Chapter 9

Demand Side Equilibrium

 Aggregate Expenditures =AE
Aggregate

NX=
300
Expenditures

I = 1000

G=
500
AE =
C+I+
G+

G= NX=
N

C = 4600 I = 1000
AE = 6,400
500
X

Y = 5,000
300

C = 9,100 I = 1000
AE = 10,900 G= NX=
500 300
Y = 10,000

Real Income = Real GDP = Y

C = 17,200 AE = 19,000I = 1000 G= NX=

500 300
Y = 19,000
C = 100 + 0.9Y
AE

I = 1000 G= NX=
C = 22,600 AE = 24,400
500 300
Y = 25,000
 100+

100
1900
100+ I+G+NX
Aggregate

NX=
300

1000+500+300
Expenditures

I = 1000

G=
500
AE =
C+I+
G+

G= NX=
N

C = 4600 I = 1000
AE = 6,400
500
X

Y = 5,000
300

Real Income = Real GDP = Y

C = 9,100 I = 1000
AE = 10,900 G= NX=
500 300
Y = 10,000

C = 17,200 AE = 19,000I = 1000 G= NX=

500 300
Y = 19,000
C = 100 + 0.9Y
AE

I = 1000 G= NX=
C = 22,600 AE = 24,400
500 300
Y = 25,000
 C = 100+0.9Y

22,600

17,200

9,100

4,600

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

Find the
4 value of consumption for each of these values of Y:
 I =1,000
G = 500
NX = 300

I+G+NX
1,800

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

Find the
5 value of I+G+NX for each of these values of Y:
Building Aggregate Expenditures
AE = C + I + G + NX
Purchases of buildings
C = 100 + 0.9Y and
Planned
equipment
Investment
PLUS
planned inventories
I = 1,000
G = 500 I + G + NX = 1,800

NX = 300
 C = 100+0.9Y

22,600

17,200

9,100

4,600

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

7 Find
Find the theofvalue
value of AE for for
consumption each of these
each values
of these of Y:of Y:
values
24,400 AE = 1,900+0.9Y
C = 100+0.9Y
19,000

10,900

6,400

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

 AE = 1,900 + 0.9 Y
Sold
AE
Produced
Produced 5,000
10,000
24,400 Produced
Produced 25,000
19,000
Sold 6,400
Sold10,900
SoldSold19,000
Inventories24,400
fall
19,000 Inventories
Inventories
Inventoriesdofall
rise
not change
Firms
Firms increase Production
Firmsincrease
do
decrease Production
not change
Production
Production
10,900

6,400

Produced
Y
5,000 10,000 19,000 25,000
 Produced 19,000
AE Sold19,000
24,400 Inventories do not change
Firms do not change Production:
19,000 Equilibrium: Y = 19,000

10,900

6,400

Y
5,000 10,000 19,000 25,000
 Firms will decrease production
Firms will not change production AE
AE Firms will increase production
Firms will increase production

Change
ChangeininInventories
Inventories==

and Aggregate Expenditures AE = 19,000

and Aggregate Expenditures AE = 24,400

and Aggregate Expenditures AE =10,900
and Aggregate Expenditures AE = 6,400
10,000
19,000
25,000 10,900
24,400
19,900
5,000 -–6,400 = 600
-900
0 (no
= -1,400
(Inventories
change)
(increase)
(Inventoriesdecrease)
decrease)

AE = 24,400
AE = 19,000
AE = 10,900
AE = 6,400

If total production Y = 25,000

If total production Y = 19,000
If total production Y = 10,000

If total production Y = 5,000

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

The Keynesian Cross
Output The
4545 line line
degree
Converts Horizontal
Distances into Vertical
Distances.

