Question

.Please fully answer the following: Explain fully the role played by unplanned investment in inventories in determining equilibrium in the Keynesian model. Use the examples of AD > GDP and AD < GDP to illustrate your answer.

Will rate answer based on completeness and justification of answer, thanks.

Answer 1

In any economy equilibrium is established when the market demand is equal to the market supply. In such a state there is no incentive for the producers or suppliers to alter the production of their goods because what they are producing is being sold completely, with no unfulfilled customer at the existing market price, i.e. no excess demand either.

In the graph shown, the x-axis represents the total output/income or GDP in the economy. The y-axis represents the total demand in the economy.

Let us assume that the aggregate demand(AD) is 6 (trillion worth of goods), i.e. it is fixed (only for this example).

The x-axis is how much the goods is produced or output. The 45 degree line repesents all those points where the output = AD, i.e. the points where the supply equals whatever is demanded.

Since the AD=6 irrespective of how much is produced, it is a straight horizontal line parallel to the x-axis. By intuition also you might have guessed, for the market to clear the output also needs to be 6. As shown in the figure, this happens at the intersection of the 45 degree line with the AD=6 line.

Now, let's consider points off this equilibrium point. Suppose the firms did not anticipate the demand accurately and produced 8 units instead of 6. This is shown at the point to the right of the output=6. In this case, what is demanded is still 6 units, and 2 units are left unsold. Therefore there is an accumulation of inventories in the firm. This is the case when,

IU(investment unplanned)= output produced(GDP)- AD >0

So, in this case, the firms will want to reduce their inventories by slowly reducing production till the equilibirum is reached at 6 units.

Similarly, if output is 4. Demand is 6. Then there is excess demand at the given market price. People are queing outside the firms to buy the good, but some customers are not able to. So, IU<0. Then the firm will bid up the production to reach the equilibrium in this case.