Q. 234.7( 3 Votes )

Explain how the e

Answer :


Savings is the remaining portion of the income after consumption. The saving function determines the level of savings according to each level of income. Savings is the function of income. MPS determines the ratio of changes in savings to the changes in income.


Investment is the addition made to the existing stock of capital assets. It is determined by the level of income. Investment can be autonomous or induced in nature. Autonomous investment is the investment made independently without considering the changes in income. Induced investment is the investment made according to the changes in income.


At equilibrium, the total savings in the economy will be equal to the total investment. This equality is brought about by adjusting the level of income. When investment is more than savings, income rises and when savings is more than investment, income falls. This adjustment between investment and savings will continue until savings becomes equal to investment. The equilibrium can be depicted in the following diagram:



Both savings and investment is in equilibrium at point E. At this point the level of income is Y. When income level is Y2, the level of an investment exceeds the level of savings. Their difference is I2 S2. This additional investment will create more income by the forward operation of the investment multiplier. Thus the level of income in the economy will rise and will reach the equilibrium level of income Y. Conversely, if the level of income is Y1, the level of savings exceeds the level of investment. Their difference is I1 S1. These additional savings will reduce the level of income by the backward operation of the investment multiplier. Thus the level of income in the economy will fall and will reach the equilibrium level of income Y.


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