1000
D
100

100 B
A C
Income
1000
AE

AE = 24,400
AE = 19,000
AE = 10,900
AE = 6,400

450

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

AE u r e s
x pe ndit
ate E
g re g
s= A g n
Sa le ti o
l
Tota u c
o d
l Pr
t a
To

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

 re a se
No change in Inventories s Inc
to e
ri AE
n
AE Inve

i t ures
e Ex pend
eg at
g gr
a l es =A
l S

n
Tota

io
ase

t
re

uc
s D ec

od
t ori e
n

Pr
Inve
l
ta
To

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

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

Total
Production = C + I + G + NX
With inventories only at the planned level
 45
AE
Aggregate Expenditures

C+I+G+NX
C+I+G+NX
Y

No unwanted change in
Inventories
Y
Y Real GDP
 45
Unwanted AE
increase in
Inventories
Aggregate Expenditures

C+I+G+NX
Y

C+I+G+NX
Firms will decrease
Output

Too High Y
Equilibrium Y Y Real GDP
 45

AE

Unwanted
Aggregate Expenditures

decrease in
Inventories Firms will
Y C+I+G+NX

increase
Output

Low Y
Equilibrium Y Real GDP
Y
 t put
m ou
br iu
eq uili
e
00 is th
6, 0
 AE
The AE line shifts
The AE line shifts

NX=
300
down +NX
up G
C+I+

NX=
300
AE =

500
G=
NX=
300
NX=
300

500
G=
When C, I, G
When C, I, G

500
G=
or NX

I = 1000
or NX

500
G=
decrease

AE = 19,000I = 1000
increase

I = 1000

AE = 24,400
C = 100 + 0.9Y

I = 1000

AE = 10,900
AE = 6,400

C = 22,600
C = 17,200
C = 9,100
C = 4600
I = 1000

500
G=
NX=
300

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

Real Income = Real GDP = Y

 Equilibrium
AE

If AE line
shifts
down

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

If AE line
shifts down

Inventories
increase

Firms
decrease
output
Equilibrium
output
decreases

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

If AE line
shifts up

Inventories
Decrease

Equilibrium
output Firms
increases Increase
Output

Y = 19,000 Y = 25,000
Determining Output Firms adjust
production to the
level of sales

In the short run, Aggregate

Expenditures determine output.
Potential GDP

The real gross domestic product (GDP) the

economy would produce if its labor force
were fully employed
 A Recessionary Gap =
5,000 – 4,000

Equilibrium output occurs below Potential GDP

An Inflationary Gap = BE

Potential GDP

Equilibrium output occurs above Potential GDP

 Potential
GDP
C+I+G+NX

AtAtYY= =5000
4,000
3000

a) Total Spending > Output

b) Inventories fall i) Economy is at equilibrium
c) Total Spending < Output j) Economy is not at equilibrium
d) Inventories rise
e) Total Spending = Output
f) There is no change in Inventories
g) The economy experiences a recessionary gap
h) The economy experiences a recessionary gap
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?
4. 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.
 Closed Economy without Government
Total
Condition that must beInsatisfied
come
for equilibrium:
Y=C+I
Since: Y = C + S (Income is either
consumed or saved) Firms
Households
We can rewrite the equilibrium condition as:
S C + S S= =C I+ I
C leakages = Injections
l
a
In a closed economy
o t ingwithout government
T nd Total
the equilibriumScondition
pe isProduction
that Savings
I to Investment
must be equal
 45
Inventories increase

C+I
AE Inventories fall

Leakages
= Y
S
Equilibrium
Injections

I
I=S
Y below equilibrium Y Equilibrium Y above equilibrium
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
For what value of GDP is:
S = I?
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.
 Open Economy without Government

Total
Condition that must be satisfied for equilibrium:
Income
Y = C + I + X-MRest of
World
Since: Y=C+S
We can rewrite the equilibrium condition
NX Firms
as:
Households C + S = C + I +X-M
S i n g
nd
CS = I + X-M
In an open economy without
S pe government the
al that our savings must be
equilibrium conditionotsays
S+M
enough to finance T = I +Investment
private X plus the trade
Total
leakages = deficit.
Injections Production
I
S = I +(X-M)
 45
Inventories increase

