Economics Chapter 2 Equilibrium of National Income Class 12 notes

Economics Chapter 2 Equilibrium of National Income Class 12 notes excursions, short question and long question. 2nd years FA/ FSC Notes.

Equilibrium of National Income Class 12 notes Chapter No 2

Q.1) Review the understanding of the following terms and concepts. Consumption, saving, investment, induced investment, autonomous investment, aggregate demand, aggregate supply, aggregate expenditure, the equilibrium of income.

Answer:

Consumption

Consumption is the leading objective of all economic activity. People work and produce in order to obtain goods and services to consume.

The part of income spent on consumer goods for getting direct satisfaction is called consumption. In this sense, all expenditure on food, clothing, housing, education etc. is treated as consumption expenditure. When we study the consumption behaviour of the people we find that consumption has close relation with income.

In the language of mathematics, we say that consumption (C) is a function of income (Y) i.e. C = f(Y). The nature of this relationship is such that as income increases consumption expenditure increases. Moreover, normally the increase in C is less than the increase in Y. This relation is true for individuals and the whole economy. In macroeconomics, we are concerned more with aggregate consumption out of national income. We illustrate the functional relationship between consumption and income in a simple table. We assume that people consume 80% of their incomes additional (i.e. marginal propensity to consume is 80/100 = 0.8). Initially, when income is zero, there will be some consumption, say, Rs.20 billion. This is done out of either borrowing or past savings.

This relationship between expenditure (C) and income (Y) is shown in the figure. The upward trend of the Cline indicates that as income increases consumption goes up. When income is 100, the whole of it is consumed.

Savings
Saving is the part of income, which is not consumed, or it is the part of income left after making consumption expenditure. So we can write,
Saving = income – consumption
i.e. S = Y – C
or Y = C + S
The relationship between savings (S) and income (Y) is direct and positive i.e. when income increases, savings increases and vice versa. Saving-income relation is shown in figure

If saving schedule is put in a graph it makes upward sloping curve. At income Rs.100 billion, saving is zero. S is negative when income is below 100.
Investment
The expenditure done by individuals, firms or countries to increase capital stock and incomes is called investment. Thus, investment is the amount spent on capital goods such as machines, tools, equipment and construction. Investment also includes increase in the stock of goods with the producers and sellers and construction of houses. Purchase of a bus, a petrol pump or a factory and building of a canal, road or airport is all investment. In macroeconomics, investment expenditure is divided into induced investment and autonomous investment.
Induced investment depends upon changes in national income while autonomous investment is determined by other factors such as inventions

Autonomous investment is that investment which is not affected by changes in national income. Most of the investment undertaken by governments in the form of roads, schools, etc. is autonomous. Investment resulting from new inventions is also autonomous investment.

Aggregate demand
Aggregate demand means total spending at different levels of national income i.e. (C+I) expenditure, while price level remains constant. But in modern economics, instead of aggregate demand it is called aggregate expenditure. In modern approach, aggregate demand means demand for goods at different price levels and not at income levels. Such as demand curve is the usual downward sloping curve.
Aggregate supply
In economics, aggregate supply (AS) or domestic final supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.
Aggregate expenditure
Total expenditure on goods and services in a country during a period is called aggregate expenditure. For example, if all goods and services bought in Pakistan in January are worth Rs.100 billion, then aggregate expenditure is 100 billion. Aggregate expenditure will be different at different levels of national income.

To get the aggregate demand (AD)⁵ curve we plot the values of the table in a graph

EQUILIBRIUM OF NATIONAL INCOME
Equilibrium of national income means a level of income, which a country can achieve in a period and can maintain the same during next period, under some given circumstances. Suppose that national income of Pakistan is some year is Rs.2000 billion and that economic circumstances in next year have been such that neither we expect a rise nor a fall in this level, then Rs.2000 billion is the equilibrium income.
Equilibrium of national income is achieved at a level where the following condition is satisfied.
Saving = Investment
How equilibrium is achieved
Equilibrium can be explained by making saving and investment schedules as done in the following table and diagram. We have assumed that initially there is consumption of 20 billion rupees. Out of every addition to income, people consume 80% and save 20% (i.e. marginal propensity to consume = 0.8). As income level increases, consumption expenditure increases but increase in consumption is less than increase in income (Y). Along with Y, saving also goes on increasing. However, to keep our study simple, we assume investment expenditure as constant at Rs.40 billion.

 Looking at the consumption and saving behavior of the people from the above table, we find that equilibrium of national income can take place at Rs.300 billion. If due to some reason is at some other level, it will not be maintained i.e. it will fall or rise.
When income level is below 300, S is less than I i.e. total expenditure is greater than total income. So income tends to rise. On the other hand at incomes level above 300, S is more than I so income tends to fall. Only income level 300 is maintainable at which S = I. This is equilibrium income

In figure, income is shown along horizontal axis and saving and investment along vertical axis. II and SS are investment and savings schedules. These lines intersect at point E. so OY is the equilibrium income. Equilibrium is not possible at any other level. Consider, for example, OY1 level. At this income, saving is BY1 while investment is aY1. If I bring more than S, income will rise towards OY. Similarly at income OY2, saving is cY2 and investment is dY2. Here, I being less than S, income level will fall towards Y. only at point E, savings equal investment, so OY is equilibrium income.

We may summarize that

If S > I, income falls

If S < I, income rises

If S = I, income is stable (i.e. equilibrium)

Q.2) Explain how equality of saving and investment brings equilibrium of national income

Answer:

EQUILIBRIUM OF NATIONAL INCOME

Equilibrium of national income means a level of income, which a country can achieve in a period and can maintain the same during next period, under some given circumstances. Suppose that national income of Pakistan in some year is Rs.2000 billion and that economic circumstances in next year have been such that neither we expect a rise nor a fall in this level, then Rs.2000 billion is the equilibrium income.

Equilibrium of national income is achieved at a level where the following condition is satisfied.

Saving = Investment

Equality of savings and investment and equilibrium

Keynes analyzed the saving-investment equality on two counts:

(1) Accounting equality, and

(2) Functional equality.

Accounting equality and equilibrium

In the matrix of any national income accounting, it will be observed that actual savings and actual investment are always identically equal. This “accounting” equality of savings and investment obviously follows when saving for national economy as a whole is defined as the aggregate of savings in the various sectors of the economy (firms, households and government) in the form of excess of current income over current consumption, the current investment being that part of current income which is spent not for the purpose of consumption but for producing further goods. Thus, there is an inevitable consistency between realised saving and investment in national income accounts because total income in a given period equals the total output, and in a matrix, income that is not spent on goods (i.e., saving) is identical in size with the quantity of goods produced which are not bought with current income (i.e., investment) briefly thus: Income = consumption plus saving.

Output = consumption plus investment.

But income = output. Investment = saving.

In the national investment income accounts, therefore, saving is numerically identical with investment.

Income = Value of output = Consumption + Investment.

Saving = Income – Consumption Saving = Investment.

Symbolically, saving and investment equality can be proved as under:

S = Y – C. Y = С + I. I = Y – C.

Since Y – С is common to both, therefore,

S = I. or, alternatively,

Y = С + I; Y = С + S, but S = Y – С

By substituting the value of Y as С + I,

we get, S = (C + I) – С S = С + I – С, S = I.

However, it should be noted that while investment and saving are always equal, they are not always in equilibrium. The definitional equality of S and I does not imply that they are not necessarily in equilibrium.

Functional equilibrium

Since the “accounting” equality of saving and investment represents the statistical result of the behaviour of the entire economic system in a given period, the concepts of saving and investment seem to be only static. But Keynes’ modern economic analysis also conceived the “functional” equality of saving and investment which emphasises the behaviour of the economy as a whole, and thus, saving and investment concepts become dynamic. Moreover, in the definitional equality of saving and investment, there is absence of the equilibrating variable. Thus, it has been a tool of static analysis. Keynes conceived the functional equality of saving and investment and introduced income as the equilibrating variable. According to Keynes, in the functional or scheduled sense, there is the saving schedule and investment schedule and the equality between investment and savings is a consequence of changes in the level of income. To him, equality between saving and investment function is an indispensable condition of equilibrium. No level of national income can be sustained without the equality of aggregate saving and aggregate investment. And he stressed the point that income is the functional variable that brings about equality between saving and investment. In his concept of functional equality of saving and investment, savers and investors react to income variations in such a way that their desire to save and to invest is expected to be harmonized in the very process of these reactions.

Thus, if saving exceeds investment (that is to say, when investment decreases), saving remains constant (because the saving schedule is a stable function of income), income will fall and, therefore, saving will also contract. Income will continue to fall until the saving out of the lower-income is equal to the reduced investment. Similarly, if investment increases, saving remains constant (thus, investment exceeding saving), income will rise until the saving out of the higher income is equal to the increased investment. It should be noted that when investment exceeds saving, that is, when investment increases, a new equilibrium between saving, and investment will materialize at a higher level of income; and when saving exceeds investment, that is, when investment decreases, the new equilibrium of saving and investment will be at a lower income level. Hence, Keynes considered shifting equilibrium in his income analysis in terms of saving and investment equality as against the traditional analysis of full employment equilibrium in which investment can be and normally are equal to each other at the point of less than full employment

Q.3) What is equilibrium of national income. Explain with diagrams.

Answer:

EQUILIBRIUM OF NATIONAL INCOME

Equilibrium of national income means a level of income, which a country can achieve in a period and can maintain the same during next period, under some given circumstances. Suppose that national income of Pakistan in some year is Rs.2000 billion and that economic circumstances in next year have been such that neither we expect a rise nor a fall in this level, then Rs.2000 billion is the equilibrium income.

Equilibrium of national income is achieved at a level where the following condition is satisfied.

