Determination of Equilibrium Level of Income & Employment

           

Determination of Equilibrium Level of Income & Employment

 An economy is in equilibrium when aggregate demand for goods and services is equal to aggregate supply during a period of time.

So, equilibrium is achieved when:

AD = AS … (1)

We know, AD is the sum total of Consumption (C) and Investment (I):

AD = C + I … (2)

Also, AS is the sum total of consumption (C) and saving (S):

AS = C + S … (3)

Substituting (2) and (3) in (1), we get:

C + S = C + I

Or, S = I

It means, there are Two Approaches for determining the equilibrium level of income and employment in the economy:

Two Approaches for Determination of Equilibrium Level:

The two approaches to determine equilibrium level of income, output and employment in the economy are:

1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)

2. Saving-Investment Approach (S-I Approach)

It must be kept in mind that AD, AS, Saving and Investment are all planned or ex- ante variables.

Aggregate Demand-Aggregate Supply Approach (AD-AS Approach):

According to the Keynesian theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C + I curve is equal to the total output (Aggregate Supply or AS).

Aggregate demand comprises of two components:

1. Consumption expenditure CC):

It varies directly with the level of income.

2. Investment expenditure (I):

 Investment expenditure is autonomous.  It is depicted by a 45° line. 

AS curve is represented by the (C + S) curve.

The determination of equilibrium level of income can be better understood with the help of the following diagram-   

In diagram-

1.The economy is in equilibrium at point ‘E’ where (C + I) curve intersects the 45° line.

2.OY is the equilibrium level of output corresponding to point E.

When AD>AS

 It means that consumers are buying more goods than firms are willing to produce. As a result, the planned inventory would fall below the desired level.

To bring the inventory back to the desired level, firms will increase output until the economy is back at output level OY, where AD becomes equal to AS and there is no further tendency to change.

When AD < AS:

 It means that consumers are buying less goods than firms are willing to produce. As a result, the planned inventory would rise. To clear the unwanted increase in inventory, firms plan to decrease the employment and output until the economy is back at output level OY, where AD becomes equal to AS and there is no further tendency to change.

SAVING - INVESTMENT APPROACH (S-l Approach):

According to this approach, the equilibrium level of income is determined at a level, when planned saving (S) is equal to planned investment (I).

Let us understand this with the help of following diagram-    

In diagram

1. The economy is in equilibrium at point ‘E’ where saving and investment curves intersect each other.

2. OY is the equilibrium level of output corresponding to point E.

When saving is more than Investment:

It means that households are not consuming as much as the firms expected them to. As a result, the inventory rises above the desired level. To clear the unwanted increase in inventory, firms would plan to reduce the production till saving and investment become equal to each other.

When saving is less than Investment:

It means that households are consuming more and saving less than what the firms expected them to. As a result, planned inventory would fall below the desired level. To bring the inventory back to the desired level, firms would plan to increase the production till saving and investment become equal to each other.