+ NX
AE Inventories fall C+I

Leakages
= Y
S+M
Equilibrium
Injections

I+X
I+X=S+M
Y below equilibrium Y Equilibrium Y above equilibrium
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
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.
 Open Economy with Government
G that must be satisfied
Condition Total for equilibrium:
Income
Y = C + I + G + X-M
Rest of
Since: Y = C + S + T (Income isWorld
used to
T
consume, save and pay taxes)
G NX Firms
We can rewrite the equilibrium condition as:
Households
C + S + T= C + I + Gin+X-M
g
S d
C
n
S+T = I + G
Savings must finance + pX-M
e
S Investment, the
l
ta
S+T+M
government’s =T I +and
o
deficit G +the X trade
Total deficit.
leakages = Injections Production
I
S = I + (G – T)+(X-M)
 45
Y > AE
Inventories increase
Y < AE

+G+ N X
AE Inventories fall C+I

Leakages
= Y
Injections
Equilibrium
+ T+M
S
I+G+X
I+G+X=S+T+M

Y below equilibrium Y Equilibrium Y above equilibrium

Leakages < Leakages >

Injections Injections
What
At Y =is 3,000
5,000
the equilibrium
are inventories
GDP?rising? Falling? Unchanged?
For
Forwhat
whatvalue
valueofofGDP
GDPis:
is:
YY==AE?
AE?
For what value of GDP is:
S = I +(G-T) +(X-M)?
I + (G-T) + (X-M)
Aggregate Expenditures
te Expendit
Aggregate
Aggrega =AE
ures =AE
Expenditures

Real Income = Real GDP = Y

Match Expenditures (C+I+G+NX) with the corresponding

value of output/income.
Building Aggregate Demand

Matches each price level with the

corresponding equilibrium value of output
Aggregate Demand
Price Level

P0

AD
Real GDP Demanded
Equilibrium Output
Y0
When prices
increase from P0
to P1,
the value of
wealth decreases
and consumption
decreases from C0
The AE line shifts
down to C1.

and the equilibrium

value of output
decreases from Y0 to
Y1 .
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
When prices
P1
increase from P0
to P1, the
P0 equilibrium value
of output
decreases from Y0
to Y1.
AD
Equilibrium Output
Y1 Y0 Real GDP Demanded
When prices
decrease from P0 to
P2 ,

The value of
wealth
The AE line shifts
up increases and
consumption
increases from
C0 to C2.

and the equilibrium value of

output increases from Y0 to
Y2 .
Aggregate Demand
Price Level
A movement ALONG the AD line NOT a SHIFT!
When prices
decrease from P0 to
P2, the equilibrium
P0
value of output
P2 increases from Y0 to
Y2.
AD
Real GDP Demanded
Equilibrium Output
Y0 Y2
 Building the Aggregate Demand Curve

Output Y1
corresponds
to P1

When prices increase Output Y2 When prices decrease from

from P0 to P1, corresponds P0 to P2,
the value of wealth to P2 the value of wealth
decreases and increases and
consumption decreases consumption increases
from C0 to C1. from C0 to C2.

The AE line shifts down The AE line shifts up

and the equilibrium value and the equilibrium value
of output decreases from Y0 of output increases from Y0
to Y1. to Y2.
 If G,I,C, NX increase
A shift of the AD line NOT a
Equilibrium Income increase movement ALONG !
AE line Shifts up

Price level
45
Aggregate Expenditures

G +
+ NXX
N
++II++G
== CC
AAEE11

+GG+NNXX
+
== C++II+
C
AAEE00 P0 AD1

AD0

Y0 Y1
Y0 Y1
Real GDP RealReal
GDP GDPDemanded
The size of the change in equilibrium Y is the size of the shift in AD
Shifts in the Aggregate Demand Line
When C, I, G or NX increase the
Price Level AE shifts up and the equilibrium
value of output increases: AD
line shifts right (outward).

P0

AD1
AD0
Y1 Real GDP Demanded
Y0
When Prices Drop…
Price Level
A movement ALONG the AD line NOT a SHIFT!

When prices decrease from

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

P2

AD
Real GDP Demanded
Equilibrium Output
Y0 Y2
 If G,I,C, NX decrease
Equilibrium Income decrease
AE line Shifts down
A shift of the AD line NOT a

Price level
movement ALONG !
Aggregate Expenditures

NX
+I+
G +
+G +NX
= C C +I
AE 0 AE 1
=

P0

AD0

AD1

Y1 Y0
Y1 Y0
Real GDP Real GDP Demanded
The size of the change in equilibrium Y is the size of the shift in AD
Shifts in the Aggregate Demand Line
When C, I, G or NX decrease AE
Price Level shifts down, equilibrium output
decreases, AD line shifts left
(inward).

