Sticky-Price Equilibrium and Equilibrium on the Income-Expenditure

Sticky-Price Equilibrium:

The economy will be in equilibrium when planned spending equals real GDP--which is according to the circular flow principle, the similar as national income. Under these circumstances there will be no short-run forces pushing for an immediate expansion or contraction of real GDP, national income and aggregate demand.

Equilibrium on the Income-Expenditure figure:

1683_income expenditure diagram.jpg

Legend: On the income-expenditure figure the equilibrium point of the economy is that point where aggregate demand (as a function of total product) is equivalent to total product.

In the algebra the equilibrium values of aggregate demand E and real GDP or national income Y must satisfy both:

E = A + MPE x Y

And:

E = Y

Alternate Y in for E in the first of these equations and regrouping then the solution is:

Y = E = A/(1 - MPE)
     
If the mathematical values of the parameters of the planned expenditure function:

E = A + MPE x Y
     
Are (in billions) A = $5600 and MPE = 0.3 after that planned expenditure as a function of real GDP is:

E = 5600 + 0.3 x Y

The equilibrium level of real GDP as well as aggregate demand is then (in billions):

Y = $8000
    
If the economy isn’t on the 45-degree line then aggregate demand E doesn’t equal real GDP Y. If Y is greater than E there is surplus supply of goods. If E is greater than Y there is surplus demand for goods. In neither condition is the economy in equilibrium.

In the first case in which production surpass demand inventories are rising rapidly as well as firms unwilling to accumulate unsold as well as unsellable inventories are about to cut production and fire workers. In the subsequent case in which demand exceeds production, inventories are decreasing rapidly. Businesses are selling additional than they are making. Some businesses will respond to the decrease in inventories by boosting prices, trying to earn supplementary profit per good sold. However the bulk of businesses will respond to the fall in inventories by expanding production to match demand. They are about to employ more workers. Real GDP as well as national income are about to expand.

Now presume that businesses see their inventories falling and respond by boosting their production to equal last month's planned expenditure. Will such a raise bring the economy into goods-market equilibrium with planned expenditure equivalent to total income and real GDP? The answer is that it will not. To improve production, firms should hire workers, paying additional in wages and causing household incomes to rise. When income increases, total spending rises as well. Therefore the increase in production and income generates a further expansion in aggregate demand.

Details: How Fast Does the Economy Move to Equilibrium?

At any one exacting moment the economy doesn’t have to be in short-run equilibrium. Aggregate demand can surpass real GDP and national income and inventories can fall for periods as long as a year. There are sturdy forces pushing the economy toward short-run equilibrium. Businesses don’t like to lose money by producing things that they can’t sell or by not having things on hand that they could sell. However it takes at least months, usually quarters as well as possibly more time for businesses to expand or cut back production

For instance between the summer of 1990 and the summer of 1991 inventories fell for five straight quarters. Real GDP was fewer than aggregate demand as businesses decided that their high levels of inventories were too huge given the economic uncertainties created by the Iraqi invasion of Kuwait as well as the subsequent recession.

Between the winter of 1994 along with the summer of 1995, for six quarters, inventories increased. For a year with a half GDP was greater than aggregate demand.

Inventories as the Balancing Item:

121_inventory investment.jpg

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