Explain national income equilibrium through aggregate demand and aggregate supply. Use diagram. Also explain the changes that take place in an economy when the economy is not in equilibrium.

 

Equilibrium means the state of balance or state of no change. By equilibrium of national income we refer to that level of national income which remains unchanged at a particular level. In a simple economy, there are two elements of national income consumption and investment. An economy is said to be in equilibrium when aggregate expenditure equals aggregate income or aggregate money value of all goods and services.

There are two alternative approaches of national income determination and the first approach determines equilibrium level by the equality of aggregate demand and aggregate supply of output.

Under this approach, the equilibrium level of income is determined at the point where Aggregate Demand (AD) is equal to Aggregate Supply (AS).

In the diagram, consumption curve is depicted by C and the investment curve is depicted by the horizontal straight line parallel to the output/income axis. Summing-up the investment curve and consumption curve, we get the Aggregate Demand curve represented by AD = C + I. The Aggregate Supply curve is represented by the 45° line. Throughout this line, the planned expenditure is equal to the planned output. The point E is the equilibrium point, where the planned level of expenditure (AD) is equal to the planned level of output (AS). Accordingly, the equilibrium level of output (income) is OQ.

In case, if AD > AS, then it implies a situation, where the total demand for goods and services is more than the total supply of the goods and services. This implies a situation of excess demand. Due to the excess demand, the producers draw down their inventory and increase production. The increase in production requires hiring more factors of production, thereby increases employment level and income. Finally, the income will rise sufficiently to equate the AD with AS, thus the equilibrium is restored back.

On the other hand, In case, if AS > AD, then it implies a situation, where the total supply of goods and services is more than the total demand for the goods and services. This implies a situation of deficit demand. Due to the deficit demand, the producers experience piling-up of stock of unsold goods, i.e. inventory accumulation. This would force the producers to cut-back the production, thereby results in the reduced employment of factors of production. This leads to fall in the income and output. Finally, the income and output will fall sufficiently to equate the AD with AS, thus the equilibrium is restored back.

Given that
Value of MPC = 0.9
Initial increase in investment = Rs 1000 crore
So, every increase of Re 1 in the income, 0.9 part of the increased income will be consumed
by people.
Consumption= Rs 0.90
Saving= Rs 0.10

It is given that initial increase in investment of RS1000 will lead to change in the income by RS1000 in the first round. As MPC is 0.9 so people will consume 0.9 of the increased income i.e 900 thereby saving RS 100. In the next round due to increase in the consumption expenditure by RS 900 there will be an increase in income by RS 900. Then people will again spend the increased income i.e RS 810 and save the rest part of the income RS 90. similarly, this process will continue and the income will go on increasing as a result of the increase in consumption. The total change in the income is RS 10,000 and the change in the investment will be RS 1,000.

B.

1/MPS

In part A, CC curve shows consumption function corresponding to each level of income whereas 45^o line represents the income. Each pointy on 45^o line is equidistant from X axis and Y axis. C curve intersects 45o line at point B at which BR=OR i.e. consumption = income. Therefore, point B is called break-even point showing zero saving.

It emphasizes that saving curve must intersect x-axis at the same income level where consumption curve and 45^o line intersect. Further, it will be seen that to the left of point B, consumption function lies above 45^o line showing that consumption is more than income, i.e. negative saving and to the right of point B, consumption function lies below 45^o line showing positive saving.

In part B, we derive saving function in the form of saving curve. In part A, the amount of saving is the vertical distance of Part A representing saving/ dissaving and by joining them, we derive a saving curve. For instance, at 0(Zero) level, of income in Part A, vertical distance OC is plotted as OS₁ below X axis in Part B.

Similarly, At OR level of income in Part A, vertical distance at point B being nil is shown as point B₁ on X axis in lower part of the figure. Likewise, LM vertical distance of part A is shown as L₁M₁ in part B. By joining points S, B1 and L₁ in the lower segment, we get saving curve. Thus saving curve or function is diagrammatically derived from consumption curve or function.