Assuming for a hypothetical economy, the following data is given :
Income (Y) Consumption (C) Investment (I) Aggregate Demand (AD) 0 50 40 90 100 120 40 – 200 190 40 – 300 260 40 300
On the basis of the given data, it can be said that the equilibrium level of income is 200.
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 | 50 | 40 | 90 |
| 100 | 120 | 40 | – |
| 200 | 190 | 40 | – |
| 300 | 260 | 40 | 300 |
On the basis of the given data, it can be said that the equilibrium level of income is 200.
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
An economy is in equilibrium when planned spending equals planned output. In the two-sector model this means \(AD = AS = Y\).
Here \(AD\) is aggregate demand, which is consumption plus investment, so \(AD = C + I\).
Step 2: Fill the missing values of AD:
At income 100, \(AD = 120 + 40 = 160\).
At income 200, \(AD = 190 + 40 = 230\).
| Income (Y) | C | I | AD = C + I | AD compared with Y |
|---|---|---|---|---|
| 0 | 50 | 40 | 90 | AD > Y |
| 100 | 120 | 40 | 160 | AD > Y |
| 200 | 190 | 40 | 230 | AD > Y |
| 300 | 260 | 40 | 300 | AD = Y |
Step 3: Test the claim that equilibrium income is 200:
At income 200, aggregate demand is 230. It is more than aggregate supply (output) of 200.
Planned spending is higher than planned output, so 200 cannot be the equilibrium level.
The only row where \(AD = Y\) is income 300, so equilibrium income is 300.
So we do not agree with the statement.
Step 4: Adjustment mechanism from 200 to 300:
At 200, households and firms plan to buy more than the firms plan to produce.
The extra demand is met from the stock of unsold goods, so inventories fall below the desired level.
Producers react by raising output and hiring more factors of production.
Output and income rise, and this continues until \(AD = AS\) at income 300.
At 300 the stock of inventories is at the desired level, so firms have no reason to change output.
Final Answer:
No, we do not agree. At income 200, \(AD = 230 > AS = 200\), so inventories fall and firms raise output until equilibrium is reached at income 300. \[ \boxed{\text{Equilibrium income} = 300} \]
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