(a) Consumption demand, and
(b)
Investment demand.
i.e., AD
=
C
+
I
(a) Total output or aggregate supply (C + I), and
(b)
National income.
One noteworthy thing about propensity to consume is that it remains stable or constant during the short period. Because the propensity to consume depends on the tastes and needs of the people and these do not change in the short run.
Since consumption is more or less stable and cannot be varied, therefore, variation in NI depends on variation in investment.
Investment is the second component of AD. Investment depends on two things:
(a) Marginal efficiency of capital, and
(b)
The rate of interest
The rate of interest is more or less stable, hence, change in investment depends on the marginal efficiency of capital (MEC).
The MEC means expectations of profit from investment. In other words, the expected rate of profit is called MEC.
The MEC depends on two factors:
(a) Replacement cost of capital goods, and
(b)
Profit expectations of investors.
If we join the investment demand with the curve C of propensity to consume, we get AD curve C + I in which C represents consumption and I investment. The distance between propensity to consume curve C and AD curve C + I is equal to investment.
The level of NI will be determined at point at which the AD and AS curves intersect each other. At this point AD and AS are in equilibrium.
In the above diagram, the equilibrium level of income is OY. At this point the AD curve and AS curve intersect each other.
If the income is more than OY, than total output or AS is greater than AD (C + I), and the entire output cannot be sold out.
If the income is less than OY, then total output or AS is less than AD (C + I), and the entire output will be sold out. In such a situation there is a shortage of supply, but the output will be increased in order to cover the shortage and the NI will also increase.
OY is the equilibrium level of income which is less than full employment level, i.e., OY_{F}. Whereas, the HF corresponds the saving.
The economy will be in full employment level only when investment demand increases so as to cover this saving. But there is no guarantee that investment demand will exactly be equal to savings.
Equality of
Saving and Investment:
I
> S or AD > AS
This would
induce the firms to increase production raising the level of income and
employment.
In the above diagram, the investment line (II curve) has been drawn parallel to the X-axis. This is done on the assumption that in any year, the entrepreneurs intend to invest a certain amount of money. That is, we assume that investment does not change with income.
The saving line (SS curve) shows intended saving at different levels of income.
The saving line and investment line intersect each other at the equilibrium point E, where the intended saving and the intended investment are equal at OY level of income. Hence OY is the equilibrium level of NI.
In the above diagram, there is no tendency for income to increase or decrease.
If the income level is greater than OY, the amount of intended investment is less than saving, as a result, the income will finally decrease.
If the income level is less than OY, the amount of intended investment is greater than intended saving, as a result, the income will continue to increase to the equilibrium level.
Inflationary
Gap:
Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP level. This means that people are demanding more goods and services than can be produced. In other words, the implication of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand is that the price level will increase. Or we may say that there will be an inflationary gap if scheduled investment tends to be greater than full employment saving. In a situation like this, more goods will be demanded than the economic system can produce. The result will be that price will begin to rise and an inflationary situation will emerge. Thus, if full employment saving falls short of scheduled investment at full employment (which means that peoples’ propensity to spend is higher than the propensity to save), there will be an inflationary gap.
In the above diagram, C + I + G
(consumption, investment and government spending) line shows the total
expenditure on demand in the economy. At
this level, Y is the real output, as shown by the intersection, point D, with
the 45^{o} line. Y_{F}
represents a full employment level on real output.
Real income of the economy, obviously cannot reach Y. At Y_{F}, total demand (C + I + G) exceeds total
output, leaving a gap AB, which is the inflationary gap in the Keynesian sense.
Deflationary
Gap:
The deflationary or recessionary gap is the amount by which the aggregate expenditure falls short of the full employment level of national income. It causes a multiple decline in real NI.
In the above diagram, Y is the total output at full employment level. Let us assume that the total demand is (C + I + G)’ which cuts the 45^{o} line at B, with real output Y’, AB then is the deflationary gap.