An alternative to the AE = Y approach to the determination
of the equilibrium level of income, output and employment, is the
leakage-injection approach. Leakages, as we saw in chapter four, are
withdrawals of potential expenditure from the income/expenditure stream. Hence,
they serve to deflate the circular flow. Injections, on the other hand, are
fresh expenditures, which serve to expand the circular flow of income. In a complete
four-sector model of income determination leakages consist of savings, taxes
and imports, while injections consists of business investment, government
expenditures and exports. Equilibrium is achieved when total planned leakages
within the economy are equal to the total planned injections, i.e.
of the equilibrium level of income, output and employment, is the
leakage-injection approach. Leakages, as we saw in chapter four, are
withdrawals of potential expenditure from the income/expenditure stream. Hence,
they serve to deflate the circular flow. Injections, on the other hand, are
fresh expenditures, which serve to expand the circular flow of income. In a complete
four-sector model of income determination leakages consist of savings, taxes
and imports, while injections consists of business investment, government
expenditures and exports. Equilibrium is achieved when total planned leakages
within the economy are equal to the total planned injections, i.e.
I + G + X = S + T + M
Equilibrium under the leakages-injection approach is usually
illustrated with the bath-water theorem. If a bath contains a specified level of
water and the drain is opened so that water can easily flow out of the bath
(i.e. there is a leakages), for the level of water (income) to remain at
equilibrium, there must be a proportionate flow of water (injection) into the
bath. The level of water will remain stable only when the outflow is equal to
the inflow. Similarly, when total planned leakages are equal to total to
planned injections in the economy, it means, by implication, that planned
aggregate expenditure is equal to the real national income (output). If we
return back to our two-sector model, the only leakage is planned savings while
planned investment is the only injection. At equilibrium, therefore, planned
savings by households must be equal to planned investment by the business
sector. In other words, we can represent our macroeconomic equilibrium in the
two-sector by the equation.
illustrated with the bath-water theorem. If a bath contains a specified level of
water and the drain is opened so that water can easily flow out of the bath
(i.e. there is a leakages), for the level of water (income) to remain at
equilibrium, there must be a proportionate flow of water (injection) into the
bath. The level of water will remain stable only when the outflow is equal to
the inflow. Similarly, when total planned leakages are equal to total to
planned injections in the economy, it means, by implication, that planned
aggregate expenditure is equal to the real national income (output). If we
return back to our two-sector model, the only leakage is planned savings while
planned investment is the only injection. At equilibrium, therefore, planned
savings by households must be equal to planned investment by the business
sector. In other words, we can represent our macroeconomic equilibrium in the
two-sector by the equation.
S = I 6.42
Where S is planned households’ savings and I is planned
business investment. While the classical economists believed that savings would
always equal investment, Keynes argued that this would be true only in the
ex-post (realized) sense. In his opinion, it is not possible for planned
savings and investment to be equal since both are undertaken by different
motives. In fact, in Keynes opinion, the equality of planned savings and
investment cannot be readily achieved. If at all it is realized, it is unlikely
that the level of output and employment associated with that equilibrium would
be the one acceptable to policy makers. In addition, the equilibrium is not
likely to be stable, because nothing guarantees, for example, that an increase
in planned investment by the business sector will be followed by an equal
increase in planned savings households, and vice versa. Hence, the economy is
more likely to experience disequilibria, rather than equilibrium.
business investment. While the classical economists believed that savings would
always equal investment, Keynes argued that this would be true only in the
ex-post (realized) sense. In his opinion, it is not possible for planned
savings and investment to be equal since both are undertaken by different
motives. In fact, in Keynes opinion, the equality of planned savings and
investment cannot be readily achieved. If at all it is realized, it is unlikely
that the level of output and employment associated with that equilibrium would
be the one acceptable to policy makers. In addition, the equilibrium is not
likely to be stable, because nothing guarantees, for example, that an increase
in planned investment by the business sector will be followed by an equal
increase in planned savings households, and vice versa. Hence, the economy is
more likely to experience disequilibria, rather than equilibrium.
In fig. 6-5, the aggregate planned savings curve is S. This
is drawing on the assumption that aggregate savings by households will always
be positive (there is no aggregate dis-saving). The planned investment curve is
I. Planned savings is equal to planned investment only at Ye. Beyond Ye (e.g.
at Yg) planned savings exceeds planned investment. In other words, there is a
savings-investment gap (surplus savings) in the system. What households planned
to save is more than what the business sector planned to invest, thereby
leaving some surplus savings in the system. This is just another way of saying
that planned aggregate expenditure in the economy is below planned output
(since savings reduces aggregate expenditure by reducing consumption expenditures
of households).
is drawing on the assumption that aggregate savings by households will always
be positive (there is no aggregate dis-saving). The planned investment curve is
I. Planned savings is equal to planned investment only at Ye. Beyond Ye (e.g.
at Yg) planned savings exceeds planned investment. In other words, there is a
savings-investment gap (surplus savings) in the system. What households planned
to save is more than what the business sector planned to invest, thereby
leaving some surplus savings in the system. This is just another way of saying
that planned aggregate expenditure in the economy is below planned output
(since savings reduces aggregate expenditure by reducing consumption expenditures
of households).
