Question

What are two alternative ways of determining equilibrium level of income? How are these related?

 

 

Answer 1

The equilibrium level of income/output can be studied using the following two approaches.
1. Aggregate Demand and Aggregate Supply approach (AD and AS approach)
2. Saving and Investment approach (S and I approach).
The two approaches are related as the savings curve can be derived from the consumption curve and vice-versa. In fact the two approaches can be drawn simultaneously as follows:
In the upper panel of the diagram, the equilibrium is represented using the AD and AS approach. The lower panel represents equilibrium using the S and I approach. The equilibrium using the AD and AS approach is established at point E. Correspondingly, in the lower panel, the equilibrium is established at point E'. 

This can be also proved mathematically.
As per the AD and AS approach, equilibrium happens at a point, where:
AS = AD
or, C + S = C + I
i.e. S = I
Thus, it can be said that in a two-sector model, when AD equals AS, then it automatically, implies that at this equilibrium point, all the leakages are equal to all the injections into the economy. That is, saving is equal to investment.