Question

Discuss the working of the adjustment mechanism in the following situation:

Ex Ante Investments are lesser than Ex Ante Savings. 

Explain the adjustment mechanism in case ex-ante savings are greater than ex-ante investments.

Answer 1

When Ex Ante Investments are lesser than Ex Ante Savings.
The situation when S exceeds I, i.e., when withdrawal from the income is greater than injections into the circular flow of income, then it implies that total consumption expenditure is less than what is required to purchase the available supply of goods and services. In other words, we can understand this as high saving implies low consumption, which means that the required output is less than the planned output. Thus, a portion of the supply remains unsold, which leads to unplanned inventory accumulation. In response to this situation, for clearing this unsold stock, the producers plan a cut in the production in the next period. Therefore reduce the employment of labourers. The reduced employment leads to a fall in aggregate income in the economy, consequently, lesser aggregate saving. The saving will continue to fall, until, it becomes equal to the investment. At the point, where saving and investment are equal, equilibrium is achieved.

This process of adjustment mechanism is explained below graphically.

In the figure, S and I represent the Saving and Investment curves. Let us suppose that the equilibrium is facing a situation, where saving (TY') exceeds investment (KY'). Consequently, the aggregate consumption expenditure is lower than what is required to buy all the goods and services. Therefore, there exists unplanned inventory accumulation of unsold stock equal to TK (i.e. TY' – KY') and the producers respond by reducing the production by reducing employment. Due to reduced employment, the income of the factors of production (of the people) falls. Subsequently, the saving will fall due to reduced income. Hence, the saving will continue to fall, until, saving equates investment at point E. The economy achieves equilibrium at point E, with saving equal to investment and OY level of national income (or output).