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Chapter 22
Equilibrium National
Income
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Economic Principles
Aggregate expenditure
The equilibrium level of
national income
The relationship between
saving and investment
The income multiplier
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Economic Principles
The relationship between
aggregate expenditure and
aggregate demand
The paradox of thrift
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Equilibrium National Income
Equilibrium price is determined
by the equal contribution of both
demand and costs of production.
In particular, it is their
interaction that determines
equilibrium price.
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Equilibrium National Income
Similarly, the interaction of
aggregate expenditure and
aggregate supply contribute to
equilibrium national income. In
this case, however, aggregate
expenditure plays a stronger role
than aggregate supply.
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Interaction Between
Consumers and Producers
Aggregate expenditure
• Spending by consumers on consumption
goods, spending by businesses on
investment goods, spending by
government, and spending by foreigners on
net exports.
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Interaction Between
Consumers and Producers
Recall that the amount of
consumer income spent on
consumption and saving is
represented by:
Y=C+S
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Interaction Between
Consumers and Producers
And recall that the amount of
production goods and investment
goods produced by producers is
represented by:
Y = C + Ii
where the subscript i indicates
intended as distinct from actual.
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Interaction Between
Consumers and Producers
If, by chance, what producers intend
to produce for consumption turns out
to be precisely what consumers
intend to consume, the match
between intended investment and
savings is written as:
Ii = S
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Interaction Between
Consumers and Producers
The I = S equation describes the
economy in macroequilibrium.
No excess demand or supply
exists. Aggregate expenditure
equal aggregate supply.
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The Economy Moves Toward
Equilibrium
The national economy, if not
already in equilibrium, is always
moving toward it.
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The Economy Moves Toward
Equilibrium
Equilibrium level of national income
• C + Ii = C + S, where saving equals
intended investment.
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The Economy Moves Toward
Equilibrium
Unwanted inventories
• Goods produced for consumption that
remain unsold.
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The Economy Moves Toward
Equilibrium
Actual investment (Ia)
• Investment spending that producers
actually make – that is, intended
investment (investment spending that
producers intend to undertake), plus or
minus unintended changes in inventories.
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EXHIBIT 1
CONSUMERS’ AND PRODUCERS’
INTENTIONS AND ACTIVITIES, BY STAGES,
WHEN Y = $900 BILLION
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
Suppose the economy is at Y
= $900 billion, autonomous
consumption = $60 billion, MPC
= 0.80 and producers’ intended
investment is $100 billion.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
1. What are consumers’
consumption expenditures and
savings in Exhibit 1?
• If Y = C + S and C = a + bY, then
consumption expenditures (C) = $60
billion + 0.8 ($900 billion) = $780 billion.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
1. What are consumers’
consumption expenditures and
saving in Exhibit 1?
• If S = Y – C, then saving (S) = $900
billion - $780 billion = $120 billion.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
2. What is intended production
by producers?
• If C = Y - Ii and Ii = $100 billion, then
intended production = $900 billion - $100
billion = $800 billion.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
3. What is the difference between
consumers’ consumption
expenditures and producers’
intended production?
• Producers’ intended production ($800
billion) - consumers’ consumption
expenditures ($780 billion) = $20 billion.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
3. What is the difference between
consumers’ consumption
expenditures and producers’
intended production?
• The $20 billion difference is described as
unwanted inventories and must be
absorbed as investment.
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Exhibit 1: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $900 Billion
3. What is the difference between
producers’ intended production
and consumers’ consumption
expenditures?
• Producers’ actual investment ($120
billion) ends up being greater than what
they had intended to invest ($100 billion). 22
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EXHIBIT 2
CONSUMERS’ AND PRODUCERS’
INTENTIONS AND ACTIVITIES, BY STAGES,
WHEN Y = $700 BILLION
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
Suppose national income changes
to Y = $700 billion, but MPC,
autonomous consumption and
intended investment all remain
the same.
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
1. What are consumers’
consumption expenditures?
• C = $60 billion + 0.8 ($700 billion)
= $620 billion.
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
2. What is intended production
by producers?
• C = $700 billion - $100 billion = $600 billion.
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
3. What is the difference between
consumers’ consumption
expenditures and producers’
intended production?
• Consumers’ consumption ($620 billion)
- producers’ production ($600 billion)
= $20 billion. Gottheil - Principles of Economics, 4e
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
3. What is the difference between
consumers’ consumption
expenditures and producers’
intended production?
• The $20 billion difference must be
converted from intended investment to
consumption goods to meet demand.
