British economist John Maynard Keynes revolutionized the economic sector in the 1930s when he presented his arguments against the classical economists and stated that the economy is led by demand rather than supply.
The theory of income and output determination was first introduced by Keynes, which was later improvised by the American economist, Paul A. Samuelson. The theory states that equilibrium level for national income is determined when aggregate demand is equal to aggregate supply.
Aggregate demand refers to the total demand made for the goods and services produced domestically by the households, firms, government, and foreigners. Aggregate supply is the total quantity of goods and services supplied at a given price level.
Equilibrium and Disequilibrium
In the Keynesian model of income and output determination, market equilibrium is a state I which aggregate expenditure and aggregate income/output are equal. A Keynesian equilibrium is maintained until an external force disrupts the pattern of expenditure or output.
The two major composition of equilibrium are aggregate production/output and aggregate expenditure. The total or aggregate production is measured by gross domestic product or GDP. Aggregate expenditure is the expenditure on final goods and services that are carried out by different macroeconomic sectors including household, firms, government, and foreigners. The four aggregate expenditures are consumption expenditure (C), investment expenditure (I), government expenditure (G), and net exports (X – M).
Symbolically, aggregate expenditure is expressed as
AE= C + I + G + X – M
Keynesian disequilibrium is when aggregate expenditure is not equal to aggregate production. In other words, it is the state where either macroeconomic sectors viz. household, firms, government, and foreign sector, do not purchase the quantities that have been produced, or the state when producers or business firms are unable to meet the demands or sell the goods they have produced.
The two conditions that arise as a result of disequilibrium are
Case 1: Y > AE
When output is in excess of planned aggregate expenditure, output exceeds purchases, and inventories accumulate. If more inventories accumulate than what was expected, it means that actual investment (I) is greater than planned investment (IP).
So, firms reduce their output in order to decrease the accumulation of inventory any further. Thus, if Y > AE or AE < Y,
- Firms reduce their level of production.
- Inventory starts accumulating since consumers are buying less than what is being produced by the firms.
Case 2: Y < AE
In the Keynesian economic system, when aggregate output/income is less than the planned expenditure, purchases made by households and other sectors exceed production made by firms. Inventories decline, and if inventories are less than the expected amount, it means that actual investment (I) is less than planned investment (IP).
In order to reach the desired level of inventories, firms invest more and expand their output. Thus, when AE > Y,
- Firms increase their level of production
- Inventories decline since consumer purchases are greater than actual production made by the firms.