SHORT RUN EQUILIBRIUM

OUTPUT
Chapter 8
 Concept of Short run

• In macroeconomics and according to Keynes, short run is defined as a

period of time during which ‘technology’ plays no role in the determination of
output in the economy. It is assumed to remain constant.
• Output is determined exclusively by the level of employment in the economy.
Higher level of employment leads to higher level of output, and vice-versa. If
employment is doubled, output will also be doubled.
• Thus the level of employment in the economy measure the level of output or
GDP in the economy. Accordingly, output cannot increase once there is full
employment in the economy.
Three basic assumptions of Keynesian theory:

• Short period analysis

• Two sector closed economy. So , AD = C + I
• AS is perfectly elastic- it means we are studying an economy in which there
is an excess production capacity or there is unemployment of resources. So
whenever there is a rise in AD there is corresponding rise to AS (as excess
capacity begins to be utilized).

Two approaches for determination of equilibrium level of output, income and

employment are
• Aggregate demand – Aggregate supply approach
• Saving – Investment approach
Aggregate demand (AD) – Aggregate supply (AS)
approach:

• According to the Keynesian theory the equilibrium level of income in an economy is

determined when planned AD is equal to the planned AS.
• Aggregate Demand (AD) comprises of two components. They are
• Household Consumption Expenditure (C): It varies directly with the level of income
i.e. consumption rises with the rise in income.
• Investment expenditure (I): It is assumed to be independent of the level of income
i.e. investment expenditure is autonomous.
• So, AD curve is represented by C+I Curve in the income determination.
• Aggregate Supply (AS) is the money value of all the goods and services produced in
a country or national income. It is represented by a 45 degree line. Since income
received is either consumed or saved, the AS curve is represented by the C+S curve.
The determination of equilibrium level of income can be explained with the help of the
following table.
The following table is based on two assumption:
1. C = 50 + 0.5Y; here C̅ = 50 and MPC = 0.5
2. Planned level of investment = ₹ 100 crores ( Autonomous)
Income (Y) Consumption Saving(S) Investment(I) AD = C+I AS = C+S
(C)

0 50 ─ 50 100 150 > 0

100 100 0 100 200 > 100
200 150 50 100 250 > 200
300 200 100 100 300 = 300
400 250 150 100 350 < 400
500 300 200 100 400 < 500

In the above table ₹ 300 crores is the equilibrium level of income at which planned AD
= planned AS = ₹ 300 crores. Any income which is less than ₹ 300 crores, planned
AD is more than planned AS. Therefore, an economy should produce further till it
reaches equilibrium. At any income which is higher than ₹ 300 crores, planned AD is
less than planned AS. Therefore, an economy should reduce its production till it
reaches equilibrium.
In the figure, AD curve shows the
desired level of expenditure by
consumers and producers
corresponding to each level of
income. The economy is in
equilibrium at point E, where AD
curve intersects the 45 degree AS
line. E is the equilibrium point
because at this point the level of
desired spending on consumption
and investment exactly equals the
level of total output. OY is the
equilibrium level of income/ output/
employment corresponding to
point E.
What happens if AS > AD?
When AS is more than AD (AS > AD), supply of goods and services in the
economy tends to exceed their demand. AS a result some of the goods would
remain unsold. To clear the unwanted stocks, the producers would plan a cut in
production. Consequently, AS would reduce to become equal to AD. This is how
AS adjust itself to AD. Briefly, equilibrium is restored through a change output or
change in income.

What happens if AS < AD?

When AS is less than AD (AS < AD), supply of goods and services in the economy
tends to be less than their demand. The existing stocks of the producers would be
sold out and the producers would suffer the loss of unfulfilled demand. To rebuild
the desired stocks and avoid the loss of unfulfilled demand, the producers would
plan greater production. AS would increase to become equal to AD. This is how
AS converges with AD. Thus equilibrium is restored through a change in output or
a change in income.
Saving (S) – Investment (I) approach

According to this approach, equilibrium level of income is

determined at a level when planned saving is equal to planned
investment.
Since, AD = C + I and AS = C + S
Therefore, if AD = AS
Or, C + I = C + S
Or, I=S
The determination of equilibrium level of income can be explained with the help of following
table and figure.
The following table is based on two assumption:
1. C = 50 + 0.5Y; here C̅ = 50 and MPC = 0.5
2. Planned level of investment = ₹ 100 crores ( Autonomous)

Income (Y) Consumption(C) Saving(S) Investment(I)

0 50 ─ 50 < 100
100 100 0 < 100
200 150 50 < 100
300 200 100 = 100
400 250 150 > 100
500 300 200 > 100

In the table, ₹ 300 crores is the equilibrium level of income determined. At this level of
income, planned saving = planned investment = ₹ 100 crores. At any income lower than ₹
300 crores, planned saving is less than planned investment. Therefore, an economy needs
to produce further till it reaches equilibrium. At any income higher than ₹ 300 crores,
planned saving is more than planned investment. Therefore, an economy should reduce
production till it reaches equilibrium.
In the figure, investment curve II is
parallel to the X-axis because of the
autonomous character of investment.
The saving curve SS slopes upwards
showing that as income increases
saving also increases. The economy
is in equilibrium at point E where
saving and investment curves
intersect each other. At point E,
Planned saving is equal to planned
investment. OY is the equilibrium level
of income corresponding to point E.
What happens when S > I?
In case S > I, it implies a situation when a fall in expenditure through saving is more than the
rise in expenditure through investment. Accordingly, aggregate expenditure in the economy
would be less than what is required to buy the planned output. Some output would remain
unsold and the producers will have undesired stocks. To clear the stocks, the producer would
now plan lesser output. Lesser output mean lesser income. Lesser income mean lesser saving.
The process would continue until S = I. Thus, the equality between saving and investment is
restored through change in the level of income.

What happens when S < I?

In case S < I, it implies a situation when a fall in expenditure through saving is less than the rise
in expenditure through investment. Accordingly, aggregate expenditure in the economy would
be greater than what is required to buy the planned output. It is a situation of higher AD than
AS. The producer would suffer the loss of unfulfilled demand. This will prompt the producer to
produce higher output. Higher output mean higher income and higher income mean higher
saving. The process would continue until S = I. Here, again the equality between saving and
investment is restored through a change in the level of income.
Numerical on AD – AS and saving – investment approach
Q.3. Calculate investment expenditure from the following data about an economy
which is in equilibrium.
National income = 1000
Marginal propensity to save = 0.25
Autonomous consumption expenditure = 200
Soln :
Given, Y = 1000
C̅ = 200
MPS (1─b) = 0.25, therefore, MPC = 1 ─ MPS= 1 ─ 0.25= 0.75
In equilibrium condition, AS = AD
Or, Y = C + I
Or, Y = C̅ + bY + I
Or, 1000 = 200 + 0.75 X 1000 + I
Or, 1000 = 200 + 750 + I
Or, I = 1000 ─ 950 = 50
Alternative method,
Given, Y = 1000
C̅ = 200
MPS (1─b) = 0.25, therefore, MPC = 1 ─ MPS= 1 ─ 0.25= 0.75

In equilibrium condition, S = I
Or, ─ C̅ + (1─b) Y = I
Or, ─ 200 + 0.25 X 1000 = I
Or, ─ 200 + 250 = I
Or, I = 50
Investment Multiplier/ Output Multiplier (K)
•
Relationship between multiplier
and MPC
•
Multiplier Mechanism (Working of a multiplier)
The working of a multiplier is based on the fact that one person’s expenditure is
another person’s income.
Let us suppose an additional investment of ₹ 100 crores (∆ I) is made to construct
a flyover. This extra investment will generate an extra income of ₹ 100 crores in
the round 1.
Round Increase in Change in Induced change Leakage or
investment (∆I) income (∆Y) in consumption saving
(∆C)
MPC = 0.5
1 100 100 50 50
2 ̶ 50 25 25
3 ̶ 25 12.5 12.5
. . . . .
. . . . .
. . . . .

Total 100 200 100 100

If MPC is assumed to be 0.5, recipients of the additional income will spend 50% of
₹ 100 i.e. ₹ 50 crores on consumption and the remaining ₹ 50 crores will be
saved. It will increase the income by ₹ 50 crores in round 2 as one person’s
expenditure is another one’s income in the economy.
In the figure, income is measured on
the X-axis and AD on the Y-axis. Let us
suppose the initial equilibrium is
determined at point E Where AD curve
intersects the AS curve. The
equilibrium level of income is OY. Now
suppose that the investment increases
by ∆ I so that the new AD curve AD1
intersects the AS curve at point E1.
Thus the new equilibrium level of
income is OY1. The income rises from
OY to OY1 as a result of an initial
increase in investment ∆ I or JK. It is
clear from the figure that the increase
in income YY1 is greater than the
increase in investment JK. This offers
the conclusion that additional
investment carries a multiplier effect on
the level of income.
Forward and Backward working of
multiplier

• Forward working of multiplier

If with the increase in investment, income increases multiple times,
it is known as forward working of multiplier.

• Backward working of multiplier

If with the fall in investment or withdrawal of investment, there is
multiple times decrease in income, it is called backward working of
multiplier. For example, if investment decreases by ₹ 100 crores and
multiplier is 2 then income will finally decrease by 100 x 2 = ₹ 200
crores.
Ex-ante saving
It refers to the desired saving or planned saving in the economy during the
period of one year.

Ex-ante investment
It refers to the desired investment or planned investment in the economy during
the period of one year.

Ex-post saving
It refers to the actual saving in the economy during the period of one year.

Ex-post investment
It refers to the actual investment in the economy during the period of one year.
Numerical on Multiplier

Q.26. In an economy investment is increased by ₹ 300

crore. If marginal propensity to consume is 2/3, calculate
increase in national income.
Solution:
Given,
∆ I = ₹ 300 crore
MPC = 2/3
∆ Y =?

Solution:
Given, ∆ I = ₹ 300 crore
MPC = 2/3
∆ Y =?
We know that, Now,
K = 1/(1 ─ MPC) K = ΔY/ΔI
Or, K = 1/(1 -2/( Or, 3 = ΔY/300
3)) Or, ∆ Y = 900
Or, K = 1/((3-
2)/3)
Or, K = 1/(1/3)
Or, K = 3