Ch9Equilibrium

Chapter 9

Demand Side Equilibrium

Aggregate Expenditures

Ag

gre

gate

Exp

en

dit

ure

s =

AE

Real Income = Real GDP = Y

I =

10

00

I =

10

00

AE = C+I+G+NX

AE

G =

5

00

G =

5

00

NX =

30 0

NX =

30

0

Y = 5,000

C = 100 + 0.9Y

C =

9,1

00

I =

10

00

G =

5

00

NX =

30

0

Y = 10,000

C =

17

,20

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 19,000A

E =

10

,90

0

AE =

19

,00

0

C =

46

00

AE =

6,4

00

C =

22

,60

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 25,000

AE =

24

,40

0



I =

10

00

I =

10

00

AE = C+I+G+NX

AE

G =

5

00

G =

5

00

NX =

30 0

NX =

30

0

Y = 5,000

C = 100 + 0.9Y

C =

9,1

00

I =

10

00

G =

5

00

NX =

30

0

Y = 10,000

C =

17

,20

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 19,000A

E =

10

,90

0

AE =

19

,00

0

C =

46

00

AE =

6,4

00

C =

22

,60

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 25,000

AE =

24

,40

0

100

100+ I+G+NX100+ 1000+500+300

1900

4

C = 100+0.9Y

5,000 10,000 19,000 25,000

4,600

9,100

17,200

22,600

Find the value of consumption for each of these values of Y:

5

I+G+NX

5,000 10,000 19,000 25,000

I =1,000G = 500

NX = 300

1,800

Find the value of I+G+NX for each of these values of Y:

Building Aggregate Expenditures

AE = C + I + G + NXC = 100 + 0.9YI = 1,000G = 500NX = 300

I + G + NX = 1,800

Purchases of buildings and

equipment PLUS planned inventories

Planned Investment

7

C = 100+0.9Y

5,000 10,000 19,000 25,000

4,600

9,100

17,200

22,600

Find the value of consumption for each of these values of Y:

Find the value of AE for each of these values of Y:

AE = 1,900+0.9Y

5,000 10,000 19,000 25,000

6,400

10,900

19,000

24,400C = 100+0.9Y

AE = 1,900 + 0.9 Y

5,000 10,000 19,000 25,000

6,400

10,900

19,000

24,400

Sold

Produced

Produced 5,000Sold 6,400

Inventories fallFirms increase Production

Produced 10,000Sold10,900

Inventories fallFirms increase Production


Inventories do not changeFirms do not change Production

Produced 25,000Sold 24,400

Inventories riseFirms decrease Production

AE

Y

5,000 10,000 19,00025,000

6,400

10,900

19,000

24,400


Inventories do not changeFirms do not change Production:

Equilibrium: Y = 19,000

AE

Y

AE

Y = 5,000 Y = 10,000 Y = 19,000

AE =

10

,90

0

AE =

6,4

00

AE =

19

,00

0

If total production Y = 5,000

an

d A

gg

reg

ate

Exp

en

ditu

res A

E =

6,4

00

Change in Inventories = 5,000 - 6,400 = -1,400 (Inventories decrease)


an

d A

gg

reg

ate

Exp

en

ditu

res A

E =

10

,90

0

Change in Inventories = 10,000 – 10,900 = -900 (Inventories decrease)


an

d A

gg

reg

ate

Exp

en

ditu

res A

E =

19

,00

0Change in Inventories = 19,000 – 19,900 = 0 (no change)

AE =

24

,40

0

an

d A

gg

reg

ate

Exp

en

ditu

res A

E =

24

,40

0


Change in Inventories = 25,000 – 24,400 = 600 (increase)

Y = 25,000

Firms will increase productionFirms will increase production

Firms will not change productionFirms will decrease production

AE

The Keynesian Cross45 degree line

1000

1000

The 45 lineConverts HorizontalDistances into VerticalDistances.

Income

100

C

D

100 BA

Output

AE

Y = 5,000 Y = 10,000 Y = 19,000

AE =

10

,90

0

AE =

6,4

00

AE =

19

,00

0

AE =

24

,40

0

Y = 25,000

450

AE

Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

Tota

l Pro

duct

ion

Total Sales=Aggregate Expenditures

AE

Y = 5,000 Y = 10,000 Y = 19,000 Y = 25,000

Inventories Decrease


No change in InventoriesAE

Total Sales=Aggregate Expenditures

Tota

l Pro

duct

ion

Inventories Increase

If firms end only with WANTED inventories: their actual investment and their planned investment are the same.

