135
5. Stock of Wealth
Vveatn includes real assets such as houses, land, automobiles etC.,
and financial assets such as cash. deposits, shares,
bonds etc. The larger
the wealth, the smaller is the saving and larger is the
1929, the stock market crashed in England that caused consumption. Durng
a drastic sliding
of the wealth holding. As a result, consumption
fúnction shifted down.
6.
Credit Availability
Another factor that affects present consumption is the availability of
credit. If credit availability is high, people will consume
more and save
However, people have to repay past debts, they are forced to save
if
and consume less.
7. Income Distribution
If the distribution of income is equitable, total
consumption will be
high. A reduction in inequality in the distribution of income
means that the
poor get more income. The propensity to consume of the
poor is high.
Thus, totalconsumption will be high if income distribution is fair.
Therefore,
as income distribution gets more equitable, the
consumption function shifts
upward. Consumption increases.
Inequality in income distribution reduces total consumption. Inequality
means the rich earns more income. Their propensity to
consume is low.
Thus, the rich save more. Therefore, unequal distribution of
income
reduces consumption and consumption function shifts downward.
NATIONAL INCOME DETERMINATION:
A
TWO SECTOR MODEL (Simple Keynesian Cross Model)
In the Keynesian system, equilibrium level of output is determined by
effective demand. Effective demand is that aggregate demand which is
equal to aggregate supply. Keynesian aggregate supply curve is perfectly
elastic up to the full employment level. At full employment level, the As
Gurve is perfectly inelastic. In the short run, aggregate supply does not
ange. Hence, the aggregate demand alone determines equilibrium level
Of output in the short
period.
36
Note: nthismodel, we express the aggregate demand as afunction
ot level of income, In the general model, we have consIdered aggregate
demand price as a function of employment. Though, the resut of both
ype of analyses are the same, the approaches are diterent. Again, in
thIs model, the aggregate supply function is implicit. if we measure the
ggregate demand on the Y-axis and we have an aggregate demand
Tunction, geometrically the equality between aggregate demand and
a9gregate supply happens somewhere on the 45° line.
Aggregate Demand
Suppose an economy with two sectors such as firms, and households.
In this economy, aggregate demand consists of consumption demand of
households and investment demand of firms.
AD=C+!
Where, AD =Aggregate demand, C=consumption demand and | =
Investment demand.
Consumption is a function of income. The psychological law of
Consumption states that as income increases, consumption also increases,
but the increase in consumption is less than the increase in income. The
consumption function is given below.
C=a+b 0<b<1
Where, C= Gonsumption, a=autonomous consumption when
income is zero, b=marginal propensity tO consume y income.
With respect to income, demand for investment in any one year is
assumed constant. It means that, in the short period, investment is
autonomous independent of income. That is:
Aggregate Supply
Aggregate supply means the value of output produced. It isequal to
theincome generated. People use their income for consumption and saving.
AS = C+S
Where,AS =Aggregate supply, C = Consumption expenditure and
= Saving.
37
Detorminatlon of Equllibrlum Lovol of Output or Incomo
Eor equillbrium, aggregate domand should be equal toaIgrogate supply.
AD AS or '+ lC+ S
That ls, Y + .Substitute ( +bY and 7 I, in thls equation,
we have,
(a+1,)
Where, is the investment multiplier. Therofore the
equilibrium
level of lnoome is the multipller times the autonomous
consumption and
autonomous investment.
Proof
Rearrange, thls equatlon Y
We have Y bY e t I,
That ls Y(1 b) a+, or Y -(a +1,)
Income determination In a two sector economy ls illustrated in fig 5.6.
Flg. 6.6 Income Determlnatlon n Two Sector
Economy
AD
AD AS
AD< AS C+1
AD A9
Y AS
M
Yr N
138
In fig 5.6, X-axis represents aggregate supply or output. Y-axis shows
aggregate demand, C+J. The 450 line shows points of equality between
aggregate demand and aggregate supply. Equality between AD and AS
OCCurs on this line. The line Cis the consumption function. The c4
line represents aggregate demand function that includes consumption and
investment spending. It shows the desired level of consumption and
investment expenditure at each level of output. The vertical distance
between the lines C and c+L0s investment demand. In any year.
investment is constant for all levels of income/output. It does not change
as income/output change. Therefore, the distance between Cand C+is
constant.
