cine TY, cars, etc. and save some part of it exact amount of additional consump!” expenditure would, however, depend upot the MPC (c). Suppose MPC is .8. Therefor consumption expenditure in the second 1 would rise by .8 x 100 (AC = ¢ x AY) = €80 °° When output and employment increas? : meet this increased demand for cons¥™ goods, further income will be generated fof firms and workers producing these const" —=_ Troan Table 12.3: Process of Income Propagation Rounds of | Increase in investment Increase in Increase in spending Spending consumption income On ao ay crore) @ crore) & crore) 1 100 ms 100 2 7 0.8 x 100 = >—_, 80 | 3 - 08 « 80 = 64 ——} 64 4 = 0.8 * 64 = 51.2———————$951.2 Total increase in income = %500 crore Total increase in consumption = %400 crore goods. The reason is that an expenditure by one person becomes the income of another person. Accordingly, income of these people will increase by %80 crore. This increased income of 880 crore will lead to a further generation of income due to increase in the consumption expenditure in the third round equal to cx AY, ie, 0.8 « 80 = 264 crore. This will generate an income of equal amount, i.e., %64 crore. This Process of increase in income will continue to be repeated in subsequent rounds with income in each round of spending being MPC (c) times the increase in income in the previous round. At this stage you might wonder whether increase in income would ever come to an end. However, this process of increase in income cannot continue indefinitely. The amount of crease in consumption passed on from one “ound to the next keeps on diminishing because “Part of the increased income is saved in every "und. Since the increase in consumption becomes Progressively smaller at every round, the total ase in income will be of some finite amount. ‘imately, as a result of a series of rounds of 'Rctease in income, total income will increase oy 1 2mOunt which is some definite multiple a increase in investment. In fact, in our le, the income would increase by %500 crore a a result of increase in investments of 7100 crore. Look at the formula for investment multiplier in 12.8.4 to know why income would increase by this amount. The whole process of multiplier can be summarised in Table 12.3. 12.8.3 Graphic Presentation of Multiplier Investment multiplier can also be explained with the help of a diagram in Fig. 6. Income is shown along the X-axis and desired aggregate expenditure (consumption plus investment expenditure) is indicated along the Y-axis. The initial equilibrium is at Ey where AE, intersects the 45° degree line (Y line). The equilibrium level of income corresponding to this point is OY). An increase in autonomous investment 4 Y=A0 poe 5 , =(C +1 + al) ; aie FI 3 IN ° % Y, Income x Fig. 6 Illustration of Multiplier expenditure (AI) shifts the desired spending function upward from AD, to AD,. The vertical shift of AE curve will be equal to increase in investment. Corresponding to the initial level of income Y,, the desired spending is more now. Therefore. income will rise. The new equilibrium occurs at F,, where the AB, curve intersects the 45° Jine. The equilibrium level of national income is now OY, Thus, as a result of increase in investment by AT (= E,M), the level of income rises by ¥,Y, ot E,N (as points E, and B, on 45° Tine indicate that income rises from F,Y, to F,), ie, by E,N). As can be seen from Fig. 5, the increase in income E,N (= Y,Y,) is greater than the increase in investment E,M. As increase in imcome ts greater than the increase in. investment, the multiplier is greater than unity. Thus. This shows that 2 given autonomous change in mvestment will lead to a change in income which exceeds the change in investment. 12.8.4 Derivation of Multiplier Formula ‘The multiplier formula can be derived by using the simple equilibnum condition for the two-sector model Recall that the equilibrium level of income in two-sector model is given by YeCer Now, let there be increase in investment by 41 When investment increases, it will lead to increase in income (4), This induces increase in consumption (4 C). This will lead to a change in the equilibrium level of income. Moving from one equilibrum t another, it is necessary that change in Y is equal to change in AE (ie, AC +41). BY-AC+Al = AY=cAY+AL (because change in total consumption equals change in income multiplied by MPC) > AY-cAY=AT =>

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