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

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Introduction to Economics ­ECO401
VU
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.
98
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Introduction to Economics ­ECO401
VU
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).
99
Table of Contents:
  1. INTRODUCTION TO ECONOMICS:Economic Systems
  2. INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost
  3. DEMAND, SUPPLY AND EQUILIBRIUM:Goods Market and Factors Market
  4. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..)
  5. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..):Equilibrium
  6. ELASTICITIES:Price Elasticity of Demand, Point Elasticity, Arc Elasticity
  7. ELASTICITIES (CONTINUED………….):Total revenue and Elasticity
  8. ELASTICITIES (CONTINUED………….):Short Run and Long Run, Incidence of Taxation
  9. BACKGROUND TO DEMAND/CONSUMPTION:CONSUMER BEHAVIOR
  10. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)
  11. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)The Indifference Curve Approach
  12. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….):Normal Goods and Giffen Good
  13. BACKGROUND TO SUPPLY/COSTS:PRODUCTIVE THEORY
  14. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):The Scale of Production
  15. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):Isoquant
  16. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS
  17. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):REVENUES
  18. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):PROFIT MAXIMISATION
  19. MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency
  20. MARKET STRUCTURES (CONTINUED………..):MONOPOLY
  21. MARKET STRUCTURES (CONTINUED………..):PRICE DISCRIMINATION
  22. MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY
  23. SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS
  24. SELECTED ISSUES IN MICROECONOMICS (CONTINUED……………)
  25. INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:
  26. INTRODUCTION TO MACROECONOMICS (CONTINUED………..)
  27. INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School
  28. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME
  29. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME (CONTINUED……………..)
  30. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME
  31. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..)
  32. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..):The Accelerator
  33. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS
  34. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)
  35. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation
  36. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS
  37. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):GROWTH
  38. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land
  39. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Growth-inflation
  40. FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget
  41. MONEY, CENTRAL BANKING AND MONETARY POLICY
  42. MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED…….)
  43. JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK
  44. AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE
  45. PROBLEMS OF LOWER INCOME COUNTRIES:Poverty trap theories: