5. Determinants of National Income.pdf

General Comments

•The level of national income is determined by aggregate demand and aggregate supply. •Supply of goods and services in a country depends on the productive capacity of the country and the capacity does not change in the shortrun. •Economy needs to adjust to changes in aggregate demand so that the aggregate supply matches with aggregate demand i.e., becomes equal to aggregate demand •Increase in effective demand (consumption demand plus investment demand) will lead to increase in aggregate supply and also, of national income. •Consumption demand depends on propensity to consume. Therefore, in order to increase national income propensity to consume should be increased. •Investment depends on marginal efficiency of capital (mec) and rate of interest but since the rate of interest is relatively stable, change in investment largely depends on change in mec and expected rate of profit from investment. •MEC depends on replacement cost of the capital goods and profit expectations of which the later is a more important determinant of investment. • Thus, if a country wants to increase national income and employment, it should create conditions in which profit expectations of investors/businessmen go high.

Effective Demand/National Income C O N S U M P T I O N

& I N V E S T

Y = C + S aggregate supply Shift in Effective E1 Demand

C+I Aggregate Demand

Effective Demand E

C Consumption

{

I=S Investment

National Income

C + I’ Shift in Aggregate Demand

Y

Y1

Abscissa shows national output (GNP) and the ordinate shows consumption demand and investment demand. The 450 line represents aggregate supply, also called Income line and shows two things: (a) total output or aggregate supply and (b) national income i,e,, national output in terms of money

The Graph AD, AS and Effective Demand The graph shows: • The propensity to consume c rises upwards with increase in income (Y = consumption + investment i.e., Y = C + S). • The distance between demand curve (C + I) intersects aggregate supply curve (the 450 line i.e., Y = C + S) at E, which determines the equilibrium level of income Y. • If income Y is more than OY, he total output or aggregate supply is greater than aggregate demand (i.e., C + S > C + I) and in this case, the entire output cannot be sold out. This will push to a decrease in the output, and a consequence, in the income also. • If income Y is less than OY, the total output or aggregate supply will fall short of aggregate demand (i.e., C + S < C + I) and this will push to an increase in the output, and a consequence, in the income also. • Increase in aggregate demand C + I’ will shift equilibrium from E to E1 where National Income will be OY1.

Shift National Income/Equilibrium of AD and AS • Increase in aggregate demand C + I’ will shift equilibrium from E to E1 where National Income will be OY1. • There is scope of increasing national income if there is the scope of increasing employment and at given stage it is not necessary that the equilibrium E is reached only at full employment level. • Income increases if the amount of intended investment is more than intended savings (i.e., I > S); but if I < S, the income will decrease and the decrease will continue till I = S. • The level of national Income is therefore determined where two conditions are fulfilled: a. Aggregate Demand = Aggregate Supply, and b. Intended Investment = Intended savings

Inflationary and Deflationary Gap Inflationary gap is a situation when consumption and investment spending together are greater than the full employment level GNP i.e., the people demand more goods and services than the amount of that produced. Deflationary gap comes into existence if total aggregate demand is insufficient to create full employment.

Inflationary Gap Y = C + S aggregate supply D

C+I+G

A

C,

{

Inflationary gap

I, G

C+I Aggregate Demand B

C Consumption

I=S Investment

YFX Output =National Income

YX

YFX = full employment limit on real output and YFX = total demand = C + I + G; YX = total real output, which is the required real output but cannot be reached (it is beyond YFX i.e., the full employment limit). Thus the demand for output is YxD and the supply is YFXB creating an inflationary gap AB

Deflationary Gap Y = C + S aggregate supply D

C+I+G

A

C, I, G

{

Deflationary gap

C + I + G’

B

C+I Aggregate Demand C Consumption

YX Output =National Income

YFX

YFX = Total out at full employment level. Total demand is (C + I + G) and it cuts the 450 line at D. But if (C + I + G) is not achieved and the actual demand is (C + I + G’), the equilibrium would be at B creating a deflationary gap AB.

Savings Investment Equality Income = Consumption expenditure and Investment Expenditure or, Y = C + I; This is from the production and sales side, but from the expenditure side and savings side, Y = C + S. It follows from the equations that I = S. This equality of investment and savings is only at equilibrium and in general, this is true as an ex=post phenomenon (realized/actual in terminal estimates). But as a process, there is always an inequality between them, which creates the scope for movements of S and I in one or another direction and the movement of the economy as a whole.