Determination of Equilibrium Income in the Short Run

How is Equilibrium Income determined in the Short Run?

Students can recollect that in microeconomic theory when we scrutinize the equilibrium of demand and supply in a single market place, the demand and supply curves simultaneously decide the equilibrium cost price and the equilibrium quantity. In macroeconomic theory we can begin in 2 steps: At the first stage, we work out a macroeconomic equilibrium taking the cost price level as fixed. At the second stage, we allow the cost price degree to vary and again, scrutinize macroeconomic equilibrium.

What is the justification for taking the cost price degree as fixed? Two reasons can be put forward :

  • At the initial stage, we are presuming an economy with unused resources: machinery, buildings and employees or labours. In such a situation, the law of diminishing returns will not apply; hence the additional output can be manufactured without increasing marginal cost
  • Accordingly, cost price level does not differ even if the quantity manufactured changes
  • This is just a simplifying presumption which will be changed later
Q.1- EXPLAIN DETERMINATION OF EQUILIBRIUM LEVEL OF INCOME USING ‘CONSUMPTION
ANSWER:
EQUILIBRIUM
  • According to the Keynesian theory, the equilibrium level of income in an economy is determined at the intersection point of AD and AS curves.

Aggregate demand:

  • Aggregate demand means the total demand for final goods in an economy.
  • AD curve has a positive slope which means when income increases, AD (expenditure) also increases. It is represented by C+I

Aggregate supply:

  • It is the value of the total quantity of final goods and services produced in the economic territory of a country.
  • An aggregate supply curve is the sum total of consumption and saving.
  • It is positively sloped 45° straight line curve starting from the origin.
Q.2- EXPLAIN THE CHANGES THAT TAKE PLACE WHEN AGGREGATE DEMAND AND AGGREGATE SUPPLY ARE NOT EQUAL.

OR

HOW DOES ADJUSTMENT MECHANISM WORKS TO REACH EQUILIBRIUM LEVEL IF AD AND AS ARE NOT EQUAL?

ANSWER:
WHEN AD>AS

 

i.e. ECONOMY IS OPERATING AT ANY LEVEL BEFORE THE EQUILIBRIUM

  • It means households and firms taken together are willing to buy more than what the firms are planning to produce, i.e. AD curve lies below the AS curve.
  • It would lead to the unplanned and undesired decrease (ê) in inventories.

 

Remedy:

  • If some unemployed or under-employed resources are there in the economy, firms would utilize them and increase production.
  • This will increase the level of income and employment.
  • This process of increase in output will continue until the economy reaches the equilibrium level where AD=AS.
WHEN AD<AS

 

i.e. ECONOMY IS OPERATING AT ANY LEVEL BEYOND THE EQUILIBRIUM

  • It means households and firms taken together are willing to buy less than what the firms are planning to produce, i.e. AD curve lies above the AS curve.
  • It would lead to unplanned/unwanted accumulation (é) of inventories.

 

Remedy:

    • In this situation, firms would decrease production and employment.
    • This will decrease the level of income as well as Aggregate Demand.
    • This process of decrease in output & income will continue until the economy reaches the equilibrium level where AD=AS.
Q.3-EXPLAIN HOW EQUILIBRIUM LEVEL OF INCOME IS DETERMINED WITH THE HELP OF

AGGREGATE DEMAND AND AGGREGATE SUPPLY SCHEDULE.

OR

EXPLAIN DETERMINATION OF EQUILIBRIUM LEVEL OF INCOME USING ‘CONSUMPTION

PLUS INVESTMENT’ APPROACH. USE HYPOTHETICAL SCHEDULE.

ANSWER:
· According to the Keynesian theory, the equilibrium level of income, in an economy, is determined at the level of output whereof AD represented by C+I is exactly equal to AS (Output) which is the sum of C & S.
Income (Y) Consumption ( C) Savings (S) Investment

(I)

AD

(C+I)

AS

(C+S)

Remarks
0 40 -40 40 80 0 AD>AS
100 120 -20 40 160 100 AD>AS
200 200 0 40 240 200 AD>AS
300 280 20 40 320 300 AD>AS
400 360 40 40 400 400 AD=AS
500 440 60 40 480 500 AD<AS
600 520 80 40 560 600 AD<AS
In the above schedule, the equilibrium level of national income is `400 crores. Because:

  • At any level before income level of `400 crores, AD>AS i.e. C+I > C+S.
  • At any level beyond income level of `400 crores, AD<AS i.e. C+I < C+S,
  • Only at an Income level of `400 crores, AD=AS.

The above mentioned is the concept that is explained in detail about Determination of Equilibrium Income in the Short Run for the class 12 Macroeconomics. To know more, stay tuned to BYJUS.

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