With inventories only at the planned level

Total Production

=C + I + G + NX

45A

ggre

gate

Exp

en

dit

ure

s

Real GDPY

No unwanted change inInventories

Y

YC

+I+

G+

NX

C+I+G+NX

AE

45A

gg

reg

ate

Exp

en

dit

ure

s

Real GDPY

Firms will decreaseOutput

Firms will decreaseOutput

Equilibrium Y

C+I+G+NX

AE

Too High Y

Y

C+

I+G

+N

X

Unwanted increase inInventories

Unwanted increase inInventories

45

Ag

gre

gate

Exp

en

dit

ure

s

Real GDPY

Firms will increaseOutput

Firms will increaseOutput

YC+

I+G

+N

X

Equilibrium Y

Low Y

AE

Unwanted

decrease in

Inventories

Unwanted

decrease in

Inventories

6,000 is the equilibrium output


I =

10

00

I =

10

00

AE = C+I+G+NX

AE

G =

5

00

G =

5

00

NX =

30 0

NX =

30

0

Y = 5,000

C = 100 + 0.9Y

C =

9,1

00

I =

10

00

G =

5

00

NX =

30

0

Y = 10,000

C =

17

,20

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 19,000A

E =

10

,90

0

AE =

19

,00

0

C =

46

00

AE =

6,4

00

C =

22

,60

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 25,000

AE =

24

,40

0

When C, I, G or NX decrease

The AE line shifts down

When C, I, G or NX increase

The AE line shifts up

AE

Y = 5,000 Y = 10,000 Y = 25,000

If AE line

shifts down

Equilibrium

Y = 19,000

AE

Y = 5,000 Y = 25,000

Equilibrium

Y = 19,000

Y = 10,000

Equilibrium

If AE line shifts down

Inventories increase

Firms decrease output

Equilibrium output

decreases

AEEquilibrium

Y = 19,000Y = 25,000


Equilibrium output increases

Firms Increa

se Output

If AE line shifts up

Determining Output

In the short run, Aggregate Expenditures determine

output.

Firms adjust production to the level of

sales

Potential GDP

The real gross domestic product (GDP) the economy would produce if its labor force were fully employed

Equilibrium output occurs below Potential GDP

A Recessionary Gap = 5,000 – 4,000

Equilibrium output occurs above Potential GDP

An Inflationary Gap = BE

B

Potential GDP

At Y = 3000

a) Total Spending > Outputb) Inventories fallc) Total Spending < Outputd) Inventories risee) Total Spending = Outputf) There is no change in Inventoriesg) The economy experiences a

recessionary gaph) The economy experiences a

recessionary gap

At Y = 4,000 At Y = 5000

i) Economy is at equilibriumj) Economy is not at equilibrium

Potential GDP

C+I+G+NX

3. If the economy is at equilibrium, is total spending greater, less than or equal to Output? Do Inventories fall, rise or remain unchanged? Does the economy experience a recessionary gap or an inflationary gap? If an inflationary (recessionary) gap exists, how can the gap be closed?


Which AE line will cause a recessionary

gap?Which AE line will cause an Inflationary

gap?

Condition for Equilibrium

Total Sales = Total Production(Otherwise inventories either increase

or decrease and we need inventories to remain the same for equilibrium)

Hypothetical Economy: No government and no foreign sector (closed economy)

In such economy, total sales are sales to consumers and firms only.

AE = C + I Only these two groups purchase

total production.

Condition that must be satisfied for equilibrium:

Y = C + ISince: Y = C + S (Income is

either consumed or saved)We can rewrite the equilibrium condition

as: C + S = C + I

S = I leakages = InjectionsIn a closed economy without

government the equilibrium condition is that Savings must be

equal to Investment

HouseholdsFirms

S

I

C

Total Incom

e

Total Producti

onTo

tal

Spendin

g

Closed Economy without Government

C+I

45

SI

Y Equilibrium

Y Equilibrium

AE

I=S

Leakages =

Injections

Y above equilibrium


Inventories fall

Y below equilibrium

What is the equilibrium GDP?

For what value of GDP is:Y = AE?

For what value of GDP is:S = I?

