Question

Why is saving called a leakage? Why is a planned investment called an injection? Why must saving equal planned investment at equilibrium GDP in a private closed economy? Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain.

Short answer

Saving is called leakage because saving reduces the amount available for consumption expenditure.

Planned investment puts money in the economic system and is therefore called an injection.

Saving and investment should be equal to stabilize the economy.

Unplanned changes are constant at equilibrium GDP.

Step-by-step solution

Step 1. Saving as a leakage

Saving is the money withdrawn from the economy’s total spending. Because of savings, part of income is excluded from the economic system, which reduces the multiplier effect.

Thus, savings reduces the amount available for spending. This is why it is treated as a leakage.

Step 2. Planned investment as an injection

The planned investment adds money to the total spending of an economy. It is the cost of capital goods purchased that are used to increase production.It encourages output growth by increasing total spending. Since investment adds money to the economy’s total spending, the planned investments are called injections.

Step 3. Equal saving and investment at the equilibrium of a private closed economy

If savings are not equal to investment, the economy will not be stable.

• Savings>investments: The total spending will fall short of output, demand will be less than supply, there will be downward pressure on prices. The firms will be forced to cut down the production. This will continue till the demand equates to supply. The decline in output will reduce the income. And eventually, savings will decrease due to income fall until it equals investment.
• Savings<investment: Total spending will exceed the output. Thus, firms need to increase the production rate to maintain the equilibrium. The increased production will increase income and saving until saving equals investment.

Therefore, for maintaining equilibrium in a private closed economy, savings should be equal to investments.

Step 4. Constant unplanned changes in inventories at equilibrium GDP

At equilibrium, there are no changes in the unplanned investment. An unexpected increase in investment would mean an excess of total spending beyond the economy’s output level. On the other hand, a sudden decline in investment would reduce the total spending and lead to an overproduction problem. Therefore, the unplanned investment has to remain constant to maintain the equilibrium of a private closed economy.