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The circular flow of income in a closed economy
A closed economy exists when there is no international trade. We shall also assume that in this particular closed economy there is no government spending or taxation. Here households have two alternatives used for their income - they can consume it or they can save it. Savings are (S).
AD consists of consumption (C) and Savings (S).S are lost to Y and will reduce the level of Y. However, some (if not all) of S will be used to finance investment (I). I is the creation of real capital goods such as machinery and factories, and adds to Y. If S = I, then Y is in equilibrium.
In this economy
Y = AD
Therefore, Y = C + I
In equilibrium S = I
However, if S is greater than I, AD and Y will fall. If I is greater than S, AD and Y will rise.
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