At Y = 5,000 are inventories rising? Falling? Unchanged?For what value of GDP is:Y = AE?

At Y = 3,000 are inventories rising? Falling? Unchanged?

Investment

Hypothetical Economy: Trades with the rest of the world (open economy) but no government

In such economy, total sales are sales to consumers, firms and foreing countries only.

AE = C + I + NX Only these three groups purchase

total production.


Y = C + I + X-MSince: Y = C + S We can rewrite the equilibrium condition

as: C + S = C + I +X-MS = I + X-

MS+M = I + XS = I +(X-M)

leakages = Injections

In an open economy without government the equilibrium condition says that our

savings must be enough to finance private Investment plus the trade deficit.

Rest of World

Firms

S

I

C

Total Incom

e

Total Producti

on

Total S

pending

NX

Households

Open Economy without Government

C+I+NX

45

S+M

I+X

Y Equilibrium

Y Equilibrium

AE

I+X=S+M

Leakages =

Injections

Y above equilibrium


Inventories fall

Y below equilibrium



For what value of GDP is:S = I+(X-M)?



Real World Economy: With government and foreign sector

In such economy, total sales are sales to consumers, firms, foreigners and the government.

AE = C + I+ G + NX These four groups purchase total

production.


Y = C + I + G + X-MSince: Y = C + S + T (Income is

used to consume, save and pay taxes)

We can rewrite the equilibrium condition as: C + S + T= C + I + G +X-M

S = I + (G – T)+(X-M)

leakages = Injections

Rest of World

HouseholdsFirms

S

I

T

G

G

C

Total Incom

e

Total Producti

on

Total S

pending

NX

Open Economy with Government

S+T = I + G + X-MS+T+M = I + G + X

Savings must finance Investment, the government’s deficit and the

trade deficit.

C+I+G+NX

45

S+T+M

I+G+X

Y Equilibrium

Y Equilibrium

AE

I+G+X=S+T+M

Leakages =

Injections

Y above equilibrium


Inventories fall

Y below equilibrium

Leakages <

Injections

Y < AE

Leakages >

Injections

Y > AE



For what value of GDP is:S = I +(G-T) +(X-M)?



I + (G-T) + (X-M)


Match Expenditures (C+I+G+NX) with the corresponding value of output/income.

Real Income = Real GDP = YReal Income = Real GDP = Y

Ag

gre

gate

Exp

en

dit

ure

s =

AE

Ag

gre

gate

Exp

en

dit

ure

s =

AE

Building Aggregate Demand

Matches each price level with the corresponding equilibrium value of output

Aggregate DemandPrice Level

Equilibrium Output

AD

P0

Y0

Real GDP Demanded

When prices increase from P0 to P1,

The AE line shifts down

the value of wealth

decreases and consumption

decreases from C0 to C1.

and the equilibrium value of output decreases from Y0 to Y1.


Equilibrium Output

AD

P0

Y0

When prices increase from P0 to P1, the equilibrium value of output decreases from Y0 to Y1.

P1

Y1 Real GDP Demanded

A movement ALONG the AD line NOT a SHIFT!

When prices decrease from P0 to P2,

The value of wealth increases and consumption increases from C0 to C2.

The AE line shifts up

and the equilibrium value of output increases from Y0 to Y2.


Equilibrium Output

AD

P0

Y0

P2

Y2

When prices decrease from P0 to P2, the equilibrium value of output increases from Y0 to Y2.

Real GDP Demanded


When prices increase from P0 to P1,

Output Y1 corresponds to P1

Output Y2 corresponds to P2the value of wealth

decreases and consumption decreases from C0 to C1.The AE line shifts downand the equilibrium value of output decreases from Y0 to Y1.

When prices decrease from P0 to P2, the value of wealth increases and consumption increases from C0 to C2.The AE line shifts upand the equilibrium value of output increases from Y0 to Y2.

Building the Aggregate Demand CurveBuilding the Aggregate Demand Curve

AE 0=

C+I+G+NXAE 0=

C+I+G+NX

45

AE1=

C+I+G+NXAE1

=

C+I+G+NX

If G,I,C, NX increaseIf G,I,C, NX increase

AE line Shifts up Equilibrium Income increase

Y0 Y1

AD0

AD1

Pri

ce level

Real GDP

P0

Y0Y1

Real GDP

Aggre

gate

Expendit

ure

s

Real GDP Demanded

A shift of the AD line NOT a movement

ALONG !


