Question

3. Discuss how spending and output influences equilibrium in a simple model where aggregate expenditure = consumption.

4. Describe how unplanned inventory can influence equilibrium in the model where AE=(C+I+G+(X-M))

Answer 1

Answer -
3) *Equilibrium level of income is that level of income where aggregate demand for goods and services (Aggregate expenditure or consumption in this case) will be equal to aggregate output.
* Income is equal to output because folks earn income by manufacturing goods and service. For example: staff earns wages because they manufacture a product that is sold in the market, and owners of companies earn profits because the merchandise they sell provide more income than the cost of producing them.
*For equilibrium (aggregate expenditure in the economy equals output) is the unique feature of the Keynesian-cross model. As income must equal output, AE equals output because folks can’t earn income until the products they produce are sold to somebody in the market.
* Every good or service that is produced in the economy must be purchased by somebody or added to inventories. As shown in the below dig. a 45-degree line representing the amount of the output in the economy on the horizontal axis, which is equal to the amount of AE in the economy on the vertocal axis.

Answer 4 -
* In an open economy AD will have the following components -:
1) Consumption Expenditure
2) Investment Expenditure
3) Government Expenditure
4) Net Exports
Therefore, at equilibrium level of income following condition must be satisfied -:
Y = C + I + G + X - M

* If output is not equal to AD then there will be unplanned inventory accumulation which is defined as difference between aggregate output and aggregate demand.
IU = Y - AD
1) If Aggregate output > Aggregate Demand then there will be unplanned inventory investment. It means that there will be increase in stock of unsold goods as a result firm produces less output in subsequent period. Therefore Aggregate output decreases.
2) If Aggregate output < Aggregate Demand then there will be unplanned inventory disinvestment. It means that stock will decline as a result firm produces more output in subsequent period.

From this it follows that If Aggregate output will continue to change so that it becomes equal to AD where unplanned inventory is equal to zero. At that point planned saving = planned investment.