If on the other hand, planned investment by the business
sector exceeds planned savings by households (e.g. at Yb), it means by implication
that planned household’s expenditure on goods and services is greater than the quantity
of investment gap characterized by low savings. Households planned to save too
little and spend too much than is required. The possibility of a
savings-investment gap introduces us to the paradox of thrift, a phrase
popularized by Keynes.
sector exceeds planned savings by households (e.g. at Yb), it means by implication
that planned household’s expenditure on goods and services is greater than the quantity
of investment gap characterized by low savings. Households planned to save too
little and spend too much than is required. The possibility of a
savings-investment gap introduces us to the paradox of thrift, a phrase
popularized by Keynes.
The habit of saving by household is desirable since savings
provide loan able funds for investment and capital accumulation so necessary
for economic growth. According to Keynes however, savings may not be as
beneficial as we make it, and is indeed not beneficial to a nation characterized
by depression or deflationary pressures. In Mr. Keynes view therefore, some
savings is good but too much savings is bad. In particular, if an economy is
faced with a deflationary gap, what is needed is not savings but consumption.
Assuming there is surplus savings in the economy (e.g., if the economy is at Yg
in fig. 6.5), how does the business sector respond to the shortfall in actual
aggregate households? Initially, business firms will be faced with a sudden
increase in stock of unsold goods (inventories). However, they will quickly
adjust to this situation by cutting down on their planned investment
expenditures for the next period. in fig. 6-5, the deficit in aggregate
expenditure occasioned by the excessive households savings (ab) is translated
into an unplanned increased in stock of the same magnitude by the business
sector.
provide loan able funds for investment and capital accumulation so necessary
for economic growth. According to Keynes however, savings may not be as
beneficial as we make it, and is indeed not beneficial to a nation characterized
by depression or deflationary pressures. In Mr. Keynes view therefore, some
savings is good but too much savings is bad. In particular, if an economy is
faced with a deflationary gap, what is needed is not savings but consumption.
Assuming there is surplus savings in the economy (e.g., if the economy is at Yg
in fig. 6.5), how does the business sector respond to the shortfall in actual
aggregate households? Initially, business firms will be faced with a sudden
increase in stock of unsold goods (inventories). However, they will quickly
adjust to this situation by cutting down on their planned investment
expenditures for the next period. in fig. 6-5, the deficit in aggregate
expenditure occasioned by the excessive households savings (ab) is translated
into an unplanned increased in stock of the same magnitude by the business
sector.
In the same way, the business sector would respond to a
deficit in planned households’ savings (an excess in planned households’
spending) by reducing the stock of inventories in the present period. This
decrease in stock (which is equal to the excess of planned households’ savings
over planned business output) is represented by cd in fig 6-5. In order to more
effectively meet the excess expenditure of households however, the business
sector would increase their planned investment expenditure for the next period.
deficit in planned households’ savings (an excess in planned households’
spending) by reducing the stock of inventories in the present period. This
decrease in stock (which is equal to the excess of planned households’ savings
over planned business output) is represented by cd in fig 6-5. In order to more
effectively meet the excess expenditure of households however, the business
sector would increase their planned investment expenditure for the next period.
While realized (actual) households’ savings and the business
sector’s realized investment are always equal, only at the equilibrium level of
income (Ye) is planned households’ savings equal to plan business investment.
At other income levels, there is a saving-investment gap characterized by
either excess or low savings. In such situations, the stock of inventories
adjusts to achieve equality between realized savings and investment.
sector’s realized investment are always equal, only at the equilibrium level of
income (Ye) is planned households’ savings equal to plan business investment.
At other income levels, there is a saving-investment gap characterized by
either excess or low savings. In such situations, the stock of inventories
adjusts to achieve equality between realized savings and investment.
From the above, it is clear that every time planned savings
differ from planned investment, there would be an expansion or contraction in
the circular flow in the form of unplanned changes in stock. In other words,
real national income will change until the equality of planned savings and
investment is achieved. In closing, it should be noted that while planned
savings by households can only equal planned investment (by the business
sector) at equilibrium, ex-post (actual) investment in the economy will always
equal savings. This is because; actual investment in the present period is
equal to planned investment plus the change in inventory investment. For
example, at Y output level (fig 6-5), actual investment is CY (planned
investment) less cd (decrease in inventory). Hence actual investment is equal
to actual (planned) savings (CY – cd = dy). Similarly, at Y actual investment
is equal to bY (planned investment) plus ab (unplanned increase in inventory).
Hence actual investment is equal to actual (planned) savings (bY + ab = aY).
differ from planned investment, there would be an expansion or contraction in
the circular flow in the form of unplanned changes in stock. In other words,
real national income will change until the equality of planned savings and
investment is achieved. In closing, it should be noted that while planned
savings by households can only equal planned investment (by the business
sector) at equilibrium, ex-post (actual) investment in the economy will always
equal savings. This is because; actual investment in the present period is
equal to planned investment plus the change in inventory investment. For
example, at Y output level (fig 6-5), actual investment is CY (planned
investment) less cd (decrease in inventory). Hence actual investment is equal
to actual (planned) savings (CY – cd = dy). Similarly, at Y actual investment
is equal to bY (planned investment) plus ab (unplanned increase in inventory).
Hence actual investment is equal to actual (planned) savings (bY + ab = aY).