1) Why must planned savings of households be equal to planned investments of firms at the equilibrium level of income and output? Explain.

2) Draw on a diagram a straight line savings curve for an economy. From it derive the consumption curve, explaining the method of derivation. Show a point on the consumption curve at which average propensity to consume is equal to 1.

Solution 1

At the equilibrium point, planned savings by the households will always be equal to planned investment by the firms. This is because any deviation from the equilibrium level of income and output, will correct itself with the help of the Automatic Adjustment Mechanism. There are two situations wherein, planned investment and planned savings may deviate from the equilibrium point. A chain of activities will restore the equilibrium in both the cases. Thus, maintaining the equilibrium at S=I.

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Solution 2

In the lower part of the diagram,  is the saving curve.  OS equal to represents the saving at zero level of income.

Steps for the derivation of consumption curve from the saving curve are as follows.

  1. Corresponding to  in the saving function, we have  in the consumption function. That is, it represents the autonomous consumption or the consumption at zero level of income. The autonomous consumption is financed by drawing down savings.
  2. At point B, saving equals zero. This suggests that whole of income is spent on consumption. That is, Y= C.  This point is also known as the break-even point. This is shown by point A in the upper panel denoting Y=C.
  3. By joining the points C and A we derive the straight upward sloping consumption curve.
  4. CC is the required consumption curve.  

(ii) The point where APC is equal to 1 is the Break-even point. Here, the consumption is equal to Income (C = Y). Thereby, APC given as () is equal to one.

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