If planned savings exceeds planned investments in an economy, explain its likely impact on income, output and employment.

Question

Accepted Answer

When planned savings exceed planned investments (S > I) in an economy, the following adjustment mechanism operates:

1. Excess Supply: Households save more than firms expected to invest. This means consumption is less than what firms anticipated. Aggregate supply exceeds aggregate demand.

2. Unplanned Inventory Accumulation: Firms experience an unplanned increase in inventories as goods remain unsold. Stocks rise above the desired level.

3. Production Cutback: To clear the excess inventory, firms reduce production. They lay off workers and decrease output.

4. Income Decline: Reduced production leads to lower employment and income. Workers and suppliers receive less income.

5. Induced Saving Reduction: As income falls, saving also decreases (since MPS > 0). The decrease 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.

Impact on Income, Output, and Employment:
- Income decreases as production falls
- Output declines as firms cut back
- Employment reduces as workers are laid off
- The economy moves towards a lower equilibrium level of income and output