Determination of Equilibrium Level
The Keynesian Theory states that the equilibrium situation is usually expressed in terms of Aggregate Demand (AD) and Aggregate Supply (AS). When aggregate demand for products and services over a given period of time equals aggregate supply, an economy is in equilibrium.
So, equilibrium is attained when:
AD = AS
Now, we know that,
AD = C + I,
and AS = C + S
Therefore,
C + S = C + I
i.e., S = I
Therefore, according to Keynes, the two approaches to determine the equilibrium level of income and employment of an economy are Aggregate Demand-Aggregate Supply Approach (AD-AS Approach) and Saving-Investment Approach (S-I Approach).
However, to determine the equilibrium output, there are certain assumptions that needs to be kept in mind.
Assumptions
- The determination of the equilibrium level will be examined using a two-sector model (households and firms). Simply put, it is assumed that there is no foreign industry or government in the economy.
- It is also assumed that investment expenditure is autonomous, i.e., that income level does not have any impact on investments.
- It is assumed that the pricing level is constant.
- Also, to determine equilibrium output, short-run will be considered.
1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)
The Keynesian theory states that when aggregate demand as shown by the C+I curve is equal to the total output (Aggregate Supply or AS), the equilibrium level of income in an economy is established.
There are two parts to the aggregate demand:
- Consumption Expenditure (C): This expenditure changes directly with income; i.e., consumption rises as income rises.
- Investment Expenditure (I): This expenditure is considered to be autonomous and independent of one’s income level.
So, in the income determination analysis, the AD curve is represented by the C+I curve.
The overall output of goods and services from the national income is known as the aggregate supply. A 45° line is used to represent it. The AS curve is represented by the (C+S) curve because the money received is either spent or saved.
Example:
The AD or (C+ I) curve in the above graph shows the desired expenditure level by consumers and businesses at each level of income. At point E where the (C+ I) curve intersects the 45° line, the economy is in equilibrium.
Observations:
- The equilibrium point, denoted by the letter E, occurs when desired expenditure on consumption and investment is equal to the total output.
- OY is the output at the equilibrium level that corresponds to point E.
- In the above table, the Aggregate Demand is equal to the Aggregate Supply; i.e., ₹200 Crores, when the equilibrium level of income is ₹200 Crores.
- It is a case of Effective Demand. Effective demand refers to that level of AD that becomes ‘effective’ since it is equal to AS.
2. Saving-Investment Approach (S-I Approach)
The Saving-Investment Approach states that when the planned saving (S) is equal to the planned investment (I), the equilibrium level of income in an economy is established.
Example:
The Investment curve in the above graph shows the autonomous investment made; therefore, it is parallel to the X-axis. The Saving Curve S slopes upward, which means that saving increases with an increase in income. At point E where the investment curve intersects the saving curve, the economy is in equilibrium.
Observations:
- The equilibrium point, denoted by the letter E, occurs where saving and investment curves intersect each other.
- Also, at point E, ex-ante saving is equal to ex-ante investment.
- The equilibrium level of output corresponding to the equilibrium point E is OY.
- In the above table, planned saving is equal to planned investment; i.e., ₹30 Crores, when the equilibrium level of income is ₹200 Crores.