Determination of Equilibrium level of National Income

Determination of Equilibrium level of National Income

Equilibrium in economics means no tendency to change in a variable. A level of national income is in equilibrium when aggregate expenditure on consumption and investment is equal to aggregate output of consumer and capital goods. Thus, level of nation income is determined by the equilibrium in the goods market. Fig. 39.4 illustrates the determination of national income in a market economy. In this figure a 45º line OZ is drawn which implies that on any point of it the vertical distance is equal to the horizontal distance, which represents Gross National Product (National income).

In Fig. 39.4 the pained aggregate expenditure curve C + I intersect the 45° line at point E. Point E corresponds to the income level OY₀ planned aggregate expenditure (C + I) equals aggregate output. Therefore, E is the equilibrium point and OY is equilibrium level of national income. Now, income cannot be in equilibrium at levels smaller than OY₀.

This is because at any level of aggregate output (national income) smaller than OY₀ planned aggregate demand exceeds aggregate output since C + I curve lies above 45° saw aggregate output. This excess expenditure on consumer and capital goods (C + I) will lead to the decline in inventories of goods with the firms in the economy below their desired levels. This unintended fall in inventories will induce the firms to expand their output of goods and services to meet the extra demand for them and keep their inventories of goods at the desired levels. Thus, at a given level of national income, aggregate expenditure exceeds aggregate output and national income will increase. Because of this employment of labour will also rise to produce more output. This process of expansion in national product under the pressure of excess demand will continue until national income OY₀ is reached.

On the contrary, the level of national income cannot be greater than OY₀, because at any level greater than OY₀, aggregate expenditure or demand falls short of aggregate output. As a result, the firms will not be able to sell the quantity of goods they have produced and will cause the increase in inventories of goods with the firms beyond the desired levels. To this situation of the unintended increase in inventories of goods, the firms will respond by cutting down production to keep their inventories at the desired levels. Thus, deficiency in aggregate demand relative to the aggregate supply of output will lead to the fall in national income and output until the level OY₀ is reached, where planned aggregate expenditure (C +1) is equal to the value of aggregate output OY_0. Thus, OY₀ is the equilibrium level of national income.