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Algebraic Analysis: Determination of Equilibrium Level of
National Income!
A study of how the level of national income is determined will become
more clear by using simple mathematics.The level of national income
is in equilibrium at which aggregate demand equals aggregate supply
of output.
In a simple model of income determination in which we do not
consider the impact of Government expenditure and taxation and also
exports and imports, the national income is the sum of consumption
demand (C) and investment demand (I), that is,
Y= C + I
where Y stands for the level of national income.
Suppose the consumption function is of the following form:
C= a + bY
a is the intercept term in the consumption function and therefore
represents the autonomous consumption expenditure which does not
very with income, b is a constant which represents the marginal
propensity to consume (mpc C/Y)- Thus total consumption
demand is equal to the sum of autonomous consumption expenditure
(a) and the induced consumption expenditure (bY).
Now suppose that investment demand equals Ia. This investment Ia is
autonomous because this does not depend on income. Thus, we get the
I = 600
Putting the values of C and I in the equilibrium (i) we have
Y = 200 + 0.8Y + 600
(Y 0.8Y) = 200 + 600
Y (1 0.8) = 800
Y = 800/0.2 = 800/2/10= Rs. 4000
Problem 2:
Suppose the consumption function of an economy is C = 0.8 Y.
Planned investment by entrepreneurs for a year is Rs. 500 crores. Find
out what will be the equilibrium level of income.
Solution:
Y= C + I
C = 0.8Y
I = Rs. 500 crores
Substituting the values of C and I in (i) we have
Y = 0.8Y + 500
Y 0.8Y = 500
Y (1 0.8) = 500
0.2 = 500
y = 500 x 10/2 = Rs. 2500 crores.
Problem 3:
Suppose the consumption of an economy is given by
C = 20 + 0.6Y
The following investment function is given:
I = 10 + 02 Y
What will be the equilibrium level of national income?
Solution:
Note that in this problem, investment varies with income. However,
this wills not hang our method of determining equilibrium level of
income.
Y=C+I
C = 20 + 0.6Y
I = 10 + 0.2Y
Substituting the values of C and I in (i) we have
Y = 20 + 0.6Y + 10 + 0.2Y
Y = 30 + 0.8Y
Y 0.8Y = 30
Y (1 0.8Y) = 30
0.2Y = 30
Y = 30 x 10/2 = 150
Thus, we find that the equilibrium level of income to be equal to 150.
How to Overcome Recession: Shifting Aggregate
Expenditure Curve Upward:
Now, an important question is what measures can be adopted to
overcome recession or involuntary unemployment which comes into