ALONG !

The size of the change in equilibrium Y is the size of the shift in AD

Shifts in the Aggregate Demand Line

Price Level

AD0

P0

Y0Y1

AD1

When C, I, G or NX increase the AE shifts up and the equilibrium

value of output increases: AD line

shifts right (outward).

When C, I, G or NX increase the AE shifts up and the equilibrium

value of output increases: AD line

shifts right (outward).

Real GDP Demanded

When Prices Drop…Price Level

Equilibrium Output

AD

P0

Y0

P2

Y2

When prices decrease from P0 to P2, the equilibrium value of output increases from Y0 to Y2.

Real GDP Demanded


AE 0= C+I+G+NX

AE 1=

C+I+G+NX

If G,I,C, NX decreaseAE line Shifts down

Equilibrium Income decrease

Y0Y1

AD0

AD1

Pri

ce level

P0

Y0Y1

Real GDP

Aggre

gate

Expendit

ure

s

Real GDP Demanded


ALONG !

The size of the change in equilibrium Y is the size of the shift in AD

Shifts in the Aggregate Demand Line

Price Level

AD0

P0

Y0Y1

AD1

When C, I, G or NX decrease AE shifts down, equilibrium

output decreases, AD line shifts left (inward).

When C, I, G or NX decrease AE shifts down, equilibrium

output decreases, AD line shifts left (inward).

Real GDP Demanded

When Prices Increase…Price Level

Equilibrium Output

AD

P0

Y0

When prices increase from P0 to P1, the equilibrium value of output decreases from Y0 to Y1.

P1

Y1 Real GDP Demanded


Factors that shift the consumption function

1. Changes in wealth shift the consumption function. Example: value of stocks, bonds,

consumer durables.2. Changes in consumer expectations

Shift the consumption function. Example: Pessimistic expectations

decrease autonomous consumption.3. Taxes and Transfers

Tax increase or decrease in transfers: decrease disposable income and shift the consumption function down.

4. Prices Affect the purchasing power of

assets.

Shift up in AE lineShift right in AD line

OrShift down in AE lineShift left in AD line

Shift up in AE lineShift right in AD line

OrShift down in AE lineShift left in AD line

Shift AE line

Movement Along AD

line

Shift AE line

Movement Along AD

line

Determinants of Investment

Interest Rates Tax Incentives Technical Change Expectations about

the strength of demand

Political Stability and the rule of law

Shift AE line

Shift AD line

Shift AE line

Shift AD line

Government expenditures are determined by the budget process: The president, Congress and the Senate.

Shift AE line

Shift AD line

Shift AE line

Shift AD line

National Incomes GDP of other

countries Relative Prices Exchange Rates

Shift AE line

Shift AD line

Shift AE line

Shift AD line

= 7,000-6,000 =1,000

A recessionary gap occurs when actual GDP falls SHORT of

full employment GDP

A recessionary gap occurs when actual GDP falls SHORT of

full employment GDP

To increase AE, we

need an increase in C, I, G

or NX

To increase AE, we

need an increase in C, I, G

or NX

To eliminate a recessionary gap, AE

must rise.

To eliminate a recessionary gap, AE

must rise.

To Eliminate a Recessionary/Deflationary Gap

Increase Consumption by a sufficiently large price drop, a decrease in taxes or an increase in transfers.

Increase Investment tax incentives. lower interest rates

Increase Government Spending Increase Exports and reduce Imports:

make dollar weaker (increasing supply of dollars)

= 7,000-8,000 =-1,000= 7,000-8,000 =-1,000

An inflationary gap occurs

when equilibrium GDP is higher than

full employment GDP

An inflationary gap occurs

when equilibrium GDP is higher than

full employment GDP

To decrease AE, we need a

decrease in C, I, G

or NX

To decrease AE, we need a

decrease in C, I, G

or NX

To eliminate

an inflationary gap, AE must fall.

To eliminate

an inflationary gap, AE must fall.

To Eliminate an Inflationary Gap Decrease Consumption by a

sufficiently large price increase, an increase in taxes or a decrease in transfers.

Decrease Government Spending Increase interest rates to decrease

spending Decrease exports and increase

imports: stronger dollar.