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Exhibit 2: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $700 Billion
3. What is the difference between
consumers’ consumption
expenditures and producers’
intended production?
• Actual investment ends up being less
than intended investment.
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EXHIBIT 3
CONSUMERS’ AND PRODUCERS’
INTENTIONS AND ACTIVITIES, BY STAGES,
WHEN Y = $800 BILLION
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Exhibit 3: Consumers’ and
Producers’ Intentions and Activities,
by Stages, When Y = $800 Billion
What is the difference between
production and consumers’
expenditures in Exhibit 3?
• Production and consumption are equal at
$700 billion. The economy is in equilibrium.
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Equilibrium National Income
Aggregate expenditure curve (AE)
• A curve that shows the quantity of
aggregate expenditures at different levels
of national income or GDP.
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Equilibrium National Income
Aggregate expenditure curve (AE)
• The intersection of the 45° income curve
and AE identifies the economy’s
equilibrium position.
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Equilibrium National Income
• When Ii > S, producers hire more
workers to replace depleted
inventories. Y increases and
continues to increase until Ii = S.
• When S > Ii, inventories build up
and producers lay off workers. Y
decreases until Ii = S.
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EXHIBIT 4A THE EQUILIBRIUM LEVEL OF NATIONAL
INCOME
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EXHIBIT 4B THE EQUILIBRIUM LEVEL OF NATIONAL
INCOME
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Exhibit 4: The Equilibrium
Level of National Income
At a national income of $700
billion, aggregate expenditure is
____ the national income in panel
a of Exhibit 4.
i. Greater than
ii. Less than
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Exhibit 4: The Equilibrium
Level of National Income
At a national income of $700
billion, aggregate expenditure is
____ the national income in panel
a of Exhibit 4.
i. Greater than
ii. Less than
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Changes in Investment Change
National Income Equilibrium
As long as the consumption function
and the investment demand function
remain unchanged, there is no
reason to suppose that the level of
national income would move away
from equilibrium.
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Changes in Investment Change
National Income Equilibrium
Functions do change, however.
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EXHIBIT 5
CONSUMERS’ AND PRODUCERS’
INTENTIONS AND ACTIVITIES, BY STAGES,
WHEN INVESTMENT INCREASES TO $130
BILLION AND Y = $800 BILLION
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Exhibit 5: Consumers’ and Producers’
Intentions and Activities, by Stages,
when Investment Increases to $130
Billion and Y = $800 Billion
What happens to the equilibrium level
of national income when intended
investment increases in Exhibit 5?
• When intended investment increases, the
supply of consumption goods decreases to
$670 billion.
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Exhibit 5: Consumers’ and Producers’
Intentions and Activities, by Stages,
when Investment Increases to $130
Billion and Y = $800 Billion
What happens to the equilibrium level
of national income when intended
investment increases in Exhibit 5?
• Consumers’ consumption expenditures
remain at $700 billion. Consumers’ demand
is greater than producers’ production.
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Exhibit 5: Consumers’ and Producers’
Intentions and Activities, by Stages,
when Investment Increases to $130
Billion and Y = $800 Billion
What happens to the equilibrium level
of national income when intended
investment increases in Exhibit 5?
• In an effort to meet consumers’ demand,
producers hire more workers and national
income increases. The equilibrium also
increases.
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EXHIBIT 6A DERIVING EQUILIBRIUM AT Y = $950 BILLION
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EXHIBIT 6B DERIVING EQUILIBRIUM AT Y = $950 BILLION
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Exhibit 6: Deriving Equilibrium at
Y = $950 Billion
What is the equilibrium level of
national income when intended
investment increases to $130
billion in Exhibit 6?
• The equilibrium level increases to
$950 billion, where Ii = S.
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Changes in Investment Change
National Income Equilibrium
The formula Y = (a + bY) + Ii can
be used to calculate equilibrium
national income when specific
values for autonomous
consumption, MPC and intended
investment are known.
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The Income Multiplier
While consumption spending,
MPC, and autonomous
consumption have all remained
relatively stable over time,
investment spending has been
volatile.
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The Income Multiplier
Economists identify changes in
aggregate expenditure, in
particular investment spending,
as the key to our understanding
of why national income changes.
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The Income Multiplier
Income multiplier
• The multiple by which income changes as a
result of a change in aggregate expenditure.
It is written as:
multiplier = (change in Y)/(change in AE)
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The Income Multiplier
The size of the multiplier depends
on the marginal propensity to
consume. An initial change in
investment sets in motion a chain
of events that creates a larger
change in national income.
