Question

In macroeconomic equilibrium total savings are equal to investment. Why is this true? Simply doing the algebra is not sufficient as an answer to this question. You must also provide an intuitive explanation.

Answer 1

According to Keynesian, an economy is said to be at equilibrium where planned aggregate demand (AD) is equal to planned aggregate supply (AS) . That is what producer is willing to supply is demanded by the households.

AD = AS... (1)

AD = C + I

AS = C + S

Aggregate demand is the money value of all the goods and services that all the sectors in an economy are willing to purchase. In a Two sector model, aggregate demand is the sum total of consumption and investment expenditure i.e AD = C + I

Aggregate supply is the total flow of goods and services in an economy. it can also be defined as the money value of all the goods and services that the producers are willing to sell. The money value of all the goods and services is distributed among the factors of production which becomes their factor income. The sum total of factor income is known as national income (Y). I.e., AS = Y. Some part of the income is consumed while some part of the income is saved i.e Y = C + S.

Putting values of AD and AS in equation 1

C+ I = C+ S

I = S...... (2)

As per the savings and investment approach, an economy is said to be at equilibrium where ex ante savings and exante investments are equal. Exante here refers to planned.

At each level of income total savings must be equal to the total investment.

According to Keynesian, savings is a difference of income and consumption i.e., S = Y - C. Further, investment is the name given to expenditures other than the consumption expenditures, it is nothing but income minus consumption or I = Y – C. Hence S = I (because both are = Y – C).

Importance of S= I approach:

1. Paradox of thrift: the equality between saving and investment approach helps to explain the concept of paradox of thrift. It explains that if all the people in the economy start saving, total savings in the economy main not rise or remain same. Rise in savings is indicated by marginal propensity to save. Rising MPS means that people are willing to consume less and they are willing to save more. low level of consumption means that low level of income generation in the economy. Low level of income generation is followed by low level of savings. ( assumption: Someone's consumption become others income).

2. Adjustment mechanism: When Savings are more than Investment ( that is households are willing to consume Less and save more then what producers are willing to invest) , then the actual inventory would rise above the desired level. To bring back the Inventory at the desired level, the producers must cut the output. Less output means low income. When income declines savings also decline till savings and investment are equal.

When S is less than I, ( that is households are are planning to consume more and save less than what producer's are willing to invest). The actual inventory level is below the desired level. To fulfill the unfulfilled demand, the producer will plan more production. This will generate more income and mausi wings. The adjustment mechanism will continue till saving and investment are equal.