Verbal Presentation

Put the reasoning in words. Given our as- sumptions about consumption and investment decisions, g.n.p. couldn’t stay lower than 400. To see why not, suppose g.n.p. were 300. Then people would be spending 225 on consumption (.75 of 300) and saving 75 (.25 of 300). But busi- ness investment spending of 100 added to con- sumption spending of 225 would give a g.n.p. of 325. This g.n.p. is inconsistent with our assump- tion of a g.n.p. of 300; 300 could not be an equilibrium level given our assumptions. Now try g.n.p. at 325; it is also too low to be consistent with our assumptions, by the the same reasoning. So is any other level below 400. At any g.n.p. below 400, the savings being withdrawn from current income would be less than the 100 of investment spending being spent into g.n.p., and thus larger investment spending would push g.n.p. up toward 400. This statement puts the reasoning in terms of the lower loop of Fig. 4-2, and lets you see the economic reasoning rather than just stating the logical requirements for an equilibrium g.n.p.

Conversely, try any level of g.n.p. higher than 400—say, 500. Then consumption plus in- vestment spending would not be enough to be consistent with that assumed level. Consumption would be 375 (.75 of 500) and investment 100, totaling only 475. At a 500 level of g.n.p., people would want to save 125, more than is being in- vested. Hence g.n.p. would fall, toward 400. Only at 400 will the sum of investment (100) plus con- sumption (three fourths of g.n.p.) just equal the current g.n.p. of 400, so g.n.p. will remain un- changed. To put it another way, equilibrium is reached only when the amount being withdrawn from the income stream through saving each period just offsets the amount being inserted through investment.

We can look at this adjustment mechanism another (equivalent) way. Assume again that g.n.p. is 500. This means that businesses are pro- ducing 500. But on the demand side buyers would purchase only 475, i.e., 375 of consumption goods (three-fourths of 500) plus 100 of investment goods. Unsold inventories would pile up, and businesses would reduce production (g.n.p.). And so it would be for any other g.n.p. above 400. Conversely, if we assume a g.n.p. less than 400, then demand (C + I) would be larger than pro- duction. For example, if g.n.p. (production) were 300, demand would be 32 5—100 of investment plus the 225 people would consume if their in- comes were 300. Inventories would be used up and businesses would increase production (g.n.p.) to meet the larger demand. G.n.p. would thus rise toward 400.

Work out as many examples as you like and you’ll always get one and only one equilibrium value of aggregate demand and g.n.p. Equilibrium requires that the public decide to save just the amount businesses have decided to invest. Of course, the particular numbers in our example are arbitrary. If business investment is higher, say 150, the equilibrium g.n.p. is higher. If consumers spend 80 per cent of their income on consump- tion, equilibrium g.n.p. will be higher. Try it and see. But the reasoning—the underlying economic adjustment process—is unchanged.

Graphic Presentation

The same reasoning can be presented in graphical terms. Note that this presentation adds nothing to the reasoning above. It’s just another way of presenting the same analysis. But in doing so, let us change the numbers and let us make the model more realistic by introducing a more realistic “consumption function,” which is what economists call the relation between people’s in- come and their consumption spending. The only difference from the example above is a new as- sumption, that people consume a lower per- centage of their incomes at high than at low incomes, instead of always just three-fourths. This shift will, of course, change the equilibrium level of g.n.p. Again, consumption and saving depend entirely on g.n.p. and investment is fixed at 100.

The Consumption and Saving Schedules

FIG. 6-1 The left-hand portion of
this figure shows that people will
spend a smaller proportian of their
income on consumption as ilicome
rises, and save a larger proportion.
The right-hand portion shows the
same saving behavior by itself.

Figure 6-1 shows these new consumption and saving functions. On the left-hand chart, line CC plots consumption spending against g.n.p. at different levels of g.n.p. In addition, the chart has a 450 line, every point on which is equidistant
from the two axes. Thus, at any point on it, total consumption would just equal total g.n.p. If line CC coincided with the 45ฐ line, there would be no saving. Whenever the consumption curve(CC) is below the 450 line, part of g.n.p. is being saved. For example, at a g.n.p. of 200, the economy would spend 160 on consumption and save 40. However, if g.n.p. were as low as 50, people would spend more than their full incomes on con-sumption; they would “dissave” by borrowing or drawing on past savings.

