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Ch206 - CHAPTER 6 DETERMINATION OF INCOME EMPLOYMENT AND...

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Output Determination by Consumption plus Investment Approach We may show output determination using the consumption plus investment (C+I) approach. This is illustrated in Fig. 6.1, which shows total spending or aggregate demand plotted against output or income. The line CC is the consumption function, showing the desired level of consumption corresponding to each level of income. We now add desired investment (which is at fixed level I o to the consumption function. This gives the level of total desired spending or aggregate demand, represented by the C + I o curve. At every point, the (C + I o ) curve lies above the CC curve by an amount equal to I o . The 45 o line will enable us to identify the equilibrium. At any point on the 45 o line, the aggregate demand (measured vertically) equals the total level of output (measured horizontally). The economy is in equilibrium when aggregate demand, represented by the C + I 0 curve is equal to the total output. D ETERMINATION OF I NCOME , E MPLOYMENT AND O UTPUT C HAPTER 6 In the previous chapter we saw the components of aggregate demand. In the Keynesian framework, the equilibrium level of output is determined solely by the level of aggregate demand. The first section of this chapter will show the determination of the equilibrium level of output in the Keynesian framework. Then, the concept and working of the multiplier will be introduced. The second section will deal with the problems of excess and deficient demand, followed by the measures to correct these problems. Determination of Equilibrium Level of Output We shall confine our analysis of the determination of the equilibrium level of output to an economy with only two sectors, households and firms. Hence, the only components of aggregate demand will be consumption demand and investment demand. The absence of the government sector and the foreign sector means that income equals output, which is equal to Gross National Product.
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D ETERMINATION OF I NCOME , E MPLOYMENT AND O UTPUT 69 The aggregate demand (C + I 0 ) curve shows the desired level of expenditure by consumers and firms corresponding to each level of output. The economy is in equilibrium at the point where the C + I 0 curve intersects the 45 o line - point E in Fig. 6.1. At point E, the economy is in equilibrium because the level of desired spending on consumption and investment exactly equal the level of total output. The level of output corresponding to point E, is the level of output 0 M. Thus, 0 M is the equilibrium level of output. The Adjustment Mechanism Equilibrium occurs when planned spending equals planned output. When planned spending is not equal to planned output, then output will tend to increases or decreases until the two are equal again. Consider the case when the economy is at a level of output greater than the equilibrium level M in Figure 6.1. At any such greater level of output, the C + I o line lies below the 45 o line, that is, planned spending is less than planned output. This means that consumers and firms together would be buying less goods than firms were producing. This
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