P0

AD1
AD0
Real GDP Demanded
Y1 Y0
 When Prices Increase…
Price Level
A movement ALONG the AD line NOT a SHIFT!
When prices
P1
increase from P0
to P1, the
P0 equilibrium value
of output
decreases from Y0
to Y1.
AD
Equilibrium Output
Y1 Y0 Real GDP Demanded
 Factors that shift the consumption
function
1. Changes in wealth
 shift the consumption function.
 Example: value of stocks, bonds, consumer Shift up in AE line
durables.
Shift right in AD line
2. Changes in consumer expectations
 Shift the consumption function. Or
 Example: Pessimistic expectations decrease Shift down in AE line
autonomous consumption. Shift left in AD line
3. Taxes and Transfers
 Tax increase or decrease in transfers:
decrease disposable income and shift the
consumption function down.
4. Prices Shift AE line
 Affect the purchasing power of assets. Movement
Along AD
line
 Determinants of Investment
 Interest Rates
 Tax Incentives
 Technical Change Shift AE line
 Expectations about the Shift AD line
strength of demand
 Political Stability and the
rule of law
Government expenditures are
determined by the budget
Shift AE line
process: The president,
Shift AD line
Congress and the Senate.
 National Incomes
 GDP of other
Shift AE line
countries Shift AD line
 Relative Prices
 Exchange Rates
AA recessionary
recessionary gap
gap
To occurs
occurs
To increase
increase
when
To
To actualaaGDP
eliminate
when actual
eliminate GDP
AE, falls
recessionary
falls
we need
recessionary
AE, we need
SHORTgap,
SHORT of full
gap,
of full
AE employment
AE must
must rise. in
employment
an increase
an increase
rise. in
GDPC,
GDP C, I,I, G
G or
or NX
NX

= 7,000-6,000 =1,000
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)
 To eliminate
To eliminate
To decrease
To decrease
an
an
AE,
AE, we need
we need aa
inflationary
inflationary
decrease
decrease
gap, AE
gap, in C,
in
AE must
mustC, == 7,000-8,000
7,000-8,000 =-1,000
=-1,000
I,I, G
Gfall.
or NX
or
fall. NX

An inflationary
An inflationary gap
gap
occurs when
occurs when
equilibrium GDP
equilibrium GDP isis
higher than
higher than full
full
employment GDP
employment GDP
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.
Questions to prepare for test
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 Improvement
h) Government spending Increase (decrease)
i) Taxes Increase (decrease)
j) Transfers Increase (decrease)
 Shift?
Movement AE
  AE component affected Along? Shifts Equilibrium Y AD
C drops due to wealth Movement
Prices Increase effect C shifts down down decreases down along
C increases due to Movement
Prices Decrease wealth effect C shifts up up increases up along
NX Increase NX increase NX shifts up up increases shifts right
NX shifts
NX Decrease NX decrease down down decreases shifts left
Exports
Increase NX increase NX shifts up up increases shifts right
Exports NX shifts
Decrease NX decrease down down decreases shifts left
Imports NX shifts
increase NX decrease down down decreases shifts left
Imports
Decrease NX increase NX shifts up up increases shifts right
C increases due to
Wealth Increase wealth effect C shifts up up increases shifts right
Wealth C drops due to wealth
Decrease effect C shifts down down decreases shifts left
 Shift? Movement AE Equilibrium
  AE component affected Along? Shifts Y AD
Interest rates shifts
increase Investment drops I shifts down down decrease left
Interest rates shifts
Decrease Investment Increases I shifts up up increase right
Technological shifts
Improvement Investment increases I shifts up up increase right
Government
Spending shifts
Increase G increases G shifts up up increase right
Government
Spending shifts
Decrease G drops G shifts down down decrease left
shifts
Taxes Increase C drops C shifts down down decrease left
shifts
Taxes Decrease C increases C shifts up up increase right
Transfers shifts
Increase C increases C shifts up up increase right
Transfers shifts
Decrease C drops C shifts down down decrease left
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?
4. 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?
Questions to prepare continued
Label 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 40,000
E. 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.
49,000

