Chapter 8: Short Run Equilibrium output

Concept of Short run

In macroeconomics and according to Keynes, short run is defined as a period of time during which
‘technology’ plays no role in the determination of output in the economy. It is assumed to remain
constant. Output is determined exclusively by the level of employment in the economy. Higher level of
employment leads to higher level of output, and vice-versa. If employment is doubled, output will also
be doubled. Thus the level of employment in the economy measure the level of output or GDP in the
economy. Accordingly, output cannot increase once there is full employment in the economy.

Three basic assumptions of Keynesian theory:

 Short period analysis

 Two sector closed economy
 AS is perfectly elastic- it means we are studying an economy in which there is an excess
production capacity or there is unemployment of resources. So whenever there is a rise in AD
there is corresponding rise to AS (as excess capacity begins to be utilized).

Two approaches for determination of equilibrium level of output, income and employment are

1. Aggregate demand – Aggregate supply approach

2. Saving – Investment approach

Aggregate demand (AD) – Aggregate supply (AS) approach:

According to the Keynesian theory the equilibrium level of income in an economy is determined when
planned AD is equal to the planned AS.

AD comprises of two components. They are

a) Household Consumption Expenditure (C): It varies directly with the level of income i.e.
consumption rises with the rise in income.
b) Investment expenditure (I): It is assumed to be independent of the level of income i.e.
investment expenditure is autonomous.

So, AD curve is represented by C+I Curve in the income determination.

AS is the money value of all the goods and services produced in a country or national income. It is
represented by a 45 degree line. Since income received is either consumed or saved, the AS curve is
represented by the C+S curve. The determination of equilibrium level of income can be explained with
the help of the following table.
The following table is based on two assumption:

1. C = 50 + 0.5Y; here C̅ = 50 and MPC = 0.5

2. Planned level of investment = ₹ 100 crores ( Autonomous)

Income (Y) Consumption(C) Saving(S) Investment(I) AD = C+I AS = C+S

0 50 ─ 50 100 150 > 0
100 100 0 100 200 > 100
200 150 50 100 250 > 200
300 200 100 100 300 = 300
400 250 150 100 350 < 400
500 300 200 100 400 < 500

In the above table ₹ 300 crores is the equilibrium level of income at which planned AD = planned AS = ₹
300 crores. Any income which is less than ₹ 300 crores, planned AD is more than planned AS. Therefore,
an economy should produce further till it reaches equilibrium. At any income which is higher than ₹ 300
crores, planned AD is less than planned AS. Therefore, an economy should reduce its production till it
reaches equilibrium.

AS = C + S

AD
& AD = C + Y
AS
E

X
O Y
Income/output/employment
In the figure, AD curve shows the desired level of expenditure by consumers and producers
corresponding to each level of income. The economy is in equilibrium at point E, where AD curve
intersects the 45 degree AS line. E is the equilibrium point because at this point the level of desired
spending on consumption and investment exactly equals the level of total output. OY is the equilibrium
level of income/ output/ employment corresponding to point E.

What happens if AS > AD?

When AS is more than AD (AS > AD), supply of goods and services in the economy tends to exceed their
demand. AS a result some of the goods would remain unsold. To clear the unwanted stocks, the
producers would plan a cut in production. Consequently, AS would reduce to become equal to AD. This
is how AS adjust itself to AD. Briefly, equilibrium is restored through a change output or change in
income.

What happens if AS < AD?

When AS is less than AD (AS < AD), supply of goods and services in the economy tends to be less than
their demand. The existing stocks of the producers would be sold out and the producers would suffer
the loss of unfulfilled demand. To rebuild the desired stocks and avoid the loss of unfulfilled demand,
the producers would plan greater production. AS would increase to become equal to AD. This is how AS
converges with AD. Thus equilibrium is restored through a change in output or a change in income.

Saving (S) – Investment (I) approach

According to this approach, equilibrium level of income is determined at a level when planned saving is
equal to planned investment.

