EQUILIBRIUM LEVEL

According to Keynes Theory, an economy is in equilibrium when aggregate demand of goods and services is equal to aggregate supply during a period of time.

Equilibrium is achieved when,

AD=AS (1)

Since,

AD= C + I   

AS = C + S

: C + I = C + S

  Or S = I

The two approaches for equilibrium are-

1. AD-AS approach.

2. S-I approach

Before proceeding, we will make the following assumption for better understanding:-

Only two-sector exists in an economy (households and firms). There is no government & foreign sector.

It is assumed that Investment is autonomous i.e. it is not influenced by the level of income.

Price level is assumed to be constant.

Equilibrium output is to be determined in the context of short-run.

AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH (AD-AS Approach)

According to Keynesian Theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C+I curve is equal to the total output (Aggregate Supply or AS).

Aggregate Demand Comprises of Two components:-

Consumption Expenditure (C):- It varies directly with the level of income i.e. consumption rises with the increase in income.

Investment Expenditure (I):- It is assumed to be independent of the level of income i.e. investment expenditure is autonomous.

Aggregate Supply is the total output of goods and services of the national income, since income is either consumed or saved, the AS curve is represented by the (C+S) curve.

Equilibrium by AD and AS approach

Observation from the above Schedule and Diagram

Investment Curve -(I) is parallel to X-axis as it is autonomous and does not depends upon the level of income whereas saving curve(S) is upward sloping as saving increase with rising in Income. The Economy would be in equilibrium at point E where saving and investment intersect each other. At this level planned savings are equal to planned investments.

When savings are more than Investments -If planned savings are more than planned investment, i.e. after point E, a household is not consuming as much as firms expected them to as a result, the inventory would rise above the desired level.

When savings are less than investments- If planned savings are less than Investments, i.e. before point E, a household is consuming more, and savings less than what firms expected them to as a result planned inventory would fall below the desired level.

The economy is in equilibrium at point E where AD=AS.

E is the equilibrium point because, at this point, the level of the desired spending on consumption and investment exactly equals the level of total output.

OY is the equilibrium level of output corresponding to point E.

The equilibrium level of income is rupees 400 crores, where AD=AS

It is a situation of effective demand. Effective demand refers to that level of AD, which become effective because it is equal to AS.

When AD is more than AS

When planned spending is more than planned output (AS) it means that people are ready to spend more and firms are willing to produce less as a result planned inventory would fall below the desired level.

When AD is less than AS

When planned to spend a less than planned output it means that people are not ready to spend more and firms are willing to produce more as a result planned inventory would rise above the desired level.

SAVING – INVESTMENT APPROACH (S-I Approach)

According to S-I approach equilibrium level is determined at a point where planned savings are equal to planned Investments.

Schedule & Diagram:

https://i.pinimg.com/originals/6b/98/9e/6b989e366a39c7adc443d2085ed377ac.png

Investment Curve is parallel to the x-axis as it is autonomous and does not depends upon the level of income. Whereas the saving curve is upward sloping as savings increases with rising in income .the economy would. Be in equilibrium at point E where saving and investment intersect each other. At this level, planned savings are equal to planned investment.

When savings are more than investment

If planned savings are more than planned investment that is after. Point E houses are not consuming as much as firms expected them to. As a result, the inventory would rise above the desired level.

When savings are less than Investments.

If plant savings are less than investment before Point E households are consuming more and saving less than what firms expected them to. As a result, planned inventory would fall below the desired level.

Equilibrium Level

According to the classical economics equilibrium level of income is attained always at full employment level i.e. there is the absence of involuntary unemployment. However, as per the Keynesian Theory of Equilibrium level can be achieved at-

1. Full Employment Level or

2. Under Employment Level i.e. less than full employment level or

3. Over Employment Level i.e. more than full employment level.

Full Employment Equilibrium

It refers to a situation when equality between AD and AS takes place at the full employment level of income.

In the given figure, Full Employment equilibrium is achieved at Point ‘E’ where EM is equal to OM. At this particular point, there is no involuntary unemployment i.e. those who are willing and able to work are getting it at a prevailing wage rate.

Under Employment Equilibrium

It refers to a situation when aggregate demand is equal to aggregate supply beyond the full employment level.

https://www.zigya.com/application/zrc/images/qvar/ECEN12051387.png

Here, AD = AS at Point E1 which is lower than full employment level. As OM1 is less than OM, Point ‘E1’ signifies the underemployment equilibrium.

Over full Employment Equilibrium

It refers to a situation when the equilibrium between AD & AS takes place at more than full Employment Level.

Here, AD, = AS at point E1 which is higher than the full employment level. Point E1 signifies the over full-employment equilibrium.