The Short-run Macroeconomic Equilibrium

A very simplified Keynesian model is used to show the short-run macroeconomic equilibrium. For example, the rate of interest is fixed to simplify the model by keeping constant money in the economy. It is also assumed that production and employment depend on the amount of spending. In that we mean that if people buy more then firms will produce more, providing that they have the spare capacity available. The basic formula we use is that the level of National Income is equal to the domestic consumption plus the three withdrawals from the circular flow of income. Or, in shortened terms: Y = Cd + W. In this model, aggregate demand is actually known as aggregate expenditure (E) and relies on the amount of domestic consumption and the injections into the circular flow of income (J). Also written as AD = E = Cd + J. We reach a point of equilibrium when withdrawals equal injections and at this same point National Income will equal aggregate expenditure. If injections were to be higher than withdrawals then National Income would rise and the withdrawals would rise until withdrawals is once again equal to injections. Now enter the 45 degree line.

The 45 degree line shows the relationship between National Income and consumption, withdrawals and injections. Consumption and withdrawals are endogenous - their value is determined by the model. However injections are exogenous, meaning their value is determined independently of the model.

At ever point on the 45 degree line (Y), the items on each axis equal each other. The C line is consumption. It differs from Cd because it doesn't contain taxes and export spending. Consumption is a function of National Income: C = f(Y). As National Income rises, so does consumption - hence the upwards slope. It crosses the 45 degree line because poorer people may be required to spending above their earnings to survive where as richer people spend less than they earn, therefore at the end of the line it is below the Y line. The slope is given by the marginal propensity to consume - the proportion of any increase in National Income that goes on consumption. It is the change in consumption divided by the change in National Income. 

Consumption is determined by a whole bunch of different things: 

• Taxes
• Expected future incomes
• Expected future prices
• Consumer confidence
• Household wealth 
• Attitudes of the lenders
• Age of 'durables'
• Distribution of income

Any changes in these cause a shift in the consumption function whereas a change in National Income causes a movement along the consumption function. 

Now onto the withdrawals. The amount saved depends on the marginal propensity to save (mps). The proportion of an increase in National Income that is saved. Mps = Change in savings / Change in N.I. Taxes is pretty much the same - it depends on the marginal propensity to tax (mpt), or changes in tax / changes in N.I. It tends to rise as National Income rises because income tax is progressive. Finally imports - depending on the marginal propensity to import. Or, mpm = change in imports / change in National Income. 

Total withdrawals will look something like this: 

Injections now and we'll start with investment. It is determined by the following things: Consumer demand, expectations, interest rate, availability of finance and cost/efficiency of capital equipment. Replacing new equipment will rely on National Income. Government spending is independent of National Income in the short term, Exports is also classed as independent on National Income to keep the model simpler.  

That's it for the background on the theory. Next we'll be moving on to how National Income is determined from all of this. Stay tuned.

Sam.