Since, AD = C + I and AS = C + S

Therefore, if AD = AS

Or, C + I = C + S

Or, I=S

The determination of equilibrium level of income can be explained with the help of following table and
figure. The following table is based on two assumption:

1. C = 50 + 0.5Y; here C̅ = 50 and MPC = 0.5

2. Planned level of investment = ₹ 100 crores ( Autonomous)

Income (Y) Consumption(C) Saving(S) Investment(I)

0 50 ─ 50 < 100
100 100 0 < 100
200 150 50 < 100
300 200 100 = 100
400 250 150 > 100
500 300 200 > 100
In the table, ₹ 300 crores is the equilibrium level of income determined. At this level of income, planned
saving = planned investment = ₹ 100 crores. At any income lower than ₹ 300 crores, planned saving is
less than planned investment. Therefore, an economy needs to produce further till it reaches
equilibrium. At any income higher than ₹ 300 crores, planned saving is more than planned investment.
Therefore, an economy should reduce production till it reaches equilibrium.

S
Saving &
investment
E
I
I

0 X
Y
Income/output/employment

In the figure, investment curve II is parallel to the X-axis because of the autonomous character of
investment. The saving curve SS slopes upwards showing that as income increases saving also increases.
The economy is in equilibrium at point E where saving and investment curves intersect each other. At
point E, Planned saving is equal to planned investment. OY is the equilibrium level of income
corresponding to point E.

What happens when S > I?

In case S > I, it implies a situation when a fall in expenditure through saving is more than the rise in
expenditure through investment. Accordingly, aggregate expenditure in the economy would be less than
what is required to buy the planned output. Some output would remain unsold and the producers will
have undesired stocks. To clear the stocks, the producer would now plan lesser output. Lesser output
mean lesser income. Lesser income mean lesser saving. The process would continue until S = I. Thus, the
equality between saving and investment is restored through change in the level of income.

What happens when S < I?

In case S < I, it implies a situation when a fall in expenditure through saving is less than the rise in
expenditure through investment. Accordingly, aggregate expenditure in the economy would be greater
than what is required to buy the planned output. It is a situation of higher AD than AS. The producer
would suffer the loss of unfulfilled demand. This will prompt the producer to produce higher output.
Higher output mean higher income and higher income mean higher saving. The process would continue
until S = I. Here, again the equality between saving and investment is restored through a change in the
level of income.

Numerical on AD – AS and saving – investment approach

Q.3. Calculate investment expenditure from the following data about an economy which is in
equilibrium.

National income = 1000

Marginal propensity to save = 0.25

Autonomous consumption expenditure = 200

Soln :

Given, Y = 1000

C̅ = 200

MPS (1─b) = 0.25, therefore, MPC = 1 ─ MPS= 1 ─ 0.25= 0.75

In equilibrium condition, AS = AD

Or, Y = C + I

Or, Y = C̅ + bY + I

Or, 1000 = 200 + 0.75 X 1000 + I

Or, 1000 = 200 + 750 + I

Or, I = 1000 ─ 950 = 50

Alternative method,

In equilibrium condition, S = I

Or, ─ C̅ + (1─b) Y = I

Or, ─ 200 + 0.25 X 1000 = I

Or, ─ 200 + 250 = I

Or, I = 50
Q. 4. Calculate autonomous consumption expenditure from the following data about an economy which
is in equilibrium.

National income = 1200

Marginal propensity to save = 0.20

Investment expenditure = 100

Soln:

Given, Y = 1200

I = 100

MPS (1─b) = 0.20, therefore, MPC = 1 ─ MPS= 1 ─ 0.20= 0.80

In equilibrium condition, AS = AD

Or, Y = C + I

Or, 1200 = C̅ + bY + I

Or, 1200 = C̅ + 0.80 X1200 + 100

Or, 1200 = C̅ + 960 + 100

Or, C̅ =1200 ─1060

Or, C̅ =140

Alternative method:

In equilibrium condition, S = I

Or, ─ C̅ + (1─b)Y = I

Or, ─ C̅ + 0.20X 1200 = 100

Or, ─ C̅ = 100 ─ 240

Or, ─ C̅ = ─ 140

Or, C̅ = 140

Q.5 Calculate MPC from the following data about an economy which is in equilibrium.

National income = 1500

Autonomous consumption expenditure = 300

Investment expenditure = 300

Solution:

Given, Y = 1500

C̅ = 300

I = 300

MPC (b) =?

