Question

Explain the determination of national income through the saving-investment approach. Illustrate your answer diagrammatically. Can this equilibrium be at less than full employment level of income?

Explain the equilibrium level of income with the help of saving-investment curves. If savings exceed planned investment, what changes will bring equality between them?

In an economy planned investment exceeds planned savings. How will be the equality between the two achieved? Explain.

Answer 1

The saving investment approach offers an alternative way to determine the equilibrium level of income. According to this method, equilibrium occurs when planned saving equals planned investment. This matches the condition where aggregate demand (AD) equals aggregate supply (AS), ensuring no unintended changes in output or inventories.

Now AD = C + I       ...(1)

and AS = C + S        ...(2)

by equaling (1) and (2),

we get C + I = C + S

∴ I = S

The equilibrium level of income is at OY₀, where the saving (S) curve intersects the investment (I) curve. At this point, aggregate demand equals aggregate supply-what households don’t spend (savings), firms invest. At any other income level, this balance doesn’t hold, so firms will either increase or decrease output to reach equilibrium.

At income level OY₁, planned saving exceeds investment by AB, meaning aggregate supply is greater than aggregate demand. Due to low consumption, not all output is sold, causing unsold inventories to rise. To reduce this, firms cut production and lay off workers, leading to a fall in income, output, and employment. This continues until the economy returns to the equilibrium level OY₀.

At income level OY₂, planned investment exceeds saving by GH. This creates excess demand, as households consume more and save less. To meet demand, firms reduce inventories, then increase production and hire more workers. As a result, income, output, and employment rise until the economy reaches equilibrium at OY₀, where saving equals investment.

Both the aggregate demand–aggregate supply and the saving investment approaches lead to the same equilibrium income, as shown in the diagram.

According to Keynesian theory, the equilibrium level of income and output is determined by aggregate spending.

• If aggregate spending is insufficient, output remains below full employment, leading to an underemployment equilibrium where some resources, including labour, remain unemployed.
• If aggregate spending equals full employment output, the economy achieves full employment equilibrium.
• If aggregate spending is excessive, output stays at full employment, but it causes inflation.

Thus, equilibrium can occur at full employment, underemployment, or with inflation, depending on the level of aggregate demand.