Q.Explain with the help of a diagram, the determination of equilibrium level of income, using saving-investment approach.

The key to this question lies in understanding inventory investment — the bridge between production and spending in the short run.

In any economy, firms produce a certain level of output (planned output). Households, firms, government, and foreigners together plan a certain level of spending (aggregate demand). These two rarely match exactly in the very short run. The difference is absorbed by inventories — stocks of unsold goods that firms hold.

When planned spending > planned output, people are buying more than what is currently being produced. Where do these extra goods come from? They come from the inventories that firms already have. So inventories fall — this is an unplanned decrease in inventories. That matches statement (i).

Now, what do firms do when they see their inventories shrinking unexpectedly? They realise demand is stronger than they thought. Their rational response is to increase production to rebuild inventories and meet the higher demand. More production means more income for workers and owners — so national income rises. That matches statement (ii). …

The question tests your understanding of the equilibrium condition in the simple Keynesian model of income determination. Let's unpack what ex-ante means and why equilibrium forces these magnitudes to align.

Ex-ante vs Ex-post: The Planning Distinction

Ex-ante refers to planned or intended magnitudes—what households plan to save and what firms plan to invest before production decisions are made. Ex-post refers to realized or actual values after all transactions have occurred. In any accounting period, ex-post savings must equal ex-post investment (because unsold inventory counts as unintended investment), but ex-ante magnitudes need not match unless the economy is in equilibrium.

The Equilibrium Condition

Equilibrium income is defined as the level of national income at which aggregate demand (AD) equals aggregate supply (AS), or equivalently, where planned spending equals planned output. In the two-sector model (households and firms), this translates to:

where $Y$ is income/output, $C$ is planned consumption, and $I$ is planned (ex-ante) investment.

Since income is either consumed or saved ($Y = C + S$), we can substitute:

Canceling consumption from both sides gives the equilibrium condition in its savings-investment form:

This equality holds only at equilibrium. When the economy is out of equilibrium—say, planned investment exceeds planned savings—aggregate demand exceeds aggregate supply, inventories fall below desired levels, and firms expand output until income rises enough that savings catch up to investment.

Evaluating the Statements

Assertion (A): "Ex-ante savings and ex-ante investments are never equal to each other."

This is false. They are equal at the equilibrium level of income. Away from equilibrium they differ, but the economy adjusts toward equilibrium where they match.

Reason (R): "At equilibrium level of income, aggregate demand may not be equal to the aggregate supply."

This is also false. Equilibrium is defined as the state where $AD = AS$. If aggregate demand did not equal aggregate supply, by definition the economy would not be in equilibrium—there would be unintended inventory changes prompting output adjustments.

In macroeconomics, understanding how an economy's output and income are determined relies on precise definitions of key terms like investment and the conditions for equilibrium. These concepts are fundamental to analyzing economic activity.

Let's examine Statement 1: "Investment is defined as addition to the physical capital and changes in the inventory."

In the context of national income accounting and macroeconomic theory, investment refers to real investment, which is the formation of new capital goods. This includes the purchase of new machinery, construction of new buildings, and other additions to the economy's stock of physical capital. Crucially, it also includes changes in inventories, which are the stocks of raw materials, semi-finished goods, and finished goods held by firms. An increase in inventories is considered an investment because it represents goods produced but not yet sold, adding to the capital stock available for future production or sale. This definition is consistent with standard macroeconomic textbooks, including NCERT.

Now, let's consider Statement 2: "At equilibrium level of income, ex-post investments and ex-post savings are always equal."

To understand this, we must distinguish between 'ex-ante' and 'ex-post' variables.

• Ex-ante refers to planned or intended values. For example, ex-ante investment is the investment firms plan to undertake, and ex-ante saving is the saving households plan to do.
• Ex-post refers to actual or realized values. Ex-post investment is the actual investment that takes place, and ex-post saving is the actual saving.

The condition for macroeconomic equilibrium in a simple economy is when planned aggregate demand equals planned aggregate supply, or equivalently, when ex-ante investment ($I_p$) equals ex-ante saving ($S_p$). If planned investment is not equal to planned saving, there will be unplanned changes in inventories, which will push the economy towards equilibrium. …