MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME

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MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..) >>

Introduction to Economics ECO401

UNIT - 10

Lesson 10.1

MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF

EQUILIBRIUM INCOME

MACROECONOMIC EQUILIBRIUM

The circular flow of money in the economy helps illustrate the Classical and Keynesian notions

of macroeconomic equilibrium. The circular flow depicts incomes flowing from firms to

households in return for factor services supplied by households to firms, and subsequently

these household incomes being expended on goods and services supplied by firms to

households.

The Concept of Leakages and Injections:

`A leakage or withdrawal is any use of the income received by households that does not return

as revenue to domestic firms. Savings, taxes and imports are examples of leakages as this

money does not fall as expenditure on goods and firms produced by domestic firms.

Injections are payments to firms not originating from households: government spending, firms'

investment and exports are all examples of injections into the circular flow.

Macroeconomic Equilibrium in Case of Keynesian and Classical Sense:

Macroeconomic equilibrium in a Keynesian sense obtains when total injections equal total

leakages (or total withdrawals), or aggregate supply equals aggregate demand. These are two

equivalent notions of Keynesian equilibrium and can be expressed respectively as:

S + T + M ≡ I + G + X and

AS = Y = AD ≡ C + I + G + (X-M);

where AS is aggregate supply, Y is national income, AD is aggregate demand, C is

consumption, I is investment, G is government spending, X is exports, M is imports, S is

saving and T is taxes.

Macroeconomic equilibrium in a Classical sense refers, by contrast, to joint equilibrium in all

the underlying sectors or markets of the economy. So S must equal I (loan able funds market;

key players are banks and financial markets), G must equal T (fiscal sector; key player is

government) and X = M (external sector, key players are importers and exporters). Any

disequilibrium at the macro level was attributable to disequilibrium in one or more of these

individual markets.

Keynes' major insight was that equilibrium in the individual markets was not a necessary

condition for equilibrium at the macro level. Indeed it was possible for all the individual markets

or sectors to be in disequilibrium but aggregate demand and supply to be equal, and therefore

the overall economy to be in equilibrium. As such, he argued that in the face of

macroeconomic equilibrium (situations like unemployment, high inflation etc.) policy needed to

focus on aggregate demand and aggregate supply rather than individual markets.

MACROECONOMIC VARIABLES

To refresh your memories, aggregate demand is the total planned or desired spending in the

economy during a given period. It is determined by the money supply, aggregate price level,

consumption, domestic investment, government spending and taxes, net exports (i.e. exports

minus imports). Aggregate supply is the total value of goods and services that firms would

willingly produce in a given time period. Aggregate supply is a function of available inputs,

technology and the price level.

Disposable income (Yd) is that part of the total national income (Y) that is available to

households for consumption or saving. So Yd = Y T.

Introduction to Economics ECO401

Consumption and Consumption Function:

Consumption (C) is the amount of national income that is spent on goods and services

produced by domestic firms in a given period of time. Consumption is the most stable and

important component of aggregate demand, accounting for about two-thirds to three-fourths of

GDP in most countries.

The consumption function is a schedule relating total consumption to personal disposable

income. It usually takes the form C = a + bYd = a + b(Y-T), where a is the minimum level of

consumption that must take place even if Yd is zero, and b is the marginal propensity to

consume.

When drawn in expenditure-income space, the consumption function plots as a straight line

with positive intercept, and a positive (but less than 1) slope. The slope is merely the MPC.

The intercept is positive because some consumption must happen even at a zero level of

income (people will borrow and spend on food for e.g.), and the slope is less than 1 because

not all the income is consumed (part of it is saved).

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS):

Marginal propensity to consume (MPC) is the extra amount that people consume when they

receive an extra dollar of disposable income. MPC's numerical value is usually between 0.5

and 1, but can vary considerably across different countries, population age groups, and stages

of a person's life.

Marginal propensity to save (MPS) is the fraction of the additional dollar of disposable income

that is saved. Thus, MPC = 1 MPS. Average propensity to consume (APC) is the ratio of

total consumption to total disposable income. Average propensity to save (APS) is the ratio of

total saving to total disposable income. As before, APC = 1 APS.

The Saving Function:

The saving function yields the amount of saving that households of a nation will undertake at

each level of income. A usual formula is S = c + d(Yd). d is MPS, positive, and usually less

than 0.5.

The relationship between saving and the interest rate is also important. The relationship is

positive, is plotted in i-S space, and implies that household saving increases as the interest

rate goes up, i.e. the incentive to keep one's money in the bank and earn interest thereon

increases as the return on that money increases.

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