The C+I line intersects the 450 line at point E. Here, AD = AS . The
equilibrium level of output/income is M. At equilibrium, total spending of
households and firms ((C+)is exactly equal to the value of goods and
services offered for sale.
Employment generated has a constant relationship with the output
produced. In the figure, suppose, Y, is the full employment level of output.
Thus, E is underemployment equilibrium and M is an output level below
full employment level.
The Adjustment Mechanism
The economy is in macro economic equilibrium when planned
expenditure equals planned output. If planned expenditure is not equal to
the planned output,output will adjust up or down to bring equilibrium.
Consider an output level greater than the equilibrium output M .Here,
AD Curve lies below 45 line. It means that planned spending of firms
and households is less than the output produced. As a result, inventories
(raw materials, work in progress, and unsold commodities) increase. This
is an unplanned increase in inventories. Firms will Cut production tor
reducing inventories to the planned level. This continues until desired
spending equals desired output.
At any output less than M,the output tends to increase. The C+Ine
lies above the 45 line. It means that thedesired spending is greaterthan
the output produced. Consequently, inventories decrease. This is an
139
unplanned decrease of inventories. In order to compensate the decrease
in inventories, firms will increase production. It goes on till the desired
spending is equal to the desired output.
A hypothetical example for the adjustment mechanism is given in
table 5.3
Saving Investment Equality
The macro economic equilibrium condition can also be stated in terms
of saving and investment. The equilibrium condition is:
AD = AS or C+I=C+S,Cis common in both sides.
Hence, for equilibrium I=S
The saving function can be derived from the consumption function.
Saving function and consumption functions are complementary functions.
Y=C+S
C=a+bY. Thus, S =Y-C
That is, S=Y-(a+ bY)
S=Y-bY - a
S=(1-b)Y a
Where, 1-bis the marginal propensity to save and -ais the
autonomous dissaving.
With respect to income, demand for investment in any one year is
assumed constant. It means that, in the short period, investment is
autonomous independent of income.
That is: I=l
Graph of I= I, is shown in fig. 5.4
t means, for equilibrium, planned saving must be equal to planned
Investment.This is shown in fig. 5.7
140
Sector Economy:
Fig. 5.7 Income Determination in a Two
Saving -Investment Approach
Saving and
Investment
I I>S
-Y = AS
B M
In fig. 5.7, X-axis represents output/income. The Y-axis represent
planned/desired saving and planned/desired investment. The line jis
investment line. The height of the investment line is equal to the vertical
distance between C and C+Ilines in fig. 5.6. For any one year,
investment is constant. It is a straight line parallelto the output axis. Here,
income.
investment is assumed independent of rate of interest and level of
line intersects
For all levels of output, investment is constant. The saving
the investment line at point E.The output corresponding to the equilibrium
investment
point is M.At equilibrium, planned saving is equal to planned
(ME).
Adjustment Mechanism
If there is disequilibrium between planned saving and planned
investment, output willincrease or decrease to bring eguilibrium. This is a
stable equilibrium position.
Consider an output level above (right of) M.The saving line lies above
the investment line. This means that desired saving is greater than desireu
investment. Increased saving means reduced consumption, As undesired aresul,
inventories which is part ofiinvestment increase as unplanned or investment.
by firms. Here, actual investment rises above the planned
Firms will redUce production to reduce the undesired increase
141
inventories. This process continues till planned savings, plánnsd
investment and actual investnent beCoMe 6qual.
At an output level below (left of) M.dosirod inv6stment 6xc66ds
desired saving.Households save less than the investrnent desirsd by firms.
Smallsaving means high consumption. Inventories with the firrms décr6as6.
As aresult, actual investment falls short of desired investment. Firms
start increase production till the output level match the 6quilibriurm output
and actual investment equals desired investments.
An lustrative Example
The above adjustment mechanism is oxplained with a numerical
example. Suppose the consumption function is ( 500 +0.6Y. The
related saving function is - 500 + 0,4Y. From theSe equations, we
calculate consumption and saving for different values of income. Planned
investment is given as 80 crores.
