Question

When is an Economy in Equilibrium? Explain with the help of saving and investment functions. Also explain the changes that take place in an economy when the economy is not in equilibrium. Use diagram.

Answer 1

The economy is in equilibrium at that income level at which saving = investment. The equilibrium level of income is OM as at this level S = I.

When the economy is not in equilibrium saving is not equal to investment : Suppose S > 1 it means , AD < AS. This leads to piling up of inventories with the producers. In order to bring down inventories to the desired level, producers cut down production which brings down AS. The trend continues till, AD = AS again and S = I where the economy is in equilibrium. Similarly, if S < I, then AD > AS. There is decrease in inventories. Producers increase production, AS rises. This continues till AD =AS.