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MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME

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Introduction to Economics ­ECO401
VU
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.
96
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Introduction to Economics ­ECO401
VU
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.
97
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: