Economics

EQUILIBRIUM NATIONAL INCOME

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Two very different groups of people are always at work making decisions concerning spending, saving, and
investment that affect each other. The income households earn is spent and saved: Y = C + S. Producers
produce an equivalent value of goods and services in the form of consumption and investment:
Y = C + I. By definition, C + I = C + S. But the I (investment) in this last equation is actual investment. It's
what producers end up investing, not necessarily what they intended to invest, Ii. Sometimes they end up with
more actual investment than they intended (creating unwanted inventories) and so cut output. At other times,
their actual investment is less than what they intended to produce, and as a result, they increase output. How
they respond to their actual investments and why they do it is what this chapter's about.
The total of what people spend on consumption, businesses spend on investment, government spends
on its purchases, and foreigners spend on net exports is described as aggregate expenditures. Are these
expenditures greater than, less than, or equal to the total income earned in the economy? The answer
determines whether national income increases, decreases, or is in equilibrium. In any case, if the economy is not
in equilibrium, it is always on its way there. Why is this so?
Suppose that consumers spend on consumption an amount less than what producers produced for
consumption. Some consumer goods remain unsold as unwanted inventories. Actual investment is greater
than intended investment. Producers lay off workers, employment declines, and national income declines until
it reaches the equilibrium level of national income where aggregate expenditures equal national income at a
lower level.
Now suppose that consumers spend on consumption an amount greater than what producers produced
for consumption. Wanted inventories (investment goods) are converted into consumption goods. Actual
investment is less than intended investment. Producers hire more workers to restore their inventories, causing
both national income and employment increase. Aggregate expenditures and national income rise toward a
higher equilibrium level of national income. Only when producers produce for consumption an amount equal
to what consumers purchase for consumption will producers’ intended investment be equal to saving by
consumers. When producers’ intended investment is equal to consumers’ saving, the economy is in
equilibrium.
Changes in intended investment cause the equilibrium level of national income to change. The
relationship between these two changes is explained by the income multiplier. An increase in intended
investment leads to an increase in income, a fraction of which is consumed (the marginal propensity to consume
multiplied by the initial increase in investment) and becomes income for other people. Repeated rounds of
income increases and consumption increases occur, with each round being smaller than the previous one. The
multiplier, equal to 1/(1
MPC), gives the factor by which the initial round of investment is multiplied into
new income. Just as an increase in investment causes a multiple expansion in national income, a decrease in
investment will cause a multiple decrease in national income.
The consumers' and producers' behavior that leads the economy to equilibrium also produces a rather
surprising consequence known as the paradox of thrift. It says: The more people try to save, the more
national income will fall, leaving them with no more, and perhaps less, saving in the end. Why? An increase
in saving is really the same as a decrease in consumption, which is a decrease in aggregate expenditures. It sets in motion a fall in national income to a new and lower level of equilibrium. There, saving is the same or less
than it was at the original level of income.

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