© 2005 Thomson C hapter 22 Equilibrium National Income.

© 2005 Thomson

CChapter 22hapter 22

Equilibrium Equilibrium National IncomeNational Income

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Aggregate expenditure

The equilibrium level of national income

The relationship between saving and investment

The income multiplier

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Economic PrinciplesEconomic Principles

The relationship between aggregate expenditure and aggregate demand

The paradox of thrift

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Equilibrium National Equilibrium National IncomeIncome

Equilibrium price is determined by the equal contribution of both demand and costs of production. In particular, it is their interaction that determines equilibrium price.

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Similarly, the interaction of aggregate expenditure and aggregate supply contribute to equilibrium national income. In this case, however, aggregate expenditure plays a stronger role than aggregate supply.

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Interaction Between Interaction Between Consumers and Consumers and

ProducersProducersAggregate expenditure

• Spending by consumers on consumption goods, spending by businesses on investment goods, spending by government, and spending by foreigners on net exports.

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ProducersProducersRecall that the amount of consumer income spent on consumption and saving is represented by:

Y = C + S

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ProducersProducersAnd recall that the amount of production goods and investment goods produced by producers is represented by:

Y = C + Ii

where the subscript i indicates intended as distinct from actual.

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ProducersProducersIf, by chance, what producers intend to produce for consumption turns out to be precisely what consumers intend to consume, the match between intended investment and savings is written as:

Ii = S

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ProducersProducersThe I = S equation describes the economy in macroequilibrium. No excess demand or supply exists. Aggregate expenditure equal aggregate supply.

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The Economy Moves The Economy Moves Toward EquilibriumToward Equilibrium

The national economy, if not already in equilibrium, is always moving toward it.

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Equilibrium level of national income

• C + Ii = C + S, where saving equals intended investment.

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Unwanted inventories

• Goods produced for consumption that remain unsold.

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Actual investment (Ia)

• Investment spending that producers actually make – that is, intended investment (investment spending that producers intend to undertake), plus or minus unintended changes in inventories.

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EXHIBIT 1 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $900 BILLION

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Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Producers’ Intentions and

Activities, by Stages, Activities, by Stages, When When YY = $900 Billion = $900 Billion

Suppose the economy is at Y = $900 billion, autonomous consumption = $60 billion, MPC = 0.80 and producers’ intended investment is $100 billion.

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1. What are consumers’ consumption expenditures and savings in Exhibit 1?• If Y = C + S and C = a + bY, then consumption expenditures (C) = $60 billion + 0.8 ($900 billion) = $780 billion.

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1. What are consumers’ consumption expenditures and saving in Exhibit 1?• If S = Y – C, then saving (S) = $900 billion - $780 billion = $120 billion.

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2. What is intended production by producers?

• If C = Y - Ii and Ii = $100 billion, then intended production = $900 billion - $100 billion = $800 billion.

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• Producers’ intended production ($800 billion) - consumers’ consumption expenditures ($780 billion) = $20 billion.

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

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• The $20 billion difference is described as unwanted inventories and must be absorbed as investment.


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3. What is the difference between producers’ intended production and consumers’ consumption expenditures?• Producers’ actual investment ($120 billion) ends up being greater than what they had intended to invest ($100 billion).

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Suppose national income changes to Y = $700 billion, but MPC, autonomous consumption and intended investment all remain the same.

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1. What are consumers’ consumption expenditures? • C = $60 billion + 0.8 ($700 billion) = $620 billion.

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2. What is intended production by producers?

• C = $700 billion - $100 billion = $600 billion.

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• Consumers’ consumption ($620 billion) - producers’ production ($600 billion) = $20 billion.


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• The $20 billion difference must be converted from intended investment to consumption goods to meet demand.


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3. What is the difference between consumers’ consumption expenditures and producers’ intended production? • Actual investment ends up being less than intended investment.

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What is the difference between production and consumers’ expenditures in Exhibit 3?

• Production and consumption are equal at $700 billion. The economy is in equilibrium.

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Aggregate expenditure curve (AE)

• A curve that shows the quantity of aggregate expenditures at different levels of national income or GDP.

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Aggregate expenditure curve (AE)

• The intersection of the 45° income curve and AE identifies the economy’s equilibrium position.

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• When Ii > S, producers hire more workers to replace depleted inventories. Y increases and continues to increase until Ii = S.

• When S > Ii, inventories build up and producers lay off workers. Y decreases until Ii = S.

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EXHIBIT 4A THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

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EXHIBIT 4B THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

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Exhibit 4: The Exhibit 4: The Equilibrium Level of Equilibrium Level of

National IncomeNational IncomeAt a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4.

i. Greater than

ii. Less than

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Exhibit 4: The Exhibit 4: The Equilibrium Level of Equilibrium Level of

National IncomeNational IncomeAt a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4.

i. Greater than

ii. Less than

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Changes in Investment Changes in Investment Change National Change National

Income EquilibriumIncome EquilibriumAs long as the consumption function and the investment demand function remain unchanged, there is no reason to suppose that the level of national income would move away from equilibrium.

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Changes in Investment Changes in Investment Change National Change National

Income EquilibriumIncome EquilibriumFunctions do change, however.

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EXHIBIT 5 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN INVESTMENT INCREASES TO $130 BILLION AND Y = $800 BILLION

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Exhibit 5: Consumers’ and Exhibit 5: Consumers’ and Producers’ Intentions and Producers’ Intentions and Activities, by Stages, when Activities, by Stages, when

Investment Increases to $130 Investment Increases to $130 Billion and Billion and YY = $800 Billion = $800 Billion

• When intended investment increases, the supply of consumption goods decreases to $670 billion.

