Chapter 18: Problem 2

Discuss the saving-investment approach to the determination of the equilibrium income and output in the Keynesian theory.

Short Answer

Expert verified

Answer: In the Keynesian saving-investment approach, the equilibrium condition occurs when the desired saving (S) equals the desired investment (I). The equilibrium income and output level is determined by finding the income level (Y*) at which desired saving equals desired investment, either graphically, by finding the point where the saving function intersects with the investment function, or mathematically, by solving the equation S(Y) = I(Y). The adjustment towards the equilibrium occurs through changes in income and output.

Step by step solution

Introduction of the Keynesian theory and Saving-Investment approach

The Keynesian theory emphasizes the role of aggregate demand in determining the equilibrium income and output in an economy. The saving-investment approach is a method used in the Keynesian theory to demonstrate how equilibrium is reached. In this approach, the equilibrium is achieved when the desired saving (S) equals the desired investment (I).

Define Saving and Investment

Saving (S) refers to the portion of income that is not consumed but set aside for future consumption. Investment (I) is the spending on capital goods, such as machinery and equipment, which are used to produce goods and services in the future. In a closed economy without government intervention, national income (Y) is equal to consumption (C) and investment (I) - Y = C + I.

Explain the Saving Function and Investment Function

The saving function, S = S(Y), describes the relationship between saving and income. The higher the income, the higher the saving. The investment function, I = I(Y), describes the relationship between investment and income. The Keynesian theory assumes that investment is autonomous or independent of income.

Derive the Equilibrium Condition

The equilibrium condition for the saving-investment approach in Keynesian theory occurs when desired saving equals desired investment, i.e., S(Y) = I(Y) or S(Y) - I(Y) = 0.

Explain how Equilibrium Income and Output are Determined

The equilibrium income and output level is determined by finding the income level (Y*) at which desired saving equals desired investment. Graphically, this occurs at the point where the saving function (S(Y)) intersects with the investment function (I(Y)). Mathematically, we can find the equilibrium income (Y*) by solving the equation S(Y) = I(Y).

Discuss the Adjustment Mechanism

In the saving-investment approach of the Keynesian theory, adjustment towards the equilibrium occurs through changes in income and output. If desired saving is greater than desired investment (S> I), there is excess saving, and income and output decrease to restore equilibrium. Conversely, if desired investment is greater than desired saving (I> S), there is excess investment, and income and output increase to establish equilibrium. Using the saving-investment approach, we have shown the process to determine the equilibrium income and output in the Keynesian theory. The equilibrium is reached when desired saving equals desired investment, and adjustments in income and output occur to maintain this balance.

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