Saving = Investment

How equilibrium is achieved

Equilibrium can be explained by making saving and investment schedules as done in the following table and diagram. We have assumed that initially there is a consumption of 20 billion rupees. Out of every addition to income, people consume 80% and save 20% (i.e. marginal propensity to consume = 0.8). As income level increases, consumption expenditure increases but the increase in consumption is less than the increase in income (Y). Along with Y, saving also goes on increasing. However, to keep our study simple, we assume investment expenditure as constant at Rs.40 billion

 Looking at the consumption and saving behavior of the people from the above table, we find that equilibrium of national income can take place at Rs.300 billion. If due to some reason is at some other level, it will not be maintained i.e. it will fall or rise.
When income level is below 300, S is less than I i.e. total expenditure is greater than total income. So income tends to rise. On the other hand at incomes level above 300, S is more than I so income tends to fall. Only income level 300 is maintainable at which S = I. This is equilibrium income.

In figure, income is shown along horizontal axis and saving and investment along vertical axis. II and SS are investment and savings schedules. These lines intersect at point E. so OY is the equilibrium income. Equilibrium is not possible at any other level. Consider, for example, OY1 level. At this income, saving is BY1 while investment is aY1. I being more than S, income will rise towards OY. Similarly at income OY2, saving is cY2 and investment is dY2. Here, I being less than S, income level will fall towards Y. only at point E, savings equal investment, so OY is equilibrium income.
We may summarize that
If S > I, income falls
If S < I, income rises
If S = I, income is stable (i.e. equilibrium)
Equilibrium of national income – Aggregate expenditure method`
Equilibrium of national income can also be explained using total expenditure method. National income is determined at a point where aggregate expenditure on consumption plus investment goods is equal to total national income shown as 45 degree line.
When people receive income, they divide it into two parts. Major part is spent on consumer goods and a small part is saved. If the whole of saved amount in the country gets spent through investment expenditure, then aggregate spending in the economy(C + I) does not fall short of total incomes received. So income level has a tendency to change.
Suppose an economy produces goods worth Rs.100 billion. On the one hand these goods come to market and on other, 100 billion rupees received is spent, the whole supply of goods would be sold and same amount of goods will be produced again. Thus national income will neither fall nor rise i.e. equilibrium will be reached.
In the following diagram C+I line shows the planned expenditure of both households and business sector at different levels of income. As income increases, expenditure also increases. At any income levels below Yo, the planned expenditure is greater than income, so national income tends to rise. At levels of income above Yo, planned expenditure falls short of income, so national income falls. Only at Oyo income, aggregate expenditure equals income. This is equilibrium position. Oyo is equilibrium income.

Paradox of Thrift
Let’s consider what happened if the saving function shifts upward. People become thriftier and save more out of any given income. This causes the saving function to shift upward from S1 to S2 as shown below. The leakage in the form of saving (AG) now exceeds the injunctions in the form of investment (AE1). National income therefore decreases to its new equilibrium. B, where saving and desired investment are again equal

So we see that an increase in the desire to save does not increase equilibrium saving. Instead, it results in a decrease in output.Now consider the case when investment function rises upward.
As more goods are produced, there is a need of more machines and functions. So desired investment slopes upward, as shown below

Q.4) Prove with the help of a diagram that national income is determined where aggregate saving is equal to aggregate investment.

Answer:
EQUILIBRIUM OF NATIONAL INCOME
Equilibrium of national income means a level of income, which a country can achieve in a period and can maintain the same during next period, under some given circumstances. Suppose that national income of Pakistan in some year is Rs.2000 billion and that economic circumstances in next year have been such that neither we expect a rise nor a fall in this level, then Rs.2000 billion is the equilibrium income.
Equilibrium of national income is achieved at a level where the following condition is satisfied.
Saving = Investment|
How equilibrium is achieved
Equilibrium can be explained by making saving and investment schedules as done in the following table and diagram. We have assumed that initially there is consumption of 20 billion rupees. Out of every addition to income, people consume 80% and save 20% (i.e. marginal propensity to consume = 0.8). As income level increases, consumption expenditure increases but increase in consumption is less than increase in income (Y). Along with Y, saving also goes on increasing. However, to keep our study simple, we assume investment expenditure as constant at Rs.40 billion

 Looking at the consumption and saving behavior of the people from the above table, we find that equilibrium of national income can take place at Rs.300 billion. If due to some reason is at some other level, it will not be maintained i.e. it will fall or rise.
When income level is below 300, S is less than I i.e. total expenditure is greater than total income. So income tends to rise. On the other hand at incomes level above 300, S is more than I so income tends to fall. Only income level 300 is maintainable at which S = I. This is equilibrium income.

n figure, income is shown along horizontal axis and saving and investment along vertical axis. II and SS are investment and savings schedules. These lines intersect at point E. so OY is the equilibrium income. Equilibrium is not possible at any other level. Consider, for example, OY1 level. At this income, saving is BY1 while investment is aY1. I being more than S, income will rise towards OY. Similarly at income OY2, saving is cY2 and investment is dY2. Here, I being less than S, income level will fall towards Y. only at point E, savings equal investment, so OY is equilibrium income.
We may summarize that
If S > I, income falls
If S < I, income rises
If S = I, income is stable (i.e. equilibrium)

Q.5) 

Answer

Read more:

• Economics Chapter 1 National Income Class 12 Notes