In equilibrium condition, AS = AD

Or, Y = C + I

Or, Y = C̅ + bY + I

Or, 1500 = 300 + b.1500 + 300

Or, 1500 = 600 + 1500b

Or, 1500b =900

Or, b = 900/1500 = 0.6

Investment Multiplier/ Output Multiplier (K)

Investment multiplier refers to the number of times by which the increase in income or output (∆ Y)
exceeds the increase in investment (∆ I). It is measured as the ratio between change in income and
change in investment.
ΔY
K=
ΔI
Here, K = Investment multiplier

∆ Y = change in income

∆ I = change in investment

If investment increases by ₹ 15 crores and as a result income increases by ₹ 60 crores, then multiplier
ΔY 60
K= = =4
ΔI 15
Relationship between multiplier and MPC
There is a direct relationship between multiplier and MPC. Higher the value of MPC, higher the
multiplier and vice-versa. It is expressed as
1 1
K= =
1 ─ MPC MPS
Multiplier Mechanism (Working of a multiplier)
The working of a multiplier is based on the fact that one person’s expenditure is another person’s
income.

Let us suppose an additional investment of ₹ 100 crores (∆ I) is made to construct a flyover. This extra
investment will generate an extra income of ₹ 100 crores in the round 1.

Round Increase in Change in income Induced change in Leakage or saving

investment (∆I) (∆Y) consumption (∆C)
MPC = 0.5
1 100 100 50 50
2 ̶ 50 25 25
3 ̶ 25 12.5 12.5
. . . . .
. . . . .
. . . . .

Total 100 200 100 100

If MPC is assumed to be 0.5, recipients of the additional income will spend 50% of ₹ 100 i.e. ₹ 50 crores
on consumption and the remaining ₹ 50 crores will be saved. It will increase the income by ₹ 50 crores in
round 2 as one person’s expenditure is another one’s income in the economy.

In the next round 50% of the additional income of ₹ 50 crores i.e. ₹ 25 crores will be spent on
consumption and the remaining amount will be saved.

In round 3 there will be an increase in income by ₹ 25 crores and ₹ 25 crores would be split into ∆C =
12.5 crores and ∆S = 12.5 crores.

In different time periods, income will go on increasing as a result of increase in consumption

expenditure. Thus, an initial investment of ₹ 100 crores leads to a total increase of ₹ 200 crores in the
ΔY 200
income as a result of multiplier K = = = 2.
ΔI 100

K = 1/ 1 ̶ MPC

= 1/ 1 ̶ 0.5

=2

K = ∆Y/ ∆I

Or, 2 = ∆Y/100

Or, ∆Y =200
Diagrammatic explanation
Y

AD = AS = Y
Aggregate
demand AD1 = C + I + ∆ I

E1
AD = C + I

E
J

X
0 Y Y1
Income/output

In the figure, income is measured on the X-axis and AD on the Y-axis. Let us suppose the initial
equilibrium is determined at point E Where AD curve intersects the AS curve. The equilibrium level of
income is OY. Now suppose that the investment increases by ∆ I so that the new AD curve AD1 intersects
the AS curve at point E1. Thus the new equilibrium level of income is OY1. The income rises from OY to
OY1 as a result of an initial increase in investment ∆ I or JK. It is clear from the figure that the increase in
income YY1 is greater than the increase in investment JK. This offers the conclusion that additional
investment carries a multiplier effect on the level of income.

Forward working of multiplier

If with the increase in investment, income increases multiple times, it is known as forward working of
multiplier.

Backward working of multiplier

If with the fall in investment, there is multiple times decrease in income, it is called backward working of
multiplier. For example, if investment decreases by ₹ 100 crores and multiplier is 2 then income will
finally decrease by 100 x 2 = ₹ 200 crores.
Ex-ante saving

It refers to the desired saving or planned saving in the economy during the period of one year.

Ex-ante investment

It refers to the desired investment or planned investment in the economy during the period of one year.

Ex-post saving

It refers to the actual saving in the economy during the period of one year.

Ex-post investment

It refers to the actual investment in the economy during the period of one year.

Numerical on Multiplier
Q.26. In an economy investment is increased by ₹ 300 crore. If marginal propensity to consume is 2/3,
calculate increase in national income.

Solution:

Given, ∆ I = ₹ 300 crore

MPC = 2/3

∆ Y =?

We know that,
1
K=
1 ─ 𝑀𝑃𝐶
1
Or, K = 2
1 −3

1
Or, K = 3−2
3

1
Or, K = 1
3

Or, K = 3
Now,
Δ𝑌
K=
Δ𝐼
Δ𝑌
Or, 3 =
300
Or, ∆ Y = 900