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Determination of Equilibrium Level of Income!
According to the Keynesian Theory, equilibrium condition is generally stated in terms of aggregate demand (AD) and aggregate supply (AS). An economy is in equilibrium when aggregate demand for goods and services is equal to aggregate supply during a period of time.
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So, equilibrium is achieved when:
AD = AS … (1)
We know, AD is the sum total of Consumption (C) and Investment (I):
AD = C + I … (2)
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Also, AS is the sum total of consumption (C) and saving (S):
AS = C + S … (3)
Substituting (2) and (3) in (1), we get:
C + S = C + I
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Or, S = I
It means, according to Keynes, there are Two Approaches for determining the equilibrium level of income and employment in the economy:
It must be noted that Equilibrium level of income and employment can also be determined according to ‘Classical Theory’. However, the scope of syllabus is limited to the Keynesian theory.
Two Approaches for Determination of Equilibrium Level:
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The two approaches to determine equilibrium level of income, output and employment in the economy are:
1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)
2. Saving-Investment Approach (S-I Approach)
It must be kept in mind that AD, AS, Saving and Investment are all planned or ex- ante variables.
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Assumptions:
Before we proceed further, let us first state the various assumptions made in determination of equilibrium output:
(i) The determination of equilibrium output is to be studied in the context of two-sector model (households and firms). It means, it is assumed that there is no government and foreign sector.
(ii) It is assumed that investment expenditure is autonomous, i.e. investments are not influenced by level of income.
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(iii) Price level is assumed to remain constant.
(iv) Equilibrium output is to be determined in context of short-run.
Aggregate Demand-Aggregate Supply Approach (AD-AS Approach):
According to the Keynesian theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C + I curve is equal to the total output (Aggregate Supply or AS).
Aggregate demand comprises of two components:
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1. Consumption expenditure CC):
It varies directly with the level of income, i.e. consumption rises with increase in income.
2. Investment expenditure (I):
It is assumed to be independent of the level of income, i.e. investment expenditure is autonomous. So, AD curve is represented by (C + I) curve in the income determination analysis. Aggregate supply is the total output of goods and services of the national income. It is depicted by a 45° line. Since the income received is either consumed or saved, the
AS curve is represented by the (C + S) curve.
The determination of equilibrium level of income can be better understood with the help of the following schedule and diagram: