Income determination

The essentials

In the Keynesian short-run model, prices are taken as fixed and firms produce whatever is demanded, as long as there is spare capacity. Output therefore adjusts to aggregate demand. Equilibrium income is the level at which planned output (aggregate supply) equals planned expenditure (aggregate demand).

In a two-sector economy: Y = C + I, with C = c̄ + bY and I = Ī. Solving gives Y = (c̄ + Ī) ÷ (1 − b). An equivalent condition is planned saving = planned investment (S = I).

Adjustment to equilibrium

• If AD > AS, firms see their inventories fall below the planned level; they raise output, and income rises.
• If AD < AS, unsold stock piles up (unplanned inventory accumulation); firms cut output and income falls.
• On the diagram, AD is a line with slope MPC cutting the vertical axis at c̄ + Ī; AS is the 45° line, on which every point has expenditure equal to income. Equilibrium is where they cross.

Key points

• Equilibrium need not be at full employment; it can occur with involuntary unemployment.
• Paradox of thrift: if everyone tries to save more (MPS rises), equilibrium income falls and total saving may not rise.
• Ex post (actual) saving always equals actual investment, because unplanned inventory changes absorb the gap.

Exam tips

Practise solving equations: write AD = AS, collect the Y terms, and divide.

Common mistakes

• Assuming equilibrium means full employment.
• Mixing planned and actual investment.