Assuming for a hypothetical economy, the following data is given :
Income (Y) Consumption (C) Investment (I) Aggregate Demand (AD) 0 20 20 40 100 100 20 – 200 180 20 – 300 260 20 280
On the basis of the given data, it can be said that the equilibrium level of income is 300.
Do you agree ? If not, explain the adjustment mechanism that may take place to attain equilibrium level of income.
Assuming for a hypothetical economy, the following data is given :
| Income (Y) | Consumption (C) | Investment (I) | Aggregate Demand (AD) |
|---|---|---|---|
| 0 | 20 | 20 | 40 |
| 100 | 100 | 20 | – |
| 200 | 180 | 20 | – |
| 300 | 260 | 20 | 280 |
On the basis of the given data, it can be said that the equilibrium level of income is 300.
Do you agree ? If not, explain the adjustment mechanism that may take place to attain equilibrium level of income.
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Solution and Explanation
In the two-sector model, the economy is in equilibrium at the level of income where ex-ante Aggregate Demand (AD) equals ex-ante Aggregate Supply (AS).
Aggregate Supply is the same as the level of income (Y), because the whole output produced is paid out as income.
So equilibrium needs AD = Y.
Step 2: Fill the missing AD values:
AD is consumption plus investment, that is AD = C + I.
At Y = 100: AD = 100 + 20 = 120.
At Y = 200: AD = 180 + 20 = 200.
The given values at Y = 0 (AD = 40) and at Y = 300 (AD = 280) already follow the same rule.
Step 3: Compare AD with income at every level:
| Income (Y) | AD | Comparison |
|---|---|---|
| 0 | 40 | AD > Y |
| 100 | 120 | AD > Y |
| 200 | 200 | AD = Y |
| 300 | 280 | AD < Y |
AD equals income only at Y = 200. At Y = 300, AD is 280, which is less than AS of 300.
Step 4: Say whether we agree:
No, we do not agree. The equilibrium level of income is 200, not 300.
At 300, planned spending falls short of planned output by 20 units.
Step 5: Explain the adjustment mechanism:
When ex-ante AD is less than ex-ante AS, households and firms plan to buy less than the firms plan to produce.
The unsold goods pile up, so the stock of inventories rises above the desired level.
Producers see this unplanned stock and cut their output (and employment) to clear it.
Output keeps falling until AD and AS become equal again, which happens at an income of 200.
Final Answer:
No. At an income of 300, AD (280) is less than AS (300), so inventories rise and producers reduce output until the economy settles at the equilibrium income of 200.
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