Determination of Equilibrium Income in the Short Run

How is equilibrium income determined in the short run?

Students can recollect that in theory of microeconomics, when we scrutinise 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 the theory of macroeconomics, we can begin in two 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, scrutinise the 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 manufactured quantity changes.

This is just a simplifying presumption that will be changed later.

Q.1- Explain the determination of the equilibrium level of income by 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.

    The AD curve has a positive slope, which means that 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 a positively sloped 45° straight line curve starting from the origin.

 

Q.2- Explain the changes that take place when the aggregate demand and the aggregate supply are not equal.

Or

How does adjustment mechanism work to reach an equilibrium level if the AD and the AS are not equal?

Answer:
When AD > AS

 

i.e., the economy is operating at any level before the  equilibrium

It means that households and firms taken together are willing to buy more than what the firms are planning to produce, i.e., the 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 utilise them and increase production.

This will increase the level of income and employment.

    This process of increase in the output will continue until the economy reaches the equilibrium level, where AD = AS.

When AD < AS

 

i.e., the economy is operating at any level beyond the equilibrium

It means that households and firms taken together are willing to buy less than what the firms are planning to produce, i.e., the 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 the aggregate demand.

    This process of decrease in the output and  income will continue until the economy reaches the equilibrium level, where AD = AS.

 

Q.3- Explain how the equilibrium level of income is determined with the help of   aggregate demand and aggregate supply schedules.

Or

Explain the determination of equilibrium level of income using consumption investment approach. Use a hypothetical schedule.

Answer:
According to Keynesian theory, the equilibrium level of income in an economy is determined at the level of output whereof the AD represented by C + I is exactly equal to the AS (output), which is the sum of C and 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 given schedule, the equilibrium level of national income is 400 crore. Because:

At any level before the income level of 400 crore, AD > AS, i.e., C + I > C + S.

At any level beyond the income level of 400 crore, AD < AS, i.e. C + I < C + S.

Only at an income level of 400 crore, AD = AS.

 

The above-mentioned concept is explained in detail about Determination of Equilibrium Income in the Short Run for the class 12 macroeconomics. Stay tuned to BYJU’S to know more. 

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