Tuesday, April 12, 2011

Simple Income Determination with Savings-Investment Equality

National income is the sum total of consumption and savings. It is the money value of all commodities and services produced in the economy. These commodities and services are of two types.

1. Supply of consumption goods and services

2. Supply of Capital (investment) goods and services.

'Y' is the aggregate supply because it is the sum total of consumption and savings. Y = C + S. To this we add tax collected (T), which is the income of the government. Then the equation becomes Y = C + S + T.

Expenditure 'E' means aggregate demand. It is composed of aggregate consumption expenditure, or demand for consumption goods and services, as well as aggregate investment expenditure, or demand for investment goods and services.
Thus E = C + I. To this if we add government expenditure (G), then the equation becomes E = C + I + G.

We know that at equilibrium, income is equal to the expenditure for the economy as a whole.

In the whole model, where there are three sectors, the consumers, the business firms and the government,

1. Income = consumption + savings + Tax. Y = C + S + T - This is the supply side.

2. Expenditure = consumption Expenditure + private Investment Expenditure + Government Expenditure - E = C + I + G. This is the demand side.

If Y = E, then C + S + T = C + I + G

In an equilibrium position, government income, in the form of tax, is equal to government expenditure. T = G.

C + S + T = C + I + G. 'C' cancels out from both the sides, and T = G. Then, as because income 'Y' is equal to expenditure 'E', savings = investment, or S = I. This is known as the equilibrium condition of the national income. This can be shown with the help of the following diagram.

We initially draw a 45 degree line OY where Y = C + S + T. This is the income line of the community. At any point on this line, income = expenditure, or every point is a point of national income equilibrium. I-I' is the fixed level of autonomous investment, irrespective of the level of national income.

Now if we merge the Y = C + S + T supply (income) schedule, the 45 degree line, and the demand (expenditure) schedule E = C + I + G, we can arrive at the equilibrium position.

The savings curve is upward sloping, because with every increase in income, savings increases. Refer to the Savings function in earlier posts.

E is the equilibrium point.

At point F, aggregate demand is greater than aggregate supply. So prices will go up. More goods will have to be produced in order to meet the excess demand.

FF' measures excess of expenditure over income. This is known as the Inflationary Gap. It shows that the community is attempting to consume more than what it is capable of producing. Due to this excess demand, prices will go up, and further production will be profitable. If production increases, National Income will also increase, until the equilibrium level of income is reached.

At point G, income is greater than expenditure, and GH measures what is called Deflationary Gap. The community is consuming less than what it is capable of producing, or demand is less than the supply. Producers are now faced with the problem of unintended accumulation of inventories. As a result prices will fall, and production will also fall, until the inventories are run down completely. In the process it will come back to the equilibrium point E. At the equilibrium point prices will be stable, because there will be neither inflation nor deflation.

No comments:

Post a Comment

Want to say something? Say it!

Update(s):Post(s) under preparation: -
View Chandra Bhanu's Art at Profoundfeeling.blogspot.com


Related Posts Plugin for WordPress, Blogger...


indifference curve investment demand-pull inflation economy fiscal policy monetary policy cost-push inflation demand demand for money destabilized economy economics stagflation supply of money Opportunity Cost Quantity Theory of Money Theory of Consumption World economy automatic stabilizer capital choice consumption function current accounts deficit deflationary gap demand for investment depression derivation effects of inflation equilibrium fiscal deficit fresh investment growth imbalance inflation interest money perfect competition savings savings function world Accounting Profit Adam Smith Alfred Marshall Diminishing Marginal Utility Economic Profit Equimarginal Utility General Equilibrium Theory IS Curve J. M. Keynes Keynes' Theory of employment LM Curve Lionel Robbins Normal Profit PPC Production Possibility curve Software system development Utility Analysis accelerator account accounting alternative uses autonomous investment balance of payments book keeping capital goods classical theory of the rate of interest commodity consumer consumer goods consumption credit debit definition deflation discretionary double entry economic functions economic wants educated education ends energy ermployment full employment functions of money growth rate habit imitation imperfect competition income income analysis income determination income effect induced investment inflationary gap investment function knowledge labour less than full employment liquidity preference theory long run long run equilibrium means monetary analysis monetary measures monopoly multiplier price price effect price maker production possibility frontier profit maximization propensity revealed preference analysis sacrifice say's Law scarce science shifts of IS LM curves short run short run equilibrium shut down conditions slow down society stagnation student subsidies subsidy substitution effect success sunk capital supply supply of savings technology unproductive wealth world economy 2012