Table 5.3 The Adjustment Mechanism of Macro Economic Equilibrium
Outputl Planned Planned Planned Aggregate State of Inventories Tendency
Income C Domand |Equilibrium of output
(AS) (AD)
300 380 -80 80 460 AD > AS -160 Increase
500 500 80 580 AD> AS -80 Increase
700 620 80 80 700 AD AS Equilibrium
900 740 160 80 820 AD < AS +80 Decrease
1000 800 200 80 880 AD < AS +120 Decrease
1300 980 320 80 1060 AD < AS +240 Decrease
Gonsider the first row. Total output or AS is Rs.300 crores whereas,
9gregate demand is Rs.460 crores. Aggregate demand
Comprises
planned Gonsumption of Rs. 380 crores and planned investment of Rs.80
eS.Aggregate demand is greater than the value of output or aggregate
supply. As a result, inventories decrease about Rs.160 crores. Therefore,
irms will increase
production.
142
Consider the last row; firms produce output equal to Rs.
Households and firms together planto spend Rs. 1060 1300 crores,
crores. Aggregate
supply exceeds aggregate demand. Inventories increase by Rs.240
Firms will cut down production to eliminate the unplanned crores.
inventories. investrment
in
At the output level of Rs.700 crores, aggregate
demand eguals
aggregate supply. This is the equilibrium level or the best levelof outouf
where aggregate demand and aggregate supply are equal. There is na
tendency to move from this output level.
Therefore, macro economic equilibrium explained by Keynes is statble.
Itdoes not change in the short run unless AD function changes.
Planned Versus Actual Investment
The equilibrium condition can also be stated in terms of planned
(desired) investment and actual investment. That is, for equilibrium, the
desired investment should equal to the actual investment.
Planned investment refers to that level of investment desired by firms
at different levels of output.
Actual investment is defined as the planned investrment +unplanned
investment. The difference between planned and actual investment is the
rise or fall in inventories. An unplanned fal! in inventories means that
actual investment is below planned investment.
An unplanned rise in inventories implies that actual investment is
greater than planned investment.
distinction
We can also make a between actual output and equilibrium
output may be
less than of greater than the
level of output. Actual
equilibrium level of output depelng upon unplanned fal or rise in
inventories.
|llustrations
Illustration-1
Given that the consumptionfunction is C- 50+0.8Y . Investment is
autonomous investment which is given as | - 80. Find equilibrium level
of income.
143
Solution
1 Income expenditure approach
Equilibrium level of income is given as Y=(+l
That is Y =a+ bY +I
1
Or Y=(a+), a= 50 , I= 80, b= 0.8
1
Y=
|-0.8
(50 +80)=130
0.2
= 5x130 =650
2. Saving investment approach
Derive the saving function from the consumption function. The saving
function is S =-50 + 0.2Y, I=80
For equilibrium, S=1.
That is - 50 +0.2Y = 80. Solve this equation for Y, we find
0.2Y = 80 + 50
130
Y= =650
0.2
Mustration-2
The consumption and investment functions are given below.
Consumption function = C+cY and investment function is /= '
MC= 40. c = 0.7 and ' =80. Then fit an equation for equilibrium level
of incomne and
estimate it.
Solution
The equation for equilibrium level of income is the equality between
ome and expenditure. Expenditure consists of consumption and
investment. Thus, the equilibrium level of income can be stated as follows.
Y =C+I
Given that C= C+ cY and | =1
144
Thus the equation for eguilibrium income is Y=C+cY+|' or
1
1-c
-(C+ I')
Substituting the values, C=40, c= 0.7 and =80, we have
1
Y= (40 + 80)
1-0.7
1
Y= -120 = 400
0.3
Illustration-3
Suppose | =60, C=70+ 0.75Y. Then find; (1) the equilibrium level
investment
autonomous
of income, (2)the equilibrium level of income when
increases to 70 and (3) the change in output due to a change in
autonomous investment of 10.
Solution
1. Equilibrium level of income Y =C+I
Y=70 +0.75Y +60
1
Or Y= (60 + 70)
1-0.75
Y=4x130 =520
2. Equilibrium level of income when autonomous investment increases
to 70
Substitute the value of I= 70 in the above equation
Y=70+ 0.75Y +70
1
Or Y=. -(70+70)
1-0.75
Y=4x140 = 560
3
Change in income due to a change in autonomous investment of 10.
1
AY =kAI, k=
1-0.75
=4, AI=10
AY =4x10= 40
