Explain the adjustment mechanism to restore equilibrium in the economy, if ex-ante Aggregate Demand exceeds ex-ante Aggregate Supply.
Explain the adjustment mechanism to restore equilibrium in the economy, if ex-ante Aggregate Demand exceeds ex-ante Aggregate Supply.
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Solution and Explanation
Ex-ante means planned or desired, before the year starts. Ex-ante AD is what households, firms and others plan to spend. Ex-ante AS is what firms plan to produce. The economy is in equilibrium only when the two are equal.
Step 2: What happens when ex-ante AD is more than ex-ante AS:
Here, households and firms plan to buy more than what firms plan to produce.
Firms sell more than they expected. Their stock of unsold goods (inventories) falls below the desired level.
This is called unintended decumulation (fall) of inventories.
Step 3: How firms react:
Firms see their stocks running low. To bring inventories back to the desired level, firms raise their output.
Higher output means more income and more employment in the economy.
Step 4: When the adjustment stops:
As output rises, ex-ante AS rises towards ex-ante AD.
The process continues till ex-ante AS becomes equal to ex-ante AD. At this point there is no unplanned change in inventories. Equilibrium output is restored.
Final Answer:
When ex-ante AD exceeds ex-ante AS, inventories fall unintentionally. Producers increase output to rebuild stocks, and this goes on till AD = AS and equilibrium is restored.
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