Equilibrium Level of Income
1 Quick Explanation 1β3 min
The economy is in equilibrium where planned output equals planned expenditure: AD = AS (Y = C + I).
This is also where saving equals investment (S = I).
2 Detailed Notes
Key idea
Two conditions
- Ex-ante (planned) identity: Y = C + I (equilibrium), where Y is the 45Β° line / AS.
- Or, in terms of flows: S = I. When planned saving equals planned investment, income is at equilibrium.
- If S > I: inventories pile up β firms cut production β income falls toward equilibrium.
- If S < I: inventories run down β firms raise production β income rises toward equilibrium.
Diagram
The diagram
Draw AS (45Β° line) and AD = C+I. E is their intersection at income level Yβ. To the right of Yβ, AS > AD (unplanned stocks), income falls. To the left, AD > AS, income rises. Label the vertical gap as unplanned change in inventories.
Diagram
Savings-investment diagram
Alternatively, draw S curve (upward) and I line (horizontal, autonomous). Equilibrium where they intersect. Left of it S < I; right of it S > I.
Important
Involuntary inventory change
The invisible hand that pushes the economy to equilibrium is the unplanned change in inventories. Equilibrium βΊ planned inventory investment = actual.
Example
Worked numerical
C = 100 + 0.8Y, I = 200. Equilibrium: Y = C + I β Y = 100 + 0.8Y + 200 β 0.2Y = 300 β Y = βΉ1,500. Check: C = 1300, S = 200 = I. β
In One Minute
Equilibrium: Y = C + I (or S = I). Unplanned inventory changes push the economy to equilibrium. Y = (CΜ + I) Γ· (1 β MPC).
Important for Exam
- β 6-marker: 'explain equilibrium with AD-AS diagram'.
- β Numerical: find equilibrium income given C function and I.
- β S = I approach β alternative condition.
- β Effect of increase in investment on equilibrium income (shift AD).
Watch & Learn
Watch on YouTubeIncome Determination and Multiplier - Chapter 8 - Class 12 - One Shot
by Rajat Arora
Why watch? Both conditions with both diagrams.
Open on YouTube Watch on YouTubeIncome Determination and Multiplier - Chapter 8 - Class 12 - One Shot
by Rajat Arora
Why watch? Board-style numerical practice.
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