Theory of Income Determination, Equilibrium Level of National Income

Sun, 06/24/2012 - 08:52 -- Umar Farooq

There are two approaches for the theory of income determination and equilibrium level of national income.

  1. Saving and Investment approach.
  2. Consumption and Investment approach.

Saving and Investment Approach

To understand Saving and investment approach it must be noted that Saving depends upon simple and automated principles, whereas investment is based upon some flexible and dynamic factors. To make it simple, suppose in a community there is only a change of Rs.10 crore investments, no more or no less. Then the National Income will be

Saving and Investment Approach - The Theory of Income Determination, Equilibrium Level of National Income

Explanation

  1. Equilibrium level of national income is one where saving is equal to investment. In the above case study a hypothetical community has only Rs.10 crores investment possibility. The community's saving match this investment level at point E. The contented community seeks no further saving. The business firms will have no problems either of excess or shortage of production. Production, employment, and income spending will stay at E.
  2. Now suppose that Net National Product NNP is higher and meets the saving schedule SS at point f. It means that the community is saving more, refraining itself from consumption spending. The inventories will pile up with the business firms and they will be forced up to cut down undesired inventory investment than the NNP will drop down and will stop at the equilibrium level at E.
  3. If the NNP is below the equilibrium level than the community consumption of goods is higher what is currently produced. The production system will expand itself to the investment level. The saving will be generated and it will match the investment target of Rs.10 crores and equilibrium will be reached at point E. Ultimately Net National Product NNP will come to the level where saving and investment schedules intersect.

Consumption and Investment Method

The consumption and investment approach is quite different method of income determination. Since we know that

NNP = C + I

Total spending is equal to consumption plus investment spending is equal to Total Income. When these two will be equal the NNP will be at equilibrium level

Let us examine

Consumption and Investment Method - Equilibrium Level of National Income

On 45° line lies the equilibrium point E where the total spending is equal to total income. We have noted the characteristic of the 45° line earlier. If the equilibrium does not lie at point E than either the business community will earn unexpected profits due to hurried inventory investment or will have losses due to sudden fall in the inventory. As a result there will be a rise or fall in the prices and thus affecting the output levels. The disequilibrium will continue until such time the conditions settle and the equilibrium level E is reached. We have seen how the two methods work. However, whatever approach is taken, the equilibrium of NNP will be the same.