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.