Explain the adjustment mechanism to restore equilibrium in the economy, if ex-ante Aggregate Demand is less than ex-ante Aggregate Supply.
Explain the adjustment mechanism to restore equilibrium in the economy, if ex-ante Aggregate Demand is less than ex-ante Aggregate Supply.
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Solution and Explanation
Ex-ante means planned or intended. Ex-ante Aggregate Demand (AD) is what households, firms and the government plan to spend.
Ex-ante Aggregate Supply (AS) is what firms plan to produce.
Here AD is less than AS. So the planned spending is smaller than the planned output.
Step 2: What happens to the unsold goods:
Firms produce more goods than buyers plan to purchase. The extra goods remain unsold.
Unsold goods pile up in the godowns of firms. This is called unintended accumulation of inventories.
It is unintended because no firm planned to hold this extra stock.
Step 3: How firms react:
Firms want their inventories back at the desired level. A heavy stock of unsold goods is costly to hold.
So firms decide to cut production in the next period. They may also reduce the use of labour and machines.
Step 4: How equilibrium returns:
As output falls, AS comes down towards AD. The gap between the two becomes smaller.
This adjustment continues till planned output equals planned spending, that is AD = AS.
Inventories are then at the desired level and the economy is in equilibrium at a lower level of output.
Final Answer:
When ex-ante AD is less than ex-ante AS, unplanned stock builds up. Firms cut output to clear it. Output keeps falling till ex-ante AD = ex-ante AS, and equilibrium is restored.
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