In this article, you will learn the process and conditions of attaining equilibrium level of national income in a hypothetical economy without government intervention, with government intervention, and with trade. You will also attempt to solve for the equilibrium level of national income from system of equations relating to a hypothetical economy. In the process of doing this, you will be introduced to the concept of the Multiplier – the principle that is central to the study of the concept of national income determination.
Overview of National Income Determination
National income determination is an investigation of how aggregate demand is related to national income, and how, in turn, this relationship determines the level of GNP. The equilibrium level of GNP is therefore that level at which aggregate demand leads to a stable GNP, ending short-term fluctuations. It is also that level of income (output) level at which Leakages (withdrawals) equals Injections. Injections are economic activities that add fund into the circular flow of income. They are considered fresh spending in the circular flow of income that relates to investment, government expenditures, and, or exports. In fact, expenditure on domestic goods such as investment, government expenditure and exports are known as injections. They are sources of revenue to firms that do not arise from household spending. Investment expenditures by firms, spending on goods and services by the government, and net exports are all injections to the circular flow.
Leakages or withdrawals on the other hand, are flows out of the circular flow model such as savings, taxes, and imports. They are economic activities that reduce funds from the circular flow of income, They can as well be described as those part ot payment by firms to households that do not automatically return to firms as spending by households on the output of firms
Determination of the Equilibrium Level of Income – The Case of a Simple and Spendthrift Economy
We define a spendthrift economy as one where the whole income received in the process of production is spent on consumption Invariably, the level of national income that can . be sustained in a private economy will be determined by the strength of (1) consumer demand for tho various categories of consumption goods the nation can produce; and (2) business demand for goods to invest – that is, to add to the stock of machines, buildings, Inventories, and other capital goods in the economy. Adding up the sum of consumer spending and business investment spending will equal national income, That is;
Y = C+1 —— (4.1)
The fact that part of the income earned by household is saved and the money put into savings is taken by the business firm for investment does not mean that saving and investment in any economy are necessarily equal It is to be noted that those who undertake investments are generally not the people who save. Savings are undertaken by households while investments are undertaken by business firms. Therefore, saving and investment in any economy need not necessarily be equal. There is the possibility that investment (1) will be greater than saving (5) or that saving (S) will be greater than investment (1). Whenever saving (5) Is greater than investment (1) the income flow will decline, On the other hand, the income flow will increase whenever Investment (1) is greater than saving (5).
Having noted that households do not spend all received income but save part of it as the case may be (the case of a frugal economy- an economy in which the whole income is not consumed, a part of it is saved and invested), it is important to bear in mind that, if all saving are invested, then saving (5) will equal investment (1) expenditure. But then, we need to have an idea about how equilibrium level of income is determined in such an economy where all received income are not spent on consumption and part not spent on consumption is saved and even invested. In what follows therefore, we shall discuss the determination of national income Ina frugal – two sector economy.
Determination of Equilibrium Level of Income – The Case of Two Sector Economy
Following the aggregate supply (value of output or income) equal aggregate demand approach to the determination of national income.
The equilibrium level of National Income Determination in a Two Sector Economy with the help of Aggregate Demand and Aggregate Supply Schedules Given the aggregate supply schedule and the aggregate demand (C+ Io) schedule, the equilibrium level of income for a two-sector model is determined at point E1 and not at point E2. Point E establishes the equilibrium income in one sector model. At point E1, the equilibrium level of income associated with the level of aggregate demand (C + lo) is YE. This level of income is higher than the equilibrium level of income, YE1, which results from aggregate demand (aggregate expenditure) made up of consumption spending alone. The equilibrium level of income, YE, is higher than the one of YEI because the inclusion of expenditure by the firm (business sector) extends the one sector model to the two sector model.
Consequently, expenditure by the m business sector tends to increase the aggregate expenditure in the economy over and above that brought forth by consumer spending alone. Thus, associated with the increased level of expenditure is a higher level of output. In fact, the inclusion of investment, lo, raises the tempo of economic activities as the opportunities to earn income increase and is expected to raise the level of disposable income. As the level of consumption increases and these series of interactive activities make the equilibrium level of income in a two sector economy to be higher than the equilibrium level of income in a one sector economy.
Part of the things that should be noted about the graphical process of determining equilibrium level of income for a two-sector economy presented is usually referred to as the simplest “Keynesians Cross” tells us that point E where the aggregate demand scheduled crosses the 45° lines, locates equilibrium national income. In contrast, point E1, locates the level of income at which the consumption function (C =a + bY) crosses the 45° line. At this level of . income, households plan to consume all, and save none of their income. Consequently, average propensity to consume (APC) equals one and average propensity to save (APS) equals zero. It is worthy of note that economists typically find the equilibrium level of national income as YE relevant because it is the level towards which the actual level of national income is expected to gravitate. Income level greater than YE or at points to the right of E, Y> C+I (aggregate supply is greater than aggregate demand), saving is greater than investment demand (Y-C> I) is the same as S (saving) > I (investment). But since saving is the same thing as actual investment; S> I means that for income level greater than YE actual investment is greater than desired investment demand. Consequently, this will result in unwarranted inventories piling up on producer shelves and in the warehouses.
Basically, this will make the firms to reduce production levels. Consequent upon this, national income falls and savings in turn falls until Ye is reached. Then, saving and actual investment would be equal to investment demand with the result that there would be no further change in production plan – equilibrium national income would remain at YE. On the other hand, at income level less than YE or at points to the left of E, Y < C + I (aggregate supply is less than aggregate demand), saving is less than investment demand (Y-C<I) which is the same thing as S (saving) < I (investment). Given that saving is the same thing as actual investment; S < I meaning that for income level less than YE actual investment is less than desired (investment demand). There will be a tendency for unplanned rundown of inventory. This will result in firms increasing their production levels towards the equilibrium position where there is neither unplanned inventory buildings nor unplanned inventory rundowns.
Thus, it can be said from the above analysis that at lower levels, we expect the national income to expand; at higher levels, national income will contract; at point E, aggregate demand will be just sufficient to match the output the economy is producing and thus, there will be no forces effecting any change in the level of national income. In fact, once equilibrium is attained at point E, no consumer, businessman, or labourer can improve his situation by indicated change in his pattern of actions.
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