Are Savings always equal to Investment ? Discuss.

According to the classical view "Savings are always equal to investment” Disequilibrium can be there
but only for a short while and changes in the interest rate will bring the economy back to the
equilibrium level. According to Keynes realised or actual investment consists of .

(a) Planned investment

(b) Unplanned investment

Planned investment is what the firm owners plan to invest in machinery equipment & building
unplanned investment is an addition to the capital stock which depends upon short term demand.

Equilibrium is established in the economy when planned savings are equal to planned investment and
this is rare. This is because the decision to save & invest in taken by different groups of people. The
decision to save is taken by households, while the decision to invest by firms & the two decisions
rarely match.

According to Keynes when the classical economists talked about savings- investment equality, they
were talking about realised savings and investment which can be equal at all times. But
equilibrium is there in the economy only when planned savings is equal to planned investment.

The term EX-ANTE means intended or planned

The term EX-POST means actual or realised.

All the variables in income determination theory are ex ante variables.

Is equilibrium always at full employment level?

According to the classical economists, equilibrium will always be at full employment level, but
according to Keynes three possibilities exist.

1. Full employment equilibrium.

2. Deficient demand/ underemployment equilibrium
3. Excess Demand
1. Full Employment Equilibrium

When AD = AS at the full employment level then we say there is full employment equilibrium.

2. DEFICIENT DEMAND/ UNDEREMPLOYMENT EQUILIBRIUM

When AD less than AS at full employment level we say that there is deficient demand in the economy

OR

If AD is for an amount of output less than the full employment level of output then it is called
deficient demand.
Whenever there is deficient demand there is a tendency for prices to fall. Therefore, the gap between
AD & AS at the full employment level is called deflationary gap. FG in the diagram.
Deflationary gap is the difference between the actual AD & the AD required to establish full
employment equilibrium. It is a measure of the deficiency in AD at full employment level.
When there is a deflationary gap or AD < AS at full employment level, producers will find their
inventories piling up. Seeing their inventories piling up, the producers try to correct the situation by
reducing employment and output.
When output falls, income will also fall and the process will continue till AD becomes equal to AS &
income level OM1, is reached.
OM1 is an underemployment equilibrium level because at this level the economy is producing less
than the full employment level of output which is OM. It means that all the resources of the economy
are not being fully utilised. The economy can reach full employment equilibrium if in this situation
AD increase by FG amount & becomes equal to AD’.

MEASURES TO CORRECT DEFICIENT DEMAND/ DEFLATIONARY GAP

Accordingly to Keynes the government can play a very important note in correcting deficient demand
through its fiscal & monetary policy.

FISCAL POLICY MEASURES

Fiscal policy measures refer to the use of the government’s legal power to tax & to spend in order to
achieve economic objectives.

● REDUCING TAXES
The government should reduce taxes so that the disposable income of the people increases.
An increase in disposable income raises consumption expenditure. The amount by which
consumption expenditure will increase will depend upon MPC, Higher the MPC, higher will
be the consumption expenditure. This will increase AD & help in correcting deficient
demand.

● INCREASE IN GOVERNMENT EXPENDITURE.

The government incurs expenditure on administrative & welfare activities. The government
should undertake rigorous public works programmes like building rural roads, rural
electrification, etc. so that employment and income increases. With an increase in disposable
income, consumption demand will also rise. Therefore AD will rise.

MONETARY POLICY MEASURES

● Monetary policy measures refer to the exerting of powers by the central bank of the country
to influence money supply to fulfil certain economic objectives.

● Reduce Bank rate / Discount Rate

● Bank rate is the interest rate at which the commercial banks can borrow from the central bank
to meet their long term needs.
● In case of deficient demand, the bank rate should be decreased which will make borrowings
by the commercial banks cheaper. As a result the commercial banks will also lower the
interest rates on lending to general borrowers so demand for borrowings from banks will rise.
This will lead to an increase in the spending capacity of people and an increase in demand for
goods and services. Thus AD will rise.

● Decrease Cash Reserve Ratio (CRR).

