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Inventory Adjustments and Equilibrium Output

The preceding example demonstrates that the economy will be in equilibrium only when total spending is exactly equal to total output.[1] In other words, an economy has arrived at its equilibrium output when the production of that output level gives rise to precisely enough spending, or demand, to purchase everything that was produced. In our example, $600 billion is the only output that satisfies this requirement. At any other output level, there will be either too much or too little demand, and producers will have incentive to alter their level of production.

Consider, for example, an output of $700 billion. As you have seen, producing $700 billion of output means creating $700 billion of income. Note, however, that not all this income will find its way back to businesses in the form of spending. Column 5 in Exh . 5 shows that only $675 billion of spending will be created—too little to absorb the period's production. Inventories of unsold merchandise will grow, signaling businesses to reduce the rate of output; this move will take the economy closer to equilibrium.

If spending initially exceeded output, the reaction of businesses would be exactly the opposite. For example, if $500 billion of output were produced, it would generate $525 billion of total spending. Because the amount that consumers and investors desire to spend exceeds the level of output, businesses can meet demand only if they supplement their current production with merchandise from their inventories. This unintended reduction in inventories is a signal to increase the rate of output, which, in turn, will push the economy closer to the equilibrium GDP.

As you can see, whenever spending is greater or less than output, producers have incentive to alter production levels; there is a natural tendency to move toward equilibrium. The only output that can be maintained is the output at which total spending is exactly equal to total output; this is the equilibrium output.

Equilibrium Output: A Graphic Presentation

The data in Exh. 5 are graphed in Exh. 6. The line labeled C + I (consumption plus investment) is the total expenditure (or total spending) function. This function is simply a graphic representation of column 5 from Exh. 5, showing the total amount of planned spending at each level of GDP. It is easy to understand why the total expenditure function looks so much like the consumption function. Because we have assumed investment spending to be an autonomous constant—$50 billion per year—the total spending function can be constructed simply by drawing a line parallel to line C (consumption) and exactly $50 billion above it. The other element of the output-expenditure diagram is the 45-degree line. At every point on this line, total spending equals total output. We locate the equilibrium output where the total spending function intersects the 45-degree line ($600 billion).

EXHIBIT 6. Determination of Equilibrium Income and Output

Determination of Equilibrium Income and Output

  • [1] You may remember that there is another way to identify the equilibrium output—by finding the output at which planned saving is equal to planned investment. You can see in Exh. 5 that planned saving is equal to planned investment at an output of $600 billion, the output already identified as equilibrium.
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