Q.Describe the adjustment mechanism, if ex-ante savings are less than ex-ante investments.

When ex-ante (planned) savings are less than ex-ante (planned) investments, it signifies a situation where the aggregate demand in the economy exceeds the aggregate supply at the current income level.

The adjustment mechanism unfolds as follows:

1. Inventory Depletion: Firms find that their planned investment exceeds the planned savings by households. This means that the demand for goods and services is higher than what firms are currently producing. Consequently, firms experience an unplanned decrease in their inventories, falling below the desired level.
2. Increase in Production: To replenish their depleted inventories and meet the higher demand, firms respond by increasing their production of goods and services.
3. Rise in Income and Employment: The increase in production leads to a rise in employment and, subsequently, an increase in the national income.
4. Increase in Savings: As national income rises, a portion of this increased income is saved. Therefore, ex-ante savings begin to increase. …

In macroeconomics, the concepts of ex-ante and ex-post are crucial for understanding how an economy adjusts towards equilibrium. "Ex-ante" refers to planned or intended values, while "ex-post" refers to actual or realized values. For instance, ex-ante savings are the savings households plan to make, and ex-ante investments are the investments firms plan to undertake. In a simple two-sector economy (households and firms), equilibrium occurs when planned aggregate demand equals planned aggregate supply, which is equivalent to planned savings ($S$) equaling planned investments ($I$).

When ex-ante savings are less than ex-ante investments ($S < I$), it means that the total amount households plan to save is less than the total amount firms plan to invest. This situation indicates a disequilibrium in the economy, specifically that planned aggregate expenditure (demand) exceeds the current level of output (supply).

Let's break down the adjustment mechanism:

1. Excess Aggregate Demand: The condition $S < I$ implies that planned aggregate demand ($AD$) is greater than planned aggregate supply ($AS$) or current output ($Y$).

   In a two-sector model, aggregate demand is $AD = C + I$, and aggregate supply is $AS = Y$.

   Also, income is either consumed or saved: $Y = C + S$.

   If $S < I$, then substituting $S = Y - C$ into the inequality gives $Y - C < I$.

   Rearranging this, we get $Y < C + I$.

   Since $C + I$ represents planned aggregate demand, this means $Y < AD$.

2. Inventory Depletion: When planned aggregate demand ($AD$) exceeds the current level of output ($Y$), firms find that they are selling more goods than they are producing. This leads to an unplanned decrease in their inventories. Firms' stock of unsold goods starts to fall below their desired levels.

3. Increase in Production: The depletion of inventories signals to firms that there is strong demand for their products. To replenish their stocks and meet the higher demand, firms respond by increasing their production levels.

4. Increase in Income: As firms increase production, they hire more factors of production (labour, capital, etc.). This leads to an increase in employment and factor payments (wages, rent, interest, profits), which in turn raises the national income ($Y$) of the economy. …