1. Determine the effect on AE, AD, Equilibrium output

a)Prices Increase (decrease): in red because changes in prices do not shift the AD line!

b)NX Increase (decrease)c) Exports Increase (decrease)d)Imports Increase (decrease)e)Wealth Increase (decrease)f) Interest rates Increase (decrease)g)Technological Improvementh)Government spending Increase (decrease)i) Taxes Increase (decrease)j) Transfers Increase (decrease)

Questions to prepare for test

AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibrium

Y AD

Prices Increase

C drops due to wealth effect

C shifts down

down decreases

Movement down along

Prices Decrease

C increases due to wealth effect C shifts up up increases

Movement up along

NX Increase NX increase NX shifts up up increases shifts right

NX Decrease NX decreaseNX shifts down

down decreases shifts left

Exports Increase NX increase NX shifts up up increases

shifts right

Exports Decrease NX decrease

NX shifts down


Imports increase NX decrease

NX shifts down


Imports Decrease NX increase NX shifts up up increases

shifts right

Wealth Increase

C increases due to wealth effect C shifts up up increases

shifts right

Wealth Decrease

C drops due to wealth effect

C shifts down


AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibriu

m Y AD

Interest rates increase Investment drops I shifts down

down decrease

shifts left

Interest rates Decrease

Investment Increases I shifts up up increase

shifts right

Technological Improvement

Investment increases I shifts up up increase

shifts right

Government Spending Increase G increases G shifts up up increase

shifts right

Government Spending Decrease G drops

G shifts down

down decrease

shifts left

Taxes Increase C drops

C shifts down

down decrease

shifts left

Taxes Decrease C increases C shifts up up increase

shifts right

Transfers Increase C increases C shifts up up increase

shifts right

Transfers Decrease C drops

C shifts down

down decrease

shifts left



Which AE line will cause a recessionary

gap?Which AE line will cause an Inflationary

gap?

Questions to prepare continuedLabel the two lines in the next slide.Use the information in the graph to find the following:A. Find the slope of the AE line. Recall the slope of the AE

line is the MPC.B. Find the intercept of the AE line.C. Write down the equation of the AE line.D. Find the value of AE when income is 40,000E. What is the equilibrium value of income/output in this

case?F. Find the value of AE when income is 50,000 and when

income is 25,000.G. Fill in the values for each box in the graph.Repeat the exercise with the graph in the next slide.

40,000 50,00025,000

49,000

26,500

40,000 50,00025,000

49,000

26,500

SlopeAE /Y = 22,500/25,000=0.9SlopeAE /Y = 22,500/25,000=0.9

40,000 50,00025,000

49,000

26,500

4,000

SlopeAE /Y = 22,500/25,000=0.9SlopeAE /Y = 22,500/25,000=0.9

0.9AE /Y0.9AE /Y

AE =Y*0.9AE =Y*0.9

AE =*0.9 =22,500AE =*0.9 =22,500

Y=-25,000Y=-

25,000

0

AE=26,500-22,500 =4,000AE=26,500-22,500 =4,000

AE =4,000+0.9YAE =4,000+0.9Y

40,000 50,00025,000

49,000

26,500

45 degree line

4,000

25,000

AE

40,000

50,000

Output/Income (Y)

AE

A. Find the slope of the AE line. Recall the slope of the AE line is the MPC = 0.9

B. Find the intercept of the AE line = 4,000C. Write down the equation of the AE line=

4,000+0.9YD. Find the value of AE when income is 40,000:

AE = 4,000 + 0.9*40,000 = 40,000E. What is the equilibrium value of

income/output in this case? Y = 40,000F. Find the value of AE when income is 50,000:

AE = 4,000 + 0.9*50,000 = 49,000 G. and when income is 25,000: AE = 4,000 +

0.9*25,000 = 26,500

40,000 50,00020,000

48,500

21,500

35,000 50,00020,000

48,500

21,500

45 degree line

3,500

20,000

AE

35,000

50,000

Output/Income (Y)

AE

AE1

450

AE2

Y0Y1

83

Y C I G NX 1000 1400 500 700 1001500 1850 500 700 1002000 2300 500 700 1002500 2750 500 700 1003000 3200 500 700 1003500 3650 500 700 1004000 4100 500 700 1005700 5630 500 700 100