26,500

25,000 40,000 50,000

 SlopeAE /Y = 22,500/25,000=0.9

49,000

26,500

25,000 40,000 50,000

 SlopeAE /Y = 22,500/25,000=0.9

49,000

0.9AE /Y
AE =Y*0.9
26,500 AE =*0.9 =22,500
=4,000
AE=26,500-22,500 =4,000
AE=26,500-22,500

4,000
Y=-25,000
Y=-25,000 AE =4,000+0.9Y

0 25,000 40,000 50,000

 45 degree line
AE AE

50,000
49,000

40,000

26,500
25,000
4,000

Output/Income (Y)
25,000 40,000 50,000
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 = 4,000
C. Write down the equation of the AE line= 4,000+0.9Y
D. Find the value of AE when income is 40,000: AE =
4,000 + 0.9*40,000 = 40,000
E. What is the equilibrium value of income/output in this
case? Y = 40,000
F. 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
48,500

21,500

20,000 40,000 50,000

 45 degree line
AE AE

50,000
48,500

35,000

21,500
20,000
3,500

Output/Income (Y)
20,000 35,000 50,000
 450
AE1
AE2

Y1 Y0
 Y C I G NX
1000 1400 500 700 100
1500 1850 500 700 100
2000 2300 500 700 100
2500 2750 500 700 100
3000 3200 500 700 100
3500 3650 500 700 100
4000 4100 500 700 100
5700 5630 500 700 100
83
 Y C =800+0.9Y I G NX AE S= -800+0.1*Y
1000 1700 500 700 100 3000 -700
1500 2150 500 700 100 3450 -650
2000 2600 500 700 100 3900 -600
2500 3050 500 700 100 4350 -550
3000 3500 500 700 100 4800 -500
3500 3950 500 700 100 5250 -450
4000 4400 500 700 100 5700 -400
5700 5930 500 700 100 7230 -230

84
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 Write
the AEthe
equation: 600 + 0.8 Y
AE equation:
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 Consumptio Investment Net Exports
n
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

 Net Change in
Output C = 0.8Y Investment AE Firms will S= 0.2*Y
Exports Inventories

1000 800 500 100 1400 -400 Increase Y 200

Equilibrium
1500 1200 500 100 1800 -300 Increase Y 300

2000 1600 500 100 2200 -200 Increase Y 400

2500 2000 500 100 2600 -100 Increase Y 500

3000 2400 500 100 3000 0 No change 600

Decrease
3500 2800 500 100 3400 100 700
Y
Decrease
4000 3200 500 100 3800 200 800
Y

88
 Net Change in
Output C = 300+0.8Y Investment AE Firms will
Exports Inventories

1000 1100 500 100 New

1700 equilibrium
-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

89
 Change in
Output C = 0.8Y Investment Net Exports AE Firms will
Inventories

1000 800 800 100 New

1700 equilibrium
-700 Increase Y

1500 1200 800 100 2100 -600 Increase Y

2000 1600 800 100 2500 -500 Increase Y

2500 2000 800 100 2900 -400 Increase Y

3000 2400 800 100 3300 -300 Increase Y

3500 2800 800 100 3700 -200 Increase Y

4000 3200 800 100 4100 -100 Increase Y

4500 3600 800 100 4500 0 No change

5000 4000 800 100 4900 100 Decrease Y

5500 4400 800 100 5300 200 Decrease Y

Aggregate Expenditures
Planned
Inventories
20 ne d t
l a n en
P estm
Inv
Government
Spending
Actual Sales
100
Consumption

Net Exports

Total
Production
Inventories do not change…
Planned Actual
Inventories
20
= Inventories
20 Total
Production =
100
Production
100

Firms do not change production

THE 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”
Planned Planned
Inventories Inventories
Actual
20 20
Inventories Total
=60
Unplanned Production =
Inventories 40 100
Production
100

Firms react by reducing production

 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”
Wanted
Inventories
20

Total
Production =
Production 100
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.