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The Meaning of Equilibrium Output

To understand the Keynesian model, you need to become more familiar with the concept of equilibrium output. As you know, equilibrium means stability: a state of balance or rest. In microeconomics an equilibrium price is a stable price, one that won't change unless there are changes in the underlying supply and demand conditions. In macroeconomics an equilibrium output is a stable output, one that is neither expanding nor contracting.

We can illustrate the concept of equilibrium output with the circular-flow diagram in Exh. 3. This diagram depicts a very simplified economy; there is no government sector (hence, there will be no government spending and no taxation) and no foreign sector (so there will be no imports and exports). These simplifications will make it easier for us to grasp the concept of equilibrium.

We assume here that businesses expect to sell $1,000 billion worth of output, and so they produce that amount. Of course, that sends to households $1,000 billion in income, which they can either spend or save. In this example we imagine that they choose to save $100 billion. Economists refer to saving as a leakage, a subtraction from the flow of spending. Leakages mean that less money returns to businesses, unless the economy can somehow compensate for the loss. In our example the $100 billion leakage means that only $900 billion will be spent on consumption goods. That $900 billion is what we called personal consumption expenditures when we showed you how to calculate gross domestic product in Chapter 10.

Consumption spending is not the only form of spending for goods and services, even in the simple private economy we are analyzing. Business investors also purchase a substantial amount of our economy's output (GDP). To keep it simple, let's assume that businesses coincidentally desire to purchase $100 billion worth of output. That investment spending is described as an injection since it adds to the basic flow of consumption spending. Total spending for goods and services (consumption spending plus investment spending) amounts to $1,000 billion. As you can see from Exh. 3, that is just enough to purchase everything that was produced—the entire $1,000 billion. That means that the producers' expectations have been fulfilled; they expected to sell $1,000 billion of output, and they have sold precisely that amount. Because producers are usually guided by their successes and failures, this would be an important finding. It would be a signal to produce the same amount next year, a response that would mean that the economy was in equilibrium.

As you can see from this example, the economy will be in equilibrium whenever the amount of total spending is exactly sufficient to purchase the economy's entire output (when total spending = total output). When that happens, producers can sell exactly what they've produced, and they have no incentive to alter the level of production.

EXHIBIT 3. Equilibrium Output with Saving and Investment

Equilibrium Output with Saving and Investment

Note that when the economy is in equilibrium, the amount that households want to save is equal to the amount that businesses desire to invest. The reason for that may be apparent to you. When the amount that is being injected into the spending flow in the form of investment is equal to the amount that is leaking out in the form of saving, the size of the flow is unchanged. The amount returning to businesses will be equal to the amount they paid out; therefore, they will be able to sell exactly what they produced, and the economy will be in equilibrium.

 
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