SESSION 3: DETERMINATION OF EQUILIBRIUM NATIONAL INCOME
After examining each category of aggregate planned expenditure and its relationship to real GDP, we can now advance the analysis by focusing on the conditions under which an equilibrium national income equals unemployment or inflation.
The equilibrium national income combines the effects of all aggregate planned expenditure components to derive the equilibrium national income.
Objectives At the end of this session, readers are expected to be able to:
- understand how the components of planned aggregate expenditure feature in national income equilibrium
- determine national income equilibrium
- draw the equilibrium national income diagram
Now read on…
3.1 Determination of Equilibrium National Income
It will be recalled from the previous session that an economy is in equilibrium when aggregate planned expenditures are equal to total output and there are no forces influencing the level of national income.
We have demonstrated that total scheduled expenditures (AE) equal C + I + G + (X – M). Therefore, as the equilibrium expenditure condition, we can write:
3.2 Graphical Representation
If the values of Y and AE are graphed together, the locus of all possible equilibrium expenditure positions for the economy will lie along the 45° line, as depicted in the figure below (assuming the same scales are used for both axes).
In other words, any point along this 45-degree line indicates equality between the level of national income (which is identical to real GDP or aggregate supply) and the level of aggregate planned expenditures.
We can determine the level of equilibrium activity in the economy at any given time by superimposing the aggregate planned expenditure schedule (AE) from the second session onto this diagram.
The figure below illustrates an example where the equilibrium level of national income is Y.
This is the only level of national income at which aggregate planned expenditures are equal, thereby achieving economic equilibrium.
Other levels of aggregate planned expenditure would result in an increase or decrease in national income and, consequently, a decrease in output.
Point A on the AE line in Figure, for instance, represents a level of aggregate planned expenditures that is greater than the national income (real GDP) and is therefore not an equilibrium point.
Point B represents an aggregate planned expenditure that is less than the corresponding real GDP value.
Again, this cannot represent a level of national income that is in equilibrium. Remember that while the line AE depicts all possible levels of aggregate planned expenditure in relation to different levels of national income, only where AE = Y can there be an equilibrium level of national income, and this must be where the AE line intersects the 45° line, which was drawn to indicate the location of all points where AE = Y.
This form of analysis makes it simple to demonstrate that the economy could be stable or in equilibrium at either low or high levels of economic activity.
Low economic activity indicates that the nation’s resources are unemployed, whereas high economic activity indicates that the economy is functioning at or near full employment.
This leads to the concept of deflationary and inflationary gaps, which will be discussed in the following session.
- When do we say the national income is at equilibrium?
- Graphically represent the national income equilibrium condition.
- Illustrate with examples how an increase or decrease in one of the components of aggregate planned expenditure affects the equilibrium condition.