Describe the adjustment mechanism, if ex-ante savings are less than ex-ante investments.

Question

Accepted Answer

When ex-ante savings are less than ex-ante investments (S < I), the economy is in a disequilibrium situation. The adjustment mechanism works as follows:

1. Excess Demand: Since households consume more than firms expected (saving less), aggregate demand exceeds aggregate supply. Consumers buy more goods than firms planned to produce.

2. Unplanned Inventory Depletion: Firms experience an unplanned decrease in their inventories as goods sell faster than anticipated. Stocks fall below the desired level.

3. Production Response: To restore inventories to the desired level, firms increase production. They hire more workers and increase output.

4. Income Generation: Increased production leads to higher employment and income. Workers and suppliers receive more income.

5. Induced Consumption and Saving: As income rises, both consumption and saving increase (since MPC and MPS are positive). The increase in saving reduces the gap between S and I.

6. Convergence to Equilibrium: This process continues until ex-ante savings equal ex-ante investments (S = I). At this point, there is no further tendency for change, and the economy reaches equilibrium.

The adjustment mechanism ensures that the economy moves towards equilibrium through changes in output, employment, and income.