● CRR refers to that percentage of deposits which the commercial banks are legally required to
keep as reserves with the Central Bank.
● In case of deficient demand, the CRR should be lowered . This will increase the funds
available with the commercial banks for credit creation i.e. the lending capacity of
commercial banks will increase. Borrowings from banks will increase leading to a rise in
demand, therefore AD increases.
● Decrease Statutory Liquidity Ratio (SLR)
● SLR refers to the minimum percentage of deposits with the commercial banks which these
banks are legally required to keep in the form of specified liquid assets as reserves with
themselves.
● In case of deficient demand, the SLR should be lowered . This will increase the funds
available with the commercial banks for credit creation i.e. the lending capacity of
commercial banks will increase. Borrowings from banks will increase leading to a rise in
demand, therefore AD increase

● Decrease Repo Rate

● It is the rate of interest at which the commercial banks can borrow from the central bank to
meet their short term needs.
● The Central Bank has the legal power in fixing this rate and in changing it.
● In case of deficient demand, the repo rate should be lowered which will make borrowings by
the commercial banks cheaper. As a result the commercial banks will also lower the interest
rates on lending to general borrowers so demand for borrowings from banks will rise. This
will lead to an increase in the spending capacity of people and an increase in demand for
goods and services. Thus AD will rise.

● Reverse Repo Rate

● Reverse Repo rate in the interest rate at which commercial banks can deposit their funds with
the Central Bank.
● In case of deficient demand the reverse repo rate should be lowered because it will discourage
the commercial banks from parking their funds with the central bank. Liquidity with the
commercial banks will increase & their credit creation capacity will also increase. Borrowings
from banks increase. Thus AD rises.

● Open Market Operations (Purchase of securities by the Central Bank)

● Open market operations refer to the buying & selling of securities by the central bank to the
public. This is done to influence money supply. Any flow of money into the central bank
reduces money supply with the public & vice versa.
● In a situation of deficient demand the central bank should purchase securities from the public
for which it makes money payments to the public. The money flows out of the central banks
& finds its way into the commercial banks through the buyer of these securities who have
accounts in the banks. Deposits with the commercial banks increase which in turn raises their
lending capacity. This increases borrowings for consumption and investment, thus AD rises.

● Lowering Margin requirement

● Margin requirement refers to the discount fixed by the Central Banks on the assets mortgaged
as security by the borrowers to the commercial banks.
● For eg. suppose a borrower pledges a building worth Rs 100 lakhs as security with the bank .
Suppose the margin fixed is 40% it means that the maximum amount of loan the banks can
give against the security is Rs. 60 lakh.
 ● In case of deficient demand, the central bank can lower minimum margin requirement in case
of selected or all commodities, against which loans are advanced the commercial banks. This
raises the borrowings capacity of the borrowers. They will borrow more as a result AD will
rise.

3. EXCESS DEMAND

When AD is greater than AS at the full employment level we say there is excess demand in the
economy.

Alternatively, if the aggregate demand is for a level of output more than the full employment level of
output we say that there is excess demand.

Whenever there is excess demand there is a tendency for prices to rise. So the gap between AD and
AS at full employment level is called the inflationary gap (FG in the dig).

Inflationary gap is the amount by which actual aggregate demand exceeds the level of aggregate
demand required the establish full employment equilibrium.

Equilibrium is to the right of the full employment level when them is a situation of excess demand.
This is practically possible because on the X axis we are taking nominal output and not real output.

Once the full employment level has been reached it is not practically possible to increase the quantity
of output. In the situation of excess demand, there is a tendency for prices to rise. Therefore, the
money value of full employment level of output increases because of rise in prices.
AT OM1 , the quantity of output produced is the full employment output level only but at a higher
1

price because of demand full inflation.

The economy can reach full employment equilibrium in this situation if AD decreases by FG amount
and becomes equal to AD’.

Measures to correct excess Demand / Inflationary Gap

Fiscal Measures.

