Inventories And Equilibrium

When firms produce more goods than they sell, what happens to the unsold output? It is added to their inventory stocks. When firms sell more goods than they produce, where do the additional goods come from? They come from firms' inventory stocks. You can see that the gap between output and spending determines what will happen to inventories during the year. More specifically,

You may be wondering why, in the short-run macro model, a firm that produces more output than it sells wouldn't just lower the price of its goods. That way, it could sell more of them, and not have to lower its output as much. Similarly, a firm whose sales exceeded its production could take advantage of the opportunity to raise its prices, which would result in lower sales. To some extent, firms do change prices—even in the short run. But they change their output levels, too. To remain as simple as possible, the short-run macro model assumes that firms adjust only their output to match aggregate expenditure. That is, in the short-run macro model, prices don't change at all. In a later chapter, we'll make the more realistic assumption that firms adjust both prices and output.

the change in inventories during any period will always equal output minus aggregate expenditure.

For example, Table 4 tells us that if GDP is equal to \$9,000 billion, aggregate expenditure is equal to \$7,800 billion. In this case, we can find that the change in inventories is

AInventories = GDP — AE = \$9,000 billion — \$7,800 billion = \$1,200 billion.

When GDP is equal to \$3,000 billion, aggregate expenditure is equal to \$4,200 billion, so that the change in inventories is

= \$3,000 billion — \$4,800 billion = —\$1,200 billion.

Notice the negative sign in front of the \$1,200 billion; if output is \$3,000 billion, then inventory stocks will shrink by \$1,200 billion.

Only when output and total sales are equal—that is, when GDP is at its equilibrium value—will the change in inventories be zero. In our example, when GDP is at its equilibrium value of \$6,000 billion, so that aggregate expenditure is also \$6,000 billion, the change in inventories is equal to zero. At this output level, we have

AInventories = GDP — AE = \$6,000 billion — \$6,000 billion = \$0.

What you have just learned about inventories suggests another way to find the equilibrium GDP in the economy: Find the output level at which the change in inventories is equal to zero. Firms cannot allow their inventories of unsold goods to keep growing for very long (they would go out of business), nor can they continue to sell goods out of inventory for very long (they would run out of goods). Instead, they will desire to keep their production in line with their sales, so that their inventories do not change. To recap,

AE < GDP =► AInventories > 0 =>- GDP \ in future periods.

AE > GDP =>- AInventories < 0 =>- GDP \ in future periods.

AE = GDP =>- Ahventories < 0 =>- No change in GDP.

Now look at the last column in Table 4, which lists the change in inventories at different levels of output. This column is obtained by subtracting column 6 from column 1. The equilibrium output level is the one at which the change in inventories equals zero, which, as we've already found, is \$6,000 billion.