84

Y C =800+0.9Y I G NX AE S= -800+0.1*Y1000 1700 500 700 100 3000 -7001500 2150 500 700 100 3450 -6502000 2600 500 700 100 3900 -6002500 3050 500 700 100 4350 -5503000 3500 500 700 100 4800 -5003500 3950 500 700 100 5250 -4504000 4400 500 700 100 5700 -4005700 5930 500 700 100 7230 -230

Output Consumption Investment Net Exports

1000 800 500 100

1500 1200 500 100

2000 1600 500 100

2500 2000 500 100

3000 2400 500 100

3500 2800 500 100

4000 3200 500 100

Write the AE equation: Write the AE equation: 600 + 0.8 Y

2. Use the table in the next slide to answer the following:

a)Calculate the MPC and the intercept.b)Write the consumption function: C = intercept (a)

+ slope (MPC)* Y c) Calculate Aggregate Expenditures (add a Col. to

the table for AE).d)Find the equilibrium value of output. e) If output is 4000 calculate the change in

inventories. Given your answer for the change in inventories, how would firms react to this change in inventories?

f) If investment increase from 500 to 800 (a 300 increase in investment). Recalculate the entire table and find the new equilibrium value of output.

g)If autonomous consumption (the intercept) increases by 300 what is the new equilibrium value of output?

Output Consumption

Investment Net Exports

1000 800 500 100

1500 1200 500 100

2000 1600 500 100

2500 2000 500 100

3000 2400 500 100

3500 2800 500 100

4000 3200 500 100

88

Output

C = 0.8YInvestme

nt Net

Exports AE

Change in

Inventories

Firms will S=

0.2*Y

1000 800 500 100140

0-400

Increase Y

200

1500 1200 500 100180

0-300

Increase Y

300

2000 1600 500 100220

0-200

Increase Y

400

2500 2000 500 100260

0-100

Increase Y

500

3000 2400 500 100300

00

No change

600

3500 2800 500 100340

0100

Decrease Y

700

4000 3200 500 100380

0200

Decrease Y

800

Equilibrium

89

Output C = 300+0.8Y Investment Net

Exports AE

Change in Inventories

Firms will

1000 1100 500 100 1700 -700 Increase Y

1500 1500 500 100 2100 -600 Increase Y

2000 1900 500 100 2500 -500 Increase Y

2500 2300 500 100 2900 -400 Increase Y

3000 2700 500 100 3300 -300 Increase Y

3500 3100 500 100 3700 -200 Increase Y

4000 3500 500 100 4100 -100 Increase Y

4500 3900 500 100 4500 0 No change

5000 4300 500 100 4900 100 Decrease Y

5500 4700 500 100 5300 200 Decrease Y

New equilibrium

Output C = 0.8YInvestmen

t Net

Exports AE

Change in

Inventories

Firms will

1000 800 800 100 1700 -700Increase

Y

1500 1200 800 100 2100 -600Increase

Y

2000 1600 800 100 2500 -500Increase

Y

2500 2000 800 100 2900 -400Increase

Y

3000 2400 800 100 3300 -300Increase

Y

3500 2800 800 100 3700 -200Increase

Y

4000 3200 800 100 4100 -100Increase

Y

4500 3600 800 100 4500 0No

change

5000 4000 800 100 4900 100Decrease

Y

5500 4400 800 100 5300 200Decrease

Y

New equilibrium


Actual Sales100

PlannedInventories

20

Total Productio

n

Net Exports

Consumption

GovernmentSpending

Planned

Investment

Inventories do not change…

Production100

PlannedInventories

20

ActualInventories

20 Total Production = 100

Firms do not change productionTHE ECONOMY IS IN EQUILIBRIUM

=

Firms end only with WANTED inventories: their actual Investment and their planned Investment are the same.

Firms will not change their production levels.

Inventories are “too high”

Production100

PlannedInventories

20

PlannedInventories

20

UnplannedInventories 40

Total Production = 100

Firms react by reducing production

Actual Inventories

=60

If firms’ inventories pile up unsold, their actual investment is greater than their planned Investment.

Firms will decrease production to adjust their inventories to the desired level.

Inventories are “too low”

Production100

WantedInventories

20

Total Production = 100

Firms react by increasing production

Firms sell part of their inventories, their actual investment is lower than their planned Investment.

Firms will increase their production levels to adjust their inventories to the desired level.

Documents

Ch9Equilibrium