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Real income is a better indicator of economic growth. The rate of change of NICOP during the year gives the rate of growth during the year. Thus, if NICOP increases by 5.4% during a given year, then in terms of economic growth it signifies 5.4% actual increase in physical production of goods and services.
Money income refers to the command over goods and services available in the economy. Real income is National Income or National Income at Constant Prices (NICOP). It is the rate of growth of NICOP that signifies rate of economic growth.

Let us make an in-depth study of the linking variables between interest rate and income.

Introduction:

The interest rate and income are linking variables transmitting changes from the monetary sector to the goods sector and from the goods sector to the money sector. We now examine this relationship in more detail and analyse the concept of general equilibrium in the whole economy, consisting of the goods and money sectors.

The money that is saved after all the expenses have been deducted is considered as an income. Money and income are two different words that refer to two different things. Money is considered as an intangible concept that is only visible in numbers. Income is the amount of money that an individual has managed to save following their spendings.

Fig. 6.1 is a summary of equilibrium in the two sectors. The IS and LM curves represent the conditions that have to be satisfied in order for the goods and money sectors, respectively, to be in equilibrium. Now our task is to determine how these markets are brought into simultaneous equilibrium. For simultaneous equilibrium, interest rates and income levels have to be such that both goods market and money market are in equilibrium.

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That condition is satisfied at the point E in Fig. 6.1 which is the point of general equilibrium. This occurs at one combination of real income and the interest rate r_e and Y_e and with this combination of income and interest rate there is no tendency for anything to change; individuals are in equilibrium in their allocation of wealth among different assets, and in their allocation of output among different uses.

Even though we are not concerned with the problem of economic dynamics, it is nevertheless important to understand the economic forces generated in this equilibrium, which tend to bring the system back to equilibrium.

Fig. 6.2(b) represents the equilibrium conditions for the goods and money sectors. Fig. 6.2(c) shows the money sector from which the LM curve in Fig.6.2(b) is derived and Fig 6.2(a) shows the desired investment schedule which together with the consumption function (not shown here) was used to derive the IS curve in Fig 6.2(b).

Point A shows the combination of real income (Y₂) and interest rate (r_e) , respectively, which represents general equilibrium for the economy. At point A in the money sector, the quantity of money demanded shown by the demand curve Y₂ is equal to the quantity of money supplied. At the interest rate r_e, desired investment is equal to I_A – this is shown in Fig. 6.2(a). As point A is on the IS curve, we know that saving generated by a real income of Y₂ is equal to I_A, because every point on the IS curve represents a situation in which saving is equal to desired investment.

Let us consider point B in Fig. 6.2(b) which shows the combination of real income and interest rate Y₂ and r_B, respectively. We want to know what forces will be generated when the economy found itself in the situation represented by point B, and how these forces will work to bring the economy back to equilibrium. We know that at point B neither the goods nor the money sector is in equilibrium, because point B, is off both the IS and LM curves. Thus, something will have to change in both sectors.

In the money sector 6.2(c), we can see that at the combination of income and interest rate represented by point B, the quantity of money demanded is less than the quantity of money supplied. Individuals will try to re-allocate their wealth from money to bonds, thus pushing interest rate down. The arrow pointing down at B represents this tendency.

At panel 6.2(a), we see that at the interest rate r_B, desired investment is I_B. However, at real income Y₂, saving is equal to I_A, because we assume that S is a function of real income only; thus at point B, S > I_B. Hence in the goods sector, point B represents a situation in which AD < Y. Given our present assumption about the effects of a disequilibrium in the goods sector, S > (desired) I will tend to reduce output (real income).

The arrow pointing to the left at B represents this tendency. (According to our assumptions about the goods sector disequilibrium, this only affects output, not the price level and as such it does not affect the LM curve).

The initial forces generated in disequilibrium have further repercussions on the whole economic system. The fall in the interest rate generated by excess supply of money will affect desired I =f(r). The fall in real income F generated by S > I (desired) in the goods sector will affect the demand for money, which is a function of real Y only. As the interest rate falls, desired I rises, reducing S > I (desired). As real Y falls, the demand for money and the interest rate fall, strengthening the effects mentioned above. All of this will continue until point A is reached — equilibrium point, in Fig. 6.2.

Disequilibrium and Dynamics in the Goods and Money Market:

Equilibrium is said to be a stable one when economic forces tend to push the market towards it. Fig. 6.3 shows that the general equilibrium described here is indeed a stable one. To show this, we consider all the points to the left of the IS curve, like point A where interest rate r₁ and the level of Y₁ are too low for equilibrium to be achieved in the real sector. This means that the total value of output is less than the demand.

In this situation, businesses find their inventories run down involuntarily and so act to increase output which pushes up Y. For all points to the left of the IS curve, there is an excess demand for goods and thus there is pressure on income to rise. Similarly, tor all points to the right of the IS curve, there is excess supply of goods and there is pressure on Y to fall.

Now we consider points above the LM curve, like point B. At this point, with the level of Y, OY₁, the interest rate is too high for money market equilibrium to be achieved. This means that the supply of money exceeds the demand for money and so downward pressure is exerted on the interest rate. This is true for all points above the LM curve, as shown in Fig. 6.3 and it is also true that upward pressure will be exerted on interest rates at all points below the LM curve as there is excess demand for money.

The direction of the pressure being exerted on incomes and interest rates in the four quadrants are indicated by arrows in Fig. 6.3. At any disequilibrium point, such as C, economic forces will be pushing the market towards the general equilibrium position.

Shifting the IS and LM Curves:

Having analysed equilibrium in the two sectors, it is useful to examine how changes in behaviour will affect the two variables in which we are interested at present — real income and interest rate. There are four behavioural functions that determine equilibrium in the two sectors – the investment function and consumption function and the supply of money function and the demand for money function.

These functions were used to derive the IS and the LM curves and thus the behaviour represented by these functions is held constant along the IS and LM curves. A change is behaviour can be represented by a shift in these functions. Such shifts will result in the shift of the IS or LM curves, or,

Money Income And Real Income