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

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• Consumers’ consumption expenditures remain at $700 billion. Consumers’ demand is greater than producers’ production.

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

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What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?• In an effort to meet consumers’ demand, producers hire more workers and national income increases. The equilibrium also increases.

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EXHIBIT 6A DERIVING EQUILIBRIUM AT Y = $950 BILLION

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EXHIBIT 6B DERIVING EQUILIBRIUM AT Y = $950 BILLION

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Exhibit 6: Deriving Exhibit 6: Deriving Equilibrium at Equilibrium at YY = $950 = $950

BillionBillionWhat is the equilibrium level of national income when intended investment increases to $130 billion in Exhibit 6?• The equilibrium level increases to $950 billion, where Ii = S.

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Changes in Investment Changes in Investment Change National Income Change National Income

EquilibriumEquilibriumThe formula Y = (a + bY) + Ii can be used to calculate equilibrium national income when specific values for autonomous consumption, MPC and intended investment are known.

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The Income MultiplierThe Income Multiplier

While consumption spending, MPC, and autonomous consumption have all remained relatively stable over time, investment spending has been volatile.

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Economists identify changes in aggregate expenditure, in particular investment spending, as the key to our understanding of why national income changes.

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Income multiplier

• The multiple by which income changes as a result of a change in aggregate expenditure. It is written as:

multiplier = (change in Y)/(change in AE)

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The size of the multiplier depends on the marginal propensity to consume. An initial change in investment sets in motion a chain of events that creates a larger change in national income.

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The Income MultiplierThe Income MultiplierFor example, suppose a business owner decides to invest $1,000 in a new technology. The producer of the technology receives an increase in income of $1,000. If MPC = 0.80, the technology producer’s consumption spending increases by $800.

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The Income MultiplierThe Income MultiplierSuppose the $800 is then spent on a custom-made water bed. The carpenter that makes the water bed receives $800 of additional income. Based on MPC, we know that she will spend $640 and save the rest. The chain of events continues.

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Exhibit 7: The Making Exhibit 7: The Making of the Income of the Income

MultiplierMultiplierThe additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds.

i. Smaller and smaller

ii. Bigger and bigger

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Exhibit 7: The Making Exhibit 7: The Making of the Income of the Income

MultiplierMultiplierThe additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds.

i. Smaller and smaller. For example, in round 2, $800 is added. In round 3, $640 is added.

ii. Bigger and bigger

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The Income MultiplierThe Income MultiplierThe formula to determine the income multiplier is written:

1/(1 - MPC).

Since (1 - MPC) = MPS, the formula can be written:

1/MPS.

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The Income MultiplierThe Income MultiplierFor example, for a $1,000 change in investment, when MPC = 0.80, the income multiplier is:

1/(1 - 0.80) = 1/(0.2) = 5.

A $1,000 investment leads to a $5,000 change in national income.

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Just as increases in aggregate expenditure stimulate the economy, cuts in aggregate expenditure drag it down.

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Changes in the price level shift the AE curve, creating changes in the equilibrium level of national income. As the price level decreases, national income increases.

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Exhibit 8: Converting Exhibit 8: Converting Aggregate Expenditure to Aggregate Expenditure to

Aggregate DemandAggregate DemandWhat happens to the equilibrium national income when the price level decreases from AE100 to AE75?• A decrease in the price level leads to an increase in aggregate expenditures and movement downward along the aggregate demand curve. National income increases from $800 billion to $1,000 billion.

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Exhibit 9: The Multiplier Exhibit 9: The Multiplier Effect in the Effect in the AEAE and and ADAD

Models of Income Models of Income DeterminationDetermination

If aggregate expenditure increases but the price level remains the same, what happens to aggregate demand?

• Aggregate demand increases, which results in an increase in national income.

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The Paradox of ThriftThe Paradox of ThriftSome people believe that putting a higher percentage of their income into saving will provide greater economic security. This is not necessarily the case, however. By trying to save more, people may actually end up saving less, or at least saving no more.

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The Paradox of ThriftThe Paradox of Thrift

The paradox of thrift

• The more people try to save, the more income falls, leaving them with no more and perhaps even less saving.

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The intention to save more causes the saving curve to shift upwards. Saving then becomes greater than intended investment (S > Ii). The equilibrium level of national income falls.

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The Paradox of ThriftThe Paradox of Thrift• If the level of intended investment curve is horizontal, then the level of saving remains unchanged.

• If the intended investment curve is upward sloping, then the level of saving declines.

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Exhibit 10: The Paradox Exhibit 10: The Paradox of Thriftof Thrift

1. What happens to national income and saving when the saving curve shifts from S to S′ in panel a of Exhibit 10? • National income falls from $800 billion to $650 billion. Saving remains unchanged.

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2. What happens to national income and saving in panel b when the saving curve shifts from S to S′? • The equilibrium level of national income falls from $800 billion to $550 billion.

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• Because the intended investment curve is upward sloping, the shift in the saving curve causes a decline in the level of investment as well.

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

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• Saving falls from $100 billion to $75 billion.

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

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Increased saving is not always detrimental to our economic health. If accompanied by increased investment, increased saving is both inevitable and desirable.

© 2005 Thomson C hapter 22 Equilibrium National Income.

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