Determination of Equilibrium Income and output

Saving And Investment Approach for determination of equilibrium income and Output

An alternative approach to the determination of equilibrium level of income is Saving Investment approach.According to this approach, equilibrium is struck at that level where planned investment equals planned saving.

i.e S = I

Since S refers to ‘withdrawal’ from the circular flow and I refers to ‘injection’ into the circular flow, equilibrium condition can be stated as:

Withdrawal = injection

The below graph shows the Saving and Investment function(already explained).

Equilibrium Income

E is the equilibrium point where S = I or Withdrawal = injection.

At this level AD = AS at all other levels of income AD is not equal to AS.

Taking two different level of income to explain the equilibrium income and output.

AT Y₁ level of income

At this level of income, saving exceeds planned investment by AB amount which implies that consumption is low due to higher amount of saving, and also AS > AD (as shown in the above graph).

Consumption expenditure of the household and investment expenditure of the firm will not be sufficient to purchase the entire output produced, leading to excess supply equal to AB amount.

This rise in unsold stock will force the producer to reduce production and thereby income (reducing production will leads to reduce factors of production and therby their factor income).

This process of accumulating unsold stock goods and falling output and income continues until income falls to the equilibrium level of Y₀. Where saving equals planned investment.

AT Y₂ level of income 

At this level of income investment exceeds saving of the household by GH amount which implies that consumption expenditure is high and thereby rise in demand for the goods will be more than the current production.

So to met the current demand inventory stocks will be used. When producer stock of inventories will fall, they will increase their production by hiring more workers to build up new inventories and thereby income will increase (increasing production will leads to increase in factors of production and therby their factor income)..

This process of falling inventories and increasing output and income continues until income rises to the equilibrium level of Y₀. Where saving equals planned investment.

We have discussed two approaches for finding the equilibrium level of income

Aggregate demand-Aggregate supply approach

Saving-Investment approach

And both of them give the same level of equilibrium income.