The determination of equilibrium level of income explained

The level of national income is determined by the equilibrium between aggregate demand and aggregate supply. The aggregate supply of goods of an economy depends on its productive capacity which in turn depends stock of capital, labour arid the levels of their productivity. In the short period the productive capacity of an economy remains constant. It is not necessary that the aggregate supply in a year must equal to the productive capacity of the economy.

The amount of productive capacity and the amount of aggregate supply depend on the aggregate demand in that year. The greater the aggregate demand, the greater the use of productive capacity and aggregate supply. Give the capacity of the economy to produce the level of national income will be determined by aggregate demand. If the aggregate demand is higher, the level of production and national income will be high.

Equilibrium level of income and employment in the short run is determined by the aggregate demand and aggregate supply. In Keynesian model the equilibrium national income or output is determined at that point where aggregate output must equal aggregate demand. The condition of equilibrium can be expressed as

Y = E or Y = C+l+G

Y = Stands for national income.

E – Stands for aggregate demand of – expenditure’ on’ good and services.

C = Stands for household consumption I = Investment demand

G = Stands for Govt, demand for goods and services.

The economy is assumed to be closed and hence in the determination of income and employment only the house hold consumption (c) and investment expenditure (I) as taken into account and the Govt, expenditure (G) and the next experts (Xn) are not included.

This has been done to show that the levels of income and employment are determined without Govt, interfere ever without Govt, expenditure, the equilibrium level of national income equals aggregate demand comprising of consumption demand and investment demand.

Equilibrium level of National Income

The equilibrium level of national income is determined by the interaction of aggregate depend and aggregate supply of goods. The aggregate demand consists of household consumption and private investment.

The 45° OZ lone measures aggregate supply curve. Every point on the OZ line represents aggregate supply of output at different levels of aggregate demand. 45° line is also called income line. The curve ‘C’ represents consumption function or the propensity to consume. The consumption function ‘C’ shows that consumption increases with increase in income. The gap between OZ 45° line and consumption function curve (c) represents the vying of the community.

All the income is not spent; a part of income is saved. The gap between income lines OZ goes on —easing as income increases. In other words the amount of saving r saving gap increases as income increases. In the short run obesity to consume remains constant. The curve ‘C’ depends on the tastes, preferences, income distribution, the population level etc. do not change.

Investment is another factor of aggregate demand. It has got a very crucial role in the determination of equilibrium level of national income and employment. Investment demand depends on two factors (i) marginal efficiency of capital (ii) rate of interest. Rate of interest is not so important in influencing investment as marginal efficiency of capital is. In the short run rate of interest is sticky. Marginal efficiency of capital is expected profitability.

The expected rate of profit which the community expects from investment in capital assets depends on two factors (i) Prospective yield from the capital assets and (ii) the supply price of the capital asset. The MEC is the ratio of there two factors. Investment is independent of the level of income.

Thus according Keynes view investment is not taken to be the function of income. Therefore in the above figure the investment is independent of the level of income. The distance between the C curve and the C+l curve represents the level of the investment. C+l curve is parallel to C curve indicating that the level of investment is constant.

In the above figure at OY, income aggregate demand-(C+l) is oY1 which exceeds aggregate supply of output Y, R. This excess of aggregate demand over aggregate output means that stock of goods will decline so that the firms expand their business and output. The output will keep on increasing until it becomes equal to the aggregate demand. At OY₂ level of national income aggregate demand is Y₂+ which falls short of aggregate supply of output Y₂S. This deficiency of demand at OY₂ level of income will result in the increase in the stock of output. This will allow the firms to reduce the level of output. At OY level of income the aggregate demand will be equal to aggregate supply of output. Thus OY represents the equilibrium level of national income. But at OY level of income all resources may not be fully employed. Thus at OY level of income represents less than full employment equilibrium or under employment equilibrium.

Than at OY level of income a large number of workers will remain unemployed. The workers who are unemployed at the equilibrium level will be involuntarily unemployed because they willing to work at the current wage rate but unable to find jobs. At this level of income the involuntary unemployment or under employment are due to lack of sufficient aggregate demand.

Therefore unemployment of labour and under- utilization of capital stock has been caused by the deficiency of aggregate, demand. The unemployment can be removed and full- employment equilibrium can be restored either by increasing consumption demand or investment demand or by increasing both. Aggregate demand (C+l) curve shifts upward so that it intersects the 45°, line QZ, at point S, assuming’ that OY„ is the full employment level of income.