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Chapter 22

Equilibrium National Income

Economic Principles

Aggregate expenditure
The equilibrium level of national income
The relationship between saving and investment
The income multiplier

Gottheil - Principles of Economics, 4e

Economic Principles

The relationship between aggregate expenditure and aggregate demand
The paradox of thrift

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.

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.

Interaction Between Consumers and Producers

Aggregate expenditure

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

interaction between consumers and producers1

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

Y = C + S

interaction between consumers and producers2

And 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.

interaction between consumers and producers3

If, 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

interaction between consumers and producers4

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

The Economy Moves Toward Equilibrium

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

Equilibrium level of national income

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

Unwanted inventories

Goods produced for consumption that remain unsold.

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.

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

Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

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

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.

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion2

1. What are consumers’ consumption expenditures and saving in Exhibit 1?

If S = Y – C, then saving (S) = $900 billion - $780 billion = $120 billion.

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion3

2. What is intended production by producers?

If C = Y - Iiand Ii= $100 billion, thenintended production= $900 billion - $100 billion = $800 billion.

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion4

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

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

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion5

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

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion6

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).

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion

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

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion1

1. What are consumers’ consumption expenditures?

C = $60 billion + 0.8 ($700 billion) = $620 billion.

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion2

2. What is intended production by producers?

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

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion3

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

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion4

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

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion5

Actual investment ends up being less than intended investment.

exhibit 3 consumers and producers intentions and activities by stages when y 800 billion

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.

Aggregate expenditure curve (AE)

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

Aggregate expenditure curve (AE)

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

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.

EXHIBIT 4A THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

EXHIBIT 4B THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

Exhibit 4: The Equilibrium Level of National Income

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

i. Greater than

ii. Less than

Exhibit 4: The Equilibrium Level of National Income

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

i. Greater than

ii. Less than

Changes in Investment Change National Income Equilibrium

As 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.

Functions do change, however.

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

Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion

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

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

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

In an effort to meet consumers’ demand, producers hire more workers and national income increases. The equilibrium also increases.

EXHIBIT 6A DERIVING EQUILIBRIUM AT Y = $950 BILLION

EXHIBIT 6B DERIVING EQUILIBRIUM AT Y = $950 BILLION

Exhibit 6: Deriving Equilibrium at Y = $950 Billion

What 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.

changes in investment change national income equilibrium2

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

The Income Multiplier

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

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

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)

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.

For 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.

Suppose 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.

EXHIBIT 7 THE MAKING OF THE INCOME MULTIPLIER

Exhibit 7: The Making of the Income Multiplier

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

i. Smaller and smaller

ii. Bigger and bigger

Exhibit 7: The Making of the Income Multiplier

The 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

The formula to determine the income multiplier is written:

1/(1 - MPC).

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

1/MPS.

For 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.

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

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.

EXHIBIT 8 CONVERTING AGGREGATE EXPENDITURE TO AGGREGATE DEMAND

Exhibit 8: Converting Aggregate Expenditure to Aggregate Demand

What happens to the equilibrium national income when the price level decreases from AE100to 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.

EXHIBIT 9 THE MULTIPLIER EFFECT IN THE AE AND AD MODELS OF INCOME DETERMINATION

Exhibit 9: The Multiplier Effect in the AE and AD Models of Income Determination

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.

The Paradox of Thrift

Some 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.

The paradox of thrift

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

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.

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.

EXHIBIT 10 THE PARADOX OF THRIFT

Exhibit 10: The Paradox of 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.

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.

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

Saving falls from $100 billion to $75 billion.

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

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