Explain the adjustment mechanism to restore equilibrium in the economy, if planned savings are greater than planned investment.
Explain the adjustment mechanism to restore equilibrium in the economy, if planned savings are greater than planned investment.
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Solution and Explanation
Planned saving is what households intend to save at a given income. Planned investment is what firms intend to invest.
Equilibrium output is reached when planned saving equals planned investment. This is the same as aggregate demand equal to aggregate supply.
Step 2: What planned saving above planned investment means:
Income is either consumed or saved, so if saving is higher, households consume less.
Here, households plan to consume less than the firms expected them to consume.
So aggregate demand (consumption plus investment) is less than the output produced.
Step 3: Unintended build-up of inventories:
Firms cannot sell all the goods they have produced, because demand is short.
The unsold goods pile up as stock. This is an unintended accumulation of inventories.
Stock above the desired level is a signal to the producers.
Step 4: Producers cut production:
To bring the inventories back to the desired level, producers reduce production.
Lower production means less employment and a lower level of income in the economy.
Step 5: Saving falls with income:
Saving depends on income. When income falls, planned saving also falls.
The fall in output and income continues till planned saving becomes equal to planned investment.
At this point inventories are at the desired level and the equilibrium level of output is restored.
Final Answer:
When planned savings exceed planned investment, households consume less than firms expected. Unsold goods pile up as unintended inventories, so producers cut output. Output and income fall, and planned saving falls with them until it equals planned investment and equilibrium output is restored.
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