4.3 - Determination of Equilibrium Income in the Short Run

In macroeconomics, the equilibrium of an economy is determined in two stages. First, we assume that the price level is constant, which allows us to analyze how total demand and total supply interact at that fixed price. Once we understand this interaction, we move to the second stage, where we allow prices to adjust and look for a new equilibrium. This approach contrasts with microeconomics, where demand and supply curves help find the equilibrium price and quantity simultaneously.

Taking the price level as fixed simplifies our analysis. First, if there are unused resources in the economy, we can increase output without raising costs – which means prices stay stable. Second, this assumption makes it easier to focus on understanding demand and supply interactions without complicating factors from price changes. Eventually, we'll factor in price changes to see how they affect equilibrium.

The consumer demand model shows how total consumption depends on autonomous expenditure (spending that occurs regardless of income) and the marginal propensity to consume (the fraction of additional income that is spent). If income increases, consumption also increases, reflecting the relationship outlined in the equation. This relationship can be visually represented in a graph which shows how changes in income affect total consumption.

Aggregate demand is the total demand in an economy at a given income level, reflecting combined consumer and investment spending. When we graph it, we can visualize how these two components interact. By stacking consumption and investment on a graph, the resulting function gives us a comprehensive picture of total demand across different income levels.

The 45-degree line graphical representation is essential for showing that every unit of GDP produced corresponds directly to the same amount supplied. Since we assume price remains fixed, as demand increases, production also increases along this line without affecting prices, indicating that the economy can respond to demand without constraints.

In macroeconomics, equilibrium occurs at the point where planned aggregate demand equals planned aggregate supply. When these two are equal, it indicates that the amount producers want to sell matches the amount consumers are willing to buy, meaning no excess supply or demand exists. This is crucial for understanding economic stability.

To find equilibrium numerically, we set our equations for planned aggregate demand equal to those for planned supply. By solving for Y (output), we can find the income level where both supply and demand match. This algebraic approach offers a precise understanding of how variables interact and reveal the economy's behavior.

Equilibrium income is sensitive to changes in aggregate demand. If, for example, consumer spending or investment increases, it can shift the aggregate demand curve. As a result, equilibrium income will rise, reflecting more activity in the economy. Understanding this relationship helps economists predict economic fluctuations and plan fiscal policies.

The multiplier effect illustrates how initial changes in spending lead to greater overall shifts in income and spending in the economy. As businesses produce more due to increased demand, they hire more labor, pay wages, and create a cycle where increased income further boosts consumption and demand in subsequent rounds. Essentially, every round of spending creates further economic activity.

The Paradox of Thrift reveals a counterintuitive concept: if everyone tries to save more money at once, it can actually lead to lower total savings in the economy. As people save more, they spend less, leading to decreased demand for goods and services. This reduction can result in lower income for workers, which in turn causes total savings to decrease as consumers have less income to save. It's a cycle that demonstrates that savings behavior must be balanced with consumption.