(i) "In an economy, ex-ante investment (I) exceeds ex-ante savings (S)." Explain the likely impact of the given situation on output, employment and income. (ii) Define excess demand.

Question

Accepted Answer

(i) When ex-ante investment (I) exceeds ex-ante savings (S):

This situation creates excess demand in the economy. Since firms invest more than households save, aggregate demand exceeds aggregate supply. The adjustment mechanism works as follows:

1. Excess Demand: AD > AS because investment is higher than what savings can finance.
2. Unplanned Inventory Depletion: Firms sell more than they expected, leading to a fall in inventories.
3. Production Increase: To restore inventories, firms increase production.
4. Income Generation: Higher production leads to increased employment and income.
5. Saving Increases: As income rises, saving also increases (since MPS > 0).
6. Convergence: This continues until S = I, establishing equilibrium.

Impact on Output, Employment, and Income:
- Output increases as firms expand production
- Employment rises as more workers are hired
- Income grows through the multiplier process

(ii) Excess Demand:
Excess demand occurs when aggregate demand exceeds aggregate supply at the full employment level of output. It means that the total planned expenditure by households and firms is greater than the total output that the economy can produce when all resources are fully employed. This situation leads to inflationary pressure as prices rise to ration the limited supply among competing demanders.