The right-hand part of Fig. 6-1 shows the corresponding saving schedule (SS). This is drawn simply by taking the amount saved at each level of g.n.p. from the left-hand portion. Saving will be negative at low income levels when CC

For readers who know mathematics, the equation of this consumption function is: C = a + b(Y), where a and b are constants with a = 40 and b = .6. Therefore, C =
40 + .6Y. That is, consumption is always 40 plus .6 of the amount of income received. The basic Y = C + I equation can be solved just as before by making che new substitution for C. Thus:

Y = (40 + .6Y) + 100, or
.6Y = 40 + 100
.4Y = 140, so
Y = 350

The Mathematical Appendix at the end of the website and the appendix to this chapter on “Econometric Models?’ show more fully how simple mathematical systems can be used to determine equilibrium g.n.p. levels under more complicated conditions.

exceeds total g.n.p., and will be positive at higher income levels. The SS curve will, of course, cross the zero line at the same income level as the CC curve cuts the 450 line, where all g.n.p. is spent on consumption—at 100 in this case.

FIG. 6-2 Equilibrium g.n.p. is established where the pub-
lic wishes to save just enough to match the amount
being invested.

Now add investment. We continue to assume that it is 100—determined “autonomously” by forces independent of .the level of consumption and income. On Fig. 6-2 we plot investment in line II. This line is horizontal because investment is 100 whatever the level of g.n.p. II intersects the SS curve at a g.n.p. of 350, and this is the equilibrium level. That is, given our assumptions on consumption and investment behavior, aggregate de- mand and g.n.p. will move to 350 if it is at any other level. No other g.n.p. can persist, under our assumptions. (Note that equilibrium g.n.p. here is different from the preceding example, because we have assumed a different consumption func- tion. People no longer spend just 75 per cent of their incomes on consumption.)

Again, why is 350 the equilibrium level? The reasoning is the same as before: because at this level of g.n.p. the amount businessmen invest is exactly offset by the amount people want to save. Thus, the circular flow of income will be complete and stable. Consumers will receive 350 each year, and (reading from the left-hand por- tion of Fig. 5-2) they will spend 250 on consump- tion and save 100. Each year, businesses will invest 100, just equal to the amount people save; and so on for each succeeding time period. Equilib- rium will be achieved only at the income level where consumers want to save just enough to match business investment spending.

Now a second way of showing the same results graphically. Figure 6-3 shows the consump- tion and investment functions on the same graph. It adds to consumption spending (the CC curve of Fig. 6-1) 100 of investment spending at each income level each year. Thus, C + I is the amount that households and businesses will spend on consumption plus investment at each level of g.n.p. Now, since consumption and investment spending are on the vertical axis, and total g.n.p. is on the horizontal axis, the 450 line shows all the points where aggregate demand (C + I) will just equal total production (g.n.p.).

FIG. 6-3 Equilibrium g.n.p. is established where the
sum of consumption- and investment.spending (On the
vertical axis) just equals g.n.p. (on the horizontal axis).
This gives the same equilibrium level as Fig. 6-2.

In Fig. 6-3 aggregate demand (C + I) just equals g.n.p. (cuts the 450 line) at 350. At 350 and only at 350 does the sum of consumption and investment spending just equal g.n.p. (pro- duction).

Test the result. As before, assume any g.n.p. lower than 350 (say 300), and you will see that it can’t last. At a g.n.p. of 300, consumption plus investment spending, shown by C + I, would be above the 45 line. Thus, business sales would exceed production, and businesses would increase production. G.n.p. would rise toward 350. The opposite is true if we assume g.n.p. is anything higher than 350, say 400. At a g.n.p. of 400, C + I would be less than 400; people would not buy all the goods being produced; unsold inventories would pile up; and g.n.p. would fall toward 350.

A crucial reminder: All the above analysis assumes that consumption and saving are func- tions solely of income received. If consumption spending changes for any other reason, the equilib- rium level of income will be changed. In the model, such a change would be shown as a shift in the consumption function (on the chart, a shift of the CC line to the right or left).