Question

Explain the adjustment mechanism, if in an economy, ex-ante Aggregate Demand (AD) is more than ex-ante Aggregate Supply (AS).

Hint:

AD more than AS means stocks fall below the desired level. Producers raise output to rebuild the stock, until the economy reaches equilibrium.

Answer 1

Step 1: Understand ex-ante AD and AS:
Ex-ante means planned or expected. Ex-ante AD is the demand that households, firms and the government plan to make.
Ex-ante AS is the output that producers plan to supply. The question asks what happens when planned demand is more than planned supply.

Step 2: Find the gap:
When ex-ante AD is more than ex-ante AS, the buyers plan to purchase more than the firms plan to produce.
Households and firms plan to consume more than what the firms plan to produce, so the economy is not in balance.

Step 3: Trace the effect on inventories:
To meet the extra demand, the producers sell goods from their stock. So the inventories fall below the desired level.
This is an unplanned fall in stock, which is a signal to the firms that demand is higher than supply.

Step 4: Trace the effect on output:
The producers want to bring back the desired level of stock. So they raise output and employ more factors of production.
Output and income rise. As income rises, planned demand also changes and the gap becomes smaller.

Step 5: Reach the equilibrium:
The process goes on till ex-ante AD becomes equal to ex-ante AS. At this point inventories are back at the desired level.
Then the economy is at the equilibrium level of output, and there is no further push to change output.

Final Answer:
When ex-ante AD is more than ex-ante AS, inventories fall below the desired level. Producers raise output to restore the desired stock, until the equilibrium level of output is reached.