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

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

Introduction to Economics ECO401

Lesson 10.2

MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF

EQUILIBRIUM INCOME (CONTINUED...........)

Investment and Investment Demand Curve:

Investment (I) or gross capital formation is any economic activity (usually undertaken by firms)

that forgoes consumption today with an eye to increase output in future. Investment is by far

the most volatile component of aggregate demand.

The investment demand curve shows the relationship between the level of investment and the

cost of borrowing for the firm (i.e. the interest rate), plotted in i-I space. The cost of borrowing

is important because most investments are financed using borrowed resources (e.g. loans

from banks). The relationship between the interest rate on such borrowing and investment

demand is obviously negative, i.e. as the interest rate goes up, investment demand decreases.

Types of Investment:

Investment can be of various types: residential and non-residential construction, purchases of

producer durables (i.e., capital equipment, machinery etc.) and buildup of business

inventories. While all these different types are affected t some extent by the interest rate, there

are other important determinants as well.

i. Residential construction depends upon the number of willing house-buying

households, their wealth and indebtedness levels, their ability to obtain a house-

building loan from financial institutions and the cost of housing units.

ii. Non-residential construction depends upon the willingness and ability of firms to

buy commercial property, the vacancy rate of existing units, the needs of

business units for additional commercial space, and firms' ability to meet

increased rental costs which are directly linked to their current and expected

costs and sales.

iii. The demand for producers' durable purchases depends on utilization of existing

productive capacity, the availability of advanced (more efficient) technology,

current and expected sales and existing and future competition.

iv. Changes in business inventories depend on current and expected sales, current

and expected inventory prices, and certainty of inventory deliveries.

Imports, Exports and Trade Balance:

Imports are goods and services that are produced in another country and consumed in the

home country. Thus a refrigerator produced in Korea brought into Pakistan to be sold here

locally would characterize as an import.

Exports are goods and services that are produced in the home country and consumed in

another country. Thus a communications satellite produced in Pakistan but sold to neighboring

Iran would categories as a Pakistani export.

A country's imports are related to its level of income, exchange rate, domestic prices relative

to prices in foreign countries, import tariffs (taxes and customs duties levied on imported

goods), and quantitative restrictions (quotas) on imported goods. Imports are influenced by the

same variables except that they are affected by foreign, not home, country income levels.

Trade balance is the excess of exports over imports. A negative trade balance is called a trade

deficit. Because the determinants of a country's exports and imports change with time, it is

reasonable to expect a country's trade balance to change over time.

Fiscal policy:

Fiscal Policy is a government program with respect to i) expenditure (G): the purchase of

goods and services and spending in the form of subsidies, unemployment benefits etc. and ii)

tax revenue (T): the amount and type of taxes.

T-G is referred to as the fiscal balance. If G>T, there is a fiscal or budget deficit; if G<T, there

is a fiscal or budget surplus. If G=T, there is a balanced budget.

Introduction to Economics ECO401

DETERMINATION OF NATIONAL INCOME

The 450 Line and Equilibrium:

The 450 line drawn in Y-X space has the feature that at any point on the line, the horizontal

and the vertical distances are the same. Thus, if the units used to measure X and Y are the

same (i.e. same scales), the values of the two variables at any point along the line are equal.

The 450 line drawn in expenditure-income (or AD-Y) space captures macroeconomic

equilibrium in the economy (recall, macroeconomic equilibrium obtains when AS = AD = Y). At

all points along this line, expenditure and income are equal.

Superimposing the aggregate demand (AD) line or expenditure function on the 450 line

diagram helps get the level at which a particular economy's equilibrium is struck; i.e. the point

at which the AD line intersects the 450 line.

The AD or expenditure function is given by AD = C + I + G + (X-M). We saw earlier that the

C function was upward sloping with positive intercept but slope between 0 and 1 (i.e. less

steep than the 450 line). Adding the I, G and X-M functions to the C function simply involves

moving the C line vertically upwards (parallel shift). So C+I will be higher than C by the amount

of I; C+I+G will be higher than C+I by the amount of G; and C+I+G + (X-M) will be higher or

lower than C+I+G depending on whether the country is running a trade surplus or deficit,

respectively.

Starting from a certain equilibrium level, any increase in G, I and (X-M) will cause a multiplied

increase in income. Thus depending on the slope of the AD line, it is possible for a $10mn

increase in G (shown by an upward vertical shift of the AD line) to lead to a $50mn increase in

equilibrium income and expenditure.

In the above example, if the economy had started from the full-employment equilibrium, then

the $10mn increase in G would lead to an inflationary gap. An inflationary gap refers to a

situation where there is pressure on prices to rise. The size of the inflationary gap is $10mn,

i.e. the amount by which the C+I+G+NX line must shift down to bring equilibrium income back

to the full employment level. Likewise, a deflationary gap could result if, starting from the full

employment level, there was a reduction in G.

Algebraic determination of equilibrium:

Algebraic determination of equilibrium can be done by inserting the plugging the consumption

function in place of C in the equation

AD = C + I + G + (X-M)

In the absence of taxes, a consumption function simply collapses to C = a + bY.

In equilibrium,

Y = AD

Therefore,

Y* = a + bY* + G + I + (X-M)

This leads to:

Y* = [1/(1-b)] . ["a" + I + G + X-M]

a is the autonomous part of consumption, i.e. the level of consumption that is independent of

income.

Equilibrium analysis can also be done using the injections-leakages approach, i.e. by

identifying the point where the upward sloping leakage function (S+M+T) intersects the

horizontal injections line (I+G+X).

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