Remember that these two approaches are alternative to each other. A study of how the level of national income is determined will become more clear by using simple mathematics.The level of national income is in equilibrium at which aggregate demand equals aggregate supply of output. This will act as an incentive to cut back output. Most simply, the formula for the equilibrium level of income is when aggregate supply (AS) is equal to aggregate demand (AD), where AS = AD. This too has a limitation because benefit of this cut in excise duty may not be fully passed on to the consumers by reducing prices. In a simple model of income determina­tion in which we do not consider the impact of Government expenditure and taxation and also exports and imports, the national income is the sum of consumption demand (C) and investment demand (I), that is. However, in a two-sector model where we do not incorporate taxation by the government, Yd = Y. In order to increase national income through upward shift in the consumption function, the Government can reduce personal income taxes. 60. This investment Ia is autonomous because this does not depend on income. 12 crore. The definitional equality of S and I does not imply that they are not necessarily in equilibrium. ... if taxes are reduced by 100, then planned expenditures _____ for any given level of income. Privacy Policy 8. Thus, the Keynesian theory of shifting equilibrium shows the S and I equality at varying levels of income. Thus, if saving exceeds investment (that is to say, when investment decreases), saving remaining constant (because the saving schedule is a stable function of income), income will fall and, therefore, saving will also contract. Assuming 1=1, the equilibrium condition becomes, From the consumption function C = 5 + 0.8Y we find the values of a and (1 – b). Aggregate demand must exceed aggregate output. We explain the derivation of LM curve in two steps. In the Keynesian two-sector economy there are only household and business sectors. Share Your PDF File But the fall in the rate of interest will affect the volume of saving adversely. Content Filtrations 6. With a given level of income, a higher rate of interest reduces investment demand and a lower rate of interest leads to more investment, that is, investment is negatively related to rate of interest. In Fig. Hence, through expansion in investment and contraction in saving, ultimately, equality between saving and investment will be brought about. This approach is, thus, known as income-expenditure approach or aggregate demand-supply approach. Let us derive IS equation incorporating proportionate income tax and lump sum transfer payments. The slope of the consumption line CC’ is the MPC whose value must always be less than unity. Now, if level of income is Rs. Share Your Word File Thus, at income of Rs. I1 is the new investment schedule indicating a shift in the I-function due to the forces of certain dynamic factors. He rejected the classical postulate of the rate of interest being a strategic or equilibrating variable in bringing about the equality between investments and saving at full employment level. But, it is a stable phenomenon and, therefore, usually, there cannot be a shift in its curve. He defined saving as the excess of income over consumption. The first two equations (g and i) are true by definition. In money terms, therefore, current investment is equal to the value of that part of current output which is not consumed. Equality between saving and investment is regarded as an essential condition of equilibrium level of income, output and employment by Keynes as well as classical economists. Y = Rs. Thus, we get the following three equations for the determination of the equilibrium level of national income. This happened in the United States in the year 2008. Give the economic interpretation of the LM curve. Thus, aggregate demand (C + I) equals aggregate expenditure (C + I). In terms of a diagram, when saving line and investment line intersect each other, equilibrium level of income is determined. Thus, given the real money balances (M/P), we can obtain a rate of interest for different values of income. Equilibrium income determined (OYE) is definitely less than full employment income (OYF). Disclaimer Copyright, Share Your Knowledge It reveals no casual relations. It is worth noting that in their demand for money people care more about the purchasing power of money, that is, people’s demand is for real money balances rather than nominal money balances. Further, it also follows that equilibrium level of income is higher, the greater the marginal propensity to consume (i.e. Thus, it has been a tool of static analysis. We can identify this equilibrium using algebra as well as graphically. In Fig. By substituting the value of Y as С + I, we get. Find the equilibrium income, saving and consumption. Now suppose that investment demand equals Ia. 100 crore the increase in income will be: Illustrations of Equilibrium Level of Income with Numerical Examples: A few numerical examples will make it clear how the equilibrium level of national income is determined. More realistically, it is usually at less than full employment level. First, since in equation (7) for LM curve, the coefficient (k) of income (Y) is positive, LM curve will slope upward. His equation of S = I is analogous to that of the supply and demand equation (S=D) in ordinary markets. To demonstrate this, investment line 1 has been drawn parallel to the horizontal axis. In this context, Prof. Kurihara rightly points out that the economic significance of this accounting equality of S and I lies in the fact that it shows the condition that must be satisfied in order to reach the equilibrium level of income, that is, a condition characterised by the quality of planned S and I as against equal or realised S and I. 10.4 that this process of reduction of the level of income will continue till the new saving is equal to investment at the lower level of income Y 2 (Rs.200 crores), that is, the level of income has declined by Rs. Before publishing your Articles on this site, please read the following pages: 1. In his concept of functional equality of saving and investment, savers and investors react to income variations in such a way that their desire to save and to invest is expected to be harmonised in the very process of these reactions. This is done in Figure 20.18. Diagrammatically, this means that the C + I line must cut the 45° line from above. Moreover, the classical economists visualised equality between saving and investment at a point of full employment only. The so-called accounting equality between saving and investment is almost meaningless when it is not related to equilibrium. Now in 2009 president Obama has planned to give a fiscal stimulus of over \$ 800 billion the major part of which is the increase in Government expenditure to raise aggregate demand to overcome recession in the Ameri­can Economy. If demand for money is not much sensitive to level of income, then k will be small. If marginal propensity to consume is equal to 0.8, with the increase in investment by Rs. 500 crores. (ii) Alternative Method: Saving-Investment Approach: Absolute, Relative and Permanent Income Hypothesis (With Diagram), Public Sector Enterprises or Undertakings in India. Hence, an excess supply of commodities will appear leading to an unplanned accumulation of inventories. Lastly, the expansion in positive net exports (NX) will also cause an increase in equilibrium level of national income and employment. Firms will now be forced to cut back production. First, we show how money demand depends on interest rate and level of income. Content Filtrations 6. It stresses that the equilibrium level of income is realised where saving out of income is just equal to the actual amount of investment. Given algebraic equations for the aggregate expenditure line and the income=expenditure line, the point where they cross can be readily calculated. Thus. Further, whereas transfer payments are assumed as lump sum amount, tax can be lump sum tax or levied as proportion of income. %PDF-1.2 %���� Prohibited Content 3. To have stability, the value of MPS must be positive but less than one. But Keynes’ modern economic analysis also conceived the “functional” equality of saving and investment which emphasises the behaviour of the economy as a whole, and thus, saving and investment concepts become dynamic. The equilibrium in the money market is established where demand for real money balances equals supply of real money balances and is given by. This means that you will need to do some research into the country's overall economy. Putting the values of C and I, we obtain, Here, Y is the equilibrium level of income. And he stressed the point that income is the functional variable that brings about equality between saving and investment.