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The Income Multiplier
For example, suppose a business
owner decides to invest $1,000 in
a new technology. The producer
of the technology receives an
increase in income of $1,000. If
MPC = 0.80, the technology
producer’s consumption spending
increases by $800.
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The Income Multiplier
Suppose the $800 is then spent on
a custom-made water bed. The
carpenter that makes the water
bed receives $800 of additional
income. Based on MPC, we know
that she will spend $640 and save
the rest. The chain of events
continues.
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EXHIBIT 7
THE MAKING OF THE INCOME MULTIPLIER
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Exhibit 7: The Making of the
Income Multiplier
The additions to national income
in Exhibit 7 become _____ as
economic activity progresses
through successive rounds.
i. Smaller and smaller
ii. Bigger and bigger
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Exhibit 7: The Making of the
Income Multiplier
The additions to national income
in Exhibit 7 become _____ as
economic activity progresses
through successive rounds.
i. Smaller and smaller. For example, in round
2, $800 is added. In round 3, $640 is added.
ii. Bigger and bigger
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The Income Multiplier
The formula to determine the
income multiplier is written:
1/(1 - MPC).
Since (1 - MPC) = MPS, the
formula can be written:
1/MPS.
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The Income Multiplier
For example, for a $1,000 change
in investment, when MPC = 0.80,
the income multiplier is:
1/(1 - 0.80) = 1/(0.2) = 5.
A $1,000 investment leads to a
$5,000 change in national income.
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The Income Multiplier
Just as increases in aggregate
expenditure stimulate the
economy, cuts in aggregate
expenditure drag it down.
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The Income Multiplier
Changes in the price level shift
the AE curve, creating changes in
the equilibrium level of national
income. As the price level
decreases, national income
increases.
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EXHIBIT 8
CONVERTING
AGGREGATE
EXPENDITURE TO
AGGREGATE
DEMAND
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Exhibit 8: Converting Aggregate
Expenditure to Aggregate Demand
What happens to the equilibrium
national income when the price level
decreases from AE100 to AE75?
• A decrease in the price level leads to an
increase in aggregate expenditures and
movement downward along the aggregate
demand curve. National income increases
from $800 billion to $1,000 billion.
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EXHIBIT 9
THE MULTIPLIER
EFFECT IN THE AE
AND AD MODELS
OF INCOME
DETERMINATION
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Exhibit 9: The Multiplier Effect in
the AE and AD Models of Income
Determination
If aggregate expenditure increases
but the price level remains the same,
what happens to aggregate demand?
• Aggregate demand increases, which results
in an increase in national income.
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The Paradox of Thrift
Some people believe that putting
a higher percentage of their
income into saving will provide
greater economic security. This is
not necessarily the case, however.
By trying to save more, people
may actually end up saving less,
or at least saving no more.
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The Paradox of Thrift
The paradox of thrift
• The more people try to save, the more
income falls, leaving them with no more
and perhaps even less saving.
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The Paradox of Thrift
The intention to save more causes
the saving curve to shift upwards.
Saving then becomes greater than
intended investment (S > Ii). The
equilibrium level of national
income falls.
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The Paradox of Thrift
• If the level of intended
investment curve is horizontal,
then the level of saving remains
unchanged.
• If the intended investment curve
is upward sloping, then the level
of saving declines.
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EXHIBIT 10 THE PARADOX OF THRIFT
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Exhibit 10: The Paradox of Thrift
1. What happens to national
income and saving when the
saving curve shifts from S to S′ in
panel a of Exhibit 10?
• National income falls from $800 billion to
$650 billion. Saving remains unchanged.
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Exhibit 10: The Paradox of Thrift
2. What happens to national
income and saving in panel b
when the saving curve shifts from
S to S′?
• The equilibrium level of national income
falls from $800 billion to $550 billion.
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Exhibit 10: The Paradox of Thrift
2. What happens to national
income and saving in panel b
when the saving curve shifts from
S to S′?
• Because the intended investment curve is
upward sloping, the shift in the saving
curve causes a decline in the level of
investment as well.
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Exhibit 10: The Paradox of Thrift
2. What happens to national
income and saving in panel b
when the saving curve shifts from
S to S′?
• Saving falls from $100 billion to $75 billion.
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The Paradox of Thrift
Increased saving is not always
detrimental to our economic
health. If accompanied by
increased investment, increased
saving is both inevitable and
desirable.
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