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When is an economy in equilibrium? Explain with the help of saving and investment functions. Also explain the changes that take place when the economy is not in equilibrium. Use diagram.

Answer:

The equilibrium level of income or output is that level at which the planned savings and planned investments are equal. It is derived from Aggregate Demand and Aggregate supply approach. Aggregate Demand (AD) in a two sector economy is defined as the sum of Consumption Expenditure [c] and Investment Expenditure (I) i.e. AD=C+I, whereas Aggregate Supply (AS) is defined as the sum of Consumption Expenditure [c] and Saving (S) i.e. AS=C+ S.          Mathematically, at equilibrium level of out             AD=AS or, C+I=C+S    Hence,   I=S Or         S=I In the graph given, OP is the equilibrium level of income. E is the equilibrium point where Aggregate Demand equals Aggregate Supply Equality between AS and AD implies the equality between S and I. When we extend the line EP vertically downward, it meets at point E? with S and I. It is the equilibrium point of saving and investment approach. OP represents the level of income at which the economy is equilibrium.