● REDUCING TAXES
The government should increase taxes so that the disposable income of the people
reduces. A decrease in disposable income lowers consumption expenditure. The
amount by which consumption expenditure will decrease will depend upon MPC,
Higher the MPC, higher will be the reduction in consumption expenditure. This will
decrease AD & help in correcting excess demand.

DECREASE IN GOVT. EXPENDITURE

● The Govt. incurs expenditure on its welfare and administrative functions like on military
police services etc.
● The govt. should reduce its wasteful, unproductive expenditure. When the govt. reduces such
expenditure, there will be a reduction in the money is circulation. As a result, income of
individuals will fall which will cause a reduction in consumption demand. Therefore, AD will
fall.

Monetary Measures

● Increase Bank rate / Discount Rate

● Bank rate is the interest rate at which the commercial banks can borrow from the central bank
to meet their long term needs.
● In case of excess demand the bank rate should be increased. This will make borrowings by the
commercial banks expensive. As a result the commercial banks will also raise the interest
rates on lending to general borrowers so demand for borrowings from banks will fall. This
will lead to a decrease in the spending capacity of people and an decrease in demand for
goods and services. Thus AD will fall.

● Increase Cash Reserve Ratio (CRR).

● CRR refers to that percentage of deposits which the commercial banks are legally required to
keep as reserves with the Central Bank.
● In case of excess demand, the CRR should be raised . This will decrease the funds available
with the commercial banks for credit creation i.e. the lending capacity of commercial banks
will decrease. Borrowings from banks will decrease, leading to a fall in demand, therefore AD
decreases.

● Increase Statutory Liquidity Ratio (SLR)

● SLR refers to the minimum percentage of deposits with the commercial banks which these
banks are legally required to keep in the form of specified liquid assets as reserves with
themselves.
● In case of excess demand, the SLR should be raised . This will decrease the funds available
with the commercial banks for credit creation i.e. the lending capacity of commercial banks
will decrease. Borrowings from banks will decrease, leading to a fall in demand, therefore AD
decreases.

● Increase Repo Rate

● It is the rate of interest at which the commercial banks can borrow from the central bank to
meet their short term needs.
● The Central Bank has the legal power in fixing this rate and in changing it.
● In case of excess demand the repo rate should be increased. This will make borrowings by the
commercial banks expensive. As a result the commercial banks will also raise the interest
rates on lending to general borrowers so demand for borrowings from banks will fall. This
will lead to a decrease in the spending capacity of people and an decrease in demand for
goods and services. Thus AD will fall.

● Increase Reverse Repo Rate

● Reverse Repo rate in the interest rate at which commercial banks can deposit their funds with
the Central Bank.
● In case of excess demand the reverse repo rate should be raised because it will encourage the
commercial banks from parking their funds with the central bank. Liquidity with the
commercial banks will decrease & their credit creation capacity will also decrease.
Borrowings from banks decrease. Thus AD rises.

● Open Market Operations (Selling of securities by the Central Bank)

● Open market operations refer to the buying & selling of securities by the central bank to the
public. This is done to influence money supply. Any flow of money into the central bank
reduces money supply with the public & vice versa.
● In a situation of excess demand the central bank should sell securities to the public, The
public withdraws money from the commercial banks and makes payment to the central bank.
The money flows out of the commercial banks and into the central bank. This reduces
deposits of people with commercial banks. Reduction in deposits adversely affects lending
power of commercial banks. This decreases borrowings for consumption and investment, thus
AD falls.

● Raising Margin requirement

● Margin requirement refers to the discount fixed by the Central Banks on the assets mortgaged
as security by the borrowers to the commercial banks.
● For eg. suppose a borrower pledges a building worth Rs 100 lakhs as security with the bank .
Suppose the margin fixed is 40% it means that the maximum amount of loan the banks can
give against the security is Rs. 60 lakh.
● In case of excess demand, the central bank can raise minimum margin requirement in case of
selected or all commodities, against which loans are advanced the commercial banks. This
lowers the borrowings capacity of the borrowers. They will borrow less as a result AD will
fall.