Question

Explain the adjustment mechanism in case ex-ante savings are greater than ex-ante investments.

Hint:

Remember, in Keynesian economics, income acts as the adjusting variable to bring savings and investment into equilibrium.

Answer 1

When ex-ante savings exceed ex-ante investments, there is an unintended accumulation of inventories in the economy. This indicates that aggregate demand is lower than aggregate supply. Firms respond by reducing output and employment, leading to a fall in income. As income falls, both consumption and saving also fall. This process continues until savings equal investment again, and equilibrium is restored in the economy. Thus, the economy automatically adjusts through changes in income until ex-ante savings equal ex-ante investments.