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Question
How is it determined by using Saving and Investment approach?
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Solution
There are two approaches to attain the equilibrium level of income:
- AD - AS approach
- Saving and investment approach. Saving and investment approach to attain the equilibrium level of income in the economy is explained below:
An economy attains equilibrium level of income only when planned savings are equal to the planned investment. Investment is assumed to be autonomous. It can be understood with the help of following:
- When planned savings are less than planned investment: At the income level below the equilibrium level of income, the planned savings is less than planned investment. This means that households are consuming more than what the firms are expecting. The firms will witness a shortfall in their inventory stock. This is termed as unplanned investment. To reach the desired level of inventory, firms will increase the production, leading to increase in output, income and employment.
- When planned savings are more than planned investment: At the income level above the equilibrium level of income, the planned savings is more than the planned investment. This means that households are consuming less than what the firms are expecting. The firms will witness a rise in their inventory stocks. Thus there is an additional investment or unplanned investment. To have a desired level of inventory, firms